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Economic Value Added

(EVA)Presented by:

Ashish Hinduja

Moumita Dey

Rohit Pandey

Shubham Kumar

Vipra Pandey

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Introduction of EVA

EVA was developed by a New Yorkconsulting firm, Stern Steward & Co. in1982 to promote value-maximizingbehaviour in corporate managers.

Value-based measure to evaluate businessstrategies, capital projects and to

maximize long-term shareholders wealth.

EVA sets managerial performance target

and links it to reward systems.

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Economic Added Value (EVA) helps companies

determine their actual profit once the taxes andcapital amount has been taken under consideration.

EVA or Economic Added Value helps organizations

determine their actual profit once the taxes and

capital amount has been taken under consideration.

This helps companies determine whether their

business or a particular project is making moremoney than what was invested in it. This makes EVA

a crucial step that companies definitely cannot afford

to skip out on.

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EVA allows companies to understand whether the

business is bringing in profit and whether the moneycan be implemented in a more profitable source. Agreater EVA is an indication of the fact that thecompany has a greater value.

EVA is based upon the concept of economic returnwhich refers to excess of after tax return on capitalemployed.

EVA is defined in terms of returns earned by thecompany in excess of the minimum expected return

of the shareholders.

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Definition for EVA

EVA is defined as net profit after taxes and after the cost ofcapital.

FORMUALE for EVA

EVA

Net operating profit Taxes Cost of capital

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if ABC 's capital is Rs 100 million - includingdebt and shareholder equity - and the cost

of using that capital (interest on debt and

the cost of underwriting the equity) is Rs 13million a year, ABC will add economic value

for his shareholders only when profits are

more than Rs 13 million a year. If ABC 'searns Rs 20 million, the company's EVA will

be Rs 7 million.

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Calculating Net Operating After Tax(NOPAT)

NOPAT is easy to calculate. From the income statement wetake the operating incomes and subtract taxes.

e.g. XYZ CompanyParticulars Amount (Rs.)

Sales 24,36,000/-Cost of Goods sold (-) 17,00,000/-

Gross Profit 7,36,000/-

Selling, general & AdminExp. (-)

4,00,000/-

Operating Profit 3,36,000/-

Taxes (-) 1,34,000/-

NOPAT 2,02,000/-

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Cost of Capital

Meaning: The cost of capital is the rate of return required bythe shareholders and lenders to finance the operations of thebusiness.

Types of Cost of Capital

Equity Capital: Equity Capital is provided by the Shareholders.

Borrowed Capital: It is the Capital borrowed by the companyfrom Banks and other Financial Institutes.

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Weighted Average Cost of Capital(WACC)

Weighted Average Cost of Capital examines the variouscomponents of the Capital structure and applies theweighting factor of after-tax cost to determine the cost ofCapital.

Calculating WACCe.g. XYZ Company

Particulars Amount (Rs.)

Long Term Debt 5,00,000/-Preferred Stockholders Equity 2,00,000/-

Total Common Equity 7,00,000/-

Total Capital 14,00,000/-

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WACC ContinueLong Term Debt

Bond Cost

Bond Rs. 100/-

Net Return(Deducting discounting & Financing cost) Rs. 96/-

Interest 14%(Rs. 14/-)

Assumed Tax 35%(Rs. 5/-)Interest After Tax(Rs.14 Rs. 5) 9%

Cost for Bond Financing(9/96 x 100) 9.47%

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WACC Continue

Preferred Stock Cost

Preference Share (Per share) Rs. 100/-

Net Revenue (Deducting discount & financing cost) Rs. 98/-

Dividend 11% (Rs. 11/-)

Cost for Preferred Share (11/98 x 100) 11.2%

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WACC Continue

Common Equity Cost

Share Price (Per Share) Rs. 100/-

Net Return (Less issuing cost) Rs. 85/-

EPS (Estimated by investors & reliable analyst) Rs. 12/-

Cost for Common Equity (12/85 x 100) 14.1%

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WACC Continue

Summarizing

Bond Cost 9.47%

Preferred Stock Cost 11.2%

Common Equity Cost 14.1%

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Calculation of WACCfor XYZ Company

Particulars Amount(Rs.)

Cost(%)

Total(Rs.)

Long Term Debt 5,00,000/- 9.47 47,375/-

Preferred Stock Cost 2,00,000/- 11.2 22,400/-Common Equity Cost 7,00,000/- 14.1 98,700/-

Total Capital 14,00,000/- - 1,68,475/-

The total Weighted Average Cost of Capital (WACC) =

1,68,478 / 14,00,000 = 12.03%

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Calculation of EVAfor XYZ Company

NOPAT Rs. 2,02,000/-

Capital Employed(Including Rs.1,00,000/- Reserve & Surplus)

Rs. 15,00,000/-

Cost of Capital 12.03%Capital Charge (12.03/100 x Rs. 15,00,000/-) Rs. 1,80,450/-

Economic Value Added (EVA)(Rs. 2,02,000 Rs. 1,80,450)

Rs. 21,550/-

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Advantages of EVA

EVA provides for better assessment of decisionsthat affect balance sheet and income statement ortradeoffs between each through the use of thecapital charge against NOPAT.

EVA decouples bonus plans from budgetarytargets.

EVA covers all aspects of the business cycle.

EVA aligns and speeds decision making, and

enhances communication and teamwork.

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EVA can be used as a tool inDecision Making within anenterprise.

It is a measure to understand andevaluate financial performance of a

company. It can help integration of customer

satisfaction, operating efficiencies,

management and financial policies.

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Limitations of EVA

EVA does not control for size differences across plants ordivisions.

EVA is based on financial accounting methods that can be

manipulated by managers .

EVA may focus on immediate results which diminishesinnovation.

EVA provides information that is obvious but offers nosolutions in much the same way as historical financialstatement do.

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Strategies for Increasing EVA

Increase the return on existing projects (improve operatingperformance).

Invest in new projects that have a return greater than the cost

of capital.

Use less capital to achieve the same return.

Reduce the cost of capital.

Liquidate capital or curtail further investment in sub-standardoperations where inadequate returns are being earned.

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Conclusion

As a performance measure, Economic Value Added forces theorganization to make the creation of shareholder value the

number one priority. EVA is changing the way managers runtheir businesses. When business decisions are aligned with theinterest of the shareholders, it is only a matter of time beforethese efforts are reflected in a higher stock price.