VALUE BASED MANAGEMENT

Value Based Management (VBM) is the management philosophy and approach that
enables and supports maximum value creation in organizations, typically the
maximization of shareholder value. VBM encompasses the processes for creating,
managing, and measuring value.
The value creation process requires an understanding of the attractiveness of the
market or industry where one competes, coupled with one’s competitive position
relative to other players. Once this understanding is established and is linked with key
value chain drivers for cash flow and profitability, competitive strategy can be
established or modified to maximize future returns.

The three elements of Value Based Management:

 Creating Value. How the company can increase or generate maximum future
value. More or less equal to strategy.
 Managing for Value. Governance, change management, organizational
culture, communication, leadership.
 Measuring Value. Value Based Management is dependent on the corporate
purpose and the corporate values. The corporate purpose can either be economic
(Shareholder Value) or can also aim at other constituents directly (Stakeholder
Value).

The benefits arise from VBM approaches are as follows:

I. VBM can maximize value creation consistently.

II. It increases corporate transparency and helps organizations to deal with globalized
capital market.

III. It aligns the interests of top managers with interests of stakeholders and
shareholders.

IV. It facilitate communication with investors, analysts and communication with

stakeholders.

V. It provide internal communication with strategy and prevent under valuation of

stock.

VI. By giving management a clear priorities, VBM helps to improve decision-making.

VII. VBM facilitates to balance short-term and long-term trade-offs.

VIII. It insists value creating investments and improves planning and budgeting.

IX. VBM sets effective targets for compensation.

X. VBM helps the use of stocks for mergers and acquisitions and also helps to
manage increased complexity and risk better.

Limitations:

The VBM concept suffers from the following drawbacks:

i. VBM is a holistic management philosophy, often requiring culture change.

ii. VBM programs are large scale initiatives. To become successful it needs
considerable time and resources.

iii. Value creation may sound simpler than corporate strategy but it is actually more or
less the same.

iv. VBM requires strong and explicit CEO and executive board support.

v. It necessitates comprehensive training and management consultancy which are

quite costly.

vi. The perfect VBM model has not been invented yet.

Marakon Model of Shareholder Value Creation

The Marakon model was developed by Marakon Associates, a management

consulting firm known for its work in the field of value-based management.
According to Marakon model, a firm’s value is measured by the ratio of its market
value to the book value. An increase in this ratio depicts an increase in the value of
the firm, and a reduction reflects a reduction in the firm’s value. The model further
states that a firm can maximize its value by following these four steps:

 Understand the financial factors that determine the firm’s value

 Understand the strategic forces that affect the value of the firm
 Formulate strategies that lead to a higher value for the firm
 Create internal structures to counter the divergence between the shareholders
goals and the management’s goals.

1. Financial Factors

The first step in this model is to identify the financial factors that affect the value of
the firm. The model states that a firm’s market value to book value ratio, and hence,
 its value depends on three factors – return on equity, cost of equity, and growth rate.
This conclusion is drawn indirectly from the constant growth dividend discount
model.

The constant growth dividend discount model says that

P/B = M/B =  (rxb) / (k-g)

where,

 M, be the current market price of the firm’s share

 k, be the cost of equity
 g, be the growth rate in earnings and dividends
 r, be the return on equity
 B, be the current book value per share
 b,  be the dividend pay-out ratio.

Thus, a firm’s market value to book value ratio can be derived from its return on
equity, its cost of equity and its growth rate. It can be observed from the formula that;

1. A firm’s market value will be higher than its book value only if its return on
equity is higher than its cost of equity. This is supported by the other theories of
valuation of equity.
2. When the return on equity is higher than the cost of equity, the higher a firm’s
growth rate, the higher its market value to book value ratio.

Hence, a firm should have a positive spread between the return on equity and the cost
of equity, and a high growth rate in order to create value to its shareholders.

2. Strategic Forces

The financial factors that affect a firm’s value are in turn affected by some strategic
forces. The two important strategic factors that affect a firm’s value are market
economics and competitive position. The market economics determines the trend of
the growth rate and the spread between the return on equity and cost of equity for the
industry as a whole. The firm’s competitive position in the industry determines its
relative rate of growth and its relative spread.

