PRESENTATION ON

ECONOMIC VALUE ADDED

Prepared By, Pankaj Motwani(11018) Purvish Shah(11039)

Stern Stewart & Company. . ‡ EVA is the surplus left after making an appropriate charge for the capital employed in the business. ‡ Peter Drucker ± a measure of total factor productivity.What is EVA? ‡ Proposed by the consulting firm.

EVA = economic value added NOPAT = net operating profit after tax c* = cost of capital CAPITAL = economic book value of the capital employed in the firm r = return on capital = NOPAT/CAPITAL PAT = profit after tax INT = interest expense of the firm t = marginal tax rate of the firm ke = cost of equity EQUITY = equity employed in the firm .FORMULAE : EVA = NOPAT ± (c*)*CAPITAL EVA = CAPITAL*(r ± c*) EVA = [PAT + INT(1 ± t)] ± (c*)*CAPITAL EVA = PAT ± ke*EQUITY where.

2-0.000) = 500 EVA = CAPITAL*(r-c*) = (10.000 c* : 15% r : 20% EVA = NOPAT ± (c*)*CAPITAL = 2.15)(10.For example. CAPITAL : 10.000 NOPAT : 2.000)(0.15) = 500 .000 ± (0.

What causes EVA to increase? ‡ The rate of return on the existing capital increases because of improvement in operating performance ‡ Additional capital is invested in projects that can earn at a return greater than the cost of capital ‡ Capital is withdrawn from activities which earn inadequate returns ‡ The cost of capital is lowered by altering the financial strategy .

The three components of EVA NOPAT NOPAT is defined as (Profit before interest and taxes)(1 ± tax rate) Cost of Capital Cost of Capital should have the following features: ‡ It represents a weighted average of all the costs of all sources of capital ‡ It is calculated in post-tax terms ‡ It reflects the risks borne by various providers of capital c* = (Cost of equity)(Proportion of equity in the capital employed) + (Cost of preference)(Proportion of preference in the capital employed) + (Pre-tax cost of debt)(1 ± tax rate)(Proportion of debt in the capital employed) Capital Employed ‡ We need to make adjustments in the µaccounting¶ balance sheet to derive the µeconomic book value¶ balance sheet. ‡ To reflect the economic value of assets rather than the accounting values .

‡ Zero ‡ -Ve .What Does EVA Show? ‡ +Ve The Company has Managed to create Shareholder Value This should be treated as the Shareholders have earned a return that compensates the risk The Company has destroyed the Shareholder Value.

etc. EVA is an integrated financial management system that provides a single.EVA as the basis for an Integrated Financial Management System ‡ A typical financial management system consists of rules. ‡ But these variables bear little relation to the value of a business. dividend policy. return on assets. unified and accurate measurement of value as well as performance ‡ It links forward looking valuation and capital budgeting analysis with actual performance measurement. ‡ EVA is the right measure for ‡ Goal setting and business planning ‡ Performance evaluation ‡ Bonus determination ‡ Investor Communication ‡ Capital Budgeting and Valuation . ‡ Thus. guidelines and procedures that employ different measures to calculate various parameters that focus on performance variables like earnings per share. return on net worth.

87 1.EVA and Valuation YEAR Beginning Capital NOPAT Cost of Capital(%) Capital Charge EVA Growth Rate(%) 1 50 6 11 5.864 12 5 11.6 20 3 72 8.504 0.61 11 10.08 8 7 14.5 20 2 60 7.5 0.64 11 7.18 8 96.72 20 4 86.4 10.36 11 9.05 .64 0.38 117.00 11 11.96 12 6 13.76 108.6 0.04 11 12.2 11 6.92 0.92 1.

.The present value of the EVA stream is = Rs. 24. 74.1 million.1 = Rs.1 million Given the beginning capital of 50 million. the EVA Valuation is : 50+24.

EVA and Capital Budgeting The standard method used by companies is the discounted cash flow (DCF) method for evaluating a project on the basis of NPV: Using EVA approach .

Bonus is linked to increases in EVA 2.EVA and Incentive Compensation ‡ ‡ ‡ ‡ Purpose of an incentive compensation plan Limitations of traditional compensation plans EVA as a unique bonus plan Key elements of the EVA bonus plan are: 1. There is no floor or ceiling on the bonus .

The target bonus is generous 4. the performance targets are set by negotiation.3. not negotiation Under conventional bonus plan. the EVA target is set and revised from year to year. . Performance targets are set by formula. µb¶ may be set between 0 and 1. say 0. whereas under the EVA bonus plan.6. One such model is µthe adaptive expectation model¶ Target EVA(t+1) = Target EVA(t) + b[Actual EVA(t) ± Target EVA(t)] In this model.

Implementing the EVA system Steps ‡ Develop Top Management Commitment ‡ Customize the definitions of EVA ‡ Identify EVA centres ‡ Analyze the drivers of EVA ‡ Tailor an incentive compensation system ‡ Train all the employees .

Problems in using EVA ‡ Disincentive for collaborative relationship ‡ Imperfect Measures ‡ Underinvestment ‡ Difficulties in Divisional Performance Measurements .

Thank You .

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