Chapter 4

An Analysis of Economic Value Added

Based on Mergers & Acquisitions

Introduction
Concept of EVA
Accounting profit versus economic profit
The Calculation for EVA
Steps in computing EVA
Issues relating to calculation of EVA
Adjustment rationale
NOPAT
Usefulness of EVA
Implementation of EVA
EVA and traditional performance measures
EVA and discounting cash flow (DCF) model
Market value added
Relationship between EVA & MVA
Problems with EVA as performance measure
Conclusion
References
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INTRODUCITON

This chapter includes the historical evolution of corporate

performance metric popularized by Stem Stewart of US, namely
Economic value added (EVA) and its twin, Market value added (MVA).
After giving the rationale of its use and its superiority over other
performance metrics like Earning Per Share (EPS) and Return On Net
Worth (RONW), the detailed theoretical methodology regarding its
computation has been discussed.

CONCEPT OF EVA

The onset of liberalization and globalization of the Indian economy

over the ten years has resulted in shift of the corporate goals from
socio-economic focus to an increasing shareholders value. Therefore, the
present day need is to choose the right metrics that would help to
measure organizational progress in meeting the above mentioned
strategic goal. Although there are few traditional performance metrics
like balance sheet measures (namely, rate of return, shareholders’ profit,
earning per share) and market driven measures (namely, market
capitalization, price earning ratio), these are subject to certain
deficiencies. Balance Sheet based measures are veiled in accounting
anomalies that generally measure notional profit, not real ones. And
market driven measures are prone to volatility of the bourses. The need
is for a mix and match measure that factor in a market’s assessment of a
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company’s value. At the same time, it should be a real measure of its

financial performance extracted from its financial statements.

Thus, corporate world’s need for a tool to measure value creation

has been filled with the emergence of a new concept namely, EVA. It has
been redefined and popularized by US based Stem Stewart & Company.
It is an attempt to resolve the need for a performance measure that is
highly correlated to the shareholders wealth and responsive to the
actions of the company’s managers. Shareholder value is considered as
an essential measure of the corporate performance. It is an accurate
reflection of the quantum of incremental value a company generates for
shareholders after accounting for its cost of operations, which include
the cost of capital. The number of companies that have adopted EVA
worldwide is startling. Stem Stewart Management Services (the founders
of EVA) claim that more than four hundred companies globally are using
EVA. Fortune magazine has termed it as today’s hottest financial idea
with underlying scope of getting hotter. Management Guru Peter
Drucker has described EVA as a vital measure that reflects all the
dimensions by which management can increase value. EVA is the
financial measure that comes closer than any other measure in capturing
true economic profit of an enterprise.

To elaborate, EVA is the same as what economists call as economic

profit. In business, revenue comes from customers and is distributed
among the shareholders. Suppliers are paid for their goods and services
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and employees for their services. Depreciation amount is deducted from

revenue as it results in loss of the value of assets. Creditors are paid
interest while loans and taxes are paid to the government. Ultimately,
shareholders are also paid a return. The shareholder’s return is not the
usual dividend payment, but iris the return commensurate with the risk
undertaken by them by investing money in the business. It is the earning
that the shareholders could have earned by investing in similar risk
profile investments i.e. they have to be paid their opportunity cost of
capital. This differentiates EVA from the accounting model as the
accounting model does not acknowledge the cost of equity. After paying
to all whatever is left out from revenue is know as EVA. EVA is thus the
residual income. As shareholders are the owners of the business, the
residual income adds to their wealth.

The current demand for adopting EVA is based on a simple i.e. you
cannot know whether your enterprise is creating value for your
shareholders until you subtract cost of the capit~l from income. To the
extent EVA is positive; the firm is adding value for its shareholders. But
if a firm’s EVA is negative, the firm is destroying value even though it
may be reporting a positive or growing earning per share (EPS) or return
on investment (ROI). This means that if a firm wants to have an
attractive investment, it has to have a return that would exceed other
investment options with a similar risk. Though EVA just reiterates the
basic tenet behind any enterprise, it is not just any other metric for the
 277

firm. It is a framework for complete financial management and

compensation system. It can guide every decision a company makes that
can a corporate culture and help produce greater wealth for shareholders,
customers and themselves.

While creating value for the shareholders is an objective measure of

corporate performance, the measure of creation of wealth for the
company as a whole is also equally important. The best measure for this
is another value add measure, namely, Market Value Added (MVA).
MVA is an absolute measure of wealth creation obtained by subtracting
the economic capital of an organization (book capital after perfect
measure of a company’s ability to create wealth but is as volatile as any
market index and so, can be calculated for the company as a whole only.

EVA on the other hand is the most accurate measure of economic

performance of the company and can be calculated at the level of
divisions and product lines. So, while EVA of a company is the excess of
its return on capital over its cost of capital, MVA is the difference
between company’s total market value and its capital employed. In
mature markets, MVA of a company is equal to the net present value of
all future EVAs. In countries like India where markets are not efficient,
MVA is volatile with no mathematical link with EVA.
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In a nutshell, EVA can be described as:

1. Most accurate value based measure of financial performance.

A registered trademark redefined and popularized by US based
Stem Stewart & Company.

