Return on Assets• Managers are often compensated based on their return on assets:• This can lead to unwanted results. Positive NPV projects with IRR < ROA will reduce a managers return on assets (and therefore reduce the managers bonus).
Economic Value Added – A Residual Income Model Difference between return on assets (ROA) and the opportunity cost ofcapital (k)EVA = above difference times the invested capitalEVA can be positive or negative for firms that have positive earnings 3
Economic Value Added• A proposed replacement for ROA.• It gives the return above and beyond the cost of capital of the firm. Rearranging: EVA = EBIT (1- TC ) - rWACC × Assets ?so EVA can be viewed as earnings after taxes and capital costs.
17.4 Economic Value Added 7
Risk and Return: Trader Compensation• Traditionally, traders are often compensated with very large bonuses when their portfolios perform well.• They receive no, or smaller bonuses (and are possibly fired) if their portfolios do poorly.
Risk-Adjusted Return• Similar to EVA, financial firms have started to compensate traders based on risk- adjusted returns.• Many different methods have been proposed, and this is a subject of active work.
ExampleThe Board of ABC is deciding on how big abonus it should give its CEO. As a Boardmember, you want to know what the EVA ofthe company has been over the last year.You are given the following information bythe company CFO.
EVA = EBIT (1- TC ) - rWACC × Assets ? Example con’tEBIT = $100 millionYTM on our company debt = 10%Market value of debt = 350 millionAverage stock price = $25 / share# of shares outstanding = 35 millionRisk free rate = 5%;beta of stock = 1.2;market risk premium = 6%;tax rate = 25%Does the CEO deserve a big bonus? No?