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Economic Value Added

A report by- Swapnil Gattewar (Roll No. 72) Chaitanya Gandhi (Roll No. 68) Rhea Baliwala (Roll No. 67) Yugesh Gobji (Roll No.75 ) Dhwani Shah (Roll No. 71) Pritesh Chaudhary (Roll No. 69 ) Anil Gawade (Roll No. 74) Aniket Deshmukh (Roll No. 70 )

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Cost Accounting Presentation On Economic Value Added

A company’s objective is to increase its shareholder's value through its operations. It is

impossible to improve anything without measuring it. And for this purpose of measuring and improving we have various tools and indicators. Economic Value Added (EVA), also known as Economic Profit is a managerial performance measurement tool introduced in 1920s by GM. Latter it was revamped and reintroduced by Stern Stewart. Today it is one of the most successful performance metric used by companies. It is different from other tools used to measure performance as it suggests profit adjustment by cost of capital. It shows economic profit by measuring the value created for shareholders via the invested capital.

What it means is we find out excess profit made a company after considering capital costs. And this can be deduced from the P & L statement in the form of operating profit and then deducting the cost of capital. Now how this can be used to measure companies or management performance. The job of management is to maximize the shareholders’ value and return on investments of investors. And this is what is exactly measured by this tool. The decisions of management are reflected in the form of operating profit that a company has, this gives us the effectiveness of management and the efficiency of utilization of resources. But this data is useless if looked at in silo. It needs to be compared with something that will give us an idea of expectations that shareholders have so that we can benchmark the performance. The cost of capital gives us a fair idea about shareholders expectations. This also gives us a basis for comparisons with other companies as it considers cost of capital which is a measure of risk as well.

Now how is EVA used or how it is read. A positive EVA means the firm generated a return to

invested capital that exceeds the opportunity cost of capital and the “Company Value”

increases. A negative EVA means the firm did not generate sufficient return to cover its cost

of capital and the “Company Value” declines. And last but not the least the trend in EVA is

more important than the absolute value of EVA.

Let's now look at the overall calculation, which can be broken down into three sets of calculations. Each of these is the mathematical implication of one of the three main ideas supporting the entire economic profit system:

1. Cash flows are the best indicators of performance. The accounting distortions must therefore be “fixed”. Translate accrual-based operating profit (EBIT) into cash-bashed net operating profit after taxes (NOPAT).

  • 2. Some expenses are really investments and should be capitalized on the balance sheet.

True investments must therefore be recognized. Reclassify some current expenses as

balance-sheet (equity or debt) items.

  • 3. Equity capital is expensive (or, at the very least, not free). This expense must therefore be

accounted for. Deduct a capital charge for invested capital.

The calculation starts with earnings before interest and taxes (EBIT), which is a pure incomestatement (accounting-based) measure.

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First, several adjustments are made to move the measure nearer to representing actual cash flow.Second, certain expense items (i.e. money spent in the current accounting period) are identified as economically really being investments. That is, they are truly meant to create a long-term asset of some sort. Those expenses are then reclassified onto the balance sheet. Those first two steps produce net operating profits after taxes (NOPAT). The idea behind NOPAT is to get a cash-based measure of operating performance. By the way, if you are looking for the exact analogue of NOPAT on the income statement, you won't find it. The nearest figure is something we might call "earnings before interest but after taxes" (EBIAT). Finally, because NOPAT represents profits before the cost of debt service and the cost of equity capital, our next step are to deduct a capital charge. The capital charge is what investors, as a group in total, will need to make their investment exactly worthwhile; it could also be called "economic rent". If NOPAT equals the capital charge, then the company just barely met its "rent obligations" to investors - but, in doing so, produced no economic or excess profits. Any NOPAT profits above the capital charge are truly in excess and are called economic profits or value added.

The methods to improve EVA

Try to improve returns with no or with only minimal capital investments

Produce the same goods and services using less capital

Invest new capital only in projects, equipment, machines able to cover capital cost

while avoiding investments with low returns Reduce the cost of capital

Benefits of Economic Value Added

  • 1. Indicates your company’s worth

Economic value added can help you determine the worth of your company as well as its stocks. It is always important to determine your firms debt load since the debt can affect your company value, as it means there is less capital for expansion. In other words, you can improve the company’s value by settling all the debts.

  • 2. Easier to sell and buy stocks

I am sure you agree with me that it is easier to sell stocks with better market value. Many a times, people experience difficulty when selling stocks of low market value, therefore make sure you buy new stocks after the company has gained market value. Stock prizes usually rise after a publicized event, for instance Apple may decide to launch a new product, which in turn increases their market value in respect to stocks.

  • 3. Better investment opportunities

Most of the time investors are not able to spot corporations that show substantial improvement in market value. Therefore, thorough research is important if you want to increase your chance of buying stocks from companies with better market value. This will

enable you to reap full benefits of economic added value. A corporation’s ability to

increase in market value is always the first criteria that will you should use when buying

shares.

  • 4. Better and True Picture of a Company

Unlike accounting profit, such as EBIT, Net Income and EPS, EVA is Economic and is based on the idea that a business must cover both the operating costs as well as the capital costs and hence it presents a better and true picture of the company to the owners, creditors, employees, shareholders and all other interested parties.

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  • 5. Improves Corporate Governance

It can also improve the corporate governance of the company because since a higher EVA implies higher bonuses to the managers they will be working hard and also honestly which in turn augurs well for the company.

  • 6. Monitors Problem Areas

It helps the company in monitoring the problem areas and hence taking corrective action to

resolve those problems.

