A

FINAL PROJECT REPORT

ON

“EVA AS A FINANCIAL PERFORMANCE

MEASUREMENT TOOL IN CASE OF SMALL

MEDIUM SCALE ENTERPRISES”

In partial fulfillment of the requirement for the degree

Of

Master of Business Administration

Specialization- Finance

Submitted By:

Gourav Sharma

94512236916

Submitted To:

Dr. Navjot Kaur

(2009-2011)

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ACKNOWLEDGEMENT

I am extremely thankful to Dr. NAVJOT KAUR, Faculty Guide,

GIAN JYOTI INSTITUTE OF MANAGEMENT AND TECHNOLOGY,

for her timely guidance and support throughout the Final Report work. In the

course of carrying out the Project work she help me out to understand the

various terms and working of economic value added as performance

measurement tool for small & medium scale enterprises.

Finally I am indebted to our other faculty members, my friends who

gave their full-fledged co-operation for successful completion of my project.

It was an indeed a learning experience for me.

Name of the Student: Gourav Sharma

Enrollment No.: 94512236916

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Introduction

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1.1 Introduction

EVA is a value based financial performance measure, an investment decision tool and a

performance measure reflecting the absolute amount of shareholder value created. It is

computed as the product of the “excess return” made on an investment or investments

and the capital invested in that investment or investments. EVA is the net operating

profit minus an appropriate charge for the opportunity cost of all capital invested in an

enterprise or project. It is an estimate of true economic profit, or the amount by which

earnings exceed or fall short of the required minimum rate of return investors could

get by investing in other securities of comparable risk (Stewart, 1990).

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

operating profit with a capital charge subtracted. Thus, EVA is a variant of residual

income, with adjustments to how one calculates income and capital. Stern Stewart

& Co, a consulting firm based in New York, introduced the concept of EVA as a

measurement tool in 1989, and trademarked it. The EVA concept is often called

Economic Profit (EP) to avoid problems caused by the trade marking. EVA is so popular

and well known that all residual income concepts are often called EVA even though they

do not include the main elements defined by Stern Stewart & Co (Pinto, 2001). 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 focus on building, operating and harvesting new

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businesses and/or products that will provide a greater return than the firm’s cost of

capital, thus ensuring maximization of shareholder value. EVA is a strategy

formulation and a financial performance management tool that helps companies make a

return greater than the firm’s cost of capital. Firms adopt this concept to track their

financial position and to guide management decisions regarding resource allocation,

capital budgeting and acquisition analysis.

Economic Value Added simply balances a company's profitability against the capital it

employs to generate this profitability. If a company's earnings, after tax, exceed the cost

of the capital employed in the business, EVA is positive. Market studies have indicated

that a company that continually generates an increasingly positive EVA will be rewarded

by a higher stock price. A definition of EVA is net operating profit after taxes (NOPAT),

less an internal charge for the capital employed in the business (i.e., opportunity cost of

capital).

Many of the traditional corporate performance measures have been found to poorly

correlate, or even conflict, with management's primary objective of maximizing the

market value of a firm's stock. Now, there are several new measures in the financial

world that attempt to align the behaviors of an organization with its stockholders'

interests. One measure that has received a great deal of notice and acceptance is

Economic Value Added (EVA), developed by Joel M. Stern and G. Bennett Stewart III of

Stern Stewart & Co.

Implementation of one of these measures, such as EVA, can fundamentally change the

behavior of an entire organization. The new measure focuses the behavior of individuals

throughout all parts of the organization in a way that is better aligned with creating

stockholder wealth. Because performance compensation incentives are based upon the

new measure, employees and stockholders mutually benefit.

The financial function is uniquely qualified to take a leadership role in communicating an

understanding of the new measure. Main challenge is to gain a deep understanding of the

underlying principles of the measure and to communicate them in a meaningful way to all

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parts of the organization. There can be pitfalls in translating the theory to practice, but

there is an opportunity to provide the appropriate counsel.

Economic Value Added (EVA) has become all the rage in the investing world. Stern

Stewart has gone so far as to trademark the concept, though many academics challenge it

as a knock-off of residual income. Stern Stewart has, however, been very successful

touting the measure as the best measure of business performance and management

discipline. Fortune Magazine annually publishes a list of top companies complete with

and EVA numbers and rankings, crediting the measures for the creation (or destruction)

of shareholder wealth. The Journal of Applied Corporate Finance annually publishes the

EVA for the Stern Stewart Performance 1000, citing EVA as "the critical driver of a

company's stock performance". Successful corporations are increasingly turning to EVA

to measure performance. General Electric, AT&T, Chrysler, and Compaq use EVA for

financial analysis. Coca Cola's late CEO, Roberto Goizueta, acknowledged the value of

EVA and declared "You only get richer if you invest money at a higher rate than the cost

of the money to you" (Fisher, 1995). In turn, investors and analysts are now scrutinizing

company EVA just as they have historically observed EPS and PE ratios. Academic

articles relating EVA success stories and promoting adoption of the measure abound

(Blair, 1996; Byrne, 1994; Carr, 1996; Copeland and Meenan, 1994; Gressle, 1996; Tully

1993; Stern 1990; Rice, 1996; Pallerito, 1997; Martin, 1996).

As described by Stern Stewart, EVA is net operating profit minus an appropriate charge

for the opportunity cost of all capital invested in an enterprise. In effect, it estimates the

economic profit (or loss) of a company's operations. Traditional accounting measures

such as EPS and ROA measure economic performance, but ignore the cost of the capital.

Including the cost of capital, as EVA does, reveals whether any economic value was

created. This forces management to focus on managing the company's assets as well as

creating income.

How does EVA promote shareholder interests? First, it clearly specifies to management

that the primary financial objective of the company is to create shareholder wealth.

Secondly, it emphasizes continuous improvement in the company's EVA as the basis for

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increased shareholder wealth. Assuming the efficient market hypothesis holds, stock

price reflects the company's current performance; therefore, the level of EVA isn't

important, but changes in that level are. Management focus on these two issues can result

in dramatically increasing EVA.

Rising EVA has been purported to cause stock price to rise, therefore satisfying

shareholder interests. Does a relationship between EVA and stock return really exist?

James Meenan, CFO of AT&T's long distance business believes that it does. According

to Meenan, his company's EVA and stock price have had an almost perfect correlation

since 1984 (Fortune, 1993). Detractors are not as enthusiastic. Corporate strategy expert

Gary Hamel argues that while EVA is a good place to start, it is not an adequate way to

measure a company's wealth creation (Hamel and Lieber 1993). In 1995, Daniel Saint of

Chrysler stated, "as a single period measure of financial performance, I believe EVA's

contribution is minimal and not much different from return on equity or other traditional

accounting measures" (Kramer and Pushner, 1997). In truth, empirical evidence

supporting the relationship between EVA and stock return is sketchy at best.

1.2 What is Performance Measurement (PM)?

Investors measure overall performance of a firm as a whole to decide whether to invest in

the firm or to continue with the firm or to exit from it. In order to achieve goal

congruence, managers’ compensation is often linked with the performance of the

responsibility centers and also with firm-performance. Therefore selection of the right

measure is critical to the success of a firm. To measure performance of a firm one needed

a simple method for correctly measuring value created/ enhanced by it in a given

time frame. All the current metrics trade off between the precision in measuring the value

and its cost of measurement. In other words, each method takes into consideration the

degree of complexities in quantifying the underlying measure. The more complex is the

process, the more is the level of subjectivity and cost in measuring the performance of

the firm. There is a continuous endeavor to develop a single measure that captures

the overall performance, yet it is easy to calculate.

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Each metric of performance claims its superiority over others. Performance of a firm is

usually measured with reference to its past record and the performance of other

firms with comparable risk profile. The various performance metrics currently in use are

based on the returns on investment generated by the business entity . Therefore to

reach a meaningful conclusion, returns generated by the firm in a particular year

should be compared with returns generated by assets with similar risk profile

(cross sectional analysis). Similarly return on investment for the current period should be

compared with returns generated in past (time series analysis). A firm creates value only

if it is able to generate return higher than its cost of capital. Cost of capital is the

weighted average cost of equity and debt (WACC).

The performance of a firm gets reflected on its valuation by the capital market. Market

valuation reflects investor’s perception about the current performance of the firm

and also their expectation on its future performance. They build their expectations

on the estimated growth of the business in terms of return on capital. This

results in incongruence between current performance and the value of the firm. Even

if the current performance is better in relative terms, poor growth prospects adversely

affects the value of the firm. Therefore any metric of performance, to be effective,

should be able to not only capture the current performance but also should be able to

incorporate the direction and magnitude of future growth. Therefore the robustness of a

measure is borne out by the degree of correlation the particular metric has with respect

to the market valuation. Perfect correlation is impossible because as shown by empirical

researchers, fundamentals of a company cannot fully explain its market capitalization;

other factors such as speculative activities, market sentiments and macro-economic

factors influence movement in share prices. However the superiority of a performance

metric over others lies in providing better information to investors.

Metrics of performance have a very important and critical role not only in evaluating the

current performance of a firm but also in achieving high performance and growth in the

future. The metrics of performance have a variety of users, which include all the

stakeholders whose well being depends on the continued well being of the firm. Principal

stakeholders are the equity holders, debt holders, management, and suppliers of material

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and services, employees and the end-users of the products and services. Value creation and

maximization depends on the alignment of the various conflicting interests of these

stakeholders towards a common goal. This means maximization of the firm value without

jeopardizing the interests of any of the stakeholders. Any metric, which measures the

firm value without being biased towards any of the stakeholders or particular class

of participants, can be hailed as the true metric of performance. However it is difficult, if

not impossible, to develop such a metric. Most of the conventional performance measures

directly relate to the current net income of a business entity with equity, total assets, net

sales or similar surrogates of inputs or outputs. Examples of such measures are return on

equity (ROE), return on assets (ROA) and operating profit margin. ROA measures the

asset productivity and operating profit margin reflects the margin realized by the firm

at the market place. The net income figure in itself is dependent on the operational

efficiency, financial leverage and the ability of the entity to formulate right strategy

to earn adequate margin in the market place.

It is important to note that none of these measures truly reflect the complete picture

by themselves but have to be seen in conjunction with other metrics. These

measures are also plagued by the firm level inconsistencies in the accounting

figures as well as the inconsistencies in the valuation methods used by

accountants in measuring assets, liabilities and income of the firm. Accounting

valuation methods are in variance with the methods that are being used to value

individual projects and firms. The value of an asset or a firm, which is a collection

of assets, is computed by discounting future stream of cash flows. The net present

value (NPV) is the surplus that the investment is expected to generate over the cost of

capital. Measures of periodical performance of a firm, which is the collection of assets

in place, should follow the same underlying principles. Economic value added (EVA) is

a measure that captures the valuation principles.

Historically, PM systems was developed as a means of monitoring and maintaining

organizational control, which is the process of ensuring that an organization pursues

strategies that lead to the achievement of overall goals and objectives (Nanni, et al 1990).

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PM plays a vital role in every organization as it is often viewed as a forward-looking

system of measurements that assist managers to predict the company's economic

performance and spot the need for changes in operations. In addition, PM can provide

managers, supervisors and operators with information required for making daily

judgments and decisions. PM is increasingly used by organizations, as it enables them to

ensure that they are achieving continuous improvements in their operations in order to

sustain a competitive edge, increase market share and increase profits.

1.3 Traditional measures

Accounts for the costs associated with capital and help firms spot areas in which capital

is being invested unprofitably. Although these financial data have the advantage of being

precise and objective, the limitations are far greater, making them less applicable in

today's competitive market. Organisations, that have adopted the traditional PM, have

experienced great difficulty in trying to fit the measures with increasing new business

environment and current competitive realities.

While the traditional financial metrics are value-based, they are nonetheless lagging

indicators. They offer little help for forward-looking investments, where future earnings

and capital requirements are largely unknown investments such as new product

introductions and capital or new market entry. This will lead to narrow short-term

decision-making based on bottom-line financial results.

On the other hand, most of the criticism of traditional PM stems from their failure to

measure and monitor multiple dimensions of performance, by concentrating almost

exclusively on financial measure (Brignall and Ballantine, 1996). They solely concentrate

on minimizing costs and increasing labour efficiency while neglecting other operational

performance measures such as quality, responsiveness and flexibility (Skinner, 1974)

Therefore focusing on financials to the exclusion of all other factors can produce

distortions such as low cost and high margin productions unnecessarily.

First let us look into the claim of EVA being superior than the conventional

measures such as ROI, ROE and ROA, which are based on the accounting figures. Most

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of these measures give us the rate of return earned by the firm with respect to capital

invested in the firm. The most important limitation of these measures are derived

from limitations inherent in the measurement of accounting profit. As per current

accounting practices, while historical-cost-based accounting measures are being

used to carry most of the assets in the balance sheet, revenue and expenses (other than

depreciation) are recognized in the profit and loss account at their current value.

Therefore accounting rate of returns do not reflect the true return from an investment

and tend to be biased downwards in the initial years and upward in the latter years.

Similarly as noted by Malkelainen (Esa Malkelainen 1998), distortion occurs basically

due to the historical cost and straight line depreciation schedule used by most

businesses to value their assets. This leads to a bias in these measures due to the

composition of assets of a firm at any given point in time.

