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EVA AND TRADITIONAL PERFORMANCE MEASURES Some Empirical Evidence

INTRODUCTION Certain value-based performance measures e.g., Cash Flow Return On Investment (CFROI), Cash Value Added (CVA), Shareholder Value Added (SVA) and Economic Value Added (EVA) have appeared on the scene to measure the corporate financial performance. Out of these new ‘trendier’ performance measures the popularity graph of EVA is touching new heights day-by-day and when compared with the traditional measures it occupies a place of pride on the following grounds: (i) EVA is a performance measure most directly linked to the definitive and reliable measure of wealth creation that is Market Value Added (MVA), the difference between the market value of an enterprise and the capital contributed by shareholder and lenders. MVA is in fact the cumulative amount by which a company has enhanced or diminished shareholder wealth. (ii) ROCE, RONW, ROI etc. consider only one side of the performance i.e., they consider the borrowing cost but ignore the cost of equity. This leads the decision makers and financial analyst towards a failure to highlight whether the return is commensurate with the risk of underlying assets that ultimately results into biased and inappropriate decisions regarding rejection of economically profitable project or acceptance of unviable projects. For instance, a company’s current ROCE is 20% and its overall cost of capital is 16%. It receives a new investment opportunity with an estimated ROCE of 18%, cost of capital remains the same (i.e., at 16%). To maximize ROCE one will reject the said opportunity. But actually, if accepted, it would have added two percent economic surplus to the shareholders’ wealth. In another case, the present ROCE of a company is 12% and cost of capital is 16%. It receives a new investment opportunity with an estimated ROCE of 14% with no change in cost of capital. Again, to maximize

with EVA the bonus targets are set every year as a percentage gain in EVA and there is no cap on the maximum amount of bonus payment. This would unite all employees in the pursuit of the single goal of creating value. but the anxiety is always in the context of their impact on EVA. A part of the bonus earned is banked and paid in later years.e. turnover ratios.ROCE the said opportunity will be accepted by the company. EVA mechanism gives. The focus on a single measure also simplifies decisions. when everyone is putting on the same oar. Managers will certainly still have to consider margins. communicating or rewarding management into an integrated criteria of creating values. But this will destroy shareholders’ wealth as shareholders want to maximize the absolute return above the cost of capital and not to maximize percentages. and parochial behavior declined. covers the full range of managerial decision against a typical traditional system with inconsistent standards. goals and terminology. On the contrary. considering strategic plan alternative. for instance. assessing performance. reviewing a capital budgeting process. decision making speeded up. it links the management compensation to the shareholder value in a much refined manner. valuing an acquisition. EVA-based compensation system ties management’s interest with those of shareholders and the value creation motion will permeate to the whole organization. unit costs and a host of other variables. due recognition to the cost of equity in all managerial decisions from board room to the shop floor and thus provides a comprehensive and reliable yardstick to measure the shareholders’ value creation (or destruction) by an individual business entity focusing towards maximization of absolute return above the cost of capital. (iii) The EVA financial management system eliminates all the inconsistencies among various parameters resulting from the use of different criteria/financial measures for different corporate functions under the typical traditional financial management system. EVA system. Thus. . (iv) Further. by incorporating all business issues. team work bolstered.. thus. EVA results that are below target will shrink the banked bonus and vice-versa. communication channels get strengthened. i.

to arrive at true profits. Combining operating costs and capital costs in a single profit measure that is expressed in rupee rather than a rate of return gives EVA another unique quality. EVA is almost a made-to-order performance metric for the knowledge industries. (vi) The utility of EVA simply does not end by indicating the degree of wealth creation. (viii) The issue of capital compels operating managers to use assets more diligently by focusing directly on the costs associated with inventories.(v) EVA captures the performance status of corporate system over a broader canvas i. EVA bonus system does this by giving employees an ownership stake in improvements in the EVA of their divisions or operations. and the companies operating in these industries are not faced with too many decisions involving huge amounts of capital.e. Hence managers could use EVA to guide their future resource allocation decisions and economic income of the firm. It goes beyond that. to pinpoint the lacunae in the business performance. The typical knowledge industry is not capital intensive. (ix) EVA is also an ideal technique for companies operating in new-age sectors. cost of borrowed capital as well as cost of equity should be deducted from net operating profits. As a result. Further to maximize earnings is not sufficient. It enables managers to routinely and automatically consider the cost of capital in every decision and accurately assess the tradeoff between operating costs and capital costs. This causes employees to behave like owners and reduces or eliminates the need for outside interference in decision making. Moreover in such industries returns on the capital invested are immediate. at the same time consumption of capital should be minimum/optimum under an EVA based system. (vii) It also fits well with the concepts of corporate governance and thus is considered to be the best corporate governance system. A regular monitoring of EVA throws light on the problem areas of a company and thus helps managers to take corrective actions. receivables and capital equipment.. .

