cost accounting eva

7/27/2019 Cost Accounting EVA

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MMS-1 JBIMS Cost Accounting

Economic Value Added A report by-

Swapnil Gattewar (Roll No. 72)

Chaitanya Gandhi (Roll No. 68)

Rhea Baliwala (Roll No. 67)

Yugesh Gobji (Roll No.75 )

Dhwani Shah (Roll No. 71)

Pritesh Chaudhary (Roll No. 69 )

Anil Gawade (Roll No. 74)

Aniket Deshmukh (Roll No. 70 )


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Cost Accounting Presentation On

Economic Value Added

A companys objective is to increase its shareholder's value through its operations. It isimpossible to improve anything without measuring it. And for this purpose of measuring andimproving we have various tools and indicators. Economic Value Added (EVA), also knownas Economic Profit is a managerial performance measurement tool introduced in 1920s byGM. Latter it was revamped and reintroduced by Stern Stewart. Today it is one of the mostsuccessful performance metric used by companies. It is different from other tools used tomeasure performance as it suggests profit adjustment by cost of capital. It shows economicprofit by measuring the value created for shareholders via the invested capital.

What it means is we find out excess profit made a company after considering capital costs. And this can be deduced from the P & L statement in the form of operating profit and thendeducting the cost of capital. Now how this can be used to measure companies or management performance. The job of management is to m aximize the shareholders valueand return on investments of investors. And this is what is exactly measured by this tool. Thedecisions of management are reflected in the form of operating profit that a company has,this gives us the effectiveness of management and the efficiency of utilization of resources.But this data is useless if looked at in silo. It needs to be compared with something that willgive us an idea of expectations that shareholders have so that we can benchmark theperformance. The cost of capital gives us a fair idea about shareholders expectations. Thisalso gives us a basis for comparisons with other companies as it considers cost of capital

which is a measure of risk as well.

Now how is EVA used or how it is read. A positive EVA means the firm generated a return toinvested capital that exceeds the opportunity cost of capital and the Company Valueincreases. A negative EVA means the firm did not generate sufficient return to cover its costof capital and the Company Value declines. And last but not the least the trend in EVA ismore important than the absolute value of EVA.

Let's now look at the overall calculation, which can be broken down into three sets of calculations. Each of these is the mathematical implication of one of the three main ideassupporting the entire economic profit system:

1. Cash flows are the best indicators of performance. The accounting distortions musttherefore be fixed. Translate accrual -based operating profit (EBIT) into cash-bashed netoperating profit after taxes (NOPAT).

2. Some expenses are really investments and should be capitalized on the balance sheet.True investments must therefore be recognized. Reclassify some current expenses asbalance-sheet (equity or debt) items.

3. Equity capital is expensive (or, at the very least, not free). This expense must therefore beaccounted for. Deduct a capital charge for invested capital.

The calculation starts with earnings before interest and taxes (EBIT), which is a pureincomestatement (accounting-based) measure.


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First, several adjustments are made to move the measure nearer to representing actualcash flow.Second, certain expense items (i.e. money spent in the current accounting period)are identified as economically really being investments. That is, they are truly meant tocreate a long-term asset of some sort. Those expenses are then reclassified onto thebalance sheet.Those first two steps produce net operating profits after taxes (NOPAT). The idea behindNOPAT is to get a cash-based measure of operating performance. By the way, if you arelooking for the exact analogue of NOPAT on the income statement, you won't find it. Thenearest figure is something we might call "earnings before interest but after taxes" (EBIAT).Finally, because NOPAT represents profits before the cost of debt service and the cost of equity capital, our next step are to deduct a capital charge. The capital charge is whatinvestors, as a group in total, will need to make their investment exactly worthwhile; it couldalso be called "economic rent". If NOPAT equals the capital charge, then the company justbarely met its "rent obligations" to investors - but, in doing so, produced no economic or excess profits. Any NOPAT profits above the capital charge are truly in excess and arecalled economic profits or value added.

The methods to improve EVA

Try to improve returns with no or with only minimal capital investments Produce the same goods and services using less capital Invest new capital only in projects, equipment, machines able to cover capital cost

while avoiding investments with low returns Reduce the cost of capital

Benefits of Economic Value Added

1. Indicates your companys worth Economic value added can help you determine the worth of your company as well as itsstocks. It is always important to determine your firms debt load since the debt can affect your company value, as it means there is less capital for expansion. In other words, you canimprove the companys value by settling all the debts.

2. Easier to sell and buy stocks I am sure you agree with me that it is easier to sell stocks with better market value. Many atimes, people experience difficulty when selling stocks of low market value, therefore makesure you buy new stocks after the company has gained market value. Stock prizes usuallyrise after a publicized event, for instance Apple may decide to launch a new product, whichin turn increases their market value in respect to stocks.

3. Better investment opportunities Most of the time investors are not able to spot corporations that show substantialimprovement in market value. Therefore, thorough research is important if you want toincrease your chance of buying stocks from companies with better market value. This willenable you to reap full benefits of economic added value. A corporations ability toincrease in market value is always the first criteria that will you should use when buyingshares.

4. Better and True Picture of a CompanyUnlike accounting profit, such as EBIT, Net Income and EPS, EVA is Economic and is basedon the idea that a business must cover both the operating costs as well as the capital costs

and hence it presents a better and true picture of the company to the owners, creditors,employees, shareholders and all other interested parties.


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5. Improves Corporate GovernanceIt can also improve the corporate governance of the company because since a higher EVAimplies higher bonuses to the managers they will be working hard and also honestly which inturn augurs well for the company.

