Answers to Questions
1. What is Economic Value Added (EVA) and what are the advantages and disadvantages of using EVA as a measure of a company’s performance?
The basis for the financial performance measurement tool called Economic Value Added (EVA) is that any capital brought into a company must create value for its shareholders. Very simply put, if the after-tax net operating profit of a company (or NOPAT), less the capital used to generate that profit is positive or greater than zero, then the company has generated true economic profit for its investors. In mathematical terms, this relationship is shown as:
Economic Value Added = NOPAT – Capital Charge
If the computed EVA is greater than zero (0) then value is created for shareholders. The formula is expanded as follows:
EVA = (r-c) x Capital
EVA = (r x Capital) – (c x Capital)
EVA = NOPAT- (c x Capital)
Where:
r = the rate of return,
c = the weighted average cost of capital (or WACC)
The disadvantage of using EVA is that this approach does not account for growth opportunities when making investment decisions. It is a performance evaluation tool that is more suited to cases wherein substantial assets are already in place and there is very little growth (such as mature industries like public utilities).
The advantages of using EVA are:
It allows managers to focus on how capital is used and how capital generates cash flows;
It creates a transparent basis for rewarding a manager’s performance;
It makes the cost of capital known to people in operations; and
It creates a singular language for evaluating growth by removing the distortion caused by historical accounting.
Using EVA to evaluate corporate performance allows managers to focus on creating additional value. By allowing a transparent approach to calculated added value, managers become aware of the impact of business decisions and are motivated to strive hard to preserve at the very least, shareholder value. Managers can also be made directly accountable for their actions and reward good performance based on the growth of EVA.
However like all corporate performance tools, the EVA does not answer all questions and is not an absolute guide. The EVA provides meaningful insight but it takes a pensive and responsible approach to corporate management to ensure success.
2. Determine the performance of Coca-Cola and Pepsi cola by looking at the historical EVA. Are there any observable trends? What could be the factors and drivers behind such trends?
Shown below is Coca-Cola’s historical performance, presented as annual NOPAT, invested capital, and EVA. This performance is presented alongside the Return on Invested Capital (ROIC), Weighted Average Cost of Capital (WACC), and the spread between ROIC and WACC.
Figure 1 Coca-Cola Company Historical Performance
The annual data shows that Coke’s NOPAT decreases by an average of 0.15% per year despite an average increase in invested capital of about 13.5% per year. Coke’s EVA decreased by 5.41% on the average yearly and the return on invested capital decreased by 12.17% in the same period.
Using simple linear regression analysis, the correlation between EVA (as the dependent variable) with NOPAT, Invested Capital, WACC, ROIC and ROIC-WACC spread (as independent variables) is determined to find out which of the independent variables exert the most influence on EVA. The linear regression tables show that there is a high degree of correlation between ROIC and EVA. The regression results show that ROIC captures 75% of the explanatory factors of the movement in EVA such that a 1% increase in ROIC increases EVA by $3,489 M. On the other hand, NOPAT is a poor predictor of EVA, with an R square value of only 25%. The effect of invested capital on EVA is also shown in the regression results. A US$ 1M increase in invested capital reduces EVA by US$ 0.05 M, a negative correlation between invested capital and EVA for Coca-Cola.
Table 1 Coca Cola Regression Results Summary
Intercept
Effect
R Square
EVA as explained by NOPAT
EVA as explained by Invested Capital
EVA as explained by WACC
EVA as explained by ROIC-WACC Spread
EVA as explained by ROIC
In contrast, the historical performance of Pepsi Cola is shown in the succeeding graph and table. The annual data shows that Pepsi’s NOPAT has increased by an average of 3.5% per year despite an average decrease in invested capital of about 5.4% per year. Pepsi’s EVA increased by 303% on the average yearly and the return on invested capital increased by 13.62% in the same period.
Figure 2 Pepsi Cola Company Historical Performance
Simple regression analysis was also conducted for Pepsi’s historical performance. The regression results for Pepsi Cola are presented in the table below.
