Economic Value AddedTM
True Economic performance of an enterprise
Vikash Goel, FCA, MS Finance
www.vikashgoel.com | www.in...
Historical performance measures in an organisation
includes:
 Profit Maximisation – age old
 Wealth Maximisation - matur...
• New York Based Consulting firm Stern Steward & Co.
developed the concept of EVA in 1982.
• Economic Value Added
TM
is a ...
EVA helps organizations determine their actual profit
once the taxes and capital amount has been taken
under consideration...
EVA = Net Operating Profit After Tax – (Capital Employed x Cost of Capital)
Net Operating Profit After Tax (NOPAT) is calc...
Capital Employed is calculated as follows:
Book Value of Equity
Add: Debt
Add: Preferred Stock
Add: Minority Interest
Add:...
EBIT = Rs 5 million
Tax rate = 40%
WACC = 12%
Debt = 10 million
Equity = 10 million
EVA = [EBIT x (1 - Tax Rate)] - [WACC ...
Profit based measure as primary measure of financial
performance has at least 2 limitations:
• Profits ignore cost of capi...
Residual Income approaches have been used since 20th
century and is calculated as
Residual Income = Profit After Tax – (Ca...
Residual Income approach relies heavily on the
Accounting Profits and does not adjust it.
Adjustments are needed to conver...
• If EVA is Positive, business has created wealth for
shareholders
• If EVA is Negative, business has destroyed wealth for...
• It is considered to be a short term measure of financial
performance
• It is not a suitable measure for a company which ...
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Economic Value Added (EVA), Finance, Performance Measurement by Vikash Goel

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Measure of Company's Financial Performance beyond the financial statements

www.vikashgoel.com, www.investmentvaluation.in

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Economic Value Added (EVA), Finance, Performance Measurement by Vikash Goel

  1. 1. Economic Value AddedTM True Economic performance of an enterprise Vikash Goel, FCA, MS Finance www.vikashgoel.com | www.investmentvaluation.in
  2. 2. Historical performance measures in an organisation includes:  Profit Maximisation – age old  Wealth Maximisation - matured  Value Maximisation – today’s wisdom “Until a business returns profit that is greater than the cost of capital, it is operating at a loss” – Peter Drucker in HBR © Vikash Goel | www.vikashgoel.com , www.investmentvaluation.in
  3. 3. • New York Based Consulting firm Stern Steward & Co. developed the concept of EVA in 1982. • Economic Value Added TM is a value based performance measure that appreciates values created by the management for its owners. • It evaluates how well the organisation performs in relation to its objectives – wealth maximisation for the shareholders. • It is most directly linked to creating shareholder wealth over time. ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in
  4. 4. EVA helps organizations determine their actual profit once the taxes and capital amount has been taken under consideration. This helps companies determine whether their business or a particular project is making more money than what was invested in it. EVA = Net Operating Profit After Tax – Currency Cost of Capital ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in
  5. 5. EVA = Net Operating Profit After Tax – (Capital Employed x Cost of Capital) Net Operating Profit After Tax (NOPAT) is calculated as follows: Net profit available to Equity Shareholders Add: Interest Expense (1 - Tax rate) Add: Preferred Dividends Add: Minority Interest Add: Amortisation of Goodwill Add: Non recurring (unusual) losses or expenses Less: Non recurring (unusual) gains Alternatively, NOPAT = Operating Income x (1 – Tax rate) ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in
  6. 6. Capital Employed is calculated as follows: Book Value of Equity Add: Debt Add: Preferred Stock Add: Minority Interest Add: Equity Equivalents Alternatively, Capital Employed = Total Assets – Current Liabilities Cost of Capital Calculate Cost of Equity using CAPM viz. Re = Rf + (Rm - Rf) x Beta Calculate After Tax Cost of Debt viz. Kd = Cost of Debt x (1-tax Rate) Calculate Weighted Average Cost of Capital based on the weights of Debt and Equity. WACC = [ E / ( E + D ) x Ke ] + [ D / ( E + D ) x Kd ( 1 - t ) ] ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in
  7. 7. EBIT = Rs 5 million Tax rate = 40% WACC = 12% Debt = 10 million Equity = 10 million EVA = [EBIT x (1 - Tax Rate)] - [WACC x Capital Employed] EVA = [5 x ( 1 - 0.40)] - [0.12 x (10 + 10)] EVA = 3.0 - 2.4 EVA = 0.6 million ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in
  8. 8. Profit based measure as primary measure of financial performance has at least 2 limitations: • Profits ignore cost of capital  While profits take into account the interest charge – cost of debt finance, they done take into account the cost of equity. Thus it doesn’t tell us if the organisation has generated wealth in excess of return required by equity shareholders – providers of equity capital. • Profits calculated are subject to manipulation by accountants. ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in
  9. 9. Residual Income approaches have been used since 20th century and is calculated as Residual Income = Profit After Tax – (Capital Employed x Cost of Capital) Example: A division A earns a profit of Rs 10000 and also has Capital (Debt + Equity) of Rs 70000 @ 12% Cost of Capital. Residual income = 10,000 – (70,000x12%) Residual income = 1,600 ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in
  10. 10. Residual Income approach relies heavily on the Accounting Profits and does not adjust it. Adjustments are needed to convert from accrual profits to cash flows Unusual items of incomes/expenditures / gains / losses should be ignored. Other adjustments: E.g. Some items such as advertising, staff training costs that bring long term benefits are expensed whereas they should be capitalised, hence these are added back to profits. ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in
  11. 11. • If EVA is Positive, business has created wealth for shareholders • If EVA is Negative, business has destroyed wealth for shareholders ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in
  12. 12. • It is considered to be a short term measure of financial performance • It is not a suitable measure for a company which has invested heavily today but expects returns in long term • It is prone to estimation errors inherent in calculating Cost of Capital ©VikashGoel|www.vikashgoel.com,www.investmentvaluation.in

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