Economic value added: Difference between revisions
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(EVA). | (EVA). | ||
The periodic addition to shareholder value resulting from the efficient management and allocation of a firm's resources. | |||
== EVA at the whole-firm level == | |||
The periodic addition to shareholder value resulting from the efficient management and allocation of a whole firm's resources. | |||
EVA can be quantified at a whole-firm level as: | EVA can be quantified at a whole-firm level as: | ||
EVA = [Return on book capital LESS Market cost of capital] x Book capital. | EVA = [Return on book capital LESS Market cost of capital] x Book capital. | ||
Taking a simplified example, | |||
'''''Example''''' | |||
Taking a simplified example, take an all-equity financed firm with: | |||
(1) A market capitalisation (P<sub>0</sub>) of $130m. | |||
(2) Book value of equity $100m. | |||
(3) Annual after tax returns of $13m. | |||
[To keep the illustration simple, we will assume no growth, in other words the whole of the annual after tax returns of $13m are paid out as dividends (D<sub>1</sub>).] | [To keep the illustration simple, we will assume no growth, in other words the whole of the annual after tax returns of $13m are paid out as dividends (D<sub>1</sub>).] | ||
Return on book capital = 13/100 = 13%. | |||
Market cost of capital = 13/130 = 10% | Return on book capital = 13/100 | ||
= 13%. | |||
Market cost of capital = 13/130 | |||
= 10% | |||
(Using Ke = D<sub>1</sub>/P<sub>0</sub>). | (Using Ke = D<sub>1</sub>/P<sub>0</sub>). | ||
''In practice a number of adjustments would be made both to the market values and to the book values used in the calculation of the EVA. So the application of EVA analysis is both more complicated, and arguably more subjective, than the simple calculation illustrated above.'' | EVA = [13% - 10% = 3%] x $100m | ||
= '''$3m'''. | |||
''In practice a number of adjustments would be made both to the market values and to the book values used in the calculation of the EVA. | |||
So the application of EVA analysis is both more complicated, and arguably more subjective, than the simple calculation illustrated above.'' | |||
'''''Example''''' | |||
Turning back for now to our simple example, EVA is also closely related to Market value added (MVA). | |||
MVA is the total present value of the expected EVA in the current and future periods. | |||
For example in this case the EVA is a simple fixed perpetuity of $3m. | |||
The total present value of the fixed perpetuity of $3m is evaluated using: | |||
(1) The simple fixed perpetuity formula 1/r. | |||
(2) The market cost of capital 10%. | |||
MVA = $3m/0.10 | |||
= '''$30m'''. | |||
== EVA at the individual project level == | |||
It is also possible to calculate and analyse EVA at the individual project level. | It is also possible to calculate and analyse EVA at the individual project level. | ||
In simple terms, EVA is positive when the project Internal rate of return exceeds the (appropriately risk-adjusted) Weighted average cost of capital. | In simple terms, EVA is positive when the project Internal rate of return exceeds the (appropriately risk-adjusted) Weighted average cost of capital. | ||
The important insight from EVA analysis is that a project or division is <u>destructive</u> of shareholder value | A simple decision rule when using EVA at the project level is: | ||
(1) Reject all negative EVA projects. | |||
(2) Positive EVA projects will be considered further. | |||
The important insight from EVA analysis is that a project or division is <u>destructive</u> of shareholder value: | |||
(1) Whenever its returns are inferior to the relevant economic cost of capital. | |||
(2) Even if it appears to be profitable when measured on an accounting basis (for example on an Earnings per share basis). | |||
== See also == | == See also == | ||
* [[Net present value]] | |||
* [[Internal rate of return]] | |||
* [[Book value]] | * [[Book value]] | ||
* [[Cost of capital]] | * [[Cost of capital]] | ||
| Line 40: | Line 100: | ||
* [[Shareholder value]] | * [[Shareholder value]] | ||
* [[Wealth Added Index]] | * [[Wealth Added Index]] | ||
Revision as of 11:36, 11 June 2013
(EVA).
EVA at the whole-firm level
The periodic addition to shareholder value resulting from the efficient management and allocation of a whole firm's resources.
EVA can be quantified at a whole-firm level as:
EVA = [Return on book capital LESS Market cost of capital] x Book capital.
Example
Taking a simplified example, take an all-equity financed firm with:
(1) A market capitalisation (P0) of $130m.
(2) Book value of equity $100m.
(3) Annual after tax returns of $13m.
[To keep the illustration simple, we will assume no growth, in other words the whole of the annual after tax returns of $13m are paid out as dividends (D1).]
Return on book capital = 13/100
= 13%.
Market cost of capital = 13/130 = 10%
(Using Ke = D1/P0).
EVA = [13% - 10% = 3%] x $100m
= $3m.
In practice a number of adjustments would be made both to the market values and to the book values used in the calculation of the EVA.
So the application of EVA analysis is both more complicated, and arguably more subjective, than the simple calculation illustrated above.
Example
Turning back for now to our simple example, EVA is also closely related to Market value added (MVA).
MVA is the total present value of the expected EVA in the current and future periods.
For example in this case the EVA is a simple fixed perpetuity of $3m.
The total present value of the fixed perpetuity of $3m is evaluated using:
(1) The simple fixed perpetuity formula 1/r.
(2) The market cost of capital 10%.
MVA = $3m/0.10
= $30m.
EVA at the individual project level
It is also possible to calculate and analyse EVA at the individual project level.
In simple terms, EVA is positive when the project Internal rate of return exceeds the (appropriately risk-adjusted) Weighted average cost of capital.
A simple decision rule when using EVA at the project level is:
(1) Reject all negative EVA projects.
(2) Positive EVA projects will be considered further.
The important insight from EVA analysis is that a project or division is destructive of shareholder value:
(1) Whenever its returns are inferior to the relevant economic cost of capital.
(2) Even if it appears to be profitable when measured on an accounting basis (for example on an Earnings per share basis).
