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GOTHENBURG STUDIESIN FINANCIAL ECONOMICS

971214

VALUE BASED MANAGEMENT:

Economic Value Added or Cash Value Added?

byFredrik Weissenrieder

Department of EconomicsGothenburg University

andConsultant within Value Based Management

Anelda ABV. Hamngatan 20

S-411 17 GteborgSweden

STUDY NO 1997:3



byFredrik Weissenrieder


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Fredrik Weissenrieder, 1998 http://www.anelda.com2



by

Fredrik Weissenrieder

Table of Content: Page:

1 Introduction 32 Value Based Management 33 CVA and the concept of Strategic Investments 54 EVA 7

4.1 EVA's corrections - Do they work in practice? 84.1.1 Not enough adjustments are carried out 94.1.2 Irrelevant issues are discussed 105 EVA instead of Cash Flow? 105.1 EVA at H&M/Wal-Mart 115.1.1 EVA at store no 6 125.1.2 EVA at the parent 135.2 CVA at H&M/Wal-Mart 145.2.1 CVA at store no 6 15

5.2.2 CVA at the parent 165.3 EVA compared to CVA at H&M/Wal-Mart 175.4 The EVA leverage 206 Completing the "Circular Reference" 226.1 CVA vs. EVA using straight line depreciation 236.2 CVA vs. EVA using annuity depreciation 256.3 CVA vs. EVA, 1st adjustment 276.4 CVA vs. EVA, 2nd adjustment 296.5 Further real analysis of the concepts' capital bases 30

7 Market Value Added - MVA 338 Conclusion 35

Appendix 1: What is value? 38


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VALUE BASED MANAGEMENT:Economic Value Added or Cash Value Added?

1 Introduction

Corporate managers now face a period where a new economic framework that better reflects value

and profitability must be implemented in their companies. Accounting systems, which has been usedup until today, are insufficient and will not stand the challenge from the increasingly efficient capitalmarkets and owners. The increased efficiency at the capital markets requires that capital allocationwithin companies become more efficient and it is therefore not possible for companies to in the futureallocate capital as inefficient as they do today. A new economic framework, a Value Based Manage-ment framework that better reflects opportunities and pitfalls, is therefore necessary.

In my opinion, there are four major frameworks within Value Based Management; Economic ValueAdded (EVA1), Cash Value Added (CVA2), Cash Flow Return on Investments (CFROI), and Share-holder Value Analysis (SVA). A company can chose one of these four for their company's economicframework of the future. The choice will have a substantial effect on management resources, strategychoices, and on how investors, analysts, media, etc view the company.

This paper will deal with EVA and CVA, the two most frequent concepts in Sweden. Many things arebeing said about the two frameworks. I will in this paper present my reflections on a few similaritiesand differences of the two frameworks.

In section 2 I will briefly discuss Value Based Management in general. Section 3 discusses the partsof the CVA concept that is necessary for the comparison with EVA. Section 4 discusses the parts ofthe EVA concept that is necessary for the comparison with CVA. Section 4 will also discuss whetherEVA functions as a Value Based Management concept (which is its objective) or just another versionof accounting. Section 5 will discuss the alleged necessity, for technical reasons, of basing a ValueBased Management tool on accounting which EVA does, contra the possibility of basing it directly onCash Flow which CVA does. Section 6 further compares EVA to CVA and it discusses the final cor-rections that are necessary to eventually have EVA become a concept that simulates cash flow. Sec-tion 7 will discuss the Market Value Added concept, and then we have the conclusion in section 8. InAppendix 1 I will discuss a company's concept of value from the shareholders' perspective. All figures,graphs and tables in the paper are my own.

I will leave out some interesting aspects in order to keep this paper a paper and not a book, e.g. theproblems that we find in accounting's consolidation of multinational corporations, i.e. consolidationeffects from inflation and currency effects, which also influence the quality of EVA.

2 Value Based Management

What we use today to follow up a company's profitability and value creation is inconsistent with thecapital market's mechanism, and what the market considers determines value (further explained inAppendix 1). That is why we have what is called Value Based Management (VBM). VBM is what weshould use instead of accounting for internal financial management. Accounting will still be used tocalculate tax and to control the company from the legal perspective. Inside companies, to understandand manage our business, we use VBM. Management, controllers, engineers, and other people in acompany that are in touch with economic issues should never use accounting simply because it doesnot improve the quality of their work3.

I have in figure 2.1 illustrated a company in what I call the "Company Golf Course". I try to illustratethe company with its two most important frontiers, the one towards its owners (Stock market) and theone towards the company's customers. To the left on the golf course we have the Business Reality,i.e. the activities that actually takes place in reality. We need to manage those activities so that ourowners' value is maximized. We must then be able to bridge the activities at the left, the BusinessReality, to how the market wants us to view it. I believe it is only possible to do that if we simulate("Financial Simulation of Business Reality") the Business Reality using the capital market's mecha-


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nism. We will then obtain relevant knowledge from our financial illustration of Business Reality. Thatwill give us the relevant feedback we need to improve the activities in the company's Business Real-ity.

The Business Reality's border line towards the capital markets' mechanism (the gray vertical line) caneasily be abused, as accounting abuses it today with the usage of P&L and balance sheets. We thenhave little or no chance of achieving the knowledge that is necessary to manage our company the

way we should manage it. We will become greatly misinformed if we stand on the border, looking atthe Business Reality using "improper glasses". Our company will be managed by using somethingelse than Value Based Management as the large arrow down to the right, pointing to the left, tries toillustrate (we lose our connection to the stock market). The company's so-called Strategic FeedbackLoop will not function. The Strategic Feedback loop is the continuous evaluation of strategies wherethey are evaluated using information from the strategies to make necessary adjustments in the strat-egy. There seems to be an infinite amount of examples in companies where the Business Reality'sfrontier does not work the way it should and can do, but rare are the examples where the frontierfunctions the way it should and can. The Financial Simulation of the Business Reality must of coursebe based on Discounted Cash Flow as concluded in the appendix

Figure 2.1; the "Company Golf Course"

A true VBM framework is consistent with the market's mechanism and our four factors that, accordingto the market, determine value (Appendix 1). It must be simple but correct. In order to further increaseour knowledge about how to increase shareholder value we must be able to simulate, view, and ana-

lyze our business from this perspective - the Financial Markets' Reality. Our Investor Relation functionshould be used to make sure that the company is priced correctly from the new perspectives VBMgives us. All this can be accomplished by structuring the business reality by e.g. using the BalancedScorecard concept and link this to the relevant VBM framework of our choice.

CU

STOMERS

IntellectualCapitalMarketing

CustomerLoyalty

CustomerSatisfaction

PricingStrategy

ProductMix

FlexibilityImprovement

ProductivityIm rovement

OperatingEfficiency

R&D

OperatingCash Flow

EconomicLife

CVA

Value Drivers

CapitalCost

StrategicInvestments

Pre-strategyValueSimulations

InvestmentBehavior

Capital

Structure

StrategyValueSimulations

Value Creation

CapitalAllocation

Accounting:Profit/shareP/E-ratios,Re, ROCE,?

Real O tions

STOCKMARKET

Logistics

SIL

Business RealityFinancial Simulation of

Business Reality

Financial Markets'Reality

TQM InvestorRelations


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The consulting market contributes four basic frameworks for VBM4: EVA5, CVA6, CFROI7 and SVA8.As I mentioned earlier I will only focus on EVA and CVA in this paper.

3 CVA and the concept of Strategic Investments

CVA (Cash Value Added) is a Net Present Value model that periodizes the Net Present Valuecalcu-lation and classifies investments into two categories, Strategic and Non-strategic Investments9. Stra-tegic Investments are those which objective is to create new value for the shareholders, such as ex-pansion, while Non-strategic Investments are the ones made to maintain the value the Strategic In-vestments create. A Strategic Investment (e.g. in a new product or an investment in a new market etc)is followed by several Non-strategic Investments. A Strategic Investment can be in a tangible or anintangible asset; the traditional view of whether an outlay of cash is an investment or not does notmatter here. What we believe in our company to be a value creating cash outlay is what we thenshould define as a Strategic Investment.

