Papers Modified TVA-based Performance Evaluation

Pitabas Mohanty

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Vol 18 No 3

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Modified TVA-based Performance Evaluation

Pitabas Mohanty

ith the increasing popularity of value-based management systems, companies have started aligning management compensation with shareholders wealth. A survey by Hewitt Associates shows that 85% of the companies in the West have variable pay schemes1. The variable pay is related to the performance of the management. The Economic Value Added (EVA)-based compensation system is one of the most popular variable compensation systems being used in the corporate world. Popularised by Stern Stewart and Company during the 1980s, EVA is widely accepted as a measure of corporate performance. Though it has gained popularity only recently, as a measure of corporate performance it is centuries old2. For years, economists have been arguing that a firm earns true profit only if it earns more than the investors expect. And EVA is just another name for this economic profit. More and more companies are using EVA to measure the performance of the management. Fernandez3 reports that the number of companies using EVA-based performance measurement systems has increased from 25 in 1993 to 250 in 1996. Biddle, Bowen and Wallace4 report that since its introduction in the 1980s, more than 300 companies worldwide have adopted EVA-based performance measurement systems. In India, some of the most successful companies, including Godrej Consumer Products, Tata Steel and Tata Consultancy Services, use EVA-based compensation systems to measure the performance of the top management5. An increasing number of companies, including several successful Indian companies, have also started reporting the annual EVA to investors6. 265

Pitabas Mohanty is Professor, Finance, at XLRI, Jamshedpur. pitabasm@xlri.ac.in IIMB Management Review, September 2006

EVA primarily serves three purposes. Apart from being used as a performance measurement tool, it is also used as a valuation and a reporting tool. Mathematically it can be derived that the value of a company can be expressed as the sum of the operating invested capital and the present value of future expected EVAs7. EVA is however often criticised as an incorrect measure of corporate performance8. It is argued firstly, that the market forms expectations based on the market value of the company and not on its book value, as EVA seems to indicate. Secondly, the expectations formed by the market consist of both periodic cash flows and capital gains. EVA does not seem to capture the effect of either of these components of expected return. Thirdly, EVA is an accounting based performance measure and hence does not accurately capture the true performance of the companies. The EVA-based management compensation system is also often criticised on the ground that it may lead to dysfunctional behaviour on the part of the

management of the company. In particular, it is argued that EVA-based compensation systems may discourage forwardlooking expenditures like capital expenditures and R&D expenditures9. In this paper we recommend a modified measure of corporate performance Modified True Value Added (Mod_TVA)10 which addresses the limitations of the traditional EVA-based performance measurement system (see box). We argue that this modified measure can also address some of the limitations of an ESOP-based management compensation system. The next section of this paper explains the modified measures of EVA and TVA and shows how they can discourage both overand under-investment by a company. Three case studies are then discussed to show how one can use the modified TVA (Mod_TVA) based performance measurement system. The paper concludes with a comparison of the Mod_TVA measure with the ESOP-based measure of management compensation.

Computation of EVA, TVA and Mod_TVA for Tata Steel

The table below gives the relevant data for computation of EVA for Tata Steel. 2003-04 Operating Invested Capital (Closing figures) ROIC Cost of Capital 2004-05

Rs. 7600.65 crores Rs. 9453.55 crores 25.19% 14.11% 38.20%

We calculate EVA as OIC x (ROIC WACC). Thus for example, the EVA of Tata Steel for the year 2004-05 would be given by Rs. 7600.65 crores (38.2% - 14.11%) = Rs. 1831 crores. The above definition assumes that investors provided Rs. 7600.65 crores of operating assets to Tata Steel as on 31st March 2004 and on that capital expected a return of 14.11%. The management of Tata Steel, however, generated return equal to 38.2% in the year 2004-05 using this capital. So the excess profit that Tata Steel generated was given by Rs. 1831 crores. This however is not the true measure of excess returns generated by Tata Steel. The market value of Tata Steel as on 31st March, 2004 was Rs. 16032 crores. Since the cost of capital is equal to 14.11% here, the investors actually expect a rupee return of 14.11% on Rs. 16032 crores (and not on the book value of Rs. 7600.65 crores as Tata Steel is not available for sale at Rs. 7600.65 crores), that is Rs. 2262 crores. In 2004-05, investors of Tata Steel actually realised capital gains of Rs. 5661 crores, and free cash flow of Rs. 1759 crores. So the investors actually realised excess profit of Rs. 5661 crores + Rs. 1759 crores Rs. 2262 crores = Rs. 5158 crores. We call this true excess return true

