The concept of Economic Value Added (EVA)

The concept of Economic Value Added spent the first 12 years of its financial managers. Then in 1995, the then CEO of Coca-Cola, Robert Goizeuta, announced to the world that it was the use of this metric that had enabled his company to add $59 billion in market value. Suddenly, Economic Value Added (EVA), a measure created by the New-York based advisory Stern Steward and Co., was the fad of the year. Only, it didn’t fade away like other fads do.

What is Economic Value Added (EVA)?

Economic Value Added (EVA) is the quantum of economic value (or profit) generated by a company in excess of its costs of capital. In other words, it is the amount by which earnings exceed or fall of the required minimum rate of return those shareholders and lenders could get away from investing in other securities of comparable risk.

EVA = Net Operating Profit after Taxes (NOPAT) – Capital Cost

= NOPAT – Cost of Capital x Capital Employed

= (Rate of Return – Cost of Capital) x Capital Employed

Where:

NOPAT

Rate of Return =

Capital Employed

Cost of Capital = Cost of Equity x Proportion of equity from capital +

Cost of Debt x Proportion of debt from capital x (1– tax rate)

Cost of capital or Weighted Average Cost of Capital (WACC):

Cost of capital or Weighted Average Cost of Capital (WACC) is the average cost of both equity capital and interest bearing debt. Cost of equity capital is the opportunity return from an investment with the same risk as the company has. Cost of equity is usually defined with the Capital Asset Pricing Model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt also includes the tax shield due to tax allowance on interest expenses. ROI is defined as above (after taxes), then EVA can be presented with familiar terms to be:

 

EVA = (ROI – WACC) x Capital Employed

 

EVA was created by Joel Stern and Bennet Stewart in the wake of the reckless spree of diversification that most large companies in the US & Europe embarked on in the late 1970’s and early 1980’s. The basis of diversification is a company’s often mistaken belief that it can invest funds far more efficiently the creation of shareholder value.

The idea behind EVA is that the shareholder must earn a return that compensates at least the same return as similarly risky investments in real profit made and actually the company operates at a loss from the view point of shareholders.

As Peter Drucker put the matter in a HARVARD BUSINESS is greater than it’s paying taxes as if it had an economy that it devours the wealth, it destroys it.”

EVA shows the rupee amount of wealth a business has created or destroyed in each define it. If the shareholders expect, say, a 10% return on their investment, they “make money” only to the extent that their share of after tax operating profit exceeds 10 per cent of equity capital.

Aligning decisions with shareholder’s wealth:

EVA was developed to help managers incorporate two basic principles of finance into their objective of any company should be tantamount to maximize the wealth of its shareholders. Shareholders value is the quintessential measure of corporate performance. It is an accurate reflection of the quantum of incremental value a company generates for its shareholders, after accounting for its cost of operations, which include the cost of capital.

The second is that the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the will bring an increase in the market value of a company. It is the continuous improvement in EVA that brings about a continuous increase in shareholders wealth.

Most companies use a numbing array of measures to express financial goals & objectives. Strategic plans often are based on growth in revenues or lines of business on the basis of gross margins of return on assets or against a budgeted investments in terms of return on assets or against a budgeted profit level.

Finance departments usually analyze capital investments in terms of net the likely contribution to unit heads typically are negotiated annually and are built on goals, and terminology usually is in.

What does it take in order to implement EVA?

Financial measure that links all decisions making with a common focus: How do we improve EVA? It is the only financial management system that provides a common language for all employees across all operating and staff functions and allows all management decisions to be modeled, monitored, communicated and compensated in a single and consistent way – always in terms of the value added to shareholder investment.

One, the primary objective of the company is the construction of EVA ensures that those companies trying to optimize it end up optimizing sales revenues, COC, ROCE, and Net Operating Profits. Entire financial reporting of the company is based on the company with a dash of reality.

EVA is the moving force behind the company’s existing and individual and department in the or RONW, but on its only if it results in an incremental EVA. And their managers focus on optimizing the COC, inventory and accounts receivable.