The Strategic Investments form the capital base in the CVA model because the shareholders' finan-

cial requirements should be derived from a company's ventures, not chairs and tables (which ac-counting's capital base consist of and instead e.g. disregards Strategic Investments in intangibles).That means that all other investments with the purpose of maintaining the original value of the venturemust be considered as costs, such as buying new chairs and tables.

So how is the capital base calculated in the CVA concept? A so-called OCFD is calculated from eachStrategic Investment (which is the first factor of our four factors that determines value) made in thecompany. The aggregate of every Strategic Investment's OCFD in a business unit is the businessunit's capital base. The OCFD is calculated as the cash flow (which is the second factor of our fourfactors that determines value), equal amount in real terms every year, that discounted using theproper capital cost (which is the fourth factor of our four factors that determines value) will give the in-vestment a Net Present Value of zero over the Strategic Investment's economic life (which is the third

factor of our four factors that determines value). The OCFD is a real annuity but adjusted for actualannual inflation (not the average inflation). The OCFD must be covered by the Operating Cash Flow(OCF), which is the cash flow before Strategic Investments but after Non-strategic Investments, in or-der for the Strategic Investment to create value. All of this is easily structured in a CVASoftware10.

The OCFD is not in any way a prediction of what the future OCF will be. It is a constant benchmark forthe future cash flows (and historic cash flows since these analyses can be made for historic as well asfor future analyses as can be seen in table 3.2). The OCFD is "fixed" in real terms over the invest-ments economic life to illustrate the financial logic. Our understanding of how our company's, or busi-ness unit's, cash flow is related to that can be called business logic. It is difficult, and sometimes im-possible, to understand our business logic if we do not have the, in real terms, fixed benchmark, aswe will see in the analyses made later in this paper.

A Strategic Investment creates value if the OCF (see below) exceeds the OCFD over time. This canbe presented as:

+ Sales- Costs= Operating Surplus

+/- Working Capital Movement11

- Non-strategic Investments= Operating Cash Flow

- Operating Cash Flow Demand= Cash Value Added (CVA)

Table 3.1


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The Cash Value Added (CVA) represents the value creation from the shareholders' point of view. Thiscan be expressed using monthly, quarterly, or yearly data. It can also expressed as an index:

Equation 3.1

The CVA Index can be split up into four margins (in relation to sales):

Equation 3.2

These, together with sales, form the CVA concept's five major Value Drivers:

Equation 3.3

Table 3.2 shows a simple example of what a CVA calculation could look like in a company. It is anexample with only one Strategic Investment of 100. The Operating Cash Flow Demand is calculatedas the cash flow that will give the investment of 100 a Net Present Value of zero over the economiclife of 11 years and with a capital cost of 15%. Inflation is 3%. Tax can be included in the cash flow orin the WACC, which is done here.

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Sales 160 170 250 185 200 215 200

Costs -150 -155 -220 -160 -170 -180 -155Operating surplus 10 15 30 25 30 35 45

Working Capital Movement 0 -1 -6 5 -1 -1 1

Non-strategic investments -1 -3 -1 -3 -12 -4 -3

Operating Cash Flow 9 11 23 27 17 30 43

Operating Cash Flow Demand 17 18 18 19 19 20 20 21 22 22 23

Cash Value Added -8 -6 5 8 -2 10 23

CVA Index 0,53 0,64 1,29 1,42 0,88 1,51 2,11

Average discounted CVA Index: 1,10

Strategic investments -100Cash Flow -100 9 11 23 27 17 30 43 0 0 0 0

Table 3.2

CVA is a concept solely based on cash flow, not even an opening balance using the current or ad-justed balance sheet is used which is common in other so-called cash flow models (those are ofcourse not true cash flow models). There is, of course, much more to this concept (it is an entire fi-nancial management concept) but this is sufficient to be able to compare the framework to the EVA.

The Cash Value Added discussed in this paper has been developed in Sweden by Erik Ottosson andFredrik Weissenrieder, see Ottosson and Weissenrieder (1996). It should not be confused with TheBoston Consulting Group's Cash Value Added. Boston Consulting Group's CVA is a development of

their Cash Flow Return on Investment (CFROI) concept. The two models are not similar in their fun-dament, i.e. the way the models calculate the return and value of a business, or how they presenttheir result. They have unfortunately, though, been named using the same three words, but that is theonly similarity.

IndexCVADemandFlowCashOperating

FlowCashOperating=

Operating Surplus margin - WCM margin - Non - strategic Investment margin

Operating Cash Flow Demand marginCVA Index=

CVASalesOCFD-

SalessInvestmentStrategic-Non-

SalesMovementCapitalWorking-

SalesSurplusOperatingSales =


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BalanceSheet

Year X

4 EVA

EVA (Economic Value Added) is a model based on a company's accounting. Its mechanism is there-fore like accounting:

Sales- Operating Expenses

- Tax= Operating Profit

- Financial Requirement= EVA

Table 4.1

EVA's capital base is formed by the company's (or unit's) balance sheet:

X WACC = Financial Requirement

Figure 4.1

Example:

MSEK 1994 1995 1996 1997 (budget)

Sales 234 258 305 420

Operating Expenses12 -200 -205 -243 -285

Tax 0 -3 -10 -28Operating Profit 34 50 52 107

Financial Requirement -45 -50 -60 -62

EVA -11 0 -8 45Table 4.2

The "Financial Requirement" is calculated as the defined capital (an adjusted balance sheet) multi-plied with a suitable WACC:

MSEK 1994 1995 1996 1997 (budget)

Capital 375 417 500 520WACC 12% 12% 12% 12%

Financial Requirement 45 50 60 62Table 4.3

Bennett Stewart has identified several errors made in accounting from the investor's perspective. Hetherefore adjusts these in order to simulate cash flow. Which adjustments must be made in order tosimulate a cash flow situation? Examples are general and specific shortcomings in Accounting suchas13:

Inventory costing and valuation

Depreciation Revenue recognition Capitalization and amortization of R&D, marketing, education, restructuring charges, acquisitionpremiums


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Bennett Stewart has identified a total of 164 adjustments and corrections. This amount will probablybe different from country to country. There is, of course, much more to this concept but this is suffi-cient to be able to compare the framework to the CVA. There is software developed for EVA 14.

4.1 EVA's cor rections - Do they work in practice?

EVA claims to be a Value Based Management framework, but is it? That will depend on how well theframework manages to simulate the "Business Reality" (in figure 2.1) from the shareholders' perspec-tive, i.e. the "Financial Markets' Reality". To do that, EVA must make several adjustments in account-ing. I strongly question the possibility of obtaining this in practice, and even if it is possible to make all164 corrections/adjustments it will still not function well enough. That is the issue this paper dis-cusses.

EVA is implemented in companies for mainly two reasons:

1) Its objective is to increase the organization's knowledge of the company and the understanding ofthe financial implications of its processes, which will improve decision making which, in turn, will

increase the value of the company.2) It is easy to understand.

EVA's ability in number one will be discussed in the remaining part of this paper, after this section, butthe second one "it is easy to understand" will be dealt with here. Yes, EVA is easy to understand butwhat is it the organization understands? Consider the following illustration, the "Circular Reference" infigure 4.2:

Figure 4.2; the "Circular Reference"

The logic behind figure 4.2 is that all companies have cash data to begin with. It is then put into theeconomic framework used today at companies, i.e. accounting. The company will be at the far rightwhen the accounting process is finished. EVA's mission is to take us all the way back again because

Here is the capitalmarket's reality: in-vestments, cash flow,economic life andcapital cost. This iswhere value andprofitability shouldbe measured. DCFmodels are thereforeapplied here. Allcompanies' eco-nomic data can bederived from here.

