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of the requirement for the degree Of Master of Business Administration Specialization- Finance Submitted By: Gourav Sharma 94512236916 Submitted To: Dr. Navjot Kaur
GIAN JYOTI INSTITUTE OF MANAGEMENT & TECHNOLOGY MOHALI (2009-2011)
I am extremely thankful to Dr. Navjot Kaur, Project Guide, faculty member, Gian Jyoti Institute of Management and Technology, for her timely guidance and support throughout the Final Report work. In the course of carrying out the Project work she help me out to understand the various terms and working of economic value added as performance measurement tool for small & medium scale enterprises. Finally I am indebted to our other faculty members, my friends who gave their full-fledged co-operation for successful completion of my project. It was an indeed a learning experience for me.
Name of the Student: Gourav Sharma Enrollment No.: 94512236916
TABLE OF CONTENTS CHAPTERS 1. INTRODUCTION 2. REVIEW OF LITERATURE 3. RESEARCH METHODOLOGY 4. ANALYSIS & DISCUSSION 5. CONCLUSION 6. SUGGESTIONS PAGE NO. 4- 44 45-51 52-61 62-71 72-73 74-75
Chapter - 1 Introduction
1.1 Introduction EVA is a value based financial performance measure, an investment decision tool and a performance measure reflecting the absolute amount of shareholder value created. It is computed as the product of the “excess return” made on an investment or investments and the capital invested in that investment or investments. EVA is the net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise or project. It is an estimate of true economic profit, or the amount by which earnings exceed or fall short of the required minimum rate of return investors could get by investing in other securities of comparable risk (Stewart, 1990). EVA is not new. Residual income, an accounting performance measure, is defined to be operating profit with a capital charge subtracted. Thus, EVA is a variant of residual income, with adjustments to how one calculates income and capital. Stern Stewart & Co, a consulting firm based in New York, introduced the concept of EVA as a measurement tool in 1989, and trademarked it. The EVA concept is often called Economic Profit (EP) to avoid problems caused by the trade marking. EVA is so popular and well known that all residual income concepts are often called EVA even though they do not include the main elements defined by Stern Stewart & Co (Pinto, 2001). Up to 1970 residual income did not get wide publicity and it was not the prime performance measure for companies (Makelainen, 1998). However, in the 1990’s, the creation of shareholder value has become recognized as the ultimate economic purpose of a corporation. Firms focus on building, operating and harvesting new businesses and/or products that will provide a greater return than the firm’s cost of capital, thus ensuring maximization of shareholder value. EVA is a strategy formulation and a financial performance management tool that helps companies make a return greater than the firm’s cost of capital. Firms adopt this concept to track their financial position and to guide management decisions regarding resource allocation, capital budgeting and acquisition analysis. Economic Value Added simply balances a company's profitability against the capital it employs to generate this profitability. If a company's earnings, after tax, exceed the cost
of the capital employed in the business, EVA is positive. Market studies have indicated that a company that continually generates an increasingly positive EVA will be rewarded by a higher stock price. A definition of EVA is net operating profit after taxes (NOPAT), less an internal charge for the capital employed in the business (i.e., opportunity cost of capital). Many of the traditional corporate performance measures have been found to poorly correlate, or even conflict, with management's primary objective of maximizing the market value of a firm's stock. Now, there are several new measures in the financial world that attempt to align the behaviors of an organization with its stockholders' interests. One measure that has received a great deal of notice and acceptance is Economic Value Added (EVA), developed by Joel M. Stern and G. Bennett Stewart III of Stern Stewart & Co. Implementation of one of these measures, such as EVA, can fundamentally change the behavior of an entire organization. The new measure focuses the behavior of individuals throughout all parts of the organization in a way that is better aligned with creating stockholder wealth. Because performance compensation incentives are based upon the new measure, employees and stockholders mutually benefit. The financial function is uniquely qualified to take a leadership role in communicating an understanding of the new measure. Main challenge is to gain a deep understanding of the underlying principles of the measure and to communicate them in a meaningful way to all parts of the organization. There can be pitfalls in translating the theory to practice, but there is an opportunity to provide the appropriate counsel. Economic Value Added (EVA) has become all the rage in the investing world. Stern Stewart has gone so far as to trademark the concept, though many academics challenge it as a knock-off of residual income. Stern Stewart has, however, been very successful touting the measure as the best measure of business performance and management discipline. Fortune Magazine annually publishes a list of top companies complete with and EVA numbers and rankings, crediting the measures for the creation (or destruction) of shareholder wealth. The Journal of Applied Corporate Finance annually publishes the 6
EVA for the Stern Stewart Performance 1000, citing EVA as "the critical driver of a company's stock performance". Successful corporations are increasingly turning to EVA to measure performance. General Electric, AT&T, Chrysler, and Compaq use EVA for financial analysis. Coca Cola's late CEO, Roberto Goizueta, acknowledged the value of EVA and declared "You only get richer if you invest money at a higher rate than the cost of the money to you" (Fisher, 1995). In turn, investors and analysts are now scrutinizing company EVA just as they have historically observed EPS and PE ratios. Academic articles relating EVA success stories and promoting adoption of the measure abound (Blair, 1996; Byrne, 1994; Carr, 1996; Copeland and Meenan, 1994; Gressle, 1996; Tully 1993; Stern 1990; Rice, 1996; Pallerito, 1997; Martin, 1996). As described by Stern Stewart, EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. In effect, it estimates the economic profit (or loss) of a company's operations. Traditional accounting measures such as EPS and ROA measure economic performance, but ignore the cost of the capital. Including the cost of capital, as EVA does, reveals whether any economic value was created. This forces management to focus on managing the company's assets as well as creating income. How does EVA promote shareholder interests? First, it clearly specifies to management that the primary financial objective of the company is to create shareholder wealth. Secondly, it emphasizes continuous improvement in the company's EVA as the basis for increased shareholder wealth. Assuming the efficient market hypothesis holds, stock price reflects the company's current performance; therefore, the level of EVA isn't important, but changes in that level are. Management focus on these two issues can result in dramatically increasing EVA. Rising EVA has been purported to cause stock price to rise, therefore satisfying shareholder interests. Does a relationship between EVA and stock return really exist? James Meenan, CFO of AT&T's long distance business believes that it does. According to Meenan, his company's EVA and stock price have had an almost perfect correlation since 1984 (Fortune, 1993). Detractors are not as enthusiastic. Corporate strategy expert
Gary Hamel argues that while EVA is a good place to start, it is not an adequate way to measure a company's wealth creation (Hamel and Lieber 1993). In 1995, Daniel Saint of Chrysler stated, "as a single period measure of financial performance, I believe EVA's contribution is minimal and not much different from return on equity or other traditional accounting measures" (Kramer and Pushner, 1997). In truth, empirical evidence supporting the relationship between EVA and stock return is sketchy at best. 1.2 Performance Measurement (PM) Investors measure overall performance of a firm as a whole to decide whether to invest in the firm or to continue with the firm or to exit from it. In order to achieve goal congruence, managers’ compensation is often linked with the performance of the responsibility centers and also with firm-performance. Therefore selection of the right measure is critical to the success of a firm. To measure performance of a firm one needed a simple method for correctly measuring value created/ enhanced by it in a given time frame. All the current metrics trade off between the precision in measuring the value and its cost of measurement. In other words, each method takes into consideration the degree of complexities in quantifying the underlying measure. The more complex is the process, the more is the level of subjectivity and cost in measuring the performance of the firm. There is a continuous endeavor to develop a single measure that captures the overall performance, yet it is easy to calculate. Each metric of performance claims its superiority over others. Performance of a firm is usually measured with reference to its past record and the performance of other firms with comparable risk profile. The various performance metrics currently in use are based on the returns on investment generated by the business entity . Therefore to reach a meaningful conclusion, returns generated by the firm in a particular year should be compared with returns generated by assets with similar risk profile (cross sectional analysis). Similarly return on investment for the current period should be compared with returns generated in past (time series analysis). A firm creates value only if it is able to generate return higher than its cost of capital. Cost of capital is the weighted average cost of equity and debt (WACC). 8
The performance of a firm gets reflected on its valuation by the capital market. Market valuation reflects investor’s perception about the current performance of the firm and also their expectation on its future performance. They build their expectations on the estimated growth of the business in terms of return on capital. This results in incongruence between current performance and the value of the firm. Even if the current performance is better in relative terms, poor growth prospects adversely affects the value of the firm. Therefore any metric of performance, to be effective, should be able to not only capture the current performance but also should be able to incorporate the direction and magnitude of future growth. Therefore the robustness of a measure is borne out by the degree of correlation the particular metric has with respect to the market valuation. Perfect correlation is impossible because as shown by empirical researchers, fundamentals of a company cannot fully explain its market capitalization; other factors such as speculative activities, market sentiments and macro-economic factors influence movement in share prices. However the superiority of a performance metric over others lies in providing better information to investors.
Metrics of performance have a very important and critical role not only in evaluating the current performance of a firm but also in achieving high performance and growth in the future. The metrics of performance have a variety of users, which include all the stakeholders whose well being depends on the continued well being of the firm. Principal stakeholders are the equity holders, debt holders, management, and suppliers of material and services, employees and the end-users of the products and services. Value creation and maximization depends on the alignment of the various conflicting interests of these stakeholders towards a common goal. This means maximization of the firm value without jeopardizing the interests of any of the stakeholders. Any metric, which measures the firm value without being biased towards any of the stakeholders or particular class of participants, can be hailed as the true metric of performance. However it is difficult, if not impossible, to develop such a metric. Most of the conventional performance measures directly relate to the current net income of a business entity with equity, total assets, net sales or similar surrogates of inputs or outputs. Examples of such measures are return on equity (ROE), return on assets (ROA) and operating profit margin. ROA measures the
asset productivity and operating profit margin reflects the margin realized by the firm at the market place. The net income figure in itself is dependent on the operational efficiency, financial leverage and the ability of the entity to formulate right strategy to earn adequate margin in the market place. It is important to note that none of these measures truly reflect the complete picture by themselves but have to be seen in conjunction with other metrics. These measures are also plagued by the firm level inconsistencies in the accounting figures as well as the inconsistencies accountants in measuring in the valuation methods used by assets, liabilities and income of the firm. Accounting
valuation methods are in variance with the methods that are being used to value individual projects and firms. The value of an asset or a firm, which is a collection of assets, is computed by discounting future stream of cash flows. The net present value (NPV) is the surplus that the investment is expected to generate over the cost of capital. Measures of periodical performance of a firm, which is the collection of assets in place, should follow the same underlying principles. Economic value added (EVA) is a measure that captures the valuation principles. Historically, PM systems was developed as a means of monitoring and maintaining organizational control, which is the process of ensuring that an organization pursues strategies that lead to the achievement of overall goals and objectives (Nanni, et al 1990). PM plays a vital role in every organization as it is often viewed as a forward-looking system of measurements that assist managers to predict the company's economic performance and spot the need for changes in operations. In addition, PM can provide managers, supervisors and operators with information required for making daily judgments and decisions. PM is increasingly used by organizations, as it enables them to ensure that they are achieving continuous improvements in their operations in order to sustain a competitive edge, increase market share and increase profits. 1.3 EVA (Economic Value Added)
EVA (Economic Value Added) was developed by a New York Consulting firm, Stern Steward & Co in 1982 to promote value-maximizing behaviour in corporate managers (O'Hanlon. J & Peasnell. K, 1998). It is a single, value-based measure that was intended to evaluate business strategies, capital projects and to maximize long-term shareholders wealth. Value that has been created or destroyed by the firm during the period can be measured by comparing profits with the cost of capital used to produce them. Therefore, managers can decide to withdraw value-destructive activities and invest in projects that are critical to shareholder's wealth. This will lead to an increase in the market value of the company. However, activities that do not increase shareholders value might be critical to customer's satisfaction or social responsibility. For example, acquiring expensive technology to ensure that the environment is not polluted might not be of high value from a shareholder's perspective. Focusing solely on shareholder's wealth might jeopardize a firm reputation and profitability in the long run. EVA sets managerial performance target and links it to reward systems. The single goal of maximizing shareholder value helps to overcome the traditional measure problem, where different measures are used for different purposes with inconsistent standards and goal. Rewards will be given to managers who are able to turn investor's money and capital into profits efficiently. Researches have found that managers are more likely to respond to EVA incentives when making financial, operational and investing decision (Biddle, Gary, Managerial finance 1998), allowing them to be motivated to behave like owners. However this behaviour might lead to some managers pursuing their own goal and shareholder value at the expense of customer satisfaction. Unlike simple traditional budgeting, EVA focuses on ends and not means as it does not state how manager can increase company's value as long as the shareholders wealth are maximized. This allowed managers to have discretion and free range creativity, avoiding any potential dysfunctional short-term behaviour. Rewards such as bonuses from the attainment of EVA target level are usually paid fully at the end of 3 years. This is because workers' performance is monitored and will only be rewarded when this target is maintained consistently. Hence, leading to long-term shareholders' wealth.
