Chapter 5 • Practical aspects of investment appraisal
SVA’s problems include:l Possible conflicts between value drivers, such that actions to enhance value in one
area lead to a net destruction of value. For example, reducing the trade receivables
settlement period (working capital reduction) might lead to a loss of sales revenue
if customers react adversely to shorter credit periods.
l The management information systems of many businesses are not geared to pro-
ducing what is necessary in an SVA environment and to make change may be costly
and risky.Economic profit and economic value added
The use of economic profit as a performance indicator reflects the notion that, for a
business to be profitable in an economic sense, it must generate returns that exceed the
required returns by investors. It is not enough simply to make an accounting profit
because this measure does not take full account of the returns required by investors.
The economic profit approach has a long history and is widely used.
Economic value added (EVA®) is a refinement of the economic profit approach that
has been developed and trademarked by a New York management consultancy firm,
Stern, Stewart and Company (SS).The principles of EVA®
EVA®is a measure of the extent to which the after-tax operating profit of the business
for a period exceeds the required minimum profit, which in turn is based on the share-
holders’ minimum required rate of return on their investment multiplied by the
amount of that investment. Thus if there is an excess of actual profit over the required
minimum, economic value will have been added, and the shareholders will be more
wealthy. If there is a shortfall, the shareholders will be less wealthy because they will
not have earned an adequate return given the amount of investment and the required
minimum rate of return.
The formula for EVA®is as follows:EVA®=NOPAT −(R×C)
where NOPAT is the net operating profit after tax, Ris the required rate of return for
investors and Cis the capital invested (that is, the net assets of the business).
Only when EVA®is positive can we say that the business is increasing shareholder
wealth. To maximise shareholder wealth, managers must increase EVA®by as much
as possible.How can EVA®be used?
As we can see from the formula, in order to increase EVA®managers need to achieve
one or more of the following:l Increase NOPAT. This may be done either by reducing expenses or by increasing
sales revenue.