FNC 330
Created for FNC 330:
Richard Lee
Case Study: Economic Value Added for IT
TOC
TOC............................................................................................................................................. 1
Case Study Overview and Learning Objectives ......................................................................... 1
Case Background and Summary ................................................................................................. 1
Case Questions ............................................................................................................................ 6
Teaching Notes ........................................................................................................................... 6
Answers to Case Questions ......................................................................................................... 7
Index of Terms ............................................................................................................................ 9
References ................................................................................................................................... 9
Case Study Overview and Learning Objectives
Economic Value Added (EVA) analysis is a recently introduced metric for measuring the return
on capital outlays. IT-intensive companies are now developing new approaches that use EVA for
valuing technical investments. This case study depicts a real-life situation showing how EVA can
be used along with more traditional valuation techniques, such as return on invested capital
(ROIC), net present value (NPV) and free cash flows during investment analysis.
The case begins by exploring a product development scenario for a fictional company call Edge
Networks. Sam Hayes, the vise president for the new product, discovers the EVA metric and
questions its similarity to existing NPV valuations techniques used by his division. To address
his questions and concerns, Sam shows how to derive EVA and provides a comparison of EVA
with NPV and ROIC calculations.
The objective of the case is to show the derivation of EVA and how it relates to NPV and ROIC
calculations. It also invokes the student to elaborate on the pros and cons for using the metric
along with the financial framework (statement adjustments) needed for deriving the calculations.
Case Background and Summary
Sam Hayes’s wait was over and he was now being summoned to report on his business unit’s
progress for the new Media Gateway 1000. Sam was attending the monthly operations review in
Toronto for business unit vice presidents (VPs). Each month the VPs gathered at company
headquarters in Toronto to review the results and progress for new or existing projects. This
month Sam was presenting results on a new product his team had developed called the Media
Gateway 1000 (MG-1000), a combination wide-area network switch and router. He noticed that
during the review the CFO Dan Riddle was questioning each of the VPs on their return on capital
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(ROIC). Dan indicated that based on market conditions, analyst were beginning to question the
company’s ROIC projections. Sam usually reported overall discounted cash flow projections for
all his projects in net present value (NPV) format. He wondered if there was another way to
report the same type of information but in a way that didn’t reveal specific product profitability
information.
Sam worked for Edge Networks, a company that designed, marketed and manufactured network
routers and switches. The company’s primary customers consisted of tier-1 public carriers and
enterprise-business customers. Market share segmentation was split roughly 70% to public
carriers and 25% to enterprise customers. The remaining 5% represented independent resellers.
The MG-1000 was targeted mainly for the public carrier segment and was slated for mass
deployment during the first quarter of 2004. Given the increasing scrutiny on bookings and order
forecast, Sam knew he needed to address the ROIC question posed by Dan.
Company and Product Background
Edge Networks was a Canadian company that had been in existence for approximated 20 years.
During the 1990’s the company experienced rapid growth, spawned primarily by the emergence
of the Internet and the demand by companies for networking equipment. As primary carriers
(called tier-1 market carriers) positioned for the huge growth in customer traffic, orders for new
equipment, much of it for Edge Network products, grew rapidly. The company posted record
earnings each year from 1996 to 1999, growing earnings from approximately $250 million to
near $1 billion in 1999. To meet the increasing demand and competition from existing vendors,
the company continually invested capital for the development of new and or improved products.
The MG-1000 was the latest of these products.
The MG-1000 was a combination gateway switch and core router. Its primary purpose was to
aggregate and multiplex network traffic from several sources onto a common backbone protocol
such as multi-protocol label switching (MPLS) or asynchronous Transfer Mode protocol (ATM).
For example, a public carrier such as US Sprint or Verizon could use the MG-1000 to combine
different access sources onto a combined network backbone. A specific scenario might involve
combining intra-company voice telephone calls with intra company data traffic. Before the MG1000, each access source used its own separate backbone, requiring the carrier to support
multiple backbone networks, one for voice and one for data. The MG-1000 would allow
convergence onto a single network backbone, thus saving the carrier millions of dollars in
ongoing capital cost and operational expenses.
The Bursting Bubble
Although the 90’s had been a time of tremendous growth for the company, the last several years
were exactly the opposite. Demand for the company’s switches and routers had dropped
significantly with the busting of the Internet Bubble. This decrease in demand directly impacted
the company’s stock price, which was selling at $12.15 per share, off from its 2000 high of
$81.00 per share. Since much of the company’s revenue originated from the public carriers,
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primarily in North America, any decline in this segment was usually noticed on the company’s
revenue and earnings projections.