For example: Coca-Cola is one of the many companies that adopted EVA for measuring its performance. Its aim, which was to create shareholders wealth, was announced in its annual report. Coca-Cola CEO Roberto Goizueta accredited EVA for turning Coca-Cola into the number one Market Value Added Company. Coca-Cola's stock price increased from $3 to over $60 when it first adopted EVA in the early 1980s. In 1995, Coca-Cola's investor received $8.63 wealth for every dollar they invested. Most companies refer to stock price increase as an outcome of implementing EVA. However, empirical studies have found that traditional accounting measure have provided a similar, or even better result in increasing stock performance (Dodd J and Johns J 'EVA reconsidered'). EVA is a financial measure based on accounting data and is therefore historical in nature. It has the same limitations as other traditional accounting measures and cannot adequately replace all measures within the company especially the non-financial ones. Due to the historical nature of EVA, manager can benefit in terms of rewards or be punished by the past history of the organization (Otley, David Performance management 1999). Dodd J and Johns J see the balanced scorecard as one approach to overcome the potential problem of using a single financial measure such as EVA. 1.4 EVA in Indian context In India EVA is being used with impunity. A case at point is the study published by Economic times (11th December 2000) ,on corporate performance. While computing EVA it used a flat rate of 15 percent as the cost of capital of all the enterprises included in the study. The study explains that an average 15 percent interest for both the years covered by the study is used as it is almost equal to the prime-lending rate of the commercial bank and financial institution. It is a basic principle of economics that ‘higher the risk higher is the expected return’. By estimating WACC at 15% this basic principle is violated. It may be argued that cost of debt should be taken post-tax and therefore effective cost of equity incorporated in the calculation is higher than 15 percent. Even if this argument is accepted the computation cannot be defended
because the cost of capital is estimated without using any accepted economic model. Moreover by using a flat rate, variation in risk profiles of firms have been ignored. This shows both the popularity of EVA in India and difficulties in measuring the same. The study has also ignored adjustments in capital and operating income suggested by proponents of EVA 1.5 Economic Value Added – The Concept EVA is the most misunderstood term among the practitioners of corporate finance. The proponents of EVA are presenting it as the wonder drug of the millennium in overcoming all corporate ills at one stroke and ultimately help in increasing the wealth of the shareholder, which is synonymous with the maximization of the firm value. The attractiveness of the EVA lies in its use of cash flow and cost of capital that are determinant of the value of the firm. In the process, EVA is being bandied about with utmost impunity by all and sundry, which includes the popular press. The academic world in its turn has come up with various empirical studies which either supports the superiority of EVA or questions the claim of its proponents. Currently the empirical evidence is split almost half way. EVA is nothing but a new version of the age-old residual income concept recognized by economists since the 1770's. Both EVA and ‘residual income’ concepts are based on the principle that a firm creates wealth for its owners only if it generates surplus over the cost of the total invested capital. So what is new? Perhaps EVA could bring back the lost focus on ‘economic surpluses from the current emphasis on accounting profit. In a lighter vein it can be said that in an era where commercial sponsorship is the ticket to the popularity of even the concept of god, the concept of residual income has not found a good sponsor until Stern Stewart and Company has adopted it and relaunched it with a brand new name of EVA. Technically speaking EVA is nothing but the residual income after factoring the cost of capital into net operating profit after tax. But this is only the tip of the iceberg as will be seen in the next few sections. The paper examines EVA both as a measure of overall
performance and a management philosophy that helps to improve the productivity of resources. Mathematically: EVA= (adjusted NOPAT - cost of capital) x capital employed----- (I) Or EVA = (Rate of return - cost of capital) x capital --------- (II) Where; Rate of Return = NOPAT/Capital Capital = total assets minus non interest bearing debt, at the beginning of the year Cost of capital = cost of equity x proportion of equity + cost of debt (1-tax rate) x proportion of debt in the capital. The above cost of capital is nothing but the weighted average cost of capital (WACC). Cost of equity is normally estimated using capital asset pricing model (CAPM) that estimates the expected return commensurate with the riskiness of the assets. If we define ROI as NOPAT/capital then the above equation can be rewritten as EVA= (ROI- WACC) x CAPITAL EMPLOYED----- (III) Capital being used in EVA calculation is not the book capital, capital is defined as an approximation of the economic book value of all cash invested in going-concern business activities, capital is essentially a company’s net assets (total assets less non-interestbearing current liabilities), but with three adjustments: • • • • Marketable securities and construction in progress are subtracted. The present value of non-capitalized leases is added to net property, plant, Certain equity equivalent reserves are added to assets: Bad debt reserve is added to receivables.
• • • R&D). •
LIFO reserve is added to inventories. The cumulative amortization of goodwill is added back to goodwill R&D expense is capitalized as a long-term asset and smoothly depreciated over
5 years (a period chosen to approximate the economic life typical of an investment in Cumulative unusual losses (gains) after taxes are considered to be a long-
term investment. A firm can motivate its managers to direct their effort towards maximizing the value of the firm only by, first measuring the firm value correctly and secondly by providing incentives to managers to create value. Both are interdependent and they complement each other. Therefore this paper examines the EVA concept from two perspectives, EVA as a performance measure and EVA as a corporate philosophy. I shall examine EVA as a performance measure to assess whether it conveys any additional information to investors over conventional performance measures. In other words, whether information on EVA leads to better decision by investors. EVA can lend a helping hand in this connection in two ways: one that it is inherently flexible and second, it helps generate flexibility within the organization: 1. The EVA concept allows adjustment of various accounting parameters (mentioned in section on EVA theory) to suit the desired end purpose. There can be various purposes for which EVA exercise might be carried out such as award of bonus to employees, relative performance of various divisions, assessment of business as a whole etc. For the purpose of award of bonus to employees, the focus is on the operational income and capital employed to generate such income. Various accounting adjustments are made accordingly. However, for the purpose of assessment of business as a whole, the strategic investment and its returns also come into picture. While comparing various divisions, the capital employed and expenses incurred on corporate centre take a back seat Thus, EVA concept provides flexibility in hands of finance manager in measuring performance. In the case study discussed later, we have discussed EVA from the point of view of award of bonus. 15
2. Not only is EVA concept inherently flexible, but also it induces flexibility in the organization. The application of concept forces the organization to release/ free the excess capital employed. This deployment of excess capital provides the much-required flexibility to finance manager to improve performance. Since application of concept questions every decision harder, it forces the managers to keep exploring options and encourages keeping the system flexible. This effect is more pronounced in companies which are in distress, and where restructuring is being carried out. 1.5.1 Implementing EVA Implementing EVA should be more than just adding one line in the monthly profit report. EVA affects the way capital is viewed and therefore, it might create some kind of change in management's attitude. Of course this depends on how shareholder-value-focused the management is and how the company has been in the past. While implementing EVA represents some kind of change in the organization, it should be implemented with care in order to achieve understanding and commitment. It is vital that group level managers thoroughly understand the characteristics of the concept, how these characteristics affect control and above all where the Strategic Business Units (SBUs) stand currently from the viewpoint of these characteristics. Before implementing EVA to any SBU, the group management ought to assess whether the business units are currently cash flow generators in mature businesses or companies in rapidly growing businesses. This assessment should absolutely include careful estimation of relative age and structure of assets in order to know whether the current accounting rate of return is over or under estimating the true rate of return. Only then can the concept be properly tailored to the unique situation of each individual business unit. Group level managers should also know how to support strategic goals of SBU with EVA and how to create value with EVA in individual SBU. At the level of SBU, gaining understanding and commitment are also the most important issues. First task is to get the support of all the managers, not only of the Managing Director but also of directors of production and marketing etc. This is achieved with
intense and thorough training. For managerial level, attaining thorough commitment can be facilitated very much by introducing good incentive plan based on EVA. Gaining commitment of middle level managers and other employees below the top management of business unit is also important. Training and some kind of EVA based compensation plans should also be considered with these target groups. Keeping EVA simple is also viewed as an important feature in successful implementation. In principle, EVA is simple concept and it should be offered to business units as such. 1.5.2 How Companies Have Used EVA Name Timeframe Use of EVA The Coca-ColaEarly 1980s Focused business managers on increasing shareholder Co. AT&T Corp. 1994 value Used EVA as the lead indicator of a performance measurement system that included "people value added" IBM Herman Inc. 1999 and "customer value added" Conducted a study with Stern Stewart that indicated that
outsourcing IT often led to short-term increases in EVA MillerLate 1990s Tied EVA measure to senior managers' bonus and compensation system
4 Ms of EVA As a mnemonic device, Stern Stewart describes four main applications of EVA with four words beginning with the letter M. Measurement EVA is the most accurate measure of corporate performance over any given period. Fortune magazine has called it "today's hottest financial idea," and Peter Drucker rightly observed in the Harvard Business Review that EVA is a measure of "total factor productivity" whose growing popularity reflects the new demands of the information age.
Management System While simply measuring EVA can give companies a better focus on how they are performing, its true value comes in using it as the foundation for a comprehensive financial management system that encompasses all the policies, procedures, methods and measures that guide operations and strategy. The EVA system covers the full range of managerial decisions, including strategic planning, allocating capital, pricing acquisitions or divestitures, setting annual goals-even day-to-day operating decisions. In all cases, the goal of increasing EVA is paramount. Motivation To instill both the sense of urgency and the long-term perspective of an owner, Stern Stewart designs cash bonus plans that cause managers to think like and act like owners because they are paid like owners. Indeed, basing incentive compensation on improvements in EVA is the source of the greatest power in the EVA system. Under an EVA bonus plan, the only way managers can make more money for themselves is by creating even greater value for shareholders. This makes it possible to have bonus plans with no upside limits. In fact, under EVA the greater the bonus for managers, the happier shareholders will be. Mindset When implemented in its totality, the EVA financial management and incentive compensation system transforms a corporate culture. By putting all financial and operating functions on the same basis, the EVA system effectively provides a common language for employees across all corporate functions. EVA facilitates communication and cooperation among divisions and departments, it links strategic planning with the operating divisions, and it eliminates much of the mistrust that typically exists between operations and finance. The EVA framework is, in effect, a system of internal corporate governance that automatically guides all managers and employees and propels them to work for the best interests of the owners. The EVA system also facilitates decentralized decision making because it holds managers responsible for-and rewards them fordelivering value.
