Advances in Information Technology and Management (AITM)

Vol. 2, No. 2, 2012, ISSN 2167-6372

Copyright World Science Publisher, United States
www.worldsciencepublisher.org

260

Efficacy of Economic Value Added Concept in Business

Performance Measurement
Sarbapriya Ray
Shyampur Siddheswari Mahavidyalaya, University of Calcutta, India.
Abstract: The idea of Economic Value Added (EVA) is somewhat new detection but the concept is age old. In
contemporary economics and finance literature, EVA holds a less debated part as well as plays crucial role in business
performance measurement. In corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart
& Co, is an estimate of a firm's economic profit being the value created in excess of the required return of the company's
investors (being shareholders and debt holders). This article tries to assess the efficacy of Economic Value Added concept
in business performance measurement. This paper analyses the notion of Economic Value Added (EVA) that is gaining
attractiveness in India and also examines whether EVA is a better business performance measure or not. EVA provides a
basis for the measurement of efficiency and motivates managers to be more efficient with funds, which is usually beneficial.
But, EVA is not contributing to the stock return because the investors reliance and belief is on the provision of dividends to
the share holder rather than increasing worth of the business. However, this method must be cautiously applied to ensure
that it is measuring economic effects appropriately and does not create time-horizon distortion.
Keywords: Residual Income (RI), Shareholders Value, Market Value Added, economic value added, wealth maximization.

1. Introduction
In contemporary economics and finance literature, EVA
holds a less debated part as well as plays crucial role in
business performance measurement. In corporate finance,
Economic Value Added or EVA, a registered trademark
of Stern Stewart & Co, is an estimate of a firm's economic
profit being the value created in excess of the required
return of the company's investors (being shareholders and
debt holders). It is the performance measure most
straightforwardly connected to the creation of shareholders
wealth over time. The very logic of using EVA is to
maximize the value for the shareholders. Economic Value
Added (EVA) analysis measures how profitable it truly is
to run a business instead of selling it.The objective of every
business entity should be to maximize shareholders wealth
by enhancing the firms value and all the activities of a firm
should be directed to achieve this objective. In order to
materialize this objective, shareholder wealth is
conventionally substituted by either standard accounting
magnitudes (such as profits, earnings and cash flows from
operations) or financial statement ratios (including earnings
per share and the returns on assets, investment and equity).
This financial statement information is then used by
managers, shareholders and other interested parties to
assess current firm performance, and is also used by these
same stakeholders to predict future performance. Business

performance is divulged in the maximization of market

value of own capital. The research findings in developed
countries reflect that the correlation between the stated
accounting net profit and stock market movement derived
from it is not physically powerful enough. Therefore, a new
model of measuring business performance-namely
economic value added (EVA) has been emerged in addition
to traditional accounting measures of business performance.
The EVA model in addition to costs of borrowed capital
also brings into consideration own capital costs, which
depend on alternative investments made by investors who
bear the same risk. EVA is the difference between net profit
after tax (NOPAT) and the required return on the financing
of own and others' capital. This way EVA offers a
fundamental role to the drop or increase in value of own
capital. Positive EVA in a given period indicates that the
management increased the value for owners, and negative
EVA implies that there is a decrease of the value for
owners.
In view of the above discussion, this article tries to assess
the efficacy of Economic Value Added concept in business
performance measurement.