By composition he refers to the current nature of the assets, more current the assets are,

the accounting rate of return is closer to the true rate of return. This distortion will not be

significant if there is a continuous stream of investments in assets i.e. the value of the mix

of assets is nearer to the current value of the assets. But the probability, that at any point

of time, a firm should have such a composition of assets is rare, in most cases either the

assets are old or relatively new. This precludes these accounting measures from being

used to reach any meaningful conclusion regarding the true performance of the firm. The

other important limitation of accounting measures is that they ignore the cost of

equity and only consider the borrowing cost. As a result it ignores the risk inherent in the

project and fails to highlight whether the return is commensurate with the risk of

the underlying assets. This might result in selecting projects that produce attractive rate of

return but destroys firm value because their cost of capital is higher than the benchmark

return established by the management. On the other hand accounting measures encourage

managers to select projects that will improve the current rate of return and to

ignore projects even if their return is higher than their cost of capital. Selection of

projects with returns higher than the current rate of return does not automatically

increase shareholders’ wealth. Taking up only those projects, which provide returns

that are higher than the hurdle rate (cost of capital) results in increasing the

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wealth of the shareholder. Therefore use of ROE, ROA or similar accounting

measures as the benchmark, might result in selection of those projects that though

provide rate of return higher than the current rate of return destroys firm-value. Similarly

use of these measures result in continuing with activities that destroys firm value until the

rate of return falls below the benchmark rate of return.

However, despite the criticisms made on traditional financial measure, many companies

still use them to measure performance. Many organizations, even until the end of 1970s,

operate performance under central control, through large functional department. Thus,

allowing managers to use slow-reacting and tactical management control system such as

'budgets'. These budgeting measures mainly focus on short-term value creation as it only

attempts to control and improve existing operations. However budgeting systems are

inflexible for today's dynamic and rapidly changing environment organizations still

continue to use them. This is because implementing new measures designed to manage

strategy and not control is very difficult.

Moreover, most companies motivate their worker through reward system. Rewards can

be financial such as cash payments, bonuses or share options and non-financial such as

promotion. Traditionally, employees are rewarded with bonuses at the end of the year

once a specific target has been achieved. However, this reward system causes short-

term’s as employees are seen to narrow down their focus by just targeting the 'rewarded'

goal. They may not take other factors, such as quality and service into consideration.

Hence leading businesses to run without long-term vision.

1.4 EVA (Economic Value Added)

EVA (Economic Value Added) was developed by a New York Consulting firm, Stern

Steward & Co in 1982 to promote value-maximizing behaviour in corporate managers

(O'Hanlon. J & Peasnell. K, 1998). It is a single, value-based measure that was intended

to evaluate business strategies, capital projects and to maximize long-term shareholders

wealth. Value that has been created or destroyed by the firm during the period can be

measured by comparing profits with the cost of capital used to produce them. Therefore,

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managers can decide to withdraw value-destructive activities and invest in projects that

are critical to shareholder's wealth. This will lead to an increase in the market value of the

company. However, activities that do not increase shareholders value might be critical to

customer's satisfaction or social responsibility. For example, acquiring expensive

technology to ensure that the environment is not polluted might not be of high value from

a shareholder's perspective. Focusing solely on shareholder's wealth might jeopardize a

firm reputation and profitability in the long run.

EVA sets managerial performance target and links it to reward systems. The single goal

of maximizing shareholder value helps to overcome the traditional measure problem,

where different measures are used for different purposes with inconsistent standards and

goal. Rewards will be given to managers who are able to turn investor's money and

capital into profits efficiently. Researches have found that managers are more likely to

respond to EVA incentives when making financial, operational and investing decision

(Biddle, Gary, Managerial finance 1998), allowing them to be motivated to behave like

owners. However this behaviour might lead to some managers pursuing their own goal

and shareholder value at the expense of customer satisfaction.

Unlike simple traditional budgeting, EVA focuses on ends and not means as it does not

state how manager can increase company's value as long as the shareholders wealth are

maximized. This allowed managers to have discretion and free range creativity, avoiding

any potential dysfunctional short-term behaviour. Rewards such as bonuses from the

attainment of EVA target level are usually paid fully at the end of 3 years. This is because

workers' performance is monitored and will only be rewarded when this target is

maintained consistently. Hence, leading to long-term shareholders' wealth.

Cola-Cola is one of the many companies that adopted EVA for measuring its

performance. Its aim, which was to create shareholders wealth, was announced in its

annual report. Coca-Cola CEO Roberto Goizueta accredited EVA for turning Coca-Cola

into the number one Market Value Added Company. Coca-Cola's stock price increased

from $3 to over $60 when it first adopted EVA in the early 1980s. In 1995, Coca-Cola's

investor received $8.63 wealth for every dollar they invested.

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Most companies refer to stock price increase as an outcome of implementing EVA.

However, empirical studies have found that traditional accounting measure have provided

a similar, or even better result in increasing stock performance (Dodd J and Johns J 'EVA

reconsidered').

EVA is a financial measure based on accounting data and is therefore historical in nature.

It has the same limitations as other traditional accounting measures and cannot

adequately replace all measures within the company especially the non-financial ones.

Due to the historical nature of EVA, manager can benefit in terms of rewards or be

punished by the past history of the organization (Otley, David Performance management

1999). Dodd J and Johns J see the balanced scorecard as one approach to overcome the

potential problem of using a single financial measure such as EVA.

1.4.1 The background of EVA

EVA is not a new discovery. An accounting performance measure called residual income

is defined to be operating profit subtracted with capital charge. EVA is thus one variation

of residual income with adjustments to how one calculates income and capital. According

to Wallace (1997) 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. According to Dodd & Chen (1996) the idea of residual

income appeared first in accounting theory literature early in this century by e.g. Church

in 1917 and by Scovell in 1924 and appeared in management accounting literature in the

1960s. Also Finnish academics and financial press discussed the concept as early as in

the 1970s. It was defined as a good way to complement ROI-control (Virtanen 1975).

Knowing this background many academics have been wondering about the big publicity

and praise that has surrounded EVA in the recent years. The EVA-concept is often called

Economic Profit (EP) in order to avoid problems caused by the trademarking. On the

other hand the name "EVA" is so popular and well known that often all residual income

concepts are often called EVA although they do not include even the main elements

defined by Stern Stewart & Co. For example, hardly any of those Finnish companies that

have adopted EVA calculate rate of return based on the beginning capital as Stewart has

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defined it, because average capital is in practice a better estimate of the capital employed.

So they do not actually use EVA but other residual income measure. This insignificance

detail is ignored later on in order to avoid more serious misconceptions. It is justified to

say that the EVA concept, Finnish companies are using corresponds virtually the EVA

defined by Stern Stewart & Co.

In the 1970s or earlier residual income did not got wide publicity and it did not end up to

be the prime performance measure in great deal of companies. However EVA, practically

the same concept with a different name, has done it in the recent years. Furthermore the

spreading of EVA and other residual income measures does not look to be on a

weakening trend. On the contrary the number of companies adopting EVA is increasing

rapidly (Nuelle 1996, Wallace 1997, and Economist). It can only be a guess why residual

income did never gain a popularity of this scale. One of the possible reasons is that

Economic value added (EVA) was marketed with a concept of Market value added

(MVA) and it did offer a theoretically sound link to market valuations. In the times when

investors demand focus on Shareholder value issues this was a good bite. Perhaps also

pertinent marketing by Stern Stewart & Co. had and has its contribution.

In some previous conducted researches, EVA was verified to suffer from the same

accounting distortions as any accounting rate of return (e.g. ROI). Therefore EVA might

in some occasions give somewhat misleading signals of the true value added to

shareholders. In spite of this fact EVA has become a very popular performance measure,

perhaps because applying it has some powerful impacts on organizational behavior.

Unlike conventional profitability measures EVA helps the management and also other

employees to understand the cost of equity capital. At least in big public companies,

which do not have a strong owner, shareholders have often been conceived as a free

source of funds. Similarly, business unit managers often seem to think that they have the

right to invest all the retained earnings that their business unit has accumulated although

the group would have better investment opportunities elsewhere. EVA might change the

attitude in this sense because it emphasizes the requirement to earn sufficient return on all

capital employed.

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Including capital costs in the income statement helps everybody in the organization to see

the true costs of capital. Rate of return does not work that way because nobody can

explicitly see the costs caused by e.g. inventories, receivables etc. The approaches

showing the consequences of invested capital under the line as profit (with ROI) or over

the line as cost (with EVA) are totally different. That is why organizations tend to

increase their capital turnover after introducing EVA, although they have formerly used

ROI that ought to take into account the capital as well. When calculating EVA, the cost

of equity (and debt) can be subtracted in the income statement earlier than after the net

operating profit. If all the revenues and costs are grouped by functions or by processes,

then it is of course practical to allocate the capital costs to these functions or processes.

The capital costs can also be allocated directly to products. Parts of the capital costs are

variable in nature (inventories, trade receivables) and thus they fluctuate according to the

sales volume. If the true capital costs were not included fully in product costs, then those

cost calculations (for price determination) are misleading. The error is the bigger, the

more capital intensive the production is.

At best EVA can be a new approach to view business. Perhaps the biggest benefit of this

approach is to get the employees and mangers to think and act like shareholders. It

emphasizes that in order to justify investments in the long run they have to produce at

least a return that covers the cost of capital. In other case the shareholders would be better

off investing elsewhere. This approach includes that the organization tries to operate

without lazy or excess capital and it is understood that the ultimate aim of the firm is to

create shareholder value by enlarging the product of positive spread (between return and

cost of capital) multiplied with the capital employed. The approach creates a new focus

on minimizing the capital tied to operations. Firms have so far done a lot in cutting costs

but cutting excess capital has been paid less attention. The power of EVA-approach is

something that most academic studies about EVA and share price correlation fail to trace.

The only way to assess the effects of this approach is to compare two sample groups,

other representing firms that use EVA and other firms that do not.

There are countless individual operational things that create shareholder value and

increase EVA. Often EVA does not directly help in finding ways to improve operational

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efficiency except when improving capital turnover. Nor does EVA help directly in

finding strategic advantages that enable a company to earn abnormal returns and thus

create shareholder value. It is however often helpful to understand the basic ways in

which EVA and thus the wealth of shareholders can be improved.

Increasing EVA falls always into one of the following three categories:

1) Rate of return increases with the existing capital base. It means that more operating

profits are generated without tying any more capital in the business.

2) Additional capital is invested in business earning more than the cost of capital.

(Making NPV positive investments.)

3) Capital is withdrawn or liquidated from businesses that fail to earn return greater than

the cost of capital.

The first method includes all the countless ways to improve operating efficiency or

increase revenues. Of course increasing rate of return with current operations and new

investments (that is categories 1 and 2) are often linked; in order to improve the

efficiency of ongoing operations, companies often do investments which enhance also the

return on current capital base.

The fact that the wealth of shareholders increase with investments returning more that the

cost of capital (category 2) is probably known in organizations if they also use some kind

of weighted average cost of capital (WACC) and Net present value (NPV) methodology

in investment calculations. This rule is actually completely same as accepting only NPV-

positive investments.

The third category, withdrawing capital, is probably not so widely understood and

applied as the previous ones. It is however also very important to realize that shareholder

value can also be increased if capital is withdrawn from businesses earning less than the

cost of capital. Even if an operation has positive net income, it might pay to withdraw

capital from that activity. It is also kind of withdrawal when access inventories and

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receivables and thus the capital costs caused by them are reduced without corresponding

decreases in revenues.

These categories and ways to improve EVA might appear to be quite simple. They are

certainly not new ways to improve the position of shareholders. Decreasing cost of

capital is not included in this list of methods. That is because it can not normally be done

without changing line of business and in that way changing business risk. Changing

financial leverage affects WACC only slightly via increased tax shield.

1.4.2 Indian context

In India EVA is being used with impunity. A case at point is the study published by

Economic times (11th December 2000) ,on corporate performance. While computing

EVA it used a flat rate of 15 percent as the cost of capital of all the enterprises included

in the study. The study explains that an average 15 percent interest for both the

years covered by the study is used as it is almost equal to the prime-lending rate

of the commercial bank and financial institution. It is a basic principle of economics

that ‘higher the risk higher is the expected return’. By estimating WACC at 15% this

basic principle is violated. It may be argued that cost of debt should be taken

post-tax and therefore effective cost of equity incorporated in the calculation is higher

than 15 percent. Even if this argument is accepted the computation cannot be defended

because the cost of capital is estimated without using any accepted economic model.

Moreover by using a flat rate, variation in risk profiles of firms have been ignored.

This shows both the popularity of EVA in India and difficulties in measuring the

same. The study has also ignored adjustments in capital and operating income suggested

by proponents of EVA

1.5 ECONOMIC VALUE ADDED – the concept

EVA is the most misunderstood term among the practitioners of corporate finance. The

proponents of EVA are presenting it as the wonder drug of the millennium in overcoming

all corporate ills at one stroke and ultimately help in increasing the wealth of the

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shareholder, which is synonymous with the maximization of the firm value. The

attractiveness of the EVA lies in its use of cash flow and cost of capital that are

determinant of the value of the firm.

In the process, EVA is being bandied about with utmost impunity by all and

sundry, which includes the popular press. The academic world in its turn has come

up with various empirical studies which either supports the superiority of EVA or

questions the claim of its proponents. Currently the empirical evidence is split almost half

way.

EVA is nothing but a new version of the age-old residual income concept recognized by

economists since the 1770's. Both EVA and ‘residual income’ concepts are based on the

principle that a firm creates wealth for its owners only if it generates surplus over the cost

of the total invested capital. So what is new? Perhaps EVA could bring back the lost

focus on ‘economic surpluses from the current emphasis on accounting profit. In a lighter

vein it can be said that in an era where commercial sponsorship is the ticket to

the popularity of even the concept of god, the concept of residual income has not found a

good sponsor until Stern Stewart and Company has adopted it and relaunched it with a

brand new name of EVA.

