AN INTERIM REPORT

ON
EVA, a criterion to evaluate the value added to
shareholders’ wealth

By
Deeksha Singhal
09BS0000648

To
Prof. Monica Chopra

A report submitted in partial fulfillment of the requirements of

MBA program of The ICFAI University, Dehradun

Date of submission
10th December 2010
Project Title

EVA, a criterion to evaluate the value added to shareholders’ wealth.

Objective of the Project

The project aims at studying in detail about the Economic Value Added concept in regard to
companies. The objectives are:

1. To study the concept of EVA in detail.

2. To calculate the value added by the companies for their shareholders.

3. Effect of EVA on average market capitalization of BSE-30 companies.

4. Whether Indian market responds to EVA?

Research Methodology

Research methodology is a way to systematically solve the research problem. It may be

understood as a science of studying how research is done systematically. In that various steps,
those are generally adopted by a researcher in studying his problem along with the logic behind
them.

The methodology to be followed for this research will include descriptive research design.

Descriptive research is also called Statistical Research. The main goal of this type of research is
to describe the data and characteristics about what is being studied. The idea behind this type of
research is to study frequencies, averages, and other statistical calculations. Although this
research is highly accurate, it does not gather the causes behind a situation. It is quantitative and
uses surveys and panels and also secondary data.
Descriptive research is the exploration of the existing certain phenomena. The details of the facts
would not be known.

Type of Research

The research type is historical analytical and quantitative.

Historical as the historical information is used for analysis and interpretation.
Analytical as facts and existing information is used for the analysis.
Quantitative as EVA is calculated and the variables are expressed in measurable terms.

Sampling Technique

The Sampling method used here is Simple Random Sampling. The companies listed in the stock
exchange are considered since the market prices can be obtained. The companies in the Sensex
are chosen because it is an ideal index and it is considered to be a good proxy for the whole
market. Also it is a barometer that indicates the state and health of the economy.

Out of 30 companies included in the list of BSE Sensex, our Sample includes 10 companies for
which relevant data is available, for a period of 5 years starting from FY 2007-08 to FY 2009-10.

At irregular intervals, the Bombay Stock Exchange (BSE) authorities review and modify its
composition to make sure it reflects current market conditions.

Therefore only 10 companies are considered for the research as the data of all the 30 companies
for all the five years is unavailable.

Data gathering procedure and instrumentation

The data collection would be secondary. The secondary data are those which have already
collected and stored. Secondary data can easily be taken from records, journals, annual reports of
the company etc. It will save the time, money and efforts to collect the data. Secondary data also
made available through trade magazines, balance sheets, books, internet etc will be used.

Therefore required data for the study will be:

· Balance Sheet
· Profit and loss Account
· History of stock prices
· History of market index
· Risk free rate of return
· Corporate tax rate

Data Source

· Balance sheet and Profit and loss Account are taken from the financial statements of the sample
companies from the database of Capital Market.
· History of stock prices and history of market index are downloaded from database of Capital
Market and Bombay stock exchange.
· Risk free rate of return of relevant years is taken from the RBI bulletin
As 365 days Treasury bill rate is considered to be the proxy for risk free rate of return.

Hypothesis formed:

H0: There is no relationship between EVA and Market Capitalization of BSE-30.

H1: There is a relationship between EVA and Market Capitalization of BSE-30.

Tools used for testing of hypothesis:

The hypothesis is tested using linear regression tool, simple co-efficient of correlation, co-
efficient of determination and t statistic.

Co-efficient of correlation is used to describe how well one variable is explained by the other
variable. It reveals the magnitude and direction of relationship. The magnitude is the degree to
which variables move in the same or opposite direction. The coefficient’s sign signifies the
direction of the relationship.

Co-efficient of determination measures the extent, or strength of the association that exists
between the two variables. t-statistic is used for testing the significance of an dependent variable
over the independent variable.

There are two methods of testing the relationship with the help of t-statistics.
They are:
• To compare the values of t- calculated with that of t- tabulated. In this case if the
calculated t-value is greater than that of table value null hypothesis has to be rejected and
alternate hypothesis has to be accepted.
• To compare the p-value with that of level of significance. In this research report this
method is adopted and if the p-value is greater than or equal to level of significance the
null hypothesis is accepted. If the p-value is less than the level of significance, the null
hypothesis is rejected.