. METHODOLODY Choice of Variables: Three independent variables are chosen to establish the relationship between shareholder wealth and certain financial variables.e.OBJECTIVES OF THE STUDY Using EVA as a performance measure and a yardstick of wealth creation as it recognizes the riskiness of firm’s operations by giving due consideration to the cost of capital inclusive of both cost of debt and cost of equity along with the returns on capital so employed therein and also gives a better idea regarding the financial performance of a firm in terms of change in shareholder wealth. Earning Before Interest and Taxes (EBIT) minus interest minus tax liability minus preference shareholder’s dividend}/number of outstanding equity shares. Economic Value Added (EVA). is considered as the dependent variable. As the corporate objective at present has been to maximize shareholder value. RONW and ROCE. The independent variables are: (i) Earnings Per Share (EPS): This is defined as Net profit available to equity shareholders {i. which is a measure of shareholder wealth. where. (iii) Return On Net Worth (RONW): This is defined as profit after tax (PAT)/Net Worth 100 where net worth is a sum total of share capital and reserves and surplus. establishing a relationship between financial variables and the corporate objective is important. the study aims towards examining the relationship between shareholder wealth and certain financial variables like. (ii) Return On Capital Employed (ROCE): This is defined as Profit Before Interest and Taxes (PBIT)/capital employed x 100. capital employed is share capital plus reserves and surplus plus loan funds (both secured and unsecured loans). EPS.

Data Conversion: To make the data comparable absolute EVA figures are converted into relative figures by applying the following formula: EVACE = (EVA/CE) x 100 Where. 200102 and 2002-03. . EVA figures in the study have been computed whereas information to compute EPS. a ratio of explained variation in dependent variable to the total variation in it. Statistical Techniques Used: Correlation analysis. Uniformity in accounting period is necessary to ensure comparability of data. ratios and percentages are used in the present study to examine the relationship between EVA and other financial variables – EPS. Karl Pearson’s coefficient of correlation is used.Sample Selection: A sample of 50 companies is selected for analysis that are of different assets sizes but having a uniform accounting year. RONW and ROCE. EVACE = Economic Value Added As a Percentage of Capital Employed. Relevant data are collected from the compilations of CMIE pertaining to the financial years 1998-99. So far as the application of correlation analysis is concerned. and CE = Capital Employed. 1999-00. 2000-01. RONW and ROCE have also been taken from the published annual reports of sample companies. that is. Further to assess the superiority of EVA over these traditional measures the coefficient of determination (R2) has been used. EVA = Economic Value Added.

63.82 0.34 0. 2000-01.53 Year 1998-1999 1999-2000 2000-2001 2001-2002 2002-2003 The results show that the relationship is positive and low with EPS and highly positive with RONW and ROCE. Co. Eicher (-18.12 EVA & RONW r R2 0. only two out of fifty companies have positive EVA – Aurobindo Pharma & Punjab Tractors.04 %) & Mangalore Refinery & Petrochemicals (-17.34 0.61 0.01 0.73 0.86 %) followed by Voltas (-24.11 0.6 (FY 1998) highest among the sample companies while its EVA is negative (-19.10 0.41 0. 1999-00.67 0.59 0.14 0. EVACE is Bombay Dyeing & Mg.83 0. hereby putting a question mark on the sole reliance on the traditional performance measures – ROCE.77 0. Hindustan Motors (-18. (-31.58 0. Table 1: Correlation results between EVA and selected variables EVA & EPS r R2 0.43 & an EVA of -85. Further Infosys has an EPS of 144. 2001-02 and 2002-03 are presented in Table 1.72 %).78 0.36%.37 0. The coefficient of determination (R2) indicates that EPS .07 %).69 0. RONW & EPS etc.14 0.52% (FY 2000).77 0. Among the remaining 48 companies with negative EVA.21 0. In the case of L&T.76 0.58 0.32% (FY 2000). while its ROCE is 12. The other companies are having negative EVA & have destroyed shareholder value. while its EVACE is -10.RESEARCH FINDINGS AND INTERPRETATION A Comparison of EVA with the traditional performance measure indicates that all the sample companies depict a rosy and positive picture in terms of EPS. Similar is the case with Hindalco with an EPS of 62. Eveready Industries (-21.59 0. the worst hit with highest negative.04 0.05 %). Similar observations have been made for the financial years 2001 and 2002.41%.01 EVA & ROCE r R2 0. The ROCE of Raymond is 11. its EVACE is -10.38 0.64 0. to get real picture of the financial performance of the corporate world.01 %).53). The correlation results for the FYs 1998-99. RONW and ROCE for all the five years.

RONW up to the extent of 61% and ROCE up to the extent of 69%. Based on the findings of the study it can be thereby concluded that traditional performance measures do not reflect the real wealth of shareholders. Larger the spread. are correlated and can’t be treated as water-tight compartments. greater will be the value addition to shareholder’s wealth and vice-versa. Comparing EVA with traditional performance measures it has been found that not even a single traditional performance metric explains to the fullest extent variation in shareholder wealth. ROCE and a positive but low correlation between EVA and EPS. .. This proves that as compared with traditional performance measures. Hence it should be measured through EVA. There exists positive and high correlation between EVA and the two financial variables – RONW.explains the total variation in shareholder wealth only up to the extent of 14%. EVA is the real key to create shareholders’ wealth and the true indicator of the financial performance of a company. The empirical results indicate that not even a single traditional performance measure can be relied upon and used to measure the variation in shareholder value in totality. CONCLUSION It can be concluded with the research findings and analysis in the study that the selected independent variables and EVA – the dependent variable. a difference between the percent ROCE and COCE that has a direct impact on shareholder wealth.e. Another finding of this study is that Return On Capital Employed (ROCE) must be greater than the Cost Of Capital Employed (COCE) to have a positive EVA and it is this spread i.