| Course | FIN 711 Financial Measures of Value Added (FIN/711) |
|---|---|
| Week | 2 |
| Paper type | Doctoral performance measurement paper |
| Length | about 1,152 words, 4 double-spaced pages plus title page and references |
| Format | APA 7 student paper |
| School | University of Phoenix |
| Program | DBA |
| Updated | October 2026 |
Free sample paper for FIN 711 Week 2
Should TerraSorb Pay Bonuses on Economic Value Added After It Scales? Theory, the Evidence on EVA Versus Earnings and the Underinvestment Problem in a Growing Company
[Student Name]
University of Phoenix
FIN/711: Financial Measures of Value Added
Week 2 Assignment
[Instructor Name]
[Date]
TerraSorb and all projections are composites written for a model paper; concepts and research findings come from the sources listed.
TerraSorb, the composite Minneapolis maker of in-field soil carbon sensors from Week 1, expects to raise a Series B round in about three years, once its sensors are approved by carbon registries and sold through agricultural cooperatives. Its plan projects revenue of about $18 million in the fourth year. The board's compensation committee, chaired by an investor who used economic value added at a previous industrial company, proposed tying executive bonuses to it once revenue stabilizes. A measure that worked well at a mature industrial company may reward the wrong behavior at a company still building its market, and the evidence on economic value added speaks to exactly that risk. This paper evaluates the proposal.
Residual Income and Value
Economic value added is a version of residual income: operating profit after tax minus a charge equal to invested capital times the cost of capital. Ohlson (1995) formalized the link between accounting numbers and value, showing that equity value equals book value plus the present value of expected future residual income, under clean surplus accounting. The framework gives residual income a theoretical foundation: if managers raise expected residual income, they raise value. Stewart (1991) built a management system on the idea, adding accounting adjustments intended to make the measure closer to economic reality.
Computing It for the Scaled Company
In the fourth year, TerraSorb projects operating profit after tax of about $1.2 million on revenue of $18 million. Invested capital, including working capital, manufacturing equipment and, under Stewart's adjustment, research and development capitalized and amortized over five years rather than expensed, totals about $14 million. With a cost of capital of about 18 percent for a company at that stage, the capital charge is about $2.5 million, and economic value added is about negative $1.3 million. The research adjustment raises operating profit, because amortization replaces the full year's spending, but also raises invested capital, so the measure stays negative while the company invests ahead of revenue.
Does It Beat Earnings?
Proponents claimed that economic value added explains stock returns better than earnings. Biddle et al. (1997) tested the claim on a large sample of firms and found that earnings were more highly associated with market-adjusted returns than economic value added or residual income, though residual income components added some explanatory power. Their evidence does not show the measure to be useless, but it undermines the claim that it captures value creation better than conventional accounting.
How Managers Respond
The behavioral evidence matters more for a compensation decision. Wallace (1997) matched adopters of residual income-based pay with control firms; after adoption, the adopters invested less in new assets, sold off more existing ones, bought back more stock and worked their remaining assets harder. Those responses are consistent with the measure's intent, discouraging low-return investment, but they could also reflect underinvestment in projects whose returns arrive late.
The Problem for Growth Firms
TerraSorb's value depends on investing in sales capacity, new sensor models and international registry approvals years before those investments pay off. A bonus tied to current-year economic value added charges the full cost of capital on each investment immediately, while the returns arrive later. A manager could raise the measure by cutting research, delaying a new manufacturing line or slowing expansion, increasing short-term economic value added while destroying long-run value. The growth options framework of Myers (1977) makes the risk explicit: when most value lies in future opportunities, a measure focused on current returns misses most of what managers should be building.
Remedies in the Practitioner Literature
Stewart and others proposed remedies. Strategic investments can be held in a suspense account, with the capital charge deferred until the project is expected to produce returns. Bonuses can be based on improvement in economic value added rather than its level, so that a company with negative economic value added can still reward progress. A bonus bank holds part of each year's award at risk against future performance, discouraging short-term gains that later reverse. Each remedy reduces the underinvestment problem but adds judgment, which weakens the measure's claimed objectivity.
What Earnings Management Adds to the Debate
Any accounting-based bonus invites manipulation of the numbers it rests on. Economic value added depends on adjustments that management proposes and the board approves, such as how much research to capitalize and over what period. A manager could lengthen amortization periods to raise reported economic value added without changing the business. The compensation committee would need an independent review of adjustments each year and a rule that changes in method apply only to future periods. These governance costs are part of the measure's real cost and are rarely discussed in practitioner accounts.
A Better Fit for TerraSorb's Stage
For a company in the fourth year of revenue, the evidence suggests combining measures. Revenue growth, gross margin per sensor, customer retention and cash runway reflect progress toward a profitable business. Economic value added, adjusted for strategic investment and measured on improvement, can be introduced gradually to build capital discipline in established product lines, while new lines are excluded until they reach scale. Equity awards, which reward long-run value directly, should remain the main incentive for executives in a company valued on growth.
The Recommended Design
The committee should adopt a bonus plan in which 40 percent of the annual award depends on milestones and revenue growth, 30 percent on gross margin and working capital efficiency, and 30 percent on improvement in economic value added for the core sensor line, with capital charges on new product lines deferred until their third year. Half of each year's award should go into a bonus bank paid over three years. Executive equity should vest over four years with performance conditions tied to the next financing round.
