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Paper 9 (Evidence on EVA - The Theory

Q: What are the steps that transform underlying cash flows from operations (CFO) into EVA?

EVA = CFO + Accruals + ATInt - CapChg + AcctAdj -- Net income (NI) -- Net operating profits after tax (NOPAT) -- Residual Income (RI) -- Economic value added (EVA) Adjusting CFO for accounting accruals (depreciation/interest expense) yields Net Income. Adding bank after tax interest expense (ATInt) to NI yields NOPAT. Subtracting the current cost of debt and equity capital (Capital charge) from NOPAT yields Residual Income. Adjusting NOPAT and RI for accounting distortions yields EVA.

12 important questions on Paper 9 (Evidence on EVA - The Theory

On what is residual income based?

Residual income is based on the premise that, in order for a firm to create wealth for its owners, it must earn more on its total invested capital than the cost of that capital

How is residual income computed?

Begin with net operating profits after tax (NOPAT) and subtract the total cost of capital measured as the weighted-average cost of capital (WACC) times to the total invested capital (CAPITAL).

Residual incomet (RIt) = NOPATt - [WACCt x CAPITALt-1] (1a)

How can NOPAT be expressed alternatively as a rate of return on invested capital?

By the return on assets (ROA) times capital, this is appealing because it separates total return on capital from the total cost of capital.

RIt = [ROAt x CAPITALt-1] - [WACC x CAPITALt-1] (1B)

How is the formula when regrouping the right hand side of (1b)?

Then we can observe that firms producing positive residual income earn a positive "spread" between the percent return on invested capital and the percent cost of capital;

RIt = [ROAt - WACCt] x CAPITALt-1

How can residual income be seen to incorporate traditional account net income?

Residual income can be seen to equal traditional accounting net income (NI) minus a charge for the cost of equity capital, where the cost of equity capital can be expressed as the beginning-of-period book value of equity (BV) times the cost of equity capital (k).

RIt = NIt - [kt x BVt-1]

What are the three main opportunities to increase residual income and owners wealth?

- Managers will increase residual income to the extent they increase NOPAT and ROA

- Decrease WACC

- Reallocate capital away from negative-"spread" toward positive-"spread" investments

Why is it wrong to expect that residual income it superior to accounting earnings in explaining firm values and stock returns?

A key problem with is that stock market participants have only past and current data to use as a basis for estimating the model's future residual income.

What are the steps that transform underlying cash flows from operations (CFO) into EVA?

EVA = CFO + Accruals + ATInt - CapChg + AcctAdj

Net income (NI)

Net operating profits after tax (NOPAT)

Residual Income (RI)

Economic value added (EVA)

Adjusting CFO for accounting accruals (depreciation/interest expense) yields Net Income. Adding bank after tax interest expense (ATInt) to NI yields NOPAT. Subtracting the current cost of debt and equity capital (Capital charge) from NOPAT yields Residual Income. Adjusting NOPAT and RI for accounting distortions yields EVA.

What are three common adjustments?

1. Adjustments that undo traditional accounting accruals (eliminating deferred tax accounting in favor of actual taxes paid).

2. Adjustments tat switch accrual methods (Lifo to Fifo).

3. Adjustments that introduce new accruals not used in traditional GAAP (capitalization of marketing and R&D expenses).

Why does median NI plot below median CFO?

Accounting accruals generally reduce net income (e.g. due to depreciation and amortization expense).

Why do EVA and RI both lie well below NI?

Because of the incremental charge for equity capital.

How do you explain a near zero EVA and RI?

It is consistent with a competitive economy in which even the typical large firm had difficulty earning more than its cost of capital.

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Paper 9 (Evidence on EVA - The Theory

12 important questions on Paper 9 (Evidence on EVA - The Theory

On what is residual income based?

How is residual income computed?

How can NOPAT be expressed alternatively as a rate of return on invested capital?

How is the formula when regrouping the right hand side of (1b)?

How can residual income be seen to incorporate traditional account net income?

What are the three main opportunities to increase residual income and owners wealth?

Why is it wrong to expect that residual income it superior to accounting earnings in explaining firm values and stock returns?

What are the steps that transform underlying cash flows from operations (CFO) into EVA?

What are three common adjustments?

Why does median NI plot below median CFO?

Why do EVA and RI both lie well below NI?

How do you explain a near zero EVA and RI?

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