A question of values
by Steve Jay
01 Oct 2001
It is generally accepted that the objective of corporate financial management is to maximise
shareholder wealth in the form of rising share prices and dividends. Whilst this is obviously in
the interest of shareholders it should also benefit society as a whole. This is because it should
lead to the most efficient companies finding it easiest to raise new share capital and thus ensure
that society’s scarce resources are allocated and managed most efficiently. Unfortunately
history shows us that accounting profit measures often appear to have little correlation with
share price performance. This is particularly true in new-economy companies, many of which
have poor profit records but who have demonstrated large increases in wealth for their investors
during the 1990s.
Market Value Added
Before proceeding with a look at economic value added it is important that we clarify our
measure of shareholder wealth. Imagine two quoted companies A plc and B plc. Both firms are
entirely equity financed. Both have a start of year stock market equity capitalisation of £400
million. A raises £20 million via a rights issue and invests it in a project that adds £100m to the
present value of its future earnings. B raises £150 million via a rights issue and invests in a
project that adds £120m to the present value of its future earnings. Table 1 demonstrates the
changes to equity market capitalisation and shareholder wealth.
Table 1 Changes in Stock market value
Opening Total Value (equity market capitalisation)
Addition to Present value of earnings stream
Closing Total Value (equity market capitalisation)
Changes In shareholder wealth
Increase in Total Value (equity market capitalisation)
Funds subscribed by shareholders
Market value added for the period
A
£400m
£100m
£500m
B
£400m
£120m
£520m
£100m
(£20m)
£80m
£120m
(£150m)
(£30m)
It is clear that although company B has the greater increase in market capitalisation it has
decreased the wealth of its shareholder’s as the present value of the future income generated by
its new project is less than the funds invested. Company A on the other hand adds £80m to the
wealth of its investors.
This is a simple but important point. Shareholder wealth is not simply the increase in stock
market value over the period; rather it is the increase in stock market value less funds
subscribed by shareholders.
This concept can be enlarged to cover the whole life of the business. Over a longer time period
the market value added is the difference between the cash that investors have put into the
business (either by purchase of shares or the reinvestment of potentially distributable profits)
and the present value of the cash they could now get out of it by selling their shares.
The link with NPV
None of the above is particularly new. NPV is a well-established rule that measures the impact
that new projects will have on shareholder wealth. Table 2 adds some more detail to the two
projects being considered by companies A and B.
Table 2 Cash Flows
t0 Initial investment
t1-t4 Net cash flow pa
CAPM based required rate of return
£m
Company A Project
(20)
35.03
15%
£m
Company B Project
(150)
46.35
20%
Net Present value Project A = (20) + Annuity factor for 4 years @ 15% * 35.03
=(20) + 2.855 * 35.03
=80
Net Present value Project B = (150) + Annuity factor for 4 years @ 20% * 46.35
=(150) + 2.589 * 46.35
=(30)
Both of these figures correspond with the Market Value Added in the period and the NPV rule
should guide managers to select projects that maximise shareholder wealth.
Economic Value Added
So far we have established that the prime objective of financial management is to maximise
investor wealth and that this can be achieved by using NPV in decision making. What is lacking
is an operating performance measure for management that will guide managers to maximise
NPV and thus shareholder wealth.
Traditionally operating managers are judged on accounting profit based measures (controllable
profit, return on investment, etc), which we have noted, often lack correlation with shareholder
wealth and largely ignore NPV. It seems very strange that we expect managers to evaluate new
projects on the basis of NPV but that we subsequently ignore NPV in appraising managerial
performance.
Economic value added attempts to cure this problem. Economic value can be defined as:
Cash Earnings before interest but after tax* – an imputed charge for the capital consumed.
*often referred to as NOPAT (net operating profit after tax)
In this way a manager’s operating performance is judged after charging a £ amount for capital
funds used.
It will be noted that this is very similar to residual income, a performance measure you will
have considered in earlier studies.
