10.3Economic Value Added (eva)

This chapter’s opening vignette, which described one of the most reprinted articles in

the history of Fortunemagazine, demonstrates that American corporations are wild

about EVAand the related measures of true protability introduced by other consulting

rms. EVAwas originally conceived as an adjustment to accounting earnings that bet-

ter measures how rms are performing.¹²

However, as this section shows, one of the

keys to EVA’s success is that its implementation provides a system in which managers

are encouraged to take on positive net present value investment projects.

Economic Value Added is simply a way of accounting for the cost of using capi-

tal in computing prot. In contrast to accounting earnings, which charge only for the

interest paid on debt capital, EVAimposes a charge on both debt and equity capital.

Also, while EVAprefers cash ow to accounting earnings, it recognizes that changes

in capital affect cash ow. When initiating a project, for example, the project’s initial

cash ow Cis probably negative because of a large capital expenditure on items such

0

as machines, land, and a factory. Similarly, at the termination date of a project, the cap-

ital is returned to the rm’s investors in the form of cash as the depreciated capital

assets are sold for their salvage value. This reduction in capital tends to make the ter-

minal cash ow Clarge even when the project may not be very protable in its nal

T

year. Along the way, there also may be additional capital expenditures, sales of capital

equipment, or reductions in the value of the capital due to economic depreciation. By

economic depreciation, we mean the reduction in the salvage value of the capital, esti-

mated by what the market is willing to pay for the project’s capital assets at the end

of a period compared with their value when the project is initiated.

One advantage of accounting earnings over cash ow is that the former tends to

smooth out the abrupt changes in cash ow due to changes in capital and to present a

more stable year-to-year picture of operating protability. Proponents of EVAadvocate

that the smoothing (or, to use accounting terminology, amortization) of capital expen-

ditures over the life of the project can be achieved in a more economically sensibleway.

¹²The

discussion of the accounting rate of return in Section 10.6 illustrates how accounting earnings

can mislead corporate managers.

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342Part IIIValuing Real Assets

Specically, EVAattempts to account for the cash ow impact of capital. To under-

stand how EVAis computed, let

I the date tbook value, adjusted for economic depreciation, of the project’s

t

capital assets (Special cases: at t 0, it is the purchase price; both at

t 1, the date before the project begins, and at t T,the terminal date at

which the assets are sold, I 0)

t

The date tcash ow, C, is broken into the sum of three components:

t

II the reduction in capital from t1 to t¹³

t1t

Ir a fair charge for the use of capital from t1 to t

t1

EVA a measure of the project’s true economic protability from t1 to t

t

Since EVAis dened as whatever is left over after accounting for the rst two com-

t

ponents, the date tEconomic Value Addedof the cash ow stream is

EVA C(II) Ir	(10.2a)
ttt1tt1

Note that if one groups the Iterms in equation (10.2a) together, then

t1

EVA CII(1 r)	(10.2b)
tttt1

There are two special cases. At beginning date 0 (as capital did not exist prior to date

0), there is no charge for capital. Hence, at date 0, equation (10.2b) states

EVA CI

000

At the terminal date T,equation (10.2b) implies

EVA CI(1 r)

TTT1

because all of the capital is liquidated at the terminal date, implying I 0.

T

Now discount the EVAstream from date 0 through date T,generating

EVAEVA

12

Discounted EVA stream EVA. . .

⁰r)r)²

(1(1

EVAEVA

T1T

(1r)^T1r)^T

(1

Substituting equation (10.2b) into this formula implies

CII(1r)

Discounted EVA stream CI¹10

0⁰1r

CII(1r)

²21. . .

(1r)²

CII(1r)CI(1r)

^T1T1T^2TT1

(1r)^T1(1r)^T

CCCC

12T1T

C. . .

⁰rr)^2T1r)^T

1(1(1r)(1

NPV

Because the Iterms, representing capital, cancel one another in the expression for the

t

discounted EVAstream, the discounted EVAstream is the same as the NPVof the project!

¹³Reduction

in capital includes the sale of capital assets as well as economic depreciation. Increases in

capital arise from capital expenditures and economic appreciation in the salvage value of a capital asset.

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Chapter 10Investing in Risk-Free Projects	343
Example 10.6 illustrates this point numerically.

