Intermediate Financial Management (with Thomson One)

See IFM9 Ch07 Tool Kit.xls
for details.
We can also calculate EVA in terms of ROIC:
EVA (Operating capital)(ROIC WACC) | 7-10a |
As this equation shows, a firm adds value—that is, has a positive EVA—if its
ROIC is greater than its WACC. If WACC exceeds ROIC, then new investments in
operating capital will reduce the firm’s value.
EVA is an estimate of a business’s true economic profit for the year, and it differs
sharply from accounting profit. 9 EVA represents the residual income that
remains after the cost of all capital, including equity capital, has been deducted,
whereas accounting profit is determined without imposing a charge for equity capital.
As we discuss in Chapter 10, equity capital has a cost, because funds provided
by shareholders could have been invested elsewhere, where they would have
earned a return. Shareholders give up the opportunity to invest elsewhere when
they provide capital to the firm. The return they could earn elsewhere in investments
of equal risk represents the cost of equity capital. This cost is an opportunity
cost rather than an accounting cost, but it is quite real nevertheless.
Note that when calculating EVA we do not add back depreciation. Although
it is not a cash expense, depreciation is a cost since worn-out assets must be
replaced, and it is therefore deducted when determining both net income and EVA.
Our calculation of EVA assumes that the true economic depreciation of the company’s
fixed assets exactly equals the depreciation used for accounting and tax
purposes. If this were not the case, adjustments would have to be made to obtain
a more accurate measure of EVA.
EVA measures the extent to which the firm has increased shareholder value.
Therefore, if managers focus on EVA, this will help to ensure that they operate in
a manner that is consistent with maximizing shareholder wealth. Note too that
EVA can be determined for divisions as well as for the company as a whole, so it
provides a useful basis for determining managerial performance at all levels. Consequently,
EVA is being used by an increasing number of firms as the primary
basis for determining managerial compensation.
Table 7-5 shows how MicroDrive’s MVA and EVA are calculated. The stock
price was $23 per share at year-end 2006, down from $26 per share the previous
year. Its WACC, which is the percentage after-tax cost of capital, was 10.8 percent
in 2005 and 11.0 percent in 2006, and its tax rate was 40 percent. Other data in
Table 7-5 were given in the basic financial statements provided earlier in the chapter.
Note first that the lower stock price and the higher book value of equity (due
to retaining earnings during 2006) combined to reduce the MVA. The 2006 MVA
is still positive, but $460 $254 = $206 million of stockholders’ value was lost
during the year.
EVA for 2005 was just barely positive, and in 2006 it was negative. Operating
income (NOPAT) rose, but EVA still declined, primarily because the amount of
capital rose more sharply than NOPAT—by about 26 percent versus 8 percent—
and the cost of this additional capital pulled EVA down.
9 The most important reason EVA differs from accounting profit is that the cost of equity capital is deducted when EVA is
calculated. Other factors that could lead to differences include adjustments that might be made to depreciation, to
research and development costs, to inventory valuations, and so on. These other adjustments also can affect the calculation
of investor supplied capital, which affects both EVA and MVA. See Stewart, The Quest for Value, listed in the Selected
Additional References at the end of the chapter.
Chapter 7 Accounting for Financial Management • 233