ECONOMIC VALUE ADDED ( EVA )& MARKET VALUE ADDED ( MVA )

FINANCIAL MANAGEMENT ASSGNMENT -2

BY SUHAS CHOWDHARY 215110068 PRASANNA KUMAR 215110069 MAHESH CHITRA 215110071 KOWSIK R 215110072 PRABHU SUNDAR 215110073

Introduction: The goal of Financial Management is to maximize the shareholder's value. The shareholder's wealth is measured by the returns they receive on their investment. Returns are in two parts, first is in the form of dividends and the second in the form of capital appreciation reflected in market value of shares of which market value is the dominant part. The market value of share is influenced by number of factors, many, of which, may not be fully influenced by the management of firm. However, one factor, which has a significant influence on the market value, is the expectation of the shareholders regarding the return on their investment. There exist very measures like return on Capital Employed, Return on Equity, earnings per share, Net Profit margin, and Operating profit margin to evaluate the performance of the business. The problem with these measures is that they lack a proper benchmark for comparison. The shareholders require at least a minimum rate of return on their vestment depending on the risk in the investment. To overcome these problems the concept of EVA vas developed. Evolution of EVA: It was Stern Stewart & Co. who devised an accounting method called Economic Value Added (EVA), which measures whether the company is generating adequate profits to reward, its shareholders. EVA is the registered trademark of Stern Stewart & Co. It is the financial performance measure that captures the true economic profit of an enterprise. It is also one of the measures most directly linked to the creation of shareholder wealth over time. Concept of EVA: A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). (Also referred to as "economic profit".) In corporate finance, Economic Value Added or EVA is an estimate of a firm's economic profit - being the value created in excess of the required return of the company's shareholders - where EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that shareholders gain when the return from the capital employed is greater than the cost of that capital; This amount can be determined, among other ways, by making adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. EVA is Net Operating Profit After Taxes (or NOPAT) less the money cost of capital. Any value obtained by employees of the company or by product users is not included in the calculations.

The company creates shareholders value only if it generates returns in excess of its cost of

capital. The excess of returns over cost of capital is simply termed as Economic Value Added. To put in a simple terms EVA is the profits generated by any economic entity over its cost of capital employed. The entity can be a company, country or the entire human civilization. If the difference between the above two parameters is positive than the entity is said to be creating wealth for its stakeholders. A negative EVA on the other hand indicates the company is a destroyer of value. EVA is just a way of measuring an operation's real profitability. EVA holds a company accountable 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.
CALCULATION OF EVA: EVA is essentially the surplus left after making an appropriate charge for the capital employed in the business. It can be calculated in the following way. EVA = NOPAT (TCE x WACC) Where, NOPAT = Net operating profit after tax TCE = Total capital employed WACC= Weighted average cost of capital ( Or )

EVA = (r-c) x Capital EVA = (r x Capital) (c x Capital) EVA = NOPAT - c x Capital EVA = operating profits a capital charge where: r = rate of return, and c = cost of capital, or the weighted average cost of capital. NOPAT is profits derived from a companys 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. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less noninterestbearing current liabilities.

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. Another perspective on EVA can be gained by looking at a firms Return on Net Assets (RONA). RONA is a ratio that is calculated by dividing a firms NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system. EVA = (Net Investments)(RONA Required minimum return) If RONA is above the threshold rate, EVA is positive. While calculation of NOPAT, the non-operating items like dividend/interest on securities invested outside the business, non-operating 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. In determining the WACC, cost of debt is taken as after tax cost and cost of equity is measured on the basis of capital asset pricing method. Under Capital asset pricing model, cost of equity Ke is given by the following: Ke = Rf + bi (Rm- Rf) Where Rf = Risk free return Rm = Expected market rate of return bi = Risk coefficient of particular investment For example an investment of Rs 1,000 in a soaps and detergent shop produces 7% return, while the similar amount invested elsewhere earns returns of 15%. EVA can be defined as a spread between a company's return on capital employed and cost of capital (similar to the opportunity cost of investing elsewhere) multiplied by the invested capital. The EVA from this case would be
EVA = (7%-15%) * Rs 1,000 = (Rs 80)

An accountant measures the profit earned while an economist looks at what could have been earned. Although the accounting profit in this example is Rs 70 (7% * Rs 1,000), there was an opportunity to earn Rs 150 (15% * Rs 1,000). So in this case the company can be called as a destroyer of wealth.

