Economic Value Economic Value AddedAdded

22

DefinitionDefinition

New York based financial advisory Stern Stewart & Co. postulated the very concept of Economic Value Added (EVA) in 1990.

• EVA : Maximum amount which the EVA : Maximum amount which the business is capable of distributing to itsbusiness is capable of distributing to its

shareholders while remaining in the shareholders while remaining in the same position at the end of the period same position at the end of the period as it was at the beginning with fair as it was at the beginning with fair practices.practices.

33

WHAT IS EVAWHAT IS EVATMTM ? ? EVA is a trademark of Stern Stewart

& Co. is a specific metric for calculating economic profit.

Enables the direct alignment of management and shareholders interest- “RICE,V.A.”

44

Necessity of E.V.ANecessity of E.V.AIt provides a suitable

framework for:

The allocation of capital among business units

measurement of corporate performance, and

The determination of executive incentive compensation.

55

It measures value creation; Eva is based on the foundation that

to create value a company must earn more than its cost of capital.

66

EVA and its ComponentsEVA and its Components

77

88

Computation of EVAComputation of EVA EVA = ANOPAT -Cost of CapitalEVA = ANOPAT -Cost of Capital

• ANOPAT =Adjusted Net operating ANOPAT =Adjusted Net operating Profit after TaxProfit after Tax

• The project’s cost of capital is the The project’s cost of capital is the minimum required rate of return on minimum required rate of return on funds committed to the project.funds committed to the project.

• The firm’s cost of capital will be the The firm’s cost of capital will be the overall (WACC), required rate of overall (WACC), required rate of return on the aggregate of return on the aggregate of investment projects the projects.investment projects the projects.

99

EXAMPLE – Consider the following firm:EXAMPLE – Consider the following firm:

Sales $100,000,000Sales $100,000,000 Operating Profit $ 9,000,000Operating Profit $ 9,000,000 Adjustments $ 1,000,000Adjustments $ 1,000,000 Debt $ 20,000,000Debt $ 20,000,000 Equity $ 40,000,000Equity $ 40,000,000 Tax Rate 30%Tax Rate 30% WACC 10%WACC 10%Thus,Thus,– – ANOPAT = $10,000,000 x (1 – 30%) = $7,000,000ANOPAT = $10,000,000 x (1 – 30%) = $7,000,000– – Total Capital = $20,000,000 + $40,000,000 = Total Capital = $20,000,000 + $40,000,000 =

$60,000,000$60,000,000– – Capital Charge = 10% WACC x $60,000,000 = Capital Charge = 10% WACC x $60,000,000 =

$6,000,000$6,000,000– – Economic Value Added = ANOPAT - Capital Economic Value Added = ANOPAT - Capital

Charge, = $7,000,000 -$6,000,000 = +$1,000,000Charge, = $7,000,000 -$6,000,000 = +$1,000,000

1010

Advantages of Economic Value Advantages of Economic Value AddedAdded

• Transparency / Ease of Use - Easy to calculate. -Less subject to manipulation than earnings

per share. -It is less variable than accounting earnings.• Flexible - Can easily be adapted across industries - Adjustments to net operating profit can be

custom - tailored to reflect company specific fact

sets.

1111

ConceptualConceptual

- - Measures if an executive Measures if an executive is generating company is generating company earnings greater than a earnings greater than a comparably risky comparably risky portfolio of debt and portfolio of debt and equity.equity.

- - E V A causes the E V A causes the manager to adopt the manager to adopt the mentality of a business mentality of a business owner, adopt sound owner, adopt sound long-term decisionslong-term decisions

1212

EVA DeficiencyEVA DeficiencyNot easy to use (for calculation of PAT, Not easy to use (for calculation of PAT,

some 144 adjustments are there) too some 144 adjustments are there) too complicated for small business.complicated for small business.

Recommends inexpensive debts in Recommends inexpensive debts in order to reduce cost of capital (COC), is order to reduce cost of capital (COC), is a very questionable strategy for small a very questionable strategy for small business.business.

A passive accounting tool : measures A passive accounting tool : measures past performance.past performance.

1313

Review of LteratureReview of Lterature FORTUNE FORTUNE

magazine has called magazine has called EVA “today’s EVA “today’s hottest idea”.hottest idea”.

Peter F. Drucker Peter F. Drucker commented in commented in HBR:EVA measures HBR:EVA measures “total factor “total factor productivity”.productivity”.

1414

ConclusionConclusionwe can definitely say that EVA™ has emerged as apowerful conceptual framework and is practicallyimplemented in most of successful corporationsacross globe. Which incorporates balance sheet datainto an adjusted income statement metric whichworks best for companies whose tangible assets(assets on the balance sheet) correlate with themarket value of assets - as is often the case withmature industrial companies.