2. Evolution of EVA
The idea of Economic Value Added (EVA) is somewhat
new detection but the concept is age old. EVA is

Sarbapriya Ray, AITM, Vol. 2, No. 2, pp. 260-267, 2012

fundamentally indistinguishable to the idea of residual

income (net income minus a charge for the cost of equity
capital) developed by economists such as Alfred Marshall
in the 1890s. Marshall defined economic profit as total net
gains less the interest on invested capital at the current rate.
The Marshallian focus of analysis has been on adjustments
to accounting earnings to reflect the opportunity cost of
capital, primarily because the unadjusted measure can be a
misleading indicator of performance in both theory and
practice.In his seminal book Principles of Economics,
Marshall (1920) is of the notion that: the gross earnings of
management which a man is getting can only be found after
making up a careful account of the true profits of his
business, and deducting interest on his capital. Afterward,
the David Solomon (1965) quantified economic profit as a
measure of wealth creation as the difference between two
quantities, net earnings and the cost of capital. This
measure of residual income is then defined in terms of
after-tax operating profits less a charge for invested capital
which reflects the firms weighted average cost of capital.
Close parallels are thereby found in the related (nontrademarked) concepts of abnormal earnings, excess
earnings, excess income, excess realizable profits and
super profits (Biddle et al., 1997). As Peter Drucker puts
it in his Harvard Business Review (1998, p. 14) article:
EVA is based upon something we have known for a long
time: What we call profits, the money left to service equity,
is usually not profit at all. Until a business returns a profit
that is greater than its cost of capital, it operates at a loss.
Never mind that it pays taxes as if it had a genuine profit.
The enterprise still returns less to the economy than it
devours in resources Until then it does not create wealth;
it destroys it. Dodd & Chen (1996, p. 27) opined that the
idea of residual income appeared first in accounting theory
literature early in twentieth century by e.g. Church in 1917
and by Scovell in 1924 and appeared in management
accounting literature in the 1960s. The origins of the value
added concepts date all the way back to the early 1900's
(Bromwich & Walker, 1998, p. 392). General Motors put
into practice a residual income measure for performance
evaluation and compensation in the 1920s [S. David
Young, 1999]. Over the last two decades, a number of
factors (deregulation and integration of capital markets,
more liquid securities markets, expansion of institutional
investment, advances in information technology) have
considerably increased the mobility of capital, forcing firms
to compete not only in product markets but also in capital
markets, where returning the cost of capitalthe return
expected by investorsis a key success factor. At the same
time, finance theory has evolved making the estimation of a
cost of equity a more accessible task. Also Finnish
academics and financial press discussed the concept as
early as in the 1970s. It was defined as a good way to
complement ROI-control (Virtanen, 1975, p.111). In the
1970s or earlier residual income did not got wide publicity
and it did not end up to be the prime performance measure
in great deal of companies. However EVA, practically the
same concept with a different name, has done it in the

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recent years. Stern Stewart & Co trademarks EVA in

1990s when the tool is introduced and subsequently
adopted by several major corporations that lead EVA to
have successful stories at the very beginning. With the
successive developments and the growing demand for new
value-based management practices that could better line
up the interests of managers with those of shareholders, the
consulting firm Stern Stewart & Company, in the 1980s and
1990s, invigorated the notion of residual income. Stern
Stewart developed this notion into a broader, EVA-based
management control system, implemented at dozens of
large, publicly traded companies including AT&T, CocaCola, and Quaker Oats. O'Hanlon & Peasnell (1998)
thoroughly discuss EVA as a value-based performance
indicator, Stern Stewart Co intricate adjustments, EVA
benchmarks, and EVA-based bonuses. Bromwich &
Walker (1998) add to the theoretical discussion by
pondering the EVA debate all the way from Hicksian
income concepts.

3. Economic Value Added (EVA)

Meaning of EVA is nothing but a new version of the
age-old residual income concept recognized by economists
since the 1770's. Both EVA and residual income concepts
are based on the principle that a firm creates wealth for its
owners only if it generates surplus over the cost of the total
invested capital. Despite the relatively recent adoption of
EVA as an internal and external financial performance
measure, its conceptual underpinnings derive from a wellestablished microeconomic literature regarding the link
between firm earnings and wealth creation (Bell, 1998).
EVA, or Economic Value Added, is such a metric that
seeks to improve and measure efficiency and value
creation (Shaked & Leroy, 1997, p. 1; Stewart, p.
3).Economic Value Added (EVA) is a trademark of the
Stern Stewart consulting organization. Stern Stewart
maintains that the implementation of a complete EVAbased financial management and incentive compensation
system gives managers both better information and superior
motivation to make decisions that will create the greatest
shareholder wealth in any publicly-owned or private
organisation. Stewart defines EVA to be the difference
between the profits each unit derives from its operations
(NOPAT) and the charge for capital each unit incurs
through the use of its credit line (Stewart, 1991,p. 224
).Economic value added as an innovative approach to the
measurement of business performance gives us a more
realistic overview about the current state of the company.
Taking into account the cost of equity and the possibility of
execution of numerous accounting modifications represent
significant innovations regarding to other concepts. EVA is
the amount of economic value added for the owners by
management. The thrust area for todays management is to
find means to create value for the owners. It is now
established that the accounting profit in no cases represents
the real value created for the owners. But, it may originate
the calculation. In other words, accounting profit is required

