economic value added(2)

8/7/2019 Economic Value Added(2)

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Economic Value AddedEconomic Value AddedEconomic Value AddedEconomic Value Added

T.P.GhoshT.P.Ghosh

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What is EVA?

Economic value-added (EVA) is the after-tax cash flow generated by a businessminus the cost of the capital it hasdeployed to generate that cash flow.

Representing real profit versus paperprofit, EVA underlies shareholder value,increasingly the main target of leadingcompanies' strategies.

Shareholders are the players who provide

the firm with its capital; they invest togain a return on that capital.

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EVA concept The concept of EVA is well established in

financial theory, but only recently has theterm moved into the mainstream of

corporate finance, as more and more firmsadopt it as the base for business planningand performance monitoring.

There is growing evidence that EVA, notearnings, determines the value of a firm.

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EVA concept The chairman of AT&T stated that

the firm had found an almost perfect

correlation over the past five yearsbetween its market value and EVA.

Effective use of capital is the key to

value; that message applies tobusiness processes, too.

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Bennett Stewart explains

Economic Value Added is the financialperformance measure that comes closer than anyother to capturing the true economic profit of anenterprise. EVA also is the performance measuremost directly linked to the creation ofshareholder wealth over time. EVA-based

financial management and incentive compensationsystem that gives managers superior information -and superior motivation - to make decisions thatwill create the greatest shareholder wealth in anypublicly owned or private enterprise.

EVA = Net Operating Profit After taxes (NOPAT) [ Capital X Cost of Capital ]

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EVA = (ROI - WACC) x Invested capital(15,5% - 9,0%) x 1190 MFIM = 80 MFIM

The market value of a company = Book value ofequity + presentvalue of future EVA

The above formula is mathematically equivalent tothe standard Discounted Cash Flow (DCF)Investors and equity analysts use EVA (e.g. CSFirst Boston, Goldman Sachs, Opstock, MeritaSecurities) This means that the valuation of a

company is similar to the valuation of a bond(premium if the coupon rate is more than theprevailing interest rate)

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Drucker on EVA Peter Drucker said "Until a business returns a

profit that is greater than its cost of capital, itoperates at a loss. Never mind that it pays taxes

as if it had a genuine profit. The enterprise stillreturns less to the economy than it devours inresourcesUntil then it does not create wealth; itdestroys it." EVA corrects this error by explicitlyrecognizing that when managers employ capital

they must pay for it, just as if it were a wage.

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Aligning decisions with

shareholder wealth Stern Stewart developed EVA to help managers

incorporate two basic principles of finance intotheir decision making.

The first is that the primary financial objectiveof any company should be to maximize the wealthof its shareholders.

The second is that the value of a companydepends on the extent to which investors expectfuture profits to exceed or fall short of the cost

of capital.

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By definition, a sustained increase in EVA

will bring an increase in the market valueof a company. This approach has provedeffective in virtually all types oforganizations, from emerging growth

companies to turnarounds. This is becausethe level of EVA isn't what reallymatters. Current performance already isreflected in share prices. It is the

continuous improvement in EVA thatbrings continuous increases in shareholderwealth

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Common Performance Measuresy -Earnings per share tells nothing about the cost of generating

those profits.

y -If the cost of capital (loans, bonds, equity) is, say, 15 percent,then a 14 percent earning is actually a reduction, not a gain, ineconomic value.

y -Profits also increase taxes, thereby reducing cash flow, so thatengineering profits through accounting tricks can drain economic

value.

y -As Bennett Stewart, the leading authority on EVA, comments, thereal earnings are the equivalent of the money that owners of awell-run mom-and-pop business stash away in the cigar box.

y

-Renowned investorW

arren Buffett calls these "owner'searnings": real cash flow after all taxes, interest, and otherobligations have been paid.

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Discounted Cash Flowy Discounted cash flow is very close to

economic value-added, with the

discount rate being the cost ofcapital.

