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ECONOMIC VALUE ADDITION (EVA)

 

Stern Stewart a leading financial consultancy firm came up with a novel tool to evaluated corporate performance. Economic value addition (EVA) is superior to conventional measures like ROI, ROE, ROCE but having its own limitations.

 

 

Introduction and origin:

 

The aim of any professional organization is to maximize the wealth of share holders, which is measured by the returns they receive on their investment. Returns are in two parts, first is in the form of dividends and the second in the form of capital appreciation reflected in the market value of shares. But the market value of shares is influenced by a lot of factors, many of which may not be fully influenced by the management of a firm. However one factor which has a significant influence on the market value is the expectation of the shareholders regarding the return on the investment.

 

The question then arises is which measure of corporate performance is liked to be expectation of the shareholders. Various measures like Earnings Per Share (EPS), Return On Equity (ROE), Return On Investment (ROI) and Return On Capital Employed (ROCE) have been used to evaluate the performance of the business. The problem with these performance measures is that they lack a proper bench mark for comparison. Because they ignore the minimum rate of return on investment expected by the share holders.

 

To overcome this problem the consultancy firm Stern Stewart came up with a performance measure that takes into account the minimum returns required by the shareholders. They called this measure the Economic Value Addition (EVA)

 

Definition & calculation of EVA :

 

EVA is the return a firm earns in excess of the minimum required by the investors. As for the formal definition, EVA is calculated using the following formula.

 

EVA = NOPAT (WACC ^ CE)

 

Where, NOPAT = Net operating profit after tax.

WACC = Weighted Average cost of capital

CE = Capital employed

 

Weighted average cost of capital is the weighted average of the cost of debt cost of equity and cost of preference capital with weightages equivalent to the proportion of each in the total capital.

 

NOPAT is measured from the income statement by adding back interest payments and subtracting and adding non operating income and expenses respectively to the net profit figure.

 

Capital employed consists of adjusted equity share holders fund, all interest bearing obligations and preference capital.

 

Improving EVA:

 

Following are the ways in which the EVA can be improved

        Increasing NOPAT with the same amount of capital

        Reducing the capital employed without affecting the earnings ie discarding the unproductive assets.

        Investing in those projects that earn a return greater than the cost of capital.

        Reducing the cost of capital,, which means employing more debt, as debt is cheaper than equity or preference capital.

 

EVA Barometer for Better Management :

 

EVA forces the management to expressly recognize its cost of equity and to take that cost into account in all its decision. It measures the amount of value a firm creates during a definite period through operating decisions that improve margins, efficiently utilize its production facilities, improve management of working capital and redeploy under utilized assets. Thus EVA can be used to hold management accountable for all economic outlays whether they appear in the income statement, on the balance sheet or in the foot notes to financial statement.

 

Draw backs of EVA:

 

        It ignores inflation. So it is biased against new assets. Whenever a new investment is made capital charge is on the full cost initially, so EVA figure is low. But as the depreciation is written off the capital charge decreases and hence EVA goes up.

 

        Since EVA is measured in Rupee terms it is biased in favour of large, low return businesses. Large businesses that have returns only slightly above the cost of capital can have higher EVA than smaller businesses that earn returns much higher than the costs.

 

        Short term EVA can be improved by reducing assets faster than the earnings and if this is pursued for long it can lead to problems in the longer run when new improvements to the asset base are made.

 

Corporate facts :

 

According to the Economic Times Research Bureau, the aggregate EVA of the 100 large sample companies works out to just Rs. 95 crore in excess of what the same capital could generate had it been invested at 13 % rate of interest.

 

 

Conclusion:

 

Any system will bear fruits only when it is well implemented and has the support of all the parties concerned and EVA is no exception to this rule. Moreover as with any other system EVA too has limitations but it still stands as an improvement over measures like ROI and ROE and if implemented will be taking the limitations into account will yield better results.

 

 

Arun Murugan V.