Sarbapriya Ray, AITM, Vol. 2, No. 2, pp. 260-267, 2012

to be converted into economic profit. Under EVA, all

distortions in conventional accounting are identified and
accounting profit is adjusted to make it distortion free and
finally we get the amount of EVA.
Peter Drucker has suggested in a Harvard Business
Review article that until a business returns a profit that is
greater than its cost of capital, it operates at a loss. This is
in spite of the fact that it still pays tax as if it had a genuine
profit. Drucker observes that such organizations return less
to the economy than they consume in resources, and that
instead of creating they are in fact destroying wealth.
EVA explicitly recognizes that when managers employ
capital they must pay for it in the same way that they would
pay other operating expenses. By taking all capital costs
into account, including the cost of equity, EVA shows the
amount of wealth a business has created or destroyed in
each reporting period. In other words, EVA represents
profit the way shareholders define it.
Economic value added is the difference between net
operating profit after taxes (NOPAT) and cost of capital. It
can be calculated using the following formula (Stewart,
1991, pp. 136-137):
EVA = NOPAT - WACC% * IC,
whereas: EVA = Economic value added; NOPAT = Net
operating profit after tax, WACC% = weighted average
cost of capital; IC = Total business capital invested.
Stewart defined EVA (1990, p.137) as Net operating profit
after taxes (NOPAT) subtracted with a capital charge.
Algebraically, it can be stated as follows:
EVA= NOPAT- Capital Costs
NOP (1-T)- Capital Employed Cost of Capital
Adjusted NOP (1-T)- Capital Employed WACC
Adjusted NOP (1-T)- [Capital Employed {(R e E/CE)+(
R d D/ CE) (1-T) + ------}]
Return- Capital EmployedWACC
(Rate of ROI- WACC) Capital Employed -------------(1)
NOPAT: Net operating profit after taxes (NOPAT) is
simply a fully taxed version of operating profits (Earnings
Before Interest and Taxes, EBIT). It is worth noting that
interest payments are not deducted prior to calculating
NOPAT. The cost of debt financing and the value of the
resulting interest-tax shields are reflected in the after-tax
cost of debt.
Cost of Capital: The weighted average cost of capital
(WACC) measures the composite return expected by all of
the firms investors. The specific returns expected by debt
and equity holders are estimated using the Capital Asset
Pricing Model (CAPM), while the weights of debt and
equity should be based on their market values.
Capital Employed: The amount of capital employed can be
calculated in two equivalent ways. One approach focuses
on the right side of the balance sheet and defines invested
capital as the sum of shareholders equity and any interest-

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bearing debt (long-term debt, short-term debt, other longterm liabilities). This method, also known as the financing
approach, is a direct expression of the net funds that
investors have committed to the firm. The other approach
focuses on the left side of the balance sheet and defines
invested capital as the difference between total assets and
short-term, non-interest bearing liabilitiesknown as the
operating approach.
In assessing EVA, one should recognize that it is an
annual measure of performance with a historic perspective.
The use of EVA represents an attempt to measure whether
the management of an entity has used available funds in
order to create or destroy value. Typical adjustments
that are required in EVA calculations include
Adjustment to net profit
Add: net capitalised intangibles
Add: goodwill written off and accounting depreciation
(deduct cumulative depreciation previously economic
depreciation)
Add: increases in provisions such as those in respect of bad
debts and deferred tax .
Capital being used in EVA calculation is not the book
capital, capital is defined as an approximation of the
economic book value of all cash invested in going-concern
business activities, capital is essentially a companys net
assets (total assets less non-interest bearing current
liabilities), but with following adjustments:
Adjustment to capital employed
Subtract marketable securities and construction in
progress
Add: net book value of intangibles
Add :present value of noncapitalized leases to net property,
plant, and equipment.
and Add cumulative goodwill written off
Add :provisions such those in respect
Add :R&D expense that is capitalized as a long-term asset
Add: back interest on debt capital
Add: debt to net assets such that it forms part of capital
employed
Add: Cumulative unusual losses (gains) after taxes that are
considered to be a long-term investment.
The purposes of such adjustments are to quantify capital
at nearer to the current value, to embrace all investments
that are treated as period costs by accountants (such as
R&D expenditure) and to get EVA closer to the real cash
flows of the company. These adjustments are done to depict
an EVA figure nearer to cash flows, and less subject to the
distortions of accrual accounting. It eliminates the arbitrary
distinction between investments in tangible assets, which
are capitalized, and intangible assets, which tend to be
written off as incurred and avert the amortization, or writeoff, of goodwill, convey off-balance sheet debt into the

