Eva vs roi 14j
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comparision between economic value added and return on investment
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Eva vs roi 14j
- 1. EVA VS ROI
- 3. What is EVA? • Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, and it attempts to capture the true economic profit of a company. • EVA is the incremental difference in the rate of return over a company's cost of capital. Essentially, it is used to measure the value a company generates from funds invested into it. If a company's EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it.
- 4. EVA(Economic Value Added) EVA was developed by a New York consulting firm, Stern Steward & Co. in 1982 to promote value-maximizing behavior in corporate managers. Value-based measure to evaluate business strategies, capital projects and to maximize long-term shareholders wealth. Implies the difference between net operating profits after taxes and total cost of funds It offers a consistent approach to setting goals and measuring performance, communicating with investors, evaluating strategies and allocating capital. Maximizing EVA means the same as maximizing long-term yield on shareholders’ investment.
- 5. Calculating EVA EVA = NOPAT – Capital Charge or EVA = NOPAT – (Capital x Cost of Capital) where, NOPAT = Net Operating Profit After Tax Capital Charge = (WACC x Capital Employed)
- 6. Calculating Net Operating After Tax (NOPAT) NOPAT is easy to calculate. From the income statement we take the operating incomes and subtract taxes. e.g. XYZ Company Particulars Amount (Rs.) Sales 24,36,000/- Cost of Goods sold (-) 17,00,000/- Gross Profit 7,36,000/- Selling, general & Admin Exp. (-) 4,00,000/- Operating Profit 3,36,000/- Taxes (-) 1,34,000/- NOPAT 2,02,000/-
- 7. Cost of Capital Meaning: The cost of capital is the rate of return required by the shareholders and lenders to finance the operations of the business. Types of Cost of Capital Equity Capital: Equity Capital is provided by the Shareholders. Borrowed Capital: It is the Capital borrowed by the company from Banks and other Financial Institutes.
- 8. Weighted Average Cost of Capital (WACC) Weighted Average Cost of Capital examines the various components of the Capital structure and applies the weighting factor of after-tax cost to determine the cost of Capital. Calculating WACC e.g. XYZ Company Particulars Amount (Rs.) Long Term Debt 5,00,000/- Preferred Stockholders Equity 2,00,000/- Total Common Equity 7,00,000/- Total Capital 14,00,000/-
- 9. Long Term Debt Bond Rs. 100/- Net Return (Deducting discounting & Financing cost) Rs. 96/- Interest 14% (Rs. 14/-) Assumed Tax 35% (Rs. 5/-) Interest After Tax (Rs.14 – Rs. 5) 9% Cost for Bond Financing (9/96 x 100) 9.47%
- 10. Preferred Stock Cost Preference Share (Per share) Rs. 100/- Net Revenue (Deducting discount & financing cost) Rs. 98/- Dividend 11% (Rs. 11/-) Cost for Preferred Share (11/98 x 100) 11.20%
- 11. Common Equity Cost Share Price (Per Share) Rs. 100/- Net Return (Less issuing cost) Rs. 85/- EPS Rs. 12/- Cost for Common Equity (12/85 x 100) 14.10%
- 12. Summarizing Bond Cost 9.47% Preferred Stock Cost 11.20% Common Equity Cost 14.10%
- 13. Calculation of WACC for XYZ Company Particulars Amount Cost (%) Total (Rs.) (Rs.) Long Term Debt 5,00,000/- 9.47 47,375/- Preferred Stock Cost 2,00,000/- 11.2 22,400/- Common Equity Cost 7,00,000/- 14.1 98,700/- Total Capital 14,00,000/- - 1,68,475/- The total Weighted Average Cost of Capital (WACC) = 1,68,478 / 14,00,000 = 12.03%
- 14. Calculation of EVA for XYZ company NOPAT Rs. 2,02,000/- Capital Employed (Including Rs.1,00,000/- Reserve & Surplus) Rs. 15,00,000/- Cost of Capital 12.03% Capital Charge (12.03/100 x Rs. 15,00,000/-) Rs. 1,80,450/- Economic Value Added (EVA) (Rs. 2,02,000 – Rs. 1,80,450) Rs. 21,550/-
- 15. Importance of EVA • Economic Value Added (EVA) is important because it is used as an indicator of how profitable company projects are and it therefore serves as a reflection of management performance. • It succinctly summarizes how much and from where a company created wealth. • It includes the balance sheet in the calculation and encourages managers to think about assets as well as expenses in their decisions. • Economic value added asserts that businesses should create returns at a rate above their cost of capital • The EVA calculation depends heavily on invested capital, and it is therefore most applicable to asset-intensive companies that are generally stable. • EVA is more useful for auto manufacturers, for example, than software companies or service companies with a lot of intangible assets.