Analyst following the communications sector and the large public carriers (AT&T, Sprint,
Verizon, SBC, Bell South, Quest, Alltel, Cingular, etc.) were beginning to wonder whether
growth and demand (CAPEX) would reappear in the market. Since much of Edge Network’s
revenue was tied to capital purchases by the major carriers, slow growth by the carriers meant no
spending for new products, and thus slower growth for Edge Networks.
Leading much of the pessimistic outlook were several studies showing that public carriers were
failing to meet ROIC objectives (Katz & Junqueira, 2003). These studies showed that only 2 out
the top 15 public carriers were actually covering their weighted average cost capital cost
(WACC), with the average ROIC to WACC spread being -3.5%1. With poor return on
investment outlooks for the carriers, analysts were now asking the same questions of the carrier’s
vendors, e.g., Edge Networks. These questions were being asked of Dan Riddle, which in turn
was now requesting return information from his product VPs. Although the company could
easily calculate returns on historical data, it really needed some visibility into future return on
capital and investment numbers, one that was easily understandable to analyst.
Product NPV and EVA Compared
On the return trip to Dallas Texas, division home of the MG-1000, Sam Hayes read about a new
financial metric that was gaining popularity with many analysts. The metric was called
Economic Value Added (EVA) and it specifically took into consideration a company’s cost of
capital in measuring return on investment, or what some called economic profit. Although he had
been using NPV calculations to do the same thing for years, he wondered if the new metric could
be used in a more general format, one that was easily understood by analyst and operationally by
upper management, such as the CFO Dan Riddle.
EVA looked similar to ROIC; however, the metric directly incorporated a company’s coast of
capital (WACC) into the equation. The basic equation was as follows:
EVA = NOPAT – (Invested Capital x WACC)
or
EVA = (ROIC – WCCC) x Invested Capital
Where NOPAT equaled the company’s net operating profit after tax, WACC the company’s cost
of capital and invested capital was the net change in capital for the period. To benchmark his
EVA calculations, Sam first needed to calculate the estimated free cash flow produced by the
MG-1000. These numbers were already available from earlier NPV calculations and were as
follows2:
1
2
The ROIC to WACC spread is (ROIC- WACC).
Note that numbers are in millions of dollars.
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Year
MG-1000 NOPAT (or EBIAT)
Less change in invested
capital
Free cash flow
PV factor
PV of cash flow
Cumulative PV
NPV
Richard Lee
2003
-
2004
40
2005
80
2006
120
2007
160
2008
120
(1,000)
(1,000)
1.00
(1,000)
(1,000)
135
200
240
0.91
218
(782)
200
280
0.83
231
(550)
200
320
0.75
240
(310)
200
360
0.68
246
(64)
200
320
0.62
199
135
In deriving NOPAT, Sam used pro-forma projections for the MG-1000 over the next 5 years and
made adjustments to net income to derive true operating earnings. In many companies net
income will be the same as NOPAT, but for Edge Networks adjustments were required for items
such as investment income (loss), non-recurring cost, interest expenses and or income plus
goodwill amortization. All of these items reflected non-operating or non-cash items. Since Sam
started with NOPAT or EBIAT, forecasted year-over-year operating expenses were already
embedded into the derivation. A forecasted growth rate for EBIAT was set at 100% for 2005,
50% for 2006, 33% for 2007 and -33% in 2008 as the product reached maturity.
To derive forecasted capital (CAPEX) investments, Sam took the forecasted capital investments
for Edge Networks for the next 5 years and came up with the following numbers:
Year
0
1
2
3
4
5
Invested capital
1,000
800
600
400
200
-
To derive forecasted capital (CAPEX) investments for the MG-1000, Sam wanted to concentrate
only on those numbers specific to MG-1000 investments. To derive this number(s) Sam needed
to determine any new or net invested long tern capital (property, plant and equipment) and any
net or new changes in networking capital, as it related to the MG-1000. His forecast came up
with the following numbers.
Year
Total Invested capital
Change in invested
Capital due to MG-1000
0
1,000
1
800
2
600
3
400
4
200
5
-
(1,000)
200
200
200
200
200
Putting the forecasted estimates together, Sam produced the following combined financial
information. This data shows how Sam originally developed and forecasted estimates for the
MG-1000 NPV.