Sarbapriya Ray, AITM, Vol. 2, No. 2, pp. 260-267, 2012

balance sheet and tries to rectify biases caused by

accounting depreciation. ( S David Young,1999).
The arguments for adjustments are depicted below:
(i).Only the costs of successful investments (those with
future economic significance) are capitalised and placed on
the balance sheet. Unsuccessful investments are
conventionally written off. EVA proponents say that the
unsuccessful investments are just as important to
shareholders as successful investments and should go on
the balance sheet and the loss will be recognized gradually
in future periods in the form of higher capital charges, and
thus lower EVA.
(ii). Proponents of EVA recommend R&D to be capitalized.
The logical ground put forth by them is that manager of a
company that does not capitalize R&D might be tempted to
under-investment because short-term profits will be
adversely affected by R&D expenditures whereas the
benefits will not be realized until future periods (Young,
1999, p. 11). To capitalize R&D, the adjustment is to add
back R&D costs to NOPAT and shareholders equity. The
capitalised costs are then written off gradually, with an
amortization period based on the number of future periods
expected to benefit from whatever products or services are
developed from the R&D (Young, 1999, p.10). It has been
observed that once a steady state is reached, operating
income is not affected by the R&D adjustment a firm that
capitalizes R&D as compared to the firm that follows
conventional accounting. However, the EVA figure is
lower in the firm that capitalised R&D, and this more
accurately reflects the higher capital charges.
(iii). Deferred tax assets arise when provisions are made for
future costs that serve to reduce current book income.
These may include provisions for warranties, restructuring
and environmental clean up. The net change of EVA is to
add (or subtract) these changes in deferred tax to more
accurately reflect the actual cash flows to tax authorities. In
other words, the deferred tax adjustment brings EVA
closer to cash flows, and thus eliminates any influence on
profits from one of the most important components of
accrual accounting (Young, 1999, p. 12).
(iv). Intangibles (especially goodwill arising from corporate
acquisitions) are not automatically written off in an EVA
system. The argument is that the write-off of goodwill
(whether at acquisition or more gradually through
capitalization and amortization) effectively removes at least
part of the acquirers investment in the target from the
balance sheet, thereby lessening managements burden
to earn a competitive return on that portion of invested
capital (Young, 1999, 12).
(v). EVA proponents argue that EVA should be constant
over the life of the asset, and should be depreciated in
exactly the same way that bank loans are amortized
(Young, 1999, p. 14).

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(vi). Restructuring changes that involve cash payments are