1.5.3 The EVA Concept of Profitability EVA is based on the concept that a successful firm should earn at least its cost of capital. Firms that earn higher returns than financing costs benefit shareholders and account for increased shareholder value. In its simplest form, EVA can be expressed as the following equation: EVA = Net Operating Profit after Tax (NOPAT) - Cost of Capital NOPAT is calculated as net operating income after depreciation, adjusted for items that move the profit measure closer to an economic measure of profitability. Adjustments include such items as: additions for interest expense after-taxes (including any implied interest expense on operating leases); increases in net capitalized R&D expenses; increases in the LIFO reserve; and goodwill amortization. Adjustments made to operating earnings for these items reflect the investments made by the firm or capital employed to achieve those profits. Stern Stewart has identified as many as 164 items for potential adjustment, but often only a few adjustments are necessary to provide a good measure of EVA. Recently, the Economic Valued Added method has gained attention worldwide. This method is intuitively appealing and measures profitability in the way shareholders define it. Economic Value Added calculates the actual dollar amount of a business's wealth created or destroyed in each reporting period. It takes into account the opportunity cost (the minimum acceptable compensation for investing in a risky asset as opposed to a less risky market instrument like government bonds) of the company's capital investment and measures the excess returns over this charge. A positive Economic Value Added indicates that value is being created; so adding to the intrinsic value of the company by that amount. A negative Economic Value Added, on the other hand, indicates that value is eroded and the company is now worth less than the initial capital employed.
Measurement of EVA Measurement of EVA can be made using either an operating or financing approach. Under the operating approach, NOPAT is derived by deducting cash operating expenses and depreciation from sales. Interest expense is excluded because it is considered as a financing charge. Adjustments, which are referred to as equity equivalent adjustments, are designed to reflect economic reality and move income and capital to a more economically-based value. These adjustments are considered with cash taxes deducted to arrive at NOPAT. EVA is then measured by deducting the company's cost of capital from the NOPAT value. The amount of capital to be used in the EVA calculations is the same under either the operating or financing approach, but is calculated differently. The operating approach starts with assets and builds up to invested capital, including adjustments for economically derived equity equivalent values. The financing approach, on the other hand, starts with debt and adds all equity and equity equivalents to arrive at invested capital. Finally, the weighted average cost of capital, based on the relative values of debt and equity and their respective cost rates, is used to arrive at the cost of capital which is multiplied by the capital employed and deducted from the NOPAT value. The resulting amount is the current period's EVA. 1.6 There are eight steps involve in applying Economic Value Added to value a company: Step 1: Determining a period of financial projection. To calculate returns on capital employed, we first need to estimate the company's earnings; for instance, in the next five years to 2016. The earnings projection is based on a set of assumptions for future volume sales growth, finished product prices, government duties and inflation. Step 2: Net operating profit after tax (NOPAT): Net operating profit after tax is equivalent to the after tax earnings generated by the company (excluding interest expense). The financing of asset (interest expense) is assumed to be independent of operating results and is instead reflected in the company's cost of capital.
Step 3: Initial capital employed: The total capital employed at the beginning of each year is the assets base from which earnings for the year are generated. Capital employed = Net fixed assets + Working capital Step 4: Return on capital employed (ROCE) the yearly returns on capital employed are determined by dividing NOPAT by capital employed at the beginning of each year. ROCE = NOPAT ÷ Capital employed Step 5: Weighted average cost of capital (WACC) after calculating the Returns on Investment (ROI), match them to the cost of capital. The most commonly used cost of capital is the WACC, which is based on the company's debt equity capital structure. WACC = Weighted cost of equity + Weighted after tax cost of debt After tax cost of debt = [Interest payment x (1-tax rate)] ÷ Total borrowings How big a risk premium required for investing in a company is dependent on how risky the stock is relative to the broad market; which known as correlation beta. A high beta implies the stock price is more volatile than the broad market. Therefore, an investor should require a higher than market average return to compensate for the additional risks. Conversely, a low beta implies that the stock returns will lag a market rally but will be more resilient during a sell down. Step 6: Excess returns over cost of capital Excess returns (ER) = ROCE - WACC Step 7: Economic Value Added and Market Value Added (MVA) Economic Value Added = ER x Capital employed
Beyond the projected period of 2016, impute a terminal value (perpetuity); on the basis that the company is an ongoing business concern (for the stream of future Economic Value Added, assuming a constant yearly growth of 1%). The stream of Economic Value Added is then discounted back to present day values using the WACC calculated previously, the sum of which is the positive value created by the company's business operations. MVA = Sum of present value of Economic Value Added stream. Step 8: Intrinsic value and shareholder value. The intrinsic value for the company is its initial capital employed enhanced by the positive value created. Intrinsic market value = Initial capital employed + MVA And finally, Shareholder value = Intrinsic market value - Net debt Fair value per share = Shareholders' value ÷ Number of shares The company's primary objective would be to maximize Economic Value Added; which is not necessarily the same as maximizing profits. If the return on an investment is below its cost of capital, then the company prefers not to make the investment at all (even if the absolute magnitude of profit is increased). 1.6.1 EVA Calculation and Adjustments As stated above, EVA is measured as NOPAT less a firm's cost of capital. NOPAT is obtained by adding interest expense after tax back to net income after-taxes, because interest is considered a capital charge for EVA. Interest expense will be included as part of capital charges in the after-tax cost of debt calculation. Other items that may require adjustment depend on company-specific activities. For example, when operating leases rather than financing leases are employed, interest 22
expense is not recorded on the income statement, nor is a liability for future lease payments recognized on the balance sheet. Thus, while interest is implicit in the yearly lease payments, an attempt is not made to distinguish it as a financing activity under GAAP. Under EVA, however, the interest portion of the payment is estimated and the after-tax amount from it is added back into NOPAT because the interest amount is considered a capital charge rather than an operating expense. The corresponding present value of future lease payments represents equity equivalents for purposes of capital employed by the firm, and an adjustment for capital is also required. R&D expense items call for careful evaluation and adjustment. While GAAP generally requires most R&D expenditures to be expensed immediately, EVA capitalizes successful R&D efforts and amortizes the amount over the period benefiting the successful R&D effort. Other adjustments recommended by Stern Stewart include the amortization of goodwill. The annual amortization is added back for earnings measurement, while the accumulated amount of amortization is added back to equity equivalents. Goodwill amortization is handled in this manner because by "unamortizing" goodwill, the rate of return reflects the true cash-on-yield. In addition, the decision to include the accumulated goodwill in capital improves the real cost of acquiring another firm's assets regardless of the manner in which the acquisition is accounted. While the above adjustments are common in EVA calculations, according to Stern Stewart, those items to be considered for adjustment should be based on the following criteria:
• • • •
Materiality: Adjustments should make a material difference in EVA. Manageability: Adjustments should impact future decisions. Definitiveness: Adjustments should be definitive and objectively determined. Simplicity: Adjustments should not be too complex.
If an item meets all four of the criteria, it should be considered for adjustment. For example, the impact on EVA is usually minimal for firms having small amounts of operating leases. Under these conditions, it would be reasonable to ignore this item in the calculation of EVA. Furthermore, adjustments for items such as deferred taxes and various types of reserves (i.e. warranty expense, etc.) would be typical in the calculation of EVA, although the materiality for these items should be considered. Unusual gains or losses should also be examined and eliminated if appropriate. This last item is particularly important as it relates to EVA-based compensation plans. 1.6.2 EVA at Work Although economic value added is considered to be the kingpin of value-based metrics, it won't work in an organization if a CEO doesn't force implementation throughout the company or if incentive-based compensation isn't offered. And a pure EVA bonus plan won't necessarily work at the middle and lower levels of a company, making it difficult to preach the EVA gospel throughout an organization. Stern Stewart & Co., a New York-based financial consulting firm which has trademarked the term EVA, promotes the idea that economic value added is a financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. "The formula for EVA looks formidable, but it's really not," says Stern Stewart vice president Tom Leander. "EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. In simple terms, EVA equals net operating profit after taxes — we use the acronym NOPAT." Stern Stewart calculates what the economic value added for a company is and then decides from what business centers the EVA will be calculated. Once the measurement is made, the firm works with the finance department to show employees how EVA can be used as an internal measure. The next and most obvious step is tying that measurement to incentive compensation. "Under classic economic theory, a problem exists in that managers' interests are not aligned with the interests of the owners," Leander says. "But one of the aspects of EVA is 24
that managers must think and act like owners of the company. The underlying principle here is that unless managers are motivated to think and feel like they're owners of the company, they're not going to create value in a way that benefits shareholders." EVA is about working smarter, not harder. It's about doing such things as reducing the number of steps in a work process, reducing cycle times or scrutinizing business expenses. Economic value added can be improved in three basic ways: 1. Growth: Invest in projects that earn more than the cost of capital. For example, investing in personal computers, which frequently increase efficiency and justify a minimal investment? 2. Improved productivity: Increase profits without using additional capital and/or eliminate business expenses which can help improve income. 3. Divestiture: Eliminate non-strategic assets that do not generate operating profits greater than the cost of capital. Examples include the reduction of inventory levels and speeding up cycle times. Many companies which use EVA have found this to be the most attractive method. According to Stern Stewart, a key to weaving EVA into the corporate culture is to make it the focal point for reporting, planning and decision-making. To do that requires two things: The first is recognizing that, because economic value added is a measure of total factor productivity, it can and should supersede other financial and operating measures, resulting in a hierarchy as opposed to a balanced scorecard. The balanced scorecard results when financial numbers are not the only consideration used to make strategic decisions. For example, if you're manufacturing a product, a balanced scorecard weighs factors such as financial impact, quality, customer satisfaction and productivity. If EVA is merely added to a list of many other performance measures, confusion and unnecessary complexity will remain. The second requirement is that EVA be incorporated into decision-making processes. The fact that such high-profile companies as The Coca-Cola Co. and Briggs & Stratton have achieved considerable success through the implementation of EVA has prompted a
wave of companies to at least consider the strategy. "You have thought leaders in the marketplace who are touting this much as they would reengineering," says Tom Hertog, manager of Chicago-based Arthur Andersen Global Best Practices. "When people come to us, they're looking for the magic bullet, but as is the case with benchmarking and best practices, there is a whole host of approaches and no single solution. But the appropriate and consistent application of EVA methodology will yield results, regardless of what size company you are or what industry you're in." Arthur Andersen promotes a four-step process for organizations that want to undertake an economic value added program: 1. Calculation or formulation: How does one measure the return on capital minus the cost of capital? This is where most of the focus is directed. Certain aspects of the EVA calculation include determining the number of capital adjustments, the number of cost of capital factors, the number of cost centers calculating EVA, and the number of NOPAT (net operating profit after taxes) adjustments 2. Application: How does one apply EVA in his/her organization, in that particular line of business? For example, if you're a service organization and you don't have a tangible product, you still need a performance measurement tool such as EVA to determine the increase or decrease of value. It's important to set a goal for increasing EVA as expressed as a percentage for the next 12 months, the next one to three years, and the next three to five years. 3. Implementation or integration: How does one make EVA part of their organizational culture? This step includes determining the extent of training needed for management and staff, the methods by which EVA will be communicated throughout the company, and the time it will take for implementation at various levels in the organization. 4. Interpretation or correlation: How will EVA impact the future of company? Organizations obviously want to focus on positive change and sometimes use MVA (market value added) as a measure of interpretation. MVA can be measured
by taking the current market value placed on the company as reflected in its stock price and then subtracting the capital invested on the balance sheet. "It comes down to ABO — awareness, buy-in, and ownership," Hertog says. "One or two people will rise to the champion level and take ownership and drive it. The business unit controllers will need to get that message from the CFO that they're going to do EVA. The way you introduce it and integrate it is absolutely critical for it to gain acceptance. Otherwise, it never happens 1.7 EVA vs. Traditional Performance Measures The development of the concept of EVA has added flexibility in measurement of performance. The traditional methods can continue side by side with EVA. Some of the traditional ways of measuring corporate performance are described here. 1.7.1 Return on Investment (ROI) Return on capital is a very good and relatively good performance measure. Different companies calculate this return with different formulae and call it also with different names like return on invested capital, return on capital employed, return on net assets, return on assets etc. The main shortcoming with all these rates of return is that in all cases maximizing rate of return does not necessarily maximize the return to shareholders. Following example will clarify this statement: Suppose a group has two subsidiaries X and Y. For both subsidiaries and so for the whole group the cost of capital is 10%. The group has maximizing ROl as its target. Subsidiary X has ROl of 15% and the other has ROl of 8%. Both subsidiaries begin to struggle for the common target and try to maximize their respective ROIs. Company X rejects all the projects that produce a return below the current 15% although there would be some projects with return 12-13%. Y, in turn, accepts all the projects with return above 8%. For a reason or another, it does not find very good projects, but the returns of its projects lie somewhere near 9%.
