In Defense of Eva(R)

27 Pages Posted: 11 Aug 2003

Abstract

Though an increasing number of companies worldwide are using EVA as a measure of corporate performance, it is often criticized as being a wrong measure of corporate performance. It is often argued that the market forms expectations on the market value of the company and not on the book value of the company, as EVA seems to indicate. Secondly, the expectations formed by the market consist of both periodic cash flows and capital gains. EVA does not seem to capture the effect of either of these components of expected return. Thirdly, it is argued that EVA is an accounting based performance measure and hence does not accurately capture the performance of the companies. In this paper, we however prove that, contrary to popular belief, EVA is actually a cash flow-based performance measure of the company. To be precise, EVA is the excess free cash flow that the management generates to meet the expectations of the investors.

EVA-based management compensation systems are also often criticized on the ground that they lead to dysfunctional behavior on the part of the top management of the company. In particular, it is argued that EVA-based management compensation systems may discourage forward-looking expenditures like capital expenditure and Research and Development expenditure. In this paper we recommend a modified measure based on EVA and TVA (True Value Added) that addresses these issues. We argue that our modified measure not only address the above shortcomings of an EVA-based management compensation system, it can also address some of the shortcomings of Employee Stock Option Program (ESOP)-based management compensation system.

Keywords: Economic Value Added, Market Value Added, True Value Added

JEL Classification: G30, J33, M41, M46

Suggested Citation

Mohanty, Pitabas, In Defense of Eva(R). Available at SSRN: https://ssrn.com/abstract=423720 or http://dx.doi.org/10.2139/ssrn.423720

Pitabas Mohanty (Contact Author)

XLRI Jamshedpur ( email )

C H Area (E)
Jamshedpur, Jharkhand 831001
India
(91)657-2225506 (Phone)
(91)657-2227814 (Fax)

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