Limits of the Evidence
Most research on economic value added studies large public companies in the 1980s and 1990s. Little evidence exists on its effects in venture-backed firms, where boards are concentrated, information is private and investment horizons are long. The recommendation therefore relies on theory and on evidence from a different population.
Research Questions
Does the use of residual income measures in venture-backed firms affect research spending and later valuation? Do deferral and bonus bank designs mitigate the underinvestment documented after adoption? How does the stage of a firm's life moderate the relation between residual income and value?
Conclusion
Economic value added rests on a sound theoretical link between residual income and value, but evidence shows it does not consistently explain returns better than earnings and that firms adopting it invest less. For a growth company like TerraSorb, a bonus tied to current economic value added risks rewarding underinvestment. A blended plan with deferred capital charges on new lines, a bonus bank and long-vesting equity uses the measure's discipline without sacrificing growth.
References
Biddle, G. C., Bowen, R. M., & Wallace, J. S. (1997). Does EVA beat earnings? Evidence on associations with stock returns and firm values. Journal of Accounting and Economics, 24(3), 301-336. https://doi.org/10.1016/S0165-4101(98)00010-X
Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5(2), 147-175. https://doi.org/10.1016/0304-405X(77)90015-0
Ohlson, J. A. (1995). Earnings, book values, and dividends in equity valuation. Contemporary Accounting Research, 11(2), 661-687. https://doi.org/10.1111/j.1911-3846.1995.tb00461.x
Stewart, G. B. (1991). The quest for value: The EVA management guide. HarperBusiness.
Wallace, J. S. (1997). Adopting residual income-based compensation plans: Do you get what you pay for? Journal of Accounting and Economics, 24(3), 275-300. https://doi.org/10.1016/S0165-4101(98)00009-3
What the FIN 711 Week 2 instructions ask
In FIN 711 Week 2, doctoral students are usually asked to analyze economic value added or residual income as measures of performance and value creation. Common requirements include the definition and computation of economic value added with its accounting adjustments, the residual income valuation framework, empirical evidence on its relation to stock returns compared with earnings and cash flow, its use in incentive compensation and the behavioral effects documented after adoption. Many versions ask students to evaluate whether a particular firm should adopt such a measure. Synthesize research rather than summarizing it, connect findings to the case, identify unresolved questions and use APA style with primary sources.
How this FIN 711 Week 2 example is built
A board designing incentives for a company about to scale must decide what to reward, and economic value added is a leading candidate that the paper tests against theory and evidence. It begins with residual income and its formal link to equity value. Projected economic value added for the scaled company is then computed, including the adjustment for research spending. The evidence is reviewed in two strands: whether the measure explains returns better than earnings, and how managers change behavior when paid on it. The underinvestment risk for a growth firm follows, with remedies such as deferring capital charges on strategic investment. The paper ends with a recommended plan design and research questions.
FIN 711 Week 2 grading rubric: where the points go
Faculty grading this doctoral week usually look for a precise account of the measure, critical synthesis of the evidence and a recommendation that follows from both. Credit goes to papers that connect economic value added to the residual income valuation framework, compute it correctly with stated adjustments, present the empirical findings accurately, including those unfavorable to the measure, and analyze how incentives shape investment decisions. Recognizing the special problems of growth firms, and proposing design features that address them, shows applied scholarship. Precise prose, defined terms and APA references to primary research complete the paper. Faculty also credit a clear statement of the population the evidence comes from, because findings from large public firms may not transfer to ventures.
FIN 711 Week 2 help: mistakes to avoid
Doctoral papers on FIN 711 Week 2 often present economic value added as a proven improvement over earnings, which the evidence does not fully support. Report the mixed findings. Another frequent problem is computing the measure without its adjustments or without explaining why each matters. Show at least the treatment of research spending. Students also overlook the behavioral evidence, such as reduced investment after adoption. Address it. Avoid recommending a measure without considering the firm's stage. Explain how a bonus bank or deferral would work. Finally, state what remains unknown and how it could be studied, naming the data a researcher would need.
Related FIN 711 sample papers
Other FIN 711 week samples
- FIN 711 Week 1: Value Creation and Financial Measures
- FIN 711 Week 3: Venture Financing Needs by Stage
FIN 711 Week 2 questions, answered
What does FIN 711 Week 2 usually cover?
It usually covers economic value added and residual income as measures of performance, their accounting adjustments, links to valuation, evidence on their relation to stock returns and their use and effects in executive compensation.
Where can I find a free FIN 711 Week 2 sample paper?
A complete doctoral paper on whether a scaling startup should pay bonuses on economic value added, with the research evidence weighed in margin notes, is available on this page. Request a free draft of your own doctoral paper.
What is residual income?
Earnings minus a charge for the capital used to produce them. Valuation models show that equity value equals book value plus the present value of expected future residual income.
Does economic value added explain stock returns better than earnings?
Not consistently. Biddle, Bowen and Wallace found that earnings were more closely associated with market returns than economic value added in their sample, though the measure added some information.
Why can economic value added discourage investment?
Because new investment adds to the capital charge immediately while its returns arrive later, managers paid on short-term economic value added may delay or avoid projects that create long-run value.
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