Introduction

Businesses have a common goal – To sustain and grow. In the pursuit they resort to
Management Control methods to rightly identify and work on opportunities. There are
various Performance Analysis used to analyse a company’s position in the market. A
successful performance measure evaluates how well an organization performs in relation to
its objectives.

Shareholder Value Addition approach is the most advocated approach for a company’s
wellbeing. Shareholders collectively are the owners of the company. These investors would
look for a good long-term Yield on their investments. Devoid of these, the firm loses
shareholders worth and trust. Profit based methods of performance measurement like ROI,
ROE, ARR etc are good for micro level business decisions but they do not accurately reflect
overall performance of the firm and is not a long-term performance measurement tool.
Value based measures are, hence gaining grounds. These Measures seek periodic
performance valuations by measuring the change in the values. An increase in Value would
mean an increase in shareholder’s Yield on investments.

EVA- Economic Value Added is one of the most sought and used Value Based measure.

Objective

This report seeks to study the utility of Economic Value Added as a tool to making
Management control decision. We would discuss the meaning and theory of EVA and its
significance. Discrepancies in trivial accounting and profit based Management control tools
such as ROE/ROI /ARR would be studied and EVAs superiority over other commonly known
performance measures like ROE/ROI/ARR etc would be detailed. We would study different
fronts at which EVA proves as an effective decision making tool. Lastly, we would learn the
pros and cons of EVA, and how should the companies improvise on its shortcomings to get
true analysis of companies’ performance and take correct Management control decisions.
Finally, we would discuss some alternatives to EVA for management control Decision
making.

Definition of EVA:

Economic Value Added (EVA) is a calculation of the financial performance of a company

based on residual wealth, measured by deducting its capital expense from its operating
profit, adjusted for cash-based taxes. EVA, as it seeks to capture a company's true economic
benefit, can also be referred to as economic profit. The management consultancy company
Stern Value in Management, which originally named as Stern Stewart & Co., invented this
measure.

Background of EVA:

EVA has not been a new invention. The operating benefit subtracted by the capital charge is
described as an accounting performance indicator called residual profits. Therefore, EVA is
one residual income variance with modifications to how one measures income and
resources. Alfred Marshall was one of the first to discuss the latent idea, according to
Wallace, in 1890. At the current pace, Marshall defined economic benefit as overall net
profits less the interest on investment capital. The notion of residual profits appeared first in
accounting theory publications at the beginning of the 20th century, as per Dodd & Chen,
and reported in the 1960-65 in accounting literature for administration. The idea was also
debated by Finnish scholars and financial media as early as the 1970s. It was described as a
great way to manage ROI-control. Many scholars have asked about the great attention and
recognition that has engulfed EVA in recent years, knowing this context. In order to prevent
complications posed by trademarking, the EVA definition is also called Economic Advantage
(EP). In the other hand, the term "EVA" is so common and well known that all residual
income terms are often referred to as EVA, but even the key elements identified by Stern
Stewart & Co. do not contain them.
In the early 1970s, residual income was not widely publicised, and, in many industries, it was
not recognised as the prime success metric. Nevertheless, EVA has made it in recent years
with basically the same theory with another fresh name. In addition, there does not seem to
be a worsening pattern in the distribution of Economic Value Added and other residual
income initiatives. On the opposite, the number of businesses implementing EVA is
increasingly growing. We can only speculate that residual profits on this scale has never
achieved attention. One of the potential explanations for this is that the idea of Markets
Value Added (MVA) was sold with Economic Value Added (EVA) which logically offered a
sound connection to market valuations. This was a nice bite in the times where investors
demand attention on corporate value problems. Maybe Stern Stewart & Co.'s related
publicity has had and has its commitment.

Theory: Compared to the overall cost of employed capital, EVA tests is the operating margin
appropriate. Stewart described EVA with a capital charge as NOPAT (Net Operating Profit)
subtracted:

EVA = NOPAT – CAPITAL COST

EVA = NOPAT – COST OF CAPITAL * CAPITAL EMPLOYED

In another way, if rate of return can be described as NOPAT/CAPITAL, we can use it as:

EVA = (RATE OF RETURN – COST OF CAPITAL) * CAPITAL

Where:
1. Rate of return = NOPAT/CAPITAL
(NOPAT is profits derived from a company’s operations after taxes but before financing
costs and noncash-bookkeeping entries. It is the total pool of profits available to provide a
cash return to those who provide capital to the firm.)

2. Capital = Difference between Total balance sheet and non-interest-bearing debt

3. Cost of Capital = [Cost of Equity * Proportion of Equity from Capital] + [Cost of debt *
Proportion of debt from Capital * (1 – tax rate)]
The overall cost of all equity capital and interest-bearing debt is the capital cost or the
Weighted Average Capital Cost (WACC). Equity capital expenditures are the yield on
opportunity at the same expense as the corporation to be purchased. In general equity costs
are defined by the capital asset pricing model (CAPM). The estimation of the debt burden is
of course, more apparent, because the result is clear. The cost of debt also requires the tax
protection because of the interest rate tax deduction.

