TITLE OF THE PAPER

ECONOMIC VALUE ADDED ANALYSIS

AREA OF PRESENTATION

FINANCIAL MANAGEMENT

NAME OF THE INSTITUTION

A.J.INSTITUTE OF MANAGEMENT
{TRASFORMATIONAL INSTITUTE FOR MANAGERIAL EXCELLENCE}

EMAIL ID: moras48@gmail.com

AUTHOUR’S NAME

NAVEEN RAJESH MORAS

PHONE NO: +919964071498

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 ABSTRACT
The concept of Economic Value Added (EVAT M) has been propounded as an economic
measure of the extent to which a company adds value to shareholders' wealth. In most
companies today the search for value is being challenged by a seriously out of date
financial management system. Often, the wrong financial focus, cash strategies, operating
goals, and valuation processes are emphasized. Managers are often rewarded for the
wrong achievements and in many cases they are not rewarded for the efforts that lead to
real value.
Adam Smith, one of the fathers of classical economic thought, observed that firms and
resource suppliers, seeking to further their own self- interest and operating within the
framework of a highly competitive market system, will promote the interest of the public,
as though guided by an ―invisible hand. ― (Smith, 1776)
Accounting tactics that could be employed to save taxes and increase value is avoided in
favor of tactics that increase profit. Economic Value Added (EVA) is a measurement tool
that provides a clear picture of whether a business is creating or destroying shareholder
wealth. EVA measures the firm’s ability to earn more than the true cost of capital.

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 SYNOPSIS

CHAPTER NO TITLE PAGE NO.

1 INTRODUCTION 4

2 EVA : AN OVERVIEW 5

3 REVIEW OF LITERATURE 7

4 COMPONENTS OF EVA 8

5 APPLICATION OF EVA AS BETTER CONCEPT 11

6 RATIONALITY OF USING EVA 13

7 CONCLUSION 14

8 BIBLIOGRAPHY 15

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 INTRODUCTION

Value creation, today, for a competitive advantage and to have edge over other – is a
widely accepted business objective over profit maximization and wealth maximization.
Value is created when all the stake holders perceive a significant difference in quality or
benefits, with the result that the offer is capable of commanding a premium relative to
competitors offer. Traditionally the methods of measurement of corporate performance
are many. Common bases used are: - Net Profit Margin (NPM), Operating Profit Margin
(OPM), Return on Investment (ROI), Return on Net Worth (RONW) etc. Profit after Tax
(PAT) is an indicator of profit available to the shareholder and Profit before Interest after
Tax (PBIAT) is an indicator of the surplus generated using total funds. ROI is still
recognized as the most popular yardstick of profitability measurement. Although these
financial data have the advantage of being precise and objective, the limitations are far
greater, making them less applicable in today's competitive market. For evaluation of the
efficiency of any decision, value creation or value addition aspect is of utmost importance
in the present backdrop of corporate governance. In order to maximize shareholder value,
decisions must be made as to how best to allocate capital, how to evaluate investment
opportunities and how to measure performance.

EVA® (Economic Value Added) was developed by a New York Consulting firm, Stern
Steward & Co in 1982 to promote value- maximizing behavior in corporate managers.
This term has been used in the book named ―The Quest for Value‖ which was published
in 1991. Stern Steward & Co claims EVA to be their registered trade mark, while Peter
Drucker claimed that he discussed EVA in 1964 in his book, ―Managing for Results‖. It
cannot be denied; however, without going into argument as to who invented EVA first
that the concept became popular only after Stern Stewart & Co. marketed it. EVA,
therefore enables the management to, invest in projects that are critical to shareholder's
wealth. This will lead to an increase in the market value of the company. However,
activities that do not increase shareholders value might be critical to customer's
satisfaction or social responsibility. For example, acquiring expensive technology to
ensure that the environment is not polluted might not be of high value from a
shareholder's perspective.

