ECONOMIC VALUE ADDED

EVA (Economic Value Added) is a performance measure directly linked to

creation of shareholder’s wealth over time.It is a value based measure
intented to evaluate business strategies,capital projects and to maximize
wealth.It enables the managers to invest in profitable activities which leads to
increase in market value of the firm.

EVA = NOPAT – (WACC* capital employed)

RETURN ON INVESTMENT
It is a measure used to calculate the efficiency of an investment or to compare
the efficiency of numbers of different investments, the results of which
expressed as a percentage.To calculate ROI return of an investment is divided
by the cost of investment

ROI- profit after tax/ capital employed

If an investment does not have positive ROI , or if there are other opportunities
with a higher ROI,then the investment should not be taken

DIFFERENCE BETWEEN ROI AND EVA

BASIS OF DIFFERENCE RETURN ON ECONOMIC VALUE
INVESTMENT(ROI) ADDED(EVA)

Tool ROI is an accounting EVA is a performance

measurement tool. it measurement tool as it
measures return on measures the company’s
capital employed. value and increase in
shareholders wealth

Concept It is a traditional concept It is a modern concept in

based on historical costs.
It is simple to calculate
and easy to understand
economics and finance.
various companies have
started using EVA in
india like coca cola, tata,
reliance, HUL etc
BASIS OF DIFFERENCE RETURN ON ECONOMIC VALUE
INVESTMENT(ROI) ADDED(EVA)

Expressed It is expressed in terms It is expressed in

of percentage currency.

Cost of capital It doesn’t take into It is a broad concept

account the cost of which considers the cost
capital. of capital.

Comparison ROI is used to make It can’t be used to make

comparisons both intra- comparisons.
firm and inter-firm.

Evaluation ROI is used to evaluate EVA is used to evaluate

the amount of income the effectiveness of
earned proportionate to asset utilization in
the capital invested. income generation.

Emphasis It focuses on profitability It focuses in maximizing

and adopts a short term shareholders wealth and
approach considers long term
results.
Measure ROI is a relative EVA is an absolute
measure. measure and a more
practical measure.
Formula Profit after tax/capital NOPAT-(WACC*capital
employed employed)
BENEFITS OF ROI OVER EVA
Most of the companies employing investment centres evaluate business units
on the basis of Return on Investment (ROI) rather than Economic Value Added
(EVA). There are three apparent benefits of an ROI measure.

1. First, it is, a comprehensive measure in which anything that

affects financial statements is reflected in this ratio.

2. Second, Return on Investment (ROI) is simple to calculate, easy to

understand, and meaningful in an absolute sense. For example, an ROI
of less than 5 per cent is considered low on an absolute scale, and an
ROI of over 25 per cent is considered high.

3. Finally, it is a common denominator that may be applied to any

organizational unit responsible for profitability, regardless of size or type
of business.

It gives quick estimate of project’s net profits The performance of

different units/projects can be compared directly to one another. Also,
ROI data are available for competitors and can be used as a basis for
comparison.

BENEFITS OF EVA OVER ROI

The collar amount of Economic Value Added (EVA) does not provide basis for
comparison. Nevertheless the EVA approach has some inherent advantages.
There are four competing reasons to use EVA over ROI:

1. 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.

Similarly , a unit currently achieving a low ROI say 10% would benefit from
anything over 10% on additional assets. Thus, ROI creates a bias toward little
or no expansion in high profit units while at the same time low profit units are
making investments at rate of return well below those rejected by high profit
units

2. The decisions that increase a centre’s ROI may decrease the

overall profits
For example an investment centre whose current ROI is 25%, the manager can
increase its overall ROI by disposing of an asset whose ROI is 20%. However if
the cost of capital is tied up in the investment centre is less than 20%, the
absolute rupee profit after deducting capital costs will decrease for the centre

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 centre’s
current ROI. If investment centre’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.

3. Different rate for different assets

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
units profitability. Thus, business unit managers should act consistently when a
deciding to invest in new assets.
4.Strong correlation with market value
A fourth advantage is that EVA, in contrast to ROI, has a stronger positive
correlation 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 growt.

