ECONOMIC PROFIT

Economic value-added (EVA®) is another name for the firm’s economic profit. Key elements of estimating economic profit are:
1. calculating the firm’s operating profit from financial statement data, making adjustments to accounting profit to better reflect a firm’s operating  results for a period,
2. calculating the cost of capital, and
3. comparing operating profit with the cost of capital.

The difference between the operating profit and the cost of capital is the estimate of the firm’s economic profit, or economic value−added.

A related measure, market value added (MVA), focuses on the market value of capital, as compared to the cost of capital. The key elements of market value added are:
1. calculating the market value of capital,
2. calculating the amount of capital invested (i.e., debt and equity), and
3. comparing the market value of capital with the capital invested.

The difference between the market value of capital and the amount of capital invested is the market value added. In theory, the market value added is the present value of all expected future economic profits.

The application of economic profit is relatively new in the measurement of performance, yet the concept of economic profit is not new.

What this recent emphasis on economic profit has accomplished is to focus attention away from accounting profit and toward clearing the cost of capital hurdle.

Share Prices and Efficient Markets
We have seen that the price of a share of stock today is the present value of the dividends and share price the investor expects to receive in the future. What if these expectations change?

Suppose you buy a share of stock of IBM. The price you are willing to pay is the present value of future cash flows you expect from dividends paid on one share of IBM stock and from the eventual sale of that share. This price reflects the amount, the timing, and the uncertainty of these future cash flows. Now what happens if some news—good or bad—is announced that changes the expected IBM dividends? If the market in which these shares are traded is efficient, the price will fall very quickly to reflect that news.

In an efficient market, the price of assets—in this case shares of stock—reflects all publicly available information. As information is received by investors, share prices change rapidly to reflect the new information. How rapidly? In U.S. stock markets, which are efficient markets, information affecting a firm is reflected in share prices of its stock within minutes.

What are the implications for financing decisions? In efficient markets, the current price of a firm’s shares reflects all publicly available information.

Hence, there is no good time or bad time to issue a security. When a firm issues stock, it will receive what that stock is worth—no more and no less. Also, the price of the shares will change as information about the firm’s activities is revealed. If the firm announces a new product, investors will use whatever information they have to figure out how this new product will change the firm’s future cash flows and, hence, the value of the firm—and the share price—will change accordingly. Moreover, in time, the price will be such that investors’ economic profit approaches zero.

Financial Management and the Maximization of Owners’ Wealth
Financial managers are charged with the responsibility of making decisions that maximize owners’ wealth. For a corporation, that responsibility translates into maximizing the value of shareholders’ equity. If the market for stocks is efficient, the value of a share of stock in a corporation should reflect investors’ expectations regarding the future prospectsof the corporation. The value of a stock will change as investors’ expectations about the future change. For financial managers’ decisions to add value, the present value of the benefits resulting from decisions must outweigh the associated costs, where costs include the costs of capital.
If there is a separation of the ownership and management of a firm—that is, the owners are not also the managers of the firm—there are additional issues to confront. What if a decision is in the best inter- ests of the firm, but not in the best interest of the manager? How can owners insure that managers are watching out for the owners’ interests?

How can owners motivate managers to make decisions that are best for the owners? We will address these issues, and more, in the next section.