- 16. Strategies for Increasing EVA • Increase the return on existing projects (improve operating performance). • Invest in new projects that have a return greater than the cost of capital. • Use less capital to achieve the same return. • Reduce the cost of capital. • Liquidate capital or curtail further investment in sub-standard operations where inadequate returns are being earned.
- 17. Advantages of EVA • EVA provides for better assessment of decisions that affect balance sheet and income statement or tradeoffs between each through the use of the capital charge against NOPAT. • EVA decouples bonus plans from budgetary targets. • EVA covers all aspects of the business cycle. • EVA aligns and speeds decision making, and enhances communication and teamwork.
- 18. Limitations of EVA • EVA does not control for size differences across plants or divisions. • EVA is based on financial accounting methods that can be manipulated by managers . • EVA may focus on immediate results which diminishes innovation. • EVA provides information that is obvious but offers no solutions in much the same way as historical financial statement do.
- 19. Using EVA within a company • EVA can be used as a financial management system that allows managers and employees to focus on how capital is used and the cash flow generated from it. There are two benefits from focusing on growth in EVA : 1) Managements focus on primary responsibilities & 2) Distortions are reduced/eliminated • EVA creates one financial statement that includes all the costs of being in business, while making managers aware of every dollar they spend. • EVA is used in a company for resolving budgeting issues and evaluating the performance of organizational units and managers.
- 21. Return on Investment (ROI) • Return on Investment (ROI) is the benefit to an investor resulting from an investment of some resource. • As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. • In purely economic terms, it is one way of considering profits in relation to capital invested. • If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the instrument, put the money in such a savings instrument, and avoid the daily struggles of small business management. • Financial statements express only monetary aspects; businesses don’t get reflected. Thus ROI doesn’t give a complete picture of the happenings in a business. • ROI leads to excessive focus on improving profitability and not wealth maximization or shareholder value maximization, recognition, social wealth etc.
- 22. Example • An investor buys $1,000 worth of stocks and sells the shares two years later for $1,200. The net profit from the investment would be $200 and the ROI would be calculated as follows: • ROI = (Net Profit / Cost of Investment) x 100 • ROI = (200 / 1,000) x 100 = 20%
- 23. Importance of ROI • ROI is one of the most used profitability ratios because of its flexibility. • That being said, one of the downsides of the ROI calculation is that it can be manipulated, so results may vary between users. • By calculating ROI, you can better understand how well your business is doing and which areas could use improvement to help you achieve your goals.
- 24. Advantages of ROI • It relates net income with investments which gives better measure of divisional profits. • Major focus of ROI is on required level of investments. • ROI helps in making comparison between different business. • Easy to calculate and easy to understand • Better Measure of Profitability • It may be used for inter firm comparisons, provided that the firms whose results are being compared are of comparable size and of the same industry. • Using ROI can give a quick estimate of the projects net profits, and can provide a basis for comparing several different projects
- 25. Limitations of ROI • ROI is based on historical cost if assets • ROI provides focus on short term results and profits • ROI considers current period revenue and cost • Investment Centre managers can manipulate ROI by changing accounting policies • Satisfactory definition of profit and investment is difficult to find • ROI method uses income data rather than cash flow and it completely ignores the time value of money
- 26. Performance measures of an Investment center – ROI v/s EVA Point ROI EVA Meaning ROI is the comparison of the income generated with the assets employed. EVA is the residual profit after taking into account the capital charge. Calculation RoI is a ratio. Numerator is income and denominator is assets employed. EVA is a value. It is found out by subtracting capital charge from Profit after Tax. Superiority Conceptually EVA is superior than RoI Conceptually EVA is superior than RoI Popularity As per one survey carried by Vijay Govindarajan of Fortune 1000 companies, RoI is more popular than EVA As per one survey carried by Vijay Govindarajan of Fortune 1000 companies, RoI is more popular than EVA Simplicity of calculation RoI is comparatively easy to calculate EVA is a bit difficult to calculate given the problems with calculating the capital charge
- 27. Superiority of EVA over ROI • EVA offer same profit objective for comparable investments, unlike ROI which may make a manager reluctant to accept lower ROI (20%) opportunities than the current ROI (30%) levels despite being more than CoC (10%). ROI creates a bias towards little or no expansion in high- profit business units while at the same time low-profit units are making investments at rates of returns well below those rejected by high-profit units. • Units can increase ROI by actually decreasing its overall profits. This thing will not happen if EVA is measured. • Different interest rates can be used for different types of assets. For more riskier assets, higher rates of costs of capital can be used. With ROI this is not possible. • EVA as compared to ROI has a stronger positive correlation with changes in a company’s market value. To induce managers at the BU level to enhance shareholders value, managers can be told to create and grow EVA.