2. Concept, a variation of residual income.

3. Concept, practically the same as economic profit.

A measure indicating amount of shareholder wealth created or
destroyed during each year.

4. A framework of complete financial management and incentive

compensation.

ACCOUNTING PROFIT BERSUS ECONOMIC PROFIT

According to conventional accounting c9ncepts, business income is

measured by matching revenues by costs. It is a purely monetary
concept. In such a system, ones sales revenues are determined; various
costs are divided between present and future. The present costs or
expenses are charged against revenues and appeared in the income
statement and future costs are treated as deferred expenditure and hence
appeared as assets in Balance Sheet to charge against revenues in later
years. The accounting concept lays more emphasis on objectivity and
accuracy through the use of certain conventions, principals and
accounting standards.
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Economic profit is also a concept that was established long ago, as

is understood by the writings of Alfred Marshall over hundred years ago.

“When a man is engaged in business, his profits for the year are the
excess of his receipts from his business. The difference between value of
stock of the plant, machinery etc. at the end and beginning of the year is
taken as part of his outlay, accordingly as there has been an increase or
decrease of value. What remains of his profits after deducting interest on
his capital at the current rate ..... is generally called his earnings of the
undertaking or management.”

Today, this concept has been developed in every principle of

economic text. The idea of economic profit is the basis of capital
budgeting techniques of net present value and internal rate of return
which can be found in finance texts over past thirty years. The cost of
capital is the return required by suppliers’ of capital. Cost reflects both,
the time value of money and compensation for risk - the more risk
associated with the firm, greater is the firm:s cost of capital. Factoring in
the cost of capital tells us whether accounting profit is sufficient to keep
suppliers i.e. creditors and owners from moving their funds elsewhere.
The cost capital in these cases is referred as “minimum acceptable
return” or “minimum revenue required”. Profit is defined as earnings in
the excess of cost of the capital. Economic concept, thus, basically deals
with the real terms instead of only monetary terms as is the case of
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accounting concept. Summary, of the difference between accounting

profit and economic profit is given below.

Table 4.1
Differences between Accounting Profit & Economic Profit

Sr. Accounting Profit Economic Profit

No.
1. Based on theory of accountancy, Based on theory of value and utility
profit is calculated as book as of economics, profit is worked out as
perceived by the accountants as per per the perception of an economist.
accounting standards.
2. Accounting profit is affected by one For calculating economic profit, one
time irregular adjustments. time adjustment as discounted by
market is considered.
3. Depreciation is based on adhoc rates. Depreciation is based on market
value and economic assets.
4. Expected losses and expenses are Expected losses and expenses are
provided for on adhoc basis. provided for as per market
perception.
5. Considers monetary transactions Considers non-monetary transactions
only. only.
6. Change in earnings not considered Changes in earnings are considered
on account of external/internal on account of external/ internal
factors unless ascertainable. factors even though not
ascertainable.
7. Does not consider cost of capital. Considers cost of capital.

CALCULATION OF EVA

The value based performance measure, namely, EVA, introduced by

Stem Stewart & Company is an incarnation of Residual Income concept.
They defined “EVA as an estimate of true economic profit, the amount
by which earnings exceed or fall short of required minimum rate of
return investors could get by investing in other securities of comparable
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risk.” It is the net operating profit minus the appropriate charge for the
opportunity cost of capital invested in an enterprise (both debt and
equity). The capital charge is the most distinctive and an important
aspect of EVA. Under conventional accounting, most of the companies
appear profitable. However, many are actually destroying shareholder
value because the profits they earn are less than their cost of capital.
EVA corrects this error by explicitly recognizing that when managers
employ capital, they must pay for it. By taking all capital costs into
consideration, including cost of equity, EVA shows the amount of wealth
a business has created or destroyed in each reporting period.

Expressed as a formula, EVA for a given period can be written as:

EVA = NOPAT - Cost of Capital Employed

= NOPAT - WACC ´ CE
Where
NOPAT : Net Operating Profit After Taxes but before financing costs
WACC : Weighted Average Cost of Capital
CE : Capital Employed
OR equivalently, if rate of return is defined as NOPAT /Capital
Employed, then, it tums into a more revealing formula.

EVA = (Rate of Return - Cost of Capital) ´ Capital Employed

Where
Rate of Return : MOPAT /Capital Employed
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Capital Employed: Total of balance sheet - Non Interest Bearing Current

Liabilities (NIBCL) in the beginning of the year

Cost of Capital: Cost of equity ´ proportion of equity in Capital

+ Cost of debt ´ proportion of debt in Capital (1- tax)

If, Return on Investment is defined as above after taxes, EVA can

be presented with the folIowing familiar terms:

EVA = (ROI - WACC) ´ Capital Employed

Where
Capital Employed: Net fixed assets - Revenue reserve
- Capital Work in progress + Current assets
- Funds Deployed outside business - NIBCL

STEPS IN COMPUTING EVA

Various steps in computing EVA are as follows:

(1) Calculation of NOPAT

NOPAT refers to amount of profit remaining of the business after

tax and adding back interest payments. It can be calculated as per
accounting concept after making necessary adjustments for certain for
non- operating incomes and expenses.

