Chapter 5 • Practical aspects of investment appraisal
l Marketable investments.Investments in shares and loan notes of other businesses are
not included as part of the capital invested in the business. This is because the
income from marketable investments is not included in the calculation of operating
profit. (Income from this source will be added in the income statement after oper-
ating profit has been calculated.)It is perhaps worth noting that SS believes that bonuses, calculated as a percentage
of EVA®, should form a very large part of the total remuneration package for man-
agers. Thus, the higher the EVA®figure, the higher the rewards to managers – with no
upper limits.An assessment of the EVA®approach to management
EVA®’s positive points include:
l Managers are subjected to a charge for the capital that has been invested. Before any
increase in shareholder wealth can be recognised, an appropriate deduction is
made for the use of business resources. Thus, EVA®encourages managers to use
these resources efficiently. Where managers are focused simply on increasing
profits, there is a danger that the resources used to achieve any increase in profits
will not be taken properly into account.
l EVA®is based on conventional financial statements, adjusted to try to remove
biases. There is no requirement for a separate management information system.
EVA®’s problems include:
l The adjustments to the financial statements are matters of judgement, which can
call into question the credibility of the economic value added for a period that has
been calculated.Value-based management in practice
Value-based management (VBM), the main examples of which are SVA and EVA®,
seems to be fairly widely used by larger businesses in practice. Ernst and Young (2003)
undertook a major survey of management accounting practices in US businesses. The
survey tended to be of larger businesses. It showed that 52 per cent of the businesses
were, in 2003, using some value-based approach to management, with a further 40 per
cent considering adopting such an approach in the future.
Ryan and Trahan (2007) examined the performances over the first five years of
84 US businesses that had adopted VBM during the period 1984 to 1997. They found
that the businesses that had adopted VBM significantly improved their economic
performances, relative to similar businesses that had not. This improvement persisted
throughout the five years that were assessed and was more marked among smaller
businesses than larger ones.
There appears not to be similar information on the position in the UK or elsewhere.
However, there is no reason to believe that the UK position differs greatly from the
US one.
One UK business that uses a value-based approach to management is the telecoms
business The Carphone Warehouse Group plc. In its 2007 annual report it said:
‘Assuming a weighted average cost of capital for the period of 6.8 per cent this rep-
resents an economic value added of £56.6 million.’