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Nam Duong Essay

1743 words - 7 pages

Chapter 12

12A-1

Economic Value Added and the Measurement
of Financial Performance
Chapter 12 shows how to calculate the appropriate discount rate for capital budgeting and
other valuation problems. We now consider the measurement of fi nancial performance.
We introduce the concept of economic value added, which uses the same discount rate
developed for capital budgeting. We begin with a simple example.
Many years ago, Henry Bodenheimer started Bodie’s Blimps, one of the largest highspeed blimp manufacturers. Because growth was so rapid, Henry put most of his effort into
capital budgeting. His approach to capital budgeting paralleled that of Chapter 12. He forecast cash flows for ...view middle of the document...

However, while ROA was generally
effective in motivating his managers, there were a number of situations where it appeared
that ROA was counterproductive.
For example, Henry always believed that Sharon Smith, head of the supersonic division, was his best manager. The ROA of Smith’s division was generally in the high double
digits, but the best estimate of the weighted average cost of capital for the division was
only 20 percent. Furthermore, the division had been growing rapidly. However, as soon
as Henry paid bonuses based on ROA, the division stopped growing. At that time, Smith’s
division had aftertax earnings of $2,000,000 on an asset base of $2,000,000, for an ROA of
100 percent (ϭ $2 million͞$2 million).
Henry found out why the growth stopped when he suggested a project to Smith that would
earn $1,000,000 per year on an investment of $2,000,000. This was clearly an attractive
project with an ROA of 50 percent (ϭ $1 million͞$2 million). He thought that Smith would
jump at the chance to place his project into her division because the ROA of the project was
much higher than the cost of capital of 20 percent. However, Smith did everything she could
to kill the project. And, as Henry later figured out, Smith was rational to do so. Smith must
have realized that if the project were accepted, the division’s ROA would become:

www.mhhe.com/rwj

Appendix 12A

Risk, Cost of Capital, and Capital Budgeting

$2,000,000 ϩ $1,000,000
_____________________ ϭ 75%
$2,000,000 ϩ $2,000,000

Earnings after tax is EBIT (1 Ϫ tc) where EBIT is earnings before interest and taxes and tc is the tax rate.

1

ros05902_ch12_appendix.indd 1

10/31/06 11:34:56 AM

12A-2

Part III Risk

Thus the ROA of Smith’s division would fall from 100 percent to 75 percent if the project were
accepted, with Smith’s bonus falling in tandem.

Henry was later exposed to the economic value added (EVA) approach,2 which seems to
obviate this particular problem. The formula for EVA is:
[ROA Ϫ Weighted average cost of capital] ϫ Total capital
Without the new project, the EVA of Smith’s division would be:
[100% – 20%] ϫ $2,000,000 ϭ $1,600,000
This is an annual number. That is, the division would bring in $1.6 million above and
beyond the cost of capital to the firm each year.
With the new project included, the EVA would jump to:

www.mhhe.com/rwj

[75% Ϫ 20%] ϫ $4,000,000 ϭ $2,200,000
If Sharon Smith knew that her bonus was based on EVA, she would now have an incentive to accept, not reject, the project. Although ROA appears in the EVA formula, EVA
differs substantially from ROA. The big difference is that ROA is a percentage number and
EVA is a dollar value. In the preceding example, EVA increased when the new project was
added even though the ROA actually decreased. In this situation, EVA correctly incorporates the fact that a high return on a large division may be better than a very high return
on a smaller division. The situation...

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