considered capital under EVA. The argument is that such
adjustments should only be made to generate returns in a
later period, and therefore should also provide an
appropriate return.
The crucial point of departure for EVA from RI is the
adjusting of both NOPAT and CAP for supposed
distortions in the accounting model of performance. EVAtype adjustments are made to both accounting measures of
operating profits (NOPAT), and accounting measures of
capital (CAP). EVA thereby reflects adjustments to GAAP
in terms of both operating and financing activities.
Therefore, net operating profit is adjusted for
accounting distortions and a charge on capital employed at
the rate of weighted average cost of capital (WACC) is
subtracted from NOPAT to reach to the amount of EVA.
The EVA equation suggests that earning a return greater
than the cost of capital increases value for the owners and
vice versa.
Stewart defined an alternative measure that evaluates
whether a company has created shareholders wealth. If the
total market value of a company exceeds the amount of
capital invested in it, the company has managed to create
shareholder value. If reverse is the case, i.e., the market
value is less than the amount of capital invested, the
company has ruined shareholder value. Stewart (1990,
p.153) calls it as Market Value Added (MVA) and can be
equated as follows:
MVA= Market Value of the Company- Capital Invested
Market Value of Equity-Book Value of Equity (It has
been assumed that capital invested is Book Value of
Equity)
( Market Value of Equity-Book Value of Equity) No of
shares outstanding
Present value of all future EVA------------ (2)
In other words,
Market Value of Equity= Book Value of Equity+ Present
value of all future EVA----- (3)
Positive MVA indicates that market-to-book ratio is
more than one. Negative MVA, on the other hand, signifies
market-to-book ratio less than one. If a companys rate of
return exceeds its cost of capital, the company will sell on
the stock markets with premium compared to the original
capital. On the other hand, companies that have rate of
return smaller than their cost of capital sell with discount
compared to the original capital invested in company.
The main distinguishing feature of MVA is that it is largely
a cumulative measure and therefore communicates the
markets present verdicts on the net present value (NPV) of
all the firms past, current and contemplated capital
investment projects (OByrne, 1996, p. 199). However, in
contrast to MVA, EVA is a measure that focuses on firm
performance over a specific period. It therefore has a
similar time perspective to the second set of firm

Sarbapriya Ray, AITM, Vol. 2, No. 2, pp. 260-267, 2012

performance measures; namely, earnings before

extraordinary items (EBEI), net cash flow from operations
(NCF) and residual income (RI).
The appeal of EVA lies in its intuitive interpretation. A
positive EVA suggests that the firm has generated profits in
excess of the amount required to remunerate investors (at
market rates) for the capital they have provided. In short,
the firm has paid its operating and capital costs and created
additional wealth. Negative EVA, instead, suggests that the
firm devours resources (in Peter Druckers terms)
without providing a commensurate return for their use.

4. Role of EVA in business performance

measurement
Stern Stewart argues that EVA is the financial
performance measure that arrests the true economic profit
of an organization, and is the performance measure most
directly linked to the creation of shareholder wealth over
time. EVA is an estimate of the amount by which earnings
exceed or fall short of the required minimum rate of return
that shareholder and debt holder could get by investing in
other securities of comparable risk. Stern et al (ed 2001)
suggest that when fully implemented EVA will be the
centerpiece of an integrated financial management system
that incorporates the full range of corporate financial
decision making.
Under conventional accounting, most companies seem
profitable but many in fact are not. Company may
intentionally pay tax to prove that they have made profit for
their shareholders and thus a falsification is done with
owners that is not a rare corporate practice. EVA corrects
this error by explicitly recognizing that when managers
employ capital, they must pay for it, as if it were a wage. It
also adjusts all distortions that are very much prevalent in
the information generated by conventional accounting.
Thus, it is the most demanded tool for the owners in every
situation. Proponents of EVA argue that EVA is a superior
measure as compared to other performance measures on the
grounds that i) it is nearer to the real cash flows of the
business entity;(ii) it is uncomplicated to calculate and
understand;(iii) it has a higher correlation to the market
value of the firm and its application to employee
compensation leads to the alignment of managerial interests
with those of the shareholders, thus minimizing the
supposedly dysfunctional behavior of the management.
EVA might also be suitable to uniting the interests of
the management/owners and ordinary employees.
According to professors Michael J. Jensen from Harvard
Business School and Kevin J. Murphy from University of
Chicago, the biggest problem with top management salaries
is that managers are currently paid like bureaucrats rather
than like value maximizing entrepreneurs (Jensen &
Murphy 1990, p.1). They also affirm that traditional bonus
systems produce far too small incentives for good
performers and guarantee too big compensation for
mediocre performers (1990, p.3). EVA can also be used in
Group-level controlling of operations. EVA may also