value added. It is defined as: TVA = FCF + Capital_gains (Value * WACC) ........ (1) Though TVA is the actual measure of excess value the investors earn on their investments, it cannot be used as a measure of corporate performance for the simple reason that it mixes up firm performance with stock market performance. Thus for example, the capital gains during recession years for a company may be negative even when the management reported betterthan-industry-average operating performance. We therefore use a new measure of corporate performance, where we replace cost of capital (WACC in Equation 1) with the conditional cost of capital ( ). The conditional cost of capital is estimated after r accounting for the performance of the industry and the economy. Thus for example, when the steel industry is in a recession, the conditional cost of capital will be much lower than the actual cost of capital. It will similarly be higher when the industry and the economy are doing well. The new measure, called modified true value added (mod_TVA) is defined as: Mod_TVA = FCF + Capital_gains value x ( 1+r ) (2)

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EVA-based Performance Measurement System

Empirical studies on the usefulness of EVA as an incentive tool (and as a performance measure) throw up contradictory evidences. Kleinman11 reports that companies using EVAbased performance measurement systems on an average generate 9% excess returns compared to their industry peers. Souza and Jancso12 similarly report better performance on the part of Brazilian companies that have adopted EVA-based performance evaluation system. Some studies find evidence that companies that adopt residual-income based compensation plans change their operating, investing and financing decisions13. Fernandez14 on the other hand reports low correlation between EVA and increase in Market Value Added (MVA). Biddle, Bowen and Wallace also report low correlation between EVA and stock returns15. It is argued that an EVA-based compensation system discourages forward-looking expenditure. For example, the management can report higher EVA by postponing or cancelling positive Net Present Value (NPV) projects with larger gestation periods. In particular, if a large part of the cash flows are expected in the distant future, then the company will report lower EVA in the initial years of accepting the project. The management may also report higher EVA by accepting projects where a large part of the cash flow is expected in the earlier years of the project even if it is a negative NPV project. According to Biddle, Bowen and Wallace, companies that adopt EVA-based performance measurement systems report a 100% increase in asset disposals, and a 21% decrease in new investments16.

However, the management cannot be held responsible for deliberately accepting a negative NPV project or avoiding a positive NPV project merely on the evidence of the final outcome (in the form of the lower stock price), without understanding the decision making process. The same outcome can also be observed if the industry faces recession, for example. A good performance evaluation system must discriminate between these two situations. It should help us in penalising the management only for deliberate over- or under-investment. We can reasonably differentiate between these two situations by comparing the actual return the company has generated with the market- and industry- adjusted stock return. If the company has generated, say a 10% return, whereas the expected return (based on industry and economy performance) is 12%17, then there is every likelihood of overand under-investment, and poor performance of the company. On the other hand, if the company actually generates 14% return in such cases, then the performance evaluation system should reward the management even if the cost of capital is greater than 14%. This paper suggests a modified performance measurement system that addresses all the limitations of EVA. Our modified performance measurement system is based on the concepts of modified EVA and modified true value added. We define Modified EVA (Mod_EVA) as:

Mod_EVA = Free Cash Flow + Capital Gains -Value0 r - [MVA1 - MVA0 (1 + r )] ....(3)18
Here, r is the market- and industry-adjusted return (see box for an explanation of the estimation of r ).

