Value Creation and its Measurement: A Critical Look at EVA

Abstract

SUBJECT AREAS: Corporate Finance, Valuation, Capital Budgeting, Investment Policy, Economic Value Added, EVA, Market Value Added, MVA, Net Present Value, NPV, cash flows, free cash flows real free cash flows

This technical note studies Economic Value Added, EVA. First, a conceptual framework regarding Net Present Value, NPV, is presented. Second, the note presents an approach for calculating the free cash flow of a project starting from the periodic net cash flows. Third, a procedure for calculating the real free cash flow is developed. Fourth, the EVA is presented and contrasted to NPV. EVA starts from accounting figures (profit) and NPV starts from net cash flows. The coincidence between MVA and NPV is examined. Four examples are presented which reveal some inconsistencies between the two measurement. The four examples show circumstances where EVA underestimates the value generated by a project or firm as compared with the NPV. An approach for calculating the real EVA is presented. The note offers reflections upon figures that should be employed in order to calculate the cost of the invested capital or equity to be included in EVA calculation. Finally, different approaches to calculate EVA and MVA are compared with NPV results.

JEL Classification: M40, M46, M41, G12, G31, J33