Market economics refers to the forces that affect the prospects of the industry as a
whole. These include:

 Level of entry barriers

 Level of exit barriers
 Degree of direct competition
 Degree of indirect competition
 Number of suppliers
 Kinds of regulations
 Customers influence.
 Competitive Position refers to a firm’s relative position within the industry, A firm’s
relative position is affected by its ability to produce differentiated products and its
economic cost position. A product can be referred to as a differentiated product when
the consumers perceive its quality to be better than the competitive products and are
ready to pay a premium for the same. The firm can benefit from a differentiated
product in two ways. It may either increase its market share by pricing it
competitively, or can command a higher price for its product than its competitors, and
forego the higher market share. Thus, the ability to produce differentiated products
improves a firm’s relative position vis-a-vis its competitors. The other factor that
helps a firm enjoy a strategic advantage over its competitors is a low per unit
economic cost. Economic costs include operating costs and the cost of capital
employed. A low economic cost may result from a number of factors like:

 Access to cheaper sources of finance

 Access to cheaper raw material
 State-of-the-art technology resulting in better quality control
 Better management
 Strong dealer network
 Exceptional labor relations.

3. Formulation of Strategies

Once a company has identified its potential growth prospects and analyzed its
strengths and weaknesses, it needs to develop strategies that would help it utilize its
strengths and underplay its weaknesses, thus achieving the maximum possible growth
and creating value. For achieving this objective two kinds of strategies are required –
participation strategy and competitive strategy.

A company, to create value for its shareholders, has to either operate in an area where
the market economies are favorable, or has to produce those products in which it can
enjoy a highly competitive position. The strategy that specifies the broad product
areas or businesses in which a firm is to be involved is referred to as its participation
strategy. At the level of a business unit, this strategy outlines the market areas (in
terms of the geographical areas, the high-end market or the low-end market, the level
of quality and differentiation to be offered) to be entered.

The strategy on the preferred markets is followed by the competitive strategy, which
specifies the plan of action required for achieving and maintaining a competitive
advantage in those markets. It includes deciding the way of achieving product
differentiation, the method for utilizing the differentiation so created (i.e. by
increasing the price of the product or the market share) and the means of creating an
economic cost advantage.

4. Creation of Internal Structures

The separation of ownership and management in the traditional manner results in the
management bearing all the risks associated with value-adding decisions, without
 their enjoying any of the benefits. This often results in the management taking sub-
optimal decisions. A firm needs internal structures which can control this tendency of
the management. These may include

 The management’s compensation being linked to the company’s performance.

 Corporate governance mechanisms that specify responsibilities and holds
managers accountable for their decisions.
 Resource allocation among projects guided by the specific requirements of the
projects rather than the past allocations and capital rationing.
 A mechanism for making sure that the various projects undertaken form part
of a strategy, rather than being disjointed, discrete projects.

Plans being made in accordance with the long-term goals and target performance
being fixed in accordance with these plans, rather than the level of achievable targets
determining the plans. Performance targets should be a function of the plans, rather
than being the base for the plans.

Target performance, when achieved, should be rewarded with promised incentives.

Non-fulfillment of such promises affects the future performance.

Alcar Model of Value Based Management:

The Alcar model, developed by the Alcar Group Inc., a company into management
education and software development, uses the discounted cash flow analysis to
identify value adding strategies.

According to Alcar Model  of Value Based Management, there are seven ‘value
drivers’ that affect a firm’s value. These are
 The growth rate of sales
 Operating profit margin
 Income tax rate
 Incremental investment in working capital
 Incremental investment in fixed assets
 Value growth duration
 Cost of capital.

