ECONOMIC VALUE-ADDED NOPAT AND ADJUSTMENTS

Presented

By:

Jyoti Shukla-49 Ganesh Sonawane-50

Milind Sonkamble-51 Rashmi Tupe-52 Kavita Upadhyay-53 Veena Vanga-54

Performance pays, but how do we measure the performance of a business entity? The first and foremost measure of performance that comes to ones mind is profit- the accounting measure of performance. Someone has aptly said- profit is an opinion, not the fact. If this were not case , one would not have seen the debacle of big companies like Enron, World Com etc. All such companies managed their earnings well and have shown better performance in terms of PAT & EPS.

Journey of Performance Measures

1920s
1970s
1980s
:

Dupont Model - ROI

:
:

Earning Per Share

Market to Book Value Ratios, Return on Equity,Return on Assets, Cash Flow,Quality Management.
Cont..

Financial & Non-Financial Performance Measures 1990s : Economic Value Added, Market value Added,CFROI, Total Shareholders Return, Balance Score Card, Customer Satisfaction 2000s : EVA (Stern stewart) BSC (Robert S Kaplan &Norton) Intellectual Capital Index (Ross) Skandia Navigator (Edvinsson) Intellectual Asset Monitor (Karl-Eric Svebiey)

Return On Investment (ROI) (From 1920 to 1970)

The DuPont Powder company formed in 1903. To guide their investment decisions, the chief financial officer Donaldson Brown developed ROI in 1920. ROI = Operating profit / Sales* Sales /Capital Employed . OR Operating Profit/ Capital Employed. OR Profit Margin Ratio*Asset Turnover

EVA vs. ROI 1. Technical Shortcoming

Santro

Maruti Suzuki

Ke
ROI

10%
15%

10%
8%

2.The Danger of ROI Control

Quarter
Q1 Q2 Q3

ROI
12.6% 13.4% 15.4%

Profit Margin
17.6% 20.2% 22.7%

Assets Turnover
0.736 0.664 0.679

EVA vs. Traditional Measures

Traditional measures ignore the definite requirement that the rate of return should be at least as high as the cost of capital. Conceptually EVA is superior to accounting profit as a measure of value creation because it recognizes the cost of capital and hence, the risk ness of a firms operations.

Economic Value Added (Residual Income)

The limitation and dysfunctional action associated with using a ratio to evaluate the performance of a manager or division have been known and discussed for decades. Business, such as general electric in the 1950s,and academics have shown how to overcome these limitations by using an alternative performance measure, originally called residual income.

How to calculate EVA ?

EVA= NOPAT CAPITAL EMPLOYED * WACC (KO)

NOPAT

Net Operating Profit after tax before exceptional items and interest i.e. NOPAT =(Profit after Tax + Non-Recurring Expenses + Revenue Expenditure on R&D + Interest Expenses + Provision for Taxes) (Non Recurring Income + R&D Amortization + cash operating Taxes) Cash operating Taxes (Provision for Taxes + Tax benefit of non recurring expenses + Tax benefit of interest expenses - Tax on non-recurring Income)

Technical Adjustments to EVA

According to Stern Stewart adjustment should be based on the
following criteria:

Materiality: Adjustment should make a material difference in EVA Manageability: Adjustment should impact future decision Definitiveness: Adjustment should be definitive & objectively determined

In Quest for Value, Bennett describes the ollowing equity equivalent adjustments:

Deferred Taxes LIFO Reserve Amortization of Goodwill Capitalized Intangibles Other Reserves and Allowances

What Does EVA Show?

+Ve Zero
The Company has Managed to create Shareholder Value This should be treated as the Shareholders have earned a return that compensates the risk

-VeThe Company has destroyed the Shareholder Value.

Usage of EVA
EVA
Bonus to employee Extra remuneration to management Incentive dividend to preference shareholders Bonus shares to equity shareholders Setting organization goal Performance measurement Motivation of manager Corporate valuation Communication with shareholder & Investor

EVA Practices in Indian Corporate Sector

In India companies like NIIT, Goderej group and TCS have implemented EVA as a performance measurement and evaluation system linked with incentives. EVA implementation helped Godrej group in segregating the entire business into several units to see which of them are creating EVA or not. As a result of this exercise, Goderej demerged the consumer products division and turned around low- EVA activities like chemicals. A number of companies like Infosys, Satyam, Dr. Reddys laboratories, Hindustan lever report EVA as an additional information in their annual reports.

CRITICISM

EVA is based on past accounting performance derived from financial statements. Accounting based measures like EVA may not be able to measure value creation. Overemphasis on EVA may leads to its manipulation.

 EVA can be biased against low return stat-up investments and can favour business with heavily depreciated assets as a result of the adjustments made to compute EVA. EVA approach can penalize companies that invest in assets with long term returns.
EVA overemphasized the need to generate immediate results,therefore it creates a disincentive for the managers to invest in innovative product or process technologies.