If ROI is described as above (after taxes), then familiar terminology may be addressed to
EVA as follows:

EVA = (ROI – WACC) * CAPITAL EMPLOYED

The concept behind EVA is that a return that compensates for the risk taken must be
received by shareholders. In simpler terms, equity capital must gain at least the return as
equally volatile equity-market investments. If it is not the case, so there is no proper benefit
made and from the standpoint of customers the company simply runs will be at loss.
Alternatively, if the EVA is zero, because the owners have got a return that compensates for
the expense, it should be treated as a satisfactory achievement. EVA is related to general
items based on accounting, such as equity capital, debt-bearing interest, and net operating
profit. It varies largely from the addition of equity expenses from conventional
interventions. Mathematically, EVA provides almost the same outcomes as Net Present
Value or Discounted Cash Flow in valuations, which have long been commonly accepted
from the perspective of shareholders as technically best analytical methods. However, it
must be stressed that the importance with EVA and the equivalence with EVA is only under
special cases (in valuations) does NPV/DCF hold and hence this equivalence is not related to
efficiency calculation. This special feature of EVA is discussed in detail later.

The discrepancy in accounting and profit based tools (ROI/ROE/ARR)

In order to be appropriate from the shareholder's point of view, any project that an
organisation undertakes should have a positive net present value (NPV). This suggests that
the cost of capital for a project should be lower than the intrinsic rate of return. The internal
rate of return cannot be calculated with realistic output analysis. Therefore, with the help of
accounting rate of return, the rate of return to capital is calculated. This rate of return is
usually is ROI. Unfortunately, with any accounting rate of return, it does not provide a
reliable approximation of the actual return rate underlying it. The following example
illustrates this dilemma, which is discussed below in more detail and with a stronger
theoretical perspective. This is an example of an investment project with an initial
investment of Rs. 1200, a period of eight years, a steady gross margin of Rs. 210, an IRR of
11% with no salvage value.
As the example above reveals, ROI is a weak predictor of true cost of return. Table and
Figure show present above how the ROI at the beginning underestimates the Internal Rate
of Return (IRR) and overestimates it by the end. Furthermore, in this scenario, ROI
incorrectly periodizes the rate of return and on average, it often struggles to estimate the
true rate of return of the project. ROI underestimates the real return in this scenario. This
Phenomenon is called “Wrong Periodizing”. Besides this an incorrect periodization is set and
that results to an incorrect Rate of Return value. In a real life project this causes a bigger
error. This is because in real life project Positive cash flow starts only after a considerable
time. Likewise, several studies deem profit based performance measurements as
inadequate to descript true performance of a firm. For example, Salmon and Laya, 1967,
studied a theoretical firm made up with project of known IRR and found that ARR of the firm
different from true IRR. De Villiers study showcases the anomalies in IRR accounting using
different asset structure in combination.

EVA as Management Control tool

EVA can be used as a management control tool that allows managers and employees to
focus on how capital is used, and the cash flow generated from it. It is better than ROI
(RONA, ROCE, ROIC) as a controlling tool and as a performance measure because of the
following reasons:
 1. Steering failure in ROI: As established ROI and other profit based measurement are
misguiding and either underestimate or overestimate the IRR, giving an incorrect
perception of companies’ performance.
2. More practical and understandable than ROI: It is more practical in the sense of
having taken into consideration all the costs including the cost of
equity capital which is ignored in normal accounting. Furthermore, EVA is quite
easily explained to non-financial employees and furthermore the impacts of different
day-to-day actions can be easily turned into EVA-figures. The calculation shows how
and where a company created wealth, through the inclusion of balance sheet items.
This forces managers to be aware of assets and expenses when making managerial
decisions.

There are several fronts at which EVA proves to be an effective Management Decision
Making tool:

1. EVA as Performance Measurement tool:

Lehn and Makhija (1996) studied companies’ performance based on EVA and
MVA and how it affected CEO firings and deduced that EVA/MVA inversely
related to abnormal CEO turnover. This essentially established EVA as a potent
tool for taking Management Control Decisions. They also Deduced in their study
that the firms with greater focus on business activities have slightly higher MVA
that the less focused counterparts. They concluded in their study that EVA and
MVA are effective performance measures and contains information about quality
of strategic decisions and signals strategic changes too.