Value growth duration refers to the time period for which a strategy is expected to
result in a higher than normal growth rate for the firm. The first six factors affect the
value of the strategy for the firm by determining the cash flows generated by a
strategy. The last term, i.e. the cost of capital, affects the value of the strategy
by determining the present value of these cash flows. The following figure represents
the Alcar approach.
According to the Alcar  approach of value based management, a strategy should be
implemented if it generates additional value for a firm. For ascertaining the value
generating capability of a strategy, the value of the firm’s equity without the strategy
is compared to the value of the firm’s equity if the strategy is implemented. The
strategy is implemented if the latter is higher than the former. The following steps are
undertaken for making the comparison.
Calculate the value of the firm’s equity without the strategy:  The present value of the
expected cash flows of the firm is calculated using the cost of capital. The cash flows
should take the firm’s normal growth rate and its effect on operating flows and
additional investment in fixed assets and working capital into consideration. The cost
of capital would be the weighted average cost of the various sources of finance, with
their market values as the weights. The value of the equity is arrived at by deducting
the market value of the firm’s debt from its present value.
Calculate the value of the firm if the strategy is implemented:  The firm’s cash flows
are calculated over the value growth duration, taking into consideration the growth
rate generated by the strategy and the required additional investments in fixed assets
and current assets. These cash flows are discounted using the post-strategy cost of
capital. The post-strategy cost of capital may be different from the pre-strategy cost of
capital due to the financing pattern of the additional funds requirement, or due to a
higher cost of raising finance. The PV of the residual value of the strategy is added to
the present value of these cash flows to arrive at the value of the firm. The residual
value is the value of the steady perpetual cash flows generated by the strategy, as at
the end of the value growth duration. The post-strategy market value of debt is then
deducted from the value of the firm to arrive at the post-strategy value of equity.
The value of the strategy is given by the difference between the post-strategy value
and the pre-strategy value of the firm’s equity. A strategy should be accepted if it
generates a positive value.

McKinsey Model of Value Based Management

The McKinsey model, developed by leading management consultants McKinsey &

Company, is a comprehensive approach to value-based management.  This approach
is based on the discounted cash flow principle, which is a direct measure of value
creation.  
McKinsey Model of Value Based Management  focuses on the identification of key
value drivers at various levels of the organization, and places emphasis on these value
drivers in all the areas, i.e. in setting up of targets, in the various management
processes, in performance measurement, etc.
Value based management is a model that allow managers to run a business focusing
on the creation, improvement, and delivery of value.  According to Copeland, Roller
and Murrin, value-based management is “an approach to management whereby the
company’s overall aspirations, analytical techniques, and management processes are
all aligned to help the company maximize its value by focusing management decision-
making on the key drivers of value”.

According to McKinsey Model of Value Based Management, the key steps in

maximizing the value of a firm are as follows:
 Identification of value maximization as the supreme goal
 Identification of the value drivers
 Development of strategy
 Setting of targets
 Deciding upon the action plans
 Setting up the performance measurement system
1. Value Maximization – The Supreme Goal
A firm may have many conflicting goals like maximization of PAT, maximization of
market share, achieving consumer satisfaction, etc. The first step in maximizing the
value of a firm is to make it the most important goal for the organization. It is
generally reflected in maximized discounted cash flows.  The organisation’s activities
can be classified into financial and non-financial types. The former helps the senior
management sustain focus, while the latter motivates the entire workforce. Non-
financial activities include product development, customer satisfaction and quality
improvement efforts, which are normally consistent with the financial goal of value
maximization. In case of conflict between financial and non-financial goals, financial
goals are given precedence.
2. Identification of the Value Drivers
The important factors that affect the value of a business are referred to as key value
drivers. It is necessary to identify these variables for value-based management. The
value drivers need to be identified at various levels of an organization, so that the
personnel at all levels can ensure that their performance is in accordance with the
overall objective. The other objectives of a firm mentioned above may act as value
drivers at some level of the organization. For example, degree of innovation in
products may be identified as the value driver for the design department. The three
main levels at which the key value drivers need to be identified are:
The generic level: At this level, the variables that reflect the achievement or non-
achievement of the value maximization objective most directly are identified. These
may be the return on capital employed or operating margin or the net profit margin,
etc.
The department level: At this level, the variables that guide the department towards
achieving the overall objective are identified. For example, for the sales department,
the key value drivers may be achieving the optimum product mix, maximizing market
share, etc.
The grass roots level: At the grass roots level, the variables that reflect the
performance at the operational level are identified. These may be the level of capacity
utilization, cost of managing inventory, etc.
3. Development of Strategy
The next step is to develop strategies at all levels of the organization, which are
consistent with the goal of value maximization, and lead to the achievement of the
same. The strategies should be aimed at and give directions for the achievement of the
desired level of the key value drivers.
4. Setting of Targets
Development of strategies is followed by setting up of specific short-term and long-
term targets. These should be specified in terms of the desirable level of key value
drivers. The short-term targets should be in tune with the long-term targets. Similarly,
the targets for the various levels of the organization should be in tune. They should be
set both for financial as well as non-financial variables.
5. Deciding upon the Action Plans
Once the strategy is in place and the targets have been determined, there is a need to
specify the particular actions that are required to be undertaken to achieve the targets
in a manner that is consistent with the strategy. At this stage, the detailed action plans
are laid out.
6. Setting up the Performance Measurement System
The future performance of personnel is affected by the way their performance is
measured, to a large extent. Hence, it is essential to set up a precise and
unambiguous performance measurement system. A performance measurement system
should be linked to the achievement of targets and should reflect the characteristics of
each individual department.
Value based management focus on value creation, but managers can take it not only
for shareholders’ value but also for value creation that can benefit stakeholders.
Developing communities in markets where firms compete can become an important
driver of value creation to achieve superior performance.