Table 2 Pepsi Cola Regression Results Summary
Intercept
Effect
R Square
EVA as explained by NOPAT
EVA as explained by Invested Capital
EVA as explained by WACC
EVA as explained by ROIC WACC Spread
EVA as explained by ROIC
The regression results show very high correlation between EVA and ROIC and ROIC-WACC Spread. Invested capital shows a high degree of correlation as well; indicating that a US$ 1M increase in invested capital decreases EVA by US$ 0.12 M only. WACC is the worst predictor of EVA in Pepsi’s case, followed by NOPAT.
In summary, the results indicate that EVA is an excellent approximation of Return on Invested Capital. In both Coca-Cola and Pepsi’s case, a positive EVA indicates a high degree of return on invested capital, which supports the theoretical basis of using EVA as a performance monitor for companies.
Also, comparing the EVA-to-Invested Capital ratio, or the dollar value generated for every dollar invested between the two companies, we see that Pepsi has been more successful at creating shareholder value. The direct comparison is shown in the graph below. The graph shows that Coke had better performance in 1994, when they only invested about 35 cents compared to Pepsi’s investment of $1 dollar. However, as their invested capital increases, the generated value decreases such that in 2000, Coke invested US$1.20 and yielded only an EVA of US$ 0.08 for the investment. In contrast, Pepsi invested US$ 1.00 in 2000 and yielded an EVA of US$ 0.11 for the investment.
Figure 3 EVA per Dollar Invested Comparison
3. What is the Weighted Cost of Capital (WACC)?
The Weighted Cost of Capital (WACC) is one of the most important financial measures used in modern financial analysis. Any corporation must use capital for its business operations. Whether that capital comes from its shareholders as Equity or from the market as Debt, that capital would have an attached cost. The proportion of Equity and Debt used by any company and the associated cost of each can be utilized to determine the capital structure of any corporation. The Weighted Average Cost of Capital (WACC) is what is called the opportunity cost of capital for new investors of a company. It is the interest rate that they should expect from the company and is directly comparable with other rates of return from other investments.
Financial managers of corporations determine the optimal capital structure of a company and therefore are the persons responsible for setting the WACC. To set the target WACC, these financial experts rely on published information on market Beta, risk free rates, market premium rates, and so on.
4. Calculating WACC and EVA
Given the financial data presented in the annexes, the WACC for Coca-Cola and Pepsi Cola for the years 2001 to 2003 are computed. This is shown in the table below. The method for calculating WACC follows the standard prescribed formula.
The comparative WACC of Coke and Pepsi is shown in the graph below. Note that the WACC trends for both companies are very similar, indicating that the companies are operating at a very striking range from their optimum capital structures.
Figure 4 WACC Trend for Coca-Cola and Pepsi Cola
WACC is used to compute the EVA for years 2001 to 2003 of both companies. The EVA trend is shown below. Pepsi has overtaken Coke in 2000, when its EVA reached US$ 1.2 billion but that changed the following year, as Coke overtook Pepsi. In the next two years, Coke will generate more value added earnings at $2,871million and $3,124 million respectively.
If EVA were the only basis for choosing which of the two companies to invest in, Coca-Cola is the logical choice. The added value, based on the projections provided indicates that Coke will provide the best returns for a dollar invested in the company. Since EVA has a long-term correlation with stock price (due to the transparency of calculating EVA), it is a very practical tool to use. However, it is not an end-all tool. Investors must be wary of using EVA because it does not account future growth potentials. But on the basis of EVA alone, Coke is it!
Table 3 WACC and EVA Calculation, 2001 to 2003
Figure 5 EVA Trend for Coca Cola and Pepsi Cola
References:
De Freitas, Z. (2002). What is EVA and how can it help your company? Management and Accounting Web. Retrieved from http://maaw.info/ArticleSummaries/ArtSumDierksPatel97.htm Retrieved on June 18, 2012
