Economic Value Economic Value Added (EVA)Added (EVA)

Presented by:Presented by:NEEL NEEL BHAVIKBHAVIKAMITAMITVINITVINIT

Introduction of EVA EVA was developed by a New York consulting

firm, Stern Steward & Co. in 1982 to promote value-maximisig behaviour in corporate managers.

Value-based measure to evaluate business strategies, capital projects and to maximise long-term shareholders wealth.

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

Unlike simple traditional budgeting. EVA focuses on ends and not means.

Definition for EVADefinition for EVAEVA is defined as net profit after taxes and after the

cost of capital.FORMUALE for EVAFORMUALE for EVA

EVA

Net operating profit Taxes Cost of capital

Calculating Net Operating Calculating Net Operating After TaxAfter Tax(NOPAT)(NOPAT)NOPAT is easy to calculate. From the income

statement we take the operating incomes and subtract taxes.

e.g. XYZ CompanyParticularsParticulars Amount Amount

(Rs.)(Rs.)Sales Sales 24,36,000/-24,36,000/-Cost of Goods sold (-)Cost of Goods sold (-) 17,00,000/-17,00,000/-Gross ProfitGross Profit 7,36,000/-7,36,000/-Selling, general & Selling, general & Admin Exp. (-)Admin Exp. (-)

4,00,000/-4,00,000/-

Operating ProfitOperating Profit 3,36,000/-3,36,000/-Taxes (-)Taxes (-) 1,34,000/-1,34,000/-NOPATNOPAT 2,02,000/-2,02,000/-

Cost of CapitalCost of CapitalMeaning:Meaning: The cost of capital is the rate of return required

by the shareholders and lenders to finance the operations of the business.

Types of Cost of CapitalTypes of Cost of Capital

Equity Capital: Equity Capital: Equity Capital is provided by the Shareholders.

Borrowed Capital: Borrowed Capital: It is the Capital borrowed by the company from Banks and other Financial Institutes.

Weighted Average Cost of CapitalWeighted Average Cost of Capital(WACC)(WACC)

Weighted Average Cost of Capital examines the various components of the Capital structure and applies the weighting factor of after-tax cost to determine the cost of Capital.

Calculating WACCe.g. XYZ Company

ParticularsParticulars Amount (Rs.)Amount (Rs.)Long Term DebtLong Term Debt 5,00,000/-5,00,000/-Preferred Stockholders EquityPreferred Stockholders Equity 2,00,000/-2,00,000/-Total Common EquityTotal Common Equity 7,00,000/-7,00,000/-Total CapitalTotal Capital 14,00,000/-14,00,000/-

WACC ContinueWACC Continue Long Term DebtLong Term Debt

Bond CostBond Cost

BondBond Rs. 100/-Rs. 100/-Net ReturnNet Return ( (Deducting discounting & Financing Deducting discounting & Financing cost)cost)

Rs. 96/-Rs. 96/-

InterestInterest 14%14% (Rs. 14/-)(Rs. 14/-)

Assumed TaxAssumed Tax 35%35% (Rs. 5/-)(Rs. 5/-)

Interest After TaxInterest After Tax (Rs.14 – Rs. 5)(Rs.14 – Rs. 5) 9%9%Cost for Bond FinancingCost for Bond Financing (9/96 x 100)(9/96 x 100) 9.47%9.47%

WACC Continue WACC Continue Preferred Stock CostPreferred Stock Cost

Preference Share Preference Share (Per share)(Per share) Rs. 100/-Rs. 100/-Net Revenue Net Revenue (Deducting discount & financing (Deducting discount & financing cost)cost)

Rs. 98/-Rs. 98/-

Dividend Dividend 11% 11% (Rs. 11/-)(Rs. 11/-)

Cost for Preferred Share Cost for Preferred Share (11/98 x 100)(11/98 x 100) 11.2%11.2%

WACC Continue WACC Continue Common Equity CostCommon Equity Cost

Share Price Share Price (Per Share)(Per Share) Rs. 100/-Rs. 100/-Net Return Net Return (Less issuing cost)(Less issuing cost) Rs. 85/-Rs. 85/-EPS EPS (Estimated by investors & reliable (Estimated by investors & reliable analyst)analyst)

Rs. 12/-Rs. 12/-

Cost for Common Equity Cost for Common Equity (12/85 x (12/85 x 100)100)

14.1%14.1%

WACC Continue WACC Continue SummarizingSummarizing

Bond CostBond Cost 9.47%9.47%

Preferred Stock CostPreferred Stock Cost 11.2%11.2%

Common Equity CostCommon Equity Cost 14.1%14.1%

Calculation of WACC Calculation of WACC for XYZ Companyfor XYZ Company

ParticularsParticulars AmountAmount(Rs.)(Rs.)

Cost Cost (%)(%)

Total Total (Rs.)(Rs.)

Long Term DebtLong Term Debt 5,00,000/-5,00,000/- 9.479.47 47,375/-47,375/-Preferred Stock CostPreferred Stock Cost 2,00,000/-2,00,000/- 11.211.2 22,400/-22,400/-Common Equity CostCommon Equity Cost 7,00,000/-7,00,000/- 14.114.1 98,700/-98,700/-

Total CapitalTotal Capital 14,00,00014,00,000/-/-

-- 1,68,475/-1,68,475/-

The total Weighted Average Cost of Capital The total Weighted Average Cost of Capital (WACC) = (WACC) = 1,68,478 / 14,00,000 = 12.03%1,68,478 / 14,00,000 = 12.03%

Calculation of EVA Calculation of EVA for XYZ Companyfor XYZ Company

NOPATNOPAT Rs. Rs. 2,02,000/-2,02,000/-

Capital Employed Capital Employed (Including Rs.1,00,000/- Reserve & Surplus) (Including Rs.1,00,000/- Reserve & Surplus)

Rs. Rs. 15,00,000/- 15,00,000/-

Cost of CapitalCost of Capital 12.03%12.03%Capital Charge Capital Charge (12.03/100 x Rs. 15,00,000/-)(12.03/100 x Rs. 15,00,000/-) Rs. Rs.

1,80,450/-1,80,450/-Economic Value Added (EVA) Economic Value Added (EVA) (Rs. 2,02,000 – Rs. 1,80,450)(Rs. 2,02,000 – Rs. 1,80,450)

Rs. 21,550/-Rs. 21,550/-

Strategies for Increasing Strategies for Increasing EVAEVA

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.

Advantages of EVAAdvantages of EVA 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.

Limitations of EVALimitations of 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.

ConclusionConclusion

As a performance measure, Economic Value Added forces the organization to make the creation of shareholder value the number one priority. EVA is changing the way managers run their businesses. When business decisions are aligned with the interest of the shareholders, it is only a matter of time before these efforts are reflected in a higher stock price.