Boston Consulting Group(BCG) Growth-Share Matrix

The BCG matrix (aka B-Box, B.C.G. analysis, BCG-matrix, Boston Box, Boston
Matrix, Boston Consulting Group analysis, portfolio diagram) is a chart that had been
created by Bruce Henderson for the Boston Consulting Group in 1970 to help
corporations with analyzing their business units or product lines. This helps the
company allocate resources and is used as an analytical tool in brand marketing,
product management, strategic management, and portfolio analysis. Analysis of
market performance by firms using its principles has called its usefulness into
question, and it has been removed from some major marketing textbooks.

Boston Consulting Group (BCG) Matrix is a four celled matrix (a 2 * 2 matrix). It is

the most renowned corporate portfolio analysis tool. It provides a graphic
representation for an organization to examine different businesses in it’s portfolio on
the basis of their related market share and industry growth rates. It is a two
dimensional analysis on management of SBU’s (Strategic Business Units). In other
words, it is a comparative analysis of business potential and the evaluation of
environment.

BCG growth share matrix is based on the observation that a company’s business
units can be classified into four categories based on combinations of market growth
and market share relative to the largest competitor, hence the name “growth-share”.
The BCG growth share matrix thus maps the business unit positions within these
two important determinants of profitability.

The Boston Consulting Group (BCG) Portfolio Matrix

According to this matrix, business could be classified as high or low according to

their industry growth rate and relative market share.  Each of the corporation’s
product lines or business units is plotted on the matrix according to both the growth
rate of the industry in which it competes and its relative market share. The relative
market share serves as a measure of SBU strength in the market. The market growth
rate provides a measure of market attractiveness.

For each product or service, the ‘area’ of the circle represents the value of its sales.
The BCG Matrix thus offers a ‘map’ of the organization’s product (or service)
strengths and weaknesses, at least in terms of current profitability, as well as the likely
cashflows.

The need which prompted this idea was, indeed, that of managing cash-flow. It was
reasoned that one of the main indicators of cash generation was relative market share,
and one which pointed to cash usage was that of market growth rate.

Relative Market Share = SBU Sales this year leading competitors sales this year.

This indicates likely cash generation, because the higher the share the more cash will
be generated. As a result of ‘economies of scale’ (a basic assumption of the BCG
Matrix), it is assumed that these earnings will grow faster the higher the share. The
exact measure is the brand’s share relative to its largest competitor. Thus, if the brand
had a share of 20 percent, and the largest competitor had the same, the ratio would be
1:1. If the largest competitor had a share of 60 per cent, however, the ratio would be
1:3, implying that the organization’s brand was in a relatively weak position. If the
largest competitor only had a share of 5 per cent, the ratio would be 4:1, implying that
the brand owned was in a relatively strong position, which might be reflected in
profits and cash flows. If this technique is used in practice, this scale is logarithmic,
not linear.
The reason for choosing relative market share, rather than just profits, is that it carries
more information than just cash flows. It shows where the brand is positioned against
its main competitors, and indicates where it might be likely to go in the future. It can
also show what type of marketing activities might be expected to be effective.