Technically speaking EVA is nothing but the residual income after factoring the cost of

capital into net operating profit after tax. But this is only the tip of the iceberg as will be

seen in the next few sections. The paper examines EVA both as a measure of overall

performance and a management philosophy that helps to improve the productivity

of resources.

Mathematically:

EVA= (adjusted NOPAT - cost of capital) x capital employed----- (I)

Or

EVA = (Rate of return - cost of capital) x capital --------- (II)

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Where;

Rate of Return = NOPAT/Capital

Capital = total assets minus non interest bearing debt, at the beginning of the year

Cost of capital = cost of equity x proportion of equity + cost of debt (1-tax rate)

x proportion of debt in the capital.

The above cost of capital is nothing but the weighted average cost of capital (WACC).

Cost of equity is normally estimated using capital asset pricing model (CAPM) that

estimates the expected return commensurate with the riskiness of the assets.

If we define ROI as NOPAT/capital then the above equation can be rewritten as

EVA= (ROI- WACC) x CAPITAL EMPLOYED----- (III)

Capital being used in EVA calculation is not the book capital, capital is defined as an

approximation of the economic book value of all cash invested in going-concern business

activities, capital is essentially a company’s net assets (total assets less non-interest-

bearing current liabilities), but with three adjustments:

Marketable securities and construction in progress are subtracted.

The present value of non-capitalized leases is added to net property, plant,

and equipment.

Certain equity equivalent reserves are added to assets:

Bad debt reserve is added to receivables.

LIFO reserve is added to inventories.

The cumulative amortization of goodwill is added back to goodwill

R&D expense is capitalized as a long-term asset and smoothly depreciated over

5 years (a period chosen to approximate the economic life typical of an

investment in R&D).

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Cumulative unusual losses (gains) after taxes are considered to be a long-

term investment.

A firm can motivate its managers to direct their effort towards maximizing the value of the

firm only by, first measuring the firm value correctly and secondly by providing

incentives to managers to create value. Both are interdependent and they complement

each other. Therefore this paper examines the EVA concept from two perspectives, EVA

as a performance measure and EVA as a corporate philosophy.

I shall examine EVA as a performance measure to assess whether it conveys any

additional information to investors over conventional performance measures. In

other words, whether information on EVA leads to better decision by investors.

EVA can lend a helping hand in this connection in two ways: one that it is

inherently flexible and second, it helps generate flexibility within the organization:

1. The EVA concept allows adjustment of various accounting parameters (mentioned in

section on EVA theory) to suit the desired end purpose. There can be various purposes

for which EVA exercise might be carried out such as award of bonus to employees,

relative performance of various divisions, assessment of business as a whole etc. For the

purpose of award of bonus to employees, the focus is on the operational income and

capital employed to generate such income. Various accounting adjustments are made

accordingly. However, for the purpose of assessment of business as a whole, the strategic

investment and its returns also come into picture. While comparing various divisions, the

capital employed and expenses incurred on corporate centre take a back seat Thus, EVA

concept provides flexibility in hands of finance manager in measuring performance. In

the case study discussed later, we have discussed EVA from the point of view of award

of bonus.

2. Not only is EVA concept inherently flexible, but also it induces flexibility in the

organization. The application of concept forces the organization to release/ free the

excess capital employed. This deployment of excess capital provides the much-required

flexibility to finance manager to improve performance. Since application of concept

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questions every decision harder, it forces the managers to keep exploring options and

encourages keeping the system flexible. This effect is more pronounced in companies

which are in distress, and where restructuring is being carried out.

1.5.1 Implementing EVA

Implementing EVA should be more than just adding one line in the monthly profit report.

EVA affects the way capital is viewed and therefore, it might create some kind of change

in management's attitude. Of course this depends on how shareholder-value-focused the

management is and how the company has been in the past. While implementing EVA

represents some kind of change in the organization, it should be implemented with care in

order to achieve understanding and commitment.

It is vital that group level managers thoroughly understand the characteristics of the

concept, how these characteristics affect control and above all where the Strategic

Business Units (SBUs) stand currently from the viewpoint of these characteristics. Before

implementing EVA to any SBU, the group management ought to assess whether the

business units are currently cash flow generators in mature businesses or companies in

rapidly growing businesses. This assessment should absolutely include careful estimation

of relative age and structure of assets in order to know whether the current accounting

rate of return is over or under estimating the true rate of return. Only then can the concept

be properly tailored to the unique situation of each individual business unit. Group level

managers should also know how to support strategic goals of SBU with EVA and how to

create value with EVA in individual SBU.

At the level of SBU, gaining understanding and commitment are also the most important

issues. First task is to get the support of all the managers, not only of the Managing

Director but also of directors of production and marketing etc. This is achieved with

intense and thorough training. For managerial level, attaining thorough commitment can

be facilitated very much by introducing good incentive plan based on EVA.

Gaining commitment of middle level managers and other employees below the top

management of business unit is also important. Training and some kind of EVA based

22

compensation plans should also be considered with these target groups. Keeping EVA

simple is also viewed as an important feature in successful implementation. In principle,

EVA is simple concept and it should be offered to business units as such.

1.5.2 How Companies Have Used EVA

Name Timeframe Use of EVA

The Coca-Cola

Co.

Early 1980s Focused business managers on increasing shareholder

value

AT&T Corp. 1994 Used EVA as the lead indicator of a performance

measurement system that included "people value added"

and "customer value added"

IBM 1999 Conducted a study with Stern Stewart that indicated that

outsourcing IT often led to short-term increases in EVA

Herman Miller

Inc.

Late 1990s Tied EVA measure to senior managers' bonus and

compensation system

4 Ms of EVA

As a mnemonic device, Stern Stewart describes four main applications of EVA with four

words beginning with the letter M.

Measurement

EVA is the most accurate measure of corporate performance over any given period.

Fortune magazine has called it "today's hottest financial idea," and Peter Drucker rightly

23

observed in the Harvard Business Review that EVA is a measure of "total factor

productivity" whose growing popularity reflects the new demands of the information age.

Management System

While simply measuring EVA can give companies a better focus on how they are

performing, its true value comes in using it as the foundation for a comprehensive

financial management system that encompasses all the policies, procedures, methods and

measures that guide operations and strategy. The EVA system covers the full range of

managerial decisions, including strategic planning, allocating capital, pricing acquisitions

or divestitures, setting annual goals-even day-to-day operating decisions. In all cases, the

goal of increasing EVA is paramount.

Motivation

To instill both the sense of urgency and the long-term perspective of an owner, Stern

Stewart designs cash bonus plans that cause managers to think like and act like owners

because they are paid like owners. Indeed, basing incentive compensation on

improvements in EVA is the source of the greatest power in the EVA system. Under an

EVA bonus plan, the only way managers can make more money for themselves is by

creating even greater value for shareholders. This makes it possible to have bonus plans

with no upside limits. In fact, under EVA the greater the bonus for managers, the happier

shareholders will be.

Mindset

When implemented in its totality, the EVA financial management and incentive

compensation system transforms a corporate culture. By putting all financial and

operating functions on the same basis, the EVA system effectively provides a common

language for employees across all corporate functions. EVA facilitates communication

and cooperation among divisions and departments, it links strategic planning with the

operating divisions, and it eliminates much of the mistrust that typically exists between

operations and finance. The EVA framework is, in effect, a system of internal corporate

governance that automatically guides all managers and employees and propels them to

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work for the best interests of the owners. The EVA system also facilitates decentralized

decision making because it holds managers responsible for-and rewards them for-

delivering value.

1.5.3 The EVA Concept of Profitability

EVA is based on the concept that a successful firm should earn at least its cost of capital.

Firms that earn higher returns than financing costs benefit shareholders and account for

increased shareholder value. In its simplest form, EVA can be expressed as the following

equation:

EVA = Net Operating Profit after Tax (NOPAT) - Cost of Capital

NOPAT is calculated as net operating income after depreciation, adjusted for items that

move the profit measure closer to an economic measure of profitability. Adjustments

include such items as: additions for interest expense after-taxes (including any implied

interest expense on operating leases); increases in net capitalized R&D expenses;

increases in the LIFO reserve; and goodwill amortization. Adjustments made to operating

earnings for these items reflect the investments made by the firm or capital employed to

achieve those profits. Stern Stewart has identified as many as 164 items for potential

adjustment, but often only a few adjustments are necessary to provide a good measure of

EVA.

Recently, the Economic Valued Added method has gained attention worldwide. This

method is intuitively appealing and measures profitability in the way shareholders define

it.

Economic Value Added calculates the actual dollar amount of a business's wealth created

or destroyed in each reporting period. It takes into account the opportunity cost (the

minimum acceptable compensation for investing in a risky asset as opposed to a less

risky market instrument like government bonds) of the company's capital investment and

measures the excess returns over this charge.

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A positive Economic Value Added indicates that value is being created; so adding to the

intrinsic value of the company by that amount. A negative Economic Value Added, on

the other hand, indicates that value is eroded and the company is now worth less than the

initial capital employed.

Measurement of EVA

Measurement of EVA can be made using either an operating or financing approach.

Under the operating approach, NOPAT is derived by deducting cash operating expenses

and depreciation from sales. Interest expense is excluded because it is considered as a

financing charge. Adjustments, which are referred to as equity equivalent adjustments,

are designed to reflect economic reality and move income and capital to a more

economically-based value. These adjustments are considered with cash taxes deducted to

arrive at NOPAT. EVA is then measured by deducting the company's cost of capital from

the NOPAT value. The amount of capital to be used in the EVA calculations is the same

under either the operating or financing approach, but is calculated differently.

The operating approach starts with assets and builds up to invested capital, including

adjustments for economically derived equity equivalent values. The financing approach,

on the other hand, starts with debt and adds all equity and equity equivalents to arrive at

invested capital. Finally, the weighted average cost of capital, based on the relative values

of debt and equity and their respective cost rates, is used to arrive at the cost of capital

which is multiplied by the capital employed and deducted from the NOPAT value. The

resulting amount is the current period's EVA.

1.6 There are eight steps involve in applying Economic Value Added to value a

company:

Step 1: Determining a period of financial projection. To calculate returns on capital

employed, we first need to estimate the company's earnings; for instance, in the next five

years to 2016. The earnings projection is based on a set of assumptions for future volume

sales growth, finished product prices, government duties and inflation.

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Step 2: Net operating profit after tax (NOPAT): Net operating profit after tax is

equivalent to the after tax earnings generated by the company (excluding interest

expense). The financing of asset (interest expense) is assumed to be independent of

operating results and is instead reflected in the company's cost of capital.

Step 3: Initial capital employed: The total capital employed at the beginning of each year

is the assets base from which earnings for the year are generated.

Capital employed = Net fixed assets + Working capital

Step 4: Return on capital employed (ROCE) the yearly returns on capital employed are

determined by dividing NOPAT by capital employed at the beginning of each year.

ROCE = NOPAT ÷ Capital employed

Step 5: Weighted average cost of capital (WACC) after calculating the Returns on

Investment (ROI), match them to the cost of capital. The most commonly used cost of

capital is the WACC, which is based on the company's debt equity capital structure.

WACC = Weighted cost of equity + Weighted after tax cost of debt

After tax cost of debt = [Interest payment x (1-tax rate)] ÷ Total borrowings

How big a risk premium required for investing in a company is dependent on how risky

the stock is relative to the broad market; which known as correlation beta. A high beta

implies the stock price is more volatile than the broad market. Therefore, an investor

should require a higher than market average return to compensate for the additional risks.

Conversely, a low beta implies that the stock returns will lag a market rally but will be

more resilient during a sell down.

Step 6: Excess returns over cost of capital

Excess returns (ER) = ROCE - WACC

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Step 7: Economic Value Added and Market Value Added (MVA)

Economic Value Added = ER x Capital employed

Beyond the projected period of 2016, impute a terminal value (perpetuity); on the basis

that the company is an ongoing business concern (for the stream of future Economic

Value Added, assuming a constant yearly growth of 1%).

The stream of Economic Value Added is then discounted back to present day values

using the WACC calculated previously, the sum of which is the positive value created by

the company's business operations.

MVA = Sum of present value of Economic Value Added stream.

Step 8: Intrinsic value and shareholder value. The intrinsic value for the company is its

initial capital employed enhanced by the positive value created.

Intrinsic market value = Initial capital employed + MVA

And finally,

Shareholder value = Intrinsic market value - Net debt

Fair value per share = Shareholders' value ÷ Number of shares

The company's primary objective would be to maximize Economic Value Added; which

is not necessarily the same as maximizing profits. If the return on an investment is below

its cost of capital, then the company prefers not to make the investment at all (even if the

absolute magnitude of profit is increased).

1.6.1 EVA Calculation and Adjustments

As stated above, EVA is measured as NOPAT less a firm's cost of capital. NOPAT is

obtained by adding interest expense after tax back to net income after-taxes, because

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interest is considered a capital charge for EVA. Interest expense will be included as part

of capital charges in the after-tax cost of debt calculation.

Other items that may require adjustment depend on company-specific activities. For

example, when operating leases rather than financing leases are employed, interest

expense is not recorded on the income statement, nor is a liability for future lease

payments recognized on the balance sheet. Thus, while interest is implicit in the yearly

lease payments, an attempt is not made to distinguish it as a financing activity under

GAAP.

Under EVA, however, the interest portion of the payment is estimated and the after-tax

amount from it is added back into NOPAT because the interest amount is considered a

capital charge rather than an operating expense. The corresponding present value of

future lease payments represents equity equivalents for purposes of capital employed by

the firm, and an adjustment for capital is also required.

