A Study on the Relationship between Capital Structure and Value Based

Performance Measurement Systems: EVA and MVA

Dr. Thejo Jose,
FISAT Business School, HormisNagar, Mookkannoor PO, Angamaly-683577
&
Mr.Abhishek Ashok,
FISAT Business School, HormisNagar, Mookkannoor PO, Angamaly-683577
Abstract
In order to maximise value for shareholders, companies should strive towards maximising Market
Value. The best way to do so is to maximise the EVA, which highlights a corporations ability to earn
returns above the cost of capital, which heavily depends on the capital structure. 1Stewart (1991)
defines EVA as follows: A companys EVA is the fuel that fires up its MVA. The popularisation of
EVA has opened up new possibilities for investigating the leverage effect of fixed costs and interest in
conjunction with EVA. The study aimed at understanding the relationship of EVA and MVA with the
capital structure, the extent or degree of influence they have on capital structure and by checking if
they are superior to EPS as a standard for deciding capital structure. A total of seventeen companies
were taken out from the BSE SENSEX Companies. The variables of the sample companies for the
period of 2009 to 2013, making the total sample size of 85, were used for analysis. After studying and
evaluating the interlinking relationships of EVA, MVA and EPS as the dependent variables with the
Term Debt-Equity (LTDE) Ratio or the capital structure, as the constant or dependent factor, it was
found that the VBPM i.e. both EVA and MVA had a significantly negative correlation to the capital
structure 2indicating an indispensable role of capital structure in value increment or decrement. And,
the R-squared value showed VBPM having a very significant impact, on the constant factor, whereas,
the EPS showed no significant relationship with the constant. This ultimately concludes the great
relevance of VBPM: EVA and MVA on Capital Structure over EPS.
Key Terms: Value Based Performance Measures (VBPM), EVA, MVA, EPS and Capital Structure
1. Introduction
It is generally believed that in order to maximize value for shareholders, companies should strive
towards maximizing Market Value. The best way to do so is to maximize the EVA, which highlights a
corporations ability to earn returns above the cost of capital, which heavily depends on the capital
structure. Stewart (1991) defines EVA as follows: A companys EVA is the fuel that fires up its
MVA. A possible avenue for EVA implementation is capital structure decision making. EVA theory
could be used for making decisions on capital structure, by comparing EVA values under different
financing solutions. It can achieve the target of an enterprise which is shareholder value maximization;
also make up the defects of traditional capital structure decision theories.
2. Literature Review
1
Shahveisi, Navid, Najafi1 and Hosseini (2012) studied the Relationship between the Capital Structure
and the Variables of the Value-based Performance Assessment. All firms listed in Tehran from Stock
Exchange had been chosen as the statistical community and the research study area. They concluded

Stern, J.M., Stewart, G.B. and Chew, D.H. (1994), The EVA and Financial Management Systems, Journal of Applied
Corporate Finance, Vol 7 No 2, pp. 32-46
2
Shahveisi, Farhad, JamshidiNavid, Babak, Najafi, Yousef and Ali Akbar Hosseini, Seyed (2012), The Study of the Relationship
between the Capital Structure and the Variables of the Value-based Performance Assessment, Research Journal of Finance
and Accounting, Vol 3, No 7, 2012
www.theinternationaljournal.org > RJCBS: Volume: 04, Number: 07, May-2015 Page 16

