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As noted earlier, a negative current FCF is not necessarily bad, provided it is dueto high growth. For example, Home Depot has negative FCF due to its rapid growth,but it also has a very high ROIC, and this high ROIC results in a high market value forthe stock.

MicroDrive had an ROIC in 2002 of 9.46 percent ($170.3/$1,800 0.0946). Isthis enough to cover its cost of capital? Well answer that question in the next section.

What is net operating working capital? Why does it exclude most short-term in-vestments and also notes payable?

What is total operating capital, or, equivalently, total operating assets? Why is itimportant for managers to calculate a companys capital requirements?

What is NOPAT? Why might it be a better performance measure than net income?

What is free cash flow? Why is free cash flow the most important determinant ofa firms value?

MVA and EVA

Neither traditional accounting data nor the modified data discussed in the precedingsection bring in stock prices, even though the primary goal of management is to max-imize the firms stock price. Financial analysts have therefore developed two new per-formance measures, MVA, or Market Value Added, and EVA, or Economic ValueAdded. These concepts are discussed in this section.8

Market Value Added (MVA)

The primary goal of most firms is to maximize shareholders wealth. This goal obvi-ously benefits shareholders, but it also helps to ensure that scarce resources are allo-cated efficiently, which benefits the economy. Shareholder wealth is maximized bymaximizing the difference between the market value of the firms stock and the amountof equity capital that was supplied by shareholders. This difference is called the Mar-ket Value Added (MVA):

MVA Market value of stock Equity capital supplied by shareholders (Shares outstanding)(Stock price) Total common equity. (9-9)

To illustrate, consider Coca-Cola. In late 2001, its total market equity value was$123.5 billion, while its balance sheet showed that stockholders had put up only $10.4billion. Thus, Coca-Colas MVA was $123.5 $10.4 $113.1 billion. This $113.1billion represents the difference between the money that Coca-Colas stockholdershave invested in the corporation since its foundingincluding retained earningsversus the cash they could get if they sold the business. The higher its MVA, the bet-ter the job management is doing for the firms shareholders.

Sometimes MVA is defined as the total market value of the company minus the to-tal amount of investor-supplied capital:

MVA Total market value Total capital (Market value of stock Market value of debt) Total Capital. (9-9a)

8The concepts of EVA and MVA were developed by Joel Stern and Bennett Stewart, co-founders of theconsulting firm Stern Stewart & Company. Stern Stewart copyrighted the terms EVA and MVA, soother consulting firms have given other names to these values. Still, EVA and MVA are the terms most com-monly used in practice.

For an updated estimate ofCoca-Colas MVA, go tohttp://finance.yahoo.com,enter KO, pick Detailed forthe quote, and click Get.This shows the market valueof equity, called Mkt Cap. Toget the book value of equity,select Research, then Finan-cials, and then BalanceSheet.

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MVA and EVA 355

For most companies, the total amount of investor-supplied capital is the sum of equity,debt, and preferred stock. We can calculate the total amount of investor-supplied capital directly from their reported values in the financial statements. The total mar-ket value of a company is the sum of the market values of common equity, debt, andpreferred stock. It is easy to find the market value of equity, since stock prices are read-ily available, but it is not always easy to find the market value of debt. Hence, many an-alysts use the value of debt that is reported in the financial statements, or the debtsbook value, as an estimate of its market value.

For Coca-Cola, the total amount of reported debt was $6.9 billion, and Coca-Colahad no preferred stock. Using this as an estimate of the market value of debt, Cokestotal market value was $123.5 $6.9 $130.4 billion. The total amount of investor-supplied funds was $10.4 $6.9 $17.3 billion. Using these total values, the MVAwas $130.4 $17.3 $113.1 billion. Note that this is the same answer that we got us-ing the previous definition of MVA. Both methods will give the same results if themarket value of debt is approximately equal to its book value.

Economic Value Added (EVA)

Whereas MVA measures the effects of managerial actions since the very inception of acompany, Economic Value Added (EVA) focuses on managerial effectiveness in agiven year. The EVA basic formula is as follows:

EVA Net operating profit after taxes (NOPAT) After-tax dollar cost of capital used to support operations (9-10)

EBIT(1 Corporate tax rate) (Operating capital)(WACC).

