To determine whether management has created or destroyed value, the market value of the firm’s capital (both equity and debt capital) may be compared to the capital invested by shareholders and lenders (the capital employed in the firm). The differences between the market value of capital and capital employed is called the Market value added or, simply, MVA.
Market value added (MVA) = Market value of capital – Capital employed
A positive MVA implies that value has been created a negative MVA means that value has been destroyed.
MVA measures creation or destruction of value at a given point in time. If you want to measure the value created or destroyed during a period of time, look at the change in MVA during that period.
To compute the MVA, you should know the market value of the firm’s equity and debt capital as well as the amount of capital invested by shareholders and debt holders. Let us look at how these are estimated.
Market Value of capital: For a firm whose equity and debt securities are publicly traded, the market value of capital can be obtained from the financial market. If a firm’s securities are not publicly traded financial market information is not available for establishing MVA. In such a case, the MVA can be estimated if someone makes an offer to buy the firm.
Consider Metachem Limited, a pharmaceutical company set up in 20X0. As on March 31, 20X5, Metachem had debt with a market value of Rs 200 million. The firm had 20 million shares outstanding that were trading at Rs 35 a share. The market value of its equity (its market capitalization) was Rs 700 million. The market value of capital was Rs 900 million (Rs 200 million of debt plus Rs 700 million of equity).
Capital Employed: The amount of capital employed by the firm can be derived from the balance sheet and the accompanying notes. Debt capital includes all forms of borrowings and other obligations like financial leases which are equivalent to debt obligations. Estimating the amount of equity capital is not so straight forward. To get a handle over the amount of equity capital employed in the firm, you have to add to the book value of equity reported in the balance sheet several items such as research and development expenses, amortization of goodwill, deferred tax provision, and allowances for bad debt. These items arbitrarily classified as expenses, lower reported profits and retained earnings. As a consequence, the equity account in the balance sheet is understated.
The first balance sheet report sources of funds (or capital employed) and application of funds (or invested capital) is according to standard accounting conventions. The second balance sheet add book value of shareholders’ funds (equity) and application of funds (invested capital) and a few items that accounting conventions exclude. These balance sheets are called adjusted balance sheets. Loan funds (debt capital) as on March 31, 20X5 (Rs 200 million), however, are the same in both types of balance sheets.
Notice that two adjustments have been made to the book value of shareholders’ funds (equity) to get the adjusted shareholders’ funds. These relate to amortization of goodwill and research and development expenses. According to standard accounting conventions, these items are arbitrarily regarded as expenses. Consequently reported profits, retained earnings and shareholders’ funds (equity) are understated. Hence adjustments are needed.
Properties of MVA:
The importance of MVA stems from the following properties:
MVA increases when the firm undertakes Positive NPV Projects
Remember that the net present value (NPV) of a project is:
NPV = Present value of cash inflows from the project – Capital employed in the project.