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 EVA: AN OVERVIEW
Economic Value Added (EVA) is a comprehensive measure of operating performance. It
measures the change in financial worth of an enterprise from one year to the next. It is a
more comprehensive financial measurement tool than net income (revenues minus
expenses) alone, because it includes the cost of the capital used to generate that income.
Definition
“A company can best maximize wealth by leveraging its most distinctive
and proprietary assets - the talent, ingenuity, and energy of its people. That's
What EVA does, and that's what makes it so powerful...‖
— Joel M. Stern, CEO, Stern Stewart & Co., 1995

In corporate finance ―Economic Value Added or EVA is an estimate of economic profit,

which under US accounting can be determined, among other ways, by after making
corrective adjustments to GAAP accounting, including deducting the opportunity cost of
equity capital‖
In simple words EVA is ―The monetary value of an entity at the end of a time period
minus the monetary value of that same entity at the beginning of that time period.‖

What separates EVA from other performance metrics such as EPS, EBITDA, and ROIC is that it
measures all of the costs of running a business—operating and financing.

. The chart helps the management following way: Deploy more and more funds to those
activities where the amount of NOPAT generated by the activities is greater than the cost
of capital. Withdraw fund from those activities wherein the amount of NOPAT is less

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than the amount of cost of capital unless there is strategic decision to lose in one act ivity
in order to gain in another. Improve the operating efficiency of the organization to retain
the same amount of NOPAT by possible continuous reduction of existing capital or / and
continuous increase of the existing NOPAT with existing amount of capital.
4 Ms of EVA
Stern Stewart describes four main applications of EVA with four words beginning with
the letter M.

Measure ment
EVA is the most accurate measure of corporate performance over any given period.
Management System
A firm’s true value comes in using EVA as the foundation for a comprehensive financial
management system that encompasses all the policies, procedures, methods and measures
that guide operations and strategy. The EVA system covers the full range of managerial
decisions, including strategic planning, allocating capital, pricing acquisitions or
divestitures, setting annual goals-even day-to-day operating decisions.

Motivation
To instill both the sense of urgency and the long-term perspective of an owner, Stern
Stewart designs cash bonus plans that cause managers to think like and act like owners
because they are paid like owners.
Mindset
When implemented EVA financial management and incentive compensation system
transforms a corporate culture. By putting all financial and operating functions on the
same basis, the EVA system effectively provides a common language for employees
across all corporate functions..
The Three Pillars of Profit

 Costs – what businesses pay for the inputs they require to produce
saleable output
 Value - the creation of well being in the eyes of your customers
 Price – what your customers pay for the output

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 REVIEW OF LITERATURE

Baatz (1994), commented that it is but one of many tools being developed to account for
thecapital invested in an organization by the true owners of that organization - the
shareholders.

Dodd and Chen (1996,) observed that EVA is the difference between companies adjusted
net operating profit (after taxes) in a particular year and it total cost of capital.

According to George Athanassakos (2007), the Value-based management (VBM) is a

management philosophy that uses analytical tools and processes to focus an organization
on the single objective of creating shareholder value.

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 COMPONENTS OF EVA
Net Operating Profit Afte r Taxes

Calculating Net Operating Profit After Taxes (NOPAT)

NOPAT is easy to calculate. From the income statement we take the operating income
and subtract taxes. Operating income is sales less cost of sales and less selling, general
and administrative expenses.

Net Operating Income

Net Operating Income or NOI is a means of expressing pure operating results. In other
words, financial results of NOI do not have the impact of financing (borrowing),
investing, or accounting adjustments, which can distort a purely operational analysis.
NOI is the amount of money generated exclusively from operations

Calculating Cost of Capital

Many businesses don’t know their true cost of capital, which means that they probably
don’t know if their company is increasing in value each year. There are two types of
capital, borrowed and equity. The cost of borrowed capital is the interest rate charged by
the bondholders and the banks. Equity capital is provided by the shareholders. An
investor’s expected rate of return on an investment is equal to the risk free rate plus the
market price for the risk that is assumed with the investment. The risk of a company can
be decomposed into two parts. An investor can eliminate the first component of risk by
combining the investment with a diversified portfolio. The diversifiable component of
risk is referred to as non-systematic risk. The second component of risk is non-
diversifiable and is called the systematic risk. It stems from general market fluctuations
which reflect the relationship of the company to other companies in the market. The non-
diversifiable risk creates the risk premium required by the investor. In the security
markets the non-diversifiable risk is measured by a firm’s beta. The higher a co mpany’s
non-diversifiable risk, the larger their beta. As the beta increases the investor’s expected
rate of return also increases. (Levy, 1982)

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Measuring Capital Employed

Accounting profits differ from economic profits. Under generally accepted accounting
principles, most companies appear to be profitable. However, many actually destroy
shareholder wealth because they earn less than the full cost of capital. EVA overcomes
this problem by explicitly recognizing that when capital is employed it must be paid for.
In financial statements, created using generally accepted accounting principles,
companies pay nothing for equity capital. As discussed earlier, equity capital is very
expensive. Economic profits are defined as total revenues less total costs, where costs
include the full opportunity cost of the factors of production. The opportunity cost of
capital invested in a business is not included when calculating accounting profits.

