EVA = net operating profit after tax (NOPAT) less capital charge
(where capital charge = weighted average cost of capital x net assets)
Evaluation of EVA
The advantages of EVA include the followings:
(a) Real wealth for shareholders. Maximization of EVA will create real wealth for the shareholders.
(b) Less distortion of certain accounting policies. The adjustments within the calculation of EVA mean that the measure is based on figures that are closer to cash flows than accounting profits.
(c) An absolute value. The EVA measure is an absolute value, which is easily understood by non-financial managers.
(d) Treatment of certain costs as investments thereby encouraging expenditure. If management are assessed using performance measures based on traditional accounting policies they may be unwilling to invest in areas such as advertising and development for the future because such costs will immediately reduce the current year’s accounting profit. EVA recognizes such costs as investment for the future and thus they do not immediately reduce the EVA in the year of expenditure.
EVA does have some drawbacks:
(a) Focus on short-term performance. It is still a relatively short-term measure, which can encourage managers to focus on short-term performance.
(b) Dependency on historical data. EVA is based on historical accounts, which may be of limited use as a guide to the future. In practice the influences of accounting on the starting profit figure may not be completely negated by the adjustments made to it in he EVA model.
(c) Number of adjustments needed to measure EVA. Making the necessary adjustments can be problematic as sometimes a large number of adjustments are required.
(d) Comparison of like with like. Investment centres, which are larger in size, may have larger EVA figure for this reason. Allowance for relative size must be made when comparing the relative performance of investment centres.
(source : BPP Learning Media)
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