2. Correlation between EVA and share prices

The market value of a company is the addition of its book value and the present
value of potential EVA. This strict association between EVA and a company's
stock valuation implies that the market prices of shares are guided by EVA.. Both
EVA and MVA compare favourably with stock market returns and the correlation
is marginally higher than conventional success metrics, such as ROA, ROE and
ROS. Above everything, stock prices are based on assumptions for future cash
 flows. Thus, adjustments in existing share prices reflect changes in projected cash
flow and hopes for future EVAs.
There are many research that correlates EVA and Share prices
Lehn and Makhija (1996) researched EVA and MVA as performance measures
and found that both measures correlate positively with stock prices better that
(ROA) and (ROE).

3. EVA in management bonus plans:

The results of implementing management bonus programmes based on EVA
were analysed by Wallace. Around 40 businesses that have EVA as a benefit base
were the sample he took. This survey is compared to the same sample size
composed of comparable businesses where accounting-based metrics are related
to the incentive. Over the twenty-four-month period, the businesses that
implemented EVA related compensation outperformed the industry by over 4
percent-points in cumulative terms.

Problems with EVA in measuring operating performance

Because EVA is derived from accounting-based estimates and any variant of the accounting
return is used to measure EVA, EVA is still influenced by all the anomalies listed we deduced
in ROI/ROE/ROS. In order to minimise these differences radically, the modified EVA also
called AEVA, is then adopted. The modified EVA makes it easy to measure the accounting
cost of return using the present valuation of all investments (ROI). The usage of current
valuation of assets would not remove the difference entirely but it does reduce it to a
fraction of initial discrepancy.

a. When calculating the returns of a single investment over a period of time, EVA
and ROI are weak. At the beginning, they understate the return and over-
estimate it at the end of the cycle.
b. EVA is not an acceptable primary success indicator for these growth firms - faced
with lucrative long-term prospects with unfavourable short-term cash flows.
Growth corporations' success is maybe best calculated by market share, market
share improvement and revenue growth.
Impact of EVA’s accounting distortions in performance measurement
Economic Value Added (EVA) also results from distortions rather than just erroneous
periodization. As the ROI does not realize the underlying true return, owing to inflation and
some other causes, the periodic EVA doesn’t give a clear picture of the value added to
shareholders. Using the actual valuation of assets and not book prices will almost entirely
eradicate this problem. The magnitude of this issue depends mostly on the composition of
the assets and the average length of the project. The magnitude and course of this issue can
therefore be measured. EVA priorities must then be changed accordingly.

Pros and Cons of EVA:

Pros:
1. EVA is very useful as a success measure. By adding balance sheet products, the
measure shows how and where a business generated wealth. This allows executives
to be careful of assets and costs when making business decisions.
2. EVA supplements financial data from numerous other company assessment and
appraisal processes.
3. By using precise values, EVA also allows to avoid issues connected to percentage
measurements.
4. It reflects the cost management of corporations and highlights the supply of working
capital by deducting the real opportunity cost.
5. Another value of EVA is that it is often seen as a management reward that
guarantees the continuation of operations for an organisation.
Cons:
1. The estimation of the EVA depends heavily on the amount of committed capital and
is better used by stable or mature asset-rich firms. Companies of intangible assets
could not be suitable candidates for an EVA review, such as technology companies.
2. Performance cannot be accurately interpreted as the EVA of a larger plant would still
be more than smaller plants, even though they are more productive and sustain a
comparatively better ROI.
 3. The economic value added does not decide how efficiently the retained gains are
used by capital asset holders by project management and other business projects.
4. The return on expenses such as research and development can also not be measured
using Economic Value Added.

Tax calculations in EVA:

In EVA monitoring and reporting, taxes are frequently overlooked. This strategy can be
explained on the basis that taxes are not part of an operational activity to be measured and
enhanced. So, in that way, having taxes in reporting would not change the situation. If taxes
are absolutely overlooked, however, pre-tax EVA= 0 cannot be the minimum appropriate
target. The pre-tax EVA could naturally be very optimistic in order to attain EVA=0. This can
be a disadvantage if EVA is considered for bonus system.

Net operating benefit is normally subtracted straight from the estimate of EVA income, and
the debt shield of tax is considered in the capital costs:

EVA = NET OPERATING PROFIT * (1 – TAX RATE) – WACC * CAPITAL

This formula does not consider the amount of taxes collected in normal life and is also
decreased by surplus reserves and depreciation. The net reserves are rising all the time with
constantly raising activities. Thus, the practical rate of tax is smaller than the nominal rate of
tax. Adapted way for tax calculation:
EVA = [NET OPERATING PROFIT – ((NET OPERATING PROFIT – EXCESS DEPRECIATION –
OTHER INCREASE IN RESERVES) * (TAX RATE))] – WACC * CAPITAL

This is the way the tax authorities also calculate EVA.

