PRESENTATION

ON

ECONOMIC VALUE ADDED

Prepared By,
Pankaj Motwani(11018)
Purvish Shah(11039)
What is EVA?

•Proposed by the consulting firm, Stern Stewart &

Company.
•Peter Drucker – a measure of total factor
productivity.
•EVA is the surplus left after making an appropriate
charge for the capital employed in the business.
FORMULAE :

EVA = NOPAT – (c*)*CAPITAL

EVA = CAPITAL*(r – c*)
EVA = [PAT + INT(1 – t)] – (c*)*CAPITAL
EVA = PAT – ke*EQUITY

where,
EVA = economic value added
NOPAT = net operating profit after tax
c* = cost of capital
CAPITAL = economic book value of the capital employed in the firm
r = return on capital = NOPAT/CAPITAL
PAT = profit after tax
INT = interest expense of the firm
t = marginal tax rate of the firm
ke = cost of equity
EQUITY = equity employed in the firm
For example,
CAPITAL : 10,000
NOPAT : 2,000
c* : 15%
r : 20%

EVA = NOPAT – (c*)*CAPITAL

= 2,000 – (0.15)(10,000)
= 500

EVA = CAPITAL*(r-c*)
= (10,000)(0.2-0.15)
= 500
What causes EVA to increase?

•The rate of return on the existing capital increases

because of improvement in operating performance
•Additional capital is invested in projects that can
earn at a return greater than the cost of capital
•Capital is withdrawn from activities which earn
inadequate returns
•The cost of capital is lowered by altering the
financial strategy
The three components of EVA
NOPAT
NOPAT is defined as (Profit before interest and taxes)(1 – tax rate)

Cost of Capital
Cost of Capital should have the following features:
• It represents a weighted average of all the costs of all sources of capital
• It is calculated in post-tax terms
• It reflects the risks borne by various providers of capital

c* = (Cost of equity)(Proportion of equity in the capital employed) +

(Cost of preference)(Proportion of preference in the capital employed) +
(Pre-tax cost of debt)(1 – tax rate)(Proportion of debt in the capital employed)

Capital Employed
•We need to make adjustments in the ‘accounting’ balance sheet to derive the
‘economic book value’ balance sheet.
•To reflect the economic value of assets rather than the accounting values
What Does EVA Show?
• +Ve The Company has Managed to
create Shareholder Value

• Zero This should be treated as the

Shareholders have earned a return
that compensates the risk

• -Ve The Company has destroyed

the Shareholder Value.
EVA as the basis for an Integrated Financial Management
System
•A typical financial management system consists of rules, guidelines
and procedures that employ different measures to calculate various
parameters that focus on performance variables like earnings per share,
return on net worth, dividend policy, return on assets, etc.
•But these variables bear little relation to the value of a business.
•Thus, EVA is an integrated financial management system that provides
a single, unified and accurate measurement of value as well as
performance
•It links forward looking valuation and capital budgeting analysis with
actual performance measurement.
•EVA is the right measure for
•Goal setting and business planning
•Performance evaluation
•Bonus determination
•Investor Communication
•Capital Budgeting and Valuation
EVA and Valuation

YEAR 1 2 3 4 5 6 7
Beginning
Capital 50 60 72 86.4 96.76 108.38 117.05
NOPAT 6 7.2 8.64 10.36 11.61 13.00 14.04
Cost of
Capital(%) 11 11 11 11 11 11 11
Capital
Charge 5.5 6.6 7.92 9.504 10.64 11.92 12.87
EVA 0.5 0.6 0.72 0.864 0.96 1.08 1.18
Growth
Rate(%) 20 20 20 12 12 8 8
The present value of the EVA stream is

= Rs. 24.1 million

Given the beginning capital of 50 million, the EVA Valuation is :

50+24.1 = Rs. 74.1 million.
EVA and Capital Budgeting

The standard method used by companies is the discounted cash flow

(DCF) method for evaluating a project on the basis of NPV:

Using EVA approach

EVA and Incentive Compensation

• Purpose of an incentive compensation plan

• Limitations of traditional compensation plans
• EVA as a unique bonus plan
• Key elements of the EVA bonus plan are:
1.Bonus is linked to increases in EVA
2.There is no floor or ceiling on the bonus
 3. The target bonus is generous
4. Performance targets are set by formula, not negotiation
Under conventional bonus plan, the performance targets are set by
negotiation, whereas under the EVA bonus plan, the EVA target is set and
revised from year to year. One such model is ‘the adaptive expectation
model’
Target EVA(t+1) = Target EVA(t) + b[Actual EVA(t) – Target EVA(t)]
In this model, ‘b’ may be set between 0 and 1, say 0.6.
Implementing the EVA system

Steps
•Develop Top Management Commitment
•Customize the definitions of EVA
•Identify EVA centres
•Analyze the drivers of EVA
•Tailor an incentive compensation system
•Train all the employees
Problems in using EVA

• Disincentive for collaborative relationship

• Imperfect Measures
• Underinvestment
• Difficulties in Divisional Performance Measurements
Thank You