Operating capital is the sum of the interest-bearing debt, preferred stock, and com-mon equity used to acquire the companys net operating assets, that is, its net operat-ing working capital plus net plant and equipment. Operating assets by definitionequals the capital used to buy operating assets.

We can also calculate EVA in terms of ROIC:

EVA (Operating capital)(ROIC WACC). (9-10a)

As this equation shows, a firm adds valuethat is, has a positive EVAif its ROIC isgreater than its WACC. If WACC exceeds ROIC, then new investments in operatingcapital will reduce the firms value.

EVA is an estimate of a businesss true economic profit for the year, and it differssharply from accounting profit.9 EVA represents the residual income that remains af-ter the cost of all capital, including equity capital, has been deducted, whereas ac-counting profit is determined without imposing a charge for equity capital. As we dis-cussed in Chapter 6, equity capital has a cost, because funds provided by shareholderscould have been invested elsewhere, where they would have earned a return. Share-holders give up the opportunity to invest elsewhere when they provide capital to thefirm. The return they could earn elsewhere in investments of equal risk represents thecost of equity capital. This cost is an opportunity cost rather than an accounting cost, butit is quite real nevertheless.

Note that when calculating EVA we do not add back depreciation. Although it is nota cash expense, depreciation is a cost, and it is therefore deducted when determining

If you want to read moreabout EVA and MVA, surfover to http://www.sternstewart.com and learnabout it from the peoplewho invented it, Stern Stew-art & Co.

9The most important reason EVA differs from accounting profit is that the cost of equity capital is deductedwhen EVA is calculated. Other factors that could lead to differences include adjustments that might bemade to depreciation, to research and development costs, to inventory valuations, and so on. These otheradjustments also can affect the calculation of investor supplied capital, which affects both EVA and MVA.See Stewart, The Quest for Value, listed in the Selected Additional References at the end of the chapter.

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356 CHAPTER 9 Financial Statements, Cash Flow, and Taxes

both net income and EVA. Our calculation of EVA assumes that the true economic de-preciation of the companys fixed assets exactly equals the depreciation used for ac-counting and tax purposes. If this were not the case, adjustments would have to be madeto obtain a more accurate measure of EVA.

EVA measures the extent to which the firm has added to shareholder value. There-fore, if managers focus on EVA, this will help to ensure that they operate in a mannerthat is consistent with maximizing shareholder wealth. Note too that EVA can be de-termined for divisions as well as for the company as a whole, so it provides a useful ba-sis for determining managerial performance at all levels. Consequently, EVA is beingused by an increasing number of firms as the primary basis for determining manage-rial compensation.

Table 9-5 shows how MicroDrives MVA and EVA are calculated. The stock pricewas $23 per share at year-end 2002, down from $26 per share at the end of 2001. ItsWACC, which is the percentage after-tax cost of capital, was 10.8 percent in 2001 and11.0 percent in 2002, and its tax rate was 40 percent. Other data in Table 9-5 weregiven in the basic financial statements provided earlier in the chapter.

Note first that the lower stock price and the higher book value of equity (due to re-taining earnings during 2002) combined to reduce the MVA. The 2002 MVA is stillpositive, but $460 $254 $206 million of stockholders value was lost during 2002.

EVA for 2001 was just barely positive, and in 2002 it was negative. Operating in-come (NOPAT) rose, but EVA still declined, primarily because the amount of capitalrose more sharply than NOPATby about 26 percent versus 8 percentand the costof this increased capital pulled EVA down.

