Certain value-based performance measures, e.g., Cash Flow Return on Investment (CFROI), Cash Value Added (CVA), Shareholder Value Added (SVA) and Economic Value Added (EVA) have appeared on the scene to measure the corporate financial performance. Out of these new `trendier' performance measures, the popularity graph of EVA is touching new heights day-by-day and when compared to the traditional measures, it occupies a place of pride on the following grounds:
. EVA is a performance measure most directly linked to the definitive and reliable measure of wealth creation that is Market Value Added (MVA), the difference between the market value of an enterprise and the capital contributed by the shareholders and lenders.
MVA is in fact the cumulative amount by which a company has an enhanced or a diminished shareholder wealth. . The Return on Capital Employed (ROCE), Return on Net Worth (RONW), and ROT, etc., consider only one side of the performance, i.e., they consider the borrowing cost but ignore the cost of equity. This leads the decision-makers and financial analysts towards a failure to highlight whether the return is commensurate with the risk of the underlying assets that ultimately result in biased and inappropriate decisions regarding the rejection of an economically-profitable project or acceptance of unviable projects. For instance, a company's current ROCE is 20% and its overall cost of capital is 16%. It receives a new investment opportunity with an estimated ROCE of 18%, and the cost of capital remains the same (i.e., at 16%). To maximize ROCE, one would reject the said opportunity. But actually, if accepted, it would have added a 2% economic surplus to the shareholders' wealth.
In another case, the present ROCE of a company is 12% and the cost of capital is 16%. It receives a new investment opportunity with an estimated ROCE of 14% with no change in the cost of capital. Again, to maximize ROCE, the said opportunity will be accepted by the company. But, this will destroy the shareholders' wealth as they want to maximize the absolute return above the cost of capital and not maximize the percentages. On the contrary, EVA mechanism gives due recognition to the cost of equity in all managerial decisions from board room to the shop floor and thus, provides a comprehensive and reliable yardstick to measure the shareholders' value creation (or destruction) by an individual business entity focusing on the maximization of absolute return above the cost of capital. |