Suppose that both subsidiaries manage to increase their ROI. The ROI of subsidiary X increases from 15 to 16% and that of Y increases from 8 to 8.5%. The company's target to increase ROI has been achieved, but what about the shareholder value. It is obvious that all the projects of subsidiary Y decrease the shareholder value, because the cost of capital is more than rate of return (and so the shareholders money would have been better off with alternative investments). The actions of the better subsidiary are not optimal for shareholders. Of course shareholders will benefit from the good projects with return greater than 15% but also all the projects with returns of 10-14% should have been accepted even though they decrease the current ROl of subsidiary X. These projects still create and increase the shareholder value. Hence, the capital can be misallocated on the basis of ROl. ROl ignores the definite requirement that the rate of return should be at least as high as cost of capital. Further, ROI does not recognize that shareholder's wealth is not maximized when the rate of return is maximized. Shareholders want the firm to maximize the absolute return above the cost of capital and not to increase percentages. 1.7.2 Return on Equity (ROE) The level of ROE does not tell the owners if company is creating shareholders' wealth or destroying it. With ROE, this shortcoming is much more severe than with ROI, because simply increasing leverage can increase the ROE. In other words, decreasing solvency does not always make shareholders' position better because of the increased financial risk. 1.7.3 Earning per Share (EPS) EPS is raised simply by investing more capital in business. If the additional capital is equity (retained earnings) then the EPS will rise if the rate of return of the invested capital is just positive. For example, let us assume that as on March 31, 2009, company A has net worth of Rs 50 million and 5 million equity shares. At a profit after tax of Rs 100 million for FY 2009, the EPS would work out to be 20. The entire income can be ploughed back in the business at a marginal return of 5%. Assuming that the return on 28
previous net worth remains the same, the profit after tax would be Rs 105 million and EPS would be 21. Though the performance has gone down, the EPS has increased. If the additional capital is debt then the EPS will rise if the rate of return of the invested capital is just above the cost of debt. In reality, the invested capital is a mix of debt and equity and the EPS will rise if the rate of return on the additional investment is somewhere between the cost of debt and zero. Therefore EPS is completely inappropriate measure of corporate performance and still is very common yardstick and even a common bonus base. Unlike conventional profitability measures, EVA helps the management and other employees to understand the cost of equity capital. At least in big companies, which do not have a strong owner, shareholders have often been perceived as free source of funds. These flaws are taken care of by the concept of economic value added. The key feature of this concept is that for the first time any measure takes cares of the opportunity cost of capital invested in business. 1.8 The Utility of EVA: Better Decision-Making EVA clarifies the concept of maximizing the absolute returns over and above cost of capital in creating shareholders' wealth. Hence better investment decisions can be taken with above aim rather than maximizing percentage of ROl. Understanding of EVA enables monitoring of investment decisions closely not only at the level of corporate but at line staff as well. Fosters New Era of Corporate Control EVA points / centres can be created within an organization and these centres would have capital, revenue and expenditure issue attached to them. It helps identify value drivers and destroyers. Responsibility of positive EVA can be delegated at these centres. It questions the decisions harder.
Long-Term Thinking Perhaps the biggest benefit of this approach is to get employees and managers to think and act like shareholders. EVA encourages long-term perspective among the managers and employees of organization. It emphasizes that in order to justify investments in the long run they have to produce at least a return that covers the cost of capital. In other case, the shareholders would be better off investing elsewhere. This approach includes that the organization tries to operate without the luxury of excess capital and it is understood that the ultimate aim of the firm is to create shareholder value by enlarging the product of positive spread multiplied with capital employed. The approach creates a new focus on minimizing the capital tied to operations. Firms have so far done a lot in cutting costs but cutting excess capital has been paid less attention. Capital Allocation Tool EVA is a capital allocation tool inside a company as it sets minimum level of acceptable performance with regard to the rate of return in the long run This minimum rate of return is based on average (risk adjusted) return on equity markets. The average return is a benchmark that should be reached. If a company cannot achieve the average return, then the shareholders would be better off if they allocated the capital to another industry or another company. Bonus System EVA has provided a platform on which a flexible bonus payment system can be based. Employees will be paid bonus only when they earn at least equal to the cost of capital employed. This links the bonus with the end result and forces employees to act like shareholders. Proponents of bonus systems based on EVA have suggested that bonuses for corporate managers should always be tied to the long-term capital because short-term EVA can sometimes be manipulated upwards to the cost of long run EVA The long run can be incorporated into EVA-based bonuses, that is, by banking the bonuses. This would mean that when EVA is good, the managers earn a certain percentage of it, but the bonus should not be paid out of them entirely. If the periodic EVA is negative, 30
then the bonus put in the bank is negative and it decreases the balance already earned. This exposes the managers partly to the risk the shareholders are used to bear. At the same time, it gives incentives to good performers and encourages the bad performers to improve their performance. For example, manager earns a bonus of an amount X of the annual salary for leading its centre to a positive EVA to the extent of 10% of capital employed. Out of the entire bonus, 50% can be paid out and the rest can be banked as entitlement if the next year EVA is not negative. In case the EVA next year is negative, the banked bonus can be reduced as disincentive for bad performance. Flexibility in EVA Today's business environment is marked by presence of a lot of change drivers like globalization, an intense competition, etc and the uncertainty surrounding them has created chaos and confusion in organizations. Consequently, flexibility has assumed key role in every facet of organization management and finance function, known for its rigidity, is not too far from application of this paradigm. 1.9 Small and Medium Enterprises (SMEs) Small and Medium Enterprises (SMEs) are considered engines for economic growth, not only in India but all over the world. Small and medium enterprises have played a vital role in the growth of the Indian economy. Small Scale Industry has a 40% share in industrial output, producing over 8000 value-added products. They contribute nearly 35% in direct export and 45% in the overall export from the country. They are one of the biggest employment-providing sectors after agriculture, providing employment to 28 million people. They account for 80% of global economic growth. Market conditions have dramatically changed for Indian SMEs after economic reforms. SMEs are regularly facing new challenges in terms of cost, quality, delivery, flexibility and human resource development for their survival and growth. In the context of a
dynamic market scenario, they have to formulate their strategies for developing various capabilities and competencies to satisfy their domestic as well as global customers. For long-term competitiveness, SMEs have to focus on all aspects of organizational functions such as assets, strategy development, processes and their performance. In Punjab the SMEs have not been growing at the pace at which they should have been as they have been facing a lot of problems. Small Scale industrial undertaking is defined as an industrial undertaking in which the investment in fixed assets in plant and machinery whether held on ownership terms on lease or on hire purchase does not exceed Rs.50 million (Subject to the condition that the unit is not owned, controlled or subsidiary of any other industrial undertaking). Small and medium-size enterprises (SMEs) in India play an important role in generating employment and creating economic wealth. Small-scale industries play a key role in the industrialization of a developing country. This is because they provide immediate largescale employment and have a comparatively higher labor-capital ratio; they need lower investments, offer a method of ensuring a more equitable distribution of national income and facilities an effective mobilization of resources of capital and skill which might other-wise remain unutilized. Table1: Small Scale Industry of Punjab: A Brief Profile (2009 – 10) No. of Registered SSI Units Employment Fixed Investment (Rs mn) Production (Rs mn) Predominant Industries Major Issues 1,97,340 8,54,000 34,050 1,50,000 Metal Products, Leather and Products, Textile and Hosiery, Nonelectrical Machine Tools & Parts, Food Products Need for Infrastructural facilities, Need for working capital, Need for marketing infrastructure
The small scale sector has stimulated economic activity of a far reaching magnitude and has played a significant role in attaining the following major objectives;
1. Elimination of economic backwardness of rural and underdeveloped regions in the country. 2. Attainment of self-reliance 3. Reduction of regional imbalance. 4. Reduction of disparities in income wealth and consumption. 5. Mobilization of resources of capital and skills and their optimum utilization. 6. Creation of greater employment opportunities and increase output, income and standards of living 7. Meeting a substantial part of the economy’s requirements for consumer goods and simple producer goods 8. Provide employment and a steady source of income to the law-income groups living in rural and urban areas of the country 9. Provide substitutes for various industrial products now being now being imported into the country. 10. Improves the quality of industrial products manufactured in the cottage industry sector and to enhance both production and exports. The development of these industries would be beneficial to the developing countries and assist them in improving their economic and social well-being. This would create greater employment opportunities and assist in entrepreneurship and skills development and ensure better use of the scarce financial resources and appropriate technology. India is ranked among the ten most industrialized countries in the world. The country has derived its economic strength from the growth of small-industries throughout its length and breadth. The pivotal role the small industry play in the economy of India can be judged by looking at the statistical data; more than 55% of total production in country today is from small-scale sector.
1.9.1 Scope of small-scale industry
The importance of small-scale enterprises is a global phenomenon encompassing both the developing and developed countries. Globally, the emphasis is on the small-enterprises holding the key to growth with equity and proficiency. In India, small industry refers to manufacturing activity. Recently it has also included servicing activities such as repair and maintenance shops and few community services. This sector covers over 7500 items involving very simple to highly sophisticated technologies and offering opportunities for the utilization of local resources and skills, the sector has emerged as a major supplier of a variety of products for mass consumption as well as parts and components to the large industry sector. Apart from handicrafts and other traditional products, small-scale manufacture some of the high value-added and sophisticated products like electronic typewriters, survey equipment, security and fire alarm system, television sets and other consumer durables. Many such products are used as original equipment items by the manufacturers in the large industry sector. The sector has the flexibility of responding to varied needs of the economy. 1.9.2 Characteristics of small-industries 1. Capital investment is small 2. Most have fewer than 20 workers 3. Located in rural and semi-urban areas 4. Virtually all of these firms are privately owned and are organized as sole proprietorships 5. Growing at a faster rate than large scale industry 6. Small-scale industries activity is beehive of entrepreneurship 7. Exploitation of natural resources 8. Human resource is exploited instead of developing it 9. Due to various constraints, cheating is a common feature 10. Organization and management is very poor and negligible in many cases. 11. Financial discipline is very weak and rules and regulation are not adhered. 12. Most of the funds come from entrepreneur’s saving. 1.9.3 Importance of small-scale industries 34
1. The small-scale sector has a high potential for employment, dispersal of industries, promoting entrepreneurship and earning foreign exchange to the country. The following are the points to demonstrate it 2. Symbols of national identity-small enterprises are almost always locally owned and controlled, and they can strengthen rather than destroy the extended family and other social systems and cultural traditions that are perceived as valuable. 3. Individual’s taste fashion and personalized service-small firms are quick in studying changes in tastes and fashion of consumers and in adjusting the production process and production accordingly. For eg: In garment industry the small units have ruled the roost, big companies delegate responsibility down the line and cannot swiftly change the trace when necessary. The garment business is personalized, oriented to changing fashions and has to be tightly controlled. 4. Facilitates capital formation-the development of small industries generated additional income and additional savings, this helps in capital formation in the economy. 5. Equitable distribution of income and wealth-By creating opportunities for small business, small enterprises can bring about can bring about a more equitable distribution of income and wealth which is socially necessary and desirable 6. Balanced regional growth-small-industries make possible transfer of manufacturing activity from congested cities to rural and semi-urban areas, this helps in regional development 7. Linkages-the large scale industries create an opportunity for growth of small-scale industry, the growth of large motor industry will create opportunities for setting up small service station and repair centers. 8. Export potential-Nearly 20% of the total value of export comes from small-scale industry. The main items of export includes pharmaceuticals, sports goods, engineering goods, finished leather, readymade cotton garments, processed foods etc.
