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Dr Sarbesh Mishra
Finance Area, NICMAR, Hyderabad.
Backdrop “If we don’ t know where we’re going, it doesn’t matter how we get there” (Attitude = 100%)
Recent Buzzword in Industry:
Transparency Accountability Business Ethics Social Responsibility Shareholder’s interest protection
Necessity of Corporate Governance
Too much of power with few individual. Large scale diversion of funds to associated companies & risky ventures. Unfocussed business decisions leading to losses. Preferential allotment of sweat equity at low prices. Spinning off profitable business operations to subsidiary companies.
World Com – Improper accounting of $3.9bn in expenses leading to bankruptcy. Enron – Off balance sheet deals used to hide the debt. AOL Warner – AOL division accused of improperly accounted for some advertising revenues. XEROX – Financial Fraud. UTI – Indiscriminate investment by UTI.
The Sarbanes – Oxley Act, 2002, a recent enactment in USA which deals with the Corporate Governance & Corporate Social Responsibilities has emphasized audit functions & financial disclosures. (Mandatory as per NYSE listing Norms)
(Benchmark practices in this regard is calculation of EVA apart from Annual Accounts)
Kumara Mangalam Birla Committee on Corporate Governance (2000) (SEBI Sponsored) Naresh Chandra Committee on Corporate Governance (2002) Narayana Murthy Committee on Corporate Governance
What is EVA?
New York based financial advisory Stern Stewart & Co. postulated the very concept of Economic Value Added (EVA) in 1990.
EVA: Maximum amount which the business is capable of distributing to its shareholders while remaining in the same position at the end of the period as it was at the beginning with fair practices.
EVA = NOPAT - Cost of Capital
NOPAT = Net operating Profit after Tax 2. The project’s cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. The firm’s cost of capital will be the overall (WACC), or average, required rate of return on the aggregate of investment projects.
Summary of Definition
EVA measures the Operating Profit, which should be fair enough to meet the cost of capital. So excess of returns over cost of capital is otherwise referred as EVA.
If EVA is +Ve = Firm is creating shareholder’s wealth -Ve = Firm is destroying shareholder’s wealth
Computation of NOPAT
Profit after tax but before Interest + Increase to Deferred Taxes + Goodwill Amortized in Current year + Increase to Net Capitalized Intangibles +/- Unusual loss or (Gains) net of tax
N. B: Some 144 adjustments are there
Implementation of EVA
Key Strategies to Enhance EVA
Operate: Set targets to Improve ROCE. Build: Invest capital only when return exceeds the cost of the capital. Divest: Divest capital when return fail to achieve cost of capital. Optimise: Restructure capital to reduce the cost of the Capital.
EVA Determination – A Case Study
Calculation of EVA for NTPC in FY 2005-06
Calculation of EVA for NTPC
EVA= NOPAT- Cost of Capital
= PAT+ Interest paid – WACC ( Average Capital)
Calculation for NTPC for FY 2004-05
= (5,500cr+1,000cr) - WACC 1/2(Capital at the beginning of the year + Capital at the end of the year)
WACC = Ke* W1 +Kd* W2
Debt : Equity
= 0.14 * 0.7 + 0.8(1- Tax) * 0.3 30 : 70 = 0.98 + 0.3 * (0.8 * 0.65) W2 : W1 = 0.98 + 0.3 * 0.52 Ke = 14% as per govt. norms = 0.098 + 0.15 Kd = Int. paid/Loan Taken = 0. 254 Tax= 35%
Calculation of Cost of Equity
Cost of Equity can also be calculated taking CAPM model
=Rf + B (Rm – Rf)
Rf = Risk Free Rate of Return
= 0.08 + 0.8 (0.14 – 0.08 ) Rm = Market Rate of Return = 0.08 + 0.8 * 0.06 B = Beta Coefficient for NTPC
B = Covariance of Rm & Rf
Variance of Rm
EVA of NTPC
EVA = 6,500 – 0.254 ( 20,000 )
= 6,500 - 5080 = Rs 1420 Cr EVA
A positive EVA indicates that this company creates value. It helps managers to create value for share holders.
Strategies for increasing EVA
Increase the return on existing project. 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. Curtail further investment in sub-standard operations where inadequate returns are being earned.
Not easy to use (for calculation of PAT, some 144 adjustments are there) too complicated for small business. Recommends inexpensive debts in order to reduce cost of capital (COC), is a very questionable strategy for small business. A passive accounting tool : measures past performance.
Thus, A company must strive continuously to increase not only profitability but also the EVA. EVA reflects high net worth of the company, thus it’s credibility increases. In India, Companies like Dr. Reddy’s Lab, WIPRO, INFOSYS are coming up with their respective EVAs along with their Annual Report.