Crucially the present value of the economic value added figures equals the NPV of the project.
Economic Value added is sometimes referred to as EVA®. EVA® is the registered trademark
of Stern Stewart and Co who have done much to popularise and implement this measure of
residual income.
Table 3 shows the calculation of economic value added for our two projects and demonstrates
its equivalence with NPV.
Table 3
£m
t1
t2
t3
t4
Company A Project
Year beginning Capital employed (net)
Net of tax operating cash flow
Economic depreciation*
Imputed capital charge (15% of capital employed)
Economic Value added
20
35.03
(5)
(3)
27.03
15
35.03
(5)
(2.25)
27.78
10
35.03
(5)
(1.5)
28.53
5
35.03
(5)
(0.75)
29.28
Company B Project
Year beginning Capital employed (net)
Net of tax operating cash flow
Economic depreciation*
Imputed capital charge (20% of capital employed)
Economic Value added
150
46.35
(37.5)
(30)
(21.15)
112.5
46.35
(37.5)
(22.5)
(13.65)
75
46.35
(37.5)
(15)
(6.15)
37.5
46.35
(37.5)
(7.5)
1.35
Equivalence with NPV
Company A Economic Value Added
PV factors @15%
Present Value
27.03
0.870
23.52
27.78
0.756
21.00
28.53 29.28
0.658 0.572
18.77 16.75
Total Present Value = £80.04 million = Project NPV (difference due to rounding)
Company B Economic Value Added
PV factors @20%
(21.15) (13.65) (6.15) 1.35
0.833
0.694
0.579 0.482
Present Value
(17.62) (9.47)
(3.56) 0.65
Total Present Value = (£30million) = Project NPV
*Economic depreciation measures the true fall in the value of assets each year through wear
and tear and obsolescence. Although depreciation would not normally be charged in
calculating discounted cash flow in this case it must be recovered from a company’s cash flow
“to provide investors with a return of their capital before they can enjoy a return on their
capital.” G Bennett Stewart . Alternatively it could be viewed as the capital expenditure the
firm would have to make each year to maintain its capital base. In this example, for simplicity,
economic depreciation is assumed to occur on a straight-line basis though clearly other patterns
are possible.
The Linkages
To recap
The increase in shareholder wealth
= Market value added
= Project NPV
= Present Value of Economic Value added.
Therefore if we tell managers that their performance will be judged upon economic value
added, this should result in the maximisation of NPV and thus shareholder wealth. We now
have a performance measure that corresponds exactly with NPV based decision-making.
Proponents therefore recommend that manager’s and division’s operating performance should
be measured on an economic value added basis.
Some complications
Geared companies
Not all companies are financed entirely by equity – many fund substantial parts of their plant
and equipment by using debt finance. The principles of economic value added still apply. Cash
earnings before interest but after tax are charged for capital at a rate that blends the after tax cost
of debt and the cost of equity in the target proportions the firm would plan to employ (rather
than the actual mix used in a particular year). Imagine that company A financed its project by
50% equity finance and 50% risk free debt finance and that this was considered to reflect the
target capital structure. To reflect this higher gearing A’s cost of equity finance increases to
18.5%. Its post tax cost of debt is 7%. This gives a weighted average cost of capital for the
project of
18.5% * 50% + 7% * 50% = 12.75%
The capital charge to the project will now be at 12.75% of year beginning capital employed.
Note that interest on the loan should not be deducted from the net of tax operating cash flow as
it is allowed for in the imputed capital charge. The tax relief on interest should not be allowed
for in the tax bill, as once again this is included in the capital charge. Students will note that this
is similar to the approach taken in estimating net cash flow in NPV calculations. This approach
is illustrated in Table 4 together with other adjustments.