NOPAT = PBIT (nnrt) (l-T)

Where,
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PBIT (nnrt) Profit before Interest and Taxes

(Net of non recurring transactions)

T = Effective tax rate

Tax paid
T=
Profit before tax

(2) Calculation of Capital Employed

In calculation of EVA capital employed refers to economic capital,

which means economic value of funds invested in a business. It consists
of total amount in circulation and total amount of borrowings or debts
raised.

Stewart defined capital employed as company’s net asset at the

beginning of the year after following three adjustments:

(i) Marketable securities and construction in progress are

subtracted.

(ii) Present value of non-capitalized leases is added to net property,

plant and machinery.

(iii) Certain equity equivalent reserves are added to assets. For

example:
(a) Bad debts reserve is added to receivables.
(b) Last in first out (LIFO) reserve is added to inventory.
(c) Cumulative amortization of goodwill is added back to
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goodwill.
(d) Research and Development (R&D) expenses is capitalized
as long term asset and depreciated over five years.
(e) Cumulative unusual losses/gains after taxes are considered
to long term investment.

(3) Calculation of Cost of Capital

It defined as the weighted average cost of both equity capital and

debt. It is the weighted average of both the specified costs with weights
equal to proportion of each in total capital. The tax shield of the debt is
adjusted with the cost of debt:

Cost of capital = Cost of equity * solvency ratio * cost of debt

* (l - solvancy ratio) * (l - tax)

Solvency ratio defines the proportion of both equity capital and

debt separately in total capital:

Equity Capital
Solvency ratio =
Total Capital

The calculation of an average cost includes solvency ratio.

Solvency ratio generally changes according to business cycles and
changes in other factors. Financial theory suggests that when solvency
changes, the cost of equity and debt shift so much that WACC itself does
not change. When solvency or debt-equity ratio decreases, risk of equity
increases. So, when relative proportion of debt from capital increases,
 285

return on equity become more fluctuating and therefore true cost of

equity capital increases. Also, lenders demand premium at high rate on
debt when leverage increases. So when solvency ratio decreases, both
the cost of equity and debt increase and vice-versa. The increase in the
cost of equity and debt cancel out the decrease in WACC, caused by
bigger relative proportion of a cheaper debt capital. Hence, the change in
WACC is zero.

This change in leverage not affecting WACC can be considered

from expected returns angle also. WACC reflects the expected return of
capital with similar risky business because opportunity cost i.e. the
expected return of capital with similar risky business because of
opportunity cost i.e. expected risk on similar risky investments. If
change in leverage does not affect the expected return on investment
(expected ROI), then WACC does not change, changing only liability
side of the balance sheet i.e. replacing equity capital with debt capital
does not affect the expected return on assets but decreased solvency
raises expected ROI because an increased financial leverage raises return
on the equity capital and risk of equity capital as well. Also, expected
return on stock market does not depend on how investors finance their
investments. For an individual investor, the expected return changes if
he uses more financial leverage i.e. debt with his investments although
this can not affect return for whole investment. Changing leverage
changes the return and risk of equity and debt capital but it can not
 286

influence the expected return of whole investment. It merely allocates

risk and return new manner. However, if tax shield of debt is considered,
when leverage increases, increase tax shield from debt will decrease
WACC to some extent. Therefore, increasing leverage might decrease
WACC slightly. On the other hand, if leverage decreases too much, then
the increased probability of bankruptcy and cost attached to it increases
WACC.

4. Calculation of Cost of Debt

Cost of debt refers to the average rate of interest the company pays
for its debt obligations. To calculate cost of debt, the company’s interest
payments are measured against the total borrowings and then adjusted
for taxes.

Interest Expenses (1- t)

Cost of Debt =
Total Borrowings

Tax:

Tax paid
Effective tax rate =
Profit before tax

5. Calculation of Cost of Equity

For computation of cost of equity, Stern Stewart & Co. (founders of

EVA concept) recommended the use of Capital Asset Pricing Model
(CAPM). This model holds that firm’s equity costs is the composition of
 287

risk free rat of return for a stock plus premium representing the volatility
of share prices.

Broadly,

Cost of equity = Risk free + Specific risk premium

Ke = Rf + B (Equity risk premium)

= Rf + B (Market rate - Risk free rate)

= Rf + B (Rm - Rf)

1) Rf : Risk free return

Normally, 364 days Treasury Bill rates are considered risk free.
Treasury securities are highly liquid and free of default risk. Interest
rates on these securities are used to measure the risk free rate. It serves
as a bench mark from which cost of risky security is calculated.

2) B (RM - Rf) : Specific risk premium

Specific risk premium is the product of level of risk and

compensation per unit of risk. More specifically, it refers to premium
required by he investors to invest in specific company. It is the multiple
of equity risk premium of the company in which the investors want to
invest their money and it’s Beta (B).

(a) Equity risk premium is the excess return over and above risk
free rate that the investors demand for holding risky security. It is
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calculated as the difference of market rate of return and risk free rate
(Rm - Rf).

(b) Beta (B) is the risk free co-efficient which measures the
volatility of a given script of a company with respect to volatility of
market. It is a measure of responsiveness of company’s shares due to
changes in economic factors (micro and macro both) of the economy. It
is calculated by comparing return on a share to return in the stock
market. Mathematically, beta is the statistical measure of volatility. It is
calculated as covariance of daily return on stock market indices and ~he
return on daily share prices of a particular company, divided by variance
of return on daily stock market indices. While considering market index,
broad based index must be considered.