Economic informa-tion has now turnedinto traditional ac-counting. Manage-ment is no longerable to measureprofitability or value.

The company inserts the in-vestments and cash flows intodifferent accounts because of

the external legal requirement.Management gets the legal re-quirement confused with eco-nomic reality.

The firms book keeping is not readjusted towards cash flow.The economic information is instead further battered by legalrequirements and illustrated using P&L statements and bal-

ance sheets.

Bennett Stewart starts the longway back. At least 164 correc-tions/adjustments are neces-sary if the "cash flow" point ofthe circle is to be restored.

"Cash Flow"

163 corrections/adjustments aremade. Here, EVA uses so-calledstraight-line depreciation.

EVA and so-called annuity depreciation.EVA, as it is today, does not get any furtherwith its 164 corrections/adjustments. At leasttwo more adjustments are necessary. Thosewill be dealt with in section 6 of this paper.

1

2 3

4

5

67


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it is only at the point to the left that we are able to, in financial terms, simulate the company's Busi-ness Reality from the shareholders perspective.

4.1.1 Not enough adjustments are carried out

Companies that implement EVA are recommended to make about 5-15 corrections/adjustments. How

far do you think they travel on the circle? Not very far. Sometimes they travel even less becausefewer corrections/adjustments than 5 are made. Sometimes only 1! This is the strongest reason forwhy I claim that EVA cannot be used for Value Based Management. As we will see later in section 6,an additional 1 or 2 corrections/adjustments suggested in this paper will substantially change the in-formation from EVA, how much different then will not the information from EVA with another 160 or socorrections/adjustments be.

But which adjustments should we be making to adjust EVA all the way to the left of the circle? That isalways a difficult question to answer. Bennett Stewart comments on this15:

"We recommend that adjustments to the definition of EVA be made only in those cases that passfour tests:

Is it likely to have a material impact on EVA? Can the managers influence the outcome? Can the operating people readily grasp it? Is the required information relatively easy to track or derive?"

Not many corrections/adjustment can pass all of these tests, which is the reason for why only a fewcorrections/adjustments are made in reality. Some further comments to these four tests:

"Is it likely to have a material impact on EVA?" - An adjustment might have a material impact on EVAbut does it improve the quality of EVA or will it only further confuse us? My opinion is that we cannotknow this without doing a cash flow based analysis (CVA) to have as a benchmark. This is why notmany adjustments will pass this test.

"Can the managers influence the outcome?" - Managers can (from the financial perspective) usuallyonly influence what is Business Reality, i.e. Strategic Investments, their cash flow and economic life.

They can do that no matter how we choose to illustrate the impact of these (accounting, EVA,CVA). They are likely to be influencing these in the future, no matter which concept we choose forthe future; accounting, EVA or CVA. The concepts are here to help us illustrate Business Reality asbest as we can. It is only then that we can achieve the necessary knowledge of our business. I be-lieve it is imperative to then make sure that they see the few things they actually can influence; Stra-tegic Investments, their cash flow and economic life. Business Reality transparency is then essential.No mysterious bundle of periodizations or non-cash items. This is why not many adjustments will passthis test.

"Can the operating people readily grasp it?" - My experience is that operating people, especially tech-nicians, have difficulties with accounting to begin with since they work with the company's BusinessReality. If we on top of that start making adjustments, which will be difficult to explain to non-accountants, we are out on thin ice. On the other hand, another experience I have is that e.g. techni-cians enjoy discussing Business Reality i.e. investments (Strategic or Non-strategic), their economiclife and the cash flow they need to produce in the future to be profitable. Finance to them must be thatclear and simple because it is not their core knowledge, especially not accounting's version of it. Wecannot require that everyone knows accounting. This is why not many adjustments will pass this test.

"Is the required information relatively easy to track or derive?" - This is probably the most difficult test.How do we e.g. adjust for actual economic life of our assets in the balance sheet, a very important

adjustment? For old assets it means that we must go far back in history and make adjustments. Wemust also change our current assets' historic and present depreciation method, which is not easy, etc,etc. Not many adjustments will pass this one. It will be much easier to implement CVA compared tomaking these adjustments.


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I understand why adjustments must pass these four tests. EVA will not be possible to implement inreal life if the ambition is set higher than that. This is unfortunate, because my opinion is that the con-cept is not too bad in theory, but just like accounting in real life.

4.1.2 Irrelevant issues are discussed

The company's dialogue must be focused on the point to the far left in figure 4.2, the cash flow point,because it is the only point on the circle that is Business Reality. The process from left to right mustbe left to people not involved in any financial or strategic evaluation or decision making because thatprocess on the circle will not enhance the organization's knowledge about the situation at the far left,which is the point they must learn and understand. The only concern management should have aboutthat process is whether it is being done or not and that it is being carried out in a proper way for con-trol and tax reasons. The information management receives for decision making must be derived frommodels that only handles the point to the far left - Discounted Cash Flow models.

Why spend time and resources on anything else but the cash flow point and why spend time on re-adjusting a process that never should occur for any other reasons than the legal ones (control andtax)? Why not instead focus on the simple and few factors that determine value and profitability; in-

vestments, cash flow, economic life and capital cost?

We can also identify a hazard in using EVA. Managers today are known to not act on information fromaccounting, much because they do not see the relevance in it. Management's intuition concerningBusiness Reality play a large role in companies today because the lack of relevance in financial in-formation. Managers in companies that implement a poor version of EVA might be lead to believe thequality of information has been substantially improved which might have negative consequences.

They might act on information that is accounting in disguise.

Companies implement EVA because it is easy to understand. It is easy to understand because theyunderstand what they always have been working with, i.e. the accounting process. This is not, how-ever, what an organization should try to understand because they have then understood somethingthat is not very relevant for managing a company. The objective of Value Based Management is not tofurther understand accounting but instead to increase the understanding of the point to the far left andits implication on shareholder value, and nowhere else on the circle - we do not need to understandaccounting better than we already do. On the contrary, most people in an organization probably needto know it less than they do today. Again, EVA is not too bad in theory, but just like accounting in reallife.

EVA might be easy to implement because it is "Accounting Reality". It can be implemented in the waymost accounting systems can, i.e. the organization is given new directives which they blindly follow.CVA is the border between the Business Reality and the Financial Reality. The implementation is aninteractive process between the people active in the Business Reality (technicians, controllers, etc)

and the ones active in the Financial Reality (Company Headquarter, owners' representatives etc). Theimplementation of CVA might therefore be perceived as being more difficult than implementing EVAbecause it requires more attention from the organization. This attention is however the attention nec-essary (and wanted) in order to reach the level of change in the organization towards ShareholderValue.

5 EVA instead of Cash Flow?

EVA is a concept based on a company's Profit&Loss statements and balance sheets so it is based onaccounting, not cash flow. I'm sure Bennett Stewart would agree with me on what determines value,

i.e. the relationship between investments, the cash flow they generate, the economic life of those andtheir capital cost. So why does he choose a method that is based on accounting and not cash flow?We can read the following in Bennett Stewart's book16:


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Abandon Cash Flow!

However important cash flow may be as a measure of value, it is virtually useless asa measure of performance. So long as management invests in rewarding projects -those with returns above the cost of capital - the more investment that is made, andtherefore the more negative the immediate net cash flow from operations, the morevaluable the company will be. It is only when it is considered over the life of the

business, and not in any given year, that cash flow becomes significant."

In other words, he writes that the Net Present Value concept is useless unless we can discount theinvestment's/project's complete cash flow over it's completed economic life. I would have agreed withhim a few years ago because it was true before the CVA concept was developed. The CVA concept,however, periodizes the Net Present Value calculation into years, quarters, months or the time periodof the user's choice and not one entire period as a traditional Net Present Value calculation does. It isthen possible to use it for measuring performance and profitability, so even though his statement wastrue when it was written, it isn't any longer.