Thus, the litmus test behind any decision to raise, invest, or retain a Rupee must be to create more value than the investor might have achieved with an otherwise alternative investment opportunity of similar risk. EVA Example:
Now consider this example based on the formula explained above. You can put different balance sheet and profit figures to know your own EVA.

Particulars Equity Capital Reserves Net worth 12.5% debentures Capital employed Weight of equity Weight of debt NOPAT (as per definition) Return on tax free government bonds * Beta * Market premium * Corporate tax rate * Cost of borrowings * Cost of equity Cost of debt WACC

(Rs) 500 7,500 8,000 2,000 10,000 0.8 0.2 1,500.0 11.0% 1.1 15.0% 33.0% 12.5% 15.4% 8.4% 14.0%

NOPAT as a % of capital employed

15.0%

Cost of Capital
EVA 100

1,400

As calculated in the above example the company has generated EVA of Rs 101 m. That means maintenance of shareholder value will require the company to earn NOPAT over Rs 1,400 m. In other words the % of NOPAT to capital employed should be greater or atleast equal to the % of WACC. Areas To Use this Concept: In the present market scenario every second company is making an attempt to impress the investors, with their excellent financial performance showing the high growth rate. With the limited resources available the investor is confused as to who is better and why? Here comes the concept of EVA, which helps the investors in simplifying investment decision making. Apart from looking at only P/E or EPS of the company, EVA helps the investors to see whether the valuation of the company really justifies the high or low P/E. EVA & P/E: EVA is the measure and reflection of a good management. A good management is one which can 'Create value, Give value and Get value'. To achieve this the management of the company has to deploy more and more capital to those activities wherein the amount of NOPAT generated by the activities is greater than the amount of WACC. Then only they will be able to generate real wealth for their stakeholders. So who are these stakeholders they are our mutual funds, pension plans, life insurance policies, and many small investors, which represent the vast majority of stock ownership. Our largest institutional investors represent the savings of everyday citizens. Investors invest their savings and bear risk, in the hopes of the best return possible. EVA and Indian Companies: There are very few companies in India, which are successful in generating EVA. As a reason these companies have been given premium valuation on the bourses. HLL, Infosys and Dr. Reddy's have been given the premium valuations by the market not only based on their EPS performance but also on the basis of their ability to consistently increase shareholders wealth.

The graph hereunder presents the growth pattern of EVA of Infosys and HLL, two companies that have been successful in generating wealth and this is also reflected in their market cap. The corporates, which were paying lowest preference to the shareholders interest, are now giving the highest preference to it to generate value for shareholders. The true example of this is the software viral, which affected investors in the past few months. Even though in short term these software companies might provide a good return to investors, in the long term only those companies will be able to survive which are actually generating the returns. EVA is too sophisticated a tool for lay investors to use. They may not indulge in the exercise of computing it but must try to understand from the numbers reported by the company whether it is generating a positive or negative EVA. Investors should be cautious enough in selecting companies, which have high EPS but low EVA and consequently lower ROCE and RONW. So only those companies can be called as Real Wealth Creators, which know the above principals. As it is rightly said by someone ' You only get richer if you invest money at a higher return than the cost of that money to you. Everyone knows that but many seem to forget it' Comparison with other approaches Other approaches along similar lines include Residual Income (RI) and Residual Cash Flow. Although EVA is similar to Residual Income, under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual Cash Flow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital); at the same time, the adjustments to NOPAT are unique to EVA. Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of "profit", the utility of having a separate and more precisely defined term such as EVA is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while actually approaching insolvency.