Limitations of the Study

The limitations of the study are as follows:

1. The secondary data used may be general and vague and may pose difficulty in decision-
making.

2. The source of data may also be checked. The data taken from unreliable sources may not
be accurate.
 3. The collection of the required data might be cumbersome.

4. Restricting ourselves to 1 year data would not represent the true returns.

What is EVA..???

Development of the concept of EVA

EVA is not new. Residual income, an accounting performance measure, is defined to be

operating profit with a capital charge subtracted. Thus, EVA is variant of residual income, with
adjustments to how one calculates income and capital.
Up to 1970 residual income did not get wide publicity and it was not the prime performance
measure for companies (Makelainen, 1998). However, in the
1990’s, the creation of shareholder value has become recognized as the ultimate economic
purpose of a corporation.
Firms adopt this concept to track their financial position and to guide management decisions
regarding resource allocation, capital budgeting and acquisition analysis.
Two views behind the concept of economic profit:

• The financial concept underlying EVA was originally propagated by Adam Smith, who
proclaimed that the social mission of an individual enterprise is to maximize the value of
shareholders.
• One of the earliest to mention the residual income concept was Alfred Marshall in 1890.
Marshall defined economic profit as total net gains less the interest on invested capital at
the current rate.

At operational level EVA approach leads often to increased shareholder value through increased
capital turnover. In many companies everything has been done in cutting costs but the capital
efficiency has been ignored. EVA has been helpful because it forces to pay attention to capital
employed and especially to excess working capital. Allocating the capital costs to their
originators i.e. individual functions of organization can further reinforce this impact.

With increased competition and greater awareness among investors, new and innovative ways of
measuring corporate performance are being developed. New tools/techniques provide flexibility
to managers in their functions, be it in terms of operational aspects or evaluation parameters.
Economic Value Added (EVA) is one such innovation. Besides the measures like Return on
Equity (ROE), Return on Net Worth (RONW), Return on Capital Employed (ROCE) and
Earnings per Share (EPS), EVA is a new measure available to the corporate managers.

In corporate finance, Economic Value Added or EVA is an estimate of economic profit, which
can be determined, among other ways, by making adjustments to GAAP accounting, including
deducting the opportunity cost of equity capital. EVA is a way to determine the value created,
above the required return, for the company shareholders.

The concept of EVA is in a sense nothing more than the traditional, common sense idea of
"profit". EVA is Net Operating Profit after Taxes (or NOPAT) less the money cost of capital.
Another, much older term for economic value added is Residual Cash Flow.

The basic formula is:

Where

, called the Return on Invested Capital (ROIC).

r is the firm's return on capital, NOPAT is the Net Operating Profit after Tax, c is the Weighted
Average Cost of Capital (WACC) and K is capital employed. To put it simply, EVA is the profit
earned by the firm less the cost of financing the firm's capital.
  NOPAT is profits derived from a company’s operations after taxes but before financing
costs and noncash-bookkeeping entries. It is the total pool of profits available to provide
a cash return to those who provide capital to the firm.

 Capital is the amount of cash invested in the business, net of depreciation

 Capital charge is the cash flow required to compensate investors for the riskiness of the
business given the amount of capital invested

 The cost of capital is the minimum rate of return on capital required to compensate debt
and equity investors for bearing risk.

 EVA can be found from a firm’s RETURN ON NET ASSETS(RONA).It is RONA =

NOPAT/Capital(after making necessary adjustments of the data according to financial
accounting system).EVA =net investments*(RONA-minimum requirements).if RONA is
above the threshold rate ,EVA is positive.

Economic Value Added (EVA) is one among various frameworks within value based
management framework. EVA is based on the common accounting based items like interest
bearing debt, equity capital, net operating profit etc. The idea behind EVA is that shareholder
must earn a return that compensates the risks taken by him. In other words, equity capital has to
earn at least the same return as similar risky investments in equity markets. If that is not the case,
then there is no real profit made and actually company operates at a loss from viewpoint of
shareholders. On the other hand, if EVA is zero, this should be treated as sufficient achievement
because shareholders have earned a return that compensates the risk.

Uses of calculating EVA are as follows:

 Setting organizational goals

 Performance measurement

 Capital budgeting

 Determining bonuses
  Motivation of the managers

Why not ROI?

Return on capital is a very good and relatively good performance measure. Different companies
calculate this return with different formulae and call it also with different names like return on
invested capital, return on capital employed, return on net assets, return on assets etc. The main
shortcoming with all these rates of return is that in all cases maximizing rate of return does not
necessarily maximize the return to shareholders.