This can be illustrated using the following (nominal) example. It can be an IT company, Wal-Mart,Hennes&Mauritz or any other fast growing company with heavy negative cash flows due to profitable

growth; I therefore call the company in the example "H&M/Wal-Mart" (tax is assumed to be included inthe WACC):

Cash Flow at H&M/Wal-Mart

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

SI 1 -1,400 238 245 252 260 268 276 284 293 301 311 320 329 339 350 360 371

SI 2 -1,400 238 245 252 260 268 276 284 293 301 311 320 329 339 350 360

SI 3 -1,400 238 245 252 260 268 276 284 293 301 311 320 329 339 350

SI 4 -1,500 255 263 271 279 287 296 304 314 323 333 343 353 364

SI 5 -1,500 255 263 271 279 287 296 304 314 323 333 343 353

SI 6 -2,000 340 350 361 372 383 394 406 418 431 444 457

SI 7 -3,000 510 525 541 557 574 591 609 627 646 665

SI 8 -3,500 595 613 631 650 670 690 710 732 754 SI 9 -4,000 680 700 721 743 765 788 812 836

SI 10 -4,500 765 788 812 836 861 887 913

CF -1,400 -1,162 -917 -764 -487 -702 -1,323 -1,263 -1,101 -834 4,541 4,678 4,818 4,963 5,111 5,265 5,423

Table 5.1

The assumptions above are that one, or a number of, stores (SI:s) are opened each year and they areestimated to each have an economic life of 20 years. The last H&M/Wal-Mart store therefore closes in2009, according to our assumptions. For simplicity, I have chosen to have the same capital cost of15% for every store. I also say that the inflation is 3% every year and that the stores earn the sameamount of money every year in real terms. Also, to make it simple, I say that the stores produce acash flow of 17% of the investment sum the first year which then increases with inflation in the fol-

lowing years. If we look at the net cash flow of H&M/Wal-Mart we can see that it is negative. We can-not stand in 1987 or in 1993, look at the "CF" line and say "So, how are we doing". The question andits answer if one comes up, are not very relevant. So far, I agree with Bennett Stewart. EVA willtherefore go into H&M/Wal-Mart's P&L statement and balance sheet and after about 164 adjustmentsproduce the following figures17:

5.1 EVA at H&M/Wal-Mart

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Operating Cash Flow18 238 483 736 1,013 1,298 1,677 2,237 2,899 3,666 4,541 4,678 4,818 4,963 5,111 5,265 5,423

Financial Requirement 280 550 809 1,077 1,334 1,680 2,211 2,820 3,502 4,254 4,073 3,891 3,710 3,528 3,347 3,165

Economic Value Added -42 -66 -73 -64 -36 -3 26 80 164 287 605 927 1,253 1,583 1,918 2,257

"EVA Index" 0.85 0.88 0.91 0.94 0.97 1.00 1.01 1.03 1.05 1.07 1.15 1.24 1.34 1.45 1.57 1.71

Table 5.2


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The EVA model claims that it can, by the use of existing accounting, tell us what the profitability of thecompany as a whole has been from the beginning to whatever year we have complete figures for(here 1996). We have a steady growth in presented profitability over the years, from an EVA of -42 in1981 to an EVA of + 2 257 in 1996. We also introduce, for the sake of the analysis, a new measurethat we can call the "EVA Index". It is simply the Operating Cash Flow divided by the "Financial Re-quirement"19. If the Index is 1.00 we meet our requirement, if it is below 1.00 we don't, and if it isabove 1.00 we return a cash flow above the requirement. We can see that it wasn't until 1987 that we

became profitable according to EVA.

5.1.1 EVA at store no 6

EVA tells us that the profitability (i.e. the difference between the Operating Profit and the FinancialRequirement) of store number 6 up to 1996 has been increasing as we can see in graph 5.1. The firstthree years were not good enough but the trend now seems very positive.

0

100

200

300

400

500

600

1986

1987

1988

1989

1990

1991

1992

1993

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1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

EVA's Operating Profit, store no 6

EVA's Financial Requirement, store no 6

Graph 5.1

Graph 5.2 tells us that the investment ended up as a success in the remaining years under the as-sumptions we made. Expansion in identical investments will be heavy on profitability for three yearsbut will be extraordinarily profitable after that. Managers in the early years will be looked upon asmanagers struggling with profitability while the managers in the later years will be looked upon as be-

ing very successful. The managers of this store are generously rewarded if bonus is based on thechange of EVA over time.


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0

100

200

300

400

500

600

1986

1987

1988

1989

1990

1991

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1993

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1996

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1998

1999

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2002

2003

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EVA's Operating Profit, store no 6


Graph 5.2

This will be reflected also at the aggregated level, the parent, since all investments made make the5.1.2 EVA at the parentsame amount of money in relation to the investment sum. The heavy growth will show poor profitabilty

This will be reflected also at the aggregated level, the parent, since all investments made make thesame amount of money in relation to the investment sum. The heavy growth will show poor profitabil-ity for a number of years but the company will show profitability in year 1987 as presented in graph5.3. Profitability boosts after the expansion is stopped in 1990. Again, the management responsiblefor the expansion will probably not be looked upon as certain heroes while the ones that stopped itprobably will. If bonus is based on the change of EVA over time, the ones receiving bonus after 1991(probably a new management) will be heavily rewarded while the ones before 1991 will be rewardedto a much lesser degree.

Graph 5.3

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Graph 5.4 will further establish this picture. Profitability is further increased as time passes. The firststore is closed down in 2001 and after that one is closed each year. In 2009, only one store remainsand that one is closed down that year. The success factor here, according to EVA, is to avoid expan-sion.

Graph 5.4

5.2 CVA at H&M/Wal-Mart

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Operating Cash Flow 238 483 736 1,013 1,298 1,677 2,237 2,899 3,666 4,541 4,678 4,818 4,963 5,111 5,265 5,423

Operating Cash Flow Demand 189 383 584 804 1,030 1,331 1,775 2,301 2,909 3,603 3,711 3,823 3,937 4,056 4,177 4,303

Cash Value Added 49 100 152 209 268 346 462 599 757 938 966 995 1,025 1,056 1,087 1,120

CVA Index 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26

Table 5.3

CVA does not include the Strategic Investments (the expansion) in the cash flow but will instead acti-vate those using the Net Present Value method. I.e. it does not measure profitability at the "CF"-line intable 5.1. The CVA concept periodizes the Net Present Value calculation, spreading the required Pre-

sent Value, based on each Strategic Investment in a business unit, over the investments' economiclives. The CVA concept uses the same original figures as the EVA concept did, that is from table 5.1,but the conclusion will be different. Now, H&M/Wal-Mart will show profitability from the start in 1981!

The profitability will be the same over the chain's existence, 1.26 in CVA Index (OCF/OCFD).

This is because CVA introduces a fixed financial requirement, the so-called Operating Cash FlowDemand. We create this "Demand" from the Strategic Investments we make, here the 10 stores. OneOCFD from each store, they can be looked upon separately or at an aggregated level. The OperatingCash Flow Demand is the cash flow that is needed in order to end up with a Net Present Value ofzero when the investment has reached its economic life. The Operating Cash Flow from each invest-ment is the same in real terms every year. The Operating Cash Flow Demand of H&M/Wal-Mart willgrow, in nominal terms, for two reasons; the growth in the number of stores until 1990 and the infla-

tion adjustment every year of the existing stores' Operating Cash Flow Demand.

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5.2.1 CVA at store no 6

This can be seen in graph 5.5 where both the Operating Cash Flow and the Operating Cash FlowDemand increases by inflation. Here, managers will probably be viewed upon equally over the period.

Graph 5.5

The next graph, graph 5.6, illustrating the completed economic life will give us the same information,which is that the investment has the same profitability over time and that it is profitable from year 1.

Growth in this concept will be rewarded from the first year.

