STRATEGY

ECONOMIC VALUE ADDED AND SMALL BUSINESSES

Charles P. Baril
S. Brooks Marshall

James Madison University

Robert F. Sartelle
Virginia Corporation Commission

ABSTRACT

Economic Value Added (EVA), a tool for creating wealth, is a leading idea in corporate
finance today. Highly regarded companies like Coca-Cola and CSX have seen their market
value soar since adopting EVA. The concept is straightforward; value is created when
earnings exceed the cost ofinvested capital. Thus, EVA is rapidly gaining acceptance among
large, publicly-tradedcorporations. However, EVA can be applied effectively to create value
in small, privately-held firms, too. This article illustrates EVA's application in small,
privately-heldfirms, examines E VA 's strengths and weaknesses, discusses ways to overcome
those weaknesses, and describes speciJic operating, investing and fmancing actions small
business managers can take to create wealth.

INTRODUCTION

Today, small businesses operate in an increasingly competitive environment. The
combination of rising global competition, saturated traditional metropolitan markets, and
advances in computer technology has prompted many large corporations to seek growth
through expansion into smaller, less developed communities. Walmart's incredible success
story is a case in point. Over the past thirty years, in one small town aAer another, the opening
of a Walmart store has signaled the death knell for dozens of locally-run businesses.

The secret to Walmart's success has been its unrelenting drive to create value, for its
customers and itself, in the form of a state-of-the-art purchasing, distribution, and
merchandising system which allows it to provide swiA, convenient service and low prices. For
small companies facing the challenge of powerful, new competitors entering their markets, the
normal "business as usual" response will not suAice. Rather, to survive these companies must
operate more elfectively and eAiciently. In short, they must act to create value.

To create value, a firm, division, or project must earn more than its capital charge. This
fundamental financial concept is the comerstoneof free enterprise. Yet, managers oAen violate
this premise, taking actions that destroy rather than create wealth. A primary reason for
management's value-destroying behavior is that the traditional earnings-based measure of

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performance does not include the cost of equity capital. Consequently, managers who focus
on accounting earnings frequently understate or ignore the cost of equity capital in their
decisions,

Since the early 1980's, this key to creating wealth, earning more than capital costs, has
resurfaced as a driver of management decisions, particularly among large, publicly-traded
companies. While a number ofbusiness consulting firms have developed their own systems
incorporating this value-creating principle, Stern, Stewart & Co. popularized the concept
calling it Economic Value Added (EVA). Focused on enhancing the value of a firm,
EVA-based systems are useful for setting goals, making operating, capital investing and
financing decisions, assessing firm and sub-unit performance, designing incentive

compensation plans, and communicating with business investors and creditors. Although the

best known adopters are large, publicly-tradedcompanies including Coca-Cola, AT&T, CSX,
Tenneco, and Briggs-Stratton, the EVA concept is equally applicable to small, closely-held
businesses.

This article illustrates EVA's fundamental components and its application for small,
privately-held companies. We describe specific operating, investing and financing actions

promoted by EVA's discipline which create firm wealth. In addition, we discuss the potential
limitations of adopting EVA and suggest ways to overcome these weaknesses.

THE COMPONENTS OF ECONOMIC VALUE ADDED

Economic Value Added (EVA) measures a company's, division's, or project's
incremental change in value of its base investment over time. Specifically, EVA is the unit's
after-tax operating profit minus its capital charges(the cost of its debt and equity capital.) The
EVA formula for a single period is presented below.

EVA = NOPAT - (Cost of Capital x Total Capital)
where NOPAT = net operating profit ai)er taxes,

Cost of Capital = weighted average cost of debt and equity financing, and
Total Capital = total cash investment in the firm, division, or project.

To illustrate, assume that Value Add, Inc. (Value Add hereafter) has total capital
invested of $ 1 million, composed of $400,000 debt outstanding and $600,000 invested by
owners. Also assume that the weighted-average cost of this invested capital is 12.2%, and
Value Add's net operating profit atter taxes, NOPAT, is $ 122,000. Value Add's EVA
calculation is shown below:

EVA = NOPAT - (Cost of Capital x Total Capital)
= $ 122,000 - ( 12.2% x $ 1,000,000)
= $ 122,000 - $ 122,000
=$0.

