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Focused Finance

& EVA

Naina Adarsh

Tanvi Chaudhary Pushpak Roy

Manishwar



Focused Finance

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EVA & Wealth Creation Warren Buffet:

“We feel noble intentions should be checked periodicallyagainst results. We test the wisdom of retaining earnings by

assessing whether retention, over time, delivers shareholdersat least $1 of market value for each $1 retained.”

Translation:

Ultimate test of any company’s success lies in increasingits market value by more than it increases its capital.

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View of the Firm

Value of firm = Value of Liabilities + Value of Equity That is the amount of invested capital

Market value of a company reflects:

Earning power of invested assets

Present value of current operations

Present value of expected improvement in operating performance.

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Market Valued Balance Sheet

Assets Liabilities

Equity



What is Required to Focus?

Tie performance methods to capital budgeting

techniques:

Economic value added (EVA)

Market value added (MVA)

Want to gauge management’s performance

Focus on:

Decisions made in the past to help project the future.

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Links to

NPV



Market Value Added

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Total

market

valueDebt &

equitycapital

Marketvalue added

Investment

In Company

Premium



What is EVA?

EVA = Economic profit

Not the same as accounting profit

Difference between revenues and costs

Costs include not only expenses but also cost of capital

Economic profit adjusts for distortions caused byaccounting methods

Doesn’t have to follow GAAP

R&D, advertising, restructuring costs, ...

Cost of capital accounted for explicitly Rate of return required by suppliers of a firm’s debt and equity capital

Represents minimum acceptable return.

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What is Cost of Capital

Evaluation of profitability should also consider thelost opportunity that the capital has.

A company has Invested capital. This could make areturn elsewhere.

Before fully evaluating the profitability allowance for the cost of this capital should be considered.

This represents an opportunity cost .

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Market Value Added

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Total

market

valueDebt &

equitycapital

Expected

improvement

in EVA

MVA

Current level

of EVA

MVA = Present value of all future EVA



Components of EVA

NOPAT Net operating profit after tax

Operating capital Net operating working capital, goodwill, and other

operating assets

Cost of capital Weighted average cost of capital %

Capital chargeCost of capital % * operating capital

Economic value added NOPAT less the capital charge.

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Explicit Vs. Implicit Costs

Explicit costs are direct attributable costs like

materials or labour used in production.

Implicit costs or otherwise known as opportunity

costs are those costs that are the result of losing an

alternative use.

Example: If I have € 1m to invest in a company, I

lose the opportunity to leave it in the bank earninginterest of say 5%.

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What is NOPAT?

Net sales 150,000

(-)Cost of sales 135,000

(-)Depreciation 2,000

(-)Selling &Admin exp 7,000

Net Operating profit 6,000

(-)Taxes @ 40% 2,400

NOPAT 3,600 Excludes financing charges

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What is Operating Capital?

Capital: Net operating assets adjusted for certain

accounting distortions

Asset write-downs, restructuring charges, …

Net operating assets: Cash, receivables, inventory, pre-paid expenses

Trade payable, accruals, deferred taxes

Net property, plant, and equipment

Exclude non-operating assets: Marketable securities, investments,...

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What is the Capital Charge?

Represents a rental charge for the use of the operating

capital

Minimum rate of return the operating capital should earn Calculated as the firm’s weighted average cost of capital % x

invested capital.

It represents the opportunity cost of capital

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Calculating EVA

NOPAT/Average capital

= Return on invested operating capital (ROIC)

- Weight average cost of capital (WACC)

= Spread (= ROIC - WACC)

* Operating capital

= Economic value added (EVA)

Net operating profit after tax (NOPAT)

- Capital charge (= WACC * Capital)

= Economic value added (EVA)

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What’s Affecting

EVA?

Sales

- Operating expenses

- Taxes

= NOPAT

- Capital charge

= EVA

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COGS, SG&A + Other

Potential gov’t actions

Market potential



Forward Looking Relationship for

EVA & MVA

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EVA EVA EVA EVA

Year 1 Year 2 Year 3 .... Year n

Market

ValueMarket

value

MVA

Capital

=

EVA + EVA + EVA + ... + EVA

1 + r (1 + r)2 (1 + r)3 (1 + r)n

Market value is based on establishing theeconomic investment made in the company(capital), making a best guess about whateconomic profits (EVA) will happen in the

future, and discounting those EVAs to the present to get market value added.

MVA



EVA Drives MVA

Companies that consistently earn profits in excess oftheir required return ...

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NOPATEVA

Market

Value

Capital

MVA

Charge

… are typically valued at premiums to book

value.



Manufacturing EVA Drivers

Reduce inventory

Reduce cycle time

Improve yields

Reduce scrap/waste

Maximize labor efficiencies

Improve vendor efficiencies Process improvements

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Staff EVA Drivers

Work group/process simplification

Consistency “monitors” – audit

Centralizing resources/synergies

Best practices benchmarking

Insourcing/outsourcing decisions

Simplify EVA measurements/reporting Ensure compliance with legislation

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Marketing EVA Drivers

Increase market share / revenue

New markets

More focused channel programs

Voice of customer / consumer

Leverage advertising / promotion

Build brand awareness

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THANK YOU

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