264

ensure optimum capital structure by making the firm

properly levered.
The capital charge is the most distinctive and important
aspect of EVA. Under conventional accounting, most
organizations appear profitable, but many, in fact, are not
creating value. By taking all capital costs into account,
including the cost of equity, EVA shows the amount of
wealth a business has created or destroyed in each reporting
period. In other words, EVA represents profit the way
shareholders define it. Stern et al (2001) argue that the
development of EVA coincides with the increased
empowerment of managers as decision makers, and is a
tool to meet the potential agency issues that are created
when ownership and management are separated. Stern et al
argue that a sustained increase in EVA will precipitate an
increase in the market value of an organization and suggest
that the adoption of an EVA approach has proved effective
in virtually all types of organisation, from emerging growth
companies to those organisations involved in turnaround
situations that bring continuous increases in shareholder
wealth.
Compensation methods based on EVA facilitates in
achieving the objective of goal congruence and minimizes
the agency cost. Use of EVA improves internal corporate
governance in the logic that it motivates manager to get rid
of value destructive activities and to invest only in those
projects that are expected to enhance shareholder value.
EVA measures for incentive compensation leads to the
improvement in operating efficiency by increasing asset
turnover.Though EVA fails to provide additional
information to the capital market, it can be used to improve
the internal governance of a firm.Preferably, a management
control system should stimulate managers for self control
rather than managers are being controlled because human
beings have general resistance to controls. Linking
compensation with EVA assists employees in conducting a
self-examination of every action taken by them to ensure
that it enhances EVA of the firm.
Another advantage of EVA is that its applicability is
practically universal. Its simplest application requires only
two of the most commonly used financial statements; the
balance sheet and the income statement, allowing it to be
applied to virtually any company with accurate financial
statements (Mkelinen & Roztocki, p.5 ).The fact that the
principles of EVA (efficiency, increasing wealth) can be
easily conveyed to others, including employees, gives them
a common goal that they can clearly contribute to and
appreciate (Mkelinen & Roztocki, p. 6).While the theory
underlying EVA and its application can be complex, the
basic points it stands for appeal to common sense. EVA can
also be used as a kind of diagnostic tool, showing managers
which sections of the firm need more work to increase a
firms value for the next period (Mkelinen & Roztocki, p.
18 ).
In a nut shell,EVA has the advantage of being
conceptually simple and easy to explain to non-financial
managers, since it starts with familiar operating profits and
simply deducts a charge for the capital invested either in the

Sarbapriya Ray, AITM, Vol. 2, No. 2, pp. 260-267, 2012

company as a whole, or in a business unit, or even in a

single plant, office, or assembly line. EVA can be used as
an effective performance measure because of its ability to
measure results periodically. Advocates of EVA affirm that
its use provides a superior measure of the year-to-year
value that the business creates. Moreover, because EVA
measures performance in terms of value, it should be the
basis of any financial management system used to set
corporate strategy, or to evaluate potential capital
investment
decisions,
corporate
acquisitions,
or
performance.

5. Flip side of EVA

The computation of economic value added emerges
straightforward at sudden look; nevertheless, in practice
there is a whole range of issues. Consequently, the idea of
EVA is simple and theoretically well-designed, but its
implementation is difficult and often takes away much of
the potential benefits. If the accounting values were based
on cash flows, economic value added would more
accurately reflect the economic performances of a
company. In addition, the selection of adaptation methods
is largely marked by subjectivity. The next great problem is
associated with the calculation of the cost of capital.
Financial theory offers a variety of methods, each of them
having their advantages and disadvantages. Although, in
most cases the calculation of the cost of capital is based on
the use of the CAPM model, which was argued to be
inadequate for the less developed capital markets. Similarly
it is complicated to use CAPM in measuring cost of equity
because of the difficulty in measuring risk-free-rate of
return, beta and market premium. Difficulties get multipled
in an economic environment like India, where interest rates
fluctuate recurrently, the capital market is volatile and the
regulators are yet to have a complete hold on the capital
market to improve its efficiency.Empirical studies show
that the volatility in the Indian capital markets, like capital
markets in other developing economies, is higher than
capital markets in developed economies (Tushar Waghmare
2000). In the same way, reseach analyses show that beta for
companies listed in Indian capital markets is not stable
(Sanyal, Guha Roy and Sanyal 2000). It is difficult to
determine the market premium because of the short history
of the Indian capital market and also because of its high
volatility. Consequently, it can be concluded that the
potential of EVA as a measure of performance can be
realized fully in an advanced economy, the argument that
EVA is a better measure is not justifiable in the Indian
context.
(i). The calculation of EVA can be intricate when many
adjustments are required. EVA is difficult to use for interfirm and inter-divisional comparisons because it is an
absolute rather than a relative measure. Allowance should
be made for size when inter-company comparisons are
made