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Because Value Add's earnings equal its capital charges, an EVA of $0 results. With a return
on investment just covering its cost of capital, Value Add's managers created no change in
value or wealth for the period.

NOPAT, EVA's measure of earnings, differs from traditional accounting measures due
to EVA's focus on value creation. To calculate NOPAT, two fundamental adjustments are
made to net income. First, all expenditures generating benefits for more than one period are
capitalized and amortized as expenses over the multiple periods benefited. Second, interest
costs are removed from the income statement and reclassified as a part of the capital charge.

Figure I
0 I ADD

Income Statement EVA

Sales $ 1,200,000 Sales $ 1,200,000

Costs and Expenses: Costs and Expenses:

Cost of goods sold 700,000 Cost of goods sold 700,000

Selling & Administration 360,000 EVA considers te dt 0 an Selling Ec Administration 360,000
investmentratherthan an

R&D 60 000~ expense of the period. 0

*0 4D ODD * '* T * 18 000
I 180 000 I 078 000

122,000
Income before taxes 50,000

Capital Charges:
T I 8207~10 000

Interest expense (net ot32,000
N a s 40 000 $8,000 tax savings)

Equity charge ~000
122,000

EVA S 00

Figure I presents Value Add's NOPAT and EVA measures compared to its income
statement. As discussed, two adjustments are made to Value Add's net income to determine
NOPAT, EVA's measure of operating performance. First, consistent with management's intent
research and development(R& D) expenditures are considered an investment benefiting future

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periods. Thus, in the period of the R&D cash outlay, Value Add's NOPAT is unatTected by the
$50,000 expenditure. Instead, for NOPAT measurement purposes, Value Add will amortize
R& D expenditures over the periods benefited, rather than expensing them in the current period
as required under generally accepted accounting principles. Similarly, Value Add would

capitalize and amortize marketing, employee hiring and employee training expenditures that
have a recognizable future benefit over the periods benefited for NOPAT measurement
purposes.

Value Add's second adjustment to traditional net income reclassifies interest expense,
net of $8 000 in tax savings. EVA excludes all financing charges from its measure ofoperating
performance, NOPAT. Instead, the cost ofboth debt and owners'quity are captured in EVA's

capital charges component. By separating operating results from financing costs, Value Add's

managers can better identify and remedy problems in new capital projects and on-going
operations. In summary, to measure NOPAT and provide an improved operating performance

measure, Value Add treats the period's R&D expenditures as an investment and classifies
interest expense as a capital charge.

While NOPAT reflects the results of operations, capital charges reflect the cost of
financing those operations. The capital charges component of EVA explicitly incorporates the
cost of all capital employed, both debt and equity. Value Add's capital charges for the period
total $ 122,000, with borrowed capital costing $32,000 and equity capital costing $90,000.
With a $ 1,000,000 total capital investment, $400,000 in outstanding debt and $600,000 in
equity, Value Add's cost of capital averages 12.2% ($ 122,000/$ 1,000,000).

Value Add's cost of debt financing is its interest expense adjusted to reflect its tax
deductibility. The income statement for Value Add shows $40,000 in interest expense,
indicating an average before-tax cost of 10% based on $400,000 in borrowed capital. Value
Add's 20% marginal tax rate creates a tax savings of $8,000, and results in an afler-tax cost of
borrowing of $32,000.

Value Add's equity charge is the return its owners could be getting if they put their
money in an alternative investment of similar risk. Over the lifetime of the company, Value
Add's owners have invested cash totaling $600,000. Value Add's owners demand a 15%
return on their invested capital. Therefore, Value Add's capital charge for equity totals

$90,000 (15% x $600,000).

Frequently, the rate of return required by owners is computed by adding a risk premium
to the cost of debt. Because equity capital carries greater risk than does debt, the

owners'equired

return is somewhat higher than the return lenders demand. Value Add's 15% equity
cost represents a 5% risk premium added to its 10% cost of borrowing.

