16 PART 1 Introduction to Managerial Finance
- For a good summary of economic value added (EVA®), see Shaun Tully, “The Real Key to Creating Wealth,”
Fortune(September 20, 1993), pp. 38–49.
economic value added (EVA®)
A popular measure used by many
firms to determine whether an
investment contributes positively
to the owners’ wealth;
calculated by subtracting the
cost of funds used to finance an
investment from its after-tax
operating profits.
In Practice
Once a small Northwest thrift,
Washington Mutual(WaMu) is
now the nation’s largest savings
institution and the seventh largest
U.S. bank. Its financial perfor-
mance has been as exceptional as
its rapid growth. Under the finan-
cial leadership of CFO William
Longbrake, its assets grew 10-fold
(to $220 billion) in a recent 5-year
period, earnings rose an average
of 18.6 percent per year, and the
stock price nearly tripled.
How has WaMu’s manage-
ment team increased shareholder
value so much? Four major acqui-
sitions played an important role in
adding branch networks. Greater
penetration in existing markets has
also been a driver. Another differ-
entiating factor is the “pay for per-
formance” plan that Longbrake
introduced. The compensation
plan encourages all employees,
from managers to tellers, to cross-sell products and to give custo-
mers the highest level of service
possible. As a result, the number of
customers and the profits per cus-
tomer have soared, helped along
by a clever advertising campaign
that emphasizes WaMu’s personal
service.
But it’s not enough to grow
revenues if expenses aren’t under
control. At the same time as its
revenues grew, the bank’s operat-
ing efficiency improved signifi-
cantly, the best among WaMu’s
major competitors.
Longbrake and his financial
managers continually look for
ways to boost revenues and
improve earnings. A successful
campaign to increase noninterest
income from depositor and other
retail banking fees, which are not
subject to interest-rate move-
ments, lessened the effect on
earnings of changes in interestrates. Another strategy was to sell
off all but the most profitable
single-family mortgages in the
bank’s loan portfolio. In spite of
interest-rate fluctuations in 2000,
WaMu earned $1.9 billion—its
most profitable year ever. The
bank continued to post record
results in 2001, as interest rates
fell, by increasing mortgage origi-
nation and refinancing activities.
As a result, the firm even
increased cash dividends at a time
when many companies were cut-
ting them. Clearly, Longbrake and
his managers’ actions were effec-
tive in creating value for WaMu’s
shareholders.Sources: Adapted from Stephen Barr, “The
Revenue Revolution at Washington Mutual,”
CFO,October 2001, downloaded from
http://www.cfo.com;“Washington Mutual Profits
Rise 84 Percent,” October 16, 2001, Reuters
Business Report,downloaded from eLibrary,
ask.elibrary.com;Washington Mutual Web
site, http://www.wamu.com.FOCUS ONPRACTICE Creating Shareholder Value and WaMu
firm’s future returns (cash flows), often appear to affect share price. Two impor-
tant issues related to maximizing share price are economic value added (EVA®)
and the focus on stakeholders.Economic Value Added (EVA®)
Economic value added (EVA®)is a popular measure used by many firms to deter-
mine whether an investment—proposed or existing—contributes positively to the
owners’ wealth.^3 EVA®is calculated by subtracting the cost of funds used to
finance an investment from its after-tax operating profits. Investments with posi-
tive EVA®s increase shareholder value and those with negative EVA®s reduce
shareholder value. Clearly, only those investments with positive EVA®s are desir-
able. For example, the EVA®of an investment with after-tax operating profits of
$410,000 and associated financing costs of $375,000 would be $35,000 (i.e.,
$410,000$375,000). Because this EVA®is positive, the investment is expected
to increase owner wealth and is therefore acceptable. (EVA®-type models are dis-
cussed in greater detail as part of the coverage of stock valuation in Chapter 7.)