Year
2003
2004
2005
2006
2007
2008
Adjusted NWC
-
-
-
-
-
-
Net PP&E
Invested capital
1,000
1,000
800
800
600
600
400
400
200
200
-
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MG-1000 Revenue
- Cost of Goods Sold
Gross Profit
Gross Margin
- Operating Expenses
EBIT
- Taxes @ 35%
-
EBIAT (MG-1000)
Less change in invested capital
Free cash flow
PV factor
PV of cash flow
Cumulative PV
NPV
Richard Lee
-
232
128
105
45.00%
43
62
22
465
256
209
45.00%
86
123
43
697
384
314
45.00%
129
185
65
930
511
418
45.00%
172
246
86
697
384
314
45.00%
129
185
65
-
40
80
120
160
120
(1,000)
(1,000)
1.00
(1,000)
(1,000)
135
200
240
0.91
218
(782)
200
280
0.83
231
(550)
200
320
0.75
240
(310)
200
360
0.68
246
(64)
200
320
0.62
199
135
-
Using the formula for EVA, (ROIC – WCCC) x Invested Capital, Sam calculated the EVA from
ROIC. The present value factor, or WACC, for Edge Networks was normally about 10%.
ROIC
EVA
PV factor
PV of EVA
Cumulative PV
Total PV of EVA
1.00
135
4%
(60)
0.91
(55)
(55)
10%
0.83
(55)
20%
60
0.75
45
(9)
40%
120
0.68
82
72
60%
100
0.62
62
135
It appeared that Sam had developed a way to reflect his original ROIC numbers in way that
directly reflected the division/company’s WACC. He already used NPV and ROIC numbers in
his projections and by adding EVA, he was able to quote a simple economic return on capital
metric. To summarize his findings he developed a simple set of steps that could be used by other
divisional VPs. The steps were as follows:
1. Calculate NOPAT (EBIAT) for the particular product. This was already being performed
by all divisional VPs and was nothing new.
2. Calculate the net invested capital for the product. This required measuring the
replacement for existing capital directly related to the product and any net or new capital
invested in the product. With the EVA approach, replacement capital is not considered
since the assumption that depreciation will equal the replacement capital, hence invested
capital considers only new net capital applied to the project. Again this step was already
being done by most VPs for ROIC calculations.
3. Use the EVA formula to solve for EVA. The WACC was easily obtained from the
division or company finance department.
EVA = (ROIC – WCCC) x Invested Capital
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4. Get the present value or discount for each year’s EVA and find the cumulative EVA cash
flow for the project. The total EVA cash flow should equal the total NPV cash flows that
were traditionally being used.
EVACashFlow 
EVA1
EVA2
EVAn

 .....
1
2
(1  WACC) (1  WACC)
(1  WACC) n
Although Sam knew much of this information by using traditional net present value techniques,
he believed that expressing the data in EVA form would provide a simpler measure for
comparing return on capital, especially for analyst. It would also allow Sam to use one metric, as
opposed to several, which achieved his earlier goal of not exposing too much of his project’s
proprietary information.
Case Questions
1. What are the benefits of using EVA and what companywide benefits could it achieve?
2. Explain Economic Value Add (EVA) and how it relates to ROIC and NPV calculations.
3. Do you think Sam has developed a significant metric that can be used for evaluating return
on invested capital? Please explain your answer.
4. In determining a company’s free cash flow and invested capital, several considerations and
financial adjustments mush be considered to derive these numbers. Please explain these
adjustments.
5. Are there possible caveats or problems with using EVA?
Teaching Notes
The concept of using economic profits as a measuring stick for return on capital has been
pondered and debated for many years now. Although most managers traditionally use net present
value estimates of free cash flow, i.e., pro forma discounted cash flows, many companies such as
GE, DuPont and others have adopted EVA as an internal metric for comparing projects and
overall company performance. These companies argue that EVA provides a simple way of
measuring and comparing projects on an apples-to-apples basis, i.e., true economic cash flows.
They also espouse its simple and understandable derivation by middle management. By using
one simple metric for management performance, all managers are now aware that their projects
require a capital cost that must be recovered before a true return is recognized.
There is a significant amount of information regarding EVA and it is recommended that at least
some of this information be assigned as reading accompanying the case. The additional reading
provides the necessary background for EVA derivations and its similarities to NPV. Please see
the references section below for a complete list. Readings that should prove easy and to the point
are as follows:
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Bennett G. Stewart, The Quest for Value, Harper Business, 1990
The original creator of EVA is Stern & Stewart Co. They provide a good book on EVA that can
serve as a reference. Students will probably not read the entire book; however, it covers the
foundations for EVA and provides a suitable reference while reading the case.
For understanding the mathematics and derivation behind EVA, the following sites are
recommended. The first is a link to Dr. Aswath Damodaran of the NYU Stern School Business.