Much of the capital invested by owners is captured in conventional accounting's
valuation of net assets, including the cost of land, plant and equipment, and working capital.
However, Value Add's R&D expenditure points to another distinguishing feature of EVA.
Consistent with management intentions, R&D is treated as a capital investment benefiting
future periods. However, by classifying R&D cash outlays as an equity capital investment,

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Value Add recognizes an additional equity charge, the cost of the $50,000 incremental cash
investment by owners.

Thus, to determine the equity capital tied up in Value Add's operations, start with the
cost of its land, plant and equipment, and working capital reported on its balance sheet. Then,
add the $50,000 cash invested in the RkD project. Value Add's total capital investment of
$ 1,000,000 results. Of this amount, $400,000 is provided by lenders, leaving $600,000
provided by owners.

The components of EVA have the advantage of resembling the conventional earnings
measure. However, EVA and other value creation tools modify these conventional measures
to better capture the economic substance of the firm's operations. In addition, EVA separates
a company into three functional categories: operating, investing, and financing activities This
categorization allows the drivers of value creation to be more easily identified. In the next
section we describe specific wealth-creating strategies promoted by EVA's discipline.

CREATING VALUE WITH EVA

According to EVA, there are but four ways to create economic value. The first is to
improve the company's operating performance. The second is to reduce the cost of capital.
The third is to eliminate investments in projects earning less than their capital charges. The
last is to invest in future projects that are projected to earn more than their capital charges.
EVA's primary virtue is that it clearly shows and measures how each strategy creates value.
While the small business owner may find these suggested actions consistent with what he or
she is already doing, some may provide insights into value-creating opportunities.

Increasin 0 eratin Profits NOPAT

The first way to create value is the most obvious. Companies can create value simply by
increasing operating profits, while adding no new capital. For example, a manufacturing firm
may find a way to operate an existing machine more efficiently by performing routine
maintenance less frequently or during idle time. Or, a service firm may find that lower-cost
employees provided with additional training can perform certain tasks assigned previously to
more senior, higher-cost employees.

Increasing operating efficiencies is a strategy familiar to most small businesses.
Traditional financial systems support this type of value-creatingactivity. However, traditional
systems that focus on enhancing periodic earnings can destroy a firm's long-term value.
Examples include slashing advertising or R&D expenditures to meet quarterly profit goals.
EVA offers the advantage of focusing management attention on long-term value creation
through an improved measure of operating performance that is more closely aligned with the
economic substance of a firm's operating decisions.

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Reducin The Cost Of Ca ital

Value is created when a firm's capital charges decrease. The most effective means of
cutting capital charges is to reduce the cost of capital. The cost of capital is composed of two
parts, the after-tax cost of debt and the rate of return owners require on their investment.
Management approaches to reducing a firm's cost of capital can include shiiting from equity
to debt financing, shrinking the cost of debt financing or slashing the cost of equity financing.

Most small businesses are financed initially with equity capital which is cash invested

by owners. Frequently, lenders are reluctant to extend credit to small, start-up companies

because they are viewed as poor credit risks. However, an extended period of successful
operations can "open doors" for a small business, providing access to debt financing.

Once debt financing becomes available, managers should consider using it in lieu of
equity capital. Value can be created through the use of additional debt because equity is a
more costly form ofcapital. From an investor'sstandpointequity capital is a scarcer resource
and it lacks a regular repayment feature. From the firm's perspective equity charges, unlike

interest payments, are not deductible for tax purposes.

A second means of reducing capital charges is to retire higher-cost debt and re-issue new
debt at a lower cost. For example, a small business manager may be able to negotiate lower
interest rates with existing lenders by demonstrating a reduction in risk Once again financial
statements documenting successful performance over an extended period can facilitate the

bargaining effort.

In negotiating reduced interest rates, small businesses need to show lenders how

expenditures for RIkD or employee training can be viewed as investments benefiting future

periods. While conventional earnings measures expense these items as incurred, many
financiers now think such discretionary expenditures enhance rather than diminish the firm's

future operations and its potential for servicing its loans. Keith Wells, Vice President of First
Union Mortgage in Richmond, Virginia, states that "In evaluating loan proposals, we ask if
some of the items expensed actually provide future, long-term benefits. If so, we capitalize
those expenditures." EVA performancemeasures aid a lender's efforts to capture the economic

substance of a firm's operations by isolating expenditures that benefit future operations.
EVA's popularity can help the manager market this view of operating performance.