ROI ignores the definite requirement that the rate of return should be at least as high as cost of
capital. Further, ROI does not recognize that shareholder's wealth is not maximized when the rate
of return is maximized. Shareholders want the firm to maximize the absolute return above the
cost of capital and not to increase percentages.

It is also very common that in ROI steered companies, many employees do not really know what
profitability is. ROI is too difficult a concept to explain to all employees.

The capital base is left to very little attention in operating activities and operating profit is
emphasized. Therefore, the meaning of capital efficiency is often forgotten and some people do
not even trying money in inventories or sales receivables is costly.

This paper will describe EVA and calculations of value added by the companies. Apart from this,
taking the real financial data of a company, the paper will show how EVA calculations can be
done to demonstrate whether the company is adding to shareholder value by generating profits
over and above the capital charge. EVA is not a tool to create wealth. Yet, it encourages
managers to think like owners and, in the process, may impel them to strive for better
performance.

What is Market Value Added (MVA)?

It is another measure for shareholder value, which holds that if the total market value of a
company is more than the amount of capital invested in it, the company has created shareholder
value. The difference between the company’s market value and book value is Market Value
Added. The basic calculation is as follows:
MVA = Company’s Total Market Value – Capital Invested, or;

MVA = Market Value Of Equity – Book Value Of Equity

ROI VS EVA Vs MVA

• Measure: ROI measures profitability, while EVA and MVA measure the shareholders
wealth.

• Profits considered: Unlike ROI, EVA focuses on after-tax income instead of before-tax
operating profit.

• Fluctuations: MVA is very volatile and fluctuates every moment while ROI and EVA
are relatively stable.

Therefore, EVA ranks the best among the three.

The companies selected for the study are Reliance Industries, State Bank of India, Tata
Consultancy Services, Infosys and Bharti Airtel, HDFC bank, ICICI bank, Maruti Udyog
Ltd., ACC Ltd., L&T Ltd. All the companies undertaken are from different sectors and would
be an interest to study.

Serial No. Company Sector

1 Reliance Industries Refineries
2 State bank of India PSU Bank
3 Tata Consultancy Services Software
4 Infosys Software
5 Bharti Airtel Telecommunications Services
6 HDFC Bank Ltd. Private Banking
 7 ICICI Bank Ltd. Private Banking
8 Maruti Udyog Ltd. Automobiles
9 ACC Ltd. Cement
10 L&T Ltd. Engineering

Method of calculating EVA

Step 1: Develop an Equity Value Added model.

– Determine appropriate adjustments to income statement and balance sheet.

– Determine total capital.

– Determine appropriate cost of capital.

– Develop model for future calculations.

Step 2: Review the determined Economic Value Added models with Company management
and establish base line values. Management utilizes in performance measurement, investment
analysis, and determination of an incentive compensation system based on annual or multi-year
change in Economic Value Added.

Step 3: Determine annual Economic Value Added based on established model.

Step 4: Company management uses annually prepared Economic Value Added to evaluate unit
performance, allocate capital and determine incentive compensation
The most difficult component of EVA to estimate is the cost of capital. The cost of capital
represents the opportunity cost or the rate of return demanded by investors. It can be calculated
by first estimating the individual cost of each source of financing (i.e., after-tax cost of debt, cost
of preferred stock, and cost of equity.) Then after each of these cost components has been
estimated the overall cost of capital is found by multiplying each individual source of capital by
its relative market value as a percentage of the aggregate market value of all sources combined.
The after-tax cost of debt is simply the bond's yield to maturity times one minus the firm's
marginal tax rate. Since interest on debt is tax deductible, this adjustment must be made to
properly reflect the true cost of the debt compo-nent. For example, if the firm's yield to maturity
on its corporate debt is 8 percent and its marginal tax rate is 40%, then the after-tax cost of debt
would be 4.8 percent [8%*(1- .40)]. Unlike debt, both preferred and common stocks' dividends
are not deductible for tax purposes. Therefore, no tax adjustment is required. The cost of
preferred stock can be found by dividing the annual dividend payment by the market value of the
preferred stock issue. Thus, if a preferred issue paid annual dividends of $4.00 per share and had
a current market value of $40.00 then its cost is 10% ($4.00/$40.00). By far the most difficult
component of the cost of capital to estimate is the cost of equity. There are several ways to
estimate this component including dividend discount model, premium over long-term debt
model, and the most frequently used, the capital asset pricing model (CAPM). The capital asset
pricing model uses the market as a benchmark for estimating the cost of equity. It assumes that
the cost of equity is simply a "risk free rate of return" plus a premium that investors require to
take on additional market risk. The risk free rate of return can be thought of as a return that an
investor will demand in the absence of risk. Here the investor receives a return reflecting the
time value of money. A surrogate used to measure this component is typically the return on U.S.
Treasury Bills. The firm's risk relative to the market is estimated using regression analysis. This
provides an estimate of market risk, commonly referred to as beta. Beta measures the relative
risk of the corporation's equity relative to that of the market. The market's beta is equal to one. A
firm's beta may be less than, equal to or greater than the market's beta.

