Summary by Michael C. Massi
Master of Accountancy Program
University of South Florida, Summer 2002
Today, firms are spending a large sum of money on environmentally related operating costs and capital investments. Unfortunately, firms are not identifying and measuring the environmental costs properly, instead these costs are hidden and buried in various administration and overhead accounts. The article discusses that if the proper tools are used, shareholder value measures such as economic value added (EVA) can significantly improve corporate decision making for environmental management and improve both environmental and general capital investment decisions.
Often, firms today are making decisions based on incomplete data and incomplete analysis. The main reason is the lack of financial expertise in environmental health and safety departments and the attitude shared by most managers throughout the corporate world. The attitude shared by most is that they have no choice between projects because they must comply with regulations, thus they use poor judgment in which tools to use in making those decisions. This attitude produces inferior decisions and comprises efforts to design, implement, and manage corporate environment strategy. Thus, firms are inhibited in developing proactive approaches that could lead to long-term corporate profitability and substantially reducing environmental impacts.
The most common procedure used to make capital investment decisions is the discounted cash flow (DCF) analysis, while the method being used for environmental projects is a simple payback analysis. The payback analysis does not consider the time value of money and thus is not a good tool for decision making, but firms use it because the projects must be completed without regard to whether they are financially sound or not. The ending result is that the firms do not identify or analyze the impacts of the projects. Most firms using the payback analysis require payback periods substantially shorter than other capital investments and do not subject the projects to the rigorous analysis the capital investment process usually entails. Consequently, by choosing short payback periods, firms avoid typical corporate technical, environmental, and financial screens, ignore full understanding of future costs and benefits, and make improper decisions.
When firms use a DCF analysis, the analysis considers the impact of a project through its entire life cycle. This can be accomplished by using cross-functional groups that examine the impacts and changes in regulations, technology, cost of technology, consumer demand, and the impacts of those changes on the proposed capital investment. The article comments that the same techniques used to forecast cash inflows and outflows for traditional investment projects should be used to forecast environmental cash inflows and outflows. Obviously, environmental and voluntary projects will have a different decision process, but the analysis of alternatives and impacts should not. Most firms focus only on minimizing costs instead of minimizing net benefits and calculate the payback period without considering the time value of money, constituencies affected, or substantial future benefits.
The article mentions EVA as a way to show the impacts of an environmental investment on shareholder value and long-term improvements. EVA is like conventional measures of profit but differs in two ways: 1) The cost of capital is considered. 2) EVA is not constrained by GAAP. The net income figures reported by firms consider only the most visible type of capital cost—interest, while ignoring the cost of equity. The cost of equity is not measured because it represents opportunity costs, that cannot be observed directly. But these costs are real and highly subjective when being estimated. EVA represents a company’s profits net of the cost of both debt and equity capital—residual income. EVA also corrects for potential distortions caused by GAAP.
For one to understand EVA, one must understand market value added (MVA). MVA is the difference between the market value of the firm and its invested capital (including equity and debt) contributed to the firm. As a result, managers want to maximize MVA and not the value of the firm. Investing increasing amounts of capital can maximize MVA. MVA only increases when invested capital earns a rate of return greater than the cost of capital (positive net present value) and vice versa. MVA relates to EVA because it is the present value of the firm’s expected future EVAs. Therefore, EVA generates more attention because it is more amenable to periodic performance measurement.
EVA is calculated as follows:
Net Sales - Operating expenses = Operating profit
Operating profit - Taxes = Net Operating profit
Net Operating profit - Capital charges = EVA
Capital changes being defined as a company’s "invested capital" multiplied by the weighted-average cost of capital. Invested capital is the sum of all the company’s financing apart from noninterest-bearing short-term liabilities. GAAP will distort capital or operating income, hence most adjustments are in the form of "equity equivalents." Certain items are charged to income by applying GAAP that artificially and misleadingly reduce stated capital. If not restored, capital charges will be understated and operating income will be misstated. The potential number of adjustments is limitless and so far EVA consultants have identified more than 150 changes.
EVA is an innovative method for managers to use for decision-making for three important reasons. First, EVA is not bound by GAAP, which allows its users to make whatever adjustments are needed to produce more economically valid numbers. Second, EVA is the responsibility of all members in an organization. EVA has been pushed to lower levels on the assumption that all employees will undertake their tasks with a goal to create shareholder value. Finally, EVA offers a means of measurement and communicating performance used in capital markets, capital investment appraisal, and evaluation and compensation of managerial performance. For example, take a typical investment that one will undertake if net present value (NPV) is positive and reject if it is negative. NPV is calculated by subtracting capital to be invested from the present value of the net cash flows. Considering how MVA is calculated, MVA is equivalent to the present value of the cash flows to all capital providers net of the capital invested in the firm. Therefore, firms use EVA/MVA to evaluate capital investments because these measurement tools yield the same answer as NPV. Meaning, communication that firms use with shareholders can be used for internal decision making.
Since both tools yield the same answer, what does EVA offer? From a valuation standpoint, EVA offers nothing. But, the advantage with EVA is that it corrects the problem with NPV. NPV creates a stock or wealth measure, which is not a flow measure. NPV measures the total amount of wealth that is expected to be created from an investment or activity, not performance. Given that NPV equals MVA and MVA is the present value of future EVAs, EVA becomes a technique to convert the stock measure of NPV into a flow.
When firms are making capital investment decisions, they must be careful to consider the impacts of their products, services, and activities on their constituents over the life of the investment. But, most firms make decisions about environmental issues without considering the life-cycle impacts that will affect long-term corporate profitability. Firms need to estimate future costs and benefits that probably will be internalized. Once the analysis of future financial impacts is complete, it should include those results in an EVA analysis. EVA can illustrate the potential contribution of a project that managers will recognize when deciding if a project maximizes shareholder value.
Firms adopt EVA because it makes managers think and act like owners. The biggest risk for owners (shareholders) of firms is that managers will act in their own interest at the expense of shareholder wealth. Implementing EVA in a firm can reverse this issue and create as much wealth for shareholders as possible over the long run. The article discusses a checklist for implementing EVA (Exhibit 1). However, implementation can be complicated, frustrating and requires:
A full commitment from top management—the philosophy must be integrated into all the key systems and must be reinforced.
A decision on which adjustments are to be made to the GAAP-based accounting numbers.
A careful consideration of transfer pricing and overhead allocation policies and their impact on EVA calculations—this is crucial because it can interfere with making managers think and act like owners.
Intensive training for any manager or employee whose bonuses will be linked to EVA—understanding of how their unit EVAs will be calculated and how EVA will be linked to compensation is extremely important.
In conclusion, EVA is an important tool for communicating information effectively throughout a firm to maximize shareholder value when making capital, environmental, and voluntary investment decisions.
Exhibit 1 - Checklist for implementing EVA:
Step 1: Establish buy-in at the board and top management levels.
Step 2: Set up a steering committee.
Step 3: The steering committee formulates a strategy.
What functions will be tied to EVA?
How far down the hierarchy will EVA be calculated?
Who will be covered?
How will the bonus plan work?
Relation to Nonfinancial Measures
Step 4: The steering committee appoints a working committee to implement this strategy.
Step 5: Set up a training program.
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