Simply calculated,

1. The market expected rate of return (Rm) is normally given as growth

rate of market index:

Today's index - Yesterday's index

Rm =
Yesterday' s index
(Independent Variable)

2. The Security Return

Today's index - Yesterday's index

Dependent Variable =
Yesterday' s index
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The statistical method of estimating this kind of dependence of one

variable on the other is known as simple linear regression. Once the
security and market returns of a long period have been computed to get a
large number pairs of returns, the regression technique can be used to
estimate Beta.

6. Calculation of Quantum of Value Addition

If NOPAT exceeds cost of capital employed, it will be construed

that an organization has created value for the shareholders during the
period of operation or vice versa.

NOPAT - Cost of capital employed = Value Addition

ISSUES RELATING TO CALCULATION OF EVA

Calculation of EVA is totally different from Generally Accepted

Accounting Principles (GAAP).

The first major departure is to recognize the full cost of capital.

Accountants generally treat cost of equity to be free. EVA calculation
recognizes that equity has a cost, hence subtracts if from profits. Also,
EVA solves the problems of GAAP accounting by converting accounting
earnings to economics earning and accounting capital to economic
capital. The result is a NOPAT figure (net operating profits after taxes)
that gives a much truer picture of funds contributed by shareholders and
lenders. The major issue involved in computation of EVA is to decide on
 290

which adjustments to make to GAAP accounts. Stern Stewrt has

identified 164 adjustments to GAAP and to internal accounting
treatments, all of which can improve the measure of operating profits
and capital. Any change in accounting adjustment will give a different
EVA. According to Ehrbar (1998), if all EVA are considered as running
along a spectrum (as shown in chart the one at the extreme left is called
basic EVA.

Chart : 4.1
The EVA Spectrum

Basic Disclosed Tailored True EVA

This is the EVA that would be computed using unadjusted GAAP

operating profits and GAAP balance sheet. Basic EVA is an
improvement on regular accounting earnings because it recognizes that
equity capital has a cost, but all other problems with GAAP remain.
Moving to the right, is the disclosed EVA which Stem stewart use in
their published EVA rankings Disclosed EVA is computed by making
about ten to twelve standard adjustments to publicly available
accounting policy available accounting data. It is better than basic EVA.
Next, is what most companies need , a custom tailored definition of EVA
peculiar to each company’s organizational structure, business mix
 291

strategy and accounting policies. This is the EVA that is assumed to

optimally balance the trade off between simplicity (the ease with it
captures true economic profit). Then, finally, at the extreme right is the
true EVA, which is the most theoretically correct and the accounting data
(these run into a huge number) and using precise cost of capital for each
business unit in a corporation.

Various types of adjustments to be made to NOPAT and capital

include treatment of such things like timing of expense and revenue
recognition, passive investment in marketable securities, securitized
assets and other off balance sheet financing, restructuring, inflation,
inventory valuation, book keeping reserves, bad debt recognition,
intangible assets, taxes, pension, post retirement expenses, marketing
expenses, goodwill and other accounting issues etc. Some avoid mixing
stocks and flows. Then, there are some adjustments which convert
GAAP accrual items to cash-flow .basis while the others convert GAAP
cashflow items to additions to capital.

These and many other like adjustments complicate the calculation

of EVA. Most of the organizations do not maintain in-depth data
required for these adjustments and even if the data is maintained,
computation is not possible without professional consultants help. Also,
many of these adjustments may not be palatable and may differ among
consultants. Thus, out of detailed 164 adjustments, only a few major
 292

ones are practically carried out to convert GAAP based accounting profit
and capital to economic profit and capital. These are given in Table 4.2 :

Table 4.2
Broad Adjustments to be made to Capital and NOPAT

Add to Capital Add to NOPAT

Equity equivalents Increase in equity equivalents
Deferred tax reserves Increase in deferred tax reserves
LIFO reserves Increase in LIFO reverses
Cumulative goodwill amortization Goodwill amortization
Unrecorded goodwill Increase in capitalized intangibles
Capitalized intangibles (R&D) Increase in other reserves unusual
cumulative unusual gains/losses gains or losses
Reduce from Capital Reduce from NOPAT
Cash and marketable security Any finance income in the form of
interest
Non interest + bearing current Interest expenses
Liabilities

ADJUSTMENT RATIONALE

Capital

1. Cash and marketable securities

These represent discretionary investment of funds not required
on day to day operations.

2. Non interest bearing current liabilities (NIBCL)

The financing cost associated with paying suppliers and
employees with some delay are already included in the cost of
goods sold. Hence, these costs are excluded from capital.
 293

3. Present value of operating leases

As long as asset being leased is required in business, the lease
is capitalized and considered as debt, hence as an asset.

4. LIFO Reserves
Under the LIFO method, cost of recently acquired and used
raw materials are charged to production while costs of earlier
purchases are accumulated. So, LIFO reporting generally
understates the inventory. During period of rising prices,
companies’ saves taxes by adopting LIFO system of inventory
valuation. Economic reality suggests that inventory should be
valued at replacement cost. Rather, keeping in view the large
number of items in large companies., it is suggested tat
inventory be valued at weighted average cost for EVA
calculations as separately identifying each batch may not be
practically feasible. Hence, for calculating EVA, LIFO system
of valuation is changed to first in first out (FIFO) system by
adding the difference to capital and NOPAT.

