Economic Value Added Analysis

TITLE OF THE PAPER: ECONOMIC VALUE ADDED™ ANALYSIS AREA OF PRESENTATION:

FINANCIAL MANAGEMENT NAME OF THE INSTITUTE: A.J.INSTITUTE OF MANAGEMENT (AJIM) (TIME)

MANGALORE

EMAIL ID: [email protected]

AUTHORS NAME:

BHARATH.P PHONE NO:

+919739459820

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ABSTRACT: EVA™ (Economic Value Added) by Stern Stewart is essentially a breakthrough in field finance especially, increasingly popular corporate performance measure one that is often used by companies not only for evaluating performance, but also as a basis for determining incentive pay. It gives the opportunity to identify and isolate the value creators and value destroyers. It has emerged as powerful signal to the capital market that the management is focused on shareholders‟ value maximization. FORTUNE magazine has called EVA “today‟s hottest idea”. Peter F. Drucker commented in HBR: EVA measures “total factor productivity”. Now more and more companies use EVA as valuation method, they use them to explain in their annual reports to show to shareholders how they are creating value by being efficient and enhanced performance. The intention is to evaluate EVA™ as a tool of performance measure and valuation concept in corporate world. The thesis below focuses on an elaborated explanation of EVA and its components. It also makes a distinction between MVA (Market Value Added) and throws some insight on how NPV and EVA are closely related. The paper also tries to explain the scope and growing application in industry. An attempt is also made to calculate EVA of one of India‟s prominent and successful company HUL (Hindustan Unilever Ltd.) and practically derived the application and quantum of insight that EVA helps to obtain from the firm‟s operations. Finally have critically analyzed the pros and cons of EVA and has suggested practicality, applicability and utility of EVA™ in corporations. KEYWORDS: Economic Value Added, Market Value Added, Net Present Value, Weighted Average Cost of Capital

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TABLE OF CONTENTS

CHAPTER I: INTRODUCTION………………………………….3 DEFINITION………………………………………3 CHAPTER II: REVIEW OF LITERATURE……………………..4 CHAPTER III: UNDERSTANDING EVA AND ITS COMPONENTS………….5 EVA MODEL………………………………………......................6 EVA V/S NPV…………………………………………………….7 EVA V/S MVA……………………………………………………8 CHAPTER IV: SCOPE OF THE STUDY……………………….9 ADVANTAGES………………………………...9 CHAPTER V: AREAS OF APPLICATION…………………….10 APPLICATION IN HUL…....................................11 CHAPTER VI: CONCLUSION…………....................................12 BIBLIOGRAPHY……………………………………..................13

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CHAPTER I: INTRODUCTION From a commercial standpoint, Economic value added (EVA™) is the most successful performance metric used by companies and their consultants. Although much of its popularity is a result of able marketing and deployment by Stern Stewart, owner of the trademark, the metric is justified by financial theory and consistent with valuation principles, which are important to any investor's analysis of a company. Economic Value Added (EVA) is a measure of financial performance based on the concept that all capital has a cost and that earning more than the cost of capital creates value for shareholders. It is after-tax net operating profit (NOPAT) minus a capital charge. It is true economic profit consisting of all costs including the cost of capital. If a company‟s return on capital exceeds its cost of capital it is creating true value for the shareholder. The term „Economic Value Added (EVA)‟ is a registered trademark of Stern Stewart & Co. of New York City (USA). Bennett Stewart in his book, “The Quest for Value”, used the term EVA with a symbol ™ as super script, which is the normal practice of referring to any registered trademark whenever the term is used. Thus EVA is actually Stern Stewart & Co.‟s trademark for a specific method of calculating economic profit. “The Quest for Value” was published in 1991. Peter Drucker claimed that he discussed EVA in 1964 in his book, “Managing for Results”. It cannot be denied, however, without going into argument as to who invented EVA first that the concept became popular only after Stern Stewart & Co. marketed it.

Definition of EVA: EVA is a financial performance measure based on operating income after taxes, the investment in assets required to generate that income, and the cost of the investment in assets (or, weighted average cost of capital).(2) The three elements used in calculating EVA are operating income after tax, investment in assets, and the cost of capital (Hansen & Mowen, 1997). A.J.INSTITUTE OF MANAGEMENT

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CHAPTER II: REVIEW OF LITERATURE Easton, P. Harris, T. and Ohlson, J (1992) suggested that Economic Value Added (EVA) is an increasingly popular corporate performance measure one that is often used by companies not only for evaluating performance, but also as a basis for determining incentive pay. Like other performance measures, EVA attempts to cope with the basic tension that exists between the need to come up with a performance measure that is highly co-related with shareholders wealth, but at the same time somewhat less subject to the random fluctuations in stock prices. This is a difficult tension to resolve and it explains the relatively low correlation of all accounting based performance measures with stock returns at least on a year to year basis.