Estimation of r
While calculating EVA, we use the unconditional cost of capital. However, for an effective performance measurement system, what is required is the conditional cost of capital, or an equation that gives us the estimate of given the actual market and industry r return for the previous accounting year. It is not possible to use a multi-factor asset pricing model because industry-risk is a non-systematic risk and hence can be diversified away. We actually do not need an asset pricing equation here from the investors point of view. The investors may be holding a diversified portfolio and hence do not expect industry-risk to be priced. However, while estimating the performance of the management, we need to put the industry factor separately (apart from the market factor). It can be done by using the Roll and Ross19 method, where we run factor analysis on the returns matrix for a group of stocks, all belonging to the same industry. Since all the stocks belong to the same industry, industry risk will appear to be priced. Alternately, we can run a simple OLS regression of the stock returns on the unexpected return of market and unexpected industry return. In order to define the unexpected returns on the market and industry indices, we subtract the actual average returns from the raw returns. This approach is simpler than the Roll and Ross approach. It is important to understand that both the above approaches are technically incorrect because industry risk is not priced in equilibrium. But we want a model that can give us a rate of return given the actual market and industry rate of return. We use the second approach in this paper to estimate . r Using this approach we estimate the conditional cost of equity of the firms in each year. We subsequently estimate the cost of capital as the weighted average of the different sources of capital. In order to estimate the cost of debt of the firm, we use the method suggested by Mohanty and Sahoo20.

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It has been shown21 that in the above definition, the actual cost of capital has been replaced with r in the original definition of EVA. That is, we can express Mod_EVA as:

Modified TVA Management Compensation System

The most appropriate tool for management compensation system is modified true value added (Mod_TVA), defined here as:

Mod_EVA = NOPAT - OIC x r ...(4)

where NOPAT is the net operating profit adjusted for tax and OIC is the operating invested capital of a firm. This makes sense because it expects the management to do better whenever the industry is doing well. And it is not very demanding during recession years. Exhibit 1

Mod_TVA = Mod_EVA - [MVA0* (1 + r )- MVA1]...(5)

In has been shown that Mod_EVA22 stands for the excess free cash flow the management generates in an attempt to

Magnitude of Modified TVA under Four Scenarios

Scenarios EHMH Factors Responsible Management Capital Market/Extraneous EHML Management Capital Market ELMH Management Capital Market ELML Management Capital Market Mod_TVA High Low Low High High Low Low Low adjusted return will be lower, and hence the Mod_TVA will be high. If however, this scenario occurs due to extraneous factors, then it means the market is very bullish even though the current performance of the companies in the industry is not satisfactory. The adjusted return will be very high in such cases and the Mod_TVA will also be low for a typical company in the industry. When the Internet companies were doing well in the stock market, most of the companies reported negative EVA but very high MVA. This phenomenon occurred mostly because the management was highly bullish on such stocks. ELML: Scenario ELML EVA Low, MVA Low If this occurs due to the poor performance of the management and not due to extraneous factors then the adjusted return will be high and hence the Mod_TVA will be low. If on the other hand, the scenario occurs because of tight industry condition, then all companies in the industry also report similar performance. This reduces the adjusted rate, and the Mod_TVA of a typical company will also be low.

EHMH: Scenario EHMH EVA High MVA High There can be two possible reasons for both EVA and MVA being high. Either the management has shown outstanding performance both in creating very high EVA for the current year and in taking some positive NPV projects to ensure a very high MVA, or the superior performance is due to extraneous factors. If the superior performance is not due to any industry condition, then the adjusted return will be lower than the actual return generated by the company. This will produce a high value for Mod_TVA. If on the other hand, the superior performance is due to extraneous factors, then the same factors must also be influencing the performance of all the companies in the industry, thereby causing a high adjusted return. This will therefore generate a low Mod_TVA. EHML: Scenario EHML EVA High and MVA Low If the EVA is high and the MVA is low, then there can be the same two factors responsible for it. If it is due to the management, then the most likely

interpretation is that the company has generated superior EVA this year. However, the market believes that this good performance cannot continue in the future because the management will not be able to show good performance in the future. In this case, the Mod_TVA will be low if the adjusted rate is high. It is also possible that management has deliberately taken wrong decisions to influence the EVA of the current year at the cost of the future years EVA. If the other firms in the industry perform better, then the Mod_TVA of our company will be low. If on the other hand, it is due to extraneous factors, then other companies in the industry must also be experiencing similar problems. In such cases, the Mod_TVA will be low. ELMH: Scenario ELMH EVA Low MVA High If this scenario arises due to the effort of the management, then it is very likely that the management has accepted positive NPV projects with high gestation periods. Since the high MVA is not due to extraneous factors (like other companies are not investing in similar projects), then the