265

(ii). A major disadvantage of EVA is the difficulty to

accept the notion of the universal suitability of EVA. Some
suggest that EVA is not the best choice for all companies.
These experts believe that EVA is more suited to
established companies with few requirements for
Economic Value Added capital expenditures likely
because capital is a major factor in the EVA equation.
(iii). Since EVA is assessed to be a short-term performance
measure, it is not possible for many corporate houses to
adopt EVA in practice because of their focus on long-term
investments. Moreover, the result on the basis of EVA
could be manipulated by early yield projects over longerterm, delayed income stream, higher yield projects.
Management might also limit its investment cash flows,
such as research and development or advertising costs, to
the long-term detriment of the business.
(iv). The inflationary factor may limit periodic EVA to
estimate the value added to shareholders properly.
(v). EVA is a short-run notion dealing only with the current
reporting period, whereas managerial performance
measures should focus on the future results anticipated as a
consequence of present managerial actions. Divisional
performance should be appraised on the basis of economic
income by estimating future cash flows and discounting
them to their present value. This calculation could be made
for a division at the beginning and end of a measurement
period. The difference between the beginning and ending
values would represent the estimate of economic income.
However, the main problem associated with the use of
estimates of economic income to evaluate performance is
that it lacks precision and objectivity. The true return or
true EVA of long-term investments cannot be measured
objectively because future returns cannot be measured; they
can only be subjectively estimated.
(vi). The use of conventional depreciation methods is
indicative of the fact that there is no assurance that the
measurement of EVA in the short-term will be in
conformity with the measurement of EVA in the longerterm. Moreover, a company may have a lot of
undepreciated new assets in its balance sheet and it might
show negative EVA even if the business would be quite
profitable in the long run. Economic depreciation is
difficult to estimate and conflicts with generally accepted
accounting principles, which may hinder its acceptance by
financial managers.
(vii). EVA is possibly not an appropriate key performance
measure for companies that have invested greatly at present
and expect positive cash flow only in a distant future.

6. Summary & Conclusion

Economic value added has become the most fashionable
measurement for determining the ability of a company to

Sarbapriya Ray, AITM, Vol. 2, No. 2, pp. 260-267, 2012

generate an appropriate rate of return. Despite the relatively

recent adoption of EVA as an internal and external
financial
performance
measure,
its
conceptual
underpinnings derive from a well established micro
economic literature regarding the link between firm
earnings and wealth creation.EVA metrics provide
managers with a commanding tool to weigh investment and
spending decisions against capital requirements and
investors expectations. The perception of EVA is based on
the effective economic principle that firms value increases
only if it is able to generate surplus over its cost of capital
and therefore it is based on well-built theoretical
foundation. It can also be linked to a companys
compensation system, so that managers are paid (or not)
based on their ability to combine efficient asset utilization
with profitable operating results. Admittedly, EVA is one
of the ways to evaluate the usefulness of a performance
measure. EVA identifies not only end results, but also the
cost of the input of funds to get the results. This provides a
basis for the measurement of efficiency and motivates
managers to be more efficient with funds, which is usually
beneficial. But, EVA is not contributing to the stock return
because the investors reliance and belief is on the
provision of dividends to the share holder rather than
increasing worth of the business. However, this method
must be cautiously applied to ensure that it is measuring
economic effects properly and does not create time-horizon
distortions.

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