ECONOMIC VALUE ANALYSIS

Defining a firms value proposition is the first step in a stream of events leading to market success. Simply stated, the value proposition is the investors perceived worth of the company in terms of its functional capability to satisfy the core need in relation to its economic cost. Economic Value Analysis is a systematic approach to evaluating the performance attributes of a company in relation to the resource expenditures required to enjoy its benefits.

Factors of Value Analysis:

1. Meaning of Value added 2. Generation of Values 3. Distribution of Values 4. Users of Value reporting 5. Value added ratios 6. EVA/MVA 7. Share holders Value analysis

1. Meaning of Value added: Value added is the change in the market value added by identifying the change in the form, location or availability for a product over service excluded the cost of materials and/or services bought from outside. Value added= Revenue from output Cost of various inputs

2. Generation of Values: The real value of a firm is generated through any or all of the parameters such as form, location, availability of the products etc.

3. Distribution of Values: These are the people/units through which these values are distributed. It include: Employees Government
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Providers of finance

4. Users of Value reporting: It includes the following: (a) External Parties: These are parties that are outside the company which uses the value generated by the firm. They include creditors, government, financial institutions, debtors, credit rating agencies etc. (b) Internal Parties: These are parties within the organization that uses the firms value. It includes the management and the employees.

5. Value added ratios: In Value Analysis the financial ratios are expressed in terms of value. Some of them include: Asset Turnover Ratio = Economic value/ Assets Gross Profit margin = Economic Value/ Sales

6. Economic Value Added (EVA)

The core function of any enterprise is to add value to its stake holders. That is the main function of a core management team in any organization. The motive behind any investment is the return that he can get from his investments. This return includes dividend return and the return from the capital appreciation. The investor sentiments and the market price of a company depend on the value added by the management to the company. This is one of the major factors that determine the market price of a share along with the brand value and brand image. This is because the market price is a reflection of investors expectation of the value added to a firm. The Economic Value Added (EVA) is a measure of surplus value created on an investment. Economic Value Added is an estimate of a firm's economic profit being the value created in excess of the required ret0urn of the company's investors (being shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital.
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The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments that could be made but in practice only five or seven key ones are made, depending on the company and the industry it competes in. Calculating EVA: EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the cost of capital and the economic capital. The Spread Method, or Excess Return Method: EVA= (ROCE-WACC) x TCE. The Residual Income Method: Also EVA= NOPAT- (TCE x WACC) Where, EVA = Economic Value Added ROCE=Return on Capital Employed WACC= Weighted Average Cost of Capital In calculating WACC, cost of debt is taken as after tax cost and cost of equity is measured on the basis of Capital Asset Pricing Model (CAPM) as follows. Cost of equity, Ke = Rf+ bi (Rm-Rf) Rf = Risk free return Rm= Market return bi= Risk Coefficient of particular investment All the capital employed by the company has the same cost (WACC) as follows:

Machinery and equipment Inventories Accounts receivable Cash and bank Other

TCE= Total Capital Employed in the Business NOPAT =It is the net operating profit after tax, with adjustments and translations, generally for the amortization of goodwill, the capitalization of brand advertising and others non-cash items and without considering interests and other non operating items. Suggestions to improve EVA: EVA is a refinement of residual income. Residual income is defined as the difference between profit and the cost of capital. It differs from EVA in the fact that profits and capital employed are book figures. EVA can be improved in the following ways: (a) Increasing NOPAT with some amount of capital (b) Reducing the capital employed without affecting the earnings i.e. discarding the unproductive assets. (c) Investing in those projects that earn a return greater than the cost of capital. (d) By reducing the cost of capital, which means employing more debt, as debt is cheaper than equity or preference capital.

Steps in implementing EVA:

It is a 4 step process which include: (a) Measurement Any company that wishes to implement EVA should institutionalize the process of measuring the metric, regularly. This is carried out after carrying the prescribed accounting adjustments.
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(b) Management System: The management system has to be aligned to the EVA process. On this basis the company takes decisions related to the choice of strategy, capital allocation, merger and acquisitions, divesting business and goal setting. (c) Motivation: The managers have to be motivated to work towards EVA. For that the best possible method is to implement an incentive system based on the economic value added. (d) Mindset: The proper mindset is very much essential for the implementation of the EVA. All the constituents of the organization has to work for this common goal. Then there will not be any confusion and the objective can be met very easily. Comparisons with other approaches: Other approaches along similar lines include residual income (RI) and residual cash flow. Although EVA is similar to residual income, under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual cash flow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital); at the same time, the adjustments to NOPAT are unique to EVA. Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of "profit", the utility of having a separate and more precisely defined term such as EVA is that it makes a clear separation from dubious accounting adjustments. Relationship to Market Value Added (MVA): Market Value Added is the market value of the capital employed in the firm less the book value of the capital employed. It is calculated by summing up the paid-up value of equity and preference share capital, retained earnings, long-term and short-term debt and subtracting this sum from the market value of the equity and debt. It is a cumulative measure of corporate performance. It shows how much a companys stock has added to or taken out of investors pocket over its life and compares it with the capital those same invests put in to the firm. EVA
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drives the MVA. Continuous improvements in EVA year after year will lead to increase in MVA. Therefore companies like Intel, Microsoft and Nokia trade many times above their book values. The firm's market value added, or MVA, is the discounted sum (present value) of all future expected economic value added.