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ensure that the investors get the adjusted rate of return. The bracketed term in the above expression, namely, MVA0 * (1 + r ) MVA1 is the excess free cash flow that the management is required to generate to ensure that the investors get the adjusted return on their investment. Mod_TVA is therefore the surplus (deficit) in free cash flow that the management has generated for the investors to ensure that they earn the adjusted rate of return. But can the Mod_TVA-based performance measure address the limitations of a standard EVA-based performance measurement system? Here, we argue that it is better than both the EVA-based and the ESOP-based performance measurement systems. It is possible that the management can report a high or low EVA for a temporary period by over- or under-investment23. However, in an efficient market the capital market will form its own judgment about the performance of the company and will reward or punish companies accordingly by changing the stock prices. If there is over- or under-investment, then the MVA and the market capitalisation will fall. Therefore, what is required is to look at both EVA and MVA while developing the compensation system for the management of a company. Based on the EVA and MVA, a company can fall into one of the following four classifications. EVA is High and MVA is High (EHMH) EVA is High and MVA is Low (EHML) EVA is Low and MVA is High (ELMH) EVA is Low and MVA is Low (ELML) Each of the four scenarios in turn can be attributed to management effort or the capital markets changed expectations (because of factors beyond the control of the management). If we try to find the value of Mod_TVA under each of the scenarios, we will notice that the management deserves incentives whenever the Mod_TVA is high. Similarly, the management team deserves penalty whenever Mod_TVA is low. Exhibit 1 shows the values taken by Mod-TVA in each scenario and explains the logic.

Methodology
Information was collected from the IBID database24 on all the firms that use EVA-based compensation systems. From this list, three companies (Tata Steel, NIIT and Godrej Consumer Products) were selected. The financial and accounting data for these three companies were then collected from the Prowess database and the websites of the respective companies. Stern Stewart & Company got the Foreign Investments Promotion Board nod to set up its Indian subsidiary in 200125. We therefore study the Mod_TVA behaviour of these three Indian firms for the period 2002-05. In order to estimate the EVA and Mod_TVA figures, the cost of capital and the conditional cost of capital, , (the cost of capital r given the actual performance of the market and the industry during the given year) had to be estimated. The Capital Assets Pricing Model (CAPM) equation was used to estimate the cost of equity of the three companies. Beta estimates were obtained from the Prowess database and estimates of the risk free rate of return from the website of the Fixed Income Money Market and Derivative Association of India (FIMMDA). The annual market risk premium in India was taken as 10%26. The model recommended by Mohanty and Sahoo27 was used to find the cost of debt. Having obtained the credit rating of the company from the three financial ratios as suggested by Mohanty and Sahoo, the cost of debt by obtained by using the spread matrix given in the FIMMDA website28.

have adopted EVA-based compensation systems.

Tata Steel Limited

Tata Steel Limited is a flagship company of the Tata Group in India. The steel industry was doing poorly in the earlier part of this decade. The return on invested capital of the steel industry was a mere 2.78% for the year ending 2001-02. Although Tata Steel was doing better than its peers, the return generated was lower than the investors expected. The cost of capital of Tata Steel was 17.19% in 2001-02, while its reported ROIC was a mere 7%. The company reported negative EVA for the year ending 2001-02. One of its first priorities was to convert itself into a positive EVA company in the next five years29. Four EVA centres were set up, namely the steel business, the non-steel business, iron ore and mining, and services like power and gas30. Though Tata Steel planned to be EVA-positive by the year 2006-07, it became EVA-positive in the year 2002-03. Its ROIC started improving along with the other steel companies. 269

Case Studies of Three Indian Companies

The following case studies show how the Modified TVA based performance evaluation system can be used to compensate the top management. Real life data is used to show the estimation of modified TVA of three Indian companies that
IIMB Management Review, September 2006

