Answer the following questions regarding economic value added (EVA):

Question

a. What is it intended to do?
b. How is it measured?
c. How is the measurement different than that of RI?
d. Why is EVA a better performance measure of RI?
e. What is the major problem with using EVA as a long-term performance measure?

Answer 1

a. The purpose of EVA is to more directly align the interests of common shareholders and managers.
b. EVA = A/Tax profit - (market value of invested capital ? cost of capital %).
c. EVA uses after-tax profit, cost of capital and market value of assets invested. RI uses segment income, target rate of return and book value of assets invested.
d. EVA is a better performance measure than RI, because it recognizes that there may be a significant difference between book value and market value of assets. The market value of a company is reflected in stock prices which are another measure of performance evaluation.
e. EVA includes the increased investment immediately even though significant income may not occur until sometime in the future. Most investments will show decreased short-term performance (EVA) and may cause a company to refuse projects that are profitable in the long-term (similar to shortcomings of the payback method).