Value based management economic value added or cash value added

In my opinion, there are four major frameworks within Value Based Management; Economic ValueAdded EVA®1, Cash Value Added CVA®2, Cash Flow Return on Investments CFROI, and Share-holder V

GOTHENBURG STUDIES

IN FINANCIAL ECONOMICS

971214

VALUE BASED MANAGEMENT:

Economic Value Added or Cash Value Added?

by

Fredrik Weissenrieder

Department of EconomicsGothenburg University

andConsultant within Value Based Management

Anelda AB

V Hamngatan 20S-411 17 GöteborgSweden

STUDY NO 1997:3

VALUE BASED MANAGEMENT:

Economic Value Added or Cash Value Added?

byFredrik Weissenrieder

VALUE BASED MANAGEMENT:

Economic Value Added or Cash Value Added?

by Fredrik Weissenrieder

VALUE BASED MANAGEMENT:

Economic Value Added or Cash Value Added?

In my opinion, there are four major frameworks within Value Based Management; Economic ValueAdded (EVA®1), Cash Value Added (CVA®2), 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 parts

of 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 version

of 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-

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 theway 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 course

be 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, according

to 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

Productivity Improvement

Operating Efficiency

R&D

Operating Cash Flow

Economic Life

CVA ® Value Drivers

Capital Cost

Strategic Investments

Pre-strategy Value Simulations

Investment Behavior

Capital Structure

Strategy Value Simulations Value Creation

Capital Allocation

Accounting:

Profit/shareP/E-ratios,

Logistics

SIL

Business Reality

Financial Simulation of Business Reality

Financial Markets' Reality

Relations

The consulting market contributes four basic frameworks for VBM: EVA, CVA , CFROI and SVA

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 Value 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)

calcu-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' 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

finan-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 thirdfactor 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 CVA® Software10

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-ment’s 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, as

we 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 can

Table 3.1

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:

ad-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 oftheir 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 the

IndexCVA Demand

Flow CashOperating

FlowCash

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

CVASales

OCFDSales

sInvestmentStrategic

NonSales

-MovementCapital

WorkingSales

SurplusOperating

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

X WACC = Financial Requirement

Bennett Stewart has identified a total of 164 adjustments and corrections This amount will probably

be different from country to country There is, of course, much more to this concept but this is cient to be able to compare the framework to the CVA There is software developed for EVA14

suffi-4.1 EVA's corrections - 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 all

164 corrections/adjustments it will still not function well enough That is the issue this paper cusses

dis-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, willincrease the value of the company

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 capital

market's reality:

in-vestments, cash flow,

economic life and

capital cost This is

where value and

profitability should

be measured DCF

models are therefore

applied here All

companies'

eco-nomic data can be

derived from here.

Economic tion has now turned into traditional ac- counting Manage- ment is no longer able to measure profitability or value.

informa-The company inserts the

in-vestments and cash flows into

different accounts because of

the external legal requirement.

Management gets the legal

re-quirement confused with

eco-nomic reality.

The firm’s book keeping is not readjusted towards cash flow.

The economic information is instead further battered by legal requirements and illustrated using P&L statements and bal- ance sheets.

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

"Cash Flow"

163 corrections/adjustments are made Here, EVA uses so-called straight-line depreciation.

EVA and so-called annuity depreciation.

EVA, as it is today, does not get any further

with its 164 corrections/adjustments At least

two more adjustments are necessary Those

will be dealt with in section 6 of this paper.

1

4

5 6

7

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 Howfar 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 formation from EVA, how much different then will not the information from EVA with another 160 or socorrections/adjustments be

in-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 pass four 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 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

tech-"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 importantadjustment? 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

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 must

be 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 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?

re-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 they

understand what they always have been working with, i.e the accounting process This is not, 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 need

how-to know it less than they do how-today Again, EVA is not how-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:

“Abandon Cash Flow!

However important cash flow may be as a measure of value, it is virtually useless as

a 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, and

therefore the more negative the immediate net cash flow from operations, the more

valuable 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 period

of 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 profitablegrowth; 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

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

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 in

1981 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 webecame 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

This will be reflected also at the aggregated level, the parent, since all investments made make the

5.1.2 EVA at the parent

same 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 rewarded

to a much lesser degree

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.

Table 5.3

CVA does not include the Strategic Investments (the expansion) in the cash flow but will instead 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)

acti-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

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 pands heavily and the expansion shows profitability all the way

ex-Graph 5.7

This expansion is however stopped in 1991 but managers at the beginning of the company's life will

be 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

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 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

pre-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 change

in 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 profitability

in the beginning but much larger after half time compared to CVA This despite the fact that each 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

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 that

expansion 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 this

situation - It must of course be possible to evaluate a business' profitability even if it is old and

written off in the accounting system!

EVA will in these cases hinder us from expansion when we create value and instead trigger us to pand when we destroy value The answer to the question asked earlier "does it matter" seems to be

ex-"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

Graph 5.11

At the aggregated level we get the following picture, shown in graph 5.12 EVA's Financial 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 After

Require-1980 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 bepresented internally and externally because the accounting way of doing things will not be taken forgranted in the future

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 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

ex-I should point out that even though the EVA ex-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

EVA Index 2 (depreciation in "Operating Profit" comparable with ROCE), store no 6

-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?

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