EVA-Equity Value Added

What is EVAEVA = 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 by accounting 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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EVA is a financial performance measure based on operating income after taxes, the investment in assets required to generate that income, and the cost of the investment in assets (or, weighted average cost of capital).

The three elements used in calculating EVA are operating income after tax, investment in assets, and the cost of capital

Formula

EVA = Net Operating Profit –Taxes – Cost of Capital

Steps for EVA Step 1: Develop an Equity Value Added model.

– Determine appropriate adjustments to income statement and balance sheet.– Determine total capital.– Determine appropriate cost of capital.– Develop model for future calculations.

Step 2: Review the determined Economic Value Added models with Company management and establish base line values. Management utilizes in performance measurement, investment analysis, and determination of an incentive compensation system based on annual or multi-year change in Economic Value Added.

Step 3: Determine annual Economic Value Added based on established model.

Step 4: Company management uses annually prepared Economic Value Added to evaluate unit performance, allocate capital and determine incentive compensation

Components of EVANOPLAT

Net operating profit after taxCapital

Net working capital, net PP&E, goodwill, and other assets

Cost of capital Weighted average cost of capital

Capital charge Cost of capital * capital

Economic value added NOPLAT less the capital charge.

NOPLATNet sales 150,000Cost of sales 135,000Depreciation 2,000SG&A 7,000Net Operating profit 6,000Taxes @ 40% 2,400NOPLAT 3,600

Topic Area Description/Examples How Economic Value AddedCompensates

Non-Recurring Gains/Losses

Uranium is discovered onsite at acompany not in the mining business; a large gain on the sale of uranium results.

The company is involved in afrivolous lawsuit, and incurs unusually high legal expenses to defend itself in a particular year.

Profits from this precious metal sale would be deducted from earnings (ANOPAT); executive does not get credit;

Unusual legal expenses would be added back to earnings;

Research & Development(can also be applied to acompany’s investment inBrand Development)

Under accounting standards, R&D is expensed, depressing profitability in the short-term.

Under Economic Value Added R&D expenses are capitalized and amortizedover the period they yield benefit. This encourages long-term investment in profitable projects.

Topic Area Examples/Implications How Economic Value AddedCompensates

Debt-financed growth projects

Managers could be tempted, for the sake of growth, to debt finance projects, since the cost of debt is lower than equity, and these projects will beat their low hurdle rates.

Economic Value Added uses the firm’s cost of capital; which includes costlier equity capital. Marginal projects willnot increase Economic Value Added.

Using bad debt reserves and other accrual accounts tomanage earnings

Managers can build up large bad debt reserves in good years, and then use them to smooth earnings in bad years.

Economic Value Added does not measure expenses based on estimated bad debt expense, but by actual bad debt expense.

What is Capital?Capital: Net operating assets adjusted for

certain accounting distortions Asset write-downs, restructuring charges,

Net operating assets:Cash, receivables, inventory, prepaidsTrade payable, accruals, deferred taxesNet property, plant, and equipment

Non-operating assets:Marketable securities, investments,...

Calculation of cost of capitalLong term debt

Preferred equities

Equity

The WACC

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.

Calculating EVANet operating profit after tax (NOPLAT)- Capital charge (= WACC * Capital)= Economic value added (EVA)

NET PRESENT VALUE(NPV)The difference between the present value of cash

inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the

profitability of an investment or project. ECONOMIC VALUE ADDED

NET PRESENT VALUE

Benett Stewart-to measure the value of the firm

Peccati - decomposition of the NPV of a financial project.

More immediateness and incisiveness

Less immediateness and incisiveness

Accounting figures Market values

Why Use EVA & Not NPV?

Present value of EVA = Present value of NPV

Provides insight into each period

Is a direct link to performance

More useful for future project audits.

Example

Hindustan Unilever LTD

EVA calculation is simple, since only main data contained in income

statement and balance sheet is needed.

EVA covers all aspects of the business cycles

EVA aligns and speeds decision making, and enhances communication

and teamwork

Positive EVA indicates value creation, Negative EVA indicates value

destruction. Series of negative EVA is a signal that restructuring in a

company may be needed.

The EVA concept is easy to understand and easy to use

Advantages of EVA

EVA helps to understand the concept of profitability even by persons

not familiar with finance and accounting

In a small company, managers can make the EVA concept transparent

to all employees in a short time

EVA helps to convert a small company’s strategy into objectives

tangible for all employees

EVA is a useful tool for allocation of a small company’s scarce capital

resources

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The EVA concept integrated in a small company’s

decisions making process improves its business

performance because managers having deeper knowledge

about capital and capital cost are able to make better

decisions.

EVA is based on financial accounting methods that can be manipulated by managers by using different method of accounting. There are different ways to calculate NOPAT and COC as there are numerous

fundamental differences exist with regard to calculation of NOPAT and COC There are 164 adjustment which is really cumbersome exercise EVA may focus on immediate results which diminishes innovation

EVA is in favour of large companies EVA favours more debt compared to equity It is difficult to implement Implementation includes significant cost EVA does not study business drivers like consumer satisfaction or learning and

growth. Traditional performance measures used by small companies, such as sales or profits

alone, are unable to describe the company´s true business results and sometimes lead to wrong business decisions.

Limitations of EVA

Case study

IMPLEMENTATION OF EVA IN GODREJ GROUP OF COMPANIES

“EVA will be the main financial parameter by which we measure our performance. It will also be used in all capital expenditure decisions including acquisitions. We have just completed an exhaustive modular training on EVA and its application for all employees. The objective is to make all employees think like owners. This should be supported by an open-ended variable remuneration scheme.” C K Vaidya

Executive Director(Corporate Personnel)

TRAINING FOR EVA AT GODREJ• Training programme for employees was conducted by consultants from Stern Stewart

• Use of simulation techniques in training

• Four tier training :

* Detailed training for top mgt & Internal Trainers by Stern Stewart

* Detailed training for middle mgt by Internal Trainers

* Basic training for other employees

* Training and awareness of performance linked variable remuneration scheme

BOOH Factor in the implementation of EVA at Godrej

Build --- Invest as long as returns exceed the cost of capital

Optimize---Reduce cost of capital by optimizing capital structure

Operate---Improve the return on existing capital

Harvest---Divest capital when the returns fail to achieve the cost of capital

10 STEPS TO SUCESSFUL EVA IMPLEMENTATION

Obtain top level organization commitment with EVA.

Education and training of the people in the project in EVA.

Scope well defined, detailed and identified, with proper WBS and package.

Schedule and budget organized according to the WBS.

Clear project responsibility Tables, with clear responsibility description.

ContinuedClear flowchart of activities and relationship with the main

participants.

Cost/Schedule Control System with database and data collection procedures.

Suitable reports related to EVA, well planned, analysed and distributed.

Procedures to consistency analysis and validation of information.

Lessons Learned – continuous improvement process.

How can the ManagementImprove EVA?

Try to improve returns with no or with only minimal capital investments

Invest new capital only in projects, equipment, machines able to cover capital cost while avoiding investments with low returns

Identify where capital employment can be reduced

Identify where the returns are below the capital cost;

divest those investments when improvements in returns are not feasible

ConclusionEVA is both a measure of value and also a measure of performance.

 The value of a business depends on investor’s expectations about the

future profits of the enterprise.

 Stock prices track EVA far more closely than they track earnings per

share or return on equity.

 A sustained increase in EVA will bring an increase in the market value of the company.

 As a performance measure, Economic Value Added forces the

organization to make the creation of shareholder value the number one priority.

Thank you