In addition, if lenders perceive the company as being less risky, so too should owners.
As a result, owners can lower their required rate of return, thereby trimming equity charges.
A short-hand method used by many small firms to determine their cost of equity is to add
approximately5% to their cost of debt (Brigham, 1995). With this method, reductions in the
cost of debt lead to similar reductions in the measured cost of equity capital.

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Reducin Investments In Pro'ects Earnin Less Than Their Ca ital Char es

Firms with substantial equity financing seldom give adequate attention to minimizing
uneconomicworking capital and capital assets (Birchard, 1994). By focusing management's
attention on the value produced by individual capital projects, product lines or business
segments, an EVA system highlights the value-creating possibilities of eliminating
unproductive capital investments.

CSX, the large railroad company, provides a well-known example of creating value
through a strategy of eliminating investments with negative EVA's. With the discipline
provided by an EVA system, CSX managers determined that three locomotives could do the
job where it once used four on certain routes (Tufly, 1993). While slower, they still arrived in
time for unloading. As a result CSX was able to reduce its locomotive fleet by one-third,
eliminating $70 million in under-productive invested capital. In addition, the decrease in
locomotives generated a 25% savings in fuel costs. Thus, CSX decreased capital charges by
reducing total capital and enhanced the company's cash operating earnings.

Another class of assets that tends to absorb the invested capital of small businesses is
working capital. Managers who can sustain their firm's operating performance while
decreasing cash, short-term receivables, or inventory will create value for their company by
eliminating unnecessary debt and equity financing and their capital charges.

For instance, the establishment of an EVA system enabled management at Quaker Oats
to recognize the substantial capital costs associated with carrying sizable inventories (Tully,
1993). By eliminating quarter-end sales promotions, they smoothed sales and reduced their
need for huge stocks of inventory. Further, by reducing inventories, the company could close
tive of 15 warehouses, saving both capital costs and salaries.

Traditional performance measures frequently fail to show the impact of holding
unproductive assets. Based on conventional earnings measures, a business segment with
operating profits in excess of its interest costs is viewed as "profitable." However, if the
business segment's equity charges are not also covered by its operating profits, the EVA
system will identify the business segment as a value destroyer. EVA-focused companies will
sell or liquidate this unprofitable unit, and either re-deploy the cash proceeds in more profitable
ventures or return the capital to the firm's owners through higher dividends or stock buybacks.
Likewise, small business owners can examine carefully the contribution of each asset group
or segment of their businesses to determine whether the capital invested is being used
effectively.

Increasin a ital Investment In Pro'ects Earnin More Than Their Ca ital Char es

An EVA system encourages managers to invest in all value-creating projects, those for
which operating profits are projected to exceed capital charges. In contrast to the strategies
previously discussed, the capital investment strategy focuses on the effective management of
growth rather than of existing operations. Not only does it provide a structure for evaluating

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the ongoing effectiveness of capital investments, an EVA system measures effectiveness in a
manner consistent with the analysis used for accepting or rejecting proposed projects.

For most firms capital investments at the proposal stage are subjected to structured,
discounted cash flow analyses. However, once accepted, a project is typically monitored, if
monitored at all, using traditional earnings-based measures such as return-on-investment. EVA

attempts to correct this inconsistency between the evaluation criterion and the monitoring
measure in two ways. First, EVA considers all expenditures intended to benefit future periods
as investments. Second, EVA performancemeasuresremind small business managers that the
investments of owners in any project require a return.

John Sherwood, Partner at Warren, Whitney and Sherwood, a contract management finn

in Richmond, Virginia,agrees that small businesses need to incorporate a return on the
owners'nvestments

into their investment and divestment decisions. "Small businesses are not
contractually obligated to compensate owners for the use of their money. As a result, equity
costs are oflen ignored in business decisions. Any system which considers such costs is a step
forward."

