Inspira- Journal of Modern Management & Entrepreneurship 41

ISSN : 2231–167X, Volume 01, No. 02, October, 2011, pp.41-47

Economic Value Added: The Invisible Hand at Work

Dr. Prakash Sharma

Adam Smith, one of the fathers of classical economic thought,

observed that firms and resource suppliers, seeking to further their own self
interest and operating within the framework of a highly competitive market
system, will promote the interest of the public, as though guided by an
“invisible hand. “(Smith, 1776).
The market mechanism of supply and demand communicates the
wants of consumers to businesses and through businesses to resource
suppliers. Competition forces business and resource suppliers to make
appropriate responses. The impact of an increase in consumer demand for
some product will raise that goods price. The resulting economic profits signal
other producers that society wants more of the product. Competition
simultaneously brings an expansion of output and a lower price.
Profits cause resources to move from lower valued to higher valued
uses. Prices and sales are dictated by the consumer. In the quest for higher
profits, businesses will take resources out of areas with lower than normal
returns and put them into areas in which there is an expectation of high
profits. Profits allocate resources.
The primary objective of any business is to create wealth for its
owners. If nothing else the organization must provide a growth dividend to
those who have invested expecting a value reward for their investment. As
companies generate value and grow, society also benefits. The quest for value
directs scarce resources to their most promising uses and most productive
users. The more effectively resources are employed and managed, the more
active economic growth and the rate of improvement in our standard of living
as a society. Although there are exceptions to the rule relating to the value of
economic wealth, most of the time there is a distinct harmony between
creating increased share value of an organization and enhancing the quality of
life of people in society.
In most companies today the search for value is being challenged by a
seriously out of date financial management system. Often, the wrong financial
focus, cash strategies, operating goals, and valuation processes are


Assistant Professor, Department of ABST, University of Rajasthan, Jaipur
42 Inspira- Journal of Modern Management & Entrepreneurship : October, 2011

emphasized. Managers are often rewarded for the wrong achievements and in
many cases they are not rewarded for the efforts that lead to real value.
Balance sheets are often just the result of accounting rules rather than the
focus of value enhancement. These problems beg for approaches to financial
focus that are completely different from current approaches. New approaches
must start nothing less than a revolution in thinking in the process of
economic evaluation.
One of the focuses that have proved to be incorrect in the valuation of
economic worth is earnings per share (EPS). Earnings per share has long been
the hallmark of executives that appear in meetings of the shareholders, as the
measure of their accomplishments. This, along with return on equity has long
been thought of as the way to attract Wall Street investment.
There is nothing that points to EPS as anything more than a ratio that
accounting has developed for management reporting. Many executives
believe that the stock market wants earnings and that the future of the
organization’s stock depends on the current EPS, despite the fact that not one
shred of convincing evidence to substantiate this claim has ever been
produced. To satisfy Wall Street’s desire for reported profits, executives fee/
compelled to create earnings through creative accounting.
Accounting tactics that could be employed to save taxes and increase
value are avoided in favor of tactics that increase profit. Capital acquisitions
are often not undertaken because they do not meet a hypothetical profit
return. R&D and market expanding investments get only lip service. Often
increased earnings growth is sustained by overzealous monetary support of
businesses that are long past their value peak.
We must ask then, what truly determines increased value in stock
prices. Over and over again the evidence points to the cash flow of the
organization, adjusted for time and risk, that investors can expect to get back
over the life of the business.
Economic Value Added (EVA) is a measurement too/ that provides a
clear picture of whether a business is creating or destroying shareholder
wealth. EVA measures the firm’s ability to earn more than the true cost of
capital. EVA combines the concept of residual income with the idea that all
capital has a cost, which means that it is a measure of the profit that remains
after earning a required rate of return on capital. If a firm’s earnings exceed
the true cost of capital it is creating wealth for its shareholders.
Definition of Economic Value Added
A discussion on Economic Value Added has to begin with the origin
of the concept. EVA is based on the work of Professors Franco Modigliani and
Merton H. Miller. In October, 1961, these two finance professors published
“Dividend Policy, Growth and the Valuation of Shares”, in the Journal of
Economic Value Added: The Invisible Hand at Work 43