Graph 5.6

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CVA's Operating Cash Flow Demand, store no 6

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5.2.2 CVA at the parent

Graph 5.7 gives us the situation up until 1996 for the parent, H&M/Wal-Mart. The chain of stores ex-pands heavily and the expansion shows profitability all the way.

Graph 5.7

This expansion is however stopped in 1991 but managers at the beginning of the company's life willbe viewed equally as the ones at the end. As they should (apart from the fact that they, if possible,should keep on expanding). The same amount of money is made from each store (in relation to theinvestments made) over the company's life. CVA illustrates that. I believe it is important to have aneconomic framework that reflects Business Reality.

Graph 5.8

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5.3 EVA compared to CVA at H&M/Wal-Mart

The two VBM concepts EVA and CVA can easily be compared. First, take a look at store 6's pre-sented CVA and EVA respectively in graph 5.9. Here the concepts' different signals are very clear.EVA is rapidly increasing over the years while the CVA increases with inflation. Note that the Net Pre-sent Value of the EVA equals the Net Present Value of the CVA.

If you were a manager whose bonus was based on the change in EVA or CVA from year to year,which concept would you want to have implemented (for the bonus reason)? EVA of course. Your bo-nus would probably be substantial every year, even though store no. 6 makes the same amount ofmoney every year in real terms20! Bennett Stewart writes21 that bonus should be based on the changein EVA from year to year which in this case, and in all other cases where straight-line depreciation isused, would be unfortunate22. Bennett Stewart's concept will, unless profitability is heavily decreased,reward the management who chose to implement EVA, but for the wrong reasons because theshareholders will not be rewarded. Business Reality has not shown any improvement.

Graph 5.9

Graph 5.10 shows us the total effect from each of the two concepts. EVA will show lower profitabilityin the beginning but much larger after half time compared to CVA. This despite the fact that each in-

vestment made makes the same amount of money in relation to the investment sum every year in realterms. Again observe that the Net Present Value's of the two concepts are exactly the same. Themanagers at H&M/Wal-Mart would become quite wealthy if EVA was used at their company and bo-nus was based on the change of EVA over time. Especially the ones who worked at the company af-ter the expansion was stopped.

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EVA, store no 6


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Graph 5.10

Well, does this matter? Surprisingly many managers and controllers seem to be just fine with thissituation. They might say, "well, no, because all that matters is future cash flow any ways" which is ofcourse true but to say that our historic reflection of our company does not matter would be like sayingthat company experience does not matter. Also, to say that we are not influenced by historic informa-tion would of course not be true either. Picture the two, out of several, following "others held equal"scenarios:

1. Was the reason why H&M/Wal-Mart stopped expanding in this case due to the fact that the ex-pansion period showed poor profitability using EVA? - It must of course be possible to see thatexpansion is value creating if that is the case!

2. What if the profitability had been substantially lower, e.g. corresponding to a CVA Index of 0.70?EVA would still show excellent profitability in the later years and expansion plans would surely bepresented. The expansion plans here would in more ways than one be influenced by the excellentprofitability given to us by the generous EVA concept. There is much room for mistakes in thissituation. - It must of course be possible to evaluate a business' profitability even if it is old andwritten off in the accounting system!

EVA will in these cases hinder us from expansion when we create value and instead trigger us to ex-

pand when we destroy value. The answer to the question asked earlier "does it matter" seems to be"yes".

If we isolate the concepts' capital bases at Store 6, the Operating Cash Flow Demand in CVA and theFinancial Requirement in EVA, we get the picture presented in graph 5.11. As expected, EVA's Fi-nancial Requirement falls rapidly while it increases (by inflation) in CVA. I should point out that EVA'sFinancial Requirement would fall even quicker if depreciation was put into Operating Profit instead ofthe Financial Requirement as is normally done. This will be further examined in 5.4.

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Graph 5.11

At the aggregated level we get the following picture, shown in graph 5.12. EVA's Financial Require-ment decreases from year 1991 when the expansion is stopped. CVA's Operating Cash Flow De-mand increases in nominal terms (however equal in real terms) until the first store is closed down,then it decreases with the closing down-rate. Still, the Net Present Value of CVA's Operating CashFlow Demand equals the Net Present Value of EVA's Financial Requirement, but only in 1980. After1980 will the Net Present Value of CVA's Operating Cash Flow Demand not equal the Net PresentValue of EVA's Financial Requirement. Management must decide how they want their company to be

presented internally and externally because the accounting way of doing things will not be taken forgranted in the future.

Graph 5.12

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5.4 The EVA leverage

It is of further interest to study the indexes. Companies that use EVA, as far as I know do not usewhat I here call the EVA Index. In a way, that is unfortunate because the Index in the CVA concepthas turned out to be useful in many situations and for different reasons. On the other hand, using theEVA Index would not be a good idea as we are about to see.

Graph 5.13 shows us the development of the different concepts' Indexes up until 1996. Here we havetwo EVA Indexes. EVA Index 1 puts depreciation into the Financial Requirement, as has been doneearlier in this case, while EVA Index 2 puts it into the Operating Profit which is done in reality. TheCVA Index presents the same profitability every year (1.26) as can be expected under the assump-tions we made about this case, but the EVA Indexes do not. EVA Index 1 shows improved profitabilitybut EVA Index 2 shows even steeper improvement. This is because the difference I analyse herebetween EVA and CVA is enhanced if we do with the EVA concept as most companies do - i.e. putdepreciation into the Operating Profit instead of the Financial Requirement. This, as we can see, hasturned out to be a mistake by the ones that use the concept.

What I believe to be the large error made by the EVA concept in the capital base (as previously ex-

plained in 5.1-5.3) is heavily leveraged if depreciation is put into Operating Profit. However, this iswhat happens in accounting with measures like ROCE, ROOC, Re and ROI because the EVA Indexequals conceptually all those measures, especially the ROCE (some say that they are identical sinceall adjustments made in EVA can be made in ROCE the only difference is that ROCE is a measureexpressed in percentages while EVA is expressed in absolute numbers). Those measures are veryvolatile and highly unreliable.

I should point out that even though the EVA Indexes 1 and 2 are different here, the calculated EVA'sare the same no matter where you put depreciation. This means that if you stick to the EVA in abso-lute numbers, which is the difference between the Operating Profit and the Financial Requirement,and do not calculate a EVA Index, which is the relation between them, you will not run into this situa-tion (apart from the fact that you will have the wrong idea about your capital base which is highly un-

fortunate). On the other hand you miss out on a highly useful tool - the Index.

Graph 5.13

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CVA Index, store no 6

EVA Index 1 (depreciation in "Financial Requirement"),

store no 6

EVA Index 2 (depreciation in "Operating Profit" -

comparable with ROCE), store no 6


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The overall picture, over the store's full economic life, is presented in graph 5.14. EVA Index 2reaches astronomic figures in the end, just as ROCE would present profitability.

Graph 5.14

Graph 5.15 illustrates H&M/Wal-Mart's total profitability up until 1996. The CVA Index will always bethe same every single year in a business that in real terms makes the same amount of money in rela-tion to the Strategic Investments made to create the business. The level of the EVA index will not bebased on that. The direction of EVA's profitability in relation to the investments made to create it willdepend on if the business is expanding (as it is here to begin with) if inflation changes etc, etc, instead

of showing true profitability.

Graph 5.15

The profitability in this simple H&M/Wal-Mart example is changing because the business is expandingheavily to begin with, and EVA presents it as being unprofitable at that point. It then presents it asbeing profitable just because the expansion ends. That is the only reason why EVA changes overtime in this example. Is this how we want to present profitability?

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EVA Index 2 (depreciation in "Operating Profit" - comparablewith ROCE), store no 6

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H&M/Wal-Mart generates the exact same amount of money every year! Why then, as in graph 5.16,measure its financial performance as if it was increasing?

