Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

For managers, EVA establishes a benchmark that measures an investment’s performance in each

period based on whether it earns an economic profit. The EVA metric subtracts ‘normal profit’ from an

investment’s cash flow to determine whether the investment is adding value for shareholders. As we have

already explained, NPV also provides a measure of value added, so it should not be surprising that these

methods are quite similar.

To illustrate how the EVA method works, consider an investment that requires $5 million of capital

funding. For simplicity, assume that the invested capital never depreciates, and generates annual cash

flow of $600,000 in perpetuity. Finally, assume that the company making this investment has a 12% cost

of capital. The formula used to calculate E VA for a particular year is:

EVA=−Cashflow ()CostofcapitalI×()nvestedcapital

=$600, 000 −×0.12 ()$5,000, 000 =$0

An EVA of zero means that the project earns exactly its cost of capital. That is, the project covers

all costs, including the cost of funds – but does not earn any economic profit above and beyond that

amount.

To determine whether the project should be undertaken, an analyst would calculate the EVA in every

year and then discount the future EVAs back to the present at the cost of capital; if the resulting value is

positive, then the investment is worthwhile. In this case, because EVA every year is zero (and the present

value of all future EVAs is also zero), we conclude that this investment provides a break-even return for

shareholders. What would the NPV method say? Using the perpetuity shortcut to value the investment’s

inflows, we find that the NPV is also zero,

NPV=−$5,000, 000 +=

$600, 000

0.12

$0

so the two methods yield the same conclusion.

EVA uses the same basic cash flows as NPV, and evaluates the economics of an investment ‘one year

at a time’, whereas NPV compares the incremental net cash inflows over the investment’s life (discounted

to the present at the company’s cost of capital) to the net cash outflows required by the investment.

Technically, discounting the time series of annual EVAs at the company’s cost of capital should result in

the project’s NPV. Thus NPV and EVA are fully compatible, and yield the same capital budgeting

decisions. The appeal of EVA is its integration of NPV analytical techniques into day-to-day managerial

decision making.

6 What does it mean if a project has an NPV of $1 million?

7 Why might the discount rates used to calculate the NPVs of two competing projects differ?

8 What do NPV and EVA have in common, and how do they differ?

CONCEPT REVIEW QUESTIONS 9-4