What Is Economic Value Added - Research Paper Example

These two metrics are able to calculate the wealth and performance of a corporation better than other quantitative models that used dividends indirectly in the valuation model. The purpose of this paper is to discuss residual income and economic value addded approach in order to compare and contrast their differennces and similarities.

In mathematical terms, EVA is calculated by taking net operating profits after tax (NOPAT) and reducing NOPAT by your total cost of capital which includes the combination of borrowing and equity costs (Exinfm, 2009). EVA has become a very popular tool in the corporate world. Many multinational corporations have utilized the concept to increase the value of their common stock. After the inception of EVA, Coca-Cola stocks rose 200% from 1987 to 1993; another example is CVX whose stock rose from $28 to $75 in a five-year span after adopting EVA (Chen & Dodd, 2001). Despite these sucesss stories, there is not enough emperical evidence to support the claim that adopting the managerial practice to optimize EVA is correlated with price increments in stock valuation. EVA is a concept that is relalative new in comparison with other financial metrics such as earnings per share (EPS) and residual income. The application of EVA and its support and validity may replace EPS in the future an indicator that is included in the income statements of public corporations. Residual income is a metric that investors have relied on to determine the creation of wealth for the shareholders of a company.        

Residual income states that the current stock price equals the current book value of equity plus the present value of expected future income (Keys & Mumin & Mckay, 2001). Another interpretation of residual income that is simpler to understand is that it represents the net operating income that an investment center earns above the minimum required return on its operating assets. Residual income was utilized by managers to evaluate the performance of companies prior to the creation of EVA. EVA is considered by the business community and academia as a derivative of Residual income that deviates because the metric considers opportunity costs, thus creating an economic profit. The economic profits metric is not accepted by the accounting profession because it does not follow the generally accepted accounting principles (GAAP). Some of the discrepancies and similarities between residual income and EVA are listed in the table below.

Economic Value Added

Residual income model

1. The model has speculative factors within its framework

1. The model applies conservatism accounting perspective

2. The model has been used for a few decades

2. The model has been used for over 50 years

3. Investors view the application as more realistic and a better indicator

3. From an accounting perspective the model has greater validity

4. Cost of capital implicit within the return on assets

4. Cost of capital is a major variable included in its mathematical formula

5. Applies concepts that deviate from GAAP

5. Applies Generally Accepted Accounting Principles

6. Funds used for research and development (R&D) are seen as an investment under EVA

6. Funds used for R&D are accounted for as an expense.

7. Allows for modification of accounting systems.

7. Traditional philosophical approach that is widely accepted because of its consistency and ability to forecast long-term trends based on historical data.

(Noreen & Garrison, 2003).

            Both the residual income and economic value-added approach serve the same purpose of being analytic tools to determine the performance of a company and its ability to create wealth for the shareholders. EVA is a new concept based on the basic principles from residual, but it incorporates principles not accepted by GAAP. Investors should utilize both of them in their evaluation process. A dual analysis of a company applying both methods can allow an investor to have a speculative perspective and a conservatism perspective. Having both sets of information allows investors to make smarter decisions.