EVAforCase

Economic Value Added 1

ECONOMIC VALUE ADDED

INTRODUCTION ANDPREPARATION FOR CASE STUDY


What is EVA?

Used to be called Residual Income

Stern Stewart & Co. re-named it Economic Value Added (and trade-marked the name)

You are supposed to write: EVA®


How to calculate EVA

1. Calculate Net Operating Profit after Taxes

2. Subtract a Cost of Capital amount = EVA

(Cost of capital amount = Net Operating Assets x % cost of capital).


Purpose of EVA

Some people believe this is an improvement on any measure of performance involving

unadjusted accounting numbers based on GAAP

The idea is that a company has to earn a return on its assets that is more than its cost of capital.


Short Term Performance Measure (can be used for bonus calculations) Many accounting adjustments are made

to the GAAP net income

There are about 160 adjustments. You can only find them if you pay Stern Stewart & Co.


Typical accounting adjustments for EVA calculation of NOPAT

Begin with Operating Earnings Before Tax (GAAP)

1. Adjust for Goodwill calculations 2. Adjust for R& D 3. Adjust for advertising expense 4. Adjust for restructuring expense 5. Subtract taxes


Goodwill amortization (add back) What is Goodwill? Where is Goodwill shown in the GAAP

financial statements? What happens to Goodwill over time in

the accounting? What does ”amortization” mean? How much do we add back? WHY DO WE ADD BACK?


R&D EXPENSE (add back)

1. What is R&D? 2. What is the accounting problem for

R&D? 3. Where is R&D expense reported in

the financial statements? 4. How much do we add back? 5. WHY DO WE ADD IT BACK?


R&D Adjustment (subtract)

The assumption is: R& D is being expensed annually in the

GAAP statements. For EVA, assume it is an asset, and is

amortized over 5 years.

Calculate the total five years’ amortization if the R&D had been capitalized, and subtract it.


Advertising expense (add back) 1. What is advertising expense? 2. What is the accounting issue with

advertising expense? 3. Where is advertising expense

reported in the financial statements? 4. How much do we add back? 5. WHY DO WE ADD IT BACK?


Advertising adjustment (subtract) The assumption is:

Advertising is being expensed annually in the GAAP statements.

For EVA, assume it is an asset, and is amortized over 3 years.

Calculate the total 3 years’ amortization if the Adv. had been capitalized, and subtract it.


Restructuring expense (add back) 1. What is restructuring expense? 2. What is the accounting issue? 3. Where is restructuring expense

reported in the financial statements? 4. How much do we add back? 5. WHY IS RESTRUCTURING

EXPENSE ADDED BACK?


Subtract Taxes

Actual payment of taxes are subtracted.

That means deferred taxes are not subtracted (although they may be expensed on the income statement).

Why are actual taxes subtracted from operating profits?


Overall result of these adjustments: Why make them? EVA make GAAP income closer to cash

flow income.

Managers are judged on an income figure which is less able to be manipulated by using the accrual accounting rules


The EVA Adjustments Debate

Read article by David S. Young

Young argues EVA is: 1. costly to implement 2. may not make managers try to create

more long-term value


Typical EVA calculations for Capital amount Begin with Net Operating Assets

(usually considered total assets less non-interest bearing current liabilities)

Add accumulated goodwill amortization(= asset add-back)

Add capitalized R&D (= asset add-back) Add capitalized advertising costs (= asset add-back)


Cost of Capital for EVA

Assumes you use a WACC

(Weighted Average Cost of Capital, which is the weighted average cost of your debt and your shareholder equity)


Advantages of EVA

1. You get a number (dollars, euros, etc.)

2. You are calculating the shareholder value-added by operations (not just increase in sales,for example)

3. You are ”correcting” GAAP numbers for various problem areas of traditional accounting numbers


Disadvantages of EVA

1. Expensive to make adjustments to GAAP income

2. The accounting adjustments seem a little ”strange.” (Is the GAAP income really ”true and fair?”)

3. Employees may lose confidence in the accounting system


Vyaderm Pharmaceuticals Case Study Background:

Company founded in 1945.Multinational, multi-productHas focused on Earnings per shareBonus system for managers: based on

various operating results and on a subjective evaluation

1997: New CEO- decides to change bonus system


New Bonus System

EVA-based Incentive Program with a variable compensation plan

This is described on page 4 of the case. Page 5 shows a two year example.You will need to study this example.


Various problems arise, but one problem especially The Dermatology (skin care) division has

a lucky opportunity when their main competitor gets into trouble with the US Food and Drug Administration (FDA)

As a result, in year 2000, the Dermatology division has a really profitable, unusual year


However, . . .

In years 2001 and forward, this temporary advantage is expected to be lost

(the competitor should be back in business)


The Problem:

The manager bonus for 2000 (for the Dermatology division) will be very good.

But what about future years? Remember how the company EVA incentive plan works.

(you have to continually improve)


What should the company do?

1. Pay out the big bonus in 2000? And set a precedent?

2. Reduce the 2000 bonus, and set a precedent?

Change the plan calculations? Consider other factors?

If situation 1, hope the manager will stay on for future years (with little or no bonus)?


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EVAforCase