What is EVA?

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.

Benefits of EVA are as follows:

One effective way to align employees’ interest with that of investors is to tie their
compensation to output from the EVA metric. People are paid for sustainable
improvements in EVA. The behavior within a company is changed through the
understanding of what drives EVA and economic returns.

Necessary properties for the incentive system to work:

 Have an objective measure of performance that cannot be manipulated.

 Plan must be simple so everyone in the organization can understand it.

 Significant bonus amount to alter employees’ behavior.

 Keep target fixed and do not move goalpost after plan gets under way.

Properties that are strongly recommended:

 No limits should be placed on the plan.

 Not paying the full bonus amount in one year in order to seek substantial
   performance.

 Include cancellation clause whereby banked bonus is lost if a person

resigns.

 Incorporate long term perspective into the plan.

 Structure of the plan should be team based.

Example:

1.AT&T used the EVA measure to evaluate business unit managers.

2.The long distance group consisted of 40 business units which sold services such
as 800 numbers,tele marketing & public telephone calls.

3.All the capital costs from switching equipment to new product development were
allocated to these 40 business units.

4.Each business unit manager was expected to generate operating earnings that
substantially exceeded the cost of capital.

5.Diageo plc whose portfolio of brands includes burger king used EVA to help
make business decisions and measure the effects of management actions.

6.An EVA analysis of returns from its liquor brands led to a mew emphasis on
producing a selling vodka which unlike scotch doesnot incur aging and storage
costs.

7.EVA is conceptually superior to ROI but it is less used when compared to ROI.