While the steel industrys ROIC increased from 2.78% in 2001-02 to 10.95% in 2002-03, the ROIC of Tata Steel increased from 7% to 17.98% in the same period. As shown in Exhibit 2, Tata Steel continued to report good results along with the other steel companies in India afterwards. Exhibit 3 shows that the EVA reported by Tata Steel also started increasing after 2002-03, as a consequence of which the bonus of the top management team also increased. The EVA-based compensation system penalises management whenever the EVA is negative, whether the reason is poor management or poor performance of the industry. Thus in a simple EVA-based compensation system, the management of Tata Steel will not get any bonus for having recorded an above-average ROIC for the year 2001-02 simply because it was lower than the cost of capital. Similarly, the EVA-based compensation system rewards management whenever the EVA is positive, even if the good performance of the company is merely due to good industry conditions. In order to be fair to the management, what is required is a compensation system that rewards management performance while taking into consideration the performance of the industry and the market. We believe that performance evaluation based on modified TVA will serve the purpose. From the traditional EVA and modified EVA figures in Exhibit 3, we can see that there is a huge difference between the unconditional and conditional costs of capital for Tata Steel in some of the years. Thus for example, 2002-03 was a bad year for the economy and the steel industry. The conditional return for Tata Steel was 3.34% for that year, though the unconditional cost of capital was 14.87%. What it means is that if Tata Steel generated return greater than 3.34% in the year 2002-03, then it would be considered to be above-average by industry and market standards. For the steel industry as a whole, 2003-04 and 2004-05 were good years. Though the unconditional costs of capital for Tata Steel remain between 14 and 15% in these two years, the conditional returns were much higher. In particular, for the Exhibit 3
Year

Exhibit 2
Years 2001-02 2002-03 2003-04 2004-05

Comparison of ROIC of Tata Steel and Steel Industry in India

ROIC of Tata Steel 7.00% 17.98% 25.19% 38.20% ROIC of Steel Industry 2.78% 10.95% 19.25% 30.01%

year 2003-04, the conditional return was 43.03%. That is, one can give credit to Tata Steels management only if the return generated for the year was greater than 43.03%, not 14.11%, as the unconditional cost of capital seems to suggest. One can see that the modified EVA for the year 2003-04 was actually negative. This is because given the performance of the industry and the economy, a return of 43% would have been considered enough for the investors. Nevertheless, the modified TVA for Tata Steel was positive for the year 200304 because the market was in a bullish phase and the capital gain for the year was very high. In order to understand how the system works, lets take the year 2002-03 for Tata Steel. The market value of Tata Steel was Rs. 9973 crores as on 31 March 2002. The adjusted cost of capital was 3.34%, meaning that ex-post the investors would have been happier with a return of 3.34% * Rs. 9973 crores, i.e, Rs. 333.1 crores. The actual free cash flow for the year 2002-03 was Rs. 1683 crores, and the actual capital gains for the year ending 2002-03 was Rs. 514.5 crores, the investors got an extra return of Rs. 1864 crores. This is the modified TVA for the year 2002-03. In all the four years, Tata Steel generated higher return on invested capital as compared to the industry peers. This superior performance gets reflected in the mod_TVA figures in Exhibit 3. Hence our model recommends higher compensation for the management as compared to an EVA based model. This is because of superior performance of the management vis--vis other companies in the industry and

Modified TVA for Tata Steel Limited

Conditional Cost of Capital (r) 13.24% 3.34% 43.03% 21.45% EVA (in Rs. Crores) Mod_ EVA (in Rs. Crores) Mod-TVA (in Rs. Crores)

Unconditional Cost of Capital

2001-02 2002-03 2003-04 2004-05

17.19% 14.87% 14.11% 15.53%

-1032.43 167.92 894.13 2431.34

820.87 1428.92 -1575.94 -4087.32

-146.50 1864.66 2746.36 3981.38

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Exhibit 4
Year

Modified TVA for Godrej Consumer Products Limited

Conditional Cost of Capital (r) 11.18% -1.76% 88.60% 27.60% EVA (in Rs. Crores) Mod_ EVA (in Rs. Crores) Mod-TVA (in Rs. Crores)

Unconditional Cost of Capital

2001-02 2002-03 2003-04 2004-05

14.86% 13.72% 12.83% 14.11%

34.91 46.05 59.13 84.37 74.50 24.45 87.94 222.06 12.87 337.65

the market. Unlike EVA, the modified_TVA is based on cash flows and market values and hence cannot be manipulated by the management by using any accounting gimmick.

