Economic Value Added (EVA)

Concept

BY : ANU DEVASSY

1
 Background of EVA
• New Value based performance measure
developed by a New York Consulting
firm, Stern Steward & Co in 1982

• The object of EVA is to promote value-

maximizing behavior in corporate
managers
 What is EVA
• EVA is single, value based measure
that was intended to evaluate

– Business strategies

– Capital projects

– Maximizing the long-term shareholders

wealth
 What is EVA (contd..)
• EVA establishes clear and Shareholders Returns
accountable links among

– Economic Return:
strategic thinking, capital
investment
EVA
– Accounting Returns:
operating decisions and
Accounting Economic
– Shareholders Returns: returns Returns
shareholder value
 Why EVA

• EVA sets managerial performance

target and links it to reward system
which motivates the managers to
behave like owners.

• EVA allow managers to have discretion

and free range creativity keeping the
long term object in mind.
 EVA Concept of Profitability

• A successful firm should earn atleast its cost of

capital.
• Firms that earn positive/higher returns than
financing costs benefit shareholders and
enhance shareholder value.

“Until a business returns a profit that is greater

than its cost of capital, it operates at a loss”
– Peter F Drucker in an article in Harward Business Review
 Composition & Mechanics of EVA
• EVA represents Net operating profit after tax
(NOPAT)
MINUS
• Cost of Capital employed to generate the operating
profits.
 Object of EVA is to know

• Whether the Entrepreneurs are really increasing

the Net Worth of the Organization or they are
destroying it gradually

• The Real growth Entrepreneurs have added to

the Shareholders’ Wealth.
 Concept of EVA

Shareholders’ Value is created by

MAXIMIZING

“ECONOMIC PROFITS”
 What it measures
• Creating value
– The Company which earns Higher
Returns (Net Operating Profit After
Tax) than the Cost of Capital

ARE CONSIDERED AS
HAS “CREATED THE VALUE”
What it measures cont..
• Destroying value
– The company which earns Lower
Return (Net Operating Profit After Tax)
than the Cost of Capital

ARE CONSIDERED AS
Destroyers of Shareholders’ Value
 Strategies for increasing EVA

• Increase the return on existing projects

(improve operating performance)
• Invest in new projects that have a return greater
that 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.
• Hence in the EVA there are three way to
increase value
– Operate: Improve the return earned on existing
capital
– Build: Invest as long as returns exceeds cost of
capital
– Optimize: Reduce cost of capital by optimizing
capital structure
 Performance
Goal Setting Measurement
Financial
Planning
Shareholder
Communication
Incentive
Compensation

Capital
Budgeting

EVA
 Advantages of EVA
• EVA is more than performance management,.
It is motivational, compensation based
management system that facilities economic
activity and accountability at all levels in the
firm.
 Limitations of EVA
• EVA is based on financial accounting methods that can be
manipulated by managers by using different method of accounting.
– There are different ways to calculate NOPAT and COC as there are
numerous fundamental differences exist with regard to calculation of
NOPAT and COC
– There are 164 adjustment which is really cumbersome exercise
– EVA may focus on immediate results which diminishes innovation
• EVA is biased against new assets
• EVA is in favour of large companies
• EVA favours more debt compared to equity
• It is difficult to implement
• Implementation includes significant cost
• EVA does not study business drivers like consumer satisfaction or
learning and growth.
 List of few Companies in India
implementing EVA and its objective

• INFOSYS -

• MARICO -
• DR. REDDY’S LABORATORIES -
• TCS -
• Godrej -
 Why EVA is implemented by only
few companies
• Implementation of EVA is costly affair
• The process is challenging and time consuming and too
complicated for small business
• Especially the key persons (Top and middle managers) have
to understand and commit to EVA thoroughly which is
difficult
• Switching over to EVA from the earlier traditional methods of
bonus system may create resistance in the employees
• EVA does not have system of Minimum and maximum cap
for bonus as the traditional methods have.
Thanks