Performance Evaluation Another Use of the WACC

Looking back at the Eastman Chemical example we used to open the chapter, we see another use of the WACC: its use for performance evaluation. Probably the best-known approach in this area is the economic value added (EVA) method developed by Stern Stewart and Co. Companies such as AT&T, Coca-Cola, Quaker Oats, and Briggs and Stratton are among the firms that have been using EVA as a means of evaluating corporate performance. Similar approaches include market value added (MVA) and shareholder value added (SVA).

Although the details differ, the basic idea behind EVA and similar strategies is straightforward. Suppose we have $100 million in capital (debt and equity) tied up in our firm, and our overall WACC is 12 percent. If we multiply these together, we get $12 million. Referring back to Chapter 2, if our cash flow from assets is less than this, we are, on an overall basis, destroying value; if cash flow from assets exceeds $12 million, we are creating value.

In practice, evaluation strategies such as these suffer to a certain extent from problems with implementation. For example, it appears that Eastman Chemical and others make extensive use of book values for debt and equity in computing cost of capital. Even so, by focusing on value creation, WACC-based evaluation procedures force employees and management to pay attention to the real bottom line: increasing share prices.

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www.sternstewart.com for more on EVA.

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