The relationship between the book value of shareholders' equity and the firm's Market Value Added (MVA) and Economic Value Added (EVA)

Yesterday, Extensive Enterprise Inc. released its annual report on the companys website. While reading the report for his boss, Musashi came across several terms about which he was unsure. He leaned around the wall of his cubicle and asked his colleague, Kyoko, for help.

MUSASHI: Kyoko, do you have a second to help me with my reading of Extensives annual report? Ive come across several unfamiliar terms, and I want to make sure that Im interpreting the data and managements comments correctly.

For example, one of the footnotes to the financial statements uses the book value of Extensives shares, and then in another place, it uses Economic Value Added. Ive never encountered those terms before. Do you know what theyre talking about?

KYOKO: Yes, I do. Lets see if we can make these terms make sense by talking through their meaning and their significance to investors.

KYOKO: The term book value has several uses. It can refer to a single asset or the company as a whole. When referring to an individual asset, such as a piece of equipment, book value refers to the assets , adjusted for any accumulated depreciation or amortization expense. The value, or difference between the machines historical cost and its accumulated depreciation expense, is called its book value.

In contrast, when the term refers to the entire company, it means the total value of the companys as reported in the firms .

MUSASHI: That makes sense. So, what makes this value important to investors is that it is value that can changebut only due to a couple of events, including the of Treasury stock, the sale of new common or preferred shares, and the payment of . Equally important, it change in response to changes in the market prices of the firms shares.

KYOKO: Right! So, how useful would a firms book value be for assessing the performance of Extensives management?

MUSASHI: Well, because Extensives book value with changes in the market price of the firms shares, the firms book value reflect managements efforts to maximize the price of the firms common stock and therefore be used to evaluate managements performance.

Now, what about Economic Value Added?

KYOKO: During the 1990s, the consulting firm Stern, Stewart & Company developed the concept of Economic Value Added, or EVA, to better assess managements performance in maximizing their shareholders wealth.

Extensives EVA equals the additional profit created in excess of the after-tax operating income necessary to finance its total after-tax cost of capital, which is expressed in annual dollars. It is computed by subtracting Extensives from its .

In turn, Extensives annual cost of capital is calculated by multiplying its total operating capital, which includes its net fixed assets and net operating working capital, by the after-tax percentage cost of capital.

OK, given that description, heres a question for you: Compared to the book value, what is the advantage of using the EVA to evaluate the performance of Extensives management?

MUSASHI: Give me a second to think. . . OK, its better to evaluate the performance of Extensives management by using the companys EVA rather than the book value of its shareholders equity because the better the managerial decisions being made, the the after-tax net operating income earned, the the difference between this net operating income and the cost of capital needed to generate that income, and the the EVA, or true economic profit, earned by the company.

KYOKO: Nicely done! Does this make your reading of Extensives annual report easier?