50 Pages Posted: 17 Apr 2008 Last revised: 1 Sep 2009
Date Written: January 15, 2008
The paper reveals some substantial defects crept in the conventional method of calculating EVA's essential component - Capital Charge. Presently the Capital Charge is derived as combination of market capital structure based WACC and accounting based Invested Capital, which is likewise joining apples with oranges. This cross-breeding deflects EVA from the Residual Income and the concept of Economic Profit, formulated by Alfred Marshall. The paper proves that the correct way to calculate Capital Charge is to use accounting WACC embracing relevant adjustments made to the Invested Capital. Properly calculated EVA adequately reflects firm's performance compared with initial opportunity costs existed when the capital was contributed. However shareholders' dollar amount opportunity costs at the moment of performance evaluation depend on the market value of capital and market WACC. The paper also establishes the Residual Market Profit that is based on Market Profit and Market Capital Charge defined as market WACC multiplied Market Value of the Firm. The Residual Market Profit effectively accounts for time value effects and manifests either the firm justifies market expectations about her performance or fails to satisfy them.
Keywords: Economic Value Added (EVA), Residual Income (RI), Performance Measurement, Capital Charge, Weighted Average Cost of Capital (WACC), Accounting WACC, Market WACC, Accounting EVA, Market-based EVA, Cross-Bred EVA, Residual Market Profit, Firm Evaluation, Project Evaluation, Corporate Finance
JEL Classification: G30, G31
Suggested Citation: Suggested Citation
By D Ramana