Relative Market Share = Sales This Year / Leading Rival’s Sales This Year

Market Growth Rate = Industry sales this year — Industry Sales last year

Market share is the percentage of the total market that is being serviced by a company
under consideration, measured either in revenue terms or unit volume terms. Higher
the market share, the higher the proportion of the market one controls. The Boston
Matrix assumes that if the company under consideration is enjoying a high market
share then it will be making more money. (This assumption is based on the idea that
company has been in the market for long enough to have learned how to be profitable,
and will be enjoying scale economies that gives an advantage). Market growth is used
as a measure of a market’s attractiveness. Markets experiencing high growth are ones
where the total market is expanding, meaning that it’s relatively easy for businesses to
grow their profits, even if their market share remains stable. While, competition in
low growth markets is often bitter, and while you might have high market share now,
it may be hard to retain that market share without aggressive discounting.

The analysis requires that both measures be calculated for each SBU. The dimension
of business strength, relative market share, will measure comparative
advantage indicated by market dominance. The key theory underlying this is existence
of an experience curve and that market share is achieved due to overall cost
leadership.

BCG matrix has four cells, with the horizontal axis representing relative market share
and the vertical axis denoting market growth rate. The mid-point of relative market
share is set at 1.0. if all the SBU’s are in same industry, the average growth rate of the
industry is used. While, if all the SBU’s are located in different industries, then the
mid-point is set at the growth rate for the economy.

Resources are allocated to the business units according to their situation on the grid.
The four cells of this matrix have been called as stars, cash cows, question marks and
dogs. Each of these cells represents a particular type of business.
1. Stars – Stars are high growth businesses or products competing in markets
where they are relatively strong compared with the competition. They are typically at
the peak of their product life cycle. Stars generate large amounts of cash because of
their strong     relative market share, but also consume large amounts of cash because
of their high growth rate. Often they need heavy investment to sustain their growth.
Eventually their growth will slow and will become cash cows.
2. Cash Cows – Cash cows are low-growth businesses or products with a
relatively high market share. These are mature, successful businesses with relatively
little need for investment. They typically bring in far more money than is needed to
maintain their market share. In this decline stage of their life cycle, these products are
“milked” for cash that will be invested in new question marks.
3. Question marks – Question marks are businesses or products with low
market share but which operate in higher growth markets. Question marks are
growing rapidly and thus consume large amounts of cash, but because they have low
market shares they do not generate much cash. A question mark (also known as a
“problem child”) has the potential to gain market share and become a star, and
eventually a cash cow when the market growth slows. If the question mark does not
succeed in becoming the market leader, then after years of cash consumption it will
degenerate into a dog when the market growth declines. Management have to think
hard about “question marks” – which ones should they invest in? Which ones should
they allow to fail or shrink?
4. Dogs – Dogs have low market share and a low growth rate and thus neither
generate nor consume a large amount of cash. However, dogs are cash traps because
of the money tied up in a business that has little potential.   Such businesses are
candidates for divestiture.

The Boston Consulting Group(BCG) Portfolio Matrix simplicity is its strength –

the relative positions of the firm’s entire business portfolio can be displayed in a
single diagram. Its limitation is market growth rate is only one factor in industry
attractiveness, and relative market share is only one factor in competitive advantage.
The   BCG growth share matrix overlooks many other factors in these two
important determinants of profitability.
 Benefits of BCG Matrix

Organizations that are very large such that they require setting up business units
usually face the test of the allocation of resources among those business units. The
BCG matrix was developed for the management of various business units.

1. The BCG is an effective management tool and it offers a good framework for
resource allocation among various units. This enables the managers to compare
several business units whenever they want. It simplifies many business factors
through showing employees the market share as well as growth rate and how to use
them to create new strategies.
2. Even though BCG matrix may be among the oldest matrices ever formulated,
it is also the most common and best known matrix taught all over the world. There are
forums on the internet where individuals share their ideas on the best methods of
using BCG matrix because of its popularity. This means that those looking to use it
will never lack assistance and support. The BCG still remains a quick and beneficial
guide for resource allocation and ensuring better profits.
3. The BCG allows for the making of comparisons so as to measure the growth
and development rate of a company against the average growth rate in that specific
industry. In addition, this particular matrix is also enjoyable to use, encouraging better
decision making.

