COSTING ASSIGNMENT

ON

ECONOMIC VALUE
ADDED

Submitted by:

DIVYA BODDU
09020242007
MBA-AB [09-11]
INTRODUCTION:

Economic Value Added (EVA) is a financial performance method to calculate the true
economic profit of a corporation. EVA is basically an estimate of the amount by which
earnings exceed or fall short of the minimum rate of return for shareholders or lenders at
comparable risk.

• Unlike market based measures, EVA can be calculated at divisional (SBU) level.

• Unlike stock measures, EVA is a flow and can be used for performance evaluation
over time.

• Unlike accounting profits, EVA is economical and is based on the idea that a business
must cover both the operating costs and capital costs.

EVA is a part of performance metric used by various corps and its corresponding wealth
metric is Market Value Added. The EVA is a registered trademark by its developer, Stern
Stewart & Co.

EVA is generally used for setting organizational goals, performance measures, determining
bonuses, communication with shareholders and investors, motivation of managers, corporate
valuation and analysing equity securities.

CALCULATION OF EVA:

EVA is calculated in three basic steps:

There are certain adjustments that are to be made while calculation of EVA:
SIGNIFICANCE OF EVA:

The use of above formula will produce either a positive or negative EVA number. A positive
EVA reflects that the company is increasing its value to its shareholders, whereas a negative
EVA reflects that it is diminishing its value to its shareholders. Also, MVA has a direct
relation with EVA.

The market value of a company = Book value of

equity + present
value of future EVA
The strengths of EVA are as follows:

• Because it is a residual performance metric, it conveniently summarizes into a single

statistic the value created above and beyond all financial obligations
• By applying a capital charge, it corrects the key deficiency of earnings and earnings
per share (EPS): they do not incorporate the balance sheet. Economic profit explicitly
recognizes - by way of the capital charge - that capital is not free
• Generally, they do it either by investing additional capital that produces returns above
WACC, by reducing capital employed in a business, by improving returns by growing
revenues or reducing expenses or by reducing the cost of capital.

Thus companies try to increase their EVA by:

 Increasing the NOPAT generated by existing Capital

 Reducing the WACC
 Investing in new projects where the Return exceeds the WACC
 Divesting Capital where the Return is below the WACC

LIMITATIONS OF USING EVA:

• EVA has the limitations of any single-period, historical metric: last year's economic
profit will not necessarily give you an insight into future performance
• EVA is difficult to use for inter-firm and inter-divisional comparisons because it is an
absolute rather than a relative measure.
 • Due to the calculation being a year-to-year performance metric, the result could be
manipulated by, for example, choosing short-term, early yield projects over longer-
term, delayed income stream, higher yield projects.
• EVA is a short-run concept that deals only with the current reporting period
• The use of conventional depreciation methods means that there is no guarantee that the
measurement of EVA™ in the short-term will be consistent with the measurement of
EVA in the longer-term.
• Economic depreciation is difficult to estimate and conflicts with generally accepted
accounting principles, which may hinder its acceptance by financial managers

REFERENCES: www.investopedia.com; www.wikipedia.org; www.evanomics.com; www.sternstewart.com