Download - EVAforCase
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ECONOMIC VALUE ADDED
INTRODUCTION ANDPREPARATION FOR CASE STUDY
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What is EVA?
Used to be called Residual Income
Stern Stewart & Co. re-named it Economic Value Added (and trade-marked the name)
You are supposed to write: EVA®
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How to calculate EVA
1. Calculate Net Operating Profit after Taxes
2. Subtract a Cost of Capital amount = EVA
(Cost of capital amount = Net Operating Assets x % cost of capital).
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Purpose of EVA
Some people believe this is an improvement on any measure of performance involving
unadjusted accounting numbers based on GAAP
The idea is that a company has to earn a return on its assets that is more than its cost of capital.
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Short Term Performance Measure (can be used for bonus calculations) Many accounting adjustments are made
to the GAAP net income
There are about 160 adjustments. You can only find them if you pay Stern Stewart & Co.
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Typical accounting adjustments for EVA calculation of NOPAT
Begin with Operating Earnings Before Tax (GAAP)
1. Adjust for Goodwill calculations 2. Adjust for R& D 3. Adjust for advertising expense 4. Adjust for restructuring expense 5. Subtract taxes
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Goodwill amortization (add back) What is Goodwill? Where is Goodwill shown in the GAAP
financial statements? What happens to Goodwill over time in
the accounting? What does ”amortization” mean? How much do we add back? WHY DO WE ADD BACK?
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R&D EXPENSE (add back)
1. What is R&D? 2. What is the accounting problem for
R&D? 3. Where is R&D expense reported in
the financial statements? 4. How much do we add back? 5. WHY DO WE ADD IT BACK?
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R&D Adjustment (subtract)
The assumption is: R& D is being expensed annually in the
GAAP statements. For EVA, assume it is an asset, and is
amortized over 5 years.
Calculate the total five years’ amortization if the R&D had been capitalized, and subtract it.
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Advertising expense (add back) 1. What is advertising expense? 2. What is the accounting issue with
advertising expense? 3. Where is advertising expense
reported in the financial statements? 4. How much do we add back? 5. WHY DO WE ADD IT BACK?
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Advertising adjustment (subtract) The assumption is:
Advertising is being expensed annually in the GAAP statements.
For EVA, assume it is an asset, and is amortized over 3 years.
Calculate the total 3 years’ amortization if the Adv. had been capitalized, and subtract it.
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Restructuring expense (add back) 1. What is restructuring expense? 2. What is the accounting issue? 3. Where is restructuring expense
reported in the financial statements? 4. How much do we add back? 5. WHY IS RESTRUCTURING
EXPENSE ADDED BACK?
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Subtract Taxes
Actual payment of taxes are subtracted.
That means deferred taxes are not subtracted (although they may be expensed on the income statement).
Why are actual taxes subtracted from operating profits?
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Overall result of these adjustments: Why make them? EVA make GAAP income closer to cash
flow income.
Managers are judged on an income figure which is less able to be manipulated by using the accrual accounting rules
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The EVA Adjustments Debate
Read article by David S. Young
Young argues EVA is: 1. costly to implement 2. may not make managers try to create
more long-term value
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Typical EVA calculations for Capital amount Begin with Net Operating Assets
(usually considered total assets less non-interest bearing current liabilities)
Add accumulated goodwill amortization(= asset add-back)
Add capitalized R&D (= asset add-back) Add capitalized advertising costs (= asset add-back)
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Cost of Capital for EVA
Assumes you use a WACC
(Weighted Average Cost of Capital, which is the weighted average cost of your debt and your shareholder equity)
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Advantages of EVA
1. You get a number (dollars, euros, etc.)
2. You are calculating the shareholder value-added by operations (not just increase in sales,for example)
3. You are ”correcting” GAAP numbers for various problem areas of traditional accounting numbers
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Disadvantages of EVA
1. Expensive to make adjustments to GAAP income
2. The accounting adjustments seem a little ”strange.” (Is the GAAP income really ”true and fair?”)
3. Employees may lose confidence in the accounting system
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Vyaderm Pharmaceuticals Case Study Background:
Company founded in 1945.Multinational, multi-productHas focused on Earnings per shareBonus system for managers: based on
various operating results and on a subjective evaluation
1997: New CEO- decides to change bonus system
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New Bonus System
EVA-based Incentive Program with a variable compensation plan
This is described on page 4 of the case. Page 5 shows a two year example.You will need to study this example.
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Various problems arise, but one problem especially The Dermatology (skin care) division has
a lucky opportunity when their main competitor gets into trouble with the US Food and Drug Administration (FDA)
As a result, in year 2000, the Dermatology division has a really profitable, unusual year
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However, . . .
In years 2001 and forward, this temporary advantage is expected to be lost
(the competitor should be back in business)
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The Problem:
The manager bonus for 2000 (for the Dermatology division) will be very good.
But what about future years? Remember how the company EVA incentive plan works.
(you have to continually improve)
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What should the company do?
1. Pay out the big bonus in 2000? And set a precedent?
2. Reduce the 2000 bonus, and set a precedent?
Change the plan calculations? Consider other factors?
If situation 1, hope the manager will stay on for future years (with little or no bonus)?
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