MVA = PV of EVA. Since MVA = NPV of Free cash flow (FCF) it follows therefore that the NPV of FCF = PV of EVA; since after all, EVA is simply the re-arrangement of the FCF formula.

7. Shareholders Value Analysis:

It is an approach to Financial management developed in 1980s which focusses on the economic value creation for the shareholders, as measured by share price performance and flow of funds ir is used to link management strategy and decsions to to the creation of value for share holders. The investment,business and financial decisions, both strategic and operational, are identified which have impact on creation of value for shareholders. The fators called value drivers are identified which will influence the shareholders value. Some of the key financial value drivers are as follows: (a) Growth in sales. (b) Improvement of profit margin (c) Capital investment decisions (d) Capital structure decisions (e) Cost of capital

Impact of managerial decisions on shareholders value:

Investment Decisions

Business Decisions

Financing Decisions

Working Capital

Sales Profit Cost Management Pricing Operational Efficiency

Capital Structure Dividend policy Tax Rate Depreciation Allowance Interest Rates

Capital Investment
Mergers & acquisitions Expansion

Cash flow from Operations

Cost of capital

Shareholders' value

Benefits of EVA: 1. EVA is closely related to NPV. It is closest in spirit to corporate finance theory that argues that the value of the firm will increase if one takes positive NPV projects. 2. EVA is most directly linked to the creation of share holders wealth over time. 3. The mechanism of EVA forces management to expressly recognize its cost of equity in all its decisions from the board room to the shop floor. 4. EVA financial management removes all inconsistencies resulting from the use of different financial measures for different corporate functions under the typical traditional financial management system. 5. It avoids the problems associates with approaches that focus on percentage spreads between ROE and Cost of Equity and ROC and Cost of Capital. These approaches may lead firms with high ROE and ROC to turn away good projects to avoid lowering their percentage spreads. 6. It makes top managers responsible for a measure that they have more control over - the return on capital and the cost of capital are affected by their decisions - rather than one that they feel they cannot control as well - the market price per share. 7. It is influenced by all of the decisions that managers have to make within a firm - the investment decisions and dividend decisions affect the return on capital (the dividend decisions affect it indirectly through the cash balance) and the financing decision affects the cost of capital. 8. EVA framework provides a clear perception of underlying economics of a business and enables managers to make better decisions. Drawbacks of EVA: 1. EVA ignores inflation and it is biased against against new assets. Whenever a new investment is made, capital charge is on the full cost initially, so EVA figure is low. But as the depreciation is written off, the capital charge decreases and hence EVA goes up. 2. EVA is measured in rupee terms which are biased in favor of large, low returns businesses. Large businesses that have returns only slightly above the cost of capital can
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have higher EVA than smaller businesses that earn returns much higher than the costs. This makes EVA a poor metric for comparing businesses. 3. It helps to manipulate or modify the value of a firm. EVA can be improved by reducing assets faster than the earnings and if this is pursued for long it can lead to problems in the longer run when new improvements to the asset base are made.

Conclusion:
EVA is a method to measure a companys true profitability and to steer the company correctly from the viewpoint of shareholders EVA helps the operating people to see how they can influence the true profitability (especially if EVA is broken down into parts than can be influenced) Economic profit - otherwise known as "Economic Value Added" (EVA) is based on classic financial theory, and, for this reason, is not entirely different from traditional free cash flow measures. Three conceptual pillars support economic profit: 1. Cash flows are more reliable than accruals. 2. Some period expenses are - in economic reality - actually long-term investments. 3. The company does not create value until a threshold level of return is generated for share holders. Thus EVA is one of the most influential measures that can be looked in to for anyone interested or related to a company/business which can give him/her an opportunity to understand a holistic view of the performance of the company/business.