· EVA sends the message than managers should invest only if the increase in earnings is enough to cover cost of capital
· EVA allows a good way for companies to set a reward system that is not overly expensive to implement because is not too difficult for top management to monitor.
· EVA makes the cost of capital visible to operating managers · Stock prices track EVA more closely than they track other popular measures. · Ways to improve EVA
o Increase earnings
o Reduce capital employed
o Invest capital in high-return projects
· EVA does not involve forecasts of future cash flows and does not measure present value.
· EVA therefore rewards managers who take on projects with quick paybacks and penalize those who invest in projects with long gestation period. · Need to make changes in income statements and the balance sheet to measure economic value.
Looking at the historical trends of Coke and Pepsi in terms of EVA we find Coca-Cola's EVA has been slowly decreasing while PepsiCo's EVA has been increasing (see Exhibit 1.1). Coca-Cola's NOPAT has decreased in recent years as a result of slowing sales growth and worsening profit margins. If it were not for Coca-Cola's decreasing WACC, its EVA would decrease more rapidly. If Coca-Cola used a WACC of 12%, about the average of the past seven years, its EVA would have been $445,000,000 in 2000. PepsiCo was able to more than double their EVA in 2000 due to higher NOPAT and lower WACC. The higher NOPAT, was mainly a result of improved margins which lead to a higher ROI. The key to EVA is the spread between ROI and WACC. It is important to invest capital at a higher rate than the capital is obtained at. In theory, as long as there are enough projects that produce ROI > WACC and enough capital supplied, EVA can grow indefinitely.
1994 1995 1996 1997 1998 1999 2000
WE mentioned above that the (WACC) Weighted Average Cost of Capital is important. So now lets take a look at what WACC is and why it is important. Firms must use capital for operations. We want to know what the cost of that capital is to that firm. Therefore we look at the cost of the companies’ debt, the companies’ equity, and other costs when applicable such as preferred. Once we determine these costs we weight them so they reflect the true structure of the company. Calculating the WACC is important because it is the opportunity cost of capital or what the owners would expect to earn on their money in an equally risky project elsewhere. It is the financial managers who usually set the WACC. They do so with the aid of published sources, financial advisors, and other sources to estimate values for Beta, risk free rate, and market premium. The type of company sometimes influences the weighting of debt to equity. A new company that faces potential bankruptcy will often take that cost into account and will be much more equity financed. A company that is relatively certain of profits will lean toward more debt to take advantage of the tax shields available.
To get a good idea of how Coke and Pepsi compare in WACC we calculated their WACC projecting out to 2003 and assuming a 35 percent tax rate (see appendix 1.2). When we look the WACC for Coke and Pepsi we can see...