Rice, V.A. (1996) observed that “previously several measurements were used to gauge the financial outlook from earnings per share to discounted cash flow and return on average assets. With EVA, one can see a way to meet business objectives and to create a new corporate culture. It permeates every level from boardroom to the shop floor. Bonuses of all managers are determined solely by whether variety achieves its EVA targets. In a company every decision and every action result from analysis that uses EVA principles. One has to focus on ensuring that every investment produces return that exceeds our cost of capital. It is believed this approach enables the direct alignment of management and shareholders interest”.

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CHAPTER III: UNDERSTANDING EVA AND ITS COMPONENTS

NOPAT is profits derived from a company‟s operations after taxes but before financing costs and non cash-bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm. Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less no interest-bearing current liabilities. Capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested. The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk. Another perspective on EVA can be gained by looking at a firm‟s Return on Net Assets (RONA). RONA is a ratio that is calculated by dividing a firm‟s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system.

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What is NPV? The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project

ECONOMIC VALUE ADDED V/S NET PRESENT VALUE EVA 1.EVA principle refers to accounting figures

NPV

1.NPV approach based on market values

2.EVA seems to provide more 2.NPV seems to provide less immediate and immediateness and incisiveness than NPV incisiveness than EVA

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What Is MVA? Market Value Added (MVA) is a measure of wealth a company has created for its investors. It is a cumulative measure of corporate performance that looks at how much a company‟s stock has added to (or taken out of) investors‟ pocketbooks over its life and compares it with the capital those same investors put into the firm. Maximizing MVA should be the primary objective for any company that is concerned about its shareholders‟ welfare.

ECONOMIC VALUE ADDED V/S MARKET

VALUE ADDED

ANALYSIS ECONOMIC VALUE ADDED

MARKET VALUE ADDED

1) Is a performance measure developed by Stern 1)Is simply the difference between the current Stewart & Co that attempts to measure the true total market value of a company and the capital economic profit produced by a company

contributed by investors

2)It is a performance metric

2) MVA is not a performance metric like EVA, but instead is a wealth metric

3) Performance metric is useful for investors who 3) Wealth metric improve the book value of the wish to determine how well a company has company's shares, and investors will likely bid up produced

value

for

its

investors the prices of those shares in expectation of future earnings, causing the company's market value to rise.

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CHAPTER IV:

SCOPE OF THE STUDY  Identifying assets and segments on the basis of value creation. It gives the opportunity to identify and isolate the value creators and value destroyers.  This way, helping in honing both investment and disinvestment strategies of the firm.  Motivating the managers. Stern Stewart has experimented with cash bonus schemes in its clients‟ organizations. The mind set of the managers are to be changed so that they could own their responsibility and be paid like the owners too.  Further motivating managers to invest in projects relatively less attractive in with reference to the existing rate of return in case the new project has the potential to generate positive spread.  Providing signal to the capital market that the management is focused on „shareholders‟ value maximization. ADVANTAGES 1) EVA can be calculated for divisions and even projects. 2) EVA is a measure that gauges performance over a period of time rather than a point of time.EVA is a flow variable and depends on the ongoing and future operations of the firm or divisions. MVA, on the other hand, is a stock variable. 3) EVA is not bound by Generally Accepted Accounting Principles (GAAP).As we discuss below, appropriate adjustment are made to calculate EVA. This removes arbitrariness and scope for manipulations that is quite common in the accounting based measures. 4) EVA is a measure of the firm‟s economic profit. Hence, it influences and is related to the firm‟s value.

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CHAPTER V: AREAS OF APPLICATION Example Applications of EVA Analysis: EVA and Growth EVA is a technique useful in changing organizational behavior and in driving the decision-making process in a manner that maximizes value to the business. Most businesses want to grow, and grow rapidly, and several scenarios are possible. In a sustainable growth condition, for example, the business is generating sufficient cash to re-invest. To increase a company‟s growth beyond the sustainable growth rate, only a few options are available and these are certainly recognizable in today‟s pharmaceutical marketplace. The prudent options are: a) To increase the financial leverage of the company by using other people‟s money, b) To reduce dividends (not very popular), c) To undertake “profitable pruning”—eliminating marginal business units or product lines, d) To outsource, e) To increase the product price, and f) To merge. Through EVA-linked compensation, employees could claim stakes at three EVA levels - at the organization level, at the business unit and the individual level in TCS.

