A division reports a profit of ₦30m. Is that good? It depends on how much capital it used. If it tied up ₦400m, and investors want 12%, it needed ₦48m to break even in economic terms and has actually destroyed value. Profit alone hides the cost of the capital that earned it.
Value-based management puts that cost back, so managers are judged on the value they create, not just the profit they report.
This topic covers value-based management (VBM) and value drivers, shareholder value analysis (SVA), cash flow return on investment (CFROI), total shareholder return (TSR), economic value added (EVA) and its adjustments, market value added (MVA) and the link between them, EVA and MVA as a valuation method, and the residual income model. The previous topic covered the efficient market hypothesis. The next covers cash flow valuation and free cash flow.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on EVA.
In 30 seconds
VBM: the measure of success is the wealth created for shareholders, which needs returns above the cost of capital; managers influence value drivers (revenue, operating margin, cash tax rate, incremental capital spending, working capital investment, cost of capital, competitive advantage period). EVA = NOPAT − (WACC × capital employed). NOPAT is operating profit after tax but before interest, adjusted (for example, capitalise R&D, add back provisions, use actual lease rentals).
If EVA is positive, value has been added. MVA = market value of capital − economic book value of capital, and equals the PV of future EVAs. TSR = (price change + cash paid) ÷ opening price. CFROI is a cash return on gross investment (like an IRR) compared with a hurdle rate. Residual income = profit after tax − equity charge; share value = book value + PV of future residual income. EVA is not a cash flow.
Key terms in plain English
| Term | What it means |
|---|---|
| Value driver | Any variable that affects the value of a company |
| NOPAT | Net operating profit after tax, before interest |
| Economic value added (EVA) | NOPAT less a charge for all capital used |
| Market value added (MVA) | The premium of market value over the economic book value of capital |
| Total shareholder return (TSR) | Share price growth plus dividends as a percentage of the opening price |
| CFROI | Cash flow return on investment: gross cash flow ÷ gross investment |
| Residual income | Profit after tax less a charge for the cost of equity |
Syllabus check
This topic is in syllabus area B (business analysis). It covers:
- value-based management, shareholder value analysis, cash flow return on investment and total shareholder return;
- economic profit methods, EVA and MVA.
CAMA 2020 and shareholder value
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 305 | A director must act in good faith in the best interests of the company | Management should aim to create value for the company and its shareholders |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors should judge performance against the cost of the capital used |
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Decisions later affect reported assets, profit and cash |
| s. 385 | The directors’ report covers performance and risk | Major plans and risks are reported to shareholders |
Value-based management
VBM holds that the ultimate measure of success is the increase in shareholder wealth. Value is created when capital is invested at returns above its cost. The aim is to guide decisions at all levels so that they create value. Value drivers are the variables that affect value. They should be ranked by impact and each given to someone who can influence it.
A commonly used set of seven: revenue; operating margin; cash tax rate; incremental capital expenditure; investment in working capital; cost of capital; competitive advantage period. Scenario analysis helps relate them. No single manager can control shareholder value directly, but managers can influence the drivers.
Shareholder value analysis (SVA) analyses how decisions affect the NPV of cash to shareholders, for example the trade-off between investment and dividends. Its techniques include EVA, MVA, CFROI and TSR. Its main advantage is that it focuses managers on value-creating activity, not short-term profit.
CFROI and TSR
CFROI is a real rate of return linking the cash a business generates to the cash invested in it, in essence an IRR. It is gross cash flow ÷ gross investment and is compared with a hurdle rate, the total cost of capital. TSR = (share price at end − share price at start + cash paid to shareholders) ÷ share price at start, often annualised as a compound growth rate with dividends reinvested. Cash paid includes dividends and buy-backs.
Economic value added
Profit measured in the accounts and ROI are unsatisfactory: ROI can encourage managers to delay capital spending and cut R&D to protect short-term results. EVA, developed by Stern Stewart, is close to residual income: managers are charged for the capital they use, including equity. EVA = NOPAT − (WACC × capital employed). If NOPAT exceeds the charge, value is added.