Editor's Notes
- All managers have the same goal of obtaining capital and a earning rate of return on it that exceeds the return offered by other seekers of capital funds. EVA can be used as a financial management system that allows managers and employees to focus on how capital is used and the cash flow generated from it. There are two benefits from focusing on growth in EVA; management’s attention is focused more towards its primary responsibility, which is increasing investors’ wealth and secondly, distortion caused by using historical cost accounting data are reduced or eliminated so that managers can spend their time finding ways to increase EVA. This increased awareness of the efficient use of capital will eventually produce additional shareholder value. Managers can do a better job of asset management and 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 footnotes to the financial statements. This is possible because EVA creates one financial statement that includes all the costs of being in business, while making managers aware of every dollar they spend. Another benefit of using EVA is that it creates a common language for making decisions, especially long-term decisions. Examples are: resolving budgeting issues and evaluating the performance of organizational units and managers. EVA quantification of results in financial terms also helps to energize other management programs such as TQM, quick response and customer development by demanding and getting continuous financial improvement. Mangers and employees adopt a long-term focus and begin to think more like owners as they start to feel responsible for and take part in the economic value of the firm.
- The ROI in the example above would be 20%. The calculation can be altered by deducting taxes and fees to get a more accurate picture of the total ROI. The same calculation can be used to calculate an investment made by a company. However, the calculation is more complex because there are more inputs. For example, to figure out the net profit of an investment, a company would need to track exactly how much cash went into the project and the time spent by employees working on it.
- First, with EVA all business units have the same profit objective for comparable investments. The ROI approach, on the other hand, provide, different incentive; for investments across business units. For example, a business unit that currently is achieving an ROI of 30 percent would be reluctant to expand unless it is able to earn on ROI of 30 percent or more on additional assets: a lesser return would decrease its overall ROI below its current 30 percent level. Thus, this business unit might forgo investment an opportunity that’s ROI is above the cost of capital but below 30 percent. The use of ROI as a measure deals with both these problems. They relate to asset investment whose ROI falls between the cost of capital and the center’s current ROI. If investment center’s performance is measured by EVA, investments that practice a profit in excess of the cost of capital will increase EVA and therefore economically attractive to the manager. A third advantage of EVA is that different interest rates may be used for different types of assets. For example, a low rate may be used for inventories while a relatively higher rate may be used for investments in fixed assets. Furthermore, different rates may be used for different types of fixed assets to take into account different degrees of risk. In short, management control systems can be made considered with the framework used for decisions about capital investments and resources allocation. It follows that the same type of asset may be required to earn the same return throughout the company, regardless of the particular business nits profitability. Thus, business unit managers should act consistently when a deciding to invest in new assets. A fourth advantage is that EVA, in contrast to ROI, has a stronger positive correction with changes in a company’s market value. There are several reasons why shareholder value creation is critical for the firm: It (a) reduces the risk of takeover, (b) creates currency for aggressiveness in mergers and acquisitions, and (c) reduces cost of capital, which allows faster investment for future growth, Thus, optimizing shareholder value is an important goal of an enterprise. However, since shareholder value measures the worth of the consolidated enterprise as whole n is nearly impossible to use it as a performance criterion for an organization individual responsibility centers. The best proxy for shareholder value at the business unit level is to ask business unit managers to create and grow EVA. It indicates that companies with high EVA tend to show high market value added (MVA) or high gains for shareholders. When used as a performance metric, EVA motivates managers to increase EVA by taking actions consistent with increasing stockholder value.