Table 4 XYZ plc Profit and loss account year ended 31/12/2000 (Unadjusted)
£m
Sales Revenue
50
Cost of sales
28.3
Depreciation
0.8
Interest paid
1.6
R&D
2.1
Advertising
2.3
Amortisation of goodwill
1.3
Profit before tax
13.6
Tax paid (30%)
4.08
Available to equity
9.52
XYZ plc Balance Sheet as at 31/12/1999 (unadjusted)
Fixed assets (net)
Current Assets
Less Current Liabilities
Borrowings
Net assets
Ordinary shareholders funds
£m
40
125
98
27
40
40
XYZ plc Profit and loss account year ended 31/12/2000 after adjustments
£m
Profit before tax
13.6
Add
Interest paid
1.6
R&D
2.1
Advertising
2.3
Goodwill
1.3
Less
Adjusted Tax bill
4.56
Adjusted profit
16.34
note 1
note 2
note 3
note 4
note 5
note 7
XYZ plc Balance Sheet as at 31/12/1999 after adjustments
Ordinary shareholders funds
Add
borrowings
£m
40
27
note 1
R&D
Advertising
Goodwill
Adjusted capital employed
Adjusted return
Required Return £104.3 m * 15% =
EVA®
13.4
15
8.9
104.3
16.34
15.645
0.695
note 2
note 3
note 6
Economic value added and reported accounting results
Published accounting profit figures are more complicated than operating cash flow less
economic depreciation as featured in Table 3. For reasons of prudence, losses are often
recognised at an early date and accruals accounting makes many timing adjustments to cash
flow in converting it to accounting profit.
As we are really interested in economic profit rather than accounting profit these adjustments
have to be eliminated or added back in. The consulting firm Stern-Stewart have identified 164
performance measurement issues in its calculation of EVA® from published accounts. The
adjustments mainly involve:
1. Converting accounting profit to cash flow
2. Distinguishing between operating cash flows and investment cash flows
They include such issues as treatment of stock valuation, revenue recognition, bad debts, the
treatment of R&D, advertising and promotion, pension expenses, contingent liabilities etc.
Whist it is unlikely that you would have to make 164 adjustments in the exam some simple
changes may be required! Some of these are demonstrated in Table 4 which includes a
calculation of EVA® from a set of published results. See Table 4.
Conclusion: this company has added value for its shareholders.
Notes
1. Interest paid is added back as this will be charged in the imputed capital charge.
Borrowings are added to the capital base as profits must cover the cost of borrowings
(see geared companies above).
2. R&D is considered an investment in the future in the same way as expenditure on capital
equipment. £2.1m is therefore removed from the P&L account. At the same time the last
say 5 years R&D expense (assumed £13.4m) is added back to the balance sheet. This
will increase the capital base and thus the imputed capital charge. A small charge for
R&D may remain in the P&L to reflect the economic depreciation of the capitalised
value.
3. Advertising is a market building investment and is removed from the P&L. The last say
5 years advertising expense is added to the capital base (assumed £15m). A small charge
for advertising may remain in the P&L to reflect the economic depreciation of the
4.
5.
6.
7.
capitalised value.
Goodwill represents the premium paid for a business on acquisition. Again this is an
investment in the future and similar adjustments as for R&D and advertising apply. The
cumulative advertising write off of (assumed) £8.9m is added to the capital base.
The tax figure will include tax relief on debt interest. As this will be allowed for in the
weighted average cost of capital it should be adjusted out. The tax bill will rise to 4.08 +
(30% * £1.6m)= £4.56m.
This is an assumed 15% WACC applied to the adjusted capital employed. Note that
WACC would be calculated following the approach outlined in geared companies
above.
No adjustment is made for depreciation as this is assumed to approximate economic
depreciation on physical assets as discussed above.
