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Measuring Corporate

Performance – An EVA
Approach

Prof. Sarbesh Mishra


M.Com, M.Phil. PhD
Assistant Professor, Finance
NICMAR’s CISC, Hyderabad – 84.
Backdrop
“If we don’ t know where we’re
going, it doesn’t matter how we
get there” (Attitude = 100%)
Recent Buzzword in Industry:
z Transparency
z Accountability
z Business Ethics
z Social Responsibility
z Shareholder’s interest protection
Necessity of Corporate Governance
1. Too much of power with few individual.
2. Large scale diversion of funds to
associated companies & risky ventures.
3. Unfocussed business decisions leading to
losses.
4. Preferential allotment of sweat equity at
low prices.
5. Spinning off profitable business
operations to subsidiary companies.
Recent Happenings
z World Com – Improper accounting of
$3.9bn in expenses leading to bankruptcy.
z Enron – Off balance sheet deals used to
hide the debt.
z AOL Warner – AOL division accused of
improperly accounted for some advertising
revenues.
z XEROX – Financial Fraud.
z UTI – Indiscriminate investment by UTI.
Origin
The Sarbanes – Oxley Act, 2002, a
recent enactment in USA which deals
with the Corporate Governance &
Corporate Social Responsibilities has
emphasized audit functions &
financial disclosures. (Mandatory as
per NYSE listing Norms)
(Benchmark practices in this regard is calculation
of EVA apart from Annual Accounts)
Indian Context
z Kumara Mangalam Birla Committee on
Corporate Governance (2000) (SEBI Sponsored)
z Naresh Chandra Committee on Corporate
Governance (2002)
z Narayana Murthy Committee on Corporate
Governance
What is EVA?
New York based financial advisory Stern Stewart
& Co. postulated the very concept of Economic
Value Added (EVA) in 1990.

EVA: Maximum amount which the


business is capable of distributing to its
shareholders while remaining in the same
position at the end of the period as it was
at the beginning with fair practices.
EVA Formula
EVA = NOPAT - Cost of Capital
1. NOPAT = Net operating Profit after Tax
2. The project’s cost of capital is the minimum
required rate of return on funds committed to
the project, which depends on the riskiness of
its cash flows.
z The firm’s cost of capital will be the overall
(WACC), or average, required rate of return on
the aggregate of investment projects.
Summary of Definition
z Thus EVA measures the Operating
Profit, which should be fair enough to
meet the cost of capital. So excess of
returns over cost of capital is otherwise
referred as EVA.

If EVA is
+Ve = Firm is creating shareholder’s wealth
-Ve = Firm is destroying shareholder’s wealth
Computation of NOPAT
Profit after tax but before Interest
+ Increase to Deferred Taxes
+ Goodwill Amortized in Current year
+ Increase to Net Capitalized
Intangibles
+/- Unusual loss or (Gains) net of tax
N. B: Some 144 adjustments are there
Implementation of EVA

zMeasurement
zManagement System
zMotivation
zMindset
Key Strategies to Enhance EVA
z Operate: Set targets to Improve ROCE.
z Build: Invest capital only when return
exceeds the cost of the capital.
z Divest: Divest capital when return fail to
achieve cost of capital.
z Optimise: Restructure capital to reduce
the cost of the Capital.
EVA Determination – A Case Study

Calculation of EVA for


NTPC in FY 2005-06
Calculation of EVA for NTPC
1. EVA= NOPAT- Cost of Capital
= PAT+ Interest paid – WACC ( Average
Capital)

z Calculation for NTPC for FY 2004-05


= (5,500cr+1,000cr) - WACC
1/2(Capital at the beginning of the year
+ Capital at the end of the year)
Workings
WACC = Ke* W1 +Kd* W2
Debt : Equity
= 0.14 * 0.7 + 0.8(1- Tax) * 0.3 30 : 70
= 0.98 + 0.3 * (0.8 * 0.65) W2 : W1
= 0.98 + 0.3 * 0.52 Ke = 14% as per govt. norms
= 0.098 + 0.15 Kd = Int. paid/Loan Taken
= 0. 254 Tax= 35%
Calculation of Cost of Equity
Cost of Equity can also be calculated taking CAPM
model

Ke =Rf + B (Rm – Rf) Rf = Risk Free Rate of Return


= 0.08 + 0.8 (0.14 – 0.08 ) Rm = Market Rate of Return
= 0.08 + 0.8 * 0.06 B = Beta Coefficient for NTPC
= 0.134

B = Covariance of Rm & Rf
Variance of Rm
EVA of NTPC
z EVA = 6,500 – 0.254 ( 20,000 )
= 6,500 - 5080
= Rs 1420 Cr EVA
A positive EVA indicates that this
company creates value. It helps
managers to create value for share
holders.
Strategies for increasing EVA
z Increase the return on existing project.
z Invest in new projects that have a return
greater than the cost of capital..
z Use less capital to achieve the same
return.
z Reduce the cost of capital.
z Curtail further investment in sub-standard
operations where inadequate returns are
being earned.
EVA Deficiency
z Not easy to use (for calculation of PAT,
some 144 adjustments are there) too
complicated for small business.
z Recommends inexpensive debts in order
to reduce cost of capital (COC), is a very
questionable strategy for small business.
z A passive accounting tool : measures past
performance.
Inference
z Thus, A company must strive continuously
to increase not only profitability but also
the EVA.
z EVA reflects high net worth of the
company, thus it’s credibility increases.
z In India, Companies like Dr. Reddy’s Lab,
WIPRO, INFOSYS are coming up with their
respective EVAs along with their Annual
Report.