A Report on fundamentals Of Economic value added

PREPARED BY: KISHAN .R. TANK ROLL NO:10F17

SUBMOTTED TO: Dr.P.K.PRIYAN

G.H.PATEL INSTITUTE OF BUSINESS MANAGEMENT S.P.UNIVERSITY V V NAGAR.

PREFACE
Knowledge is not power but the applied knowledge is power As the above line suggests the importance of application of knowledge, this report contains the pragmatic approach of financial concepts. The practical approach is much more important to have an exposure of concepts which have been learning in the class room teaching. This report contains the fundamentals aspects of ECONOMIC VALUE ADDED concept

ACKNOWLEDGEMENT
I would like to pay my thanks to all who helped me while doing this project work. Without the support of colleague and guide this project would have not been prepared. I would like to pay my special thanks to Dr.P.K.Priyan who helped me in clearing the concepts of financial management. I would also pay my thanks to my friends who helped me in preparing this report.

TABLE OF CONTENT

Sr. no. 1

Particulars Background of the study

1.1 1.2 1.3 Introduction Objective of the study Review of literature

Page no. 5

Concepts of EVA
2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 Introduction to the topic What do we mean by EVA? Calculating EVA Three pillars for calculating EVA Accounting adjustments for EVA Economic value added model The uses of EVA The strength and limitations of EVA The EVA v/s other performance measures EVA- how does it create value? The concept of MVA

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3 4

Conclusion Bibliography

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Chapter 1 Background Of Study

INTRODUCTION

The basic objective of any company is to earn profit as well as creating the value for its shareholders. Creating the value for the share holders implies the objective of the company that is wealth maximization. And for wealth maximization the company has to maintain the profitability and growth. And for maintaining and sustaining the profitability, a company must have a better performance measurement. There are some traditional as well as modern performance measurement tools available, we can list down the financial measures as follow: ROI i.e. return on investment ROCE i.e. return on capital employed Ratio analysis Putting the all above measures, we have one more i.e. DU PONT analysis

But all above all performance measures were not considering the opportunity cost i.e. cost of capital. Thus the issue of exclusion of opportunity cost gave the birth to the new concept called EVA i.e. economic value added. This report contains the fundamentals of EVA concept

OBJECTIVE OF STUDY

The basic objective of the study is to know the fundamental aspects of EVA i.e. Economic Value Added. The study also aims at knowing analyzing the practicability of EVA. This report also includes the methodology of calculating the EVA This study also aims at knowing the Pros and cons of using EVA This study includes the comparison of EVA with other performance measures.

Methodology: This report contains the secondary data and information analysis

REVIEW OF LITERATURE

The review of literature contains the information regarding past studies and research papers presented by different legend professors in different university.
1) Economic Value-Added: A Review of the -Theoretical and Empirical

Literature by Andrew C. Worthington1 School of Economics and Finance Queensland University of Technology, Australia Abstract: With increasing pressure on firms to deliver shareholder value, there has been renewed emphasis on devising measures of corporate financial performance and incentive compensation plans that encourage managers to increase shareholder wealth. One professedly recent innovation in the field of internal and external performance measurement is a trade-marked variant of residual income known as economic value-added (EVA). This paper attempts to provide a synoptic survey of EVAs conceptual underpinnings and the comparatively few empirical analyses of value-added performance measures. Special attention is given to the GAAPrelated accounting adjustments involved in EVA-type calculations.

2) Economic Value Added - A General Perspective

--by Asish K Bhattacharyya & B.V.Phani , Abstract: This paper explains the concept of Economic Value Added (EVA) that is gaining popularity in India. The paper examines whether EVA is a superior performance measure both for corporate reporting and for internal governance. It relied on empirical studies in U.S.A. and other advance economies. It concluded that though EVA does not provide additional information to investors, it can be adapted as a corporate philosophy for motivating and educating employees to differentiate between value creating and value destructing activities. This would lead to direct all efforts in creating shareholder value. The paper brings to attention the dangerous trend of reporting EVA casually that might mislead investors.

