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

$($EVA$)$

Yesterday, Western Gas & Electric Co$.$ released its $2018$ annual report on the company's website. While reading the report for his boss, Alexis came

across several terms about which he was unsure. He leaned around the wall of his cubicle and asked his colleague, Claire, for help.

ALEXIS: Claire, do you have a second to help me with my reading of Western G&E$\text{'}$s annual report? I've come across several unfamiliar terms,

and I want to make sure that I$\text{'}$m interpreting the data and management's comments correctly.

For example, one of the footnotes to the financial statements uses "the book value of Western G&E$\text{'}$s shares," and then in another place, it

uses "Economic Value Added." I've never encountered those terms before. Do you know what they're talking about?

CLAIRE: Yes, I do$.$ Let's see if we can make these terms make sense by talking through their meaning and their significance to investors.

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 asset's

$,$ adjusted for any accumulated

depreciation or amortization expense. The

value, or difference between the machine's 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 company's.

as reported in

the firm's

ALEXIS: That makes sense. So$,$ what makes this value important to investors is that it is

value that can change$-$but

only due to a couple of events, including the

payment of

$.$ Equally important, it

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 firm's shares.

CLAIRE: Right! So$,$ how useful would a firm's book value be for assessing the performance of Western G&E$\text{'}$s management?

ALEXIS: Well, because Western G&E$\text{'}$s book value

$\_.$ with changes in the market price of the firm's shares, the firm's book

value

reflect management's efforts to maximize the shareholder wealth and therefore

be used to evaluate

management's performance.

Now, what about "Economic Value Added"?

CLAIRE: During the $1990$s$,$ the consulting firm Stern, Stewart & Company developed the concept of Economic Value Added, or EVA, to better

assess management's performance in maximizing their shareholders' wealth.

Western G&E$\text{'}$s 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 Western G&E$\text{'}!$

from its

In turn, Western G&E$\text{'}$s 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, here's a question for you: Compared to the book value, what is the advantage of using the EVA to evaluate the

performance of Western G&E$\text{'}$s management?

ALEXIS: Give me a second to think. $..$ OK$,$ it's better to evaluate the performance of Western G&E$\text{'}$s management by using the company's 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.