Graph 5.16

Some say that these errors in accounting/EVA are "cancelled out" or self-adjusted since a companycontinuously makes investments, i.e. that the EVA curves in 5.16 are pushed down to where the CVAIndex is. It is my experience that this is a comment that arises when the person in question no longercan explain the relationships between investments made and the cash flow they produce. The fact

that the errors in accounting, from the investors point of view, are cancelled out does to begin with notimprove the situation conceptually - what has caused what and why? Also, I think that the only waywe can find out if errors have been cancelled out or not is to compare EVA curves with something thatdoes not have the accounting's errors, e.g. to use the CVA curve as a benchmark. We must until thenlive with uncertainties such as is my ROCE of 14% actually 4% and my EVA of 100 actually 100.

The distribution of accounting based measures as ROCE and EVA around true profitability is wide too wide to grasp or ever understand.

6 Completing the "Circular Reference"

Some of you may think that EVA and CVA seem similar. In theory they are, but not in reality. They aresimilar in theory because CVA stands to the very left in the circle, figure 4.2, which is the point of thecircle EVA tries to get to, so of course they are similar in theory. As we all know, however, only a fewcorrections/adjustments are made so in reality we will not travel very far, if at all, on the circle. Theyare therefore not similar in real life.

But lets say that we actually made all the corrections/adjustments that are necessary in order tosimulate an operating cash flow (which is EVA's Operating Profit but without the depreciation whichinstead is put into the Financial Requirement). Also, we adjust EVA's Financial Requirement to be arequirement that is solely based on investments made. We make all 164 corrections/adjustments.Economic life equals actual economic life, the Financial Requirement is calculated using opening bal-ance (which is a balance totally free from everything that should not be there, i.e. a balance that con-

sists only of actual investments made and still in use), etc., etc. Do we then close the circle? Almost,but a couple of adjustments are still necessary.

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Lets go through those last adjustments using a (nominal) example. The investment of 2,000 in the ex-ample below has an economic life of 12 years. The WACC is 15% and estimated inflation is 3%. TheOperating Profit (here defined as the Operating Surplus adjusted for Working Capital, WC, move-ments but without depreciation) is a bit volatile so it does not increase with inflation as in theH&M/Wal-Mart example. This unit experiences four investments after the initial investment is made.

Those are activated into the balance sheet. Those are normal investments that are necessary tomaintain the value and economic life of the unit as was planned/estimated in the decision process for

the initial investment. A major investment is almost always followed by investments that are made(have to be made) because the major investment was made.

Year: 0 1 2 3 4 5 6 7 8 9 10 11 12

Strategic investment -2,000

Operating surplus +WC movement 300 450 450 600 900 700 600 800 600 400 300 200

Non-strategic investments -150 -200 -250 -300

Cash Flow -2,000 150 450 250 600 650 700 300 800 600 400 300 200

Table 6.1

These are everything we need in order to do both CVA and EVA. CVA would look like this:

Year: 0 1 2 3 4 5 6 7 8 9 10 11 12

Operating Cash Flow 150 450 250 600 650 700 300 800 600 400 300 200Operating Cash Flow Demand 327 337 347 358 368 379 391 402 414 427 440 453

CVA -177 113 -97 242 282 321 -91 398 186 -27 -140 -253

Table 6.2

The Operating Cash Flow equals Operating Surplus adjusted for Working Capital movements minusNon-strategic Investments. The Operating Cash Flow Demand is the cash flow that is necessary eachyear (the same cash flow in real terms every year) to give the Strategic Investment a Net PresentValue of zero25. The CVA is the difference between the Operating Cash Flow and the Operating CashFlow Demand.

CVA has classified the investments that follow the initial investment of 2,000 as being "value main-

taining" investments, not value creating. They have in other words not added extra value to the busi-ness. This does not mean that it is useless to make investment calculations to evaluate those (eventhough they usually have to be made). However, the Net Present Value calculated will not be a valuethat is added to the business if the Non-strategic Investment is carried out. It is instead the value thatwill be lost from the initial investment if it is not carried out. This is of course in many aspects thesame thing but I believe it to be essential to realize that the Net Present Value a calculation generatesnot always means that new value has been added to the company and therefore for the shareholders.Value is added to a company when a strategic decision is taken (if it has a positive Net Present Value,of course), not when decisions are taken to preserve a strategy's value.

6.1 CVA vs. EVA using st raight line depreciation

EVA using straight line depreciation would look like this:

Year: 0 1 2 3 4 5 6 7 8 9 10 11 12

Operating Profit 300 450 450 600 900 700 600 800 600 400 300 200

EVA's Financial Requirement 467 494 465 505 470 522 449 515 428 386 295 261

EVA -167 -44 -15 95 430 178 151 285 172 14 5 -61

Table 6.3

Again, the Operating Profit consists of Operating Surplus adjusted for Working Capital movement.The Financial Requirement is calculated as each year's opening balance of the fully adjusted balancesheet, which includes the four investments since they are investments in large tangible assets, multi-plied with the WACC plus that year's depreciation. It cannot be better than it is in table 6.3 if straight-line depreciation is used.

We can see in graph 6.1 that CVA and EVA, straight line depreciation, are not very similar, eventhough we have made a large number of adjustments. I claim that CVA is at the far left of the circle,


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figure 4.2. We then, obviously, need to make further adjustments in EVA because this situation is notacceptable. Consider, though, that this is a very good and precise situation for EVA compared to EVAin real life.

Graph 6.1

We can see in graph 6.2 that the Operating Cash Flow Demand behaves as we can expect it to do. Itincreases with inflation (3%) because it is only based on the Strategic Investment. A so-called Strate-gic Marginal Investment26 could occur in real life, which would increase the size of the capital base,and hence the Operating Cash Flow Demand, but that has not occurred here.

EVA's Financial Requirement jumps however up and down in a seemingly random manner. Thisbusiness and its annual balance sheets are fairly isolated which enables us to make further analysesof EVA's Financial Requirement in graph 6.3.

Graph 6.2

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Graph 6.3 analyses EVA's Financial Requirements further. The requirement from each of the five in-vestments included in the capital base is rapidly falling, as can be expected from EVA using straightline depreciation. It is clear that we cannot have a Financial Requirement that decreases like this, al-though it has always been like this in accounting. Bennett Stewart, together with others before him,has identified this. He therefore suggests using the annuity method (sinking-fund depreciation) for theFinancial Requirement.

Graph 6.3

6.2 CVA vs. EVA using annui ty depreciation

We now use the annuity method for calculating EVA's Financial Requirement. Annuity means that theFinancial Requirement will be the same every year in nominal terms just like annuity payments to abank on a mortgage. I.e. it will decrease by the inflation rate in real terms. It may initially be difficult tosee in graph 6.4, but EVA is now much closer to CVA.

Year: 0 1 2 3 4 5 6 7 8 9 10 11 12

Operating Profit 300 450 450 600 900 700 600 800 600 400 300 200

EVA's Financial Requirement 369 414 414 473 473 548 503 593 533 533 458 458

EVA -69 36 36 127 427 152 97 207 67 -133 -158 -258Table 6.4

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Graph 6.4

The reason for why EVA looks more like CVA is found in the Financial Requirement (because theOperating Profit has not been changed), graph 6.5. CVA's Operating Cash Flow Demand is un-changed but EVA's Financial Requirement has changed substantially.

Graph 6.5

We can further analyse EVA's Financial Requirement as in graph 6.6. Here it is clear that substantialchanges have been made.

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EVA's Financial Requirement from Strategic Investment, annuity depreciation

Graph 6.6

I would like to point out that the initial investment of 2,000 is in reality probably depreciated over 10years in accounting, and not over 12 years as in this example. The only remaining asset in the capitalbase would then be the fourth Non-strategic Investment. This is something that must be adjusted forevery asset if EVA is to function. Otherwise profitability will suffer even more at the beginning of aproject and be even better at the end than it automatically already does in EVA (as was shown in 5.4).