3) The ability of EVA (Economic Value Added) attributes in predicting company performance by Issham Ismail School of Distance Education, Universiti Sains Malaysia, Minden 11800, Penang, Malaysia. Published in African Journal of Business Management Vol. 5(12), pp. 4993-5000, 18 June, 2011

Abstracts: In this study the major question is, can positive EVA (economic value added) outperform negative EVA in predicting company performance and either the period of study may play a vital role in explaining the variation of the stock return. The study found that neither value creator nor value destroyer had a relationship with stock return, as both models prove to be statistically insignificant. This finding is contrary to findings by Turvey et al. (2000). The value creators had a better relationship with earnings than value destroyers and this study indicates that, value creators have better earnings multiplier than value destroyers. It also indicates that, EVA had a better relationship with stock return over a longer period of the study.

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4) Economic Value Added as a Management Tool Masters thesis, Submitted to Helsinki school of economics and business administration, Department of accounting & finance.

Objective of the study: This study aimed at clarifying the concepts of EVA from the view point of controlling the business units performance. Firstly the study describes the meaning and nature of EVA. It also describes the framework for using the EVA as a performance measures.

It includes three main chapters namely: 1) The theory behind economic value added. 2) A review of EVA as a performance measure and its role in creation of corporate wealth. 3) EVA as a performance measure in the corporate world.

Conclusions: An author comes to conclusion that in spite of having shortcomings, EVA is a simple tool to measure the performance. Though it is a simple measure, it measure the ultimate aim of any company, the increase or decrease in shareholders wealth. Simply speaking, the thought like companys profit must cover the capital cost, it is neither new nor popular but still it is eye opening.

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Chapter 2 The concept Of Economic value added

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INTRODUCTION
EVA i.e. economic value added is a registered trade mark by Stern Stewart & Co. of New York City (USA). Bennett Stewart in his book, The Quest for Value, used the term EVA with a symbol Thus EVA is actually Stern Stewart & Co.s trademark for a specific method of calculating economic profit. The Quest for Value was published in 1991. Peter Drucker claimed that he discussed EVA in 1964 in his book, Managing for Results. It cannot be denied; however, without going into argument as to who invented EVA first that the concept became popular only after Stern Stewart & Co. marketed it. Just earning profit is not enough, a business should earn sufficient profit to cover its cost of capital and create surplus to grow. Stated simply, any profit earned over and above the cost of capital is Economic Value Added. The traditionally used profit indicators are ineffective parameters in explaining whether the reported profit covers the cost of capital. Old profit concept fails to indicate clear surplus. The basic proposition is that the Return on Capital Employed should be greater than the Cost of Capital (i.e. ROCE > K0).

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WHAT DO WE MEAN BY EVA? Simply speaking, EVA means the surplus of net profit over capital charges or cost of capital.

Definition: EVA is an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return for shareholders or lenders at comparable risk.

Traditionally, Profit after Tax is shown in the Profit & Loss Account to indicate the profit available to the shareholders, both preference and equity. Ability to maintain dividend is not a test of profit adequacy. Ability to generate Economic Value Added is the only test of profit adequacy. Any surplus generated from operating activities over and above the cost of capital is termed as EVA.

It is a new measure of corporate surplus that should be shared by the employees, management and shareholders. EVA focuses on clear surplus in contradiction to the traditionally used profit available to the shareholders. It is used by companies as a performance indicator and also as a basis for executive compensation. Surplus should be derived by deducting cost of capital from profit before interest but after tax. Formula for calculating EVA: = NOPAT WACC X Capital Employed.

Where, NOPAT means Net Operating Profit before Interest and after Tax. WACC represents Weighted Average Cost of Capital.

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Capital Employed = Net Block + Trading Investment + Net Current Assets.

It is free from subjective assumption that needs to be adopted while identifying profit and cost of capital. Cost of equity is derived on the basis of Capital Assets Pricing Model (CAPM).

The founders of EVA traditionally use CAPM. Under CAPM Cost of

Equity (Ke) is given by the following Ke = Rf + ( Rm Rf) Where, Rf = Risk free return. Rm = Market expected Rate of Return = Risk Co-efficient.

