Value Creation, Net Present Value, and Economic Profit

19 Pages Posted: 21 Oct 2008

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

Abstract

This technical note compares economic-profit (economic value added) and net-present-value techniques for evaluating corporate investments and performance. The note shows the relationship between the two approaches and sets out the conditions under which they yield the same conclusions about value creation. It also discusses the differences in their estimation and use and talks about some of the difficulties of application. The note is useful for students who have already been exposed to net-present-value techniques.

Excerpt

UVA-F-1164

VALUE CREATION, NET PRESENT VALUE, AND ECONOMIC PROFIT

This note discusses two approaches that companies frequently use to gauge value creation. The first class includes the discounted cash flow techniques that are the mainstays of “bottom up” corporate evaluation of future investments. Each investment is evaluated over its entire use life based on the cash flows it is expected to generate. The result is a measure of whether the multiperiod investment creates value (a positive net present value, [NPV]). The second class includes estimates of economic profit. Economic profit is calculated by subtracting a capital charge from net operating profit after taxes. Economic profit figures are often calculated over a particular calendar period (often a year) and used as “top down” measures of an entire firm's (or division's) performance. A positive economic profit is a signal of value creation.

Four messages for corporate managers and financial analysts are stressed:

· Both NPV and economic profit are tied to shareholder value. Both methods tell us that value is created only if the company can earn returns in excess of investor required returns as measured by the cost of capital.

· The two approaches give identical estimates of value creation only if the analyst projects economic profit into the future. NPV is equal to the present value of future economic profit.

. . .

Keywords: capital budgeting, economic analysis, net present value, performance evaluation

Suggested Citation

Harris, Robert S., Value Creation, Net Present Value, and Economic Profit. Darden Case No. UVA-F-1164, Available at SSRN: https://ssrn.com/abstract=909391

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
1,660
Abstract Views
8,600
rank
11,101
PlumX Metrics