If I have understood Bennett Stewart's EVA concept correctly, this is as far as they take it. As the cir-cle (figure 4.2) tries to illustrate, they have not reached the point at the far left yet. Two more adjust-ments are necessary in my opinion, which I do not think has been discussed in the EVA concept.

6.3 CVA vs. EVA, 1st adjustment

The first of the two adjustments that I want to add concerns the so-called Non-strategic Investments.Why would we want to put our "chairs and tables" into our Financial Requirement? A company's own-ers will never walk into the company, point at a table and ask "how much money have you made onthis table this year?" The question is irrelevant in most companies. An owner is interested to find outwhich strategies create value and which don't27. Still we have our chairs and tables in accounting andEVA's Financial Requirement.

Some may disagree with me on this, but why let accounting principles instead of Business Logic

command us on what we consider to be an investment. Bennett Stewart is very right when he claimsthat some costs, like some R&D and marketing, should be considered to be investments and then beactivated. The same thinking should lead to that some payments, that are today considered to be in-vestments, are in actual fact costs.

Traditional accounting has an industry-focused view on what an investment is. The confusion broughtupon us in today's environment, where an cash outlay in a machine is far from enough to reach suc-cess in selling a product or service on a global market, has many faces. "Hidden values" are suddenlyfound in companies and companies rush into the quest for the value of intangibles or intellectualcapital instead of initiating a change of the company's fundamental economic framework. Is it really asurprise that companies often make their money from investments not represented by the balancesheet? Hopefully not. The construction of the balance sheet is lead by accountants and ruled by law,not Business Reality or Business Logic. The discussion about a company's total strategic assets (tan-gibles and intangibles) is relevant and important but must be much more structured and focused onrelevant issues. An example of the confusion is when companies identify the value of the intangiblesor the intellectual capital as the difference between the value of the company at the stock market andthe (corrected/adjusted) equity.


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Owners of a company should be concerned over statements like that. It indicates that the company'sknowledge about Business Reality (figure 2.1) has not been tied to the Financial Markets' Reality,which surely will lead to sub optimization of the company's strategic assets (tangibles and intangibles)and to inefficient and costly capital allocation. A few comments to the example in the previous para-graph:

The reasoning would e.g. result in a higher perceived value of intangibles or intellectual capital if

an expansion is stopped or if inflation rises (as explained in section 5). This is due to the, from theinvestors' perspective, technical error in accounting's reflection of the Financial Markets' Realityand should not have any effect on management's view on Business Reality.

Not only do they confuse an asset "at cost" (the equity) with an asset "at value" (the intangible orintellectual capital) but also would the value of a company's (corrected/adjusted) equity be un-changed if the value if the intangibles or intellectual capital were to become zero? Of course not.

Neither would the value of the intangibles or intellectual capital (if measured as the stock marketvalue minus the equity) remain the same if all computers, desks and telephones were thrown outof a bank or an insurance company.

The value of a company is created by a confluence of strategic assets, fixed and non-fixed. Fixed andnon-fixed - goes together like a horse and carriage. This is the relationship management must under-

stand. Only then have they tied Business Reality to the Financial Markets' Reality. Bringing in ac-counting's investment concept only enhances confusion. Unfortunately this happens in most compa-nies today.

An effective VBM concept structure the strategic assets to a capital structure that will include bothtangibles and intangibles and the concept will make no difference between the two. The capital will be"at cost" and the discussion on the capital structure's (the strategic assets') value will become morerelevant. The comparison with a stock market value must be handled with caution. This is becausethe stock market value will not only include the Present Value of current strategic assets (the Pre-strategy Value, figure 2.1) but also the Net Present Value of the Strategic Investments that lie in thefuture (the Strategy Value, figure 2.1). The Net Present Value of those future Strategic Investmentscan be both positive and negative (a Net Present Value of zero in the average stock market com-

pany).

Graph 6.7 compares EVA, annuity method, 1st adjustment (Non-strategic Investments are put into theoperating cash flow instead of being activated) to CVA and the picture is much better than graph 6.4.

Graph 6.7

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CVA EVA annuity method, 1st adjustment


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The Financial Requirement will then look even more like CVA's Operating Cash Flow Demand as wecan see in graph 6.8. It is now clear to us what the next adjustment must be.

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CVA's Operating cash flow demand

EVA's Financial Requirement, annuity method, 1st adjustment

Graph 6.8

6.4 CVA vs. EVA, 2nd adjustment

Why have a Financial Requirement whose level and movements are dependent on inflation? EVA'sFinancial Requirement, using the annuity method and after the adjustment we just made, will "fall and

rise" with inflation. It will decease with the inflation rate every year. It seems to me that the nominalannuity method that EVA uses here assumes that inflation is 0%. Wouldn't probably 1% be a betterestimate and then an improvement? If it is, why not try to improve the estimate?

Graph 6.9 has "inflated" EVA's Financial Requirement and turned it into a real annuity. EVA will thenbe identical with CVA, as we should expect.

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Graph 6.9


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We made the change in Financial Requirement that we discussed, we inflated it with actual inflation,so it will be identical to CVA's Operating Cash Flow Demand.

Graph 6.10

We have now closed the circle, figure 4.2.

6.5 Further real analysis of the concepts ' capital bases

I have in this section made a simple real analysis to further clarify the differences between CVA's andEVA's capital bases and to analyse the effect of different economic lives on the capital base. As-sumptions are as before; an investment of 2,000, an inflation of 3% and a nominal capital cost of 15%(a real capital cost of 11.7%) will give us the real figures for EVA and CVA as presented in table 6.5. Ihave, again, put the depreciation into the Financial Requirement to get a fair picture and to make thecomparison possible. The differences of an economic life of 20 years are illustrated in graph 6.11. Themost common version of EVA, EVA with straight line depreciation, puts a heavy burden on the busi-ness in the early years and a very low burden in the late years. An investment that makes e.g. 300 incash flow per year in real terms will be presented as unprofitable in the early years and extremelyprofitable in the later years. Despite the fact that it produces the same amount of cash flow every

year, EVA will never when comparing any two years, in this case show anything but improved profit-ability.

We can also express the Financial Requirement in percent. If we assume that 262 corresponds to anominal capital cost of 15%, then EVA straight line depreciation requires 22% the first year and 4% inthe last year, an unwheighted average of 11.6%, not 15%. The Internal Rate of Return will howeverbe 15%, but that will not be measured or presented in EVA. The average Financial Requirement willthen have shifted from 15% to 11.6%! The business will on the average be presented as being sub-stantially more profitable than it should be presented, just as accounting. EVA, using annuity method,requires 18% in the first year and 10% in the last year, an unwheighted average of 13.6%. The Inter-nal Rate of Return will also here be 15%. I do not think that this will improve the operative personnel'sunderstanding of a company's capital base. CVA's Operating Cash Flow Demand and EVA using an

inflation adjusted (real) annuity will both require 15% every year. The Net Present Values are thesame for each curve.

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EVA's Financial Requirement, 2nd adjustment


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Years: 1 2 19 20

EVA's Financial Requirement, straight line depreciation 388 363 74 64

EVA's Financial Requirement, annuity depreciation 310 301 182 177

EVA's Financial Requirement, inflation adjusted annuity depreciation 262 262 262 262

CVA's Operating Cash Flow Demand 262 262 262 262

Table 6.5

Graph 6.11

As I wrote earlier in 5.3, EVA will trigger us to avoid expansion when it is profitable and to expandwhen we shouldn't. Who wants to invest under these circumstances? Profitability will be low in theearly years if we e.g. make 300 per year and we then actually produce sufficient cash flow. On theother hand, in year 17-18 will calls for a replacement be raised? The business might only be able togive us a cash flow of 150 per year but this investment will be presented as being very profitable un-der those circumstances. This will undoubtedly have an effect on management's decision.