that both the dependent variables i.e. EVA and MVA have a significant and negative correlation with
the capital structure.3Wet and Hall (2004) presented their paper on the relationship between
EVA,MVA and leverage wherein an attempt is made to analyse the impact of different levelsof
operating and financial leverage on profits, EVA and MVA. The spreadsheet model was used to
investigate the leverage effect ofthree items, namely fixed costs (DOL), interest on borrowed capital
(DFL) and the costof own capital (EVA leverage). Five different scenarios, each with a different
levelleverage was assumed to determine the relationships between the different kinds impacton profits,
EVA and MVA (and therefore, also the value of the firm).
4
Chengfeng and Ma Wei (2012) explained in their paper Discussion of CapitalStructure Decisionmaking Based on EVA Theory that the management of enterprisescould determine the financing
selection by judging the impact of the interest rate oflong-term debt financing on the EVA,
consequently, the financial risk and the cost ratioof equity capital are all taken into account. The results
prove that this improvement is afeasible and effective method of capital structure decision-making and
it can help themanagement to achieve the target of enterprise which is shareholder
valuemaximization.5Modigliani and Miller (1958) in their paper established that capital structure does
not affect firm value, subject to a number of stringent assumptions. The assumptions are that there are
no taxes, there are perfect capital markets and the investment and financing decisions are independent.
However, once these restrictive assumptions are removed, capital structure decisions may affect firm
value.6Megginsonet al. (2010) say that another point of view wealth or value is created by applying
financial leverage, employing debt in the company's capital structure. Financial leverage is referred to
as "gearing" in Britain according to Megginsonet al. A firm's financial performance, positive and
unfortunately negative as well, can be magnified via the leveraging effect.7Bossert (2012) in her paper
capital structure: a value-based management framework in the healthcare sector, identified share
prices and change in share price as dependent variable and EVA, NOPAT, EBIT, ROA and FCF as
independent variables. The author concluded that VBM practicing firms should be managed according
to a dynamic target capital structure rather than a rigid capital structure and sustainable shareholder
wealth creation would be positively related to the optimisation of the DE ratio and EVA.
3. Research Methodology
3.1 Research objectives
Primary Objective
To check whether either of EVA or EPS is superior to the other for determining the capital structure
Secondary Objectives

To check the correlation of EVA, MVA and EPS with the Capital Structure.

To check the extent or degree of influence of the variables on Capital Structure

3.2 Variables used in the study
The dependent variables are EVA, MVA and EPS which will be analyzed against the constant factor
or independentvariable, which is the Long Term Debt-Equity Ratio or the capital structure.
Where,
EVA= operating income after tax Cost of capital
Cost of capital = Capital employed Weighted Average Cost of Capital (WACC)
WACC= [Ke E/(D+E)] + [ (Kd(1-Tax)) D/(D+E)]

3

Wet, JH de and Hall, JH (2004), The relationship between EVA, MVA and leverage,, Meditari Accountancy Research Vol.
12 No. 1, pp 3959
4
Chengfeng, Long and Wei, Ma (2012), Discussion of Capital Structure Decision-making Based on EVA Theory,
International Conference on Information Management and Engineering (IPCSIT vol. 52)
5
Modigliani, F. & Miller, M. (1958), The cost of capital, corporation finance, and the theory of investment, American
Economic Review, pp 655-669.
6
Megginson, W.L., Smart S.B. & Graham J.R. (2010), Financial Management, 3rd edition, pp 1-96
7
Bossert, Anthea H.H. (2012 ), Capital Structure: A Value Based Management Framework in the Healthcare Sector, Mini-
dissertation submitted in partial fulfilment of the requirements for the degree Master in Business Administration at the
Potchefstroom Campus of the North-West University , April 2012
www.theinternationaljournal.org > RJCBS: Volume: 04, Number: 07, May-2015 Page 17

MVA = EVA / WACC

Cost of Equity (Ke)= (Rf +( Rm - Rf )) (CAPM)
3.3 Research design and data
This research follows a quantitative descriptive research. The population of the research includes all
the companies listed in BSE. A total of 17companies were taken out from the BSE SENSEX 30
companies. Banking and financialcompanies were excluded from the sample due to their certain nature
of their capital structure which is commonly debt free. The historical data of five years i.e. 2009 to
2013 was analyzed and tabulated. So, for all
17 companies EVA and MVA were calculated for the last five years beginning 2009 to 2013 and
making the overall sample of 85. The research relies entirely on Secondary Data. The sources
consulted include Audited Annual Reports of the sample companies, Research Journals and articles
and Reuters.com.
3.4 Hypotheses of the study
H1: There is no significant relationship between MVA and the Capital Structure
H2: There is no significant relationship between MVA and the Capital Structure
4. Computation of EVA and MVA
According to 8Stern Stewart and Co, the originators of EVA, Economic value added is an index based
on value-based thinking to control the entire value created in business deals. Generally, economic
value added is a measure of internal performance. Indicator of economic value added
Economic Value-Added (EVA):
EVA= operating income after tax Cost of capital
MVA = present value of all future EVA
Cost of capital = (Capital employed WACC)9The link between MVA and EVA is that, MVA is equal
to the present value of all future EVA to be generated by the company. i.e., MVA = EVA / WACC