Example 2:

The following example from XYZ Company illustrates the NOPAT calculation. XYZ Company Sales 2,436,000 Cost of Goods Sold 1,700,000 Gross Profit 736,000

Selling, General & Admin Expenses Operating Profit Taxes NOPAT

400,000 336,000 134,000 202,000

Calculating Cost of Capital Many business dont know their true cost of capital, which means that they probably dont know if their company is increasing in value each year. There are two types of capital, borrowed and equity. The cost of borrowed capital is the interest rate charged by the bondholders and the banks. Equity capital is provided by the shareholders. An investors expected rate of return on an investment is equal to the risk free rate plus the market price for the risk that is assumed with the investment. The relationship between expected return and risk is measured by comparing a company to the market. The risk of a company can be decomposed into two parts. An investor can eliminate the first component of risk by combining the investment with a diversified portfolio. The diversifiable component of risk is referred to as non-systematic risk. The second component of risk is non-diversifiable and is called the systematic risk. It stems from general market fluctuations which reflects the relationship of the company to other companies in the market. The non-diversifiable risk creates the risk premium required by the investor. In the security markets the non-diversifiable risk is measured by a firms beta. The higher a companys non-diversifiable risk, the larger their beta. As the beta increases the investors expected rate of return also increases. (Levy, 1982) Current estimates of beta for a wide variety of companies are available from Value Line and Bloomberg. Shareholders usually expect to earn about six percent more on stocks than government bonds. With long term government bonds earning 7.5%, a good estimate for the cost of equity capital would be about 13.5 %. The true cost of capital would be the weighted average cost of debt and equity. Measuring Capital Employed The next step is to calculate the capital that is being used by the business, from the economist point of view. Accounting profits differ from economic profits. Under generally accepted accounting principles, most companies appear to be profitable. However, many actually destroy shareholder wealth because they earn less than the full cost of capital. EVA overcomes this problem by explicitly recognizing that when capital is employed it must be paid for. In financial statements, created using generally accepted accounting principles, companies pay nothing for equity capital. As discussed earlier, equity capital is very expensive. Economic profits are defined as total revenues less total costs, where costs includes the full opportunity cost of the factors of production. The opportunity cost of capital invested in a business is not included when calculating accounting profits. Capital would include all short and long term assets. In addition, other investments that have been expensed using accrual accounting methods are now included as capital. For example,

research and development, leases, and training, which are investments in the future, that GAAP requires to be expensed in the year they occur, would be treated as a capital investment and assigned a useful life. If the business invest in developing new products this year, that amount would be added back to operating profits and to the capital base. If the product has a five-year life, deduct 1/5 of the investment would be deducted each year from operating profits and from the capital base in each of the next five years. For XYZ Company we determine that the adjusted capital balance is $1,500,000. Weighted Average Cost of Capital Weighted average cost of capital examines the various components of the capital structure and applies the weighting factor of after-tax cost to determine the cost of capital. The following example will show the formation of the weighted average cost of capital. XYZ Company Long Term Debt Preferred Stockholders Equity Common Stock Paid in Surplus Retained Earnings Total Common Equity Total Capital $500,000 $200,000 $300,000 $100,000 $300,000 $700,000 $1,400,000

Long Term Debt Long Term Debt includes bonds, mortgages and long term secured financing. Bond Cost Lets say we can issue bonds with a face value of $100 per bond and it is estimated that the bond will generate $96.00 net proceeds to the company after discounting and financing costs. The normal interest is $14.00 or approximately $9.00 after taxes (assuming a 35% tax rate). To obtain the cost, we divide the after tax interest by the proceeds. $9.00/ $96.00 = 9.475% which is the after tax cost of bond financing Mortgage and Long Term Financing Costs Our banker has informed us that our long term rate is two points above prime, which is currently 10%, putting our lending rate at 12%. With a 35% tax rate it comes to a 7.8% cost. Our banker has informed us that our mortgage rates are presently 11%, which would give us an after tax cost on mortgage money of 7.15%. We weight the cost of long term debt, by taking the average of the cost of long term debt, which would give us: (7.8% +7.15%)/2 = 7.48%

