EVA AND TRADITIONAL PERFORMANCE MEASURES Some Empirical Evidence

INTRODUCTION Certain value-based performance measures e.g., Cash Flow Return On Investment (CFROI), Cash Value Added (CVA), Shareholder Value Added (SVA) and Economic Value Added (EVA) have appeared on the scene to measure the corporate financial performance. Out of these new trendier performance measures the popularity graph of EVA is touching new heights day-by-day and when compared with the traditional measures it occupies a place of pride on the following grounds: (i) EVA is a performance measure most directly linked to the definitive and reliable measure of wealth creation that is Market Value Added (MVA), the difference between the market value of an enterprise and the capital contributed by shareholder and lenders. MVA is in fact the cumulative amount by which a company has enhanced or diminished shareholder wealth. (ii) ROCE, RONW, ROI etc. consider only one side of the performance i.e., they consider the borrowing cost but ignore the cost of equity. This leads the decision makers and financial analyst towards a failure to highlight whether the return is commensurate with the risk of underlying assets that ultimately results into biased and inappropriate decisions regarding rejection of economically profitable project or acceptance of unviable projects. For instance, a companys current ROCE is 20% and its overall cost of capital is 16%. It receives a new investment opportunity with an estimated ROCE of 18%, cost of capital remains the same (i.e., at 16%). To maximize ROCE one will reject the said opportunity. But actually, if accepted, it would have added two percent economic surplus to the shareholders wealth. In another case, the present ROCE of a company is 12% and cost of capital is 16%. It receives a new investment opportunity with an estimated ROCE of 14% with no change in cost of capital. Again, to maximize

ROCE the said opportunity will be accepted by the company. But this will destroy shareholders wealth as shareholders want to maximize the absolute return above the cost of capital and not to maximize percentages. On the contrary, EVA mechanism gives, due recognition to the cost of equity in all managerial decisions from board room to the shop floor and thus provides a comprehensive and reliable yardstick to measure the shareholders value creation (or destruction) by an individual business entity focusing towards maximization of absolute return above the cost of capital. (iii) The EVA financial management system eliminates all the inconsistencies among various parameters resulting from the use of different criteria/financial measures for different corporate functions under the typical traditional financial management system, by incorporating all business issues, for instance, reviewing a capital budgeting process, valuing an acquisition, considering strategic plan alternative, assessing performance, communicating or rewarding management into an integrated criteria of creating values. This would unite all employees in the pursuit of the single goal of creating value. Managers will certainly still have to consider margins, turnover ratios, unit costs and a host of other variables, but the anxiety is always in the context of their impact on EVA. EVA system, thus, covers the full range of managerial decision against a typical traditional system with inconsistent standards, goals and terminology. The focus on a single measure also simplifies decisions, communication channels get strengthened, decision making speeded up, team work bolstered, and parochial behavior declined, when everyone is putting on the same oar. (iv) Further, it links the management compensation to the shareholder value in a much refined manner, i.e., with EVA the bonus targets are set every year as a percentage gain in EVA and there is no cap on the maximum amount of bonus payment. A part of the bonus earned is banked and paid in later years. EVA results that are below target will shrink the banked bonus and vice-versa. Thus, EVA-based compensation system ties managements interest with those of shareholders and the value creation motion will permeate to the whole organization.

(v)

EVA captures the performance status of corporate system over a broader canvas i.e., to arrive at true profits, cost of borrowed capital as well as cost of equity should be deducted from net operating profits. Further to maximize earnings is not sufficient, at the same time consumption of capital should be minimum/optimum under an EVA based system.

(vi)

The utility of EVA simply does not end by indicating the degree of wealth creation. It goes beyond that, to pinpoint the lacunae in the business performance. A regular monitoring of EVA throws light on the problem areas of a company and thus helps managers to take corrective actions.

(vii)

It also fits well with the concepts of corporate governance and thus is considered to be the best corporate governance system. EVA bonus system does this by giving employees an ownership stake in improvements in the EVA of their divisions or operations. This causes employees to behave like owners and reduces or eliminates the need for outside interference in decision making.

(viii)

The issue of capital compels operating managers to use assets more diligently by focusing directly on the costs associated with inventories, receivables and capital equipment. It enables managers to routinely and automatically consider the cost of capital in every decision and accurately assess the tradeoff between operating costs and capital costs. Combining operating costs and capital costs in a single profit measure that is expressed in rupee rather than a rate of return gives EVA another unique quality. Hence managers could use EVA to guide their future resource allocation decisions and economic income of the firm.

(ix)

EVA is also an ideal technique for companies operating in new-age sectors. The typical knowledge industry is not capital intensive, and the companies operating in these industries are not faced with too many decisions involving huge amounts of capital. Moreover in such industries returns on the capital invested are immediate. As a result, EVA is almost a made-to-order performance metric for the knowledge industries.

OBJECTIVES OF THE STUDY Using EVA as a performance measure and a yardstick of wealth creation as it recognizes the riskiness of firms operations by giving due consideration to the cost of capital inclusive of both cost of debt and cost of equity along with the returns on capital so employed therein and also gives a better idea regarding the financial performance of a firm in terms of change in shareholder wealth, the study aims towards examining the relationship between shareholder wealth and certain financial variables like, EPS, RONW and ROCE. As the corporate objective at present has been to maximize shareholder value, establishing a relationship between financial variables and the corporate objective is important.