Implementing EVA is a 4-step process and is also called the 4M process. The 4M’s is:

  1. Measurement
  2. Management System
  3. Motivation
  4. Mindset
1.MEASUREMENT

EVA is the most accurate measure of corporate performance over any given period. In calculating EVA, we first make a number of adjustments to conventional earnings in order to eliminate accounting anomalies and bring them closer to true economic consequences. The following adjustments are normally made to the financial statements to convert the book profits and book capital to operating profits and economic capital:

  1. i) Non-recurring income & expenditure: are excluded from NOPAT, and capitalized after tax. Non-recurring losses or expenditure are taken as additions to capital whereas non-recurring incomes or gains are found to be reductions to it.

ii)Research & development: Revenue expenditure on R&D is a strategic investment. So, the after tax R&D expenditure is contained in the capital and added back to NOPAT. The amount included in the capital is amortised over 5 years.

iii) Goodwill: Goodwill is a permanent investment in the business on which the shareholders expect returns and should not be amortised. Thus, goodwill amortization is excluded from the calculations of NOPAT, and gross goodwill is incorporated into capital.

  1. iv) Interest: All interest expenses is added back to profits. The tax benefits of interest are also removed, and the cash operating taxes for the company are adjusted accordingly.
  2. v) Non-Interest Bearing Current Liabilities (NIBCLS): NIBCLS are part of the ongoing operations of the business, and are a source of finance. All NIBCLS are exempt from the calculation of capital.
  3. vi) Investments in Marketable Securities: These are included in capital, and the income from these securities as showed in the books of accounts is included in the NOPAT.

vii)Cash Operating Taxes: The tax-adjustment starts with the provision for taxes, which are restated to reflect taxes paid items are eliminated. The marginal tax rates for the respective years are employed to all the adjustments.

viii) Revaluation Reserve: Revaluation reserves are considered for all companies, and excluded from capital.

  1. ix) Construction in progress: Construction in progress is included in Capital. Thus, EVA is the difference between NOPAT and the shareholder’s expectation, which are the capital charge.
  2. EVA = NOPAT – (Cost of capital x Economic capital) The Calculations:

 

NOPAT = (Profits after-tax + Non-Recurring Expenses + Revenue Expenditure on R&D + Interest Expense + Goodwill written off + Provision for taxes) – Non-Recurring Income - R&D Amortization - Cash Operating Taxes.

 

Cash Operating Taxes = (Provision for Taxes + Tax Benefit of Non-Recurring Expenses + Tax Benefit of Interest - Tax on Non-recurring income)

 

 

Economic Capital = Net Fixed Assets + Investments + Current Assets - (NIBCLS + Miscellaneous Assets) - (Cumulative Non-Recurring losses + Capitalized Expenditure on R&D + Gross Goodwill) – Revaluation Reserve - Cumulative Non-Recurring Gains.

 

  1. MANAGEMENT SYSTEM

The true value of EVA comes in using it as the foundation for a comprehensive financial management system that encompasses all operations and strategy. In a very important sense, the process of becoming an EVA company is part of subtraction as well as addition. Involves the paring away of all other financial metrics, each of which can frequently mislead managers to the wrong decision. For example, if the stated corporate goal is tantamount to maximize the rate of return on net assets, the highly profitable divisions will be reluctant to invest even in attractive projects for fear of eroding their returns. Underperformers, meanwhile, will be keen to invest in almost anything, even if the expected return is below the firm’s cost of capital, in order to lift their average return and buy their way out of trouble. The uniform focus on continuously improving EVA, in contrast provides the best insurance that all managers are doing the right decisions for shareholders.

  1. MOTIVATION

To instill both the sense of urgency and the long-term perspective of an owner, cash bonus plans are designed which cause managers to think like and act like owners because they are improvements in EVA is the source of the greatest power in can make more money for they is by creating even greater value for with no for managers, the happier the shareholders will be. An EVA based in such a way so as to maximize the EVA, not just of the operation aims to make every employee of an organization an entrepreneur who seeks not just to perform his or her function well, but to do so in such a way that will enhance the EVA of the company.

  1. MINDSET

Effective implementation of EVA necessitates a change in the culture and mindset of the company. When implemented in compensation system transforms an on language for employees across all corporate functions. EVA facilitates divisions, and it eliminates much of the mistrust that typically exists between operations and finance. The EVA framework is, in effect, a system of internal corporate governance that automatically guides all managers and employees and propels them to strive for the best interests of the owners. The EVA system also facilitates decentralized decision making because it holds managers accountable for and rewards them for delivering value.

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