Economic Value Added _Formated_.pdf

Jahur & Riyadh:Economic Value Added as a Management Tool 49
3. Economic Value Added - The concept
EVA is a term developed and used by a US based consulting firm named
Stren Stewart & Co. This measure is its registered trademark 1 . It has
done much to popularize and implement this measure of residual income.
But the concept of residual income has been around for some time2 and
many companies that are not Srern-Stewart clients use this concept to
measure and reward manager’s performance (Brealey and Myers 2000).
EVA is a measure to assess the extent to which companies have
succeeded in achieving the objective of enhancing shareholders' wealth. (
Brewer et al.1999). Conceptually simple, EVA is a method of
ascertaining whether and to what extent a company has been able to
enhance shareholder value at the end of a particular year. A firm creates
value only if it can generate return higher than its cost of capital. Cost of
capital is the weighted average cost of capital. The rationale of EVA is
that shareholders have an expectation about what to expect from the
company at the initial period. This is based on well-known principles of
calculation of equity cost of capital which is given by a company.
However, EVA measures what shareholders get over and above cost of
equity capital.
4. Computation of Economic Value Added (EVA):
There are three methods of computing EVA or for judging whether
management of the company has increased shareholder value.
Method I
Under this method, EVA is computed based on net return on investment.
In this method, the EVA is calculated by multiplying spread between return on
investment (ROI) and weighted average cost of capital with capital employed.
i.e. EVA = (ROI – Weighted Average Cost of Capital) × Capital Employed
1 For details please see G. Bennett Stewart, The quest for value, New York, Harper Collins,
1991.
2 EVA is conceptually the same as the residual income measure long advocate by some
accounting scholars (See, for example, R. Anthoney “Accounting for the cost of equity”,
Harvard Business Review, 51, 1973 pp.88-102).