S.No.
1
2
3
4
5
6
7
8
9
10

Year
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000

Close
1,908.85
2,615.37
3,346.06
3,926.90
3,110.49
3,085.20
3,658.98
3,055.41
5,005.82
3,972.12

11

2001

3,262.33

Table-1: BSE Sensex 30 Historical Data

% Change
S.No.
Year
Close
12
2002
3,377.28
37.01286
13
2003
5,838.96
27.9383
14
2004
6,602.69
17.35892
15
2005
9,397.93
-20.7902
16
2006
13,786.91
-0.81306
17
2007
20,286.99
18.59782
18
2008
9,647.31
-16.4956
19
2009
17,464.81
63.83464
20
2010
20,509.09
-20.65
21
2011
15,454.92
22
2012
19,426.71
-17.8693
2013
21,170.68
23

Rm (Market Return in % )
Table-2: Calculation of EVA and MVA

% Change
3.523555
72.88943
13.0799
42.33487
46.70156
47.14675
-52.4458
81.03295
17.43094
-24.6436
25.69919
8.977176
16.811

Stern, J.M., Stewart, G.B. and Chew, D.H. (1994), The EVA and Financial Management Systems, Journal of Applied
Corporate Finance, Vol 7 No 2, pp. 32-46
9
Wet, JH de and Hall, JH (2004), The relationship between EVA, MVA and leverage,, Meditari Accountancy Research Vol.
12 No. 1, pp 3959
www.theinternationaljournal.org > RJCBS: Volume: 04, Number: 07, May-2015 Page 18

5. Data analysis and interpretation

For understanding the relationship between variables Karl Pearsons Correlation has been used. The
presence of a significant relationship will be checked using the correlation tool. Adjusted R-squared
(R2) value was taken to analyse the degree or extent of relationship between variables. ANOVA has
been used to ascertain the level of significance and the general fit.
Table-3
Correlation between EVA and Capital Structure 2009-2013
Economic Value The Long Term Debt Equity
Added
Ratio of the companies
Pearson
1
-.447**
Correlation
Economic Value Added
Sig. (2-tailed)
.000
N
85
85
Pearson
-.447**
1
The Long Term Debt Equity Correlation
Ratio of the companies
Sig. (2-tailed) .000
N
85
85
**. Correlation is significant at the 0.01 level (2-tailed).
From Table 3 it can be concluded that the Null hypothesis (H1) of There is a no significant
relationship between EVA and the Capital Structure can be rejected and the alternate hypothesis that
there is a significant and negative correlation between capital structure and economic value added be
approved with 99% confidence level.
Table-4
Model Summary 2009-2013
R
R Square
Adjusted R Square
Std. Error of the Estimate
.447
.200
.190
2371.157
The independent variable is The Long Term Debt Equity Ratio of the companies.
From the model summary it was observed that .190 or 19% of change in EVA was caused by the
capital structure during 2009 to 2013.
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Table-5
ANOVA data set 2009-13
Sum of Squares
df
Mean Square
F
Regression
116728374.064
1
116728374.064
20.761
Residual
466657842.433
83 5622383.644
Total
583386216.497
84
The independent variable is The Long Term Debt Equity Ratio of the companies.