5. Bad debt reserve

Management must be held accountable for bad debts and so
add back to capital.

6. New R&D expense

GAAP requires companies to immediately charge all outlays
for R&D. But these expenses may not be truly revenue in
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nature. EVA treatment considers R&D as an asset, hence to be

capitalized (add current outlays to the balance sheet as an
asset) and amortized (charge a position against earning each
year) over the period during which benefits of successful R&D
project will be reaped.

7. Deferred tax reserves

GAAP earning statements generally report book ta~es which
are not the same as taxes actually paid by the company.
Accumulation of this difference of accounting provision of
taxes and tax actually paid is called reserve for deferred taxes.
These are to be added back to capital.

8. Cumulative after tax gains or losses

Any successful or unsuccessful investment which gives rise to
loses or gains should be recognized in capital calculation.

NOPAT

1. Interest expense on operating lease.

Since EVA determines profits before financing costs, an
estimate of the interest component is subtracted from operating
costs.

2. Interest on LIFO reserves

This backs out the excess consumption created by LIFO
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accounting. However, if weighted average costing method is

foIled, no adjustment will be required to be made.

3. Change in bad debt reserve

By considering change in bad debts in earings, NOPAT
accurately reflects the timings of cash receipts and
disbursements.

4. Increase in net capitalized R&D

Since investment in R&D is treated as an asset and capitalized,
depreciation on the same has to be treated as an expense or it
has to be amortized over the appropriate period. The average
useful life of R&D for all industries is generally considered as
five years which is the amortization period that Stern Stewart
have used.

5. Increase in deferred tax reserves

Deferred tax reserves arise due to difference in the timing of
recognition of revenues and expenses for financial reporting as
against reporting for tax purposes. It is an accumulation of the
difference between accounting provision of taxes and tax
amount actually paid under the head “Reserve for deferred
taxes”. NOPAT is to be adjusted for tax actually paid instead of
any provisions.

6. Other incomes
Ay non finance income or expense not included in operating
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expenses and not part of unusual loss or gain in the capital

calculation is included to reflect the real operating costs.
However, in Indian context, this component would be included
in the “Miscellaneous income? Expenses” head. Hence,
miscellaneous income after reducing finance income should be
considered.

Apart from these broad adjustments, similar other adjustments that

can distort the accounting profits and capital employyd figures are made
to achieve the following objectives:

i) To produce an EVA figure that is closer to cash flows’ and

subject to less distortions of accrual accounting.

ii) To remove arbitrary distinction between investments in

intangible assets which are capitalized and intangible assets
which tend to be written off as incurred.

iii) To correct biases caused by accounting depreciation.

iv) To prevent amortization or write off of goodwill.

v) To bring all off-balance sheet items such uncapitalised leases

and securitized receivables back into balance sheet to avoid
mixing of operating and financing decisions.

However, each company’s EVA has to be tailored specifically to its

needs, so which adjustments would give the best results cannot be
 297

defined. Also, certain conditions need to be fulfilled for enabling

computation of adjusted EVA namely,

(i) The necessary data is available.

(ii) The amounts of adjustments are significant.

(iii) The adjustments are understandable to the operating managers.

(iv) The adjustments can be made completely and left unchanged

for a period of three years.

(v) The adjustments align calculated EVA more closely with

market value of the firm.

So, for the Indian corporate sector, accounting adjustments to

GAAP profit are largely non existent or inapplicable; due to frequent
fluctuation in interest rates and relatively high volatility in Indian capital
markets than capital markets in developed economies. Moreover, there is
an incomplete grip of the regulators on the capital market to enhance its
efficiency and difficulty in ascertaining risk premium because of short
history of Indian capital market that has become active only in the last
decade.

USEFULNESS OF EVA

The EVA method can be used in areas like valuation, mergers and
acquisitions, capital budgeting, equity research etc. But its best use is in
corporate strategy making and management compensation setting. In
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EVA model, total business can be divided in to small units and each
manager is held responsible for unit’s EVA. Based on performance,
management may divest those businesses which have consistently
negative EVA invest in positive EVA projects. As unit manager’s
compensation is related to yearly EVA figure and its growth, it’s
ensuring better management. Each employee’s bonus gets related to EVA
generated by him. Thus, whole company is geared up for shareholder’s
value maximization. EVA, thus, ensures capital allocation efficiency.
Usefulness of EVA is concluded as below.

1. EVA is closely related to Net Present Value (NPV). It is

theoretically linked to corporate finance theory that value of
firm will increase if you opt for positive NPV projects.

2. It makes the top managers responsible for a measure that they

have more control over (the return on capital and the cost of
capital are affected by their decisions) rather than the one that
they feel they cannot. control (the market price per share).

3. It is influenced by all the decisions that the managers have to

make within a firm the investment decision and the dividend
decisions affect the return on capital (dividend decisions affect
it indirectly through cash balance) and the financing decisions
affect the cost of capital.
 299

4. EVA as a performance measure is also gaining grounds because

of its unbiasness towards any of stakeholders (for example
equity holders, debt managers, management, suppliers of
materials and services, employees and customers).