Limitations of BCG Matrix

The BCG Matrix produces a framework for allocating resources among different
business units and makes it possible to compare many business units at a glance. But
BCG Matrix is not free from limitations, such as;

1. BCG matrix classifies businesses as low and high, but generally businesses
can be medium also. Thus, the true nature of business may not be reflected.
2. Market is not clearly defined in this model.
3. High market share does not always leads to high profits. There are high
costs also involved with high market share.
4. Growth rate and relative market share are not the only indicators of
profitability. This model ignores and overlooks other indicators of
profitability.
5. At times, dogs may help other businesses in gaining competitive advantage.
They can earn even more than cash cows sometimes.
6. This four-celled approach is considered as to be too simplistic.

Economic Value Added (EVA) – Definition, Calculation and

Implementation

Economic Value Added (EVA) is a value based financial performance measure, an

investment decision tool and it is also 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.
“Economic Value Added (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 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.”

Economic Value Added (EVA) is a variation 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 on EVA as a measurement tool in 1989, and
trade marked it. The EVA concept is often called Economic Profit (EP) to avoid
problems caused by the trade marking.

Economic Value Added is the financial performance measure that comes closer than
any other to capture the true economic profit of an enterprise; Economic Profit = Total
revenues from capital — Cost of capital. The basic idea of this criterion is to find, in
microeconomics, where it is said that the main goal of a company is maximization of
profit. However it does not mean book profit (the difference between revenues and
costs) but economical profit. The difference between economical and book profit is,
economical profit. It is the difference between revenues and economical costs, which
includes book costs and opportunity costs. Opportunity costs are presented by the
amount of money lost by not investing sources (like capital, labor, and so on) to the
best alternative use. Opportunity costs are in reality represented mainly by interests
from equity capital including risk reward and sometimes lost wages too. In short;
Book profit = Revenues — Costs. This leads to the conclusion that economical profit
appears when its amount is higher than “normal” profit derived from average cost of
capital invested both by creditors (cost interests) and owners— shareholders
(opportunity costs). This is the basic idea of new measure, EVA.

Calculation of  Economic Value Added (EVA)

Economic Value Added (EVA) is an operational measure that differs from

conventional earnings measures in two ways. First, it explicitly charges for the use of
capital (residual income measure). Secondly, it adjusts reported earnings to minimize
accounting distortions and to better match the timing of revenue and expense
recognition. As such, wealth maximization correlates with EVA maximization. A
positive EVA indicates that a company is generating economic profits; a negative
EVA indicates that it is not; A measure of a company’s financial performance based
on the residual wealth calculated by deducting cost of capital from its operating profit
after taxes. It is also known as economic profit.

Economic Value Added (EVA) is defined as an estimate of true economic profit, the
amount by which earnings exceed or fall short of required minimum rate of return
investors could get by investing in other securities of comparable risk. It is the net
operating profit minus the appropriate charge for the opportunity cost of capital
invested in an enterprise (both debt and equity). The capital charge is the most
distinctive and an important aspect of EVA. Under conventional accounting, most of
the companies appear profitable. However, many are actually destroying shareholder
value because the profits they earn are less than their cost of capital. EVA corrects
this error by explicitly recognizing that when managers employ capital, they must pay
for it. By taking all capital costs into consideration, including cost of equity, EVA
shows the amount of wealth a business has created or destroyed in each reporting
period.

Expressed as a formula,  Economic Value Added (EVA) for a given period can be
written as:

Economic Value Added (EVA)  = NOPAT – Cost of Capital Employed = NOPAT –

WACC x CE

Where;

NOPAT :  Refers to amount of profit remaining of the business after tax and adding
back interest payments. It can be calculated as per accounting concept after making
necessary adjustments for certain for non-operating incomes and expenses.