Long Term Debt

Long Term Debt includes bonds, mortgages and long term secured financing

Calculation of EVA

EVA is sales less operating costs (including taxes) less all financing costs. Put another
way, EVA is net operating profit after tax (NOPAT) less the cost of all capital, equity as
well as debt
EVA = NOPAT - (Cost of Capital x Total O EVA = (ROTC - Cost of Capital) x
R Total Capital
Capital)

Example: For example, consider a company that earns NOPAT of $100 and ties up $800
in capital from debt and equity sources to support its business assets. Assume further that
the firm's overall cost of capital is 10%, a rate that blends the after-tax cost of debt and
equity at the proportions management would intend to use as a target. In this case, the
firm must set aside $80 ($800 x 10%) to "rent" its capital from the market, and its EVA is
$20, the profit residual.
EVA = NOPAT - (Cost of Capital x Total EVA = (ROTC - Cost of Capital) x Total Capital
Capital) OR
$20 = $100 - (10% x $800) $20 = (12.5% - 10%) x $800

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EXAMPLE: MOTOROLA
For each of these firms, the payoff from a successful strategy can be very large. For
instance, Motorola which has a value per share of $32.39 with a high growth period of 5
years would be able to increase its value if it were able to grow longer

Figure 12 .6 : Len g th o f Gro wth Period a nd Va lu e per Sh are

$45.00

$40.00

$35.00

$30.00

$25.00

$20.00

$15.00

$10.00

$5.00

$-
0 1 2 3 4 5 6 7 8 9 10

EVA can be a powerful tool. When properly applied, it allows a firm to ascertain where
it’s creating value and where it’s not. More specifically it allows a firm to identify where
the return on its capital is outstripping the cost of that capital.
Analysis of NPV and other techniques
Unlike simple traditional budgeting, EVA focuses on ends and not means as it does not
state how manager can increase company's value as long as the shareholders wealth are
maximized. This allowed managers to have discretion and free range creativity, avoiding
any potential dysfunctional Short-term behavior

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APPLICATION OF EVA AS BETTER CONCEPT

WAYS TO RAISE EVA OF THE FIRM

A Stern Stewart team works closely with a steering committee of representatives from
line and staff functions to adapt EVA to the client's unique culture and management
practices. The EVA implementation process generally involves the following steps:

Obtaining senior management commitment

Evaluating corporate and financial strategy, position, and alternatives
Understanding where, how and why value is created in your markets and company
Defining an action based value improvement plan
Re-engineering financial management to focus on value creation
Strengthening and aligning incentive compensation with value
Educating line managers
Communicating with investors

Goals
Incentives Communication

EVA
Measurement

Planning

Decisions Capital
Budgeting

Value-focused Decision Making

To maximize shareholder wealth, decision makers at all levels must be value- focused.
The market value of any firm is a function of its expected future performance, which in
turn is a function of the effectiveness of management. Stern Stewart helps clients improve
performance by better understanding the value inherent in their strategy and operations.

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Whether we are assessing the value of an acquisition target, analyzing the economics of a
product portfolio, formulating the structure of a compensation plan, or introducing a new
financial management framework, we approach all projects from one vantage point –
what strategy best maximizes the value creation of the business over time?

Managers Who Think and Act like Owners

We believe the most effective way to motivate managers to make value-based decisions
is to link their incentives to goals that relate directly to value creation itself. Under this
type of incentive structure, managers stand to gain substantially when, for example, EVA
increases; when EVA falls, their incentive compensation should be at risk. This approach
effectively makes a manager think like an owner, and provides strong motivation to make
decisions that focus on the continuous improvement in EVA – decisions that the market
will reward.

A Commitment to Continuous Improve ment

A final condition for maximizing wealth is to focus on continuous improvement rather

than short-term goals. Investors don't reward companies because managers have met their
annual budget; they reward companies when managers regularly seek out and undertake
initiatives that improve long-term performance. Stern Stewart encourages clients to stay
focused on continuous improvement.