1.9.4 Advantages of small-scale enterprises 1. Small-scale industry do not require as heavy and costly infrastructure as larger enterprises. 2. They have favorable capital output ratio 3. Helps to create economic stability in society by diffusing prosperity and by checking the expansion of monopolies 4. Most developing countries are rich in certain agricultural, forest and mineral resources; small-scale industries can be based on processing of locally produced raw materials 5. It is possible to save and to earn a foreign exchange by producing and exporting goods process from local resources. 6. Small-scale industries are generally labour-intensive and do not require large amount of capital. The energy of unemployed and under-employed people may be used for productive purposes in an economy in which capital is scarce. 7. They bring integration with rural economy on one hand and large scale enterprise on other. 8. They facilitate mobilization of resources of capital and skills which often would remain inadequately utilized. 1.9.5 Role of small business in national economy Small business has played a very crucial role in transforming the Indian economy from a backward agrarian economy to its present stature. Its benefits range from creating job opportunities for millions of people, including many with low levels of formal education. It has nurtured the inherent entrepreneurial spirit in far flung corners of the nation resulting in the growth and development of all regions. It has been instrumental in raising the standard of living of the multitudes. The small scale sector has contributed specifically in the following areas: 1. Employment Generation: The SSI sector in India is the second largest manpower employer in the country next only to the agriculture sector. India is characterized by abundant labour supply and is plagued by unemployment and underemployment. Under these circumstances the small-scale sector is a boon
.For every Rs.0.1million of investment, the small-scale sector provides jobs to 26 people as compared to 4 jobs created in the large-scale sector. 2. Low Initial Capital Investment: Another feature of the Indian economy and most of the developing economies is the scarcity of capital. The modern largescale sector requires colossal investments whereas the small sector is just the opposite. Not only is the employment capital ratio high for the SSI but the output capital ratio is also high. 3. Balanced Regional Development: Dispersion of small business in all parts of the country helps in removing regional imbalances by promoting decentralized development of industries. It helps in industrialization of rural and backward areas. It also helps to reduce problems of congestion, pollution housing, sanitation etc 4. Equitable Distribution of Income: This is a natural corollary of the above. When entrepreneurial talent is tapped in different regions and areas the income is also distributed instead of being concentrated in the hands of a few individuals or business families. 5. Promotes Inter-Sectoral Linkages: SSI units are supplementary and complementary to large and medium scale units as ancillary units. Many small units produce sub-parts, assemblies, components and accessories for the largescale sector especially in the electronic and automotive sectors. 6. Exports: The most significant contribution of the SSI has been in the field of exports. There has been a significant increase in the exports from this sector of both traditional and non-traditional goods including jewellery, garments, leather, hand tools, engineering goods, soft ware etc. 7. Development of Entrepreneurship: Small business taps the latent potential
available locally. This way they facilitate the spirit of enterprise, which results in overall growth, and development of all the regions /sectors of the nation Companies that succeed with economic value added (EVA) initiatives tend to possess the following characteristics: 1. Strong support from the CEO. If the CEO takes a wait-and-see attitude, EVA stands a greater chance of failing, because employees are less likely to take it seriously. 2. Effective EVA education. If employees understand why they should start using EVA principles in their everyday tasks, there’s a greater chance of success in the implementation phase. 3. Links between EVA performance and employee compensation. Connecting the performance measure with incentives gives EVA implementation teeth and lets everyone know how they will be evaluated. 4. Realistic income stream projections. EVA is based on the educated guess of how much potential a capital asset has to produce a rate of return over and above its cost. If the people making those estimates are too rosy in their projections, the number of capital expenditures that produce a positive EVA will shrink 5. An overall attitude of economic efficiency. Successful EVA companies look not only at the cost of capital, but also at a variety of ways to improve economic efficiency within their organization, such as reducing inventory costs and improving operational processes. 6. An overall attitude of economic efficiency. Successful EVA companies look not only at the cost of capital, but also at a variety of ways to improve economic efficiency within their organization, such as reducing inventory costs and improving operational processes. 7. EVA-based budgets. Traditional budgets impede EVA’s effectiveness by, essentially, saying, "We have X dollars, and all of that money needs to go someplace." If a company’s calculations indicate that only 60 percent or 75 percent of that money can be spent within its EVA parameters, then that company
should allocate its resources only to capital projects that will produce an acceptable rate of return. 1.10 Strategies for increasing EVA
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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
1.10.1 Advantages of EVA EVA is more than just performance measurement system and it is also marketed as a motivational, compensation-based management system that facilitates economic activity and accountability at all levels in the firm. Stern Stewart reports that companies that have adopted EVA have outperformed their competitors when compared on the basis of comparable market capitalization. Several advantages claimed for EVA are:
EVA eliminates economic distortions of GAAP to focus decisions on real economic results 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
Academic researchers have argued for the following additional benefits: 39
Goal congruence of managerial and shareholder goals achieved by tying compensation of managers and other employees to EVA measures (Dierks & Patel, 1997)
• • • •
Better goal congruence than ROI (Brewer, Chandra, & Hock, 1999) Annual performance measured tied to executive compensation Provision of correct incentives for capital allocations (Booth, 1997) Long-term performance that is not compromised in favor of short-term results (Booth, 1997) Provision of significant information value beyond traditional accounting measures of EPS, ROA and ROE (Chen & Dodd, 1997)
1.10.2 Limitations of EVA EVA also has its critics. The biggest limitation is that the only major publicly-available sample evidence on the evidence of EVA adoption on firm performance is an in-house study conducted by Stern Stewart and except that there are only a number of single-firm or industry field studies. It would be wrong to say that EVA is not beset with any drawbacks. Though it provides a new tool in the hands of management, it has its own limitations. For example, EVA does not take into cognizance current market value of assets and book value is taken into account in calculations. This is of course misleading and presents distorted picture but estimating the current market value of assets is very difficult and often impractical. EVA has established superiority over other measures of performance but that does not mean that EVA alone can clearly tell how the plans are going and strategic goals being met. The companies that have invested heavily today and expect positive cash flow only in distant future are extreme examples that have negative EVA in near future. Their performance can be better judged by market share, sales growth etc. For the equity analysts, there is a word of caution. The concept of EVA requires knowledge of accounts internal to organization to a great extent and their availability to the external world is a big constrain. This constraint becomes even more pronounced in
countries like India where even the annual reports published by companies have scanty disclosures. Moreover, it has to be borne in mind that EVA gives one year snapshot of company's operational performance. Brewer, Chandra & Hock (1999) cite the following limitations to 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
Also, Chandra (2001) identifies the following two limitations of EVA:
Given the emphasis of EVA on improving business-unit performance, it does not encourage collaborative relationship between business unit managers EVA although a better measure than EPS, PAT and RONW is still not a perfect measure
Brewer et al (1999) recommend using other performance measures along with EVA and suggest the balanced scorecard system. Other researchers have noted that EVA does not correlate as strongly with stock returns as its proponents claim. Chen & Dodd (1997) found that, while EVA provides significant information value, other accounting profit measures also provide significant information and should not be discarded in favor of EVA alone. Biddle, Brown & Wallace (1997) found only marginal information content beyond earnings and suggest a greater association of earnings with returns and firm values than EVA, residual income, or cash flow from operations. Finally, a key criticism of EVA is that it is simply a retreated model of residual income and that the large number of "equity adjustments" incorporated in the Stern Stewart system may not be necessary (Barfield, 1998; Chen & Dodd, 1997; O'Hanlon & Peasnell, 1998; Young, 1997). The similarity between EVA and residual income is supported by
Chen and Dodd (1997) who note that most of the EVA and residual income variables are highly correlated and are almost identical in terms of association to stock return. 1.10.3 Common EVA errors:
They don't make it a way of life. You can't just calculate EVA; you have to adopt it. Companies must make it the centerpiece of a comprehensive financial management system. Economic value added must be linked to how companies set overall financial goals, how they communicate those goals internally and to the investment community, and how they evaluate opportunities to build the business and invest capital.
They rush the implementation process. Depending on the size of a company, the implementation process could take anywhere from three months to two years. Companies that make the mistake of trying to implement EVA all at once often find there are too many people to train and disruption results. Top managers must be able to understand economic value added so they can train those down the line.
There is a lack of conviction from senior management. The CEO must be totally committed to prevent staff from creating fiefdoms. Direction from the top is critical because moving to EVA is something not all managers will want to do if they already can easily meet budget. Approximately 50 percent of the power of EVA can be lost if the incentive plan is not driven by it.
Managers complain too much. Instead of making economic value added a philosophical crusade to create shareholder value, communicate a simple message to employees: "What if we found a measure of financial performance that really captures all the things a person can do to run the business more efficiently, to satisfy customers, and to reward shareholders. Wouldn't it make sense to use that to shape our financial decision-making?"
There is a lack of quality training. It is important that the fundamentals of EVA be communicated throughout the organization because even those with the smallest jobs can create value. This means things like linking EVA to such key operating metrics as cycle time or inventory turns and making certain the people involved know how economic
value added fits in. After all, the faster you turn inventory, the greater the reduction of needed capital, resulting in increased EVA. 1.11 Objectives of the Study Whenever a study is conducted, it is done on the basis of certain objectives in mind. A successful completion of a project is based on the objectives of the study that could be stated as under: 1) To determine how to calculate EVA of a company. 2) To develop an EVA model for SME’s. 3) To determine how EVA as a tool act as a financial performance measure in SME’s. 4) To examine how EVA is different from other performance measures i.e. pitfalls of traditional performance measures are discussed here. 1.12 Limitations of the study Though every care has been taken to make this report authentic in every sense, yet there were a few uncomfortable factors, which might have their influence on the final report. Linking factors can be stated as: There were many problems regarding the collection of secondary data internally i.e. Income Statement and Balance Sheet of the firm. None of the owner managers and employees of the firm is keeping a proper record of Sales, Inventory, costs associated and other facts required for the purpose of research. Nobody was willing to share any kind of information and it was hard to get the real fact about the firm’s profitability. Lack of resources available on Economic Value Added (EVA) model for SME.
