Economic Value AddedTM

True Economic performance of an enterprise

Vikash Goel, FCA, MS Finance

www.vikashgoel.com | www.investmentvaluation.in

Historical performance measures in an organisation includes:

Profit Maximisation – age old

Wealth Maximisation - matured

Value Maximisation – today’s wisdom

“Until a business returns profit that is greater than the cost of capital, it is operating at a loss” – Peter Drucker in HBR

© Vikash Goel | www.vikashgoel.com , www.investmentvaluation.in

• New York Based Consulting firm Stern Steward & Co. developed the concept of EVA in 1982.

• Economic Value Added TM

is a value based performance measure that appreciates values created by the management for its owners.

• It evaluates how well the organisation performs in relation to its objectives – wealth maximisation for the shareholders.

• It is most directly linked to creating shareholder wealth over time.

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EVA helps organizations determine their actual profit once the taxes and capital amount has been taken under consideration.

This helps companies determine whether their business or a particular project is making more money than what was invested in it.

EVA = Net Operating Profit After Tax – Currency Cost of Capital

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EVA = Net Operating Profit After Tax – (Capital Employed x Cost of Capital)

Net Operating Profit After Tax (NOPAT) is calculated as follows:

Net profit available to Equity ShareholdersAdd: Interest Expense (1 - Tax rate)Add: Preferred DividendsAdd: Minority InterestAdd: Amortisation of GoodwillAdd: Non recurring (unusual) losses or expensesLess: Non recurring (unusual) gains

Alternatively,

NOPAT = Operating Income x (1 – Tax rate)

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Capital Employed is calculated as follows:Book Value of EquityAdd: DebtAdd: Preferred StockAdd: Minority InterestAdd: Equity Equivalents

Alternatively, Capital Employed = Total Assets – Current Liabilities

Cost of Capital

Calculate Cost of Equity using CAPM viz. Re = Rf + (Rm - Rf) x BetaCalculate After Tax Cost of Debt viz. Kd = Cost of Debt x (1-tax Rate)Calculate Weighted Average Cost of Capital based on the weights of Debt and Equity.

WACC = [ E / ( E + D ) x Ke ] + [ D / ( E + D ) x Kd ( 1 - t ) ]

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EBIT = Rs 5 million

Tax rate = 40%

WACC = 12%

Debt = 10 million

Equity = 10 million

EVA = [EBIT x (1 - Tax Rate)] - [WACC x Capital Employed]

EVA = [5 x ( 1 - 0.40)] - [0.12 x (10 + 10)]

EVA = 3.0 - 2.4

EVA = 0.6 million

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Profit based measure as primary measure of financial performance has at least 2 limitations:

•Profits ignore cost of capital While profits take into account the interest charge – cost of debt

finance, they done take into account the cost of equity. Thus it doesn’t tell us if the organisation has generated wealth in excess of return required by equity shareholders – providers of equity capital.

•Profits calculated are subject to manipulation by accountants.

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Residual Income approaches have been used since 20th

century and is calculated as

Residual Income = Profit After Tax – (Capital Employed x Cost of Capital)

Example:

A division A earns a profit of Rs 10000 and also has Capital (Debt + Equity) of Rs 70000 @ 12% Cost of Capital.

Residual income = 10,000 – (70,000x12%)

Residual income = 1,600

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Residual Income approach relies heavily on the Accounting Profits and does not adjust it.

Adjustments are needed to convert from accrual profits to cash flows

Unusual items of incomes/expenditures / gains / losses should be ignored.

Other adjustments: E.g. Some items such as advertising, staff training costs that bring long term benefits are expensed whereas they should be capitalised, hence these are added back to profits.

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• If EVA is Positive, business has created wealth for shareholders

• If EVA is Negative, business has destroyed wealth for shareholders

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• It is considered to be a short term measure of financial performance

• It is not a suitable measure for a company which has invested heavily today but expects returns in long term

• It is prone to estimation errors inherent in calculating Cost of Capital

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