Business. The ideas of free cash flow and the evaluation of business on a cash
basis were developed in this article.
These ideas were extended into the concept of EVA by Bennett
Stewart and Joel Stern of Stern, Stewart & Company.
Economic Value Added is defined as net operating profit after taxes
and after the cost of capital. (Tully, 1993) Capital includes cash, inventory, and
receivables (working capital), plus equipment, computers and real estate. The
cost of capital is the rate of return required by the shareholders and lenders to
finance the operations of the business. When revenue exceeds the cost of
doing business and the cost of capital, the firm creates wealth for the
shareholders.
EVA Net Operating Profit Taxes Cost of Capital
Calculating Net Operating Profit After Taxes (NOPAT)
NOPAT is easy to calculate. From the income statement we take the
operating income and subtract taxes. Operating income is sales less cost of
sales and less selling, general and administrative expenses. The following
example from XYZ Company illustrates the NOPAT calculation.
XYZ Company
Sales $2,436,000
Cost of Goods Sold 1,700,000
Gross Profit 736,000
Selling, General & Admin Expenses 400,000
Operating Profit 336,000
Taxes 134,000
NOPAT 202,000
Calculating Cost of Capital
Many business don’t know their true cost of capital, which means that
they probably don’t know if their company is increasing in value each year.
There are two types of capital, borrowed and equity. The cost of borrowed
capital is the interest rate charged by the bondholders and the banks.
Equity capital is provided by the shareholders. An investor’s expected
rate of return on an investment is equal to the risk free rate plus the market
price for the risk that is assumed with the investment. The relationship
between expected return and risk is measured by comparing a company to
the market.
The risk of a company can be decomposed into two parts. An investor
can eliminate the first component of risk by combining the investment with a
diversified portfolio. The diversifiable component of risk is referred to as non
systematic risk.
44 Inspira- Journal of Modern Management & Entrepreneurship : October, 2011

The second component of risk is non diversifiable and is called the

systematic risk. It stems from general market fluctuations which reflects the
relationship of the company to other companies in the market. The non
diversifiable risk creates the risk premium required by the investor. In the
security markets the non diversifiable risk is measured by a firm’s beta. The
higher a company’s non diversifiable risk, the larger their beta. As the beta
increases the investor’s expected rate of return also increases. (Levy, 1982)
Current estimates of beta for a wide variety of companies are available
from Value Line and Bloomberg.
Shareholders usually expect to earn about six percent more on stocks
than government bonds. With long term government bonds earning 7.5%, a
good estimate for the cost of equity capital would be about 13.5 %. The true
cost of capital would be the weighted average cost of debt and equity.
Measuring Capital Employed
The next step is to calculate the capital that is being used by the
business, from the economist point of view. Accounting profits differ from
economic profits. Under generally accepted accounting principles, most
companies appear to be profitable. However, many actually destroy
shareholder wealth because they earn less than the full cost of capital. EVA
overcomes this problem by explicitly recognizing that when capital is
employed it must be paid for.
In financial statements, created using generally accepted accounting
principles, companies pay nothing for equity capital. As discussed earlier,
equity capital is very expensive.
Economic profits are defined as total revenues less total costs, where
costs includes the full opportunity cost of the factors of production. The
opportunity cost of capital invested in a business is not included when
calculating accounting profits.
Capital would include all short and long term assets. In addition,
other investments that have been expensed using accrual accounting methods
are now included as capital. For example, research and development, leases,
and training, which are investments in the future, that GAAP requires to be
expensed in the year they occur, would be treated as a capital investment and
assigned a useful life. (Stern, 1996)
If the business invest in developing new products this year, that
amount would be added back to operating profits and to the capital base. If
the product has a five year life, deduct 1/5 of the investment would be
deducted each year from operating profits and from the capital base in each of
the next five years. For XYZ Company we determine that the adjusted capital
balance is $1,500,000.
Economic Value Added: The Invisible Hand at Work 45

Weighted Average Cost of Capital

Weighted average cost of capital examines the various components of
the capital structure and applies the weighting factor of after tax cost to
determine the cost of capital. (O’Byrne, 1996) The following example will
show the formation of the weighted average cost of capital.
XYZ Company
Long Term Debt $500,000
Preferred Stockholders’ Equity $200,000
Common Stockholders’ Equity
Common Stock $300,000
Paid in Surplus $100,000
Retained Earnings $300,000
Total Common Equity $700,000
Total Capital $1,400,000
Long Term Debt
Long Term Debt includes bonds, mortgages and long term secured
financing.
Bond Cost Let’s say we can issue bonds with a face value of $100 per bond
and it is estimated that the bond will generate $96.00 net proceeds to the
company after discounting and financing costs. The normal interest is $14.00
or approximately $9.00 after taxes (assuming a 35% tax rate). To obtain the
cost, we divide the after tax interest by the proceeds.
$9.00/ $96.00 = 9.475% which is the after tax cost of bond financing
Mortgage and Long Term Financing Costs Our banker has informed us that
our long term rate is two points above prime, which is currently 10%, putting
our lending rate at 12%. With a 35% tax rate it comes to a 7.8% cost. Our
banker has informed us that our mortgage rates are presently 11 %, which
would give us an after tax cost on mortgage money of 7.15%.
We weight the cost of long term debt, by taking the average of the cost of long
term debt, which would give us:
(7.8% +7.15%)/2 = 7.48%
and multiplying the long term debt of $500,000 by 7.48% will give us a
weighted average cost of LTD of $34,400.
Preferred Stock Costs
We take the present market value of the preferred stock less discounts
or finance costs and divide dividends per share by this value. For example,
Preferred stock of $100 per share less $2.00 finance costs or $98.00 proceeds.
Dividends on Preferred are $11.00 per share.
$11.00/ $98.00 = 11.2% after tax cost of preferred
46 Inspira- Journal of Modern Management & Entrepreneurship : October, 2011

