EVA As A Performance Evaluation System--A Theoretical Analysis

For a long time the major corporate financial theory has believed the aim of business operation is to maximize enterprise value and managers' primary job is to create wealth for the shareholders. But this idea hasn't gotten much attention before 1980s. Though shareholders expected managers to do their best and compensated them on the basis of their performance, those unappropriate evaluation index and systems didn't make it easy for shareholders to monitor managers. An uncompetitive capital market and global economic growth concealed the managers' low effort to maximize the shareholders' wealth .By the end of 1970s, managers learned a lesson from the fast changing capital market and the trend of globalization that capital has highmobility-----if you couldn't bring the required reward to shareholders' capital theywould flow to where they could make it. As well as the cost of labor and the cost of raw materials, enterprises must pay for the capital that is employed. And the shareholders realize that opportunity cost. A real evaluation of managers' performance must take all the cost into account. Obviously the traditional evaluation methods based on accounting profit don't meet the demand. Actually accounting profit includes the real economic profit and the cost of equity capital which should be subtracted in order to evaluate the managers' performance. This leaves much room for managers to adjust the accounting profit and their immoral behavior become unavoidable. So Economic Value Added arises at the historic moment.EVA is defined as the after-tax profit minus the cost of capital whether it is borrowed or contributed by shareholders. In comparison with accounting profit the main advantage of EVA is that it takes the cost of all the production factors into account and it represents the notion of economic profit proposed by Marshall more than 100 years ago. It is very clear that EVA could be a valuable tool in performance evaluation since it shows the increase or decrease of enterprise value and shareholders' wealth. More than being a simple index, EVA has become the central concept of an evaluation system and compensation plan designed by Stern Stewart Co. of New York City. Since EVA is the source of the shareholders' wealth the managers would act like the shareholders, if their compensation and motivation plan are linked with EVA. Thus EVA becomes the primary goal in managers' each decision.As China is developing market economy people become more or more aware of the use of capital .In early 1990s EVA was introduced into China by some scholars and Stern Stewart Co also extended its consulting trade to China in late 1990s. But untilnow most of the EVA proponents only referred to its advantages, and avoided to discuss its defect. The thesis attempts to make a full review of EVA as an evaluation system, focusing on its thinking rather than its practice.This thesis is divided into five parts. Part 1 gives a general account of the application of EVA in business world and asks what is EVA and where its appeals come from.In Part Two the concept and theory of EVA are expounded. EVA is essentially the economic profit. The basic difference between EVA and accounting profit is that the calculation of EVA follows the fundamental principle of economics-only if the earning of an enterprise covers the cost of all the capital that are employed the shareholders' wealth increases. Historically speaking EVA is not a new concept. It develops from Residual Income which adjusts the generally accepted accounting standards in order to get a closer imitation of economic profit. Since accounting records very detailed information about the business operation in an enterprise ,applying EVA only requires a new method of calculation rather than erecting a new data system.The effectiveness of EVA evaluation system lies in the correlation between EVA and value, which are proved by a series of theoretical models in Part three. Furthermore a new measure called Market Value Added(MVA) is coined to make EVA a more useful tool i...