Arguments for and against Economic Value Added
FOR

It makes the cost of capital visible to managers. Under conventional management
accounting performance measures the only profit and loss charge for capital is
depreciation on the asset. Under the economic value added approach managers will also
be charged the financing cost of capital employed. This should cause managers to be
more careful in investing new funds and to control working capital investment. It can
also lead to under-utilised assets being disposed of. To improve their performance
managers will have to:
– Invest in positive NPV projects; or
– Eliminate negative NPV operations; or
– Reduce the firms Weighted average cost of capital.
Or hopefully all three.

It supports the NPV approach to decision making. If managers pursue negative NPV
projects they will eventually find that the imputed capital charge outweighs earnings and
will lead to a deterioration in their reported performance.
AGAINST

Economic Value added does not measure NPV in the short term. Some projects have
poor cash flows at the beginning but much better ones at the end (and vice versa).
Projects with good NPVs may show poor economic value added in earlier years and thus
be rejected by managers with an eye on their performance measure. Managers who have
a short-term time horizon (possibly due to impending promotion or retirement) could
still make decisions that conflict with NPV and thus the maximisation of shareholder
wealth.
If we return to projects being considered by companies A and B but this time alter the pattern of
cash flows (but not the NPVs) the point will be clearer. Table 5 illustrates this point.
Table 5 Cash Flows
t0 Initial investment
t1
t2
t3
t4
£m
Company A Project
(20)
5
5
5
154.87
Company B Project
(150)
133.52
5
5
5
CAPM based required rate of return
NPV
15%
80
20%
(30)
NPVs are unchanged and should therefore have the same effect on Market value added as
before.
Economic Value added computation
Company A Project
Year beginning Capital employed (net)
Net of tax operating cash flow
Economic depreciation
Imputed capital charge
(15% of capital employed)
Economic Value added
Company B Project
Year beginning Capital employed (net)
Net of tax operating cash flow
Economic depreciation
Imputed capital charge
(20% of capital employed)
Economic Value added
20
5
(5)
15
5
(5)
10
5
(5)
5
154.87
(5)
(3)
(2.25)
(1.5)
(0.75)
(3)
(2.25)
(1.5)
149.12
150
133.52
(37.5)
112.5
5
(37.5)
75
5
(37.5)
37.5
5
(37.5)
(30)
(22.5)
(15)
(7.5)
66.02
(55.0)
(47.5)
(40.0)
Conclusion
The present value of the economic value added figures is still equal to the projects NPV (check
it for yourselves) but the year-by-year distribution of economic value added has changed.
Managers with a short term time horizon may well accept company B’s project but reject
company A’s project

Validity of EVA® adjustments
Part of the problem with economic value added in the short-term lies in the accounting
measurement of profit. In table 5 company A’s project might show poor cash flow
earlier on due to large investments in R&D. To a certain extent this problem can be
removed by using the adjustments proposed by Stern and Stewart covered above.
However Brealey and Myers question if these adjustments to accounting profit are
sufficient. They cite the case of Microsoft and question whether its capital base has been
understated in published Stern Stewart EVA® figures. “The value of its intellectual
property- the fruits of its investment in software and operating systems is not shown in
the balance sheet” This would undervalue its capital base and result in imputed capital
charge being too small and thus overstate its EVA®
Shareholder Value Added (SVA)
Shareholder value is a much-discussed concept and many companies now express a
commitment to it. It should be noted however that economic value added is simply one way of
measuring the increase in shareholder wealth achieved by the company.
Kevin Mayes gave a useful overview of the various shareholder value metrics in a students’
newsletter article in the November/December 2000 edition. Of these competitors to EVA®
Shareholder Value Added is also included in the Paper 3.7 syllabus.
Shareholder Value Added involves calculating the present value of the projected future free
cash flows of the business. Any increase in this present value should result in an equivalent
increase in market value added and thus increase shareholder wealth.