Impact of discrepancies in performance measured

EVA also suffers from distortions other than just inaccurate periodization. As the ROI fails to
estimate the underlying true return, due to inflation and other factors, the periodic EVA
figure fails to estimate the value added to shareholders. This issue can be almost entirely
removed by using the actual value of assets instead of book prices. Without any special
modifications to the capital base, EVA may and has also been successfully introduced in
many businesses. This is also the way that without massive scrutiny, businesses have
measured their ROI for decades.

Improvement Measures

There are innumerable individual operational things that make investor worth with
shareholder value and increment EVA. Expanding EVA falls consistently into one of the
accompanying three classes:

 Rate of return increments with the current capital base. It implies that all the more
working benefits (ie. Operating profits) are created without tying any more capital in
the business.

 Additional capital is put resources into business procuring more than the expense of
capital. (Making NPV positive speculations.)

 Capital is removed or sold from organizations that neglect to procure return more
noteworthy than the expense of capital.

The main technique incorporates all the incalculable approaches to improve operational
effectiveness or increment incomes. Obviously expanding pace of rate of return with current
operations and new investments are frequently connected; to improve the productivity of
ongoing operational activities, organizations regularly do investments which upgrade
likewise the profit for current capital base.

The way that the abundance of investors increments with ventures returning more that the
expense of capital is most likely known in organisations in the event that they additionally
utilize some sort of weighted normal expense of capital (WACC) and Net present value
(NPV) procedure in speculation figuring. This standard is entirely same as tolerating just
NPV-positive speculations.

The third one, pulling out capital, is likely not all that generally comprehended and applied
as the past ones. It is anyway likewise critical to understand that shareholder value can
likewise be expanded if capital is removed from organizations acquiring not exactly the
expense of capital. Regardless of whether an activity has positive overall gain, it may pay to
pull out capital from that action. It is likewise sort of withdrawal when access inventories
and receivables and in this way the capital expenses brought about by them are diminished
without comparing decrease in revenues.

Alternatives to EVA

Other than EVA there are a lot of other Value-based or Shareholder esteem measures. They
are made by consulting industry and additionally by economists. Consultants are totally
compelled to utilize their specific abbreviation of their specific idea although it would not
contrast a whole lot the competitor’s measure. In this way the scope of these various
abbreviations is wide.

1. DISCOUNTED CASH FLOWS (DCF) AND NET PRESENT VALUE (NPV)

This method involves the following tasks:

1. Decide the important, incremental cash flows.

2. Discount the cash flows using appropriate rate that reflects the risk of the task.
3. Acknowledge the project only if the NPV>0.

The advantage of this methodology is the high relationship among NPV and shareholder
value. This would help project the shareholders wealth.

2. SHAREHOLDER VALUE ADDED (SVA)

SVA is a creation of Dr. Alfred Rappaport and LEK/Alcar Consulting Group. SVA is to limit
assessed future incomes to introduce and thus consistently figure the estimation of the firm.

The key parameters of SVA are sales growth, operating profit margin, incremental working
capital investment, fixed capital investments, incremental fixed capital investment, cost of
capital and competitive advantage period.

The SVA method involves the following steps:

 1. Estimate the free cash flows within the competitive advantage period by reference
to the value drivers.
2. Discount these cash flows, using either a company-wide weighted average cost of
capital (WACC) or separate business unit discount rates.
3. Add to the present value of the firm at the end of forecast period. Ie. Residual value.
4. Add market value of non-operational assets to the present value to gain corporate
value that belongs to all investors.
5. The value of equity is determined by reducing the value of debt from result.

3. CASH FLOW RETURN ON INVESTMENT (CFROI)

Investment return on cash flow (CFROI) is the result of the Boston Consulting Group (BCG)
and Associates of HOLT Meaning. It is the internal long-term rate of return, almost
established as a typical IRR. By translating profitability data into gross cash flow and using
actual gross assets as an implicit investment, CFROI is calculated. In two phases, CFROI is
computed:

The first inflation-adjusted cash flows available to all owners of the company's capital are
estimated and compared to the inflation-adjusted gross investment produced by the owners
of the capital. After that by considering the limited economic existence of depreciating
assets and the residual value of non-depreciating assets such as land and working capital,
the ratio of gross cash flow to gross investment is transformed into an internal rate of
return. This strategy has the following measures for its evaluation: Convert profitability data
into inflation-adjusted gross cash flows available to all capital owners in the firm. The
approach works with real cash flows rather than nominal flows, hence the need for inflation
adjustments.

1. Based on real gross assets, measure the implied investment, again inflation-adjusted
where needed. Intangibles are usually omitted here such as goodwill.
2. Estimate the depreciating assets' limited economic existence and the residual value
of the non-depreciating assets such as land and working capital.
 3. CFROI is then determined by BCG as the internal rate of return that equates the
present value of potential cash flows with the current gross investment value
calculation.

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