Sig.
.000

From table 5 it is found that the test statistic is the F value of 20.761. Using of 0.05 level of
significance, numerator degree of freedom (v1) as 1 and denominator degree of freedom (v2) as 83, we
have F0.05,1,83= 3.96. Since the test statistic is much larger than the critical value and the P value for
20.761 is 0.0001, i.e. conventional criteria, this difference is considered to be extremely statistically
significant, we confirm the rejection of null hypothesis i.e. There is a no significant relationship
between EVA and the Capital Structure and accept the R-square value.
Figure-1

Figure 1 is a plot of the calculated EVA and capital structure i.e. Long term DE ratio for the entire data
range of 2009-2013. The plot depicts the inverse or negative relationship between EVA and Capital
structure. It can be interpreted in simple words that with more and more use of leverage in the capital
structure, the EVA comes down, which affects the firm value.
Table-6
Correlation between MVA and Capital Structure for the period 2009-2013
The
Market The Long Term Debt Equity
Value Added
Ratio of the companies
Pearson
1
-.443**
Correlation
The Market Value Added
Sig. (2-tailed)
.000
N
85
85
Pearson
-.443**
1
Correlation
The Long Term Debt Equity
Ratio of the companies
Sig. (2-tailed) .000
N
85
85
www.theinternationaljournal.org > RJCBS: Volume: 04, Number: 07, May-2015 Page 20

**. Correlation is significant at the 0.01 level (2-tailed).

From Table 6 it can be concluded that the Null hypothesis (H1) of There is a no significant
relationship between MVA and the Capital Structure can be rejected and the alternate hypothesis that
there is a significant and negative correlation between capital structure and economic value added be
approved with 99% confidence level.
Table-7
Model Summary 2009-13
R
R Square
Adjusted R Square
Std. Error of the Estimate
.443
.196
.187
17416.962
The independent variable is The Long Term Debt Equity Ratio of the companies.
From the model summary it was observed that .187 or 18.7% of change in MVA was caused by the
capital structure during 2009 to 2013.
Table-8
ANOVA 2009-2013
Sum of Squares
df
Mean Square
F
Sig.
Regression
6149819497.336
1
6149819497.336
20.273
.000
Residual
25178095530.511
83 303350548.560
Total
31327915027.847
84
The independent variable is The Long Term Debt Equity Ratio of the companies.
From table 5 it is found that the test statistic is the F value of 20.273. Using of 0.05 level of
significance, numerator degree of freedom (v1) as 1 and denominator degree of freedom (v2) as 83, we
have F0.05,1,83= 3.96. Since the test statistic is much larger than the critical value and the P value for
20.273 is 0.0001, i.e. by conventional criteria, this difference is considered to be extremely statistically
significant, we confirm the rejection of null hypothesis i.e. There is a no significant relationship
between MVA and the Capital Structure and accept the R-square value along with the alternate
hypothesis.
Figure-2

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Figure 2 is a plot of the calculated MVA and the capital structure i.e. Long term DE ratio for the entire
data range of 2009-2013. The plot depicts the inverse or negative relationship between MVA and
Capital structure. It can be interpreted in simple words that with more and more use of leverage in the
capital structure, the MVA or the value of the firm comes down.
6. Conclusion
From the analysis of data of five years (2009-13), the following conclusions can be made:
1.
There exists a significantly negative correlations between the VBPMs i.e. EVA and MVA, and
the capital structure with Karl Pearsons Correlation (r ) values -0.447 and -0.443 respectively.
2.
From the F-test it was also found that the relationship is an extremely significant one.. The
Adjusted R-squared (Adj. R2) values of both VBPMs towards capital structure indicate that, Capital
Structure alone has an impact of 19% on EVA and 18.7% on MVA respectively.
3.
Even though the impact percentage depicted through R-squared value is less than 50% in both
cases, it is of vital importance to remember that capital structure alone is responsible for an impact of
19% and 18.7% on EVA and MVA respectively. The remaining 81% in the case of EVA and 81.3%
in the case of MVA may be caused by several other factors, not necessarily some other single factor,
which opens up new avenues for further research.
This proves that EVA and MVA as Value Based Performance Measures (VBPM) have a significant
relationship with the capital structure and the null hypotheses There is no significant relationship
between EVA and the Capital Structure and There is no significant relationship between MVA
and the Capital Structure can be rejected.
A company's capital structure is of vital importance. The way a company manages its Debt
Equity ratio will have a profound impact on a company's financial risk, which in return will have a
great influence on the market's sentiment towards the company and as a consequence on its share
price. This would lead to a firm's value being affected by the capital structure in a perfect market
condition. The managers should aim to build firm value, and not firm profitability alone as it is
popularly believed.
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