ECONOMIC VALUE ADDED

CONCEPT OF ECONOMIC VALUE ADDED (EVA)

The concept of EVA was originally proposed by the famous consulting firm, Stern Stewart, a pioneer in the field. Peter Drucker, management guru, defines EVA as a measure of total factor productivity.
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DEFINITION OF EVA
EVA is surplus left after making an appropriate charge for the capital employed in the business.

WHAT IS APPROPRIATE CHARGE ?

Appropriate charge is the cost incurred by the company for the capital employed in the business of the company. This cost is what the providers of capital viz. shareholders and lenders expect from the company for the risk borne by them by investing in the company. This is called cost of capital.
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PHILOSOPHY OF EVA
One should get return on every rupee that has been spent.
Recover more than or equal to cost of capital. Make optimum utilisation of the available resources
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WHY EVA ?
The GAAP have failed to generate accounting reports that reflect economic reality. The fragile association between accounting data and capital market values suggests that the usefulness of financial reports is limited. EVA comes as a reliable guide to value creation where a Net Operating Profit After Tax (NOPAT) figure is arrived at which reflects economic performance and a capital figure that measures the capital contributed by shareholders and lenders.
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COMPUTATION OF EVA
EVA = NOPAT - c* x CAPITAL where EVA is economic value added NOPAT is net operating profit after tax c* is cost of capital CAPITAL is economic book value of the capital employed in the firm
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THE THREE COMPONENTS OF EVA

Net Operating Profit after Tax (NOPAT)

Cost of capital Capital Employed

Net Operating Profit After Tax (NOPAT)

NOPAT is defined as :
(Profit before interest and taxes) (1 - tax rate)

This definition is based on two principles : Financing charges like interest and dividend are not considered for arriving at profits (or cash flows) on the investment side. Financing charges will be reflected in the cost of capital figure used for discounting the profits (or cash flows) on the investment side. All analysis to be done in post tax terms. 9

COST OF CAPITAL
Cost of Capital
It represents a weighted average of the costs of all sources of capital It is calculated in post tax terms It reflects the risks borne by various providers of capital viz. shareholders and lenders

Formula :
(cost of equity) (proportion of equity in the capital employed) + (cost of preference) (proportion of preference in the capital employed) + (pre-tax cost of debt) (1-tax rate) (proportion of debt in the capital employed) 10

CAPITAL EMPLOYED
Capital Employed
Capital employed in the business can be obtained by making adjustments to the accounting balance sheet to reflect the economic value of assets rather than the accounting values determined by the historical cost based generally accepted accounting principles.
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CERTAIN ADJUSTMENTS TO ARRIVE AT EVA

Research and Development :
The R&D outlays are treated as assets on the balance sheet and amortised over a period of time that represents the useful life on R&D.

Strategic Investments :
Outlays on a strategic investment are held back in a suspense account. Capital charges on the balance in the suspense account are left out from the EVA calculation till the time the investment is expected to generate operating 12 profits.

CERTAIN ADJUSTMENTS TO ARRIVE AT EVA. Contd...

Marketable Securities : Investments held in other companies Hence, not included in the capital employed and income from the same not included in arriving at NOPAT. Restructuring Charges : A restructuring opportunity is welcomed as it facilitates a more productive deployment of capital.
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CERTAIN ADJUSTMENTS TO ARRIVE AT EVA. Contd...

Expense Recognition :
The advertising / marketing expenses incurred to establish brands, enter new markets, expand customer base and gain market share are capitalised and amortised over an appropriate period.

Depreciation :
Under GAAP, straight line method is used in which the capital charge goes on decreasing with the depreciated carrying value of the asset. This makes the old assets look much cheaper than new ones and hence managers would not like to replace the old assets since this would show a declining EVA. Sinking fund method is the solution where the depreciation is small initially and goes on increasing in the later years and the sum of depreciation and capital charge remains constant till the useful life of 14 the asset which keeps EVA constant during the useful life of the asset.

CERTAIN ADJUSTMENTS TO ARRIVE AT EVA. Contd...

Taxes :
Companies use written down value method of depreciation for computing taxable profits to calculate tax owed by the company called book taxes and Companies use straight line method of depreciation for shareholder reporting purposes which is the actual tax payment called cash taxes This improves EVA since there is a difference between book taxes (WDV) which is higher than cash taxes (straight line) Only cash taxes are deducted to arrive at NOPAT The difference in book taxes and cash taxes is treated as 15 deferred tax liability which is payable in future.

COMPUTATION OF EVA
EVA = NOPAT - c* x CAPITAL where EVA is economic value added NOPAT is net operating profit after tax c* is cost of capital CAPITAL is economic book value of the capital employed in the firm
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OTHER FORMULAE TO COMPUTE EVA

EVA = ROCE WACC where:
ROCE is the Return on Capital Employed ROCE = Net Operating Profit after Tax / Total Capital WACC is the Weighted Average Cost of Capital WACC = Combination of cost of debt and equity employed
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OTHER FORMULAE TO COMPUTE EVA

EVA = CAPITAL (r - c*) where CAPITAL is economic book value of the capital employed in the firm r is return on capital = NOPAT / CAPITAL c* is cost of capital
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OTHER FORMULAE TO COMPUTE EVA

EVA = {PAT + INT (1-t)} - c* CAPITAL PAT = Profit after Tax INT = Interest expense of the firm t = marginal tax rate of the firm c* is cost of capital CAPITAL = economic book value of the capital employed in the firm EVA = PAT - keEQUITY PAT = Profit After Tax ke = cost of equity 19

EXAMPLE
EVAcalculation

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Four Fundamental Strategy to improve EVA

4. Optimize - reduce cost of capital by optimizing capital structure

EVA = [NOPAT/Capital - Cost of Capital] *Capital

1. Operate - Improve the return earned on existing capital

3. Harvest Divest capital when returns fail to achieve the cost of capital 21

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

STRATEGIES TO IMPROVE EVA

Deploy more capital to those activities wherein NOPAT generated by the activities is greater than the Cost of Capital Withdraw capital from those activities wherein NOPAT is less than the Cost of Capital, unless there is a strategic decision to lose in an activity in order to gain in other activities. Optimize the capital structure through optimum debt equity mix in order to have the lowest possible Cost of Capital and Improve the efficiency of the organization to retain the same amount of NOPAT by possible continuous reduction of existing capital and/or continuously increase the existing 22 NOPAT with the existing amount of capital.

LIMITATIONS OF EVA
While EVA helps firms in achieving higher business unit efficiency, it may not encourage collaborative relationship between business unit managers. While EVA is the best flow measure of performance, it is not the universal answer to the search for the perfect performance measure. Perfect measures of capitalized value will never be found because value cannot be known with certainty until after a project has run its course to competition and shutdown.
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CONCLUSION
EVA is a reasonable valuation tool which identifies the gap left by GAAP. It provides valuable insights into value creation. It ensures that the company makes productive use of all the available resources. It is a performance measure that lays emphasis on shareholder wealth creation. It teaches business literacy to everyone by converting accounting information into economic reality that is readily grasped by non-financial managers. As the basis of incentive compensation, it truly aligns the interest of managers with that of shareholders and makes managers think and act like owners. It motivates everyone to work enthusiastically to achieve the 24 best attainable performance.

THANK YOU
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