His web site on Finance is extensively sourced with EVA material. The second reference is a
paper written by Dr Ronald Shrieves and Dr John Wachowicz of the University of Tennessee
and provides a good comparison of NPV and EVA. These sites are located at:
NYU Site: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html
University of Tennessee paper: Free Cash Flow (FCF), Economic Value Added (EVATM), and
Net Present Value: A Reconciliation of Variations of Discounted-Cash-Flow (DCF) Valuation
A very good paper written on EVA and ROIC entitled “The Mechanics of the Economic Model”
can be found at McGill University and was actually written by an undergraduate student,
Andrew Chan. It provides a comparison EVA, WACC, NPV and ROIC and includes a
discussion and derivation of the measures.
http://www.intranet.management.mcgill.ca/mic/education/EconomicModelV16.pdf
Answers to Case Questions
1. What are the benefits of using EVA and what companywide benefits could it achieve?
The answers to this question will vary for each student, but something similar to the
following should be represented:
One of the major reasons for using EVA is its ability to consider the cost of capital into
return calculations. Often analysts and outside investors only consider earnings per share or
price to earnings ratios for comparison purposes. These measures fail to consider the cost of
capital. EVA directly uses the WACC when measuring return on capital. Almost all
companies use some form of discounted cash flow process in evaluating capital projects,
expressing this information at the company or divisional level can be confusing. Many
divisions, subsidiaries, international units may have very different capital cost. Using EVA
can help reduce the confusion by using one metric that all divisions are accountable for.
The student should also recognize that discounted cash flows (NPV) of a project should equal
the present value of EVA flows for the same project. This implies the following general
assumption:
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NPV of Firm’s Free Cash flow (FFCF) = Present Value of the firms EVA cash flow.
Students may have other explanations, but they should at minimum include some or all of the
above concepts.
2. Explain Economic Value Add (EVA) and how it relates to ROIC and NPV calculations.
EVA is very similar to ROIC and NPV and can be easily expressed mathematically.
EVA = NOPAT – (Invested Capital x WACC) and ROIC = NOPAT / Invested Capital.
Normally when using only ROIC as a measure, it is compared with the company’s WACC,
with the difference represented as the ROIC to WACC spread (ROIC – WACC). A result less
than zero does not meet the company’s return on invested capital. EVA simply combines
WACC directly into the calculation.
EVA is very closely tied to NPV; NPV measures the company’s discounted free cash flow
against its cost of capital, i.e., the discount rate. The present value of EVA cash flows should
be equal to the company’s discounted free cash flow. Or,
EVACashFlow 
EVA1
EVA2
EVAn
= NPV FFCF

 .....
1
2
(1  WACC) (1  WACC)
(1  WACC) n
3. Do you think Sam has developed a significant metric that can be used for evaluating
return on invested capital? Please explain your answer.
Yes, however the student should understand that the measure is not bullet-proof. Other
metrics (quantitative and qualitative) should be considered when determining the best
allocation of capital. These explanations will vary from student-to-student but should include
such things as management and companywide adoption of the metric, side effects on being
too overly dependant on the metric, etc.
4. In determining a company’s free cash flow and invested capital, several considerations
and financial adjustments mush be considered to derive at these numbers. Please
explain these adjustments.
The student here should list how the derivation of NOAPT (EBIAT) is derived and invested
capital. Although the paper assumes a working WACC, they may include a description of
calculation for the company’s cost of capital. The NOPAT description should explain
adjustments for anything that is considered non-operational, such as the exclusion of outside
investment income, non-recurring interest, gains or losses, tax shields, etc. Invested capital
shows only the net new capital invested into the project.
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5. Are there possible caveats or problems with using EVA?
Yes, for firms in their growth stage (entrepreneurial start-ups, etc.) EVA may appear
extremely low or even negative. The student should understand that it may be desirable in
certain situations to have poor returns on capital. This could occur when the firm is investing
heavily to capture initial market share, with the tradeoff being eventual long term or back
ended profits. For this reason, the student should understand that is important to compare
firms at the same stage of development within a certain sector and that EVA will change
depending on the life-cycle of the product or company.
Index of Terms
ATM – Asynchronous Transfer Mode: A communications protocol for wide area networks
CAPEX – Capital Expenditures
EVA – Economic Value Added
MPLS – Multi protocol label switching: A communications protocol for wide area networks
NOPAT – Net operating profit after tax
NPV – Net present value
ROIC – Return on invested capital
WACC – Weighted average coast of capital
References
Bennett G. Stewart (1990). The Quest for Value, Harper Business
Berry, J. (January, 2003) How to Apply EVA to I.T. CIO Magazine, Retrieved July 7, 2004,
from http://www.cio.com/archive/011503/eva.html
Damordoran, W. Economic Value Added (EVA). Notes posted to
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html
Katz, R., L., Junqueira, C. Managerial Strategies and the Future of ROIC in
Telecommunications. Booz Allen Hamilton.
Shrieves, R., E., Wachowicz, J., M. (2001). Economic Value Added (EVATM), and Net Present
Value: A Reconciliation of Variations of Discounted-Cash-Flow (DCF) Valuation. The
Engineering Economist, 46, 33-53.
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