Chapter - 2 Review of Literature
Review of Literature: Bartoloma Deya Tortella and Sandro Brusco (2001) examined that Economic Value Added (EVA) is a widely adopted technique for the measurement of value creation. Using different event study methodologies they test the market reaction to the 45
introduction of EVA. Additionally, they analyze the long-run evolution before and after EVA adoption of profitability, investment and cash flow variables. They first show that the introduction of EVA does not generate significant abnormal returns, either positive or negative. Next, they show that firms adopt EVA after a long period of bad performance, and performance indicators improve only in the long run. With respect to the firm investment activity variables, the adoption of EVA provides incentives for the managers to increase firm investment activity, and this appears to be linked to higher levels of debt. Finally, they observe that EVA adoption affects positively and significantly cash flow measures. Andrew Worthington and Tracey West (2003) noticed that with increasing pressure on firms to deliver shareholder value, there has been a renewed emphasis on devising measures of corporate financial performance and incentive compensation plans that encourage managers to increase shareholder wealth. One professedly recent innovation in the field of internal and external performance measurement is a trademarked variant of residual income known as economic value-added (EVA). This paper attempts to provide a synoptic survey of EVA’s conceptual underpinnings and the comparatively few empirical analyses of value-added performance measures. Special attention is given to the GAAP-related accounting adjustments involved in EVA-type calculations. Roztocki, N. and Needy, K. L. (1999) this paper examines introducing Economic Value Added as a performance measure for small companies. Advantages and disadvantages of using Economic Value Added as a primary measure of performance as opposed to sales, revenues, earnings, operating profit, profit after tax, and profit margin are investigated. The Economic Value Added calculation using data from a company’s income and balance sheet statements is illustrated. Necessary adjustments to these financial statements, that are typical for a small company, are demonstrated to prepare the data for the Economic Value Added determination. Finally, potential improvement opportunities resulting from Economic Value Added implementation as a performance measure in small manufacturing companies is discussed. M Geyser & IE Liebenbergn (2003) examines long-term shareholder wealth is equally important for all profit seeking organizations, regardless of their size. This paper examines introducing Economic Value Added (EVA) as a performance measure for agribusinesses and co-ops in South Africa. EVA is an effective measure of the quality of managerial decisions as well as a
reliable indicator of an enterprise’s value growth in future. The question posed is whether South African agribusinesses and cooperatives are capable of creating shareholder and member value after the deregulation of the agricultural markets. Linda M. Lovata and Michael L.Costigan (2002) found that Economic Value Added is a new measure of performance that is purported to better align managers’ incentives to that of the shareholders. Accordingly, firms that experience higher agency conflicts should be more inclined to use this performance evaluation system. Additionally, the organizational strategy of the firm should influence the likelihood of employing EVA. Prospector firms are defined as firms that apply a differentiation strategy while defender firms focus on being cost-leaders. Firms identified as prospectors should be less likely to use EVA. One hundred and fifteen firms were identified as being adopters of EVA. Logistic regression was performed to contrast these firms to a control group of 1271 non-adopters. The results indicate that firms using EVA exhibit a higher percentage of institutional ownership and a lower percentage of insider ownership than non-adopters. Prospector firms as defined by a higher ratio of research and development to sales tend to use EVA less than defender firms. Accounting adjustments are a focal point of the EVA formulation and the results presented in this study suggest that providing appropriate incentives may be more complex than the developers of EVA imply. Financial Management Department ;University of Pretoria (2003) studied that several researchers and practitioners, notably Stern Stewart Consulting Company and Associates, have claimed that economic value added (EVA) is superior to traditional accounting measures in driving shareholder value. Other researchers have refuted these claims by supplying data in support of traditional accounting indicators such as earnings per share (EPS), dividends per share (DPS), return on assets (ROA) and return on equity (ROE). This study endeavored to analyses the results of companies listed on the JSE Securities Exchange South Africa, using market value added (MVA) as a proxy for shareholder value. The findings do not support the purported superiority of EVA. The results suggest stronger relationships between MVA and cash flow from operations. The study also found very little correlation between MVA and EPS, or between MVA and DPS, concluding that the credibility of share valuations based on earnings or dividends must be questioned. Raghunatha Reddy (2008) examined that for the past two
decades many countries started transforming their economies from traditional protected ones to those of more liberalized, globalize and market driven. This period has also seen the economies becoming more knowledge oriented and Human Resources started assuming more prominence in the growth of the economies and businesses posing a greater challenge for companies to acquire and retain talented workforce (especially at the strategic & managerial levels). The knowledge economy also started witnessing the rapid rise of the agency problem- conflict of interest between managers and owners. So it is very essential to align the interests of the mangers and shareholders or at least reduce the difference between them. In this regard Economic Value Added has been seen as better alternative to the stock price and traditional performance measures. While successful EVA stories in the west are quite encouraging, Corporate India is slowly catching up the EVA adoption. Although not a panacea, EVA based compensation plans will drive managers employ a firm's assets more productively and EVA should help reduce the difference in the interests of the managers and shareholders, if not perfectly align them. Girotra, Arvind; Yadav, Surendra S (2001) noted that with increased competition and greater awareness among investors, new and innovative ways of measuring corporate performance are being developed. New tools/techniques provide flexibility to managers in their functions, be it in terms of operational aspects or evaluation parameters. Economic Value Added (EVA) is one such innovation. Besides the measures like Return on Equity (ROE), Return on Net Worth (RONW), Return on Capital Employed (ROCE) and Earnings per Share (EPS), EVA is a new measure available to the corporate managers.Michael F. Shivey and Jeffery J. McMillan (2002) This paper first provides an overview of the standard asset; market and income valuation methods that are used to estimate the value of small businesses. It then discusses economic value added (EVA) and demonstrates its potential use inn the valuation of small business. Gary C. Biddle, Robert M. Bowen, James S. Wallace (1998) Traces the growth in the use of economic value added (EVA, previously known as (residual income) and uses two previous research studies to assess some claims for its merits. Compares EVA’s ability to explain stock returns with that of earnings before extraordinary items (EBEI) and cash flow using 1984-1993 US data; and finds EBEI is most closely related. Examines EVA’s incentive effects on management investing,
financing and operating decisions and shows that, although EVA users decreased new investment, increased dispositions of assets, increased share repurchases, used assets more intensively and increased residual income, market reactions to this were weak. Suggests possible reasons for this and concludes that EVA may align management incentives with shareholders’ interests but this does not necessarily increase shareholder value. Samuel C.Weaver (2001) analyzed that over the past decade, consultants, the popular business press, a number of companies and a few investment analysts have heralded Economic Value Added (EVA). In theory, EVA is net operating profit after tax (NOPAT) less a capital charge for the invested capital (IC) employed in the business. This survey bridges the gap between "theory" and "practice" by detailing how EVA proponents measure EVA. This survey is important because its fieldwork identifies significant inconsistencies in the measurement of EVA and its major components. Storrie & Sinclair (1997) present that EVA based on historical values can be somewhat misleading. They first demonstrate that the valuation formula of EVA is theoretically exactly the same as the valuation formula of discounted cash flow (DCF) (Proved also by Kappi 1996). After that Storrie & Sinclair also prove mathematically that this equivalence is due to the fact that the book value in EVA valuation formula is irrelevant in determining value. That is because an increase in "book value of equity" decreases the periodic EVA-figures ("present value of future EVA") and these changes cancel each other out. Stewart, (1991) explained that by explicitly assigning a cost of equity capital and removing the distortions of accounting conventions, EVA allegedly better measures the wealth that a firm has created during a period than does traditional accounting earnings. In other words, EVA allows investors to evaluate whether the return being earned on invested capital exceeds its cost as measured by the return from alternative capital uses. Since wealth (or value or return) created is a primary concern to investors, proponents claim that EVA® is the only measure that ties directly to the intrinsic value of a company’s stock As mentioned earlier, all anecdotal EVA stories allude to this as the primary advantage of adopting EVA. Weissenreider (1998) criticized EVA because it is based on accounting items only. He opined that financial managers might be compelled to act on information that is accounting in disguise and might have serious consequences. Weissenreider (1998) compared EVA with Cash Value Added (CVA) and concluded that
the latter is a better performance measure. Tully, (1993) In contrast, in this paper EVA has been hailed as the most recent and exciting innovative measure of corporate performance that corrects both types of errors in accounting earnings and that EVA should, therefore, replace earnings in both security analysis and performance evaluation. Asish K Bhattachary and B.V. Phani (2004) this paper explains the concept of Economic Value Added (EVA) that is gaining popularity in India. The paper examines whether EVA is a superior performance measure both for corporate reporting and for internal governance. It relied on empirical studies in U.S.A. and other advance economies. It concluded that though EVA does not provide additional information to investors, it can be adapted as a corporate philosophy for motivating and educating employees to differentiate between value creating and value destructing activities. This would lead to direct all efforts in creating shareholder value. The paper brings to attention the dangerous trend of reporting EVA casually that might mislead investors. Mahfuzul Hoque and Mahmuda Akter (2004) this paper examines performance measurement matters in today’s complex business arena irrespective of the type, nature, and volume diversity in business. If the result of performance measurement goes wrong due to the faulty or inaccurate selection of tool(s), then the total process will prove wrong in due time. This paper evaluates Economic Value Added (EVA) as a smart and powerful alternative to traditional performance measures like gross margin, percentage change in sales, net margin etc. in a small manufacturing company perspective. Small manufacturing companies are the focus of the study, as most of the people in such companies believe that EVA is truly designed for large companies and the equation of EVA cannot be applied in small companies due to the non-availability of required data. This paper results in a typical model applicable to small manufacturing companies where all adjustments and other technicalities are discussed with a real life example. Finally, the possible advantages and opportunities of using EVA as a performance measurement tool is discussed that may encourage the users/readers to incorporate EVA with their current setup to reap the potential benefits from it.
Chapter - 3 Research Methodology
Research Methodology Research by the name itself means re-search i.e. to search again. The task of research is to generate accurate information for the use of decision making. Research is a systematic and objective process of gathering, recording and analyzing data for the aid of making decisions relating to a particular problem. 52
Objectives of the Study: Whenever a study is conducted, it is done on the basis of certain objectives in mind. A successful completion of a project is based on the objectives of the study that could be stated as under: 1. To determine how to calculate EVA of a company. 2. To develop an EVA model for SME’s. 3. To determine how EVA as a tool act as a financial performance measure in SME’s. 4. To examine how EVA is different from other performance measures i.e. pitfalls of traditional performance measures are discussed here. 3.1 Need and Focus of the Research The study consists of three main chapters. The first discusses the general theory behind EVA. This chapter presents the background and basic theory of EVA as well as main findings about EVA in financial literature. The chapter also explains in general what EVA has to give to corporate world. This chapter also focuses on the use of EVA in group-level controlling. It discusses how EVA could be defined in controlling and reporting, how it can be used in any company as a financial performance tool and what are the problems faced in implementing EVA. The second chapter consists of review of literature mentioning findings of various research papers and various other studies conducted on the use of EVA as a financial performance tool. Third and final main chapter deals with EVA more practically inside and for this the case of SME has been taken from Ludhiana city, Punjab. (Name of the firm has not been disclosed due to ethical reasons just to hide their explicit identity). The chapter presents with numerical example the calculation of EVA and its impacts as a financial performance tool. 3.2 Research design
The research design is a master plan specifying the method and procedures for collecting and analyzing needed information. The research design in this project is exploratory in nature. Secondary data was used in doing the study “Economic Value Added (EVA) as a financial performance tool: A case of SME’s” Sampling plan: Sampling plan is an effective step in collection of different data from different sources and has a great influence on the quality of results. Mainly secondary data i.e. Income Statement and Balance Sheet of the firm was used in doing this study to develop an EVA model for small manufacturing firms. The sampling plan includes the population, sample size and sampling technique. Population: The study is aimed to include any SSI / SME from Punjab state. Sample Size: To conduct this study and to develop an EVA model a case of one small manufacturing firm has been taken from Ludhiana; Punjab. Sampling Technique: The sample was drawn from the population using convenience sampling. Data Sources: Secondary data was used in doing the study which has been collected internally as Income statement and Balance sheet of the firm and externally from published materials like research papers and from the internet. 3.3 Data Analysis Technique How to calculate EVA
The EVA is a measure of surplus value created on an investment. Here, surplus value simply stands for the difference between return and cost of capital. In a small manufacturing firm, the EVA model is modified, or more appropriately, simplified to some extent. This simplification comes due to the less complexity of operation, nonavailability of required information and comparatively lower amount of financial involvement. This proposed EVA model seeks six sequential steps to be followed before getting a periodic EVA, i.e., to what extent the owners‘ equity or wealth is changed (increased/decreased). These steps are outlined below followed by an illustration with one of my sampled small manufacturing firm. Step 1: Review the company‘s financial data EVA is based on the financial data. Most of these data are available from the generalpurpose financial statement consisting of at least income statement and balance sheet. Sometimes additional data from the notes to financial statements may also be required. In most of the cases, the last two years information prove sufficient to get all the required information to calculate EVA for any specific year. Income statement is used to calculate net operating profit after tax (NOPAT) and balance sheet is used to identify the capital invested in the business. Notes are used to find out the adjustments in NOPAT and cost of capital (COC) invested. Step 2: Identify the necessary adjustments require to be considered The conventional GAAP income statement and balance sheet are required to be adjusted to find out net operating profit and the true capital. Companies cannot replace GAAP earnings with EVA in their public reporting, of course. The first departure from GAAP accounting is to recognize the full COC (Cost of Capital). EVA also fixes the problems with GAAP by converting accounting earnings to economic earnings and accounting book value to economic book value, or capital. The result is a NOPAT figure that gives a much truer picture of the economics of the business and a capital figure that is far better measure of the funds contributed by shareholders and lenders. Stern Stewart identified around 164 potential adjustments to GAAP and to internal accounting
treatments, all of which can improve the measure of operating profits and capital. Now the question comes, to what extent it can be adjusted. The “Basic EVA” is the unadjusted EVA quoted from the GAAP operating profits and Balance sheet. “Disclosed EVA” is used by Stern Stewart in its published MVA/EVA ranking and computed after a dozen standard adjustments to publicly available accounting data. “True EVA”, is the accurate EVA after considering all relevant adjustments to accounting data. However, our interest is at the “Tailored EVA”. Each company must develop their tailored EVA definition, peculiar to its organizational structure, business mix, strategy and accounting policies, i.e., one that optimally balances the trade-off between the simplicity and precision. Once the formula is set, it should be virtually immutable, serving as a sort of constitutional definition of performance. According to John Shiely, The CEO of Briggs and Stratton Corp, —Adopting EVA simply as a performance measurement metric, in the absence of some ideas as to how you are going to create value, is not going to get you anywhere“ (Kroll, 1997). The list of potential adjustments is too lengthy to detail here. Some adjustments are necessary to avoid mixing operating and financial decisions, others provide a long-term perspective, and some are needed to convert GAAP accrual items to a cash-flow basis while others convert cash flow items to additions to capital. Step 3: Identify the company‘s capital structure Because of the deficiency of GAAP in describing a company‘s real financial position (Clinton and Chen, 1998), Stewart proposes up to 164 adjustments to regain the real picture of a firm‘s financial performance (Stewart, 1991; Blair, 1997). These adjustments are needed to eliminate financing distortions in a company‘s NOPAT and capital (Stewart, 1991). Regarding adjustments, some accounting items such as costs for research and product development, restructuring charges, and marketing outlays are considered more as capital investments as opposed to expenses (Stewart, 1991).