  • 7. Decision Making

Using EVA company can evaluate the projects independently and hence decide on whether to execute the project or not

Limitations of EVA

  • 1. EVA does not control for size differences across plants or divisions. It does not permit a very good comparison between different sectors of the enterprise because it is not taken into account their dimension.

  • 2. EVA is based on financial accounting methods that can be manipulated by managers. All the component elements of EVA, being calculated in accordance with the book-keeping information, do not grant a very objective evaluation without certain adjustments. Thus the accent lays upon the profit obtained on short intervals of time and not on the long- termed ones, achieved with present, significant costs and recognized in book-keeping. The present reduction of the economic value added may lead to more reduced remunerations for the managers of the enterprise, fact that determines them to act in order to maximize the present incomes.

  • 3. EVA may focus on immediate results which diminishes innovation: EVA has a short-term orientation. The intent of a performance measurement system should be to match employees' effort, ingenuity, and accomplishments with their compensation. If a manager conceives of an innovative idea, researches it, organizes it, presents it to superiors, and begins implementing it in the current accounting period, some measure of compensation should be afforded to the manager in the current period for the effort and ingenuity expended. However, that is not how financial measures, such as EVA, work when they are used to evaluate employee performance.

  • 4. EVA provides information that is obvious but offers no solutions in much the same way as historical financial statement do. EVA just gives an indication about the economic value added but fails to offer solutions which will enable to improve this value if a negative value is obtained.

  • 5. Difficulty is in finding correct cost of equity. The first difficulty is in finding correct cost of equity. It is not suitable for all kinds of companies. It may not correctly understand efficiency as the EVA of bigger plant will always be more than smaller plant even when they are more efficient and maintain a better ROI comparatively.

  • 6. It does not permit a very good comparison between different sectors of the enterprise because it does not take into account their dimension. All the component elements of EVA, being calculated in accordance with the book-keeping information, do not grant a very objective evaluation without certain adjustments. Thus the accent lays upon the profit obtained on short intervals of time and not on the long-termed ones, achieved with present, significant costs and recognized in book-keeping. The present reduction of the

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economic value added may lead to more reduced remunerations for the managers of the enterprise, fact that determines them to act in order to maximize the present incomes.

EVA CALCULATION (For example please refer the attached excel file)

To determine what economic profit tells us as an analytical tool for investors, we need to

compare it to several other popular metrics. Let's start by determining the levels of analysis:

does the metric capture dollars created for the entire entity (both lenders and shareholders) or only the shareholders, or does it capture excess (residual) dollars created for both shareholders and lenders? Figure 2 below summarizes which levels of analysis the different types of valuation metrics occupy, and it indicates which are performance metrics and which are wealth metrics.

economic value added may lead to more reduced remunerations for the managers of the enterprise, fact
economic value added may lead to more reduced remunerations for the managers of the enterprise, fact

In Figure 1, the levels of analysis are labeled across the top row. Under entity, we show two columns of metrics: before reinvestment and after reinvestment. These columns distinguish between those metrics that include capital expenditures and those that don't. For example, EBITDA is before depreciation and amortization (D&A) and therefore is before the non-cash charge that reduces earnings by the amortized investment. But EBIT is after D&A and, although not cash based, does recognize a charge for investments.

Down the left-hand side we have three rows of performance metrics and one row of wealth metrics. The first row of performance metrics shows accrual metrics, which are based on accounting flows, and below each accrual metric is the cash flow metric analog based on the same level of analysis. For example, the cash flow analog to EBIT is free cash flow to the

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firm (FCFF). EBIT is the earnings that accrue to both shareholder and lenders - in other words, it accrues to the entire entity or enterprise. And FCFF is the equivalent in cash flows. By looking at the chart, you may be asking yourself what the difference is between economic profit and cash value added (CVA), both of which are residual dollar returns. Despite its use of adjustments, economic profit is essentially accrual based. Consider NOPAT's inclusion of

  • - or put another way, reduction by - depreciation and amortization, which are non-cash

charges. So, whatever adjustments we make, we are still incorporating accruals. CVA, on

the other hand, is a metric designed to correct/reverse this by adding back the non-cash charges of depreciation and amortization. Figure 1 also shows how the performance metrics

  • - whether capturing enterprise, shareholder or residual dynamics - have corresponding

return metrics and wealth metrics. Return on gross invested capital (ROGIC), for example, corresponds to EBITDA because it adds back depreciation to capital in the denominator - ROGIC is before D&A just as EBITDA is before D&A. (ROGIC is similar to return on gross assets (ROGA).) Economic spread, which expresses economic dollars in percentage terms, is the returns- metric analogue to economic profit. To understand this, we simply rearrange our basic

economic profit calculation:

Economic profit = NOPAT - [WACC × Invested Capital] (NOPAT = ROIC × Invested Capital) Therefore Economic profit = [ROIC × Invested Capital] - [WACC × Invested Capital] Economic profit = [ROIC - WACC] × Invested Capital

KEY POINTS FROM THE VIDEO

  • 1. Economic value added is calculated as Earnings Opportunity Cost of Capital.

  • 2. To do this subtract (Amount of capital)*(minimum rate of return that would entice an investment) from the NOPAT of the company.

  • 3. It is possible that the company is earning net profit but has a negative EVA which means that although it is earning profit it is not performing to the expectations of the shareholders.

  • 4. Uses It is used for evaluating how your investments are performing as compared to other investments or to choose between two projects in a company or two evaluate performance of managers for evaluating bonuses.

  • 5. It is effective in ensuring that you are targeting smartest investments in capital intensive sectors.

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