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Application in HUL(Hindustan Unilever Ltd) Traditional approach to measuring shareholders value creation has used parameters such as earnings capitalization, market capitalization and present value of estimated future cashflows. Extensive new research has now established that it is not earnings per se, but VALUE that is important. A new measure called „Economic value Added‟ (EVA) is increasingly being applied to understand and evaluate financial performance.

PARTICULARS

2006

2005

2004

2003

2002

2001

2000

1999

COST OF CAPITAL EMPLOYED(COCE) 1.Average Debt

163

360

1588

881

45

50

93

162

2.Average Equity

2515

2200

2116

2899

3351

2766

2296

1908

3.Average Capital employed(1+2)

2678

2560

3704

3780

3396

2816

2389

2070

4.Cost of Debt, post-tax %

5.9

3.38

5.19

4.88

6.45

7.72

8.46

8.61

5.Cost of Equity %

16.38

15.5

14.77

12.96

14.4

16.7

19.7

19.7

15.74

13.8

10.66

11.07

14.3

16.54

19.27

18.83

421.52

353.28

394.85

418.45

485.63

465.77

460.36

389.78

8.Profit after tax, before exceptional items

1540

1355

1199

1804

1716

1541

1310

1070

9.Add:Interest,after taxes

7

12

82

43

6

5

8

14

10.Net operating profits After Taxes(NOPAT)

1547

1367

1281

1847

1722

1546

1318

1084

COCE ,as per (7) above

421

353

395

418

486

466

460

390

12.EVA:(10-11)

1126

1014

886

1429

1236

1080

858

694

6.Weighted Average %(WACC) 7.COCE(3*6)

Cost

of

Capital

ECONOMIC VALUE ADDED(EVA)

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CHRONOLOGY OF EVA GROWTH:HLL

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CHAPTER VI: CONCLUSION: Economic profit - otherwise known as "Economic Value Added" (EVA™) is based on classic financial theory, and, for this reason, is not entirely different from traditional free cash flow measures. Three conceptual pillars support economic profit: firstly, Cash flows are more reliable than accruals. Second is that some period expenses are - in economic reality - actually long-term investments. Lastly, the company does not create value until a threshold level of return is generated for shareholders. However, economic profit is an appropriate performance metric for the company to be evaluated and one can identify the many pros and cons in the process of its application. With only one single performance number, economic profit is probably the best because it contains so much information (mathematicians would call it "elegant"): economic profit incorporates balance sheet data into an adjusted income statement metric. Economic profit works best for companies whose tangible assets (assets on the balance sheet) correlate with the market value of assets - as is often the case with mature industrial companies. In contrary, some proponents argue economic profit is "all you need", it is very risky to depend on an single metric. The companies least suited for economic profit are high-growth, neweconomy and high-technology companies, for whom assets are 'off balance sheet' or intangible. But in overall, we can definitely say that EVA™ has emerged as a powerful conceptual framework and is practically implemented in most of successful corporations across globe. It‟s likely to stay as widely accepted concept because of its practical application and in depth insights it throws on performance, efficiency and most importantly how much value has been created to the shareholders

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BIBILIOBRAPHY

1. “FINANCIAL

MANAGEMENT”

INDIAN

EDITION

BY

EUGENE

BRIGHAM AND MICHEAL EHRHARDT 104-112 2. PANDEY I M “FINANCIAL MANAGEMENT” VIKAS PUBLISHING HOUSE,PP 733-748 3. DAVID S YOUNG AND F.O.BYRNE STEPHEN “EVA AND VALUE BASED MANAGEMENT” MCGRAW-HILL 4. PETER

C.BREWER,GYAN

CHANDRA,CLATON

A.HOCK,

“SAM

ADVANCED MANAGEMENT” JOURNAL,VOL.64 1999

5. http://www.dma.unive.it/mmef/2007/Modesti_2_1_2007.pdf-19th Sept 2009 6.

http://www.investopedia.com/terms/e/eva.asp-15th Sept 2009

7.

http://www.investopedia.com/ask/answers/06/economicvsmarketv alueadded.asp - 14th Sept 2009

8. http://www.contractpharma.com/articles/2004/01/eva-apimanagement-practic-15th Sept 2009

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