The following illustration will be used to show how the cost of equity is calculated.

Assume that Treasury Bills are currently at 5%.

Assume further that the market return (S&P 500) is expected to be 12%. Finally, assume that the
firm's beta is 1.5. The firm’s cost of equity can be estimated by using the following formula: RI
= Rf + (Rm - Rf )*BI RI = 5% + (12% - 5%)*1.5 RI = 5% + (7%)*1.5 RI =15.5% Where, RI =
Cost of Equity Rf = Return on Treasury Bills Rm= Market return BI = Firm’s beta

The above formula yields a cost of equity of 15.5%. Thus, the firm's higher market risk (i.e.,
1.5>1.0) results in a higher required return (i.e., 15.5%>12%). As this approach reveals,
estimates of the risk free rate market return, and the firm's beta must be made in order to arrive at
the cost of equity. Once all of the component costs have been estimated, the final step is to
calculate a weighted average cost of capital by applying a weight to each individual component
cost. For example, assume that the firm has a market value of $10,000,000 ant that debt
comprises $4,000,000, preferred stock $2,000,000, and equity the remaining $4,000,000.
Accordingly, the weight of debt would be 40%, the weight for preferred stock would be 20%,
and the weight for equity would be 40%. Given this information, the cost of capital would be
calculated as follows: Ko = (4.8%)(40%)+(10%)(20%)+(15.5%)(40%).

Therefore, the overall cost of capital is 10.18 percent.

The use of an overall EVA is only appropriate if all units within the firm have identical risks. In
instances where this is not true, the EVA of each division or project is more suitable.

Advantages of EVA

 EVA calculation is simple, since only main data contained in income statement and
balance sheet is needed.

 EVA covers all aspects of the business cycles

 EVA aligns and speeds decision making, and enhances communication and teamwork

 Positive EVA indicates value creation, Negative EVA indicates value destruction. Series
of negative EVA is a signal that restructuring in a company may be needed.

 The EVA concept is easy to understand and easy to use.

 EVA helps to understand the concept of profitability even by persons not familiar with
finance and accounting

 In a small company, managers can make the EVA concept transparent to all employees
in a short time.

 EVA helps to convert a small company’s strategy into objectives tangible for all
employees.
  EVA is a useful tool for allocation of a small company’s scarce capital resources.

 The EVA concept integrated in a small company’s decisions making process improves its
business performance because managers having deeper knowledge about capital and
capital cost are able to make better decisions.

Limitations of EVA

 EVA is based on financial accounting methods that can be manipulated by managers by

using different method of accounting.

 There are different ways to calculate NOPAT and COC as there are numerous
fundamental differences exist with regard to calculation of NOPAT and COC

 There are 164 adjustment which is really cumbersome exercise

 EVA may focus on immediate results which diminishes innovation

 EVA is in favour of large companies

 EVA favours more debt compared to equity

 It is difficult to implement

 Implementation includes significant cost

 EVA does not study business drivers like consumer satisfaction or learning and growth.

 Traditional performance measures used by small companies, such as sales or profits

alone, are unable to describe the company´s true business results and sometimes lead to
wrong business decisions.
References:

1. www.google.com

2. www.evanomics.com

3. www.wikipedia.com

4. www.bseindia.org

5. www.ril.com

6. www.tcs.com

7. www.airtel.in

8. www.infosys.com

9. www.statebankofindia.com

10.www.marutisuzuki.com

11.www.larsentoubro.com

12.www.acclimited.com

13.www.hdfc.com

14.www.icicibank.com