Understanding Economic Value Added

Understanding Economic Value Added

1. Read the technical note titled “Understanding Economic Value Added” written by Desai

and Ferri.

2. Answer the following questions (please think thru these carefully and write a

well-reasoned, and complete answer)

a. What is the major difference between Net Income as reported on an income

statement and EVA?

Well, to define the two terms, net income is essentially the difference between revenues and expenses. Estimated value added is all based on residual income. Both net income and EVA are ways that a company can showcase their value to investors. Net income is a strong indicator of financial success, but EVA seems to go more concrete into the idea that it is a more accurate measure of a company’s profitability. According to the article and investopedia, to calculate EVA, you need to find the difference between net operating profit after tax and cost of capital and multiply it by total investment capital. EVA essentially unearths the cost of capital that net income or other financial measures ignore. In this case, EVA is a better indicator of which investments work for the company and if you compare it with other companies’ EVA, you can see if your business is outperforming them.

b. What is the major difference between Return on Investment and EVA?

ROI is essentially how much return you can get on your investments. It takes into two factors: income and invested capital. ROI also takes into account the different divisions of the business that have many differences such as size, income of the division’s manager, capital, etc.

Because ROI is almost biased towards managers who are paid based on their numbers, this measure can be manipulated to profit themselves instead of the bu...

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... can still show a strong ROA. The assets that a company has basically run the business, so managers have a higher incentive to focus their attention on the leverage of the assets of the company. But if I had to pick one from the choices, it would have to be cash flows. Everything else can be manipulated so easily. There’s a lot of noncash items that be shown on the financial statements and you can manipulate those (like depreciation) to show investors exactly what they want. But at the end, the amount of cash that is readily available in the business after everything has been paid and taken care of is cash flow. So, putting aside all of the measures that everything in list can account for, cash flow is essential to understand if the business is growing or out. If a company’s cash flow is growing year to year, then it would probably be a smart company to invest in.