ECONOMIC VALUE ADDED (EVA®) (for personal use only)
EVA was originally proposed by the consulting firm Stern Stewart & Co., Economic Value Added (EVA) is currently a very popular idea. Fortune Magazine has called it “today’s hottest financial idea and getting hotter” and management guru Peter Drucker refers it to as a measure of total factor productivity. Companies across a broad spectrum of industries and across a wide range of countries have joined the EVA bandwagon.
EVA is essentially the surplus left after making an appropriate charge for the capital employed in the business. It may be calculated in any of the following, apparently different but essentially equivalent, ...view middle of the document...
EVA is a modified version of Residual Income concept. EVA has provided financial discipline in many companies in US. It has encouraged the managers to act like the owners and boosted shareholders’ returns and the value on their companies. The excess of returns over cost of capital is simply termed as EVA. EVA measures whether the operating profit is sufficient enough to cover the Cost of Capital.
If a company’s EVA is negative, the firm is destroying the shareholders wealth even though it would be reporting positive and growing EPS or return on capital employed. EVA is just a way of measuring an operation’s real profitability. EVA holds a company responsible for the cost of capital it uses to expand and operate its business and attempts to show whether a company is creating a real value for its shareholders. EVA measurement also requires a company to be more careful about resource mobilisation, resource allocation and investment decisions. EVA can also be shown as:
EVA = NOPAT – (TCE x WACC)
Where, TCE = Total Capital Employed
WACC = Weighted Average Cost of Capital
While calculating NOPAT, non-operating items like dividend/interest in securities invested outside the business, non-operation expenses etc. will not be considered. The total capital employed is the sum of shareholders funds as well as loan funds. But this does not include investments outside the business. To determine WACC, cost of debt is taken after tax cost and cost of equity is measured on the basis of Capital Asset Pricing Model (CAPM). CAPM is traditionally used by the founders of EVA. Under CAPM, Cost of Equity (Ke) is given by:
Ke = Rf + β (Rm + Rf)
Where Ke = Cost of Equity
Rf = Risk free return
Rm = Expected market rate of return
β = Risk coefficient of particular investment
EVA is expressed in terms of rupee figure and not as a percentage i.e. EVA measures the absolute rupee value of wealth created. EVA calculation removes the distinction between the providers of capital because the total capital employed in the business taken, whether provided by shareholders or creditors.
Adjustments for determination of EVA
EVA calculation involves the three figures NOPAT, TCE and WACC. EVA requires the following adjustments.
1. Adjustment to Net Operating Profit After Tax (NOPAT):
• EVA calculations write back the R&D expenses and amortises them over a period during which benefits of the successful R&D projects will be reaped.
• For EVA calculations the LIFO system of valuation of stock of materials is changed to FIFO system which is a better basis for estimating current replacement costs.
• NOPAT is adjusted for the tax actually paid instead of accounting provisions. The reserves for deferred taxes are added to the equity.
• The depreciation charge, if excessive, needs adjustments.
• Marketing expenses having accrued benefits should be amortised and capitalised over the period during which benefits will be reaped....