METHODOLODY Choice of Variables: Three independent variables are chosen to establish the relationship between shareholder wealth and certain financial variables. Economic Value Added (EVA), which is a measure of shareholder wealth, is considered as the dependent variable. The independent variables are: (i) Earnings Per Share (EPS): This is defined as Net profit available to equity shareholders {i.e. Earning Before Interest and Taxes (EBIT) minus interest minus tax liability minus preference shareholders dividend}/number of outstanding equity shares. (ii) Return On Capital Employed (ROCE): This is defined as Profit Before Interest and Taxes (PBIT)/capital employed x 100, where, capital employed is share capital plus reserves and surplus plus loan funds (both secured and unsecured loans). (iii) Return On Net Worth (RONW): This is defined as profit after tax (PAT)/Net Worth 100 where net worth is a sum total of share capital and reserves and surplus.

Sample Selection:

A sample of 50 companies is selected for analysis that are of

different assets sizes but having a uniform accounting year. Uniformity in accounting period is necessary to ensure comparability of data. Relevant data are collected from the compilations of CMIE pertaining to the financial years 1998-99, 1999-00, 2000-01, 200102 and 2002-03. EVA figures in the study have been computed whereas information to compute EPS, RONW and ROCE have also been taken from the published annual reports of sample companies. Data Conversion: To make the data comparable absolute EVA figures are converted into relative figures by applying the following formula: EVACE = (EVA/CE) x 100 Where, EVACE = Economic Value Added As a Percentage of Capital Employed, EVA = Economic Value Added, and CE = Capital Employed. Statistical Techniques Used: Correlation analysis, ratios and percentages are used in the present study to examine the relationship between EVA and other financial variables EPS, RONW and ROCE. Further to assess the superiority of EVA over these traditional measures the coefficient of determination (R2) has been used, that is, a ratio of explained variation in dependent variable to the total variation in it. So far as the application of correlation analysis is concerned. Karl Pearsons coefficient of correlation is used.

RESEARCH FINDINGS AND INTERPRETATION A Comparison of EVA with the traditional performance measure indicates that all the sample companies depict a rosy and positive picture in terms of EPS, RONW and ROCE for all the five years; only two out of fifty companies have positive EVA Aurobindo Pharma & Punjab Tractors. The other companies are having negative EVA & have destroyed shareholder value. Among the remaining 48 companies with negative EVA, the worst hit with highest negative. EVACE is Bombay Dyeing & Mg. Co. (-31.86 %) followed by Voltas (-24.07 %), Eveready Industries (-21.01 %), Hindustan Motors (-18.72 %), Eicher (-18.04 %) & Mangalore Refinery & Petrochemicals (-17.05 %). Further Infosys has an EPS of 144.6 (FY 1998) highest among the sample companies while its EVA is negative (-19.53). Similar is the case with Hindalco with an EPS of 62.43 & an EVA of -85.63. In the case of L&T, while its ROCE is 12.32% (FY 2000), its EVACE is -10.36%. The ROCE of Raymond is 11.52% (FY 2000), while its EVACE is -10.41%. Similar observations have been made for the financial years 2001 and 2002, hereby putting a question mark on the sole reliance on the traditional performance measures ROCE, RONW & EPS etc. to get real picture of the financial performance of the corporate world. The correlation results for the FYs 1998-99, 1999-00, 2000-01, 2001-02 and 2002-03 are presented in Table 1. Table 1: Correlation results between EVA and selected variables EVA & EPS r R2 0.11 0.01 0.37 0.14 0.38 0.14 0.21 0.04 0.34 0.12 EVA & RONW r R2 0.58 0.34 0.77 0.59 0.78 0.61 0.77 0.59 0.10 0.01 EVA & ROCE r R2 0.64 0.41 0.82 0.67 0.83 0.69 0.76 0.58 0.73 0.53

Year 1998-1999 1999-2000 2000-2001 2001-2002 2002-2003

The results show that the relationship is positive and low with EPS and highly positive with RONW and ROCE. The coefficient of determination (R2) indicates that EPS

explains the total variation in shareholder wealth only up to the extent of 14%; RONW up to the extent of 61% and ROCE up to the extent of 69%. This proves that as compared with traditional performance measures, EVA is the real key to create shareholders wealth and the true indicator of the financial performance of a company. The empirical results indicate that not even a single traditional performance measure can be relied upon and used to measure the variation in shareholder value in totality. Based on the findings of the study it can be thereby concluded that traditional performance measures do not reflect the real wealth of shareholders. Hence it should be measured through EVA.

CONCLUSION It can be concluded with the research findings and analysis in the study that the selected independent variables and EVA the dependent variable, are correlated and cant be treated as water-tight compartments. There exists positive and high correlation between EVA and the two financial variables RONW, ROCE and a positive but low correlation between EVA and EPS. Comparing EVA with traditional performance measures it has been found that not even a single traditional performance metric explains to the fullest extent variation in shareholder wealth. Another finding of this study is that Return On Capital Employed (ROCE) must be greater than the Cost Of Capital Employed (COCE) to have a positive EVA and it is this spread i.e., a difference between the percent ROCE and COCE that has a direct impact on shareholder wealth. Larger the spread, greater will be the value addition to shareholders wealth and vice-versa.