NOPAT is after tax but before interest, because the cost of debt is in the capital charge. EVA is not a cash flow: NOPAT includes depreciation and the charge includes the non-cash cost of equity.
Adjustments
Stern Stewart originally listed 164 adjustments; firms use about 5 to 15 material ones.
- Capital employed: capitalise and amortise spending on intangibles that add value (such as R&D, and perhaps training and brand building); add back provisions and allowances (deferred tax reserve, doubtful debt allowance); do not capitalise long-term leases, and if capitalised, deduct them.
- NOPAT: add back capitalised expenses and deduct amortisation; add back lease depreciation and finance charges and deduct actual rentals; add back increases in the deferred tax reserve; and use the cash tax charge plus the tax relief on interest to avoid double-counting.
- Depreciation: no adjustment, since accounting depreciation is taken to approximate economic depreciation.
ICAN’s example. Opening accounting capital employed is ₦150m. PBIT ₦24m, interest ₦4m, current tax ₦6m, deferred tax ₦2m. R&D of ₦5m was expensed, with ₦1m of amortisation. The allowance for doubtful debts rose from ₦1.5m to ₦2m. Tax is 30% and WACC 10%.
- NOPAT = 24.0 − 6.0 − 1.2 (tax relief on interest, 30% × 4) + 0.5 (increase in allowance) + 5.0 (R&D) − 1.0 (amortisation) = ₦21.3m.
- Economic capital employed.
150 + 2.0 (allowance) + 4.0 (R&D net) = ₦156m.
Capital charge = 10% × 156 = ₦15.6m (ICAN uses the year-end figure here; normally the opening figure is used). - EVA = 21.3 − 15.6 = ₦5.7m.
Year-end capital = 156 + 5.7 − 5.0 dividends = ₦156.7m.
Market value added
MVA links EVA to market value: market value of capital (equity and debt) − economic book value of capital. If MVA rises, value has been created; if it falls, destroyed. A positive MVA is the premium investors place on growth opportunities, which equals the PV of expected future EVAs. Over time, a company that adds EVA each year should see MVA rise.
ICAN’s valuation. ABC will bid for XYZ, whose economic book value is ₦50m. EVA has been ₦4m a year and is expected to be ₦4.5m a year for ten years. The cost of capital is 9%.
- MVA = 4.5 × 6.418 = ₦28.9m.
- Value of XYZ.
50.0 + 28.9 = ₦78.9m. - This can value private companies or divisions.
Advantages of EVA/MVA: simple in concept; applicable to private companies and divisions; links value to shareholder value created. Disadvantages: EVA was devised as a historical measure but valuations use forecasts; and it may be argued that the PV of free cash flows is a more sound basis.
Residual income
Residual income (RI) = profit after tax − charge for the cost of equity, so a firm can show a profit yet earn less than shareholders require. ICAN’s Eko Plc: net profit ₦80.52m, equity ₦800m at 12.3%, so the equity charge is ₦98.4m and RI = −₦17.88m: profitable in the accounts but not economically.
Forecast: RIt = Et − (r × Bt−1) = (ROE − r) × Bt−1. Value: P0 = B0 + PV of expected residual incomes. ICAN’s Z Plc: cost of equity 14%, book value ₦6.50, earnings ₦1.10, ₦1.00 and ₦0.95, with a liquidating dividend in 2028. RIs are ₦0.19, ₦0.01 and −₦0.10, so value = 6.50 + 0.19 ÷ 1.14 + 0.01 ÷ 1.142 − 0.10 ÷ 1.143 = ₦6.61.
Strengths: the terminal value does not dominate; it uses accessible accounting data; it works for firms that pay no dividends or have negative free cash flows; it focuses on economic profit. Weaknesses: it relies on accounting data that can be manipulated and needs many adjustments; and it assumes the clean surplus relation (closing book value = opening + earnings − dividends).
The rules in more depth
Why EVA is not cash flow
It includes non-cash depreciation and a notional charge for equity, and it is based on profit, not receipts and payments.
