Discussion Issues and Derivations
Economic Value Added as a Measure of Asset Quality
- Project failures, divestiture and project termination
Conventional wisdom holds that firms should get rid of poorly performing assets or divisions, either by selling the division to someone else or salvaging the underlying assets. It is not as simple as that.
A poorly performing asset is one which earns a return that is less than the hurdle rate. Consider first the alternative of salvaging the underlying assets and terminating the project. If you could get back the initial investment back, this would make sense. If, however, the salvage value is less than the initial investment, the firm may better off keeping the asset and allowing the project to continue.
Consider next the alternative of selling the project to a third party. Again, the price obtained in the divestiture has to be greater than the continuing value of the project for it to make sense.
Economic value added is a value enhancement concept that has caught the attention of both firms interested in increasing their value and portfolio managers, looking for good investments. EVA is a measure of dollar surplus value created by a firm or project and is measured by doing the following:
Economic Value Added (EVA) = (Return on Capital - Cost of Capital) (Capital Invested)
where the return on capital is measured using "adjusted" operating income, where the adjustments eliminate items that are unrelated to existing investments, and the capital investment is based upon the book value of capital, but is designed to measure the capital invested in existing assets. A project with positive EVA is creating value, whereas one with negative EVA.
In the context of investment analysis, the present value of the EVA created by a project should be equal to the net present value of the project.