By Mark Storrie and David Sinclair "First of all, it's important for everyone dealing with EVA and

CFROI to nderstand that they prod !e identi!al res lts," says "teve "tet#, !orporate vi!e president $%A at $onsanto& "'he !ons ltants will try to tell yo they're not identi!al& One's no (etter than the other ) if yo loo* (ehind these models they're nothing more than !ash flow& 'hey are theoreti!ally e+ ivalent and yo !an relate the res lts ,they prod !e- to the fo rth de!imal point&" Investor Relations, $ar!h .//0 The above quotation illustrates one of the key benefits attributed by EVAs proponents - that EVA produces identical results to standard D ! in valuation analysis" #roponents further ar$ue that since EVA can be used for perfor%ance %easure%ent and co%pensation syste%s - for &hich D ! is not suited - it should be used for strate$ic plannin$ and valuation analysis rather than D !" 'f EVA and D ! produce identical valuation results( &hy co%plicate thin$s by usin$ t&o syste%s &hen EVA can replace D ! for valuation and strate$ic plannin$) *nfortunately the above ar$u%ent has three fla&s+ !irstly( the equivalence &ith D ! for valuation purposes can be %athe%atically correct but not necessarily helpful in providin$ a profile of cash flo&s on &hich to base a co%pany,s fundin$ require%ents nor in understandin$ the short ter% versus the lon$er ter% risks in a particular invest%ent or valuation decision" The %athe%atical equivalence is achieved because the EVA for%ula is a %odified version of a standard D ! for%ula &ithin a %athe%atical construct in &hich all of the ad-ust%ents in the EVA for%ula to the D ! results %ust net to .ero" The result of this construct is that it does not %atter &hat be$innin$ capital base is used in an EVA valuation - the resultin$ value &ill al&ays be identical" Secondly( in EVA the value of the startin$ capital base /one of the %ost sub-ective co%ponents of EVA since you could have scores of ad-ust%ents to capital over varyin$ periods of ti%e0 deter%ines &hether future EVAs are positive or ne$ative and by ho& %uch" This %eans that &here &e have a lo& capital base it is easy to $enerate lar$e positive EVAs even thou$h standard D ! analysis can sho& clearly that &e are locked into a value destroyin$ strate$y /i"e" returnin$ less than our 1A 0"

Thirdly( the %athe%atical equivalence only holds true prior to any ad-ust%ents %ade to the co%ponents of EVA /either 23#AT or capital base0 over the course of a forecast" 'f any such ad-ust%ents are %ade &hich &ill nor%ally be the case for perfor%ance %easure%ent purposes the %athe%atical equivalence bet&een D ! and EVA valuation is lost" Appendi4+ Mathe%atical #roof of 'rrelevance of apital Base in EVA Valuation

'f &e take the standard EVA forecast for t&o years

'f &e e4pand the for%ula

E4pandin$ further Since

1e rearran$e the for%ula

The first part of this equation is the standard D ! calculation" The second part al&ays nets to .ero" The follo&in$ tables illustrate the first t&o of the above proble%s - na%ely that the capital base used in an EVA valuation is both irrelevant in ter%s of i%pactin$ value( and %isleadin$ in ter%s of analysin$ periodical EVA" The tables are adapted fro% those developed by S!B in a docu%ent entitled 5EVA #ri%er5 /67780" !i$ure 6 illustrates a standard D ! analysis( &hilst !i$ure 9 illustrates the EVAs bein$ $enerated usin$ net book value as the be$innin$ capital nu%ber" As discussed earlier( the total value produced is identical( but the EVAs $enerated on a periodic basis are co%pletely contrary to the cashflo&s actually bein$ $enerated durin$ those sa%e periods" !i$ure 6+ !ree
Year 6 NOPAT <=::"::

ashflo& Model 1A
Inv. <=>:":: FCF /<>:"::0

6:;
Cum. PV of FCF /<=>"=>0

PV of FCF /<=>"=>0

9 @ = > 8

<=?>":: <>>:":: <8=:":: <??>":: <??>"::

<>::":: <8::":: <8>:":: <=7?"::

/<9>"::0 /<>:"::0 /<6:"::0 <9?A"::

/<9:"880 /<@?">?0 /<8"A@0 <6?9"89 <=(A69"6=

/<88"690 /<6:@"8A0 /<66:">60 <89"6:

<89"6: <=(A69"6= <=(A?="9= <A::":: <=(:?="9= <6@>"A: <@:(::

u%ulative #V of ! ! B #V of Cesidual Value D orporate Value - Debt D Value of Equity Shares #er Share Value

!i$ure 9+ EVA Model /Book apital0 1A

Year 6 9 @ = > 8 Beginning Capital Inv NOPAT Capital Charge EVA

6:;
PV of EVA Cum. EVA <9@8"@8 <9@7"8? <9@8"88 <9@>"8= <9>?"8A <9(98A"9@ <@(=?="9= <6(=::":: <=(A?="9= <A::":: <=(:?="9= 6@>"A <@:(:: <9@8"@8 <=?8":@ <?69"?: <7=A"@= <69:8":9

<6(=::":: <=>:":: <=::":: <6(A>:":: <>::":: <=?>":: <9(@>:":: <8::":: <>>:":: <9(7>:":: <8>:":: <8=:":: <@(8::":: <=7?":: <??>":: <=(:7?":: <??>"::

<6=:":: <98:":: <6A>":: <97:":: <9@>":: <@6>":: <97>":: <@=>":: <@8:":: <=6>":: <=:7"?: <@8>"@:

u%ulative #V of EVA B Be$innin$ apitalD orporate Value - Debt D Value of equity Shares #er Share Value

!i$ure @ illustrates the EVAs bein$ $enerated assu%in$ that the be$innin$ capital balance is equal to the &orth of the co%pany if it only returned its cost of capital /i"e" no value creation since 23#AT D Be$innin$ apitalE 1A D <@(?::E 6:; D <@?:0 based on the 23#AT for year :" This %ethodolo$y reflects %ore accurately the value created" 2ote that the final value re%ains the sa%e as in !i$ures 6 and 9( but that the annual EVA fi$ures are very different" This &ould obviously have hu$e i%plications for both strate$ic plannin$ and co%pensation syste%s" !i$ure @+ EVA Model /#re Strate$y apital0 1A
Year 6 9 Beginning Capital Inv. NOPAT Capital Charge <@?:":: <=6>":: EVA <@:":: <8:":: PV of EVA <9?"9? <=7">7

6:;
Cum. EVA <9?"9? <?8"A8

<@(?::":: <=>:":: <=::":: <=(6>:":: <>::":: <=?>"::

<@(?::":: <=(A?="9= <A::":: <=(:?="9= 6@>"A <@:(::

u%ulative #V of EVA B Be$innin$

apital D orporate Value

- Debt D Value of equity Shares #er Share Value 23#AT /FEAC :0 <@?:":: To prove that the capital base is truly irrelevant in calculatin$ the total value usin$ EVA( !i$ure = uses the nu%ber of %iles bet&een Gondon and 2e& Fork as the be$innin$ capital base" A$ain the final value is the sa%e( but the annual EVA fi$ures %ust be considered %eanin$less"

Figure 4: EVA

o!el " ile# from $on!on to Ne% Yor&' (ACC )*+