Both market return and Beta are highly volatile, and if annual market return and yearly beta of a company are chosen for finding cost of equity, abnormally high or low market related cost of equity may be obtained. To avoid this difficulty, one may apply Long run approach. While deriving EVA it becomes necessary to make certain accounting adjustments, which are required only for corporate reporting purposes. It is sometimes alleged that EVA talks too much about the shareholders value added rather than focusing on the interest of all stakeholders. But EVA is a powerful performance measurement tool and it is argued that if a company is able to serve its shareholders then it can better serve all other stakeholders also.
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CALCULATING EVA

Net Sales - Operating Expenses --------------------------------------------------------Operating Profit (EBIT)

- Taxes --------------------------------------------------------Net Operating Profit after Tax (NOPAT)

- Capital Charges (Invested Capital x Cost of Capital) --------------------------------------------------------Economic Value Added (EVA

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If we calculate by using formula then EVA = NOPAT COC Or

where:

, is the Return on Invested Capital (ROIC);

is the weighted average cost of capital (WACC); is the economic capital employed; NOPAT is the net operating profit after tax, with adjustments and translations, generally for the amortization of goodwill, the capitalization of brand advertising and others non-cash items.

Or

EVA Calculation: EVA = net operating profit after taxes a capital charge [the residual income method] Therefore EVA = NOPAT (c capital), or alternatively EVA = (r x capital) (c capital) so that EVA = (r-c) capital [the spread method, or excess return method]

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THREE PILLARS FOR CALCULATING ECONOMIC VALUE ADDED

1) Adjusted net profit after tax 2) Weighted average cost of capital 3) Capital employed

1) NOPAT:

NOPAT is profits derived from a companys operations after cash taxes but before financing costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm. But here we are concerned with the adjusted net profit. Except adjusting the net profit by adding noncash items like depreciation and amortization, there are some other accounting adjustments that we have to consider at the time of calculating Economic Value Added of the company. We will be covering these adjustments later on in this report. 2) Weighted average cost of capital

Weighted average cost of capital or WACC or COC is a minimum rate of return required to justify the use of fund invested for carrying on the business or scale of operation. The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost.

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3) Capital employed Capital employed can be calculated by total of fixed assets plus net of current assets minus current liabilities. Capital employed 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 non-interest-bearing current liabilities (NIBCLs).

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ACCOUNTING ADJUSTMENTS IN EVA

Although EVA is a measure of accounting profitability, it is not bound by the accounting conventions. For improving the precision of EVA, we can make some adjustments. The logic behind such adjustments is that certain expenses which are to be capitalized are charged to income statement which lowers the income or we can say that the operating income is misstated. At the same time the investment base in the balance sheet will also be reduced. Such items are deferred tax, goodwill, expense related to R&D etc which are to be adjusted. 1) Research and Development expenses: Most of the companies consider the R&D expense as cost. But unless it is capitalized we can get a clear picture of capital invested. By doing so, the managers will be sowing higher ROI then the actual. So for adjusting the amount of R&D, we have to add back this amount to operating profit; we have to add this figure to owners equity. And we have to write off or amortize the amount equals to total amount divided by no. of future years of benefits. 2) Differed tax: This situation arises due to timing difference between taxable income and book income recognized under GAAP. The biggest source of differed tax is depreciation on fix assets. However any temporary deference between book income and taxable income will give rise to the differed tax. Normally this situation results in to more book income than the taxable income hence
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differed liability. The situation of differed tax asset can also arise when companies make provision for future cost which reduces the current book income that are not tax deductible until the company actually spend the cash amount in a latter accounting years. The adjustment is done by adding or subtracting the change in differed tax to NOPAT that year.