Mechanisms To Promote Value Creation

These four strategies for creating value provide a framework for thinking about the
whole firm's performance and identifying areas for improvement. However, as most small
business owners will attest, conceptualizing value creation is only part of a manager's task.
Motivating its implementation is the other. One mechanism available to companies adopting
EVA systems is a restructuring of their management compensation packages to reflect the
importance of creating value. For small firm owners seeking to transfer managerial
responsibilitiesto non-owners, value-based compensation arrangements can be an integral part
of the solution.

The EVA system includes an executive compensation plan that rewards managers for
EVA wealth creation, thereby simulating the risks and rewards of ownership (Stewart, I 991:
p.249). Incentive plans promoting the creation of value make the ultimate payout contingent
on continued, long-term success. These plans place golden handcuffs on the best performers

by smoothing the annual payout for cyclical ups-and-downs. And, they provide for the
potential of both unlimited bonuses and unlimited losses.

Stern, Stewart gc Co. suggest another mechanism for promoting entrepreneurial,
value-creating, behavior among managers, increased debt levels. Sometimes sustained

prosperity, a temporary lull in competition, or stable markets can produce a sense of
complacency, resulting in unfocused management and "flabby" business operations. When
economic conditions worsen, these unprepared firms lose market share, are bought out, or even
fail. To avoid this fate, Stern, Stewart & Co. recommend a regular cycle of higher debt levels
to put companies through the equivalent of boot camp. The discipline of servicing debt forces
management to continually squeeze operating efficiencies out of the business and shed
unproductive assets, focusing its attention on the remaining core businesses.

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Thus far we have presented the components of EVA and four strategies for creating
value encouraged by an EVA-based system. Because EVA was not widely publicized until
1991, much of what we know has been provided by the consultants selling the system
(Peterson & Peterson, 1996). More valuable insights can be gained from the experiences of
firms adopting EVA systems in the early 1990's. Next. we discuss some of the limitations
experienced by firms implementing EVA systems, consider how these limitations apply to
small businesses, and suggest some remedies small business managers may find effective.

EVA LIMITATIONS AND REMEDIES

EVA's popularity is based in large part on its alleged (Boston Consulting Group, Inc.,
1996) relationship with market valuation. "Investors who know about EVA, and know which
companies are employing it, have grown rich" (Tully, 1993). However, while "the theory is
compelling, the evidence is abysmal" (Lowenstein, 1997). Yet, market value relationships
should not drive the adoption decisions of closely-held, small businesses. Small businesses
should emphasize value creation, not valuation by an external constituency.

In deciding whether to adopt an EVA system, small business owners should examine
the experiences of publicly-traded companies and consider the applicability of these
experiences to their own firms. Further, these owners should reflect on additional limitations
which may be encountered by small-firm adopters and possible remedies. Then, using their
common sense small business owners must weigh the potential benefits and costs. Finally, if
convinced that adopting an EVA system will increase the value of their companies, they must
carefully develop plans for its implementation.

For the implementation of an EVA system to be successful, experience has shown that
management must embrace the concept. As with any new performance measurement system,
managers are likely to meet the adoption of an EVA-based system with apprehension. Despite
all of the arguments in favor of performance metrics that reward capital productivity, many
managers will continue to prefer retaining traditional, earnings-based measures. An EVA
system's implementation is seriously handicapped if management is not deeply committed to
enhancing value and if the existing corporate culture is too rigid to accept a program that aims
to affect how people behave (Stern, 1994).

To get managers to buy into an EVA system, they must understand the system and its
performancemeasures. Ochsner(1995) advises adoptingcompaniesto implementan extensive
education program for managers. Of course, management education programs are costly. But,
Stewart (1995) wams'that scrimping on training is one of the main ways business people err
in applying EVA.

One avenue for controlling training costs and facilitating understanding is to simplify
the system, reducing complexity. Facing substantial write-offs, Valmont Industries, Inc., a
small, mid-western manufacturer of metal structures, needed to get a firm grip on managing
existing capital. In response, Valmont's management adopted a bare-bones version of EVA.
They chose a simple performance measure, net operating profit minus a ten percent charge for
invested capital. Valmont found that the nature of its financial position and operations made

75



adjustments for intangibleassets, off balance sheet financing and inflation unnecessary. The
impact of these adjustments on Val mont's performance measure was minimal (Birchard, 1996).

