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Economic value added
- 1. Economic Value Added (EVA) www.studygalaxy.com/
- 2. Today’sAgenda Need for EVA What went wrong withexisting measurement tools Plusand Minus EVA How to useEVAeffectively
- 3. Need for EVA • Previously Discounted Cash Flow (DCF) techniques such as IRR, NPV were there but no tooltomeasureoverallcorporate performance • People concentrated on net-income growth (example- EastIndia Company). • New tools – ROA, RONW, etc – but these gave wrong signals such as asset being to have ROA.
- 4. Youcannotknowwhether your businessoperation iscreating value. . UNTILYOUAPPL Y • • the TRUECostof Capital To ALLthe CapitalEmployed Most companies have no idea what either amount is
- 5. Howto CalculateEVA? EVA=(ReturnonCapital–Costof Capital) ×(CapitalInvestedin Project) ALTERNATIVELY EVA=NOP A T–(CostofCapital×Capital) Note: NOPAT is ‘Net Operating Profit After Tax’
- 6. • ‘Costofcapital’istheminimumrateofreturnto compensateinvestorswhoarereadytobear the riskofinvestinginthefirm. • It isdependentoncompany’sfinancial structure,businessrisk,currentinterestlevel, andinvestors’expectation. • ‘NOPAT’is profit derived from a company’s operations after taxes, but before financing costs.
- 7. • ‘Amountofcapital’istheamountofcash investedinthebusiness,netofdepreciation. • CapitalEmployedwillalsoincludeinvestments onR&D,marketing,andrestructuringrelated. • NOP A Tisacompany’scashgeneration capabilityfromrecurringbusinessactivities (disregardingitscapital structure) • NOP A T=PAT+TotalAdjustments–Tax SavingsonAdjustments
- 8. • CostofCapital(Kc)isaweightedaverageoftwo components–(a)costofdebt(Kd);(b)costof equity(Ke). • Kc =We *Ke + Wd *Kd • We ,Wdintheaboveaboveequationare respectiveweightsofindividual components. • Note:Costofdebt(Kd)isalwaystakenpost-tax.
- 9. • Costofequity(Ke)istakenbasedonCAPMmodel Ke =Rf+(Rm– Rf) • Where, • Rfisriskfreerateofreturn(say, t-billrate) • isleveredbetaofthestockpriceofthefirm (w.r.t.market price). • (Rm –Rf)isalsoknownasmarket premium • R misthemarketrateofreturnonall stocks. • Therearealsootherwaysofcalculating Ke
- 10. STRATEGIESFORMAXIMISINGE.V.A. EARN MORE WITHOUT INCREASING CAPITAL USE LESS CAPITAL INVEST IN HIGH RETURN PROJECTS REDUCE THE COST OF CAPITAL HUNT OUT LAZY CAPITAL
- 11. • Hence,EVAisafinancialtechniquetomeasure whetheracompanyiscreatingeconomicvalue ov.erandabovethecostofcapitalofassets employed. • i.e., it alsomeasuresvaluecreatedduringa periodoftimethroughincreasedmarginsand profitabledeploymentofunderutilized assets.
- 12. More Advantagesof EVA… EVAinspiritismostcloselyrelatedto NPV. Avoids problems associated with approaches that focus onpercentage spreads i.e., too high ROAor RONWproblems. It makestopmanagersresponsibleforameasure thattheyhavecontrol over. It isinfluencedbyall thedecisionsthatmanagers havetomakewithinafirm(say,investmentdecision anddividend decisions).
- 13. Limitationsof EV A AllcalculationsinWACC(especiallycostofequity related)areusuallybasedonex-post data. Actuallytheyshouldbeex-ante.Tothatextent,it isaquestionableconcepttobankon. • • It isjustafinancialnumberi.e., it missesthe advantagesofratios[cannotcompareEVAofone firmwithotherfirms(say,sizeofafirmisnot takencare of)].
- 14. Market ValueAdded • In terms of market and book values of shareholder investment, shareholdervalue creation (SVC)may be defined asthe excessof market value over book value. SVCis also referred to asthe market value added(MVA): Market value added = Market value – invested capital (capital employed)
- 15. Market-to-Book Value(M/B) • An alternative measure of shareholder value creation: Market value of equity = Market value of the firm – Market value of debt • The market-to-book value (M/B) analysis implies the following: – Value creation – If M/B >1, the firm is creating value of shareholders. – Value maintenance – If M/B =1, the firm is not creating value of shareholders. – Value destruction –If M/B < 1, the firm is destroying value of shareholders.