Value Based Strategy and Management

Stern Stewart's mission is to help clients establish clear, accountable links between
management action and the creation of shareholder wealth. In our view, the most
effective way to align management initiatives with shareholder interests is to implement a
framework for decision-making that is based on our proprietary EVA measure. EVA has
gained broad acceptance in the business community for its ability to help managers
increase the value of their companies. More than 400 major corporations, globally, have
adopted our EVA framework and been rewarded with significant improvements in
corporate performance and share price.

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 RATIONALE FOR USING EVA

EVA is the gain or loss that remains after assessing a charge for the cost of all types of
capital employed. What an accountant calls profits in an income statement includes a
charge for the debt capital employed which is commonly referred to as interest expense.
However, an income statement does not include a charge for the equity capital that was
employed during the accounting period. Therefore, EVA goes beyond conventional
accounting standards by including a provision for the cost of equity capital. The cost of
equity needs to be factored into business investment decisions in order to enhance
shareholder value.

Although EVA is couched in financial analysis, its primary purpose is to shape

management behavior. EVA can be used as a performance measure to evaluate an overall
company, a division within a company, a location within a division, or an individual
manager. By setting goals, EVA can become a motivational tool at various levels of
management. EVA can also be used in downsizing decisions.
Perhaps the real key to appreciating EVA lies in its simplicity. Often times non-
financial managers are hard pressed to understand financial tools; EVA can help to
facilitate communication thereby enhancing coordination within a company. Managers
need to train to recognize the opportunity to strive for an increase in economic value
added. Once properly trained, managers can then pinpoint key financial focal concerns
germane to decisions.

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 CONCLUSION
EVA is both a measure of value and also a measure of performance. The value of a
business depends on investor’s expectations about the future profits of the enterprise.
Stock prices track EVA far more closely than they track earnings per share or return on
equity. A sustained increase in EVA will bring an increase in the market value of the
company. As a performance measure, Economic Value Added forces the organization to
make the creation of shareholder value the number one priority. Under the EVA approach
stiff charges are incurred for the use of capital. EVA focused companies concentrate on
improving the net cash return on invested capital

The value of a firm has three components. The first is its capacity to generate cash flows
from existing assets, with higher cash flows translating into higher value. The second is
its willingness to reinvest to create future growth, and the quality of these reinvestments.
Other things remaining equal, firms that reinvest well and earn significant excess returns
on these investments will have higher value. The final component of value is the cost of
capital, with higher costs of capital resulting in lower firm values. EVA emphasize
economic value added and reward managers for increasing the same often assume that
increases in economic value added are not being accomplished at the expense of future
growth or by increasing risk.

The EVA based performance measurement system is the basis on which the company
should take appropriate decisions related to the choice of strategy, capital allocation,
merger & acquisitions, divesting business and goal setting. While deciding resource
allocation it becomes necessary to appreciate the EVA Impact of such decision.
Management Accountants have the full knowledge about the company that would create
value. They are in a position to guide a company in its restructuring mission for value
creation.

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 BIBLIOGRAPHY

1. KUMAR.D.N.S ―MANAGEMENT OF COST, FINANCE AND HUMAN

RESOURCE FOR GOOD GOVERNANCE‖ KARNATAKA LAW SOCIETY’S
INSTITUTE MANAGEMENT EDUCATION & RESEARCH, PP 1 – 17, 38 –
48.

2. ASIA-PACIFIC INSTITUTE OF MANAGEMENT ―ASIA PACIFIC BUSINESS

REVIEW‖,AMERENDRA KR. SHRIVASTAVA,PP 75 – 79

3. JAIN AND KHAN ―FINANCIAL MANAGEMENT‖ MCGRAW-HILL, FIFTH

EDITION,PP 11.1 – 11.7

4. http://www.investopedia.com/university/EVA/19th Sept 2009

5. http://www.scribd.com/doc/19138134/4-EVA-Based-Performance-Measurement.
15th Sept 2009

6. http://www.evanomics.com/download/Intro.pdf. 16TH Sept 2009

7. http://seminars.sternstewart.com/whatiseva.html. 19th Sept 2009.

8. http://seminars.sternstewart.com/Value_Based_Management.html. 19th Sept 2009

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