Godrej Consumer Products Limited

The Godrej group introduced value-based management and reward system in 2000-0131. Initially, the group decided to implement the system in two of its group companies, namely, Godrej Consumer Products Limited (GCPL) and Godrej Industries Limited. The group arrives at all business decisions in terms of its impact on EVA32. The project involved four overlapping phases, namely performance measurement, management process, motivation and training, and communication. The group planned on reaping the benefits in a period of about 3 to 4 years. Exhibit 4 presents the key financials of GCPL. The company grew at a rate of 10% in 2001-02, when the industry growth was negative. Its return on invested capital increased from 64.79% in 2001-02 to 183% in 2004-05. Since its ROIC was very high, its EVA was positive in all the years. However, 2002-03 was a bad year for the FMCG industry as most of the stocks were fairing poorly in the industry. This was reflected in a negative conditional cost of capital for Godrej for that year. As can be seen in Exhibit 4, the conditional cost of capital of GCPL for 2002-03 was -1.76%. Modified TVA is based on this conditional cost of capital, and as can be Exhibit 5
Year

seen for the year ending 2002-03, the management of GCPL generated excess cash flow of Rs. 222.06 crores (much higher than EVA) and hence deserves compensation based on this higher figure. On the other hand, in the year 2003-04, because of the good performance of the economy and the FMCG stocks (to some extent), the investors would not be satisfied with a return just exceeding 12.83% (the unconditional cost of capital). The Mod_TVA for the year ending 2003-04 is a mere Rs.12.87 crores and hence the management deserves much lower variable compensation for the year than what EVA suggests.

NIIT Limited
NIIT Limited is an information technology company in India with focus on software education, training and export. It had an EVA-based performance management system in place even before Stern, Stewart and Co. formally set up its Indian subsidiary33. In spite of this, its performance was never satisfactory from the investors perspective. In fact, NIIT was reported34 to have eroded wealth equivalent to Rs. 3498 crores during the period 1998-2003. Exhibit 5 shows that, while both modified EVA and modified TVA are negative for NIIT, the magnitude of the modified TVA figures is much higher than that of the modified EVA. This shows that the performance of NIIT is much poorer than EVA seems to suggest.

Modified TVA for NIIT Limited

Conditional Cost of Capital (r) -0.94% 99.60% 12.23% EVA (in Rs. Crores) Mod_ EVA (in Rs. Crores) Mod-TVA (in Rs. Crores)

Unconditional Cost of Capital

2001-02 2003-0435 2004-05

19.14% 18.27% 19.41%

-1.59 -35.37 -10.24

-14.37 -1105.12 -21.8

-7595.68 -466.25 -401.01

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Limitations
The modified TVA compensation measure will help in preventing both over- and under-investment provided we estimate the adjusted rate correctly. For the purposes of the study, it has been assumed that on an average the companies in the industry have not over- or under-invested. If this assumption does not hold, then the model will not yield the desired result. For example, if most (or all) of the companies in an industry have over-invested , then the adjusted rate will be low36. In such a case, we will not be able to penalise overinvestment by another company. However, we will not reward the management either. Ferguson and Leistikow37 argue that abnormal returns (TVA in this article) should not be used to compensate the management. The logic is that, if the compensation for such a decision is an immediate one-time payment based on the size of the associated abnormal return, the managers have less incentive to remain with the firm. Ferguson and Leistikow also qualify this argument by saying that the problem can be avoided theoretically by extending the payments to management over time. While this concern about retention of managers also exists in an EVA-based performance measurement system, this measure, unlike the modified TVA measure, does not discourage either over- or underinvestment. The use of adjusted return to compute Mod_TVA also partially addresses the concerns raised by Ferguson and Leistikow. If for example, after getting compensated based on the positive NPV of a project, the team of management leaves the company, then there is no reason why they will get better compensation elsewhere if the other company also uses a compensation system similar to Mod_TVA38.

companies became worthless pieces of paper. In the modified TVA-based performance evaluation system, the use of adjusted return instead of the cost of capital to compute both the Mod_EVA and Mod_TVA means that the management is not unnecessarily punished when the market becomes bearish, nor indiscriminately rewarded when the market becomes bullish.