Example 10.6:Computing EVAs

Assume that NASA is allowed to select one of three commercial projects for the next space

shuttle mission.Each of these projects has industrial spin-offs that will generate cash for

NASA over the next two periods.The cash ows and NPVs of the projects are described

below.

Cash Flow
(in $millions) at Date
	NPV at 2%
012	(in $millions)

Project A	17.0	12	9	3.42
Project B	16.8	10	11	3.58
Project C	16.9	11	10	3.50

What are the EVAs and the discounted values of the EVAstreams of the three projects?

Assume a discount rate of 2 percent per period and, for simplicity, no changes in capital at

date 1.Also assume that the negative cash ow at date 0 is entirely a capital expenditure,

implying that EVA 0.

0

Answer:The EVAs of the three projects occur only at dates 1 and 2.The following table

gives the six EVAs and their present values for each project.

PV(EVA)

1

PV(EVA)

2

at 2%

EVA(in $millions)EVA(in $millions)(in $millions)

1 2

Project A	11.660 1217.0(.02)	8.34 1917.0(.02)17.0	3.42
Project B	9.664 1016.8(.02)	6.14 1116.8(.02)16.8	3.58
Project C	10.662 1116.9(.02)	7.24 1016.9(.02)16.9	3.50

Note, as suggested earlier, that the summed discounted values of EVAand EVAfor

12

the three projects in Example 10.6 (which assumes EVA 0) are the same as their

0

respective NPVs. Result 10.4 states this formally.

Result 10.4

The discounted value of the stream of EVAs of a project is the same as the net present valueof the project.

10.4	Using NPVforOtherCorporate Decisions

Although the techniques examined in this chapter have typically been applied only to

the evaluation of capital investments, the introduction of EVAhas had the effect of

getting managers to think about other uses for the net present value rule. These could

include labor strategies, pricing strategies, product development strategies, and so forth.

To illustrate this point, this section considers two examples. The rst, Example 10.7,

analyzes a labor decision.

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Markets and Corporate		Projects	Companies, 2002
Strategy, Second Edition

344Part IIIValuing Real Assets

Example 10.7:Laying Off Workers as an Investment Decision

Ace Farm Equipment is currently suffering from a slowdown in sales and temporary over-

stafng.The company can save $600,000 at the end of each of the next three years if it

cuts its workforce by 25 individuals.In four years, however, it expects that its market will

improve and that it will have to hire replacements for the 25 individuals who were laid off.

Ace estimates that the cost of hiring and training workers is $100,000 per employee,or

$2.5million for the 25 employees.If the discount rate is 10 percent per year, should Ace

temporarily cut its workforce?

Answer:The incremental cash ows associated with the layoffs are as follows:

Cash Flow (in $millions)

at End of Year

1234

0.60.60.62.5

$.6 million$.6 million$.6 million$2.5 million

NPV$.215 million

1.11.1²³⁴

1.11.1

The negative NPVimplies that layoffs destroy shareholder wealth.

Example 10.8 analyzes a project pricing decision.

Example 10.8:Cutting Product Price as an Investment Decision

Assume that Buzz Beers, a local distributor in Akron, Ohio, currently sells about 10,000 cases

of beer per month, which is 15 percent of the Akron market.Management at Buzz Beers is

considering a temporary price cut to attract a larger share of the market.If management

chooses to lower beer prices from $4.00 to $3.80 a case, Buzz Beers will expand its mar-

ket by 50 percent.Elmer Buzz, the CFO, estimates that the beer costs $3.50 per case, so

that the company would be making $5,000 per month with the higher price but only $4,500

per month with the lower price.However, the company plans to stick with the lower price for

two years and then raise the price to $3.90 per case.Management believes that at this higher

price they still will be able to keep their new customers for the subsequent two years, allow-

ing Buzz Beers to generate a monthly cash ow of $6,000 per month in years 3 and 4.If

the discount rate is 1 percent per month, should prices be lowered?

Answer:The incremental cash ows are as follows:

		Cash Flow at the End of Month
1	2	...242526	...	48
$500	$500	...$500$1,000$1,000	...	$1,000

$500$500$500$1,000$1,000$1,000

NPV $6,109 … …

1.011.01^224252648

1.011.011.011.01

The positive NPVmeans that cutting prices is worthwhile.

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Markets and Corporate		Projects	Companies, 2002
Strategy, Second Edition

Chapter 10

Investing in Risk-Free Projects

345