and multiplying the long term debt of $500,000 by 7.48% will give us a weighted average cost of LTD of $34,400. Preferred Stock Costs We take the present market value of the preferred stock less discounts or finance costs and divide dividends per share by this value. For example, Preferred stock of $100 per share less $2.00 finance costs or $98.00 proceeds. Dividends on Preferred are $11.00 per share. $11.00/ $98.00 = 11.2% after tax cost of preferred To calculate the weighted preferred stock, we multiply the after tax cost of 11.2% by the preferred stock of $200,000 which gives us $22, 400. Common Equity Costs Common equity has three components common stock, paid in surplus and retained earnings. From the shareholders viewpoint, all three are costs. If retained earnings are used in the business, the stockholders cannot use them elsewhere to earn money and therefore they carry an opportunity cost. Stockholders invest because they expect to receive benefits, which will be equivalent to what they would receive on the next best investment when risk is considered. Stockholders expect two benefits from common stock, dividends present and future and capital appreciation from growth. The valuation of common equity must take into consideration both the present and future earnings of the stock. To calculate the weighted cost of common equity we consider the present market price of the stock less issuing costs. For example we issue common stock for $100 a share less $15.00 issuing cost or proceeds of $85.00 per share. This is divided into the future earnings per share estimate by investors or reliable analysts. If we use $12.00 per share, then the weighted cost will look like this: $12.00/$85.00 = 14.1% after tax cost of common stock Using the 14.1% and the total common equity of $700,000 our cost of common equity is $98,700. Total Weighted Average Cost of Capital A summary of the three components gives us the weighted average cost of capital. XYZ Company Long Term Debt $500,000 * 7.48% $37,400 Preferred Stockholders Equity $200,000 * 11.2% $22,400 Common Equity $700,000 * 14.1% $98,700 Total Capital $1,400,000 $158,500 The Weighted Average Cost of Capital is $158,500/$1,400,000 = 11.3%.

Cost of capital is calculated by multiplying total capital by the weighted average cost of capital. Calculating EVA After tax operating earnings less the cost of capital is equal to EVA. From the above example we can calculate XYZ Companys EVA and determine if this business is creating wealth for its owners. XYZ Company NOPAT $202,000 Capital Employed $1,500,000 Cost of Capital 11.3% Capital Charge $169,500 ECONOMIC VALUE ADDED $32,500 Methods Used to Increase EVA The only way to increase EVA is through the actions and decisions of managers. People make the decisions and changes that create value. Companies that use EVA as their financial performance measure focus on operating efficiency. It forces assets to be closely managed. There are three tactics that can be used to increase EVA: earn more profit without using more capital, use less capital, and invest capital in high return projects. HOW EVA IS USEFUL FOR A FINANCIAL MANAGER: Thus, EVA can simply be viewed as earnings after capital costs. Although accountants subtract many costs (including depreciation) to get the earnings number shown in financial reports, they do not subtract out capital costs. We can see the logic of accountants because the cost of capital is very subjective. By contrast, costs such as COGS (cost of goods sold), SGA (sales, general, and administration), and even depreciation can be measured more objectively. However, even if the cost of capital is difficult to estimate, it is hard to justify ignoring it completely. EVA can increase investment for firms that are currently underinvesting. However, there are many firms in the reverse situation: The managers are so focused on increasing earnings that they take on projects for which the profi ts do not justify the capital outlays. These managers either are unaware of capital costs or, knowing these costs, choose to ignore them. Because the cost of capital is right in the middle of the EVA formula, managers will not easily ignore these costs when evaluated on an EVA system. One other advantage of EVA is that it is so stark: The number is either positive or it is negative. Plenty of divisions have negative EVAs for a number of years. Because these divisions are destroying more value than they are creating, a strong point can be made for liquidating these divisions. Although managers are generally emotional.

