In this paper these issues will be discussed:
•the main purpose and functions of the financial performance management and how it is related to the problem of shareholders value creation, company growth and managers decision making process and management motivation;
•the appropriate measures of management performance from the shareholders point of view;
•contradictions or goal incongruence between shareholders, management and company long-term growth.
Table of Contents
I. INTRODUCTION
II. THE MAIN FUNCTIONS OF THE FINANCIAL PERFORMANCE MANAGEMENT
III. FROM ROI TO VALUE-BASED MANAGEMENT
IV. EVA AS THE BEST MANAGEMENT PERFORMANCE MEASURE
V. CONCLUSION
Research Objectives and Themes
This paper examines the effectiveness of various financial performance measures, specifically focusing on Economic Value Added (EVA) as a tool for aligning management decisions with shareholder wealth maximization, while critically assessing its limitations and practical challenges in corporate governance.
- The role and purpose of financial performance management in organizational success.
- The transition from traditional accounting metrics like Return on Investment (ROI) to value-based management systems.
- Conceptual and practical limitations of EVA as a performance indicator.
- The challenge of goal incongruence between management, shareholders, and long-term corporate growth.
- Alternative performance frameworks such as Refined Economic Value Added (REVA).
Excerpt from the Book
III. From ROI to Value-based management
The traditional performance management tool is ROI (Return on Investment). It was developed by the DuPont Powder Company in the early 1900s to help manage the vertically integrated enterprise. The purpose of this measure is to evaluate the performance of the company or its department by comparing its accounting measure of income to its accounting measure of investment. The formula to measure ROI is:
ROI = Income/Investment.
ROI is the apex of the DuPond “pyramid of ratios” as an overall measure of profitability. It can be broken down into two ratios the profit margin on sales and the capital turnover:
ROI = Investment Turnover*Return on Sales = Sales /Investment * Income /Sales.
Depending on the need of user the overall return on investment ratio can be calculated in different ways. A general principle is that each part of the ratio should be relevant to the audience being addressed, and that the overall ratio should reflect the interests of the specific user of the information it provides. For example, it can be simply modified to calculate return on equity (ROE), just excluding debt and other liabilities from capital employed and taking net income divided by shareholder equity.
Summary of Chapters
I. INTRODUCTION: Outlines the significance of financial performance measures in aligning management interests with shareholder wealth and introduces the growing popularity of EVA.
II. THE MAIN FUNCTIONS OF THE FINANCIAL PERFORMANCE MANAGEMENT: Defines the three core functions of performance management: organizational objective, financial management tool, and motivation mechanism for managers.
III. FROM ROI TO VALUE-BASED MANAGEMENT: Traces the historical shift from traditional ROI-based metrics to modern value-based approaches like Added Value and EVA, highlighting the limitations of accounting-based numbers.
IV. EVA AS THE BEST MANAGEMENT PERFORMANCE MEASURE: Analyzes the theoretical benefits and significant practical drawbacks of EVA, including the potential for manipulation and lack of correlation with stock returns.
V. CONCLUSION: Summarizes that while EVA provides a useful framework for incentive systems, it is not a perfect indicator and should be integrated within a broader strategy that considers stakeholder interests.
Keywords
Economic Value Added, EVA, Financial Performance Management, Return on Investment, ROI, Shareholder Wealth, Corporate Governance, Agency Theory, Value-Based Management, Incentive Compensation, Capital Cost, NOPAT, WACC, Performance Measurement, Goal Congruence
Frequently Asked Questions
What is the fundamental focus of this paper?
The paper explores the role of financial performance measures, specifically investigating whether Economic Value Added (EVA) serves as the superior metric for aligning manager behavior with the long-term wealth of shareholders.
What are the core thematic areas discussed?
The study covers the functions of financial performance management, the evolution from ROI to value-based metrics, the theoretical foundation of EVA, and the inherent conflicts of interest between corporate managers and shareholders.
What is the primary objective of the author?
The primary goal is to critically evaluate if EVA truly overcomes the limitations of traditional performance measures and if its adoption effectively motivates managers to maximize firm value.
Which scientific methodology is employed?
The paper utilizes a literature-based analytical approach, reviewing existing academic theories, empirical studies, and financial frameworks to compare different performance measurement techniques.
What topics are covered in the main section?
The main sections detail the mechanics of ROI, the introduction of Added Value and EVA formulas, the economic logic behind capital charges, and an assessment of why EVA may fail to provide a significant informational advantage to capital markets.
How can the paper be summarized by its keywords?
The research is characterized by terms like EVA, shareholder wealth, agency theory, WACC, and management incentives, which collectively define the tension between accounting logic and true economic value creation.
Why is ROI considered limited by the author?
The author argues that ROI is based on accounting numbers rather than economic logic, which can discourage managers from undertaking profitable investments if those investments temporarily lower the division's ROI.
What is the author's stance on Refined Economic Value Added (REVA)?
The author presents REVA as an alternative to EVA, noting that it incorporates the market value of the company, which some researchers believe offers a more accurate representation of shareholder wealth creation.
Does the author believe EVA is a perfect system?
No, the author concludes that EVA has significant limitations, such as a lack of correlation with actual stock returns and the risk of managers manipulating decisions to meet short-term EVA targets at the expense of long-term value.
- Quote paper
- Alina Ignatiuk (Author), 2008, EVA as the best financial performance measure: the theory of reality, Munich, GRIN Verlag, https://www.grin.com/document/124462