Conclusion
This paper argued that, contrary to popular perception, EVA is actually the excess free cash flow the company generates to meet the expectations of the investors. In this sense, it is both a cash flow based measure and it is also positively associated with the return the investors get on their investment in the company. The paper recommends an alternative performance measurement that addresses some of the limitations of both the traditional EVA-based and ESOP-based performance measurement systems.

References and Notes

1 Business Standard, July 18, 2001, p 11. 2 Biddle, G C, R M Bowen, and J S Wallace, 1999, Evidence on EVA, Journal of Applied Corporate Finance, Vol 12, No 2, pp 69-79. In fact Martin, Petty, and Rich comment that General Motors used some variant of residual income in the 1920s. Martin, J D, J W Petty, and S P Rich, 2003, An Analysis of EVA and Other Measures of Firm Performance Based on Residual Income, Working Paper, Hankamer School of Business. 3 Fernndez, Pablo, 2001, EVA and Cash Value Added Do Not Measure Shareholder Value Creation, http://ssrn.com/ abstract=270799, last viewed, April 24, 2004. 4 Biddle, Bowen and Wallace, Evidence on EVA. 5 A survey by Price Waterhouse Coopers shows that over 106 corporate companies in India use variable pay schemes. 6 The list of Indian companies following this practice includes some of the famous companies like Asian Paints, BHEL, BPL, Carborandum Universal, Dr. Reddys Lab, Godrej Consumer Products, HLL, HPCL, Infosys, Jindal Steels, Marico Industries, NIIT, Nicholas Piramal, Reliance Industries, Satyam Computer, TCS, Tata Chemicals, Tata Motors, Tata Refractories, Tata Steel, VSNL and Voltas. India TCS linked the salary of the executives to EVA in the year 2000-01 and introduced EVA based bonus plans in 2001-02. In fact about a thousand employees left TCS after being classified as non-performers by the EVA standards in 200405. The Godrej group introduced EVA-based performance measurement system in 2001-02, following which the combined market capitalisation of Godrej Consumer Products and Godrej Industries increased from Rs. 357 crores in 2001-02 to Rs. 1318 crores in December 2003. India Business Insight Database (IBID); Business Standard, July
Modified TVA-based Performance Evaluation

Modified TVA and ESOP

An ESOP-based management compensation system addresses problems relating to over- and under-investment very well because it rewards the management for accepting positive NPV projects and discourages management from taking on negative NPV projects39. In an efficient market, the stock market keeps track of the investments done by the management and stock prices increase whenever the management announces any unexpected positive NPV project. ESOP-based management compensation systems however suffer from the changing expectations of the capital market. If the market suddenly turns bearish, then the stock prices of companies start falling, as in the dotcom crash, when the stock options held by the management of the dotcom 272

