EVA Example

What is EVA? Economic Value Added –EE VE AYE, not a women’s name! One of a number of shareholder value metrics. –CFROI, SVA, EP, … Shareholder value is the goal. –Not inconsistent with stakeholder theory!

Which firm is better? Firm AFirm B Invested Capital$1000$5000 Net income$200$750 ROIC20%15%

Case 1 Cost of Capital17.5%AB Invested Capital$1000$5000 ROIC20%15% Net Income$200$750 Capital Charge$175$875 Residual Income$25$(125)

Case 1 Opportunity costs matter! In this case it is the foregone profit of investing elsewhere at 17.5% –$175 for A –$875 for B Residual income considers this cost explicitly while traditional GAAP earnings does not. Only A exceeds the opportunity cost of capital and therefore is the only “good” investment.

Question? Why not just go with the higher return on investment? Won’t that lead to the correct decision just as residual income does?

Case 2 Cost of Capital12%AB Invested Capital$1000$5000 ROIC20%15% Net Income$200$750 Capital Charge$120$600 Residual Income$80$150

Case 2 With a 12% opportunity cost of capital both investments exceed this hurdle and have positive residual income. But residual income is higher for B even though B has a lower (15% versus 20%) return. What is going on?

Case 2 Think in terms of an extreme example: –How excited would you be to earn 1000% on your investment if you could only invest $1? Would you rather earn a smaller return, say 20%, on a much larger investment?

ROI Problems Feed the Dogs Starve the Stars

Summary (1 of 2) GAAP earnings can lead to investing in and retaining projects that fail to cover their full cost of capital, especially if they are internally financed. –Case 1 – Investment B has positive earnings yet is a bad investment. ROIC can lead to starving the stars (underinvestment) and feeding the dogs (overinvestment). –Case 2 – Investment A has the higher ROIC but is not the better investment.

Summary (2 of 2) Residual income is able in incorporate both the magnitude of the return and the magnitude of the investment in its calculation. Unlike simple return metrics it also incorporates the opportunity cost of capital. The decision rule is simple. Choose the investment with the highest residual income given your opportunity cost of capital.