Introduction to Corporate Finance

16: Financial Planning

detrimental to shareholders. For now, we put aside the question of whether growth is desirable. Assuming

that companies seek growth, they can focus on one or a number of measures of growth.

Popular Measures of Growth

Three of the most popular measures of growth are the accounting return on investment (ROI), economic

value added (EVA) and growth in sales or assets. All of these methods rely on accounting data, and are

typically measured on an annual basis. We next describe ROI and EVA more fully.

Return on Investment

The accounting return on investment (ROI) is the company’s earnings available for ordinary shareholders

divided by its total assets. (In Chapter 2 we referred to this measure by its alternative name, return on

total assets or ROA.) Return on investment measures the company’s overall effectiveness in using its

assets to generate returns to ordinary shareholders.

Companies that use this metric as a measure of growth attempt to maintain ROI above some minimum

hurdle rate and often raise this standard over time. These companies frequently set hurdle rates for

minimum ROI based on the company’s cost of capital. They assume that if the ROI is greater than the

cost of capital (plus perhaps a fudge factor), then shareholder value will be created. The problem with

this approach is that it compares the accounting-based ROI to an economic-based measure of the return

demanded by suppliers of capital. Although use of this method has practical appeal, its theoretical roots

are shallow at best.

Economic Value Added (EVA)

As noted in Chapter 9, economic value added (EVA) is the difference between net operating profits after

taxes (NOPAT) and the cost of funds; when applied correctly, EVA prompts managers to make the same

investment decisions that the NPV method directs them to do. The cost of funds is found by multiplying

the company’s cost of capital by its investment. Analysts can apply EVA to individual investments or to the

entire company, but its use in financial planning tends to focus on the entire company or on entire divisions.

Companies that employ EVA in the planning process typically build the EVA model into their

spreadsheets and evaluate various scenarios by calculating the EVAs of the scenarios. By comparing all

positive EVAs, the company can implement the set of plans with the highest EVA, which should create the

most value for shareholders. Although widely examined in the financial literature,^3 EVA’s degree of positive

correlation with actual share valuations remains unclear. It is sometimes difficult to implement, because it

requires accrual-based accounting inputs (NOPAT and investment). This disconnection between theory and

practice, coupled with its complex computations, tends to result in greater planning focus on growth rates.

Defining Growth

Companies frequently set planning goals in terms of target growth rates, typically annual growth in sales

or assets. For the moment, we set aside the question of whether growth creates or destroys shareholder

value. Instead we focus on measuring target growth rates in light of their intuitive, computational and

3 For some critical analyses of EVA, see Ray D Dillon and James E Owers, ‘EVA as a Financial Metric: Attributes, Utilization, and Relationship
to NPV’, Financial Practice and Education (Spring/Summer 1997), pp. 32–40; John D. Martin, J. William Petty and Steven P. Rich, ‘A Survey of
EVA and Other Residual Income Models of Firm Performance’, Journal of Finance Literature (Winter 2005), pp. 1–20; and John M Griffith, ‘The
True Value of EVA’, Journal of Applied Finance (Fall/Winter 2004), pp. 25–9.

return on investment

(ROI)

A measure of a company’s

overall effectiveness in using

its assets to generate returns

to ordinary shareholders; also,

return on total assets (ROA)

economic value added

(EVA)

A measure of the value

created by an investment, a

division or an entire company,

calculated as the difference

between net operating profits

after taxes and the cost of

funds

What metrics do companies use

as growth targets, and what

role, if any, does economic

value added (EVA) play in

planning processes?

thinking cap

question