Strategic Value Management: Stock Value Creation and the Management of the Firm

Appendix A. Deconstructing the EVA Model

This Appendix expands on the details of the economic value added (EVA) model; it is separated from Chapter 2 in order to avoid scaring the nonfinancial readers. The Appendix relies on and has adapted ideas from the following books: Stewart's The Quest for Value (1990); Copeland, Koller, and Murrin's Valuation (McKinsey, 2000); and Sharpe, Alexander, and Bailey's Investments (1998).

WHY THE EVA MODEL WAS DEVELOPED

The EVA was developed to address the limitations of traditional accounting. Traditional accounting describes the profit and loss (P&L) statement as shown in Figure A.1

This approach has an implicit limitation: shareholders and creditors are treated differently. Creditors receive interest as a compensation for the use of their funds, but this kind of relationship does not exist with the shareholders.

Figure A.1. Traditional versus EVA Accounting

The EVA model (at the right of the chart) reelaborates the same P&L but suggests a benefit for the shareholders in the form of compensation for the use of their funds.

The chart shows the two main differences:

• A: The EVA accounting pays to the lenders and shareholders a weighted average cost of capital (WACC) rate instead of the interest rate of traditional accounting, and such a rate is applied on the operating capital, which incorporates debt and capital, whereas in traditional accounting the rate ...