Finance Case Write-up
In this writing, we will discuss about WACC, EVA, their uses in evaluate a firm's performance and apply into a particular case of comparing performance of Coca Cola and Pepsi based on the past and forecasted data.
1.Definitions of EVA and its strengths and limitations
Economic value added (EVA) has been getting plenty of attention in recent years as a new form of performance measurement. An increasing number of companies are relying heavily upon EVA to evaluate and reward managers from all functional departments.
So what is EVA?
EVA is a value-based financial performance measure based on Net Operating Profit after Taxes (NOPAT), the Invested Capital required to generate that income, and the Weighted Average Cost of Capital (WACC). Quite simply, EVA is the after-tax cash flow a firm derives from its invested capital less the cost of that capital. EVA represents the owners' earnings, as opposed to paper profits. The formula to measure EVA is: EVA = NOPAT - (Invested Capital x WACC). (1)
EVA is a dollar amount. If the dollar amount is positive, the company has earned more net operating profit after taxes than the cost of the assets used to generate that profit, in other words, the company has created wealth. If the EVA dollar amount is negative, the company is consuming capital, rather than generating wealth. A company's goal is to have positive and increasing EVA. However, as companies introduce new tools for managing their businesses, it is required that each manager also develops a working knowledge of those tools by discussing not only their definitions but also their strengths and limitations.
In order to understand the strengths of EVA, the limitations of a predecessor called return on investment (ROI) must be discussed first. The intent of ROI is to evaluate the success of a company or division by comparing its operating income to its invested capital. ROI can be measured with the following formula:
ROI = Operating Income / Investment
The appeal of ROI is that it controls for size differences across plants or divisions. For example, assume the managers of divisions A and B earned $1,000,000 and $800,000 in operating income respectively. A naive interpretation of that difference would be that the manager of division A outperformed the manager of division B. This viewpoint is naive because the cause of division A's higher income may be its greater size relative to division B. To control this problem, ROI is used to measure each division's income relative to the asset base deployed, thereby standardizing the computation into a ratio while de-emphasizing the absolute amount. The primary limitation of ROI is that it can encourage managers, who are evaluated and rewarded based solely on this measure, to make investment divisions that are in their own best interests, while not being in the best interests of the company as a whole.
We see the following example:
A division has received a proposal from headquarters expand its activities into alternatives A and B. The company has enough funds to finance both projects and has a 10% weighted-average cost of capital. Projected earning and investment for the division are:
Assuming the division manager is compensated based solely on ROI, he will be motivated to proceed with only the alternative B because it would increase the projected ROI of 15% currently being earned in the traditional activities. He would not accept the alternative A because it would lower his projected ROI and negatively affect his performance evaluation and compensation. Conversely, the company would prefer that he accepts both alternatives because each exceeds the 10% cost of capital. Should the division manager be blamed for not being a team...