6. Monitors Problem AreasIt helps the company in monitoring the problem areas and hence taking corrective action toresolve those problems.

7. Decision MakingUsing EVA company can evaluate the projects independently and hence decide on whether to execute the project or not

Limitations of EVA

1. EVA does not control for size differences across plants or divisions. It does not permit avery good comparison between different sectors of the enterprise because it is not taken

into account their dimension.

2. EVA is based on financial accounting methods that can be manipulated by managers. Allthe component elements of EVA, being calculated in accordance with the book-keepinginformation, do not grant a very objective evaluation without certain adjustments. Thusthe accent lays upon the profit obtained on short intervals of time and not on the long-termed ones, achieved with present, significant costs and recognized in book-keeping.The present reduction of the economic value added may lead to more reducedremunerations for the managers of the enterprise, fact that determines them to act inorder to maximize the present incomes.

3. EVA may focus on immediate results which diminishes innovation: EVA has a short-term

orientation. The intent of a performance measurement system should be to matchemployees' effort, ingenuity, and accomplishments with their compensation. If a manager conceives of an innovative idea, researches it, organizes it, presents it to superiors, andbegins implementing it in the current accounting period, some measure of compensationshould be afforded to the manager in the current period for the effort and ingenuityexpended. However, that is not how financial measures, such as EVA, work when theyare used to evaluate employee performance.

4. EVA provides information that is obvious but offers no solutions in much the same wayas historical financial statement do. EVA just gives an indication about the economicvalue added but fails to offer solutions which will enable to improve this value if anegative value is obtained.

5. Difficulty is in finding correct cost of equity. The first difficulty is in finding correct cost of equity. It is not suitable for all kinds of companies. It may not correctly understandefficiency as the EVA of bigger plant will always be more than smaller plant even whenthey are more efficient and maintain a better ROI comparatively.

6. It does not permit a very good comparison between different sectors of the enterprisebecause it does not take into account their dimension. All the component elements of EVA, being calculated in accordance with the book-keeping information, do not grant avery objective evaluation without certain adjustments. Thus the accent lays upon theprofit obtained on short intervals of time and not on the long-termed ones, achieved with

present, significant costs and recognized in book-keeping. The present reduction of the
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economic value added may lead to more reduced remunerations for the managers of theenterprise, fact that determines them to act in order to maximize the present incomes.

EVA CALCULATION (For example please refer the attached excel file)

To determine what economic profit tells us as an analytical tool for investors, we need tocompare it to several other popular metrics. Let's start by determining the levels of analysis:does the metric capture dollars created for the entire entity (both lenders and shareholders)or only the shareholders, or does it capture excess (residual) dollars created for bothshareholders and lenders? Figure 2 below summarizes which levels of analysis the differenttypes of valuation metrics occupy, and it indicates which are performance metrics and whichare wealth metrics.

In Figure 1, the levels of analysis are labeled across the top row. Under entity, we show twocolumns of metrics: before reinvestment and after reinvestment. These columns distinguishbetween those metrics that include capital expenditures and those that don't. For example,EBITDA is before depreciation and amortization (D&A) and therefore is before the non-cashcharge that reduces earnings by the amortized investment. But EBIT is after D&A and,although not cash based, does recognize a charge for investments.

Down the left-hand side we have three rows of performance metrics and one row of wealthmetrics. The first row of performance metrics shows accrual metrics, which are based onaccounting flows, and below each accrual metric is the cash flow metric analog based on thesame level of analysis. For example, the cash flow analog to EBIT is free cash flow to the


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firm (FCFF). EBIT is the earnings that accrue to both shareholder and lenders - in other words, it accrues to the entire entity or enterprise. And FCFF is the equivalent in cash flows.By looking at the chart, you may be asking yourself what the difference is between economicprofit and cash value added (CVA), both of which are residual dollar returns. Despite its useof adjustments, economic profit is essentially accrual based. Consider NOPAT's inclusion of - or put another way, reduction by - depreciation and amortization, which are non-cashcharges. So, whatever adjustments we make, we are still incorporating accruals. CVA, onthe other hand, is a metric designed to correct/reverse this by adding back the non-cashcharges of depreciation and amortization. Figure 1 also shows how the performance metrics- whether capturing enterprise, shareholder or residual dynamics - have correspondingreturn metrics and wealth metrics. Return on gross invested capital (ROGIC), for example,corresponds to EBITDA because it adds back depreciation to capital in the denominator -ROGIC is before D&A just as EBITDA is before D&A. (ROGIC is similar to return on grossassets (ROGA).)Economic spread, which expresses economic dollars in percentage terms, is the returns-metric analogue to economic profit. To understand this, we simply rearrange our basiceconomic profit calculation:

Economic profit = NOPAT - [WACC Invested Capital](NOPAT = ROIC Invested Capital)ThereforeEconomic profit = [ROIC Invested Capital] - [WACC Invested Capital]Economic profit = [ROIC - WACC] Invested Capital

KEY POINTS FROM THE VIDEO

1. Economic value added is calculated as Earnings Opportunity Cost of Capital.

2. To do this subtract (Amount of capital)*(minimum rate of return that would entice aninvestment) from the NOPAT of the company.

3. It is possible that the company is earning net profit but has a negative EVA whichmeans that although it is earning profit it is not performing to the expectations of theshareholders.

4. Uses It is used for evaluating how your investments are performing as compared toother investments or to choose between two projects in a company or two evaluateperformance of managers for evaluating bonuses.

5. It is effective in ensuring that you are targeting smartest investments in capitalintensive sectors.

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