Proponents of EVA argue that EVA is a superior measure as

compared to other measures due to the following reasons:

I) It is near to the real cash flows of the business entity.

II) It has higher correlation with the market value of the firm

III) It is easy to calculate and understand.

IV) It’s application to employee’s compensation lead to the

alignment of managerial interest with those of the
shareholders.

IMPLEMENTATION OF EVA

EVA has been implemented successfully and used as an important

tool in the following areas:

l. Valuation : Leading investment firm such as First Boston,

Goldman Sashes, Merrylynch and Mogan Stanley in U.S. and Banque
Paribas flemming in Europe are using EVA as a primary valuation tool.
In India, NIIT is the first co’mpany to adopt EVA from Stern Stewart &
Co. as a measure of corporate performance followed by Infosys
Technologies, Godrej Industries.
 300

2. Acquisitions : In one of the largest acquisition in recent years,

AT&T used EVA method to decide on $126 billion purchase of McCAW
Cellular. The ball Corpotation rejected acquisition of Eastman Kotak
unit because it failed the EVA test for creating value.Heekin Can Inc
assed the EVA test and so, was acquired.

3. Strategic Decision Making : International Business Machine

(IBM) applied EVA to evaluate strategic plans for the key Latin
American markets such as Mexico, Brazil and Argentina. At Georgia
Pacific, strategic focus shifted from profit creation to value creation:

4. Operational Improvement : Briggs and Stratton realized that its

return on capital was poor and getting lower. They restructured their
operations and adopted EVA as a way of focusing manager’s attention on
how they were employing capital. EVA is, now the firms’ benchmark for
product introduction, equipment purchases, process improvements ect.

5. Product Line Discontinuation : EVA helped Coca Cola to identify

and sell those businesses that failed to recover cost of capital. Perfect
Data Corporation and Incstar both discontinued unprofitable product
lines based on EVA analysis.

6. Incentive Compensation : Compensation of supervisors and

managers above certain salary in Coke is linked to EVA. At
Transamerica, 100% of annual bonuses of Chief Executive Officers
(CEO’s) and Chief Finance Officers (CFO’s) is based on EVA. In India,
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at NUT, Infosys Technologies and Godrej Soaps, EVA linked

compensation plan has been adopted.

7. Cost of Capital Focus : Dow Chemicals used EVA to shed light

on cost to run business and return a positive economic profit. Deere and
Company used EVA to focus management on the value drivers of its
business and the true cost of its asset base. AT&T changed its focus from
income statement earnings to a broader view that included balance sheet.
SPX, a Michigan based corporation, large manufacturer of specialty
tools and parts for auto industries used EVA framework to concentrate
on cost of capital in every phase of company’s work. They discovered
lots of assets which were uselessly employed in business.

8. Working Capital Focus : Quaker Oats used EVA to account for

large dollar amount tied up in finished goods and packaging materials
inventory. Morrison Restaurants used EVA to focus on management and
its receivables.

EVA AND TRADITIONAL PERFORMANCE MEASURES

EVA is a standardized accounting process independent of balance

sheet approach. It is a potential financial tool for continued economic
growth. of organization and all its constituents. This approach ensures
that growth is not sacrificed at the cost of short term results.
Conceptually, EVA is superior to accounting profits as a measure of
value creation because it recognizes the cost of capital and the riskiness
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of firms operations. Further EVA can be constructed in a way that

maximizing any accounting profit of accounting rate of return leads to
undesired outcome. Benefits of EVA as compare to conventional
performance measures are summarized as under:

EVA AND DISCOUNTING CASH FLOW (DCF) MODEL

Determination of value of the company is very important.

Discounting Cash Flow (DCF) and Net Present Value (NPV) models
have been used very widely over the years to determine the value with
which to discount the future free cash flows to the present value. Also,
DCF approach has been considered as an important tool in analyzing
mergers and acquisitions. However, in EVA model, value of a company
can be determined. Mathematically, EVA gives the same results in
valuation as DCF or NPV models, which have been for long
acknowledged as theoretically best tools from shareholders’ perspective.
Both measures include opportunity cost of capital, take into account time
value of money and do not suffer from any accounting distortions.
However, NPV and DCF model are not relevant in performance
evaluation since they are exclusively based on cash flows. A benefit of
discounting EVA with free cash flow is the additional insight it provides
being a period by measure. EVA also imposes an added accountability
for capital over only enforces capital discipline and accountability at the
initial approval of capital expenditure. Further, benefit is derived from
power of commonality and focus in using EVA as single financial
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measure for budgeting, capital planning, performance evaluation and

incentive compensation.

NPV of a project provides a standard for assessing its contribution

to value and also can be used to compare relative value among a
selection of investment opportunities. The conventional procedure for
calculating NPV involves discounting of projects forecast with free cash
flows. Typically, as initial investment is made, cash flow is negative.
Then, as benefits are realized, cash flows become positive. The
discounting to present value indicates whether project benefits offset
initial investment and provide value to investors.