To calculate the weighted preferred stock, we multiply the after tax

cost of 11.2% by the preferred stock of $200,000 which gives us $22, 400.
Common Equity Costsss
Common equity has three components common stock, paid in
surplus and retained earnings. From the shareholder’s viewpoint, all three are
costs. If retained earnings are used in the business, the stockholders cannot
use them elsewhere to earn money and therefore they carry an opportunity
cost.
Stockholders invest because they expect to receive benefits, which will
be equivalent to what they would receive on the next best investment when
risk is considered. Stockholders expect two benefits from common stock,
dividends present and future and capital appreciation from growth. The
valuation of common equity must take into consideration both the present
and future earnings of the stock.
To calculate the weighted cost of common equity we consider the
present market price of the stock less issuing costs. For example we issue
common stock for $100 a share less $15.00 issuing cost or proceeds of $85.00
per share. This is divided into the future earnings per share estimate by
investors or reliable analysts. If we use $12.00 per share, then the weighted
cost will look like this:
$12.00/$85.00 = 14.1 % after tax cost of common stock
Using the 14.1% and the total common equity of $700,000 our cost of
common equity is $98,700.
Total Weighted Average Cost of Capital
A summary of the three components gives us the weighted average
cost of capital.
XYZ Company
Long Term Debt $500,000 * 7.48% $37,400
Preferred Stockholders’ Equity $200,000 * 11.2% $22,400
Common Equity $700,000 * 14.1% $98,700
Total Capital $1,400,000 $158,500
The Weighted Average Cost of Capital is $158,500/$1,400,000 = 11.3%.
Cost of capital is calculated by multiplying total capital by the weighted
average cost of capital.
Calculating EVA
After tax operating earnings less the cost of capital is equal to EVA.
From the above example we can calculate XYZ Company’s EVA and
determine if this business is creating wealth for its owners.
XYZ Company
NOPAT $202,000
Charge for Capital
Economic Value Added: The Invisible Hand at Work 47

Capital Employed $1,500,000

Cost of Capital 11.3%
Capital Charge $169,500
Economic Value Added $ 32,500
Methods Used to Increase EVA
The only way to increase EVA is through the actions and decisions of
managers. People make the decisions and changes that create value.
Companies that use EVA as their financial performance measure focus on
operating efficiency. It forces assets to be closely managed. There are three
tactics that can be used to increase EVA: earn more profit without using more
capital, use less capital, and invest capital in high return projects. (Tully, 1998)
Conclusion
EVA is both a measure of value and also a measure of performance.
The value of a business depends on investor’s expectations about the future
profits of the enterprise. Stock prices track EVA far more closely than they
track earnings per share or return on equity. A sustained increase in EVA will
bring an increase in the market value of the company.
As a performance measure, Economic Value Added forces the
organization to make the creation of shareholder value the number one
priority. Under the EVA approach stiff charges are incurred for the use of
capital. EVA focused companies concentrate on improving the net cash return
on invested capital.
EVA is changing the way managers run their businesses and the way
Wall Street prices them. When business decisions are aligned with the interest
of the shareholders, it is only a matter of time before these efforts are reflected
in a higher stock price.

References
1. Levy, Haim and Marshall Sarnat, Capital Investment and Financial Decisions,
Englewood Cliffs, New Jersey; Prentice Hall International, 1982.
2. O’Byrne Stephen F., EVA and Market Value, Journal of Applied Corporate Finance,
Spring 1996, 116 126.
3. Smith, Adam, The Wealth of Nations (New York: Modern Library, Inc., originally
published in 1776), p.28.
4. Stern, Joel M., EVA and Strategic Performance Measurement, Global Finance 2000, The
Conference Board, Inc., 1996.
5. Tully, Shawn, America’s Greatest Wealth Creators, Fortune, November 9, 1998, 193 196.
6. Tully, Shawn, The Real Key to Creating Wealth, Fortune, September 20, 1993, 123 132.