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EVA Computation NOPAT/ CE WACC = Spread

Spread * CE = EVA

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Calculating Net Operating Profit After Taxes (NOPAT)

XYZ CompanySales $2,436,000-Cost of Goods Sold 1,700,000Gross Profit 736,000-Selling, General & Admin Expenses 400,000Operating Profit 336,000-Taxes 134,000=NOPAT 202,000

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Cost of capital

Determining a firm's cost of capitalrequires making two calculations, onesimple and one complex.

The simple one figures the cost of debt,which is the after-tax interest rate onloans and bonds.

The more complex one estimates the costof equity and involves analyzing

shareholders' expected return implicit inthe price they have paid to buy or holdtheir shares.

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Investors have the choice of buying risk-free

Treasury bonds or investing in other, riskiersecurities.

They obviously expect a higher return forhigher risk. To attract investors, weak firmsmust offer a premium in the form of a lowerstock price than stronger firms can command.

This lower price amounts to the equivalent ofa higher interest rate on loans and bonds; theinvestor's premium increases the firm's costof capital.

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Accounting Policy

Implications Cash flow and the cost of capital employed

to generate that flow have become the keydeterminants of business performance,

with earnings per share increasingly amisleading or even damaging target forstrategy and investment.

When a firm switches from FIFO (first in,first out) to LIFO (last in, first out), itscost of goods assumes the price of themost recent purchases of materials ininventory.

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This typically reduces its profits becausethe older purchases cost less than the morerecent ones.Yet the firm's stock price will rise, eventhough its reported profits drop, because itpays less in taxes, thus increasing its after-tax cash flow.The money spent to acquire the goods ininventory is exactly the same regardless ofwhich method is used, but LIFO increases

economic value-added.The key business processes of the firm arecapital.

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Accounting Policy Implications

That fact is obscured by accounting systems thatexpense salaries, software development, rent,training, and other ongoing costs that are integralto a process capability and that treat the cost ofdisplacing workers-a frequent by-product of

process reengineering, downsizing, and the like-asan "extraordinary item" on the income statement. By treating processes as capital assets or

liabilities, firms can and should ensure that theydirectly contribute to economic value-added.

The following quotation summarizes the issueshere. For "operations" in the first sentence, wecan just as accurately substitute "businessprocesses."

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Risk Premium

Risk Premium used in the CAPM is theexcess average return on select stocksover average return on risk free securitiesover the measurement period.

Arithmetic mean is justified as it is moreconsistent with the mean varianceframework of the CAPM .

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Whereas the geometric mean isjustified on the grounds that it takes

compounding into account and that is abetter predictor of the average premiumin the long term.

There can be significant difference inpremiums depending upon the choice ofaverage. For computing risk premium , itis possible to take return on broad basedmarket index over risk free rate.

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Risk Free Rate

Variants on the risk free rate - three variants ofrisk free rate for computing cost of equity : Short term government security rate : This

may be justified in the CAPM framework which isconsidered as a one period model;

Short term forward rate : This is based onsuperiority of the forward rate in forecastingfuture short term rate; and

Current long term government bond rate : Thistakes a strict view of matching the duration ofthe risk free security with the duration of assetsbeing analyzed.

finally used long term rate for computing riskfree rate.

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Risk Free Rate As per Indian Fixed Income Securities

Market , National Stock Exchange , April2002 issue Yield on Government Securitiesof maturity range over 10 years was 8.05%in February 2002 , 8.06% in March 2002and 7.79% in April 2002.

So for illustrative purpose 8.06% is taken

as risk free rate, which is maximum of thelatest yield.

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Market return During April 2000 March 2005 for

determining market return. Average

of 84 monthly return is 12.37%.Thereafter , no trend of marketreturn during April 2007 March2009 can set. So 12.37% is taken aslong term market return.

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The summary of EVA theory EVA is a method to measure a companys true profitabilityand to steer the company correctly from the viewpoint ofShareholdersEVA helps the operating people to see how they caninfluencethe true profitability (especially if EVA is broken down intoparts than can be influenced)Clarifies considerably the concept of profitability (the

former operating profit/capital (ROI %) -observation isturned into EVA.EVA improves profitability usually through the improvedcapital turnover Companies have usually done a lot in cuttingcosts but there is still much to do in improving the use ofcapital.EVA is at its best integrated in incentive systems

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economic value added(2)

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