WACC : Weighted Average Cost of Capital.  It defined as the weighted average cost
of both equity capital and debt. It is the weighted average of both the specified costs
with weights equal to proportion of each in total capital. The tax shield of the debt is
adjusted with the cost of debt

CE : Capital employed or Invested capital refers to total assets (net of revaluation) net
of non-interest bearing liabilities. From an operating perspective, invested capital can
be defined as Net Fixed Assets, plus investments plus Net Current Assets. Net Current
Assets denote current assets net of Non-Interest Bearing Current Liabilities
(NIBCLS). From a financing perspective, the same can be defined as Net Worth plus
total borrowings. Total borrowings denote all interest bearing debts.

OR equivalently, if rate of return is defined as NOPAT /Capital Employed, then, it

tums into a more revealing formula.

Economic Value Added (EVA)  = (Rate of Return – Cost of Capital) x Capital

Employed

Where;

Rate of Return : NOPAT /Capital Employed

Capital Employed: Total of balance sheet – Non Interest Bearing Current Liabilities
(NIBCL) in the beginning of the year

Cost of Capital: (Cost of equity x Proportion of equity in Capital) + (Cost of debt x

Proportion of debt in Capital)(1- Tax)

If, Return on Investment is defined as above after taxes, EVA can be presented with
the following familiar terms:

Economic Value Added (EVA)  = (ROI – WACC) x Capital Employed

Where;
Capital Employed: Net fixed assets – Revenue reserve – Capital Work in progress +
Current assets – Funds Deployed outside business – NIBCL

Economic Value Added (EVA)  is measured by comparing Return on Capital

Employed with Cost of Capital, also called Return Spread. A positive Return Spread
indicates that earning is more than cost of capital —there by creating wealth for
owners or stockholders. A negative Return Spread means earning is less than cost-of-
capital — thus reducing the wealth of owners and stockholders.  Economic Value
Added (EVA) is an indicator of the market value of service center’s owner’s equity, a
measure especially important to closely held companies, which do not have the
benefit of a published stock price. For publicly traded companies, EVA correlates
very closely with stock price.

Economic Value Added (EVA)  is an estimate of true economic profit and a tool that
focuses on maximizing shareholders wealth. Companies best utilize EVA as a
comprehensive management tool. EVA has the strategic importance of focusing
management and employees on the company’s primary goal of maximizing
shareholder value. With this goal in mind, EVA can be used tactically in a number of
ways including: shareholder reporting, financial benchmarking, management
decision-making tool, and foundation for incentive compensation plans.

Measurement of Economic Value Added (EVA)

It must be noted that measurement of  Economic Value Added (EVA) can be made by
using either an operating or financing approach. Under the operating approach,
deducting cash operating expenses and depreciation from sales derives NOPAT.
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.

Implementing  Economic Value Added (EVA)

When a company decides to adopt EVA as a corporate performance measure, here is

what it must do:
Step 1: Run an EVA analysis of the company, its publicly traded peers and business
units.

Step 2: Draw up a definition of EVA that is simple and meets the company’s
information needs, existing accounting data, organization and management.

Step 3: Work out a compensation scheme that fits into the company’s business and
culture. The incentive plan has to marry the EVA design with traditional concerns of
shareholders and directors.

Step 4: Train all employees on the basics of EVA and how it affects shareholder
value.

Step 5: Demonstrate the difference between EVA-led decisions vis-à-vis

conventional methods through computer simulation exercises.

Positives of EVA

No ceiling on the amount managers can take home as incentive pay.

Managers think like, act like and are paid like owners.

Targets are set over a time horizon that is more than one year – usually three to five
years – forcing a long-term view into managerial decision-making.

Cuts capital cost and inculcates financial discipline among employees.

Increasing EVA directly benefits the shareholder and has been found to have a
positive influence on a company’s stock price.

Negatives of EVA

Involves lots of complexity. Globally, Stern Stewart is said, in some cases, to make as
many as 165 adjustments to work out the weighted average capital cost of companies.

Works better at the individual level than team level, unless goals are appropriately
structured.

May make companies risk-averse. New investments that look risky or difficult to
quantify in terms of expected payback may never be made using EVA.