R&D expense items call for careful evaluation and adjustment. While GAAP generally

requires most R&D expenditures to be expensed immediately, EVA capitalizes

successful R&D efforts and amortizes the amount over the period benefiting the

successful R&D effort.

Other adjustments recommended by Stern Stewart include the amortization of goodwill.

The annual amortization is added back for earnings measurement, while the accumulated

amount of amortization is added back to equity equivalents. Goodwill amortization is

handled in this manner because by "unamortizing" goodwill, the rate of return reflects the

true cash-on-yield. In addition, the decision to include the accumulated goodwill in

capital improves the real cost of acquiring another firm's assets regardless of the manner

in which the acquisition is accounted.

While the above adjustments are common in EVA calculations, according to Stern

Stewart, those items to be considered for adjustment should be based on the following

criteria:

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Materiality: Adjustments should make a material difference in EVA.

Manageability: Adjustments should impact future decisions.

Definitiveness: Adjustments should be definitive and objectively determined.

Simplicity: Adjustments should not be too complex.

If an item meets all four of the criteria, it should be considered for adjustment. For

example, the impact on EVA is usually minimal for firms having small amounts of

operating leases. Under these conditions, it would be reasonable to ignore this item in the

calculation of EVA. Furthermore, adjustments for items such as deferred taxes and

various types of reserves (i.e. warranty expense, etc.) would be typical in the calculation

of EVA, although the materiality for these items should be considered. Unusual gains or

losses should also be examined and eliminated if appropriate. This last item is

particularly important as it relates to EVA-based compensation plans.

1.6.2 EVA at Work

Although economic value added is considered to be the kingpin of value-based metrics, it

won't work in an organization if a CEO doesn't force implementation throughout the

company or if incentive-based compensation isn't offered. And a pure EVA bonus plan

won't necessarily work at the middle and lower levels of a company, making it difficult to

preach the EVA gospel throughout an organization.

Stern Stewart & Co., a New York-based financial consulting firm which has trademarked

the term EVA, promotes the idea that economic value added is a financial performance

measure that comes closer than any other to capturing the true economic profit of an

enterprise. "The formula for EVA looks formidable, but it's really not," says Stern

Stewart vice president Tom Leander. "EVA is net operating profit minus an appropriate

charge for the opportunity cost of all capital invested in an enterprise. In simple terms,

EVA equals net operating profit after taxes — we use the acronym NOPAT."

Stern Stewart calculates what the economic value added for a company is and then

decides from what business centers the EVA will be calculated. Once the measurement is

made, the firm works with the finance department to show employees how EVA can be

30

used as an internal measure. The next and most obvious step is tying that measurement to

incentive compensation.

"Under classic economic theory, a problem exists in that managers' interests are not

aligned with the interests of the owners," Leander says. "But one of the aspects of EVA is

that managers must think and act like owners of the company. The underlying principle

here is that unless managers are motivated to think and feel like they're owners of the

company, they're not going to create value in a way that benefits shareholders."

EVA is about working smarter, not harder. It's about doing such things as reducing the

number of steps in a work process, reducing cycle times or scrutinizing business

expenses. Economic value added can be improved in three basic ways:

1. Growth: Invest in projects that earn more than the cost of capital. For example,

investing in personal computers, which frequently increase efficiency and justify

a minimal investment?

2. Improved productivity: Increase profits without using additional capital and/or

eliminate business expenses which can help improve income.

3. Divestiture: Eliminate non-strategic assets that do not generate operating profits

greater than the cost of capital. Examples include the reduction of inventory levels

and speeding up cycle times. Many companies which use EVA have found this to

be the most attractive method.

According to Stern Stewart, a key to weaving EVA into the corporate culture is to make

it the focal point for reporting, planning and decision-making. To do that requires two

things: The first is recognizing that, because economic value added is a measure of total

factor productivity, it can and should supersede other financial and operating measures,

resulting in a hierarchy as opposed to a balanced scorecard. The balanced scorecard

results when financial numbers are not the only consideration used to make strategic

decisions. For example, if you're manufacturing a product, a balanced scorecard weighs

factors such as financial impact, quality, customer satisfaction and productivity. If EVA

is merely added to a list of many other performance measures, confusion and unnecessary

31

complexity will remain. The second requirement is that EVA be incorporated into

decision-making processes.

The fact that such high-profile companies as The Coca-Cola Co. and Briggs & Stratton

have achieved considerable success through the implementation of EVA has prompted a

wave of companies to at least consider the strategy. "You have thought leaders in the

marketplace who are touting this much as they would reengineering," says Tom Hertog,

manager of Chicago-based Arthur Andersen Global Best Practices.

"When people come to us, they're looking for the magic bullet, but as is the case with

benchmarking and best practices, there is a whole host of approaches and no single

solution. But the appropriate and consistent application of EVA methodology will yield

results, regardless of what size company you are or what industry you're in."

Arthur Andersen promotes a four-step process for organizations that want to undertake an

economic value added program:

1. Calculation or formulation: How does one measure the return on capital minus the

cost of capital? This is where most of the focus is directed. Certain aspects of the

EVA calculation include determining the number of capital adjustments, the

number of cost of capital factors, the number of cost centers calculating EVA, and

the number of NOPAT (net operating profit after taxes) adjustments

2. Application: How does one apply EVA in his/her organization, in that particular

line of business? For example, if you're a service organization and you don't have

a tangible product, you still need a performance measurement tool such as EVA to

determine the increase or decrease of value. It's important to set a goal for

increasing EVA as expressed as a percentage for the next 12 months, the next one

to three years, and the next three to five years.

3. Implementation or integration: How does one make EVA part of their

organizational culture? This step includes determining the extent of training

needed for management and staff, the methods by which EVA will be

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communicated throughout the company, and the time it will take for

implementation at various levels in the organization.

4. Interpretation or correlation: How will EVA impact the future of company?

Organizations obviously want to focus on positive change and sometimes use

MVA (market value added) as a measure of interpretation. MVA can be measured

by taking the current market value placed on the company as reflected in its stock

price and then subtracting the capital invested on the balance sheet.

"It comes down to ABO — awareness, buy-in, and ownership," Hertog says. "One or two

people will rise to the champion level and take ownership and drive it. The business unit

controllers will need to get that message from the CFO that they're going to do EVA. The

way you introduce it and integrate it is absolutely critical for it to gain acceptance.

Otherwise, it never happens

1.7 EVA vs. Traditional Performance Measures

The development of the concept of EVA has added flexibility in measurement of

performance. The traditional methods can continue side by side with EVA. Some of the

traditional ways of measuring corporate performance are described here.

1.7.1 Return on Investment (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.

Following example will clarify this statement:

Suppose a group has two subsidiaries X and Y. For both subsidiaries and so for the whole

group the cost of capital is 10%. The group has maximizing ROl as its target. Subsidiary

X has ROl of 15% and the other has ROl of 8%. Both subsidiaries begin to struggle for

the common target and try to maximize their respective ROIs. Company X rejects all the

33

projects that produce a return below the current 15% although there would be some

projects with return 12-13%. Y, in turn, accepts all the projects with return above 8%. For

a reason or another, it does not find very good projects, but the returns of its projects lie

somewhere near 9%.

Suppose that both subsidiaries manage to increase their ROI. The ROI of subsidiary X

increases from 15 to 16% and that of Y increases from 8 to 8.5%. The company's target

to increase ROI has been achieved, but what about the shareholder value. It is obvious

that all the projects of subsidiary Y decrease the shareholder value, because the cost of

capital is more than rate of return (and so the shareholders money would have been better

off with alternative investments). The actions of the better subsidiary are not optimal for

shareholders. Of course shareholders will benefit from the good projects with return

greater than 15% but also all the projects with returns of 10-14% should have been

accepted even though they decrease the current ROl of subsidiary X. These projects still

create and increase the shareholder value.

Hence, the capital can be misallocated on the basis of ROl. ROl 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.

1.7.2 Return on Equity (ROE)

The level of ROE does not tell the owners if company is creating shareholders' wealth or

destroying it. With ROE, this shortcoming is much more severe than with ROI, because

simply increasing leverage can increase the ROE. In other words, decreasing solvency

does not always make shareholders' position better because of the increased financial

risk.

1.7.3 Earning per Share (EPS)

34

EPS is raised simply by investing more capital in business. If the additional capital is

equity (retained earnings) then the EPS will rise if the rate of return of the invested

capital is just positive. For example, let us assume that as on March 31, 2009, company A

has net worth of Rs 50 million and 5 million equity shares. At a profit after tax of Rs 100

million for FY 2009, the EPS would work out to be 20. The entire income can be

ploughed back in the business at a marginal return of 5%. Assuming that the return on

previous net worth remains the same, the profit after tax would be Rs 105 million and

EPS would be 21. Though the performance has gone down, the EPS has increased.

If the additional capital is debt then the EPS will rise if the rate of return of the

invested capital is just above the cost of debt. In reality, the invested capital is a mix of

debt and equity and the EPS will rise if the rate of return on the additional investment is

somewhere between the cost of debt and zero. Therefore EPS is completely inappropriate

measure of corporate performance and still is very common yardstick and even a

common bonus base.

Unlike conventional profitability measures, EVA helps the management and other

employees to understand the cost of equity capital. At least in big companies, which do

not have a strong owner, shareholders have often been perceived as free source of funds.

These flaws are taken care of by the concept of economic value added. The key feature of

this concept is that for the first time any measure takes cares of the opportunity cost of

capital invested in business.

1.8 The Utility of EVA: Better Decision-Making

EVA clarifies the concept of maximizing the absolute returns over and above cost of

capital in creating shareholders' wealth. Hence better investment decisions can be taken

with above aim rather than maximizing percentage of ROl. Understanding of EVA

enables monitoring of investment decisions closely not only at the level of corporate but

at line staff as well.

Fosters New Era of Corporate Control

35

EVA points / centres can be created within an organization and these centres would have

capital, revenue and expenditure issue attached to them. It helps identify value drivers

and destroyers. Responsibility of positive EVA can be delegated at these centres. It

questions the decisions harder.

Long-Term Thinking

Perhaps the biggest benefit of this approach is to get employees and managers to think

and act like shareholders. EVA encourages long-term perspective among the managers

and employees of organization. It emphasizes that in order to justify investments in the

long run they have to produce at least a return that covers the cost of capital. In other

case, the shareholders would be better off investing elsewhere. This approach includes

that the organization tries to operate without the luxury of excess capital and it is

understood that the ultimate aim of the firm is to create shareholder value by enlarging

the product of positive spread multiplied with capital employed. The approach creates a

new focus on minimizing the capital tied to operations. Firms have so far done a lot in

cutting costs but cutting excess capital has been paid less attention.

Capital Allocation Tool

EVA is a capital allocation tool inside a company as it sets minimum level of acceptable

performance with regard to the rate of return in the long run This minimum rate of return

is based on average (risk adjusted) return on equity markets. The average return is a

benchmark that should be reached. If a company cannot achieve the average return, then

the shareholders would be better off if they allocated the capital to another industry or

another company.

Bonus System

EVA has provided a platform on which a flexible bonus payment system can be

based. Employees will be paid bonus only when they earn at least equal to the cost of

capital employed. This links the bonus with the end result and forces employees to act

like shareholders. Proponents of bonus systems based on EVA have suggested that

36

bonuses for corporate managers should always be tied to the long-term capital because

short-term EVA can sometimes be manipulated upwards to the cost of long run EVA The

long run can be incorporated into EVA-based bonuses, that is, by banking the bonuses.

This would mean that when EVA is good, the managers earn a certain percentage of it,

but the bonus should not be paid out of them entirely. If the periodic EVA is negative,

then the bonus put in the bank is negative and it decreases the balance already earned.

This exposes the managers partly to the risk the shareholders are used to bear. At the

same time, it gives incentives to good performers and encourages the bad performers to

improve their performance.

For example, manager earns a bonus of an amount X of the annual salary for leading its

centre to a positive EVA to the extent of 10% of capital employed. Out of the entire

bonus, 50% can be paid out and the rest can be banked as entitlement if the next year

EVA is not negative. In case the EVA next year is negative, the banked bonus can be

reduced as disincentive for bad performance.

Flexibility in EVA

Today's business environment is marked by presence of a lot of change drivers like

globalization, an intense competition, etc and the uncertainty surrounding them has

created chaos and confusion in organizations. Consequently, flexibility has assumed key

role in every facet of organization management and finance function, known for its

rigidity, is not too far from application of this paradigm.

1.9 Small and Medium Enterprises (SMEs)

Small and Medium Enterprises (SMEs) are considered engines for economic growth, not

only in India but all over the world. Small and medium enterprises have played a vital

role in the growth of the Indian economy. Small Scale Industry has a 40% share in

industrial output, producing over 8000 value-added products. They contribute nearly 35%

in direct export and 45% in the overall export from the country. They are one of the

biggest employment-providing sectors after agriculture, providing employment to 28.28

million people. They account for 80% of global economic growth.

37

Market conditions have dramatically changed for Indian SMEs after economic reforms.

SMEs are regularly facing new challenges in terms of cost, quality, delivery, flexibility

and human resource development for their survival and growth. In the context of a

dynamic market scenario, they have to formulate their strategies for developing various

capabilities and competencies to satisfy their domestic as well as global customers.

For long-term competitiveness, SMEs have to focus on all aspects of organizational

functions such as assets, strategy development, processes and their performance. In

Punjab the SMEs have not been growing at the pace at which they should have been as

they have been facing a lot of problems.

Small Scale industrial undertaking is defined as an industrial undertaking in which the

investment in fixed assets in plant and machinery whether held on ownership terms on

lease or on hire purchase does not exceed Rs.50 million (Subject to the condition that the

unit is not owned, controlled or subsidiary of any other industrial undertaking). Small and

medium-size enterprises (SMEs) in India play an important role in generating

employment and creating economic wealth. Small-scale industries play a key role in the

industrialization of a developing country. This is because they provide immediate large-

scale employment and have a comparatively higher labor-capital ratio; they need lower

investments, offer a method of ensuring a more equitable distribution of national income

and facilities an effective mobilization of resources of capital and skill which might

other-wise remain unutilized.

Table1: Small Scale Industry of Punjab: A Brief Profile (2009 – 10)

No. of Registered SSI Units

1,97,340

Employment 8,54,000Fixed Investment (Rs mn)

34,050

Production (Rs mn) 1,50,000Predominant Industries

Metal Products, Leather and Products, Textile and Hosiery, Non-electrical Machine Tools & Parts, Food Products

Major Issues Need for Infrastructural facilities, Need for working capital, Need for marketing infrastructure

38

The small scale sector has stimulated economic activity of a far reaching magnitude

and has played a significant role in attaining the following major objectives;

1. Elimination of economic backwardness of rural and underdeveloped regions in the

country.

2. Attainment of self-reliance

3. Reduction of regional imbalance.

4. Reduction of disparities in income wealth and consumption.

5. Mobilization of resources of capital and skills and their optimum utilization.

6. Creation of greater employment opportunities and increase output, income and

standards of living

7. Meeting a substantial part of the economy’s requirements for consumer goods and

simple producer goods

8. Provide employment and a steady source of income to the law-income groups living in

rural and urban areas of the country

9. Provide substitutes for various industrial products now being now being imported into

the country.

10. Improves the quality of industrial products manufactured in the cottage industry

sector and to enhance both production and exports.

The development of these industries would be beneficial to the developing countries and

assist them in improving their economic and social well-being. This would create greater

employment opportunities and assist in entrepreneurship and skills development and

ensure better use of the scarce financial resources and appropriate technology. India is

ranked among the ten most industrialized countries in the world. The country has derived

its economic strength from the growth of small-industries throughout its length and

breadth. The pivotal role the small industry play in the economy of India can be judged

by looking at the statistical data; more than 55% of total production in country today is

from small-scale sector.

1.9.1 Scope of small-scale industry

39

The importance of small-scale enterprises is a global phenomenon encompassing both the

developing and developed countries. Globally, the emphasis is on the small-enterprises

holding the key to growth with equity and proficiency. In India, small industry refers to

manufacturing activity. Recently it has also included servicing activities such as repair

and maintenance shops and few community services. This sector covers over 7500 items

involving very simple to highly sophisticated technologies and offering opportunities for

the utilization of local resources and skills, the sector has emerged as a major supplier of

a variety of products for mass consumption as well as parts and components to the large

industry sector. Apart from handicrafts and other traditional products, small-scale

manufacture some of the high value-added and sophisticated products like electronic

typewriters, survey equipment, security and fire alarm system, television sets and other

consumer durables. Many such products are used as original equipment items by the

manufacturers in the large industry sector. The sector has the flexibility of responding to

varied needs of the economy.

1.9.2 Characteristics of small-industries

1. Capital investment is small

2. Most have fewer than 20 workers

3. Located in rural and semi-urban areas

4. Virtually all of these firms are privately owned and are organized as sole

proprietorships

5. Growing at a faster rate than large scale industry

6. Small-scale industries activity is beehive of entrepreneurship

7. Exploitation of natural resources

8. Human resource is exploited instead of developing it

9. Due to various constraints, cheating is a common feature

10. Organization and management is very poor and negligible in many cases.

11. Financial discipline is very weak and rules and regulation are not adhered.

12. Most of the funds come from entrepreneur’s saving.

1.9.3 Importance of small-scale industries

40

1. The small-scale sector has a high potential for employment, dispersal of industries,

promoting entrepreneurship and earning foreign exchange to the country. The following

are the points to demonstrate it

2. Symbols of national identity-small enterprises are almost always locally owned and

controlled, and they can strengthen rather than destroy the extended family and other

social systems and cultural traditions that are perceived as valuable.

3. Individual’s taste fashion and personalized service-small firms are quick in studying

changes in tastes and fashion of consumers and in adjusting the production process and

production accordingly. For eg: In garment industry the small units have ruled the roost,

big companies delegate responsibility down the line and cannot swiftly change the trace

when necessary. The garment business is personalized, oriented to changing fashions and

has to be tightly controlled.

4. Facilitates capital formation-the development of small industries generated additional

income and additional savings, this helps in capital formation in the economy.

5. Equitable distribution of income and wealth-By creating opportunities for small

business, small enterprises can bring about can bring about a more equitable distribution

of income and wealth which is socially necessary and desirable

6. Balanced regional growth-small-industries make possible transfer of manufacturing

activity from congested cities to rural and semi-urban areas, this helps in regional

development

7. Linkages-the large scale industries create an opportunity for growth of small-scale

industry, the growth of large motor industry will create opportunities for setting up small

service station and repair centers.

8. Export potential-Nearly 20% of the total value of export comes from small-scale

industry. The main items of export includes pharmaceuticals, sports goods, engineering

goods, finished leather, readymade cotton garments, processed foods etc.

41

1.9.4 Advantages of small-scale enterprises

1. Small-scale industry do not require as heavy and costly infrastructure as larger

enterprises.

2. They have favorable capital output ratio

3. Helps to create economic stability in society by diffusing prosperity and by checking

the expansion of monopolies

4. Most developing countries are rich in certain agricultural, forest and mineral resources;

small-scale industries can be based on processing of locally produced raw materials

5. It is possible to save and to earn a foreign exchange by producing and exporting goods

process from local resources.

6. Small-scale industries are generally labour-intensive and do not require large amount

of capital. The energy of unemployed and under-employed people may be used for

productive purposes in an economy in which capital is scarce.

7. They bring integration with rural economy on one hand and large scale enterprise on

other.

8. They facilitate mobilization of resources of capital and skills which often would

remain inadequately utilized.

1.9.5 Role of small business in national economy

Small business has played a very crucial role in transforming the Indian economy from a

backward agrarian economy to its present stature. Its benefits range from creating job

opportunities for millions of people, including many with low levels of formal education.

It has nurtured the inherent entrepreneurial spirit in far flung corners of the nation

resulting in the growth and development of all regions. It has been instrumental in raising

the standard of living of the multitudes. The small scale sector has contributed

specifically in the following areas:

42

1. Employment Generation: The SSI sector in India is the second largest

manpower employer in the country next only to the agriculture sector. India is

characterized by abundant labour supply and is plagued by unemployment and

underemployment. Under these circumstances the small-scale sector is a boon

.For every Rs.0.1million of investment, the small-scale sector provides jobs to

26 people as compared to 4 jobs created in the large-scale sector.

2. Low Initial Capital Investment: Another feature of the Indian economy and

most of the developing economies is the scarcity of capital. The modern large-

scale sector requires colossal investments whereas the small sector is just the

opposite. Not only is the employment capital ratio high for the SSI but the

output capital ratio is also high.

3. Balanced Regional Development: Dispersion of small business in all parts of

the country helps in removing regional imbalances by promoting decentralized

development of industries. It helps in industrialization of rural and backward

areas. It also helps to reduce problems of congestion, pollution housing, sanitation

etc

4. Equitable Distribution of Income: This is a natural corollary of the above.

When entrepreneurial talent is tapped in different regions and areas the

income is also distributed instead of being concentrated in the hands of a few

individuals or business families.

5. Promotes Inter-Sectoral Linkages: SSI units are supplementary and

complementary to large and medium scale units as ancillary units. Many small

units produce sub-parts, assemblies, components and accessories for the large-

scale sector especially in the electronic and automotive sectors.

6. Exports: The most significant contribution of the SSI has been in the field of

exports. There has been a significant increase in the exports from this sector

43

of both traditional and non-traditional goods including jewellery, garments,

leather, hand tools, engineering goods, soft ware etc.

7. Development of Entrepreneurship: Small business taps the latent potential

available locally. This way they facilitate the spirit of enterprise, which results

in overall growth, and development of all the regions /sectors of the nation

Companies that succeed with economic value added (EVA) initiatives tend to

possess the following characteristics:

1. Strong support from the CEO. If the CEO takes a wait-and-see attitude, EVA

stands a greater chance of failing, because employees are less likely to take it

seriously.

2. Effective EVA education. If employees understand why they should start using

EVA principles in their everyday tasks, there’s a greater chance of success in the

implementation phase.

3. Links between EVA performance and employee compensation. Connecting the

performance measure with incentives gives EVA implementation teeth and lets

everyone know how they will be evaluated.

4. Realistic income stream projections. EVA is based on the educated guess of how

much potential a capital asset has to produce a rate of return over and above its

cost. If the people making those estimates are too rosy in their projections, the

number of capital expenditures that produce a positive EVA will shrink

5. An overall attitude of economic efficiency. Successful EVA companies look not

only at the cost of capital, but also at a variety of ways to improve economic

efficiency within their organization, such as reducing inventory costs and

improving operational processes.

6. An overall attitude of economic efficiency. Successful EVA companies look not

only at the cost of capital, but also at a variety of ways to improve economic

44

efficiency within their organization, such as reducing inventory costs and

improving operational processes.

7. EVA-based budgets. Traditional budgets impede EVA’s effectiveness by,

essentially, saying, "We have X dollars, and all of that money needs to go

someplace." If a company’s calculations indicate that only 60 percent or 75

percent of that money can be spent within its EVA parameters, then that company

should allocate its resources only to capital projects that will produce an

acceptable rate of return.

1.10 Strategies for increasing EVA

Increase the return on existing projects (improve operating performance)

Invest in new projects that have a return greater than the cost of capital

Use less capital to achieve the same return

Reduce the cost of capital

Liquidate capital or curtail further investment in sub-standard operations where

inadequate returns are being earned

1.10.1 Advantages of EVA

EVA is more than just performance measurement system and it is also marketed as a

motivational, compensation-based management system that facilitates economic activity

and accountability at all levels in the firm.

Stern Stewart reports that companies that have adopted EVA have outperformed their

competitors when compared on the basis of comparable market capitalization.

Several advantages claimed for EVA are:

EVA eliminates economic distortions of GAAP to focus decisions on real

economic results

45

EVA provides for better assessment of decisions that affect balance sheet and

income statement or tradeoffs between each through the use of the capital charge

against NOPAT

EVA decouples bonus plans from budgetary targets

EVA covers all aspects of the business cycle

EVA aligns and speeds decision making, and enhances communication and

teamwork

Academic researchers have argued for the following additional benefits:

Goal congruence of managerial and shareholder goals achieved by tying

compensation of managers and other employees to EVA measures (Dierks &

Patel, 1997)

Better goal congruence than ROI (Brewer, Chandra, & Hock, 1999)

Annual performance measured tied to executive compensation

Provision of correct incentives for capital allocations (Booth, 1997)

Long-term performance that is not compromised in favor of short-term results

(Booth, 1997)

Provision of significant information value beyond traditional accounting measures

of EPS, ROA and ROE (Chen & Dodd, 1997)

1.10.2 Limitations of EVA

EVA also has its critics. The biggest limitation is that the only major publicly-available

sample evidence on the evidence of EVA adoption on firm performance is an in-house

study conducted by Stern Stewart and except that there are only a number of single-firm

or industry field studies. It would be wrong to say that EVA is not beset with any

drawbacks. Though it provides a new tool in the hands of management, it has its own

limitations. For example, EVA does not take into cognizance current market value of

assets and book value is taken into account in calculations. This is of course misleading

and presents distorted picture but estimating the current market value of assets is very

difficult and often impractical.

46

EVA has established superiority over other measures of performance but that does not

mean that EVA alone can clearly tell how the plans are going and strategic goals being

met. The companies that have invested heavily today and expect positive cash flow only

in distant future are extreme examples that have negative EVA in near future. Their

performance can be better judged by market share, sales growth etc.

For the equity analysts, there is a word of caution. The concept of EVA requires

knowledge of accounts internal to organization to a great extent and their availability to

the external world is a big constrain. This constraint becomes even more pronounced in

countries like India where even the annual reports published by companies have scanty

disclosures. Moreover, it has to be borne in mind that EVA gives one year snapshot of

company's operational performance.

Brewer, Chandra & Hock (1999) cite the following limitations to EVA:

EVA does not control for size differences across plants or divisions

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

managers

EVA may focus on immediate results which diminishes innovation

EVA provides information that is obvious but offers no solutions in much the

same way as historical financial statement do

Also, Chandra (2001) identifies the following two limitations of EVA:

Given the emphasis of EVA on improving business-unit performance, it does not

encourage collaborative relationship between business unit managers

EVA although a better measure than EPS, PAT and RONW is still not a perfect

measure

Brewer et al (1999) recommend using other performance measures along with EVA and

suggest the balanced scorecard system. Other researchers have noted that EVA does not

correlate as strongly with stock returns as its proponents claim. Chen & Dodd (1997)

found that, while EVA provides significant information value, other accounting profit

47

measures also provide significant information and should not be discarded in favor of

EVA alone. Biddle, Brown & Wallace (1997) found only marginal information content

beyond earnings and suggest a greater association of earnings with returns and firm

values than EVA, residual income, or cash flow from operations.

Finally, a key criticism of EVA is that it is simply a retreated model of residual income

and that the large number of "equity adjustments" incorporated in the Stern Stewart

system may not be necessary (Barfield, 1998; Chen & Dodd, 1997; O'Hanlon & Peasnell,

1998; Young, 1997). The similarity between EVA and residual income is supported by

Chen and Dodd (1997) who note that most of the EVA and residual income variables are

highly correlated and are almost identical in terms of association to stock return.

1.10.3 Common EVA errors:

They don't make it a way of life. You can't just calculate EVA; you have to adopt

it. Companies must make it the centerpiece of a comprehensive financial

management system. Economic value added must be linked to how companies set

overall financial goals, how they communicate those goals internally and to the

investment community, and how they evaluate opportunities to build the business

and invest capital.

They rush the implementation process. Depending on the size of a company, the

implementation process could take anywhere from three months to two years.

Companies that make the mistake of trying to implement EVA all at once often

find there are too many people to train and disruption results. Top managers must

be able to understand economic value added so they can train those down the line.

There is a lack of conviction from senior management. The CEO must be totally

committed to prevent staff from creating fiefdoms. Direction from the top is

critical because moving to EVA is something not all managers will want to do if

they already can easily meet budget. Approximately 50 percent of the power of

EVA can be lost if the incentive plan is not driven by it.

Managers complain too much. Instead of making economic value added a

philosophical crusade to create shareholder value, communicate a simple message

48

to employees: "What if we found a measure of financial performance that really

captures all the things a person can do to run the business more efficiently, to

satisfy customers, and to reward shareholders. Wouldn't it make sense to use that

to shape our financial decision-making?"

There is a lack of quality training. It is important that the fundamentals of EVA be

communicated throughout the organization because even those with the smallest jobs can

create value. This means things like linking EVA to such key operating metrics as cycle

time or inventory turns and making certain the people involved know how economic

value added fits in. After all, the faster you turn inventory, the greater the reduction of

needed capital, resulting in increased EVA.

49

Objectivesof the Study

50

1.11 Objectives of the Study

Whenever a study is conducted, it is done on the basis of certain objectives in mind. A

successful completion of a project is based on the objectives of the study that could be

stated as under:

1) To determine how to calculate EVA of a company.

2) To develop an EVA model for SME’s.

3) To determine how EVA as a tool act as a financial performance measure in SME’s.

4) To examine how EVA is different from other performance measures i.e. pitfalls of

traditional performance measures are discussed here.

1.12 Limitations of the study

Though every care has been taken to make this report authentic in every sense, yet there

were a few uncomfortable factors, which might have their influence on the final report.

Linking factors can be stated as:-

There were many problems regarding the collection of secondary data internally

i.e. Income Statement and Balance Sheet of the firm.

51

None of the owner managers and employees of the firm is keeping a proper record

of Sales, Inventory, costs associated and other facts required for the purpose of

research.

Nobody was willing to share any kind of information and it was hard to get the

real fact about the firm’s profitability.

Lack of resources available on Economic Value Added (EVA) model for SME.

52

Reviewof

Literature

Review of Literature

2.1 Bartoloma Deya Tortella and Sandro Brusco (2001) examined that Economic

Value Added (EVA) is a widely adopted technique for the measurement of value

creation. Using different event study methodologies they test the market reaction to the

introduction of EVA. Additionally, they analyze the long-run evolution before and after

EVA adoption of profitability, investment and cash flow variables. They first show that

the introduction of EVA does not generate significant abnormal returns, either positive or

negative. Next, they show that firms adopt EVA after a long period of bad performance,

and performance indicators improve only in the long run. With respect to the firm

53

investment activity variables, the adoption of EVA provides incentives for the managers

to increase firm investment activity, and this appears to be linked to higher levels of debt.

Finally, they observe that EVA adoption affects positively and significantly cash flow

measures.

2.2 Andrew Worthington and Tracey West (2003) noticed that with increasing

pressure on firms to deliver shareholder value, there has been a 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 EVA’s conceptual underpinnings and the

comparatively few empirical analyses of value-added performance measures. Special

attention is given to the GAAP-related accounting adjustments involved in EVA-type

calculations.

2.3 Roztocki, N. and Needy, K. L. (1999) this paper examines introducing Economic

Value Added as a performance measure for small companies. Advantages and

disadvantages of using Economic Value Added as a primary measure of performance as

opposed to sales, revenues, earnings, operating profit, profit after tax, and profit margin

are investigated. The Economic Value Added calculation using data from a company’s

income and balance sheet statements is illustrated. Necessary adjustments to these

financial statements, that are typical for a small company, are demonstrated to prepare the

data for the Economic Value Added determination. Finally, potential improvement

opportunities resulting from Economic Value Added implementation as a performance

measure in small manufacturing companies is discussed.

2.4 M Geyser & IE Liebenbergn (2003) examines long-term shareholder wealth is

equally important for all profit seeking organizations, regardless of their size. This paper

examines introducing Economic Value Added (EVA) as a performance measure for

agribusinesses and co-ops in South Africa. EVA is an effective measure of the

quality of managerial decisions as well as a reliable indicator of an enterprise’s

54

value growth in future. The question posed is whether South African agribusinesses and

cooperatives are capable of creating shareholder and member value after the deregulation

of the agricultural markets.

2.5 Linda M. Lovata and Michael L.Costigan (2002) found that Economic Value

Added is a new measure of performance that is purported to better align managers’

incentives to that of the shareholders. Accordingly, firms that experience higher agency

conflicts should be more inclined to use this performance evaluation system.

Additionally, the organizational strategy of the firm should influence the likelihood of

employing EVA. Prospector firms are defined as firms that apply a differentiation

strategy while defender firms focus on being cost-leaders. Firms identified as prospectors

should be less likely to use EVA. One hundred and fifteen firms were identified as being

adopters of EVA. Logistic regression was performed to contrast these firms to a control

group of 1271 non-adopters. The results indicate that firms using EVA exhibit a higher

percentage of institutional ownership and a lower percentage of insider ownership than

non-adopters. Prospector firms as defined by a higher ratio of research and development

to sales tend to use EVA less than defender firms. Accounting adjustments are a focal

point of the EVA formulation and the results presented in this study suggest that

providing appropriate incentives may be more complex than the developers of EVA

imply.

2.6 Financial Management Department ;University of Pretoria (2003) studied that

several researchers and practitioners, notably Stern Stewart Consulting Company and

Associates, have claimed that economic value added (EVA) is superior to traditional

accounting measures in driving shareholder value. Other researchers have refuted these

claims by supplying data in support of traditional accounting indicators such as earnings

per share (EPS), dividends per share (DPS), return on assets (ROA) and return on

equity (ROE). This study endeavored to analyses the results of companies listed on the

JSE Securities Exchange South Africa, using market value added (MVA) as a proxy for

shareholder value. The findings do not support the purported superiority of EVA. The

results suggest stronger relationships between MVA and cash flow from operations. The

study also found very little correlation between MVA and EPS, or between MVA and

55

DPS, concluding that the credibility of share valuations based on earnings or

dividends must be questioned

2.7 Raghunatha Reddy (2008) examined that for the past two decades many countries

started transforming their economies from traditional protected ones to those of more

liberalized, globalize and market driven. This period has also seen the economies

becoming more knowledge oriented and Human Resources started assuming more

prominence in the growth of the economies and businesses posing a greater challenge for

companies to acquire and retain talented workforce (especially at the strategic &

managerial levels). The knowledge economy also started witnessing the rapid rise of the

agency problem- conflict of interest between managers and owners. So it is very essential

to align the interests of the mangers and shareholders or at least reduce the difference

between them. In this regard Economic Value Added has been seen as better alternative

to the stock price and traditional performance measures. While successful EVA stories in

the west are quite encouraging, Corporate India is slowly catching up the EVA adoption.

Although not a panacea, EVA based compensation plans will drive managers employ a

firm's assets more productively and EVA should help reduce the difference in the

interests of the managers and shareholders, if not perfectly align them.

2.8 Girotra, Arvind; Yadav, Surendra S (2001) noted that 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

2.9 Michael F. Shivey and Jeffery J. McMillan (2002) This paper first provides an

overview of the standard asset ; market and income valuation methods that are used to

estimate the value of small businesses. It then discusses economic value added (EVA)

and demonstrates its potential use inn the valuation of small business.

56

2.10 Gary C. Biddle, Robert M. Bowen, James S. Wallace (1998) Traces the growth in

the use of economic value added (EVA, previously known as (residual income) and uses

two previous research studies to assess some claims for its merits. Compares EVA’s

ability to explain stock returns with that of earnings before extraordinary items (EBEI)

and cash flow using 1984-1993 US data; and finds EBEI is most closely related.

Examines EVA’s incentive effects on management investing, financing and operating

decisions and shows that, although EVA users decreased new investment, increased

dispositions of assets, increased share repurchases, used assets more intensively and

increased residual income, market reactions to this were weak. Suggests possible reasons

for this and concludes that EVA may align management incentives with shareholders’

interests but this does not necessarily increase shareholder value.

2.11 Samuel C.Weaver (2001) analyzed that over the past decade, consultants, the

popular business press, a number of companies and a few investment analysts have

heralded Economic Value Added (EVA). In theory, EVA is net operating profit after tax

(NOPAT) less a capital charge for the invested capital (IC) employed in the business.

This survey bridges the gap between "theory" and "practice" by detailing how EVA

proponents measure EVA. This survey is important because its fieldwork identifies

significant inconsistencies in the measurement of EVA and its major components

2.12 Storrie & Sinclair (1997) present that EVA based on historical values can be

somewhat misleading. They first demonstrate that the valuation formula of EVA is

theoretically exactly the same as the valuation formula of discounted cash flow (DCF)

(Proved also by Kappi 1996). After that Storrie & Sinclair also prove mathematically that

this equivalence is due to the fact that the book value in EVA valuation formula is

irrelevant in determining value. That is because an increase in "book value of equity"

decreases the periodic EVA-figures ("present value of future EVA") and these changes

cancel each other out.

2.13 Stewart, (1991) explained that by explicitly assigning a cost of equity capital and

removing the distortions of accounting conventions, EVA allegedly better measures the

wealth that a firm has created during a period than does traditional accounting earnings.

57

In other words, EVA allows investors to evaluate whether the return being earned on

invested capital exceeds its cost as measured by the return from alternative capital uses.

Since wealth (or value or return) created is a primary concern to investors, proponents

claim that EVA® is the only measure that ties directly to the intrinsic value of a

company’s stock As mentioned earlier, all anecdotal EVA stories allude to this as the

primary advantage of adopting EVA.

2.14 Weissenreider (1998) criticized EVA because it is based on accounting items only.

He opined that financial managers might be compelled to act on information that is

accounting in disguise and might have serious consequences. Weissenreider (1998)

compared EVA with Cash Value Added (CVA) and concluded that the latter is a better

performance measure.

2.15 Tully, (1993) In contrast, in this paper EVA has been hailed as the most recent and

exciting innovative measure of corporate performance that corrects both types of errors in

accounting earnings and that EVA should, therefore, replace earnings in both security

analysis and performance evaluation

2.16 Asish K Bhattachary and B.V. Phani (2004) 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.

2.17 Mahfuzul Hoque and Mahmuda Akter (2004) this paper examines performance

measurement matters in today’s complex business arena irrespective of the type, nature,

and volume diversity in business. If the result of performance measurement goes wrong

due to the faulty or inaccurate selection of tool(s), then the total process will prove wrong

58

in due time. This paper evaluates Economic Value Added (EVA) as a smart and powerful

alternative to traditional performance measures like gross margin, percentage change in

sales, net margin etc. in a small manufacturing company perspective. Small

manufacturing companies are the focus of the study, as most of the people in such

companies believe that EVA is truly designed for large companies and the equation of

EVA cannot be applied in small companies due to the non-availability of required data.

This paper results in a typical model applicable to small manufacturing companies where

all adjustments and other technicalities are discussed with a real life example. Finally, the

possible advantages and opportunities of using EVA as a performance measurement tool

is discussed that may encourage the users/readers to incorporate EVA with their current

setup to reap the potential benefits from it.

59

Research

Methodology

Research Methodology

Research by the name itself means re-search i.e. to search again. The task of research is

to generate accurate information for the use of decision making. Research is a systematic

and objective process of gathering, recording and analyzing data for the aid of making

decisions relating to a particular problem.

3.1 Need and Focus of the Research

The study consists of three main chapters. The first discusses the general theory behind

EVA. This chapter presents the background and basic theory of EVA as well as main

60

findings about EVA in financial literature. The chapter also explains in general what

EVA has to give to corporate world. This chapter also focuses on the use of EVA in

group-level controlling. It discusses how EVA could be defined in controlling and

reporting, how it can be used in any company as a financial performance tool and what

are the problems faced in implementing EVA. The second chapter consists of review of

literature mentioning findings of various research papers and various other studies

conducted on the use of EVA as a financial performance tool. Third and final main

chapter deals with EVA more practically inside and for this the case of SME has been

taken from Ludhiana city, Punjab. (Name of the firm has not been disclosed due to

ethical reasons just to hide their explicit identity). The chapter presents with numerical

example the calculation of EVA and its impacts as a financial performance tool.

3.2 Research design

The research design is a master plan specifying the method and procedures for

collecting and analyzing needed information. The research design in this project is

exploratory in nature. Secondary data was used in doing the study “Economic Value

Added (EVA) as a financial performance tool: A case of SME’s”

Sampling plan:

Sampling plan is an effective step in collection of different data from different sources

and has a great influence on the quality of results. Mainly secondary data i.e. Income

Statement and Balance Sheet of the firm was used in doing this study to develop an EVA

model for small manufacturing firms. The sampling plan includes the population, sample

size and sampling technique.

Population:

The study is aimed to include any SSI / SME from Punjab state.

Sample Size:

To conduct this study and to develop an EVA model a case of one small manufacturing

firm has been taken from Ludhiana; Punjab.

61

Sampling Technique:

The sample was drawn from the population using convenience sampling.

Data Sources:

Secondary data was used in doing the study which has been collected internally as

Income statement and Balance sheet of the firm and externally from published materials

like research papers and from the internet.

3.3 Data Analysis Technique

How to calculate EVA

The EVA is a measure of surplus value created on an investment. Here, surplus value

simply stands for the difference between return and cost of capital. In a small

manufacturing firm, the EVA model is modified, or more appropriately, simplified to

some extent. This simplification comes due to the less complexity of operation, non-

availability of required information and comparatively lower amount of financial

involvement. This proposed EVA model seeks six sequential steps to be followed

before getting a periodic EVA, i.e., to what extent the owners‘ equity or wealth

is changed (increased/decreased). These steps are outlined below followed by an

illustration with one of my sampled small manufacturing firm.

Step 1: Review the company‘s financial data

EVA is based on the financial data. Most of these data are available from the general-

purpose financial statement consisting of at least income statement and balance sheet.

Sometimes additional data from the notes to financial statements may also be required.

In most of the cases, the last two years information prove sufficient to get all the

required information to calculate EVA for any specific year. Income statement is used

to calculate net operating profit after tax (NOPAT) and balance sheet is used to identify

the capital invested in the business. Notes are used to find out the adjustments in

NOPAT and cost of capital (COC) invested.

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Step 2: Identify the necessary adjustments require to be considered

The conventional GAAP income statement and balance sheet are required to be

adjusted to find out net operating profit and the true capital. Companies cannot replace

GAAP earnings with EVA in their public reporting, of course. The first departure from

GAAP accounting is to recognize the full COC (Cost of Capital). EVA also fixes the

problems with GAAP by converting accounting earnings to economic earnings and

accounting book value to economic book value, or capital. The result is a NOPAT figure

that gives a much truer picture of the economics of the business and a capital figure that

is far better measure of the funds contributed by shareholders and lenders. Stern Stewart

identified around 164 potential adjustments to GAAP and to internal accounting

treatments, all of which can improve the measure of operating profits and capital. Now

the question comes, to what extent it can be adjusted.

The “Basic EVA” is the unadjusted EVA quoted from the GAAP operating profits and

Balance sheet. “Disclosed EVA” is used by Stern Stewart in its published MVA/EVA

ranking and computed after a dozen standard adjustments to publicly available

accounting data. “True EVA”, is the accurate EVA after considering all relevant

adjustments to accounting data. However, our interest is at the “Tailored EVA”. Each

company must develop their tailored EVA definition, peculiar to its organizational

structure, business mix, strategy and accounting policies, i.e., one that optimally balances

the trade-off between the simplicity and precision.

Once the formula is set, it should be virtually immutable, serving as a sort of

constitutional definition of performance. According to John Shiely, The CEO of Briggs

and Stratton Corp, —Adopting EVA simply as a performance measurement metric, in

the absence of some ideas as to how you are going to create value, is not going to get you

anywhere“ (Kroll, 1997). The list of potential adjustments is too lengthy to detail here.

Some adjustments are necessary to avoid mixing operating and financial decisions,

others provide a long-term perspective, and some are needed to convert GAAP

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accrual items to a cash-flow basis while others convert cash flow items to

additions to capital.

Step 3: Identify the company‘s capital structure

Because of the deficiency of GAAP in describing a company‘s real financial position

(Clinton and Chen, 1998), Stewart proposes up to 164 adjustments to regain the real

picture of a firm‘s financial performance (Stewart, 1991; Blair, 1997). These

adjustments are needed to eliminate financing distortions in a company‘s NOPAT and

capital (Stewart, 1991). Regarding adjustments, some accounting items such as costs for

research and product development, restructuring charges, and marketing outlays are

considered more as capital investments as opposed to expenses (Stewart, 1991).

A company‘s capital structure comprises all of the money invested in the company

either by the owner or by borrowing from outsiders formally. It is the proportions of debt

instruments and preferred and common stock on a company‘s balance sheet (Van Horne,

2002). Stewart (1990) defined capital to be total assets subtracted with non- interest

bearing liabilities in the beginning of the period. However, it can be computed by either

of the following methods:

Direct Method: By adding all interest bearing debts (both short and long term) to owner‘s equity.

Indirect Method: By subtracting all non- interest bearing liabilities from total assets.

Step 4: Determine the company‘s COC rate for the individual sources of capital in capital structure

Estimation of COC is a great challenge so far as EVA calculation for a company is

concerned. It becomes more complex when small companies are considered whose

sources of capital are unstructured and varied over the years. The cost of capital

depends primarily on the use of the funds, not the source (Ross et al, 2003). It depends

on so many factors like financial structures, business risks, current interest level,

investors expectation, macro economic variables, volatility of incomes and so on. It is

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the minimum acceptable rate of return on new investment made by the firm from the

viewpoint of creditors and investors in the firms‘ securities (Schall and Haley, 1980).

Some financial management tools are available in this case to calculate the COC. A more

common and simple method is Weighted Average Cost of Capital (WACC)

(Copeland et al, 1996).

The overall COC is the weighted average of the costs of the various components of the

capital structure. WACC, though a good tool to compute accurate cost of capital, is less

useful for a small company. WACC includes both debt and equity part of financing. Each

element in the capital structure has an explicit, or opportunity, cost associated with it

(Block and Hirt, 2002). The cost of each component of the firm‘s capital, debt, preferred

stock, or common stock equity is the return that investors must forgo if they are to invest

in the firm‘s securities (Kolb and DeMong, 1988). Thus, the difficulty arises in both of

the cases. Cost of debt cannot be calculated because the debt instruments in this case are

not traded in the open market. It is measured by the interest rate, or yields, paid to

bondholders (Block and Hirt, 2002). Sometimes, these instruments have no developed

market. Again, cost of equity is also difficult to calculate due to the non- applicability of

the tools developed to this effect. For example, for large companies, the

Capital Asset Pricing Model (CAPM) is a common method in estimating the cost of

equity (Copeland et al, 1996). CAPM postulates that the cost of equity is equal to the

return on risk-free security plus a company‘s systematic risk, called beta, multiplied

by the market risk premium (Copeland et al, 1996). Risk premium is associated

with the specific risks of a given investment (Block and Hirt, 2002).

In our financial environment, even the betas for all large companies are not available. For

large publicly traded companies, betas are published regularly by services such as Value Line

(Reimann, 1988). For small companies, regression analysis may be used in order to

estimate their betas (Ross et al, 1999). The next obstacle is to get a proper value of

market risk premium. For large U.S. companies, the recommended market risk

premium is 5 to 6 percent (Copeland et al, 1996; Stewart, 1991). For publicly traded

65

small companies, the market risk premium is significantly higher with values around 14

percent (Ross et al, 1999). These rates are not absolute rather relative as these depend on

time, location, macro economic variables and some other factors. In our environment,

market risk is so volatile that the appropriate premium, demanded by the

owners against their investment, for even the large companies cannot be

accurately estimated. Even no company takes the responsibility to work in this area. For

a small company, it cannot be thought of in current eco-financial setup.

Dividend discount model is another popular model in this case where market price of a

share is equal to the present value of future streams of dividends (Khan and Jain, 1999).

This model presupposes that the company under consideration is matured and normal

growth one that I have assumed in my case. However, in this case also, the presence

of an active market for securities is a must, otherwise, the COC (Equity ) cannot

be determined which is the discount rate (ke) in the following simplified version

of Gordon‘s dividend capitalization model:

P = E (1-b) / ke – br

Where, P = Price of shares E = Earnings per share b = Retention ratio Ke = Capitalization rate/ COC (Equity) br = g = growth rate in i.e., rate of return on investment in an all-equity firm.

Considering all of the obstacles, we suggested a method derived from the WACC

estimation and the CAPM model which have been adapted to the needs of small

companies. We identify this rate as COC rate just to make a distinction between WACC

that is used for large companies with the modified WACC. The COC that is developed

here with the applicability option of small companies as considered here. The COC

replaces the formal WACC in the following way:

COC = COC (Debt) (Debt/(Debt + Equity)) (1-t) + COC(Equity) (Equity/(Debt +

Equity))

66

Where (t) represents the corporate tax rate and incorporated with the weight of debts only

as debt has the tax deductibility advantage.

Again, COC (Debt) can be estimated as follows:

COC (Debt) = Prime Rate + Bank Charges

Where, prime rate is the core rate (explicit rate) charged on loan and bank charges are

additional charges over the prime rate. Average bank charges in my study for small

manufacturing companies vary from one percent to two percent.

COC (Equity) can be estimated as follows:

COC (Equity) = Rf +RpWhere, Rf = Risk free rate Rp = Risk premium

Rf is the arbitrary rate of governmental treasury bill on which it is assumed that this

rate does not vary with the actions and reactions of the market factors. In contrast, Rp

reflects the risk resulting from the investment in the equity. The riskier the investment,

the higher would be the Rp . If the Rp is not higher, investors will not agree to invest

their funds in risky business. This table suggests various Rp ranges depending upon the

investment risk

RP Ranges Investment Risk

6 % and less Extremely low risk, established profitable company with extremely stable cash flows.

6 % - 12 % Low risk, established profitable company with relative low fluctuation in cash flow

12 % - 18 % Moderate risk, established profitable company with moderate fluctuation in cash flow

18 % and more High business risk

67

(Source: Narcyz Roztocki &Kim LaScola Needy; University of Pittsburgh; Department of Industrial

Engineering)

Step 5: Calculate the company‘s NOPAT

NOPAT is derived from NOP simply by deducting calculated taxes from NOP i.e.,

NOPAT = NOP (1- Tax rate). These calculated taxes do not correspond the taxes

actually paid because e.g. interest on debt decreases real taxes. The tax shield of debt is

however taken into account with the capital costs. NOPAT is a measure of a company‘s

cash generation capability from recurring business activities, while disregarding its

capital structure (Dierks and Patel, 1997).

Most of the needed adjustments, to convert the accounting profit to economic profit as

identified in step 2, are appropriate for large companies. On the other hand, small

companies have some peculiar adjustments that are not required in case of large

companies. For example, some researchers observed that an owner-manager‘s salary in

a small business represents a much larger fraction of revenues than that in a large

company (Welsh and White, 1981). It may imply that in a small business owner-

manager‘s salary is not only salary but it also includes a charge for the capital that they

invested in the company. To remove this distortion, an adjustment is needed with the

accounting profit to find out the economic profit. Thus, here NOPAT can be calculated

as follows:

NOPAT = Net Profit after tax + Total Adjustments – Tax Savings on investments

Step 6: Calculation of Economic Value Added

At last, the EVA can be calculated by subtracting capital charges from NOPAT

as follows (Stewart, 1991; Reimann, 1988):

EVA = NOPAT - Capital Charges

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= NOPAT - C COC

Where, C and COC include all types of capital proportionately.

Positive EVA indicates value creation while negative EVA indicates value destruction for

the company‘s owners.

Analysis

69

&

Discussion

Analysis & Discussion

4.1 The EVA and its status in India

In India, most of the companies use traditional measures. Even, they do not use it to

evaluate internally. It seems to be that people are reluctant to accept new but strong tool.

In our environment, people are very much cautious to abide by the legal

requirements. Disclosure is strictly governed by the legal framework and people always

want to avoid voluntary disclosure. In terms of efficiency, our market is in weak form.

Therefore, large companies, whether public or private, do not feel that they should

incorporate tools like EVA in their present setup. However, in a large company

70

perspective, it is simple to calculate EVA, as the required information is very simple to

find or compute. It is a matter of time and intention only for the calculation and

disclosure of EVA’s so far as large companies are concerned. Nevertheless, the

necessary data for calculating EVA is not available for small companies. That is why;

I focus on small manufacturing companies here where performance evaluation is of

paramount importance.

4.2 Empirical illustration

To propose EVA calculation for small manufacturing firms, as a realistic example, I have

used data from one of the sample firm of Ludhiana city. This firm is managed by three

owner-managers and has approximately 20 employees working in a firm. The company‘s

line of business is manufacturing of cotton, woolen and acrylic fabrics for the local user

groups with a vision to extend the market over the boundary in near future. As per my

commitment, I will refer to this company as — XYZ firm throughout the paper just

to hide their explicit identity. The financial data are simplified for the readers just to turn

their attention towards the process rather than on accounting details.

Step 1: Review the company‘s financial data

To assemble necessary financial information, I just collected their income statement,

Balance sheet and notes to the accounts. These are sufficient for all required information

for my study. Table 2 shows the income statements for the years 2009 and 2010 and

Table 3 shows the balance sheet for three consecutive years in a simplified way.

Table 2: XYZ‘s Income statement for the years 2009 and 2010 (in lac Rupees)

Particulars 2009 2010

1.0 Sales Revenues (Less return, VAT etc.) 193.19 271.17

1.1 Cost of Goods Sold 163.71 236.30

1.2 Gross Profit (1.0-1.1) 29.48 34.87

1.3 General and Administration Expenses 14.24 15.64

1.4 Selling Expenses 1.86 2.12

1.5 Total Administration & Selling Exp. (1.3 + 1.4) 16.10 17.76

71

1.6 Operating Profit (Loss) (1.2 - 1.5) 13.38 17.11

1.7 Other Income __ __

1.8 Other Expenses 0.25 0.42

1.9 Financial Expenses (Interest) 1.44 2.47

2.0 Net Profit (Loss) before tax (1.6 + 1.7 -1.8 – 1.9) 11.69 14.22

2.1 Taxes (31.10%) 3.64 4.42

2.2 Net Profit (Loss) after tax (2 - 2.1) 8.05 9.80

Step 2: Identify the necessary adjustments requires to be considered

Now, after assembling all necessary financial information, the next step necessitates to

identify all required adjustments to be considered. In case of XYZ firm, I do not find any

documentation of cost related to research and development, extension of current

facilities, employee training, unusual write-offs or gains and thus adjustments are

insignificant. One adjustment is needed in net profit for interest expense and

tax shield. These adjustments are needed to find out the true NOPAT. Because, NOPAT

is a measure of a company‘s cash generation ability from recurring business activities

(Dierks and Patel, 1997).

Step 3: Identify the company‘s capital structure

Capital structure includes all forms of financing whether generated internally or by

borrowing externally. It can be estimated under each of the two methods as identified

earlier. In case of direct method (financing approach), all interest-bearing debts (both

short and long term) are added to owner‘s equity to find out the total amount of capital

invested.

On the other hand, in case of indirect method (operating approach), all non- interest

bearing debts like accounts payable, sundry creditors, accrued expenses are

subtracted from the total liabilities to calculate the total capital invested in the business.

Tables 4 represent the amount of capital invested by XYZ firm under indirect method

respectively.

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Table 3: XYZ’s Balance Sheet for the years 2009 and 2010 (in lac Rupees)

Liabilities 2008 2009 2010 Assets 2008 2009 2010

Current Liabilities: Current Assets:

2.0 Accounts payable/ Sundry Creditors

6.61 11.76 16.89. 3.2 Cash in hand 0.26 0.39 0.47

2.1 Secured loan/Bank loan

2.25 5.40 15.91 3.3 Accounts Receivable 8.64 16.31 27.54

2.2 Accrued Expenses 0.35 0.67 0.75 3.4 Inventory/Stock 10.55 17.83 27.81

2.3 Other Current Liabilities 0.17 0.26 0.39 3.5 Prepaid Expenses 0.06 0.08 0.12

2.4 Total Current

Liabilities

(2.0 to 2.3)

9.38 18.09 33.94 3.6 Other Current Assets 0.28 0.37 0.54

Non-Current Liabilities: 3.7 Total Current

Assets

(3.2 to 3.6)

19.79 34.98 56.48

2.5 Long Term Loan 3.10 6.15 4.45 Fixed Assets:

2.6 Unsecured loans 6.37 8.81 10.85 3.8 Land &Building (net of dep.)

4.78 7.89 8.91

2.7 Total Non Current

liabilities

(2.5 to 2.6)

9.47 14.96 15.30 3.9 Plant and Machinery(net of dep.)

3.88 6.54 7.25

2.8 Total Liabilities

(2.4 + 2.7)

18.8

5

33.05 49.24 4.0 Furniture and Fixtures(net of dep.)

0..29 0.42 0.54

Equity/Net Worth:

4.1 Other fixed Assets 0.17 0.49 1.76

2.9 Capital (Less Drawing) 10.1

7

17.41 25.97 4.2 Total Fixed

Assets

9.12 15.34 18.46

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(3.8 to 4.1)

3.0 Less: Intangible Assets (i.e. Goodwill, patent etc.)

0.11 0.14 0.27

3.1 Tangible Net worth/equity(2.9 – 3.0)

10.0

6

17.27 25.70

Total Liabilities and equities(2.8 + 3.1)

28.9

1

50.32 74.94 Total Assets

(3.7 + 4.2)

28.91 50.32 74.94

Table 4: An estimation of the capital employed by XYZ firm under indirect method or operating approach (in lacs Rupees) Components of Capital 2009 2010

Total Liabilities 50.32 74.94

Accounts Payable/ SundryCreditors

(11.76) (16.89)

Accrued Expenses (0.67) (0.75)

Other current liabilities (0.26) (0.39)

Capital 37.63 56.91

In calculating the capital, I assumed the book value of the liabilities truly

represent the current market value. Furthermore, since the XYZ‘s equity and other debts

are not traded in a financial market, it is assumed that the values on the balance sheet are

74

good estimators of market values. Finally, no adjustment is made to convert the

accounting capital to financial capital just to keep the illustration simple and precise.

Step 4: Determine the company‘s COC rate for the individual sources of capital in capital structure

The COC rate has two parts. The prime rate for the cost of debt is 14% for this typical

firm and on an average, they have to pay other charges of 1% of the amount

borrowed. Thus, the pre-tax COC (Debt) will be 15% for the year 2010 if I put the values

in equation

. COC (Debt) = Prime Rate + Bank Charges

= 14 % + 1 % = 15 %

For the COC calculations, I have taken weighted average yield of 91days

government treasury bill rate (ranges between 6.50% - 7.50%) of 7.50% as a

proxy for risk free rate and according to my analysis; the company lies in average

risk area that requires 12% of risk premium. Having this information and equation,

COC (Equity) can be estimated as follows:

COC (Equity) = Rf +Rp = 7.50% + 12 % = 19.5% Where, Rf = Risk free rate Rp = Risk premium

The 19.5% cost of equity rate will be same for both of the years if the company will

remain in the same risky area over the years. As I got both cost of debt and cost of equity,

now I can calculate overall COC using capital structure as shown in Table 4 and

equation, as follows:

COC = COC (Debt) (Debt/(Debt + Equity)) (1-t) + COC(Equity) (Equity/(Debt + Equity))

In 2009,

COC = 9.03 %

75

In 2010,

COC = 8.64 %

Step 5: Calculate the company‘s NOPAT

As I have already identified the necessary adjustments of net operating profit in step

2, it becomes very simple here to compute adjusted NOPAT. In 2010, I have to adjust

NOPAT by the capital charge in interest expense with the tax shield. However, in

2009 also, I have to adjust the capital charge embedded interest expense with respective

tax shield, as the company had sufficient debt in their capital structure in the

specified year. Using equation, the NOPAT for the years will be as follows:

2009 2010

NOPAT = Net Profit after Tax + Total

Adjustments – Tax savings on adjustments

NOPAT = Net Profit after Tax + Total

Adjustments – Tax savings on adjustments

NOPAT = 8.05 + 1.44 – (1.44 .3110)

= 9.04

NOPAT = 9.80 + 2.47 – (2.47 .3110)

= 11.50

Step 6: Calculation of EVA

Finally, the XYZ’s EVA can be calculated by putting the values in equation as follows:

In 2009,

EVA = NOPAT – Capital Charges = NOPAT – C COC = 9.04 – 37.63 9.03 = 9.04 – 3.40

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= 5.64

In 2010,

EVA = NOPAT – Capital Charges = NOPAT – C COC = 11.50 – 56.91 = 11.50 – 4.92 = 6.58

Thus, in both of the years, XYZ creates positive value for its owners amounting to

Rupees 5.64 lacs and Rupees 6.58 lacs in years 2009 and 2010 respectively. It

means that the actual wealth of the owners have increased by the amount of EVA.

4.3 Implications of findings

After the calculation of EVA, I met the owner-managers of the company and

explained the result to them. They showed their best interest with the EVA measure as

compared with their current measure of earning after interest and taxes (EAIT). They

were amazed with adding borrowed fund in their capital structure that helped them to get

tax advantage by way of reducing tax liability. Thus, they may add more wealth in the

year 2009 as compared with 2010 due to the presence of more debt in 2010. Moreover,

they found that EVA approach is consistent with the objectives of the business, which is,

wealth creation for the owners that was not prima facie considered in case of

traditional measures. The XYZ’s owner-managers assured me that they would

incorporate EVA measure very soon to evaluate performance and compare the changes

with the current measure. They agreed that EVA measure would help them to

utilize their financial resources more economically. Their reactions satisfied me and

encouraged me to conduct some vigorous study in the same field if demand arises to

develop the proposed model for small manufacturing companies with the new business

situation.

4.4 EVA Implementation by a Small Company

EVA calculation is just a starting point

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Permanent EVA improvement has to be the main management objective

EVA has to be calculated periodically (at least every three months)

Changes in EVA have to be analyzed

EVA development is the basis for a company’s financial and business policy.

Compared to conventional measures, EVA is an epochal measure since it can be

maximized: it is the better the bigger EVA is. With traditional measures that is not

the case, since ROI can be increased with ignoring below average projects and

EPS/Operating Profit/Net profit can be increased simply investing more money in

the company

Since EVA helps the organization to realize that capital is a costly resource the

most immediate effect of EVA implementation is in most cases dramatic

improvement in capital efficiency (improved capital turnover)

4.5 Pitfalls of Traditional Performance Measurement

The maxim “what gets measured gets managed” does not only refer to shareowner

value. A review of businesses’ favorite financial performance measures – and their

pitfalls – shows that managers and executives should be very careful. While

business schools have been preaching valuation concepts for decades, earnings per

share and other traditional financial measures continue to rule supreme. However,

these metrics have many risks.

Overinvestment

Profit and profit margin measures often drive over-investment and vertical

integration because they overlook capital and its cost. Increasingly, different businesses

and business models consume varying levels of capital at varying costs. Managers are

often drawn to higher margin businesses that, on the surface, may seem more attractive.

For example, profits are often improved with newer production technology – but

they must be, to compensate for the higher levels of investment. Because

traditional financial measures ignore the returns that shareholders expect, any

corporate project with just a positive – but not necessarily an adequate – return above

78

zero can improve a manager’s margins, unit cost, profit and productivity measures.

However, such a project can also destroy value.

Overproduction

Traditional measures of unit cost, utilization and income frequently promote

troublesome over- production, particularly at the end of a year or quarter.

Producing to capacity rather than to demand often appears to reduce costs, yet doing so

can also raise the cost of invested capital. The bias toward over-production, despite

demand, is exacerbated by absorption accounting practices, which convert operating costs

into inventory. This practice gives the illusion of lower costs from the distorted

perspective of a cost per part, while creating operating burdens (e.g., uneven and

inflexible production) and vast quantities of unnecessary inventory. Foregone revenue is

endemic to this vicious circle, because heavy discounting and trade promotion are

needed to unload the extra product, often at the end of each quarter.

Service Economy

Traditional financial measures, being based on traditional business models, have not kept

up with the pace of change. New business models are often based on services,

outsourcing, partnerships and other innovative ways of doing business. Therefore,

traditional financial measures are inherently biased against the new service economy.

Their blunt nature is too simplistic, creating impediments to profitable growth in a world

where more and more service-oriented businesses are being designed around razor-thin

margins, but with low capital investment. Similarly, a bias against viable, long-term

investments and economic growth can result from a simplistic, near term income focus.

Poor Decisions

Traditional financial measures exclude the shareholders’ investment in the business; an

incomplete measure that ignores capital is entirely inappropriate to handle the many

79

business decisions that trade-off between profit margin and capital utilization (velocity).

Traditional financial measures confuse accounting anomalies with the underlying

economics of business. When tied to incentive compensation, this can lead to

dysfunctional behavior among managers and top executives alike.

Conclusion80

Conclusions

Creation of value for the owners is important in business, irrespective of the volume of

investment or type of operation. Moreover, in case of EVA measurement, companies,

whether large or small, have to earn more than capital charges if they want to add value

positively. Thus, in an EVA controlled world, everybody works to maximize the gap

between NOPAT and capital charges that will ultimately ensure both financial

efficiency and operational efficiency. Financial efficiency means the construction of

capital structure in such a way and from such sources that will ensure minimal capital

charges. On the other side, operational efficiency will ensure more NOPAT.

However, it is to some extent difficult to implement EVA in small manufacturing

companies, a tailored definition of EVA is required to be set on the specific type of

operation and the needs of the business. EVA is the most widely used value-based

performance measure (Myers, 1996) probably just because it happens to be an easier

81

concept compared to the others. In implementing EVA, one of the most important

things is to get the people in organizations to commit to EVA and thereby also

to understand EVA (Klinkerman, 1997). It may have some impurities in it. Nevertheless,

in future courses of time, the EVA model can be made error free. Once the employees

get motivated to maximize EVA, wealth creation becomes a regular phenomenon

in a business.

In this paper, I have tried to develop an EVA model for small manufacturing business

setup with considering all of their hindrances and technicalities. I was confronted with the

question, —Whether EVA can be used in small manufacturing companies as a tool to

measure performance? “Through this paper, I employed my best effort to give an answer

to the question. Whatever may be the size and nature of operation, EVA is suited with

some adjustments. In most cases, the additional effort in calculating EVA is outweighed

by the value of the additional information showing improvement opportunities

i.e. benefit is always greater than the cost of incorporating EVA as a new tool replacing

the traditional tools.

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Suggestions

Suggestions

EVA is the only operating measure to account for the many income statement and

balance sheet trade-offs involved in creating value because of its simultaneously focuses

on both profit and capital. Donaldson Brown, Chief Financial Officer of General Motors,

wrote in 1924, “The objective of management is not necessarily the highest rate of return

on capital, but … to assure profit with each increment of volume that will at least equal

the economic cost of additional capital required.”

Management in a Small Company can improve EVA in the following ways:

Try to improve returns with no or with only minimal capital investments

Invest new capital only in projects, equipment, machines able to cover capital cost

while avoiding investments with low returns

Identify where capital employment can be reduced

Identify where the returns are below the capital cost; divest those investments

when improvements in returns are not feasible

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EVA is an appropriate management tool for small business

Economic Value Added (EVA) is easy-to-calculate

Periodical EVA calculation and analysis can be done with minimal effort because

only few basic data have to be entered in a common spreadsheet

EVA calculation is a starting point for improvement in financial and business

policy

Scarce capital resources of a small company can be more efficiently allocated

using EVA than using intuition or traditional methods

EVA implementation in a small company will result in a better business

performance, because of better understanding the objectives (especially near the

floor/operating activities)

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