EVA can be used for performance measurement, where we believe it properly belongs. To us, EVA seems a clear improvement over ROA and other financial ratios. However, EVA has little to offer for capital budgeting because EVA focuses only on current earnings. By contrast, net present value analysis uses projections of all future cash flows, where the cash flows will generally differ from year to year. Thus, as far as capital budgeting is concerned, NPV analysis has a richness that EVA does not have. Although supporters may argue that EVA correctly incorporates the weighted average cost of capital, remember that the discount rate in NPV analysis is the same weighted average cost of capital. That is, both approaches take the cost of equity capital based on beta and combine it with the cost of debt to get an estimate of this weighted average. Under EVA, a manager will be well rewarded today if earnings are high today. Future losses may not harm the manager because there is a good chance that she will be promoted or have left the fi rm by then. Thus, the manager has an incentive to run a division with more regard for short-term than long-term value. By raising prices or cutting quality, the manager may increase current profi ts (and therefore current EVA). However, to the extent that customer satisfaction is reduced, future profi ts (and, therefore, future EVA) are likely to fall. But we should not be too harsh with EVA here because the same problem occurs with ROA. A manager who raises prices or cuts quality will increase current ROA at the expense of future ROA. The problem, then, is not EVA per se but with the use of accounting numbers in general. Because stockholders want the discounted present value of all cash flows to be maximized, managers with bonuses based on some function. Conclusion EVA is both a measure of value and also a measure of performance. The value of a business depends on investors expectations about the future profits of the enterprise. Stock prices rack EVA far more closely than they track earnings per share or return on equity. A sustained increase in EVA will bring an increase in the market value of the company. As a performance measure, Economic Value Added forces the organization to make the creation of shareholder value the number one priority. Under the EVA approach stiff charges are incurred for the use of capital. EVA focused companies concentrate on improving the net cash return on invested capital. EVA is changing the way managers run their businesses and the way Wall Street prices them. When business decisions are aligned with the interest of the shareholders, it is only a matter of time before these efforts are reflected in a higher stock price.

MARKET VALUE ADDED: What is Market Value Added? Description

Market Value Added (MVA) is the difference between the equity market valuation of a listed/quoted company and the sum of the adjusted book value of debt and equity invested in the company. In other words: it is the sum of all capital claims held against the company; the market value of debt and the market value of equity. Market Value Added (MVA) is a calculation that measures the difference between the current market value of a company and the capital contributed to the company by its investors. The market value added is the current market value of company debt and equity, less the total of all capital claims held against the company. Generally speaking, the higher the market value added the better as it demonstrates the creation of wealth for the companys shareholders. Negative market value added indicates an erosion of wealth.
Calculation :

Market Value Added (MVA) = Market Value - Invested Capital. ( or ) MVA = EVA/WACC ( or ) MVA = PV( Future EVA ) The higher the Market Value Added (MVA) is, the better it is. A high MVA indicates the company has created substantial wealth for the shareholders. MVA is equivalent to the present value of all future expected EVAs. Negative MVA means that the value of the actions and investments of management is less than the value of the capital contributed to the company by the capital markets. This means that wealth or value has been destroyed. The aim of a firm should be to maximize MVA. The aim should not be to maximize the value of the firm, since this can be easily accomplished by investing ever-increasing amounts of capital. Difference Between Market Value Added and Economic Value Added In contrast to the market value added, Economic Value Added (also known as economic profit) measures company financial performance by deducting the companys cost of capital from its operating profits to provide an indication of the residual wealth created for investors. Economic value added is determined by making corrective adjustments to GAAP accounting.

Limitations:

1. MVA does not take into account the opportunity costs of the invested capital. 2. MVA does not take into account the interim cash returns to shareholders. 3. Market Value Added (MVA) cannot be calculated at divisional (Strategic Business Unit) level and cannot be used for private held companies.

Example Company Z has invested capital amounting to Rs. 100 at the beginning of the year. This is financed by 60% equity and 40% debt. The debt carries an interest rate of 12% before tax. The tax rate is 30% and the WACC is 15%. The net income for the year before interest and tax is Rs.30. The return on invested capital after tax (ROIC) is 30/100 (1 tax rate of 30%) = 21%. EVA = (ROIC WACC) IC = (21% 15%) 100 = 6% 100 =6 MVA can be calculated as follows: MVA = EVA / WACC = 6 / 15% MVA = Rs. 40