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The eva calculation is similar to calculating

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Unformatted text preview: that the result is stated in dollars rather than percentages. It can be applied to the company as a whole as well as to specific long-term investments such as new facilities or equipment and acquisitions. According to its proponents, EVA® represents “real” profits and provides a more accurate measure than accounting profits. Over time, it also has better correlation with stock prices than does earnings per share (EPS). Income calculations include only the cost of debt (interest expense), whereas EVA® uses the total cost of capital—both debt and equity (an expensive form of capital). In addition, EVA® treats research and development (R&D) outlays as investments in future products or processes and capitalizes rather than expenses them. A growing EVA® can signal future increases in stock prices. Companies that use EVA® believe doing so leads to better overall performance. Managers who apply it focus on allocating and managing assets, not just accounting profits. They will accelerate the development of a hot new product even if it reduces earnings in the near term. Likewise, EVA®-driven companies will expense rather than capitalize the cost of a new venture. Although earnings will drop for a few quarters, so will taxes—and cash flow actually increases. EVA® is not a panacea, however. Its critics say it’s just another accounting measure and may not be the right one for many companies. They claim that because it favors big projects in big companies, it doesn’t do a good job on capital allocation. Each year Fortune and Stern Stewart publish a “wealth creators” list that answers a critical question: Is the company creating or destroying wealth for its shareholders? This list uses both EVA® and market value added (MVA®)— the difference between what investors can now take out of a company and what they put in—to rank companies. In 2001 the list also included another measure, future growth value, an estimate of the value of the companies’ future growth today, based on current net operating profits after taxes. General Electric again topped the 2001 list, followed by Microsoft, Wal-Mart, IBM, and Pfizer. EVA® is gaining acceptance worldwide as well. At the French corporation Danone, chief executive Franck Riboud uses an EVA® formula to measure performance. “It’s a question of tools and language,” says Riboud. “If I talk EVA®, I will be understood all over the world.” Sources: Geoffrey Colvin, “Earnings Aren’t Everything,” Fortune (September 17, 2001), p. 58; Janet Guyon, “Companies Around the World Are Going the America Way,” Fortune (November 26, 2001), pp. 114–120; Randy Myers, “Measure for Measure,” CFO (November 1997), downloaded from www. cfonet.com; Stern Stewart Web site, www. sternstewart.com; and David Stires,“ America’s Best and Worst Wealth Creators,” Fortune (December 10, 2001), pp. 137–142. Review Questions 9–6 9–7 9–8 What is the internal rate of return (IRR) on an investment? How is it determined? What are...
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