Why interest is not deducted in NOPAT
The cost of debt is already inside the WACC charge. Deducting interest as well would charge it twice.
Why R&D is capitalised
It creates value over several years. Expensing it all at once makes short-term results look worse and discourages long-term investment.
Why MVA and EVA are linked
Investors pay for expected future economic profit, so market value exceeds the capital invested by the PV of expected EVA.
Effect on analysis
Calculate NOPAT and the capital charge, state the EVA, comment on the adjustments and say what it means for management.
Worked examples
Example 1: EVA. NOPAT is ₦30m. Capital employed is ₦400m and the WACC is 12%.
- Capital charge.
12% × 400 = ₦48m. - EVA = 30 − 48.
- EVA = −₦18m: value destroyed.
Example 2: MVA. The market values equity at ₦500m and debt at ₦150m. The economic book value of capital is ₦480m.
- Market value of capital.
500 + 150 = ₦650m. - MVA = 650 − 480.
- MVA = ₦170m.
Example 3: TSR. A share costs ₦200, is worth ₦230 a year later and paid a ₦10 dividend.
- Price change = ₦30.
- Cash paid = ₦10.
- TSR = (30 + 10) ÷ 200 = 20%.
Example 4: an MVA valuation. The economic book value is ₦80m. EVA is expected to be ₦3m a year for eight years. The cost of capital is 10% (annuity factor 5.335).
- MVA = 3 × 5.335 = ₦16.0m.
- Value = 80 + 16.0.
- Value = ₦96.0m.
How to score full marks
- Start with NOPAT before interest and after tax.
- List each adjustment and its effect on profit and capital.
- Compute the charge on the right capital employed.
- Interpret the sign of EVA.
- For MVA, discount the expected EVAs.
- Give advantages and limits.
Common mistakes in the exam
- Deducting interest in NOPAT.
- Forgetting tax relief on interest.
- Not capitalising R&D or adding back provisions.
- Treating EVA as a cash flow.
- Confusing MVA with EVA.
- Using the equity charge only in EVA.
Quick revision
- VBM: create value above the cost of capital; manage value drivers.
- EVA = NOPAT − WACC × capital employed; adjust for R&D, provisions, leases.
- MVA = market value of capital − economic book value; equals PV of future EVA.
- TSR = (price change + cash paid) ÷ opening price.
- CFROI: cash return on gross investment vs hurdle.
- RI = PAT − equity charge; value = B0 + PV of RI.
- CAMA 2020: ss. 305, 308, 377(1), 378, 385.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. EVA equals:
- NOPAT − WACC × capital employed
- Profit − dividends
- Revenue − costs
- Cash flow − tax
Show the answer
A. After a capital charge.
Question 2. NOPAT is measured:
- After tax and before interest
- After interest and before tax
- Before tax and interest
- After dividends
Show the answer
A. The cost of debt is in the charge.
Question 3. In EVA, R&D expenditure is usually:
- Capitalised and amortised
- Ignored
- Deducted twice
- Treated as a dividend
Show the answer
A. It creates value over several years.
Question 4. MVA equals:
- Market value of capital − economic book value of capital
- Equity − debt
- EVA × WACC
- Profit − tax
Show the answer
A. Premium over invested capital.
Question 5. MVA should equal the PV of:
- Expected future EVAs
- Past dividends
- Interest
- Sales
Show the answer
A. Investors price expected economic profit.
Question 6. TSR is:
- (Price change + cash paid) ÷ opening price
- Dividends ÷ earnings
- Price ÷ earnings
- EVA ÷ capital
Show the answer
A. It combines growth and income.
Question 7. EVA is:
- Not a cash flow
- The same as free cash flow
- The same as net profit
- Always positive
Show the answer
A. It includes non-cash items.
Question 8. Residual income is profit after tax less:
- A charge for the cost of equity
- Interest
- Depreciation
- Dividends
Show the answer
A. It shows economic profit.
Question 9. Which is a value driver?