3) LIFO reserves: In some countries, the companies can use the LIFO method for inventory costing. LIFO offers a considerable tax advantage in the situation of rising prices. It also generates the cost of sales which is equivalent to replacement cost of inventory in the rising prices, resulting in better matching of revenues and expenses. LIFO has a serious drawback. When inventory increases in any year, the LIFO layer of old product cost is created. Old LIFO layer creates to problems for EVA. First, inventory is under stated which understates the net assets and capital invested. Secondly, when old inventory is liquidated, which happens when inventory decrease during the year, both EVA and operating income during the year are over stated. This over valuation accurse due to matching of low cost against current level of revenue or sales price. For overcoming this problem, companies using LIFO report LIFO reserve in the notes to their financial statements which reports the difference between carrying value of inventory and its cost. The amount of the reserve is added to invested capital and the year on year increase(decrease) in the LIFO reserve is added back to (subtracted from) NOPAT.
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4) Goodwill: Goodwill arises when a company acquires another company at more price than the faire market value of all identifiable assets net of liabilities. The write off of goodwill weather at the time of acquisition or gradually in subsequent years may differ from country to country. But as far as EVA is concerned both the approaches are wrong because the write off or amortization of goodwill reduces the value of assets and capital invested which shows the rosy picture of ROI. So as to avoid these practices, we have to add back the written off goodwill. Any amortization is added back to capital and NOPAT. If the goodwill is tax deductible then the adjustment is made on an after tax basis. In addition all prior cumulative amortizations must be added back to capital. If the goodwill was written off at the time of acquisition of the company, that goodwill too must be added to capital.

5) Operating lease: Leasing is the most common form of financing machines, building and other long term fixed assets. Although the lease is considered to be the form of secured lending, companies are often able to structure their lease contract in such a way as to keep the debt off the balance sheet. Such contracts are known as operating lease. As far as accounting is concerned such lease payments are considered as rent payment. And the asset acquired through lease is not capitalized. This accounting treatment not only understates the capital invested but also NOPAT, because a portion of lease payment also includes the implied interest cost of lease. So EVA analysts consider this noncancelable operating leases to be Debt equivalents.

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The adjustment is made by adding present value of future lease payments discounted at companies cost of debt for invested capital. The adjustment for interest expense is calculated by multiplying the capitalized value of lease by borrowing rate. This amount is added to NOPAT net of tax shield on interest. There are more than 150 such adjustments specified by EVA analysts. But the most of the companies make adjustments fewer than 5 so as to keep the system less complicated or easy.

The adjustments are to be made only if The amounts are significant The managers can influence the outcomes of the item being adjusted. The required information is readily available. Non financial professionals can also understand the adjustments.

Snap shot of adjustments that are required to be made for calculating the EVA

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ECONOMIC VALUE ADDED MODEL

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THE USES OF ECONOMIC VALUE ADDED Basically EVA i.e. economic value added is performance measure. But it has a lot of practicable implications.
EVA can be used for the following purposes:

1. setting organizational goals: 2. performance measurement 3. determining bonuses 4. communication with shareholders and investors 5. motivation of managers 6. capital budgeting 7. corporate valuation 8. analyzing equity securities

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STRENGTH AND LIMITATIONS OF EVA To understand the strength of EVA, we have to see the limitations of conventional measure that is ROI.

The primary limitation of ROI is that it can encourage managers, who are evaluated and rewarded based solely on this measure, to make investment divisions that are in their own best interests, while not being in the best interests of the company as a whole. So the manager of a particular division will be least bothered about the companys performance so the problem of goal congruence will arise. EVA helps overcome the goal incongruence that exists between the manager and the firm in this situation. Using EVA instead of ROI to reward the printing division manager would motivate her to accept any investment alternatives that generate a return greater than the company's 10% cost of capital

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LIMITATIONS OF EVA Despite EVA's advantage over ROI, this measure has four limitations that are presented under the following headings: 1. Size differences 2. Financial orientation 3. Short-term orientation
4. Results-orientation

1) Size Differences: EVA does not control for size differences across plants or divisions. A larger plant or division will tend to have a higher EVA relative to its smaller counterparts. While EVA is more effective than ROI at aligning plant managers' goals with corporate goals, it does not control for size differences across organizational units like ROI does.
2) Financial Orientation:

EVA is a computed number that relies on financial accounting methods of revenue realization and expense recognition. If motivated to do so, managers can manipulate these numbers by altering their decision making processes. Two examples will help illustrate this point. First, managers can manipulate the revenue recognized during an accounting period by choosing which customer orders to fill and which to delay. Highly profitable orders may be expedited at the end of the accounting period and shipped to the customers a few weeks before the agreed-upon delivery date, while less
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profitable orders may be delay and shipped after the end of the accounting period and after the agreed-upon delivery date. The end result of this scenario is a boost to current period EVA and an adverse blow to customer satisfaction and retention Second, managers may decide not to replace completely depreciated assets. Keeping the outdated equipment on the accountant's books lowers the asset base and ensures that no depreciation expense charges are recognized, thereby increasing EVA; however, product quality and customer satisfaction may suffer if outdated manufacturing equipment continues to be used. Each of these examples reflects a choice on the part of managers for personal gain over corporate welfare 3) Short-Term Orientation: EVA overemphasizes the need to generate immediate results; therefore, it creates a disincentive for managers to invest in innovative product or process technologies. After all, every investment in innovation has the same economic profile. The costs or expenses associated with the project are recognized, at least in part, by the accountants immediately. The benefits or revenues associated with the initiatives are not recognized by the accountants until a few years down the road. The net effect for managers investing in innovation is a lower EVA in the current period. So its a short term orientation. The project which can create the benefit for long time can be neglected by the EVA.

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4) Results Orientation: The accountants' reports state the obvious - that performance was less than expected - but they do not help offer solutions to the nonaccounting business managers who are responsible for continuously improving the value delivered to customers. Like its predecessor financial metrics, EVA is guilty of this charge

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EVA V/S Other Performance measures.

The following table shows the comparison between Economic value added and other matrices for performance measurement.

EVA can be a performance measurement of ongoing business results, and can also be utilized in a project justification of future investment projects. A project EVA can be incremental (net profit impact minus the cost of capital impact), or absolute (resultant P & L and Balance Sheet).

In above mentioned comparison chart we can clearly make an inference that other performance measures do not consider the opportunity cost i.e. cost of capital.
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BALANCED SCORECARD VS. ECONOMIC VALUE ADDED

The balanced scorecard is a preferred method because it can be used in conjunction with other performance systems. The balanced scorecard (BSC) is a system that coordinates and operates with goals and objectives of the company. A main objective of this system is to direct the organization on the right path in order to reach the company's goals. BSC includes the objective of adding value to the company's goals. BSC first came about after studies of multiple methods was evaluated regarding performance efficiency. The BSC method is based on several factors: One, cause and effect; two, relation of indicators which the company can measure within certain periods and also indicate which of these can be evaluated right away; and three, subordination of indicators regarding financial results. BSC has the capability to target all actions at implementing strategic goals and objectives. BSC encourages staff to contribute to the changes of objectives through communication and motivation. BSC also has the ability to link budgets and strategies with the assistance of analysis; this is to make the flow continuous. BSC also helps to create motivation for staff of all education and experience levels. While EVA is a measure to create value addition. It indicates the companys capacity to earn more than the cost of fund invested. BSC is non financial measure to coordinate and operate the goal while the EVA is a financial measure to improve the financial performance as well as for creating the value to the shareholders. But BSC and EVA are more complimentary to each other than contradictory to each other.
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EVA- HOW DOES IT CREATE VALUE?

The ultimate aim of the concepts like Economic Value added is to create value for the company as well as share holders. We can examine the contribution made by EVA in value creation by studying the following propositions which represents the relationship between various factors.

1) The relationship between positive and negative EVA with stock return Positive EVA means the company is experiencing an excess of dollar amount of net operating profit after tax (NOPAT) after deducting the dollar charge for capital (both debt and equity) which is obtained by multiplying the percentage of weighted average cost of capital (WACC). It means the company had excess real profit that the company gained after deducting cost of investment by investors from net profit. It is the norm nowadays for companies to only declare profit that, while not taking into account of the cost of capital or investment. In contrast, in case of negative EVA i.e. NOPAT is not enough to cover cost of capital. The company is running in losses after deducting cost of capital. This companies are known as value destroyers where as formers are known as value creator. This is clearly reflected in the concept of MVA i.e. market value added discussed in this report latter on. As far as the stock prices are concerned, the bigger expected EVA the company has, the bigger is the market value of the company and the stock price Especially profitable growth (growth in EVA) gears up stock prices. Therefore companies like Intel, Microsoft and Nokia trade many times above their book values. Stock prices reflect the future EVA expectations. Those expectations are very uncertain and continuously changing and thus also stock prices are volatile
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2) The relationship between positive and negative EVA with accounting performance. Companies that have positive EVA value or value creator companies have a strong accounting returns and better market positions. In addition, they might also have higher profits and good accounting indicators, since a positive EVA is indicative that companies have high excess profit after deducting cost of investments. This again will be indicating that, the company is well organized in reaping higher returns exceeding investors expectations. Returns on investment made by this type of company will also be higher than returns expected by the investors.

