Value-based managementl Use capital invested more efficiently. This includes selling off any assets that are not
generating returns that reflect their market value and investing in assets that will
do so.
l Reduce the required rate of return for investors. This might be achieved by borrow-
ing to supply part of the total funding of the business. However, this strategy can
create problems, as we shall see in Chapter 11.
Targets can be set for EVA®for a business as a whole or for individual parts of it.
These target EVA®s can then be assessed against the actual value added, once the
relevant planning period has ended.
EVA®relies on conventional financial statements to measure the wealth created for
shareholders. However, the NOPAT and capital figures shown on these statements are
used only as a starting point. They have to be adjusted because of the problems and
limitations of conventional accounting measures. According to SS, the major problem
is that profit and capital tend to be understated because of the conservative bias in
accounting measurement. As we saw in Chapter 3, the prudence convention tends to
encourage this bias.
Capital is understated because assets are reported at a value based on their original
cost (following the historic cost convention), which can produce figures considerably
below current market values. In addition, certain assets, such as internally generated
goodwill and brand names, are omitted from the financial statements because no
external transactions have occurred.
SS has identified more than 100 adjustments that could be made to the conventional
financial statements in an attempt to correct for the conservative bias. However, SS
believes that, in practice, only a handful of adjustments will usually have to be made
to the accounting figures of any particular business. Unless an adjustment is going to
have a significant effect on the calculation of EVA®, it is considered not worth mak-
ing. The adjustments made should reflect the nature of the particular business. Each
business is unique and so must customise the calculation of EVA®to its particular
circumstances.
The most common adjustments that have to be made are as follows:
l Research and development costs.R and D costs should be written off (treated as an
expense) over the period that they benefit. In practice, however, these costs are
often written off in the period in which they are incurred. This means that any
amounts written off immediately should be added back to the assets on the balance
sheet, thereby increasing invested capital, and then written off over time.
l Brand names and goodwill.In theory, these should receive the same treatment as
R and D. However, SS suggests leaving them on the balance sheet. One argument
in favour of this treatment is that brand names and goodwill can have infinite lives.
Thus, any amounts written off in the income statement should be added back
to assets.
l Restructuring costs (that is, costs of reorganising the business’s operations or finances).
This item can be viewed as an investment in the future rather than as an expense
to be written off. Supporters of EVA®argue that, by restructuring, the business is
better placed to meet future challenges, and so restructuring represents an asset.
Any amounts written off should be added back to assets.