An Introduction to Corporate Finance: Transactions and Techniques, Second Edition

Chapter 10

SHAREHOLDER VALUE ADDED

(Economic profit)

 

One of the most important developments in corporate finance during the 1990s was the rediscovery of the concept of economic profit developed by an English economist, Alfred Marshall, in the 1890s. Economic profit evaluates a firm’s, division’s or business unit’s financial performance over a specific time period. A firm with positive economic profit is creating value for its shareholders. Negative economic profit destroys value: shareholders would be better off making an alternative investment.

 

Economic profit travels under many guises, depending on which firm of consultants you are talking to. The most widespread term is EVA™ which is the acronym for Economic Value Added. Others use Shareholder Value Added (SVA) or Cash Flow Return on Investment (CFROI).

JUST ANOTHER NUMBER?

Accounting profit is the figure struck after all expenses and taxes are deducted from the firm’s revenues during the period under evaluation. These expenses include interest paid to the holders of the firm’s debt obligations (bankers and bondholders). However, there is no explicit treatment of returns to shareholders – i.e., what is the cost of equity?

 

Another shortcoming of financial accounting performance figures is that they do not incorporate a figure for risk. Thus, senior management is not able to discern whether a project’s performance has delivered a return that is commensurate with its risk.

 

Thus, traditional measures, using accounting data, ...