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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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EVA AND M&A

In the wake of accounting scandals and governance reform, we have witnessed a back-to-basics renaissance in security analysis and corporate financial management. Value-based management is back in fashion, and business development professionals are again wrestling with the practical difficulties of making it work for mergers and acquisitions. We outline some requisite adaptations, based on our own experience with EVA and mergers and acquisitions.

The heart of most problems is that accounting book capital serves as the basis for returns. Economic profit (EP), return on equity (ROE), and ROCE are all return-based measures where book capital forms the founding basis for returns.24 Market values remain detached from book values and unrecorded unless there is an acquisition.

Acquisitions force a mark-to-market event by creating goodwill. Accounting goodwill recognizes the full market value plus premium paid over historic book capital, capitalizing this onto the balance sheet. The higher capital employed does not imply any fundamental change in assets or business process, just recognition of preexisting value. This records acquired assets on a different basis.

Acquisitions mark up the capital base for EVA and other return-based measures even if no acquisition premium is paid. Therefore, EVA, ROE, and ROCE will always be diluted even though there is no change in assets or underlying economics, only an exchange in ownership at a fair market price. Therefore, organic growth will ...

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