Thus, optimizing shareholder value is an important goal of an enterprise.

However, since shareholder value measures the worth of the consolidated
enterprise as whole it is nearly impossible to use it as a performance criterion
for an organization’s individual responsibility centres. 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.

5.EVA puts decisions in big picture perspective

EVA puts the incentive to manage assets in the context of the greater good. A
manager, for example, can appreciate the merits of holding more working
capital and incurring a greater capital charge if that supports additional sales
that generate added profits that increase EVA overall.

It is impossible to evaluate opportunities like that with ROI because it offers an

incomplete picture. ROI myopically focuses on efficiency and ignores the
potential value of growth or increasing the scale of an investment, a point that
deserves elaboration.

6. ROI ignores the value of growth,where EVA incorporates it

As was suggested, ROI is like rewarding a basketball player for shooting
percentage. In business, a goal to increase ROI or just maintain a high one
encourages managers to pass up worthwhile opportunities, to under-invest,
under-innovate, and under-scale, and to leave valuable growth on the table.
but that does not happen with EVA.

So long as an investment covers the cost of capital, which means it adds to

NPV, it adds to EVA, and will do so even if a business unit’s existing margins or
returns come down. Add a 15% ROI investment to a 20% ROI business, and the
blended ROI comes down. But EVA goes up and value goes up so long as the
hurdle rate is less than 15%

7. ROI also is a very poor measure to evaluate the optimal scale or

pacing of individual projects
The deficiency applies to specific investment proposals shaped by field
operating teams, which means ROI-minded companies can never optimally
allocate capital.
Suppose a new plant, product line, marketing campaign or R&D program is
forecast to generate a 20% return. Suppose increasing the size of the
investment—with a larger plant, or more product lines, or a stepped-up ad
or innovation budget—would incrementally return 15%. Managers that
look to maximize IRR or ROI will reject the bigger scale, the larger plant, the
extra products, and the added marketing or research oomph. But again, so
long as the cost of capital is less than 15%—say it is 10%—they should
eagerly embrace the more ambitious proposals. They should seek the
additional funding, drive for the bigger scale, and punch harder, because
that will add EVA and that will add value.

8. EVA is value additive and harmonises corporate and line of

business perspectives
EVA gets the incentives right incrementally and at the margin. Add
something good enough to something that’s great, and EVA is greater still.
The value adds up, whether for a whole business division or for sizing up an
individual investment decision. But that’s not true of ROI. ROI increases
only when the returns from new investments or new decisions exceed the
existing return or some arbitrary target return, which are completely
irrelevant considerations.
 EVA harmonizes corporate and line-of-business perspectives EVA is
additive in another way: When a business unit initiates a positive EVA
decision, its EVA increases by the EVA of the decision, and the parent’s EVA
goes up, too, in exactly the same amount. EVA adds up, from bottom to
top, so that managers at all levels reach the same conclusion about a given
decision and its significance.
ROI does not possess this important attribute (neither does margin, or
growth, nor any other conventional ratio statistic for that matter—they’re
all biased by the beginning point). The ROI impact of a given decision will
look different depending on which unit sponsors it, and will have a different
impact on corporate ROI than by line of business. It is an incredibly clumsy
and confusing metric, when you think about it.

9. EVA is more realistic than ROI

The EVA Momentum and the EVA Margin schedules are unquestionably
used in the analysis of business plans and business performance than any
other technique. They are based on sales, and express all productivity
drivers as ratios to sales, which is a familiar and comfortable construct,
much more so than looking at ROI. Face it, managers don’t naturally think in
terms of investing capital and earning returns on capital. Real world
business managers naturally think in terms of sales—of driving sales
growth, serving customers, entering markets, expanding share, innovating
products, and the like—and earning a profitable margin on the sales.

