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EVA (Economic Value Added) in Finite-Lived Project Decision Making


I have found EVA (Economic Value Added) measurement to be superior in many ways compared to free cash flow when it comes to evaluating whether a stock of a company is attractive or not. For one thing, and it is a big issue, we just simply don’t know whether it’s a good or a bad thing when free cash flow increases this year. I have found that it is true, just as the theory says, improvement in EVA is good for stocks. That is because EVA is the only measure that more is better than less. That is because EVA has a special relationship with NPV. With its accompanying ratios proposed by Bennett Stewart, it is just that powerful for me as an investor looking for opportunities to invest. I am proud to say that I do not make spreadsheets and financial models just for formality or brain exercise. The insight gained from a spreadsheet focusing on EVA is real.

But for all its prowess, I still have an issue that is troubling me. Namely, all of EVA examples that I have read is done, whether implicitly or explicitly, by assuming perpetuity. What about those cases in all of corporate finance textbooks where the projection is finite and cash flows vary? You can’t just simply multiply the investment by cost of capital, right? That would implicitly assume perpetuity. So one day, I decided to sharpen my pencil. I think I have found the answer when I get the sum of present value of EVA equals NPV.

Suppose that an investment of USD 1.000 today is needed to bring a projected 5-year cash flows as follows:

Year 1 USD 250

Year 2 USD 325

Year 3 USD 175

Year 4 USD 230

Year 5 USD 350

If the cost of capital is 6%, is the investment worth it? How does EVA reconciles with NPV?

First, EVA needs an Equivalent Uniform Calculations.

First, let’s calculate NPV in the traditional way. Discount them at 6% and the cumulative Present Value of 5-year benefit is USD 1.115,75

Minus The PV of investment USD 1.000

NPV is 115,75. The investment is worthwhile because it is positive NPV. It adds to the owner wealth and should be taken.

Now let’s see how PV of EVA is in fact NPV. But it is a far more superior performance metric than cash flow.

In order to calculate EVA in finite-lived projection, EVA needs a Uniform Equivalent adjustment. This is easily done using financial calculator. At the heart of EVA calculation is spreading investment cost over time, not deducting investment cost in just one period. So the crucial concept to grasp is we have to match the life of benefit with the life of the cost. We will need to put into practice the calculation of uniform equivalent to do that for finite-lived projection. Uniform equivalent in short, is spreading over the lump sum number over a period of time with the same amount. To calculate uniform equivalent benefit and cost, we will need cumulative present value that we just calculated. Here’s how you do it using financial calculator.

The uniform annual equivalent benefit is USD 264,87 (PV=1115,75; N=5; I/Y=6%)

The uniform annual equivalent cost is USD 237,40 (PV=1000; N=5; I/Y=6%)

EVA is just the difference (264,87 – 237,40). EVA = USD 27,47. This is the number that can be used as a benchmark. Line teams are responsible to at least get this number for 5 years.

Back to NPV. As I said, the present value of EVA is NPV. Let’s see how. EVA of USD 27,47 is being generated over 5-years..so, at a cost of capital of 6%, its cumulative EVA is 115,75 (PMT=27,47; N=5; I/Y=6%). The same NPV calculated using traditional cash flow. It all checks out.

Now, EVA of USD 27,47 could be used as performance benchmark for annual progress review and bonus compensation. EVA encourages line teams to be rewarded when they get more EVA (> USD 27,47) and penalized when EVA is less. Investors can be confident that management is increasing their wealth in the company when EVA increases. As a benchmark, it is also very useful in one other thing: If EVA this year turns out to be negative, it is a very good indication that the operation is destroying shareholders’ value.

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