11, 2005, p 1; Business India, Dec 8, 2002, p 114; Financial Express, March 3, 2004, p 4. 7 To the best of our knowledge, Miller and Modigliani prove this result for the first time. Miller, M H, and F Modigliani, 1961, Dividend Policy, Growth and the Valuation of Shares, Journal of Business, Vol 34, Oct, pp 411-433. Miller and Modigliani however, used the term goodwill for residual income. More recently, Shrieves, and Wachowicz also proved this result formally. Shrieves, R E, and J M Wachowicz, 2001, Free Cash Flow(FCF), Economic Value Added (EVA) and Net Present Value (NPV): A Reconciliation of Various Discounted Cash Flow (DCF) Valuation, Engineering Economist, Vol 46, No1, pp 33-51. 8 See the related discussion in Goetzmann, W N, and S J Garstka, 1999, The Development of Corporate Performance Measures: Benchmarks before EVA, Yale ICF Working Paper No. 99-06. 9 Of course Stern, Stewart and Co recommend certain accounting adjustments like capitalising R&D expenditures while computing the EVA. However, it can be shown that if such expenditures are not expected to give immediate benefits, or if the gestation period is large, then the immediate EVA figures will get adversely affected despite these accounting adjustments. 10 Fernandez uses the term Created Shareholders Value for the excess return generated for the shareholders. Fernndez, Pablo, 2001, EVA and Cash Value Added Do Not Measure Shareholder Value Creation, http://ssrn.com/ abstract=270799, last viewed, April 24, 2004. Here, TVA captures the risk-adjusted excess return for all the investors in the company. 11 Kleinman, R, 1999, Some New Evidence on EVA Companies, Journal of Applied Corporate Finance, Summer. 12 Souza, Jos Guilherme C, and Jancso, Peter, 2003, Does It Pay to Implement a Full-Scale EVA Management System? Evidence from Brazilian Companies, http://ssrn.com/ abstract=381541, last viewed, April 24, 2004. 13 Biddle, Bowen and Wallace, Evidence on EVA; Wallace, J S, 1998, EVA Financial Systems: Management Perspectives, Advances in Management Accounting , pp 1-15. These changed decisions lead to an increase in EVA. However, they may not lead to creating more investors wealth. 14 Fernandez, EVA and Cash Value Added Do Not Measure Shareholder Value Creation. 15 Biddle, G C, Robert M Bowen and James S Wallace, 1997, Does EVA Beat Earnings? Evidence on Associations with Stock Returns and Firm Values, Journal of Accounting and Economics , Vol 24, No 3, Dec, pp 301-336. Of course theoretically, there is no reason why one should expect a high correlation between the change in MVA and EVA in an efficient market. 16 Biddle, Bowen and Wallace, Evidence on EVA. Asset disposals may mean that the management has hived off poorly performing divisions. It may also mean a different type of under-investment where the management is disposing of projects with long gestation period. 17 This can be determined by a two-factor model where the first factor is the market and the second factor is industry.
IIMB Management Review, September 2006

18 One can find a related term Wealth Created in Period t in Martin, Petty, and Rich, An Analysis of EVA and Other Measures of Firm Performance Based on Residual Income. The difference between Mod_EVA and wealth created is the last term in the bracket. 19 Roll, R, and S Ross, 1980, An Empirical Investigation of the Arbitrage Pricing Theory, Journal of Finance, Vol 35, pp 1073-1104. 20 Mohanty, P, and B Sahoo, 2002, An Alternative to CRISIL Credit Rating using Discriminant Analysis, ICFAI Journal of Applied Finance, Vol 8, No 1. 21 Mohanty, P, 2003, In Defense of EVA, http://ssrn.com/ abstract=423720. 22 Ibid. 23 In these cases, EVA will still be the excess free cash flow the management generates for the investors. However, this is against the interests of the shareholders as the TVA becomes negative. 24 http://www.ibid.informindia.co.in. The list is by no means exhaustive because IBID database does not include all the newsclippings available in India. 25 Economic Times, April 16, 2001, p 10. 26 Mohanty, P, 2002, Efficiency of the Market for Small Stocks, NSE Research Initiative, NSE Working Paper No 1. 27 Mohanty and Sahoo, An Alternative to CRISIL Credit Rating using Discriminant Analysis. 28 http://www.fimmda.org 29 Business Line, April 6, 2002, p 4. 30 Business World, June 23, 2003, p 42. 31 Financial Express, Aug 30, 2001, p 4. 32 Financial Express, March 3, 2004, p 4. 33 Data Quest, Nov 15, 1998, p 35. 34 Business Today, April 11, 2004, p 82. 35 Oct 2002- March 2004. 36 For a related discussion on over-investment by the companies in the oil industry in the US, see Jensen, M C, 1986, Agency Costs of Free Cash Flow, Corporate Finance and Takeovers, American Economic Review, Vol 76, May, pp 323-329. 37 Ferguson and Leistikow, Search for the Best Financial Performance Measure. 38 Unless we assume that our team of management is the only team that can implement such positive NPV projects, the expected TVA will be zero for even the other companies in the industry from the next year onwards. 39 Using the option-pricing framework, it can be shown that an ESOP-based compensation system can sometimes encourage highly risky negative NPV projects. Since ModTVA does not depend on the total risk of the firm, it discourages such negative NPV projects.

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