Problem with free cash flow approach is that, once invested, the
new capital is mixed with all other assets on the balance sheet. After
that, rarely does the management look back to assess whether actual
returns are in line with forecasts used to justify the project. Also free
cash flow as a single period measure cannot be used in post investment
audits, since it mixes profits and investments and forgets about early
investment. As a result accountability is lost.
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Table 4.3
Differences between EVA and DCF/NPV Models
DCF/NPV Model EVA Model
1. These are generally employed to This is a measure of past and current
analyze the attractiveness of an performance. EVA for past perform-
acquisition activity or when to ance can be used for trend analysis.
divest from business.
2. These measures do not take into This measure takes into consideration
account opportunity cost of capital opportunity cost of capital irrespec-
i.e. expected return to stakeholders. tive of cash flows.
They consider dividend payment
only when paid.
3. Manager’s compensation cannot be Manager’s compensation can be tied
tied to DCE/NPV because these are to achieve EVA as it is a measure of
measures of future expected current and past performance.
performance.
4. These measures do not help in This measure results in coordinated
coordinated working in an working in an enterprise.
enterprise.
5. These measures do not indicate EVA indicates the amount of
whether shareholder value is created shareholders value created or eroded
or not. during a particular period.

Example : Assume, a project with an initial investment of Rs. 100

is expected to create a perpetual free cash flow (FCF) of Rs. 12 every
year. Depreciation is charged at 10% straight line method and the same
amount is reinvested which makes net operating profit after axes
(NOPAT) and FCF same. Let cost of capital be assumed at 10%. Values
given by both these methods are given underneath in Table 4.4:
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Table 4.4
Valuation of Business: EVA and DCF Models
Year 0 1 2 Infinite
FCF (100) 12 12 12
NOPAT 12 12 12
ROIC 12% 12% 12%
WACC 10% 10% 10%
ROIC-WACC 2% 2% 2%
EVA 2 2 2

In DCF model
Value = 12/0.1 = 120
Net Present Value (NPV) = 120 - 100 = 20
In EVA Model
MVA = 2/0.1 = 20
Value = 100 + 20 = 120

Both models give identical results but each has some inherent
advantages over the other. EVA model tells us how much value is added
in better strategic decision making and communication with
shareholders. Moreover, Eva method gives warning signals if major part
of valuation comes from terminal values. This makes EVA a better tool
in capital budgeting and corporate strategy making. On the other hand
DCF model tells about the cash in hand situation. Managers can use this
information to plan the use of excess cash or borrow capital from the
market to meet shortages. This makes DCF a better tool in asset liability
management, financial restructuring and working capital management.
EVA, as pointed out earlier, tells management instantly whether value
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has been added or not without discounting it. A growing EVA figure
shows better management.

EVA and Earning Per Shares (EPS)

Earning Per share (EPS) is a measure relevant to only shareholders.

It is prone to accounting distortions and also, does not capture risk factor
associated with business. The measure simply tells the shareholders how
much each share has earned for them. This means that if the opportunity
cost per share is reduced from EPS, it would give them EVA per share
and a mush better idea of whether the company is creating value or
destroying it. EPS, in isolation, cannot give any information on value
creation. EPS can be increased, simply by investing more capital in
business. If additional capital is equity capital is debt only, EPS will rise
if rate on return on invested capital is more than cost of debt only. In
reality, however, invested capital is generally mix of debt and equity and
EPS will increase if rate of return on additional capital is somewhere
between cost of debt and zero. Therefore, it is completely inappropriate
measure of corporate performance.

Example : Assume, profits available for equity shareholders of a

company for the years 2006, 2007, 2008 were Rs. 150 lakhs and Rs. 200
lakhs respectively. The subscribed capital of the company has remained
constant at Rs. 1000 lakhs (l00 lakhs share of Rs.10 each). The
opportunity cost of capital has also remained constant at 18.50%. If EPS
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is looked in isolation, performance trend would appear as given in Table

4.5.

Table 4.5
Performance Trends : With EPS
Years 2009 2010 2011
Earning for equity 100 lacs 150 lacs 200 lacs
Shareholders
No. of equity shares 100 lacs 100 lacs 100 lacs
EPS Rs. 1.00 Rs. 1.50 Rs. 2.00

The above trend shows that the performance of company is

improving each year. There is no indication of whether value of firm is
being created or not.

If opportunity cost is brought into the picture performance would

look as given in Table 4.6.

Table 4.6
Performance Trend : With EVA
Years 2009 2010 2011
EPS 1.00 1.50 2.00
% Return on Capital 10% 15% 20%
of Rs. 10.0
Opportunity cost of 18.50% 18.50 18.50
capital
EVA -8.50% -3.5% 1.5%

The above trend shows that company’s performance is improving

but in the last two years, it has destroyed value. Only in the year 2011, it
had added value.
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EVA and Return on Investment (ROI)

Rate of return on capital is quite common and a relatively good

performance measure. Different companies calculated this return in
different ways and call it with different names like Return on Investment
(ROI), Return on invested capital (ROIC), Return on capital employed
(ROCE), Return on net assets (RONA), Return on assets (ROA) etc. The
main short coming in all these measures is that the maximizing rate of
return does not necessarily maximize the return to shareholders. As a
relative measure and without risk component, ROI fails to steer
operations completely. Therefore, capital can be misallocated on the
basis of ROI. Firstly, ROI ignores the definite requirement that the rate
of return should be at least equal (if not more) to cost of capita.
Secondly, ROI does not recognize that shareholders wealth is not
maximized when rate of return is maximized. Shareholders want the firm
to maximize the absolute return over and above the cost of capital and
not of capital just because the expected return is less than the present
return. Cost of capital is a much more important hurdle rate than
company’s current rate of return.