One can always argue that the Operating Cash Flow generated from a Strategic Investment shouldbe higher in the beginning when the product is competitive and lower at the end when it is less com-petitive. EVA's Financial Requirement, straight line depreciation, would then reflect this pattern. Thiswould however be an unfortunate mix up between an investment's Financial Logic and its BusinessLogic. The knowledge we have, that a certain investment makes more in the beginning, is our Busi-

ness Logic and can only be obtained if we separate it from the Financial Logic. The Financial Logic isthe, in real terms, constant benchmark, which enables us to obtain our Business Logic, a true Busi-ness Logic reflecting Business Reality and a Financial Logic reflecting the Financial Markets' Reality.We will not be able to obtain that knowledge if we measure the investment as being equally profitableover its economic life, an "EVA Index" of 1.00, as EVA would in this case.

Is this picture dramatically improved if we have an economic life of 10 years instead? No. As we cansee in graph 6.12 we still find a high requirement from the common EVA even if it does look a bit bet-ter than before.

We can also here express the Financial Requirement in percent. If we assume that 349 correspondsto a nominal capital cost of 15%, then EVA straight line depreciation requires 21% the first year and7% in the last year, an unwheighted average of 13.7%, not 15%. EVA using the annuity method re-quires 17% in the first year and 13% in the last year, an unwheighted average of 14.6%. CVA's Oper-ating Cash Flow Demand and EVA, using inflation adjusted annuity, will both require 15% every year.

The Net Present Values are the same for each curve.

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EVA's Financial Requirement, annuity depreciation

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Years: 1 2 9 10

EVA's Financial Requirement, straight line depreciation 485 443 199 171

EVA's Financial Requirement, annuity depreciation 387 376 305 297

EVA's Financial Requirement, inflation adjusted annuity depreciation 349 349 349 349

CVA's Operating Cash Flow Demand 349 349 349 349

Table 6.6

Graph 6.12

If we have an economic life of only 5 years as in graph 6.13 the picture will be further improved butEVA's Financial Requirement will not be corrected.

We can also here express the Financial Requirement in percent. If we assume that 550 correspondsto a nominal capital cost of 15%, then EVA straight line depreciation requires 19% the first year and11% in the last year, an unwheighted average of 14.6%, not 15%. EVA using the annuity method re-quires 16% in the first year and 14% in the last year, an unwheighted average of 14.9%. CVA's Oper-ating Cash Flow Demand and EVA using an inflation adjusted annuity will both require 15% everyyear. The Net Present Values are the same for each curve.

Years: 1 2 3 4 5EVA's Financial Requirement, straight line depreciation 680 603 531 462 397

EVA's Financial Requirement, annuity depreciation 579 562 546 530 515

EVA's Financial Requirement, inflation adjusted annuity depreciation 550 550 550 550 550

CVA's Operating Cash Flow Demand 550 550 550 550 550

Table 6.7

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Graph 6.13

7 Market Value Added - MVA

The goal of a company's Value Based Management (and Shareholder Value) process is to make theshareholders as wealthy as possible, but how is that measured? Bennett Stewart and his companyStern&Stewart have introduced a measure called Market Value Added. Bennett Stewart writes28:"Shareholders' wealth is maximized only by maximizing the difference between the firm's total value

and the total capital that investors have committed to it. We call this difference Market Value Added,or MVA:

MVA = Total Value - Total Capital"

The total value is the market values of debt and equity. The Total Capital is the adjusted total assetsfrom the balance sheet. It is adjusted according to the EVA concept.

Figure 7.1

Examples from the Swedish Stock Exchange29:

MSEK Market Value Capital MVA MVA Index30

AssiDomn 21,000 20,000 1,000 1,05Astra 166,000 44,000 122,000 3,77Ericsson 142,000 85,000 57,000 1,67

Incentive 32,000 29,000 3,000 1,10Stena Line 2,000 4,000 -2,000 0,50Volvo 99,000 100,000 -1,000 0,99Hufvudstaden 7,000 2,000 5,000 3,50Table 7.1

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Stern&Stewart frequently have listings published in many countries of the current MVA rating. Theseare often discussed in companies as something important and relevant, but are they? I agree withBennett Stewart on the fact that shareholder's wealth is maximized only by maximizing the differencebetween the firm's total value and the total capital that investors have committed to it. One thing wecannot do, however, is to define the Total Capital as something from a company's balance sheet. Ihere want to refer to all previous sections of this paper that discusses the weakness of the balance

sheet and especially the section on tangibles and intangibles in 6.3.

In table 7.1 we find some Swedish companies. We know (without using the MVA) that some of thosecreate value and some do not. We also know how much because we can measure it by looking at thestock development + dividends over time, which is the total return to the shareholders. So, does theMVA increase our knowledge or understanding? If the balance sheets used as the defined capitalwere adjusted for everything that we must adjust for when using EVA, then we would have a measurethat may increase our understanding of the company in question. We must then make at least the 164adjustments Bennett Stewart suggests. We must adjust the assets' time period, in which they are de-preciated over, for actual economic life. We must use real annuity, etc, etc. We must travel all the wayback on the circle 4.2.

We will not often see developments in balance sheets so extreme as the one we saw in graph 5.14. Itwill look more like the development in graph 5.15 where additional investments are carried out. So,you might think, what does my company's balance sheet look like in a graph like this? Well, I amafraid the answer is "we will never know". The example in section 5 presents a highly theoreticalsituation. It is a situation that is easy to analyse from EVA's point of view because the balance sheetis "clean" in the sense that it only consists of the depreciated remains of actual investment made innew stores, nothing more and nothing less, and the time period they are depreciated over equals ac-tual economic life.

In reality, the asset side of the balance sheet is a mess from a non-accounting point of view. It will notonly consist of depreciated remains of actual (Strategic) Investments made in stores. It will also in-

clude items such as Non-strategic Investments, advances to suppliers, prepaid expenses and ac-crued income, inventories and supplies, etc, etc. Some randomly chosen assets will be (incorrectly, ofcourse) adjusted for market values, etc. The time periods the assets are depreciated over will notequal actual economic life. The balance sheet will also leave out all Strategic Investments made inintangibles discussed in 6.3. The list can be made very long which is exactly what Bennett Stewarthas done listing the possible adjustments in the EVA concept. These "errors" from the non-accountingpoint of view will appear very different from one company to another, from one line of business to an-other. Some of the major differences will depend on if it is a local or multinational corporation, if thecompany's assets have long or short lives (one company could look like graph 6.11 another like 6.13),if the company is expanding or not, if it has been expanding in earlier years or not, etc, etc and finally,of course, how the company chooses to present the balance sheet over time. Again the list can bemade very long and companies can therefore not be compared using the balance sheet as one of the

components (or a balance sheet with less than at least 50-100 large and relevant corrections/adjust-ments).

The "Capital" in an MVA calculation must be a fully adjusted balance sheet, any other capital wouldmake no sense in a calculation together with a market value. Since it is not possible to obtain infor-mation on the corrections/adjustments necessary to make, in order to close the circle for the balancesheet in figure 4.2, those are not made. MVA listings are therefore not relevant and must be dis-missed. They do not increase our knowledge or understanding, on the contrary.

Also, a company's balance sheet illustrates the investments made to generate the business as wesee it today. In other words, it is the capital base for the Present Value of the future cash flow that willbe generated from the business if no further Strategic Investments are made. The market value, how-

ever, is the sum of the Present Value of the future cash flow from the business without any furtherStrategic Investments and the Net Present Value of the cash flow from future Strategic Investments.

The market values the company's ability to produce positive (or negative) Net Present Values in thefuture. An MVA does therefore not present a value added of the business today, it also includes the


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Net Present Value of the companys future business. We compare apples with oranges. A financialmanagement concept must naturally be able to separate those two values.

The "punch-line" here is the Hufvudstaden case. Hufvudstaden is an old real estate company thatowns some of Sweden's most beautiful (commercial) estates. Hufvudstaden's MVA is extremely good.

This should