Now there are many software and models which are licenced to the
companies that transforms the financial complexities of cash flow and IRR
and ROI and NPV into a simple and intuitive sale based, margin-driven
management model which makes implementation simple and
administrative automatic. Eg- EVA enterprise software solution

EXAMPLE
Following is performance measurement of HUL for 5 years from 2002 to
2006
 PARTICULARS 2006 2005 2004 2003 2002
1.Debt 163 360 1588 881 45
2.Equity 2515 2200 2116 2899 3351
3.Capital employed(1+2) 2678 2560 3704 3780 3396
4.Profit after tax(PAT) 1540 1355 1199 1804 1716
5.ROI% (4/3) 57.51 52.93 32.37 47.72 50.53
6.Cost of debt ,post tax% 5.9 3.38 5.19 4.88 6.45
7.Cost of equity % 16.38 15.5 14.77 12.96 14.4
8.weighted average cost of 15.74 13.8 10.66 11.07 14.3
capital %(WACC)
9.Cost of capital 421.52 353.28 394.85 418.45 485.63
employed(3*8)
10.Profit after tax (PAT) 1540 1355 1199 1804 1716
ECONOMIC VALUE
ADDED(EVA)
11.Add: interest after taxes 7 12 82 43 6
12.Net operating profits after 1547 1367 1281 1847 1722
taxes(NOPAT)
13. COCE( as per 9) 421 353 395 418 486
14. EVA(12-13) 1126 1014 886 1429 1236

EVA and ROI for last 5 years is as:

YEARS EVA CAPITAL EVA AS % ROI

EMPLOYED OF CAPITAL
EMPLOYED
2002 1236 3396 36.4% 50.53%
2003 1429 3780 37.8% 47.72%
2004 887 3704 23.9% 32.37%
2005 1014 2560 39.6% 52.93%
2006 1125 2677 42.0% 57.51%

Thus, there exists a divergence between performance results measured

through ROI and EVA.

The ROI doesn’t reflect the real value addition to the shareholder’s wealth
and its is not possible to judge the efficiency of any decision, value creation
and addition which is of utmost importance in the present backdrop of
corporate governance,.

But EVA based measure gives a clear idea about shareholder’s value creation
or destruction.

And in this case company has been able to successfully create the value for its
shareholders over the period of 5 years.

CASE STUDY – TATA GROUP

The Tata group's openness to ideas has served it well throughout its 134-year
history. Over time, the group has imbibed revolutionary technologies, new
business models, innovative human resource strategies, and better accounting
methods to build a dynamic and vibrant conglomerate in sync with the modern
world.

But it has not been smooth sailing for the group. One of the main problems it
faced was the issue of how to measure the performance of its 80 companies
spread over seven sectors. Also in the modern era of CSR and corporate
governance the performance-review systems at the centre and at individual
companies needed to focus on creating value for shareholders which
traditional measures like ROI were unable to capture explicitly.

That’s when tata group decided to introduce EVA in 2003 to measure the
wealth of shareholders but its implementation was not easy and require some
adjustments, as mangers had to juggle with balance sheet and other long term
considerations instead of revenues and costs only. People were more
comfortable with ROI and they were of the view EVA restrict further capital
growth in the company. Also EVA recognises that in capital-intensive industries
returns cannot be expected in a short time. The company needs to show that
future growth value of the company would be positive, although the current
operational value was not so high.

To overcome all these problems the group implemented EVA in three

modules-value diagnostic module,value based audit, measurement and
management phase which include value creation.
As a result , EVA enhanced the quality of decision making, incentives and
compensation was linked to the performance of shareholders, used for
performance measurement evaluation, capital expenditure evaluation etc.
after adopting EVA, TATA group got in the list of top 5 wealth generating
company ,ranked at 3rd position after Reliance and ONGC.

CONCLUSION
In the corporate world, in spite of differences between EVA and ROI, they both
go hand in hand. The former stresses on shareholders wealth and latter is used
to calculate the rate of return that’s why I cannot be abandoned. However
decisions cannot be solely based on ROI when goal of various enterprises today
is to satisfy the shareholders by enhancing the wealth also EVA provides for
better assessment of decisions, better goal congruence and focus on real
economic results. That’s why it can be said that EVA is better than ROI and
companies should Stop Using ROI, and Use EVA Instead.