Simply speaking, EVA builds the team spirit by removing goal incongruence and we can improve financial as well as overall performance of an organization.

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THE CONCEPT OF MVA I.E. MARKET VALUE ADDED.

EVA is aimed to create value for share holders. This is the basic assumption. Because returned earned greater than cost of capital creates the wealth for the share holders and vice versa. For listed company stewart defined another measures to check whether the company has created value for share holders or not. This concept is known as MVA i.e. Market value added. If the total market value of the firm is more than the capital invested then it is known as MVA. Market value added = companys total market value capital invested As the market value and book value of debt are same, we can be more specific. Market value added = market value of equity book value of equity. The equity also includes the equity equivalents like reserves and surplus.

Market value added is identical by meaning with market to book value ratio. The only difference is market value to book value ratio is a relative measure while MVA is an absolute measure.

MVA, what does it indicate? According to stewart , market value added tells us how much value the company has added or subtracted from the share holders investment. Successful companies earns more return than the cost of capital so they sells the share in market at premium over and above the book value of shares it means the company has added the value to the wealth of share holders, the real owners of the company. Whether the company has created MVA or not depends on the level of rate of return as

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compared cost of capital. All these factors apply to the EVA. Thus positive EVA means positive MVA and vice versa.

Thus, Marketing Value Added = Present Value of all future EVAs.

Thus, M.V. of Equity = Book value of Equity + Present value of all future EVAs.

The following chart will better indicate the relation between EVA and MVA.

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Chapter 3 Conclusion

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CONCLUSIONS

EVA .i.e. Economic Value Added, a concept developed by stewart is a type of financial performance measurement. This study contains each and every aspects of the concept called EVA. After studying each aspects of EVA, we can conclude some of the points as follow.

The economic value added method is an estimate of profits which is calculated by using the net operation profit after taxation, minus the capital value. The economic value added (EVA) is generally used to measure the efficiency in which the organization uses resources. EVA shows the difference between investments returns and the cost of resources.

EVA is a financial management system that offers a firm basis for decision making, as well as the capability to make, monitor, and measure decisions, while adding value to investments. The main objective of EVA is to add value to the company. EVA became a tool of return on investments and return on capital employed. The main objectives of EVA are: one, business owners invest capital to get profits; two, the company is wanting to get additional profits; and three, the company personnel aims at increasing shareholders value through motivation .
EVA indicator has the capability to balance interests of managers and shareholders. EVA indicator can lead to changes in the corporate culture.

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Chapter 4 Bibliography

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BIBLIOGRAPHY & REFERENCES.

Book: Management Control System, By Robert Anthony & Vijay Govindarajan, Twelfth edition, Tata McGraw Hill Education Private Ltd.

Websites: www.investopedia.com www.evanomix.com www.joinfreearticles.com www.valuebasedmanagement.net

References: 1) Eva based performance measurement: a case study of Dabur India limited,
Debdas Rakshit, Faculty Member, Department of Commerce, The University of Burdwan, Burdwan 713104. Published in Vidyasagar University Journal of Commerce Vol.11, March 2006.

2) Worthington, Andrew and West, Tracey (2001) Economic Value-Added: A Review of the Theoretical and Empirical Literature. Asian Review of Accounting 9(1):pp. 67-86. 3) Economic Value Added - A General Perspective Asish K Bhattacharyya & B.V.Phani 4) Economic Value Added, a note prepared by S David Young, Professor at INSEAD. Copy right 1998 INSEAD, Fountainebleau, France. Distributed by European case clearing house in USA and UAE.

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