- Operating margin
- Dividend date
- Company name
- Auditor
Show the answer
A. One of seven common drivers.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Explain value-based management and list four value drivers. (6 marks) (b) Explain why EVA is better than accounting profit as a measure of performance. (4 marks)
Question 12 (20 marks). A company has accounting capital employed of ₦300m. PBIT is ₦60m, interest ₦10m, current tax ₦15m and WACC 11%. Tax on profits is 30%. R&D of ₦8m was expensed with ₦2m of amortisation to be charged. The allowance for doubtful debts rose by ₦1m to ₦3m. (a) Calculate NOPAT and EVA, using the year-end economic capital employed for the capital charge.
(10 marks) (b) State two advantages and two disadvantages of EVA and MVA. (5 marks) (c) The economic book value is ₦90m and EVA is expected to be ₦6m a year for ten years at 10% (annuity factor 6.145). Value the company by the MVA method. (5 marks)
Question 13 (10 marks). (a) A share costs ₦200, is worth ₦230 a year later and paid a ₦10 dividend. Calculate the TSR. (3 marks) (b) A company has EPS of ₦2.00, opening book value per share of ₦12 and a cost of equity of 12%. Calculate residual income per share. (3 marks) (c) Explain what CFROI measures. (4 marks)
Model answers
Show the model answer to Question 11
(a) VBM (6 marks). VBM is a management approach based on the idea that the measure of success is the increase in shareholder wealth, created when capital earns more than its cost. (3) Value drivers include revenue, operating margin, cash tax rate, incremental capital expenditure, investment in working capital, cost of capital and competitive advantage period. Any four. (3)
(b) EVA (4 marks). EVA charges managers for all capital used, equity as well as debt, so it shows whether returns beat the cost of capital. (2) Accounting profit and ROI can lead to short-term decisions such as delaying investment or cutting R&D. (2)
Show the model answer to Question 12
(a) EVA (10 marks).
- Tax relief on interest.
30% × 10 = ₦3m. (1) - NOPAT = 60 − 15 − 3 = ₦42m. (2)
- Adjustments.
+ 1 (increase in allowance) + 8 (R&D) − 2 (amortisation) = + 7, so adjusted NOPAT = ₦49m. (3) - Economic capital employed.
300 + 3 (allowance) + 6 (R&D less amortisation) = ₦309m. (2) - Capital charge.
11% × 309 = ₦34.0m. - EVA = 49 − 34.0 = ₦15.0m. (2)
(b) Advantages and disadvantages (5 marks). Advantages: simple concept; applies to private companies and divisions; links value to shareholder value created. Disadvantages: devised as a historical measure but valuations use forecasts; a PV of free cash flows may be a sounder basis. Any two of each; the fifth mark for linking MVA to the PV of EVA. (1 each)
(c) MVA valuation (5 marks).
- MVA = 6 × 6.145 = ₦36.9m. (3)
- Value = 90 + 36.9 = ₦126.9m. (2)
Show the model answer to Question 13
(a) TSR (3 marks). (230 − 200 + 10) ÷ 200 = 40 ÷ 200 = 20%. (3)
(b) Residual income (3 marks).
- Equity charge.
12% × 12 = ₦1.44. (1.5) - RI = 2.00 − 1.44 = ₦0.56 per share. (1.5)
(c) CFROI (4 marks). It is a real rate of return that links the cash a business generates to the cash invested in it, in effect an IRR. (2) It is gross cash flow divided by gross investment and is compared with a hurdle rate, the total cost of capital. (2)
Pathfinder on Value drivers, EVA, MVA, TSR, CFROI and residual income
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic. Performance measures appear in scenario questions. Worked examples 1 to 4 show the calculations.
Revise first: Worked examples
Questions ask for NOPAT, the capital charge and the EVA, with adjustments. See the section on economic value added.
Revise first: Economic value added
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: No stand-alone question in the May 2014 or November 2014 Pathfinder.
Spotted a mistake? Tell us and we will check it.