Many small businesses can alleviate the dual problems of management apprehension and
added cost by adopting such a simplified system of measurement which retains EVA's
value-creating strengths. By employing a measure of operating performance available from
its conventional income statement, Valmont minimized training costs and spared itself the cost
of creating two sets of books. However, before adopting a similarly simple system it is
imperative that small businesses ensure that the simplifications do not sacrifice important
information. Ultimately, the system adopted must promote managerial attention to creating

value.

Additionally, a simple measure of operating performance like Valmont's helps focus
management on the costs of using equity capital. This is paramount when working to create
value. And, to measure its charges for equity capital Valmont applied a straightforward, ten
percent rate. While publicly-traded firms may face difficulties in estimating their cost of
capital (Peterson Ec Peterson, 1996), small business owners need only answer the question,

"

what expected retumdo you require on your investment?" Ifconsensus is too hard to reach,
Brigham (1995) recommends adding approximately 5% to the firm's cost of debt. Small
businesses can start there and revise if deemed appropriate. The point is not to fine-tune the
estimate, but to ensure that the costs associated with investments by owners are incorporated

into the decisions of the business.

Beyond the hurdles of added implementation costs for new systems and gaining
managementacceptance.small businessesmay find it unrealistic to adopt Stem and Stewart's

suggestion to increase debt financing. Many small businesses have limited sources for added

borrowing, making increasedborrowingdifficultto obtain. Compoundingthis problem, small

businesses otten lack diversity as to products and customer base. Higher debt levels magnify
this operating risk. With greater variation in cash flows, some of these businesses may be
subjected to unacceptable levels of risk (Brigham, 1995).

Moreover, increased debt levels can diminish a Iirm's financial tlexibility. The ability

to respond quickly to investment opportunities, a competitive advantage of many small
businesses, depends on having ready access to additional funds. Rising debt levels magnify
the difliculties of securing borrowed capital.

Nevertheless, small firms can overcome these constraints. Instead of employing high
debt levels to align the interests of managers with owners, they can introduce effective
incentive compensation arrangements. Or, consistent with the limited scope of their

firms'perations,

small business owners can control management behavior through effective

oversight.

Finally, for the small business introducing an EVA based system, some of the problems
of conventional accountingsystems remain. Economic profit is still subject to manipulation.
And, periodic performance measures may encourage management to reject promising projects

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due to negative, short-termimpactson EVA(Boston Consulting Group, 1996; Birchard, 1996).
Once again active participation by owners can mitigate these problems for many small
businesses.

CONCLUSION

Touted as today's hottest financial idea, EVA commun ic ates in a straightforward manner
the message that most firms can become more competitive and valuable by shiRing
management's perspective from profit enhancement to value creation. EVA systems are
grounded in the fundamental principle that value is created when operating earnings exceed
the cost of Rnancing those operations. Accordingly, EVA's performance measures take into
account the cost of the money owners have provided, as well as the cost of borrowed capital.
With no contractuallyspecified cash payments, many small business managers resist the idea
that real costs are incurred when they employ equity capital. By restructuring management
compensation plans, EVA systems encourage managers to consider the total cost of their
operations'capital when making operating, investing and financing decisions. EVA systems
direct managers to create value.

However, EVA is no panacea. While the fundamental concepts are broadly accepted,
successful EVA system implementations have been limited generally to publicly-traded
companies with substantial resources. In addition, some of the problems of conventional
systems remain. Bearing in mind the competitive importanceof fostering a concern for capital
efficiency among managers, small businesses should examine the experiences of EVA
adopters, and tailor any implementation of value-based measurement systems to their unique
business settings.

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Executives, 10 (10), 30-38.

Birchard, B. (1996). How Valmont Industries implemented EVA. CFO The Magazine for
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Boston Consulting Group, Inc. (1996, October). Shareholder Value Management.
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Dryden Press.
Lowenstein, R. (1997, February 13). Testing the latest economic elixir. The IVall Street

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Ochsner, R. C. (1995, March/April). Welcome to the new world of economic value added.

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Stem, J. (1994, March). No incentive for bad management. Corporate Finance, 43-44.
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