ECONOMIC VALUE ADDED

ECONOMIC VALUE ADDED

Economic Value Added

Introduction                                    

Economic Value Added (EVA) is a current financial that assists to establish the real wealth of the shareholder within an organization. Even though the net profit margin, the capital adequacy ratio and the return on equity (ROE) are commonly used as proxies that analyze the organization’s performance, the effective inclusion of a capital employed cost makes the EVA method more superior from other accepted measures. EVA is principally calculated as the difference between NOPAT (Net Operating Profit After Taxes) and the capital invested cost (Grant, 2003).

EVA is a new management tool which is incredibly powerful and is gaining a humongous international acceptance that is equated as a standard of corporate governance.

EVA (Economic Value Added) is a financial performance measure that is value based, a performance measure showing the absolute shareholder amount of value created and also an investment tool. A recent research shows that a lot of companies have embraced EVA as a management discipline, a measure of an organization’s performance and also as an analytical tool that assists in making decisions regarding portfolio selection. According to the research, there is substantial evidence showing that EVA motivates managers in creating shareholder value in a firm. There is also credible evidence showing that firms that adopt EVA based incentive plans have a tendency of increasing the firm’s capital disposition. EVA is calculated as the main product of the excess return that is made on an investment (s) and the invested capital in that investment (s) (Issham, 2011).

According to Das & Pramanik, (2009), the EVA measurement is basically the net operating profit less a suitable charge for the opportunity cost of all the capital invested in a firm. EVA is an assessment of the true economic profit or the sum by which income or earnings surpass or fall short of the requisite minimum rate of return inventors could get by investing in other investment securities that have comparable risk. Residual income which is an accounting performance measure is effectively defined as the difference between the operating profit and a charge on capital. Therefore, EVA is a deviation of residual income which consists of adjustments on how the firm calculates income and capital.

The concept of EVA is often referred to as Economic Profit (EP) in order to avoid problems due to trade marking. The concept of EVA is well known and popular that every residual income concepts are mostly called EVA. EVA is a financial performance tool and a strategy formulation that assists firm’s make a return which is greater than the organization’s cost of capital. Organizations ultimately adopt this noble concept for guidance in management decisions in regard to resource allocation as well as tracking the organization’s financial position. The EVA concept also helps firms in acquisition analysis and in capital budgeting. An analysis of EVA contains information which is credible in predicting future earnings as well as adding value to an analyst’s forecast. This concept evaluates a firm’s performance, in rewarding managers and in price transactions (Savarese, 2000).

In accordance to Young & O’Byrne (2001), EVA encourages managers to effectively think as real owner of the firm’s they manage and thus in the process, EVA enables them to strive and work harder for better performance. Since EVA is efficiently used as an incentive tool, this encourages the managers to set workable systems in the firm that ensure exemplary performance. Therefore, the concept of EVA is elaborately used as a motivational tool. EVA has been helpful and instrumental since it forces firms to pay extreme attention to the capital employed and specifically to excess working capital. EVA computation also involves substantial subjectivity that reduces its informative value.

According to an interview of various senior managers in a research conducted recently, a lot of managers comprehensively concluded that they use EVA to improve and measure the financial performance of their firms. They emphasized on the numerous advantages of EVA as compared to the other performance indicators. Additionally, since EVA takes into consideration the interests of the firm’s shareholders, the effective use of EVA by the management leads to a variety of informed investment decisions as compared to if the management only relied on other measures. Other measures of a firm’s performance do not take into consideration the vital cost of equity capital employed whereas EVA considers this noble factor. Therefore, EVA shows the true picture of what a firm is actually doing with the investor’s hard earned cash. EVA is also used as an improvement of other metrics which came before it and thus assists managers in creation of shareholder value (Stern, Ross & Shiely, 2001).

EVA Computation

According to Issham (2011), EVA application requires the use of an organization’s WACC (Weighted Average Cost of Capital). EVA is computed as the difference between the NOPAT (Net Operating Profit After Tax) of an investment and the cost of funds that are used in financing the investment. The computation of the cost of funds involves the multiplication of the amount of currency funds that is used in financing the investment by the organization’s WACC.

EVA is stated as:

EVA = NOPAT – [WACC x Capital Invested]                                 (1)

NOPAT = Operating Profit x (1 – Tax Rate) + Provisions                (2)

The most common used WACC computation is elaborately illustrated in formula 3

WACC = w _d k _d (1 – T) + w _p k _p + w _s k _s

Where w _d, w _s and w _p stands for the using debt weight, common stock and preferred respectively; k _p, k _s and k _d is used in the cost of using every component. Tax is deductible and therefore (1 – T) effectively adjusts the debt net cost.

From the computations, it is evident that EVA is a much superior measure since it is closer to the actual cash flows of the firm’s entity, it is easy to comprehend and calculate, and it has a huge correlation to the firm’s market value. Its application to compensation for the employees leads to managerial and shareholders interest alignment which thus minimizes the expected management dysfunctional behavior. A positive EVA effectively builds up a premium in the equity market value since investors adequately pay for any excess return. Because EVA has a shareholder wealth maximization accelerator effect, this shows that the greater the creation by EVA, the higher and greater the market perception (Ehrbar, 1998).

Conclusion

EVA (Economic Value Added) is an investment decision tool, a financial performance measure that is value based and a performance measure that effectively shows the exact amount of shareholder value that is created. EVA is computed as the results of excess return that is made on investments or an investment and the invested capital in that particular investment or investments. This paper employs the application of the EVA concept as a key performance indicator in firms. Although past research showed that ROE (Return on Equity) was widely accepted as an indicator for measuring a firm’s performance, recent studies effectively propose that EVA (Economic Value Added) is comparatively more feasible and viable to consider in organizations performance ranking (Ehrbar, 1998). This paper comprehensively elaborates that EVA ranking and ROE rankings are evidently different. Despite the usage of a number of proxies that are popular which include ROE, capital adequacy and net income being used to compare firm’s performances, EVA is most recently being implemented for valuations manner. This paper outlines that even though firms may report high amounts of total equity and net income thus ROE, they may not adequately create substantial amount of economic profit. Thus EVA/Equity and EVA ratios are used as effective determinants. EVA is also used as a motivation tool in a firm since it assists the managers to think and explore a number of viable options in order to make higher returns. This equally translates to higher incomes and incentives for them and the other employees. They therefore work as part of the shareholders and this also ensures that each and every staff in that firm manages various numerous costs that the firm incurs. Ideally this is reflected in the income statements since operational costs will have greatly reduced and therefore better revenues are achieved in the process. EVA enables shareholders and managers to have a clear picture on the true position of the firm and guides them on the decisions they need to make in order to achieve their visions and missions (Das & Pramanik, 2009).

References

Das, B., & Pramanik, A. K. (2009). Economic value added. New Delhi: Deep & Deep Publications.

Ehrbar, A. (1998). EVA: The real key to creating wealth. New York [u.a.: Wiley.

Grant, J. L. (2003). Foundations of Economic Value Added, Second Edition. Hoboken, NJ: John Wiley & Sons.

Issham, I. (2011). Economic value added (EVA): The company performance predictor. Saarbrücken: Lambert Academic Publishers.

Savarese, C. (2000). Economic value added: The practitioner’s guide to a measurement and management framework. Warriewood: Business + Pub.

Stern, J. M., Ross, I., & Shiely, J. S. (2001). The EVA challenge: Implementing value-added change in an organization. New York, NY [u.a.: Wiley.

Young, S. D., & O’Byrne, S. F. (2001). EVA and value-based management: A practical guide to implementation. New York, NY [u.a.: McGraw Hill.

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