In the corporate control, in spite of differences between EVA and

ROI, they both go hand in hand. The former stresses on impact on
shareholders wealth and the latter tell about rate of return. ROI cannot be
abandoned since it is a very good and illustrative measure about rate of
return. However, decisions cannot be based on ROI since maximizing
rate of return does not matter when aim is to maximize return to
shareholders.
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EVA and Return on Net Worth (RONW)

Rate of return on equity (ROE) or net worth (RONW) is again a

function of returns the company’s products and projects generate,
irrespective of its cost of capital. ROE suffers from the same
shortcoming as ROI. Risk component is not included and hence, there is
no comparison. The level of RONW does not tell the owners if company
is creating shareholders wealth or destroying it. With ROE, this
shortcoming is much more than ROI for simpiy increasing leverage can
increase financial risk. As ROI, RONW is also an informative measure
but it should not guide the operations.

Thus, all accounting based rate of returns (ROI, ROE, RONA,

RONW, ROIC etc.) fail to assess true or economic return of a firm
because they are based on historical asset values, which in turn, are
distorted by inflation and other factors. Stewart defined. EVA as after tax
return on beginning capital. EVA is like a corporate nervous system. It
enables organization is to add to its shareholders value and EVA is an
accurate measure of incremental annual shareholder value generated by a
company. By using EVA to evaluate options, a company chooses
strategies that result in maximum addition to shareholder value. This
makes EVA an ideal tool for equity analysis. Also, since EVA
standardizes financial information, it provides common platform for
comparison of companies across the globe. EVA has thus, taken the best
of residual income concept, eliminated the worst of accounting practices
and emerged as a reliable performance metric.

· A performance measure that can be maximized as an objective.

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· It can be used as a metric to evaluate capital budgeting

proposals (it is the only measure of both, performance
evaluation and strategic decision making).

· It integrates effect of profitability and growth into the same

measure.

· It simplifies the concept of profitability which was earlier

complex with traditional measures.

· It unifies the goal of companies and their shareholders.

· It has good correlation with market capitalization (not yet

demonstrated in India).

MARKET VALUE ADDED

EVA is aimed to be a measure of the wealth of shareholders.

According to this theory, earning a return greater than the cost of capital
increase value of company while earning less than the cost of capital
decreases the value. For listed companies, Stewart defined another
measure that assesses if the company has created shareholder value or
not. If the total market value of a company is more than the amount of
capital invested in it, the company has managed to create shareholder
value. However, if market value is less than capital invested, the
company has destroyed shareholder value. The difference between the
company’s market value and book value is called Market Valued Added
or MVA.
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Simply stated,
Market Value Added (MVA)
= Market value of the company – Capital invested in the company
Where,

Market value :- For a public listed company it is calculated as the

number of shares outstanding ´ share price + book value of debt (since
market value of debt is generally not available).

Capital invested :- It is the book value of investments in the

business made up of debt and equity.

Effectively, the formula becomes

MVA = Market value of equity - Book value of equity

According to Stewart, MVA tells us how much value company has

added to or subtracted from its shareholders investments. Successful
companies add their MVA and thus, increase the value of capital
invested in the company. Unsuccessful companies decrease the value of
capital originally invested in the company. Whether a company succeeds
in creating MVA (increasing shareholder value) or not, depends on its
rate of return. If a company’s rate of return exceeds its cost of capital,
the company will sell on stock markets with premium compared to the
original capital and thus, have positive MVA. On the other hand,
companies that have rate of return smaller than their cost of capital, sell
with discount compared to the original capital invested in the company.
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Whether a company has positive or negative MVA depends on the level

of rate of return compared to the cost of capital. All this applies to EVA
also. Stewart has defined relationship between EVA and MVA.

RELATIONSHIP BETWEEN EVA AND MVA

When a business earns a rate of return higher than its cost of

capital, EVA is positive. In other words, investors are earning more than
their investment in that business than they could elsewhere. In response,
investors bid up share prices, increasing the value of their business and
driving up its MVA. Similarly, investors discount the value of businesses
that earn a return below their cost of capital. Thus, in a way, EVA drives
MVA as is shown in Chart 4.2.

Chart : 4.2
EVA drives MVA

Thus, MVA is an estimate made by the investors of the net present

value of all current and expected future investments in the business. In
other words, it can be said that MVA is same as NPV and can be
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calculated as the present values of all future EVAs. Similarly, it can be

the present value of future free cash flows, because discounted EVA and
discounted free cash flows are mathematically equivalents.

From the definition of MVA, value of firm can be expressed as

Market Value = Capital + MVA of firm

However, MVA is the present value of all future EVAs. Therefore,

the value of the firm can be expressed as sum of its capital; current EVA
capitalized as perpetuity and the present value of all the expected future
EVA improvements.

Market Value = Capital + Value of current EVA as perpetuity

+ Present value of expected EVA Improvement

Since, