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Chapter - 6

Economic Value Addition [ EVA]

Origin & Introduction of EVA


The New York based financial advisory Stern Stewart & Co. postulated a concept of economic income in 1990 in the name of Economic Value Added.

The company creates shareholder value only if it generates returns in excess of cost of capital. So excess of returns over cost of capital is simply termed as EVA. It measures whether the operating profit is sufficient enough to cover the cost of capital.

Concept of EVA
It is measure of true economic performance of a company & a strategy for creating shareholder wealth. It is based on the idea that business must cover both operating costs & Capital costs. It is value based financial performance measure. A measure reflecting absolute amount of shareholder value created or destroyed each year.

Concept of EVA
A tool more useful than rate of return ROI in controlling & steering day-to-day operations. Also a useful tool for choosing the most promising financial investment. EVA shows that until a company earns profits greater than its investors, it really operates at loss. Peter Drucker in HBR has wrote, Until a business returns a profit that is greater than its cost of capital, it operates at loss. Never mind that it pays taxes as if it had a genuine profit, the enterprise still returns less to the economy.

Calculation of EVA
Net sales - Operating expenses Operating Profit [EBIT] - Taxes xxx xxx xxx xx

Net operating profit after tax [NOPAT] - Capital charges(capital invested * ccc) EVA

xxx xx xxx

EVA = NOPAT-( Capital employed * WACC)


EVA measurement also requires a company to be more careful in resource mobilization, resource allocation & investment decisions. If the companys EVA is negative, the firm is destroying shareholders wealth even though it may be reporting positive EPS.

Usage of EVA
Setting organizational economic goals Performance measurement Determining bonuses Communication with shareholders & investors Motivation to managers Capital budgeting Corporate Valuation Analyzing the securities

Advantages of EVA
Reduce the cost of capital : Adoption of EVA focused Finance platform as ways to increase investors confidence & their willingness to advanced funds to the firm on favorable terms. Operate Efficiently: It helps in cutting costs, saving taxes & raising NOPATs & in enhancing transparency, Mgt. accountability Manage assets & Re-deploy capital: Capital tied up in non productive assets & activities can be freed & return to the investors. Completely new business models can be set that helps in capital conservation. Grow profitably: The way to increase EVA is to invest, to innovate, to grow and take calculated risk. + NPV projects can be taken.

Superiority of EVA
Eva is a better way to plan for value :

While entering new markets, setting product prices, adding new services lines, or making new acquisitions, managers need a way to value the alternatives and choose the one that will produce the highest stock price.
Other techniques are: ROI , EPS, RI, Cash Flows

EVA is preferable because.


It is simpler, More informative, More accountable way to measure & manage value, It is easy to explain to non-financial managers as it starts with Op. profit & simply deducts capital charge. It eliminates the confusion by using single financial measure. It provides a common language for all employees & allows all management decisions to be modeled, monitored, communicated & compensated in consistent way- always in terms of value added to shareholder investment.

Steps in Implementing EVA


Measurement

Management system

Motivation

Mindset

What is MVA ?
MVA measures the difference between total market value of company as reflected in its stock price & the total capital employed on its balance sheet. Thus MVA = Total value Total capital OR MVA = Present value of consolidated future EVA

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