Free cash flow is the cash flow available to a company from operations after interest expenses,
tax, debt repayments and lease obligations, any changes in working capital and capital spending
on assets needed to continue existing operation (i.e. replacement capital expenditure equivalent
to economic depreciation)). Although different definitions of free cash flow exist they all relate
to cash flow after replacement capital expenditures. Free cash flow in our definition represents
the cash available to shareholders, which in principle could be used to invest in new positive
NPV projects, paid out as dividend or used for share repurchase. The present value of this free
cash flow should equal the current equity market capitalisation of the business, and any changes
in this present value (less shareholder funds subscribed) represent the market value added.
Table 6 gives an example of the types of calculation involved.
Table 6
A company prepares a forecast of future free cash flow at the end of each year. A period of 15
years is used as this is thought to represent the typical time horizon of investors in this industry.
The company’s CAPM derived cost of equity is 10%. During 2000 a rights issue of £5m is
made which is invested in a project that will increase future earnings. Note that present values
are calculated at a cost of equity as free cash flow is measured after debt servicing costs i.e. it
represents a return to equity holders. If debt interest and principal payments had been excluded
from the free cash flow calculation then the present value would have been calculated at the
WACC as this version of free cash flow represents a return to both equity and debt holders.
The resultant present values would then represent the value of debt plus equity in the company.
The value of equity could be calculated by subtracting the stock market value of debt.
Free cash flow forecast as at 31 /12/99
Sales
Operating costs
Interest
Debt repayments
Working Capital
Replacement capital Expenditure
Tax
Free cash flow
PV factors @10%the company’s cost of equity
Present Value of free cash flow
Total present value
£m
t1
10.000
-4.000
-1.000
0.000
-0.500
0.000
-1.000
3.500
0.909
3.182
36.337
Free cash flow forecast as at 31 /12/00
Sales
Operating costs
Interest
Debt repayments
Working Capital
Replacement capital Expenditure
Tax
Free cash flow
PV factors @10%the company’s cost of equity
Present Value of free cash flow
Total Present Value
t1
12.000
-5.000
-1.000
-4.000
-0.500
-3.000
-1.000
-2.500
0.909
-2.273
43.773
Present value of free cash flow as at 31/12/99
Present value of free cash flow as at 31/12/00
Increase in present value
Funds subscribed by shareholders in the year
Market value added
36.337
43.774
7.436
5.000
2.436
Conclusion
This company has increased the wealth of its shareholders.
Arguments for and against the Shareholder value added approach
For
t2
12.000
-5.000
-1.000
-4.000
-0.500
-3.000
-1.000
-2.500
0.826
-2.065
t3-t15
14.000
-6.000
-0.500
0.000
-0.500
0.000
-1.000
6.000
5.870
35.220
t2
14.000
-6.000
-0.500
0.000
-0.500
0.000
-1.000
6.000
0.826
4.956
t3-t15
15.000
-6.000
-0.500
0.000
-0.500
0.000
-1.000
7.000
5.870
41.090

It takes a multiperiod view and should therefore overcome some of the “short termism”
of EVA.
Against


The estimates of future free cash flow are very subjective and are very difficult to
verify. This technique would almost be impossible for outsiders to the business use.
The time horizon over which free cash flow is forecast is difficult to determine. If you
use a short period you lose the present value earned in later years, but if a long period is
used the forecasting of cash flows becomes very subjective.
Conclusions
Shareholder value is high on the agendas of many companies as shareholders increasingly look
for competitive rates of return on their investments.
The two metrics discussed here draw heavily on traditional financial management and
management accounting theory. EVA, SVA and free cash flow are all included in the Paper
P4 syllabus and are 'fair game' for future exam questions.
References and Acknowledgements
1. G. Bennett Stewart III, EVA Fact or Fantasy, Journal of Applied Corporate Finance,
Summer 1994.
2. R. Brealey & S. Myers, Principles of Corporate Finance, McGraw Hill, 6th Edition,
2000.
3. K. Mayes Shareholder Value, ACCA Students’ Newsletter, November/December 2000.
Thanks to Scott Goddard for his valuable comments on the drafts of this article.