Recall also that net income fell somewhat from 2001 to 2002, but not nearly sodramatically as the decline in EVA. Net income does not reflect the amount of equity

TABLE 9-5 MVA and EVA for MicroDrive (Millions of Dollars)

2002 2001

MVA Calculation

Price per share $ 23.0 $ 26.0Number of shares (millions) 50.0 50.0Market value of equity $1,150.0 $1,300.0Book value of equity $ 896.0 $ 840.0MVA Market value Book value $ 254.0 $ 460.0

EVA Calculation

EBIT $ 283.8 $ 263.0Tax rate 40% 40%NOPAT EBIT(1 T) $ 170.3 $ 157.8Total investor-supplied operating capitala $1,800.0 $1,455.0After-tax cost of capital, WACC (%) 11.0% 10.8%Dollar cost of capital Capital (WACC) $ 198.0 $ 157.1EVA NOPAT Capital cost ($27.7) $ 0.70ROIC NOPAT/Operating capital 9.46% 10.85%ROIC Cost of capital ROIC WACC (1.54%) 0.05%EVA (Operating capital)(ROIC WACC) ($27.7) $ 0.7

aInvestor-supplied operating capital equals the sum of notes payable, long-term debt, preferred stock, and com-mon equity, less short-term investments. It could also be calculated as total liabilities and equity minus accountspayable, accruals, and short-term investments. It is also equal to net operating working capital plus operating long-term assets.

See Ch 09 Tool Kit.xlsfor details.

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The Federal Income Tax System 357

capital employed, but EVA does. Because of this omission, net income is not as usefulas EVA for setting corporate goals and measuring managerial performance.

We will have more to say about both MVA and EVA later in the book, but we canclose this section with two observations. First, there is a relationship between MVAand EVA, but it is not a direct one. If a company has a history of negative EVAs, thenits MVA will probably be negative, and vice versa if it has a history of positive EVAs.However, the stock price, which is the key ingredient in the MVA calculation, dependsmore on expected future performance than on historical performance. Therefore, acompany with a history of negative EVAs could have a positive MVA, provided in-vestors expect a turnaround in the future.

The second observation is that when EVAs or MVAs are used to evaluate manage-rial performance as part of an incentive compensation program, EVA is the measurethat is typically used. The reasons are (1) EVA shows the value added during a givenyear, whereas MVA reflects performance over the companys entire life, perhaps evenincluding times before the current managers were born, and (2) EVA can be applied toindividual divisions or other units of a large corporation, whereas MVA must be ap-plied to the entire corporation.

Define the terms Market Value Added (MVA) and Economic Value Added(EVA).

How does EVA differ from accounting profit?

The Federal Income Tax System

The value of any financial asset (including stocks, bonds, and mortgages), as well asmost real assets such as plants or even entire firms, depends on the stream of cashflows produced by the asset. Cash flows from an asset consist of usable income plus de-preciation, and usable income means income after taxes.

Our tax laws can be changed by Congress, and in recent years changes have oc-curred frequently. Indeed, a major change has occurred, on average, every three tofour years since 1913, when our federal income tax system began. Further, certainparts of our tax system are tied to the inflation rate, so changes occur automaticallyeach year, depending on the rate of inflation during the previous year. Therefore, al-though this section will give you a good background on the basic nature of our tax sys-tem, you should consult current rate schedules and other data published by the Inter-nal Revenue Service (available in U.S. post offices and on the Web) before you fileyour personal or business tax returns.

Currently (early 2002), federal income tax rates for individuals go up to 39.6 per-cent, and, when Social Security, Medicare, and state and city income taxes are in-cluded, the marginal tax rate on an individuals income can easily exceed 50 percent.Business income is also taxed heavily. The income from partnerships and proprietor-ships is reported by the individual owners as personal income and, consequently, istaxed at federal-plus-state rates going up to 50 percent or more. Corporate profits aresubject to federal income tax rates of up to 39 percent, plus state income taxes. Fur-thermore, corporations pay taxes and then distribute after-tax income to their stock-holders as dividends, which are also taxed. So, corporate income is really subject to double taxation. Because of the magnitude of the tax bite, taxes play a critical role in many financial decisions.

As this text is being written, Congress and the administration are debating themerits of different changes in the tax laws. Even in the unlikely event that no explicitchanges are made in the tax laws, changes will still occur because certain aspects of thetax calculation are tied to the inflation rate. Thus, by the time you read this chapter,

A web site explaining fed-eral tax law is http://www.taxsites.com. From thishome page one can visitother sites that providesummaries of recent tax leg-islation or current informa-tion on corporate and indi-vidual tax rates. The officialgovernment site is http://www.irs.gov.

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