Abstract
Economic Value Added (EVA) is a value based performance measure that gives importance on value creation by the management for the owners. Profit maximization as a concept is age-old, wealth maximization is matured and value maximization is today’s wisdom. Stern Stewart’s EVA raises storm in corporate world and gives a new way to think about rewarding management. Usability of EVA largely depends on the quality of accounting information system, as traditional information system will not provide sufficient information to compute true EVA. Thus, EVA is required to be tailored in line with accounting system, management philosophy and the degree of demand of such a system. In this paper, an earnest effort has been made to explain theoretical foundation of EVA with its origination, definition, ways to make it tailored, adjustments required, scope and some other related issues. The methodology used is a type of theoretical mining of logics resulting a step-by-step process required for EVA implementation. As corporate house plans to move from traditional to value based performance measures, EVA would yield good result and the paper may become helpful to them to comprehend the methodology.
Keywords: Value Based Performance Measure, Tailored EVA, Residual Income (RI), Accounting Distortions,
Shareholders’ Value, Value Based Measure, Market Value Added, True EVA
1. Introduction
Economic Value Added (EVA) is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. Thus, in modern economics and finance area, EVA holds an important part that has less debate among practitioners. It is the performance measure most directly linked to the creation of shareholders wealth over time. Shareholders are very much choosy for their interest into the business and they like management to come up with very specific solution. By the time, it is established that the very logic of using EVA is to maximize the value for the shareholders. More explicitly, EVA measure gives importance on how much economic value is added for the shareholders by the management for which they have been entrusted with. EVA is exceptional from other traditional tools in the sense that all other tools mostly depend on information generated by accounting. And we know, accounting, more often produces historical data or distorted data that may have no relation with the real status of the company. But, EVA goes for adjustments to accounting data to make it economically viable.
Under conventional accounting, most companies appear profitable but many in fact are not. As Peter Drucker put the matter in a Harvard Business Review article, "Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources…until then it does not create wealth; it destroys it." Company may intentionally pay tax to prove that they have made profit for their shareholders and thus a falsification is done with owners that is not a rare corporate practice. EVA corrects this error by explicitly recognizing that when managers employ capital they must pay for it, as if it were a wage. It also adjusts all distortions that are very much prevalent in the information generated by conventional accounting. Thus, it is the most demanded tool for the owners in every situation. It has been implemented in numerous large companies to motivate managers to create shareholder value (Dodd and Chen, 1996).
The decision role is very simple; if the EVA is positive, the company creates shareholder wealth. Negative EVA indicates that shareholder wealth is destroyed (Stewart, 1991). De facto, EVA is the same as residual income (RI) that has been in existence for several decades. The only significant difference between the two lies in the handling of accounting distortions (Dodd and Chen, 1997). EVA removes existing distortions by using up to 164 adjustments to