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Abstract

Determining how to properly measure corporate performance is one of the most important problems in contemporary corporate finance. Without a sound mechanism to evaluate managerial performance, a corporation's management has no adequate standard to be judged by. This can destroy the firm's value very quickly through poor managerial decisions. For this reason, managers need to be evaluated and compensated based on a performance measure that truly demonstrates the changes in a company's value. The interests of executives and shareholders do not always coincide, as can be seen through many of the current corporate scandals. Thus, it is almost universally argued that the best way to align these interests is through incentive-based managerial compensation. As a result, the corporate world is constantly searching for the best financial performance measure to use for managerial compensation; the better a measure explains the changes in a corporation's value, the more beneficial it is in assessing managerial performance. Some typical methods to used to compensate and evaluate management include plans based on accounting performance or stock options/ownership. Recently, a new method has become a popular method to better align these interests- Economic Value Added (EVA). This paper focuses on the improvements in firms that adopt EVA for managerial evaluation and compensation. It compares the performance changes in firms that adopt EVA and matching firms (based on industry, asset size, and profitability) that do not adopt EVA. The time period of this study spans from 1985-1997. The results of this study show what types of companies would likely improve corporate performance through the adoption of EVA, and in addition, firms that could benefit from adopting EVA will choose to do so. After the adoption of EVA, numerous studies claim the adopting firms experience significant improvement in operating performance and stock performance. Accordingly, I observed the changes in both the operating performance (measured by returns on assets) and the stock performance (measured by abnormal stock returns, based on a portfolio of similar firms) of adopting and non-adopting firms. The results of this study provide strong evidence that Finns which adopt Economic Value Added tend to experience significant improvement in important performance metrics, specifically changes in returns on assets and abnormal stock returns. Adopting firms increased (from one year prior to adoption to three years after adoption) their annual return on assets by 2.68%, while non-adopters' annual return on assets declined by 0.58%. Even more convincingly, a large disparity exists in the stock performance of the adopting firms and non-adopting finns. Contrary to the results of certain previous studies, I found in the three years following EVA adoption, adopting firms outperformed the rest of the market by 25.66%, while the non-adopting finns under-performed the rest of the market by -21.10%. All of the results fisted in this paragraph are significant at the 5% level. These findings are consistent with prior research arguing that firms which adopt Economic Value Added tend to experience significant improvement in important performance metrics, specifically changes in returns on assets and abnormal stock returns. In summary, EVA can be a great way to create value for shareholders.

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