Coke vs Pepsi

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Category: Business and Industry

Date Submitted: 08/03/2011 11:34 PM

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Question 1

Economic Value Added is an estimate of a firm’s economic profit-being the value created in excess of the required return of the company’s investor (being shareholders and debt holders). It is the profit earned by the firm less the cost of financing the firm’s capital. The idea is that, the value is created when the return on the firms economic capital employed is greater than the cost of capital. Eva measures economic rather than accounting profits created by a business after the cost of all resources including both debts and equity capital have been taken into account. It is a financial measure refers to as economic profit or economic rent by economists.

The difference between economic profit and accounting profit is essentially the cost of equity capital an accountant does not subtract a cost of equity capital in the computation of profit, so in fact an accountants’ measure of income or profit is in essence the residual return to that equity capital since all resources in his computation of profit including an opportunity cost for the equity capital invested in the business. So an economist’s definition and computation of the profit is net above the cost of all resources.

Fundamental concept of EVA is not the whether the business or venture is profitable, but whether that profit is sufficient to compensate the equity capital invested in the firm at its opportunity cost and has any revenue remaining after compensating the cost of all resources.

In other words, is there any value created after invested capital has been compensated at a market determined required rate of return?

Even profitable firms do not always create values unless they earn enough to cover the cost of debt as well as the opportunity cost of equity capital. Since the primary objective of any business is to create wealth to its shareholders, overtime, a firm that consistently exhibits a negative EVA will be shinned by investors because it is not generating an adequate...