A company‘s capital structure comprises all of the money invested in the company either by the owner or by borrowing from outsiders formally. It is the proportions of debt instruments and preferred and common stock on a company‘s balance sheet (Van Horne, 2002). Stewart (1990) defined capital to be total assets subtracted with non- interest bearing liabilities in the beginning of the period. However, it can be computed by either of the following methods: Direct Method: By adding all interest bearing debts (both short and long term) to owner‘s equity. Indirect Method: By subtracting all non- interest bearing liabilities from total assets. Step 4: Determine the company‘s COC rate for the individual sources of capital in capital structure Estimation of COC is a great challenge so far as EVA calculation for a company is concerned. It becomes more complex when small companies are considered whose sources of capital are unstructured and varied over the years. The cost of capital depends primarily on the use of the funds, not the source (Ross et al, 2003). It depends on so many factors like financial structures, business risks, current interest level, investors expectation, macro economic variables, volatility of incomes and so on. It is the minimum acceptable rate of return on new investment made by the firm from the viewpoint of creditors and investors in the firms‘ securities (Schall and Haley, 1980). Some financial management tools are available in this case to calculate the COC. A more common and simple method is Weighted Average Cost of Capital (WACC) (Copeland et al, 1996). The overall COC is the weighted average of the costs of the various components of the capital structure. WACC, though a good tool to compute accurate cost of capital, is less useful for a small company. WACC includes both debt and equity part of financing. Each element in the capital structure has an explicit, or opportunity, cost associated with it (Block and Hirt, 2002). The cost of each component of the firm‘s capital, debt, preferred stock, or common stock equity is the return that investors must forgo if they are to invest
in the firm‘s securities (Kolb and DeMong, 1988). Thus, the difficulty arises in both of the cases. Cost of debt cannot be calculated because the debt instruments in this case are not traded in the open market. It is measured by the interest rate, or yields, paid to bondholders (Block and Hirt, 2002). Sometimes, these instruments have no developed market. Again, cost of equity is also difficult to calculate due to the non- applicability of the tools developed to this effect. For example, for large companies, the Capital Asset Pricing Model (CAPM) is a common method in estimating the cost of equity (Copeland et al, 1996). CAPM postulates that the cost of equity is equal to the return on risk-free security plus a company‘s systematic risk, called beta, multiplied by the market risk premium (Copeland et al, 1996). Risk premium is associated with the specific risks of a given investment (Block and Hirt, 2002). In our financial environment, even the betas for all large companies are not available. For large publicly traded companies, betas are published regularly by services such as Value Line (Reimann, 1988). For small companies, regression analysis may be used in order to estimate their betas (Ross et al, 1999). The next obstacle is to get a proper value of market risk premium. For large U.S. companies, the recommended market risk premium is 5 to 6 percent (Copeland et al, 1996; Stewart, 1991). For publicly traded small companies, the market risk premium is significantly higher with values around 14 percent (Ross et al, 1999). These rates are not absolute rather relative as these depend on time, location, macro economic variables and some other factors. In our environment, market risk is so volatile owners against that the appropriate premium, demanded by the their investment, for even the large companies cannot be
accurately estimated. Even no company takes the responsibility to work in this area. For a small company, it cannot be thought of in current eco-financial setup. Dividend discount model is another popular model in this case where market price of a share is equal to the present value of future streams of dividends (Khan and Jain, 1999). This model presupposes that the company under consideration is matured and normal growth one that I have assumed in my case. However, in this case also, the presence
of an active market for securities is a must, otherwise, the COC (Equity ) cannot be determined which is the discount rate (ke) in the following simplified version of Gordon‘s dividend capitalization model: P = E (1-b) / ke – br Where, P = Price of shares E = Earnings per share b = Retention ratio Ke = Capitalization rate/ COC (Equity) br = g = growth rate in i.e., rate of return on investment in an all-equity firm. Considering all of the obstacles, we suggested a method derived from the WACC estimation and the CAPM model which have been adapted to the needs of small companies. We identify this rate as COC rate just to make a distinction between WACC that is used for large companies with the modified WACC. The COC that is developed here with the applicability option of small companies as considered here. The COC replaces the formal WACC in the following way: COC = COC (Debt) × Equity)) (Debt/(Debt + Equity)) (1-t) + COC(Equity) × (Equity/(Debt +
Where (t) represents the corporate tax rate and incorporated with the weight of debts only as debt has the tax deductibility advantage. Again, COC (Debt) can be estimated as follows: COC (Debt) = Prime Rate + Bank Charges Where, prime rate is the core rate (explicit rate) charged on loan and bank charges are additional charges over the prime rate. Average bank charges in my study for small manufacturing companies vary from one percent to two percent. COC (Equity) can be estimated as follows:
COC (Equity) = Rf +Rp Where, Rf = Risk free rate Rp = Risk premium Rf is the arbitrary rate of governmental treasury bill on which it is assumed that this rate does not vary with the actions and reactions of the market factors. In contrast, Rp reflects the risk resulting from the investment in the equity. The riskier the investment, the higher would be the Rp . If the Rp is not higher, investors will not agree to invest their funds in risky business. This table suggests various Rp ranges depending upon the investment risk
RP Ranges 6 % and less 6 % - 12 % 12 % - 18 %
Investment Risk Extremely low risk, established profitable company with extremely stable cash flows. Low risk, established profitable company with relative low fluctuation in cash flow Moderate risk, established profitable company with moderate fluctuation in cash flow High business risk
18 % and more
(Source: Narcyz Roztocki &Kim LaScola Needy; University of Pittsburgh; Department of Industrial
Step 5: Calculate the company‘s NOPAT NOPAT is derived from NOP simply by deducting calculated taxes from NOP i.e., NOPAT = NOP × (1- Tax rate). These calculated taxes do not correspond the taxes actually paid because e.g. interest on debt decreases real taxes. The tax shield of debt is however taken into account with the capital costs. NOPAT is a measure of a company‘s cash generation capability from recurring business activities, while disregarding its capital structure (Dierks and Patel, 1997).
Most of the needed adjustments, to convert the accounting profit to economic profit as identified in step 2, are appropriate for large companies. On the other hand, small companies have some peculiar adjustments that are not required in case of large companies. For example, some researchers observed that an owner-manager‘s salary in a small business represents a much larger fraction of revenues than that in a large company (Welsh and White, 1981). It may imply that in a small business ownermanager‘s salary is not only salary but it also includes a charge for the capital that they invested in the company. To remove this distortion, an adjustment is needed with the accounting profit to find out the economic profit. Thus, here NOPAT can be calculated as follows: NOPAT = Net Profit after tax + Total Adjustments – Tax Savings on investments Step 6: Calculation of Economic Value Added At last, the EVA can be calculated by subtracting capital charges from NOPAT as follows (Stewart, 1991; Reimann, 1988): EVA = NOPAT - Capital Charges = NOPAT - C × COC Where, C and COC include all types of capital proportionately. Positive EVA indicates value creation while negative EVA indicates value destruction for the company‘s owners.
Chapter - 4 Analysis & Discussion
Analysis & Discussion 4.1 The EVA and its status in India In India, most of the companies use traditional measures. Even, they do not use it to evaluate internally. It seems to be that people are reluctant to accept new but strong tool. 62
In our environment, people are very much cautious to abide by the legal requirements. Disclosure is strictly governed by the legal framework and people always want to avoid voluntary disclosure. In terms of efficiency, our market is in weak form. Therefore, large companies, whether public or private, do not feel that they should incorporate tools like EVA in their present setup. However, in a large company perspective, it is simple to calculate EVA, as the required information is very simple to find or compute. It is a matter of time and intention only for the calculation and disclosure of EVA’s so far as large companies are concerned. Nevertheless, the necessary data for calculating EVA is not available for small companies. That is why; I focus on small manufacturing companies here where performance evaluation is of paramount importance. 4.2 Empirical illustration To propose EVA calculation for small manufacturing firms, as a realistic example, I have used data from one of the sample firm of Ludhiana city. This firm is managed by three owner-managers and has approximately 20 employees working in a firm. The company‘s line of business is manufacturing of cotton, woolen and acrylic fabrics for the local user groups with a vision to extend the market over the boundary in near future. As per my commitment, I will refer to this company as — XYZ firm throughout the paper just to hide their explicit identity. The financial data are simplified for the readers just to turn their attention towards the process rather than on accounting details. Step 1: Review the company‘s financial data To assemble necessary financial information, I just collected their income statement, Balance sheet and notes to the accounts. These are sufficient for all required information for my study. Table 2 shows the income statements for the years 2009 and 2010 and Table 3 shows the balance sheet for three consecutive years in a simplified way. Table 2: XYZ‘s Income statement for the years 2009 and 2010 (in lac Rupees) Particulars 1.0 1.1 Sales Revenues (Less return, VAT etc.) Cost of Goods Sold 2009 193.19 163.71 2010 271.17 236.30 63
1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2
Gross Profit (1.0-1.1) General and Administration Expenses Selling Expenses Total Administration & Selling Exp. (1.3 + 1.4) Operating Profit (Loss) (1.2 - 1.5) Other Income Other Expenses Financial Expenses (Interest) Net Profit (Loss) before tax (1.6 + 1.7 -1.8 – 1.9) Taxes (31.10%) Net Profit (Loss) after tax (2 - 2.1)
29.48 14.24 1.86 16.10 13.38 __ 0.25 1.44 11.69 3.64 8.05
34.87 15.64 2.12 17.76 17.11 __ 0.42 2.47 14.22 4.42 9.80
Step 2: Identify the necessary adjustments requires to be considered Now, after assembling all necessary financial information, the next step necessitates to identify all required adjustments to be considered. In case of XYZ firm, I do not find any documentation of cost related to research and development, extension of current facilities, employee training, unusual write-offs or gains and thus adjustments are insignificant. One adjustment is needed in net profit for interest expense and tax shield. These adjustments are needed to find out the true NOPAT. Because, NOPAT is a measure of a company‘s cash generation ability from recurring business activities (Dierks and Patel, 1997).
Step 3: Identify the company‘s capital structure Capital structure includes all forms of financing whether generated internally or by borrowing externally. It can be estimated under each of the two methods as identified earlier. In case of direct method (financing approach), all interest-bearing debts (both short and long term) are added to owner‘s equity to find out the total amount of capital invested. On the other hand, in case of indirect method (operating approach), all non- interest bearing debts like accounts payable, sundry creditors, accrued expenses are subtracted from the total liabilities to calculate the total capital invested in the business. Tables 4 represent the amount of capital invested by XYZ firm under indirect method respectively.
Table 3: XYZ’s Balance Sheet for the years 2009 and 2010 (in lac Rupees) Liabilities 2.0 2.1 2.2 2.3 2.4 Current Liabilities: Accounts payable/ Sundry Creditors Secured loan/ Bank loan Accrued Expenses Other Current Liabilities Total Current Liabilities (2.0 to 2.3) Non-Current Liabilities: 3.7 Total Assets 2.5 2.6 Long Term Loan Unsecured loans 3.10 6.37 6.15 8.81 4.45 10.85 3.8 (3.2 to 3.6) Fixed Assets: Land &Building (net 4.78 of dep.) Plant and Machinery (net of dep.) Furniture Fixtures (net of dep.) 3.88 7.89 8.91 Current 19.7 9 34.9 8 56.48 2008 6.61 2.25 0.35 0.17 9.38 2009 11.76 5.40 0.67 0.26 18.09 2010 16.89. 15.91 0.75 0.39 33.94 3.2 3.3 3.4 3.5 3.6 Assets Current Assets: Cash in hand Accounts Receivable Inventory/Stock Prepaid Expenses Other Current Assets 2008 0.26 8.64 10.5 5 0.06 0.28 2009 0.39 16.3 1 17.8 3 0.08 0.37 2010 0.47 27.54 27.81 0.12 0.54
Total Non Current liabilities (2.5 to 2.6) Total Liabilities (2.4 + 2.7) Equity/Net Worth:
Other fixed Assets
Capital (Less Drawing)
Total Assets (3.8 to 4.1)
Less: Intangible Assets 0.11 (i.e. Goodwill, patent etc.) Tangible worth/equity (2.9 – 3.0) Total Liabilities equities (2.8 + 3.1) Net 10.0 6 and 28.9 1
Total Assets (3.7 + 4.2)
Table 4: An estimation of the capital employed by XYZ firm under indirect method or operating approach (in lacs Rupees) Components of Capital Total Liabilities Accounts Payable/ Sundry Creditors Accrued Expenses Other current liabilities Capital 2009 50.32 (11.76) (0.67) (0.26) 37.63 2010 74.94 (16.89) (0.75) (0.39) 56.91
In calculating the capital, I assumed the book value of the liabilities truly represent the current market value. Furthermore, since the XYZ‘s equity and other debts are not traded in a financial market, it is assumed that the values on the balance sheet are good estimators of market values. Finally, no adjustment is made to convert the accounting capital to financial capital just to keep the illustration simple and precise. Step 4: Determine the company‘s COC rate for the individual sources of capital in capital structure The COC rate has two parts. The prime rate for the cost of debt is 14% for this typical firm and on an average, they have to pay other charges of 1% of the amount borrowed. Thus, the pre-tax COC (Debt) will be 15% for the year 2010 if I put the values in equation
. COC (Debt) = Prime Rate + Bank Charges = 14 % + 1 % = 15 % For the COC calculations, I have taken weighted average yield of 91days government treasury bill rate (ranges between 6.50% - 7.50%) of 7.50% as a proxy for risk free rate and according to my analysis; the company lies in average risk area that requires 12% of risk premium. Having this information and equation, COC (Equity) can be estimated as follows: COC (Equity) = Rf +Rp = 7.50% + 12 % = 19.5% Where, Rf = Risk free rate Rp = Risk premium The 19.5% cost of equity rate will be same for both of the years if the company will remain in the same risky area over the years. As I got both cost of debt and cost of equity, now I can calculate overall COC using capital structure as shown in Table 4 and equation, as follows: COC = COC (Debt) × (Debt/(Debt + Equity)) (1-t) + COC(Equity) × (Equity/(Debt + Equity)) In 2009, COC = 9.03 % In 2010, COC = 8.64 % Step 5: Calculate the company‘s NOPAT As I have already identified the necessary adjustments of net operating profit in step 2, it becomes very simple here to compute adjusted NOPAT. In 2010, I have to adjust NOPAT by the capital charge in interest expense with the tax shield. However, in 2009 also, I have to adjust the capital charge embedded interest expense with respective tax shield, as the company had sufficient debt in their capital structure in the specified year. Using equation, the NOPAT for the years will be as follows: 2009 2010
NOPAT = Net Profit after Tax + Total NOPAT = Net Profit after Tax + Total Adjustments – Tax savings on adjustments Adjustments – Tax savings on adjustments NOPAT = 8.05 + 1.44 – (1.44 × .3110)
NOPAT = 9.80 + 2.47 – (2.47 × .3110)
Step 6: Calculation of EVA Finally, the XYZ’s EVA can be calculated by putting the values in equation as follows: In 2009, EVA = NOPAT – Capital Charges = NOPAT – C × COC = 9.04 – 37.63 × 9.03 % = 9.04 – 3.40 = 5.64 In 2010, EVA = NOPAT – Capital Charges = NOPAT – C × COC = 11.50 – 56.91 × 8.64 % = 11.50 – 4.92 = 6.58 Thus, in both of the years, XYZ creates positive value for its owners amounting to Rupees 5.64 lacs and Rupees 6.58 lacs in years 2009 and 2010 respectively. It means that the actual wealth of the owners have increased by the amount of EVA. 4.3 Implications of findings After the calculation of EVA, I met the owner-managers of the company and explained the result to them. They showed their best interest with the EVA measure as compared with their current measure of earning after interest and taxes (EAIT). They were amazed with adding borrowed fund in their capital structure that helped them to get
tax advantage by way of reducing tax liability. Thus, they may add more wealth in the year 2009 as compared with 2010 due to the presence of more debt in 2010. Moreover, they found that EVA approach is consistent with the objectives of the business, which is, wealth creation for the owners that was not prima facie considered in case of traditional measures. The XYZ’s owner-managers assured me that they would incorporate EVA measure very soon to evaluate performance and compare the changes with the current measure. They agreed that EVA measure would help them to utilize their financial resources more economically. Their reactions satisfied me and encouraged me to conduct some vigorous study in the same field if demand arises to develop the proposed model for small manufacturing companies with the new business situation. 4.4 EVA Implementation by a Small Company
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EVA calculation is just a starting point Permanent EVA improvement has to be the main management objective EVA has to be calculated periodically (at least every three months) Changes in EVA have to be analyzed EVA development is the basis for a company’s financial and business policy. Compared to conventional measures, EVA is an epochal measure since it can be maximized: it is the better the bigger EVA is. With traditional measures that is not the case, since ROI can be increased with ignoring below average projects and EPS/Operating Profit/Net profit can be increased simply investing more money in the company
Since EVA helps the organization to realize that capital is a costly resource the most immediate effect of EVA implementation is in most cases dramatic improvement in capital efficiency (improved capital turnover)
4.5 Pitfalls of Traditional Performance Measurement The maxim “what gets measured gets managed” does not only refer to shareowner value. A review of businesses’ favorite financial performance measures – and their pitfalls – shows that managers and executives should be very careful. While 69
business schools have been preaching valuation concepts for decades, earnings per share and other traditional financial measures continue to rule supreme. However, these metrics have many risks. Overinvestment Profit and profit margin measures often drive over-investment and vertical integration because they overlook capital and its cost. Increasingly, different businesses and business models consume varying levels of capital at varying costs. Managers are often drawn to higher margin businesses that, on the surface, may seem more attractive. For example, profits are often improved with newer production technology – but they must be, to compensate for the higher levels of investment. Because traditional financial measures ignore the returns that shareholders expect, any corporate project with just a positive – but not necessarily an adequate – return above zero can improve a manager’s margins, unit cost, profit and productivity measures. However, such a project can also destroy value. Overproduction Traditional measures of unit cost, utilization and income frequently promote troublesome over- production, particularly at the end of a year or quarter. Producing to capacity rather than to demand often appears to reduce costs, yet doing so can also raise the cost of invested capital. The bias toward over-production, despite demand, is exacerbated by absorption accounting practices, which convert operating costs into inventory. This practice gives the illusion of lower costs from the distorted perspective of a cost per part, while creating operating burdens (e.g., uneven and inflexible production) and vast quantities of unnecessary inventory. Foregone revenue is endemic to this vicious circle, because heavy discounting and trade promotion are needed to unload the extra product, often at the end of each quarter. Service Economy Traditional financial measures, being based on traditional business models, have not kept
up with the pace of change. New business models are often based on services, outsourcing, partnerships and other innovative ways of doing business. Therefore, traditional financial measures are inherently biased against the new service economy. Their blunt nature is too simplistic, creating impediments to profitable growth in a world where more and more service-oriented businesses are being designed around razor-thin margins, but with low capital investment. Similarly, a bias against viable, long-term investments and economic growth can result from a simplistic, near term income focus. Poor Decisions Traditional financial measures exclude the shareholders’ investment in the business; an incomplete measure that ignores capital is entirely inappropriate to handle the many business decisions that trade-off between profit margin and capital utilization (velocity). Traditional financial measures confuse accounting anomalies with the underlying economics of business. When tied to incentive compensation, this can lead to dysfunctional behavior among managers and top executives alike.
Chapter - 5
Creation of value for the owners is important in business, irrespective of the volume of investment or type of operation. Moreover, in case of EVA measurement, companies, whether large or small, have to earn more than capital charges if they want to add value positively. Thus, in an EVA controlled world, everybody works to maximize the gap between NOPAT and capital charges that will ultimately ensure both financial efficiency and operational efficiency. Financial efficiency means the construction of capital structure in such a way and from such sources that will ensure minimal capital charges. On the other side, operational efficiency will ensure more NOPAT. However, it is to some extent difficult to implement EVA in small manufacturing companies, a tailored definition of EVA is required to be set on the specific type of operation and the needs of the business. EVA is the most widely used value-based performance measure (Myers, 1996) probably just because it happens to be an easier
concept compared to the others. In implementing EVA, one of the most important things is to get the people in organizations to commit to EVA and thereby also to understand EVA (Klinkerman, 1997). It may have some impurities in it. Nevertheless, in future courses of time, the EVA model can be made error free. Once the employees get motivated to maximize EVA, wealth creation becomes a regular phenomenon in a business. In this paper, I have tried to develop an EVA model for small manufacturing business setup with considering all of their hindrances and technicalities. I was confronted with the question, —Whether EVA can be used in small manufacturing companies as a tool to measure performance? “Through this paper, I employed my best effort to give an answer to the question. Whatever may be the size and nature of operation, EVA is suited with some adjustments. In most cases, the additional effort in calculating EVA is outweighed by the value of the additional information showing improvement opportunities i.e. benefit is always greater than the cost of incorporating EVA as a new tool replacing the traditional tools.
Chapter - 6 Suggestions
EVA is the only operating measure to account for the many income statement and balance sheet trade-offs involved in creating value because of its simultaneously focuses on both profit and capital. Donaldson Brown, Chief Financial Officer of General Motors, wrote in 1924, “The objective of management is not necessarily the highest rate of return on capital, but … to assure profit with each increment of volume that will at least equal the economic cost of additional capital required.” Management in a Small Company can improve EVA in the following ways:
Try to improve returns with no or with only minimal capital investments Invest new capital only in projects, equipment, machines able to cover capital cost while avoiding investments with low returns Identify where capital employment can be reduced Identify where the returns are below the capital cost; divest those investments when improvements in returns are not feasible
• • •
EVA is an appropriate management tool for small business Economic Value Added (EVA) is easy-to-calculate Periodical EVA calculation and analysis can be done with minimal effort because only few basic data have to be entered in a common spreadsheet EVA calculation is a starting point for improvement in financial and business policy Scarce capital resources of a small company can be more efficiently allocated using EVA than using intuition or traditional methods EVA implementation in a small company will result in a better business performance, because of better understanding the objectives (especially near the floor/operating activities)
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