Economic Value Added (EVA)

Presented by: NEEL BHAVIK AMIT VINIT

Introduction of EVA


EVA was developed by a New York consulting firm, Stern Steward & Co. in 1982 to promote value-maximisig behaviour in corporate managers. Value-based measure to evaluate business strategies, capital projects and to maximise long-term shareholders wealth. EVA sets managerial performance target and links it to reward systems. Unlike simple traditional budgeting. EVA focuses on ends and not means.

Definition for EVA

EVA is defined as net profit after taxes and after the cost of capital. FORMUALE for EVA EVA

Net operating profit

Taxes

Cost of capital

Calculating Net Operating After Tax (NOPAT)

NOPAT is easy to calculate. From the income statement we take the operating incomes and subtract taxes. e.g. XYZ Company Particulars Sales Cost of Goods sold (-) Gross Profit Amount (Rs.) 24,36,000/24,36,000/ 17,00,000/17,00,000/ 7,36,000/36,000/

Selling, general & Admin 4,00,000/00,000/ Exp. Exp. (-) Operating Profit Taxes (-) NOPAT 3,36,000/36,000/ 1,34,000/34,000/ 2,02,000/02,000/

Cost of Capital
Meaning: Meaning: The cost of capital is the rate of return required by the shareholders and lenders to finance the operations of the business. Types of Cost of Capital Equity Capital: Equity Capital is provided by the Shareholders. Capital: Borrowed Capital: It is the Capital borrowed by the company Capital: from Banks and other Financial Institutes.

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital examines the various components of the Capital structure and applies the weighting factor of after-tax cost to determine the cost of Capital. Calculating WACC e.g. XYZ Company Particulars Long Term Debt Preferred Stockholders Equity Total Common Equity Total Capital Amount (Rs.) 5,00,000/00,000/ 2,00,000/00,000/ 7,00,000/00,000/ 14,00,000/14,00,000/

WACC Continue

Long Term Debt

Bond Cost Bond Net Return (Deducting discounting & Financing cost) Interest Assumed Tax Interest After Tax
(Rs.14 Rs. 5) (9/96 x 100)

Rs. 100/100/Rs. 96/96/14% 35% 9% 9.47%

(Rs. 14/-) 14/(Rs. 5/-) 5/-

Cost for Bond Financing

WACC Continue

Preferred Stock Cost

Preference Share (Per share) Net Revenue (Deducting discount & financing cost) Dividend Cost for Preferred Share
(11/98 x 100)

Rs. 100/100/Rs. 98/98/11% (Rs. 11/-) 11/11.2%

WACC Continue

Common Equity Cost

Share Price Rs. 100/100/Rs. 85/85/Rs. 12/12/14.1%

(Per Share)

Net Return (Less issuing cost) EPS (Estimated by investors & reliable analyst) Cost for Common Equity
(12/85 x 100)

WACC Continue

Summarizing

Bond Cost Preferred Stock Cost Common Equity Cost

9.47% 11.2% 14.1%

Calculation of WACC for XYZ Company

Particulars Long Term Debt Preferred Stock Cost Common Equity Cost Total Capital Amount (Rs.) 5,00,000/5,00,000/2,00,000/2,00,000/7,00,000/7,00,000/14,00,000/14,00,000/Cost (%) 9.47 11.2 14.1 Total (Rs.) 47,375/47,375/22,400/22,400/98,700/98,700/1,68,475/1,68,475/-

The total Weighted Average Cost of Capital (WACC) = 1,68,478 / 14,00,000 = 12.03% 68, 14,00, 12.03%

Calculation of EVA for XYZ Company

NOPAT Capital Employed
(Including Rs.1,00,000/- Reserve & Surplus) Rs.1,00,000/-

Rs. 2,02,000/2,02,000/Rs. 15,00,000/15,00,000/12.03%

(12.03/100 x Rs. 15,00,000/-) 15,00,000/-

Cost of Capital Capital Charge

(Rs. 2,02,000

Rs. 1,80,450/1,80,450/Rs. 21,550/21,550/-

Economic Value Added (EVA)

Rs. 1,80,450)

Strategies for Increasing EVA

 Increase the return on existing projects (improve operating performance).  Invest in new projects that have a return greater than the cost of capital.  Use less capital to achieve the same return.  Reduce the cost of capital.  Liquidate capital or curtail further investment in sub-standard operations where inadequate returns are being earned.

Advantages of EVA
 EVA provides for better assessment of decisions that affect balance sheet and income statement or tradeoffs between each through the use of the capital charge against NOPAT.  EVA decouples bonus plans from budgetary targets.  EVA covers all aspects of the business cycle.  EVA aligns and speeds decision making, and enhances communication and teamwork.

Limitations of EVA
 EVA does not control for size differences across plants or divisions.  EVA is based on financial accounting methods that can be manipulated by managers .  EVA may focus on immediate results which diminishes innovation.  EVA provides information that is obvious but offers no solutions in much the same way as historical financial statement do.

Conclusion
As a performance measure, Economic Value Added forces the organization to make the creation of shareholder value the number one priority. EVA is changing the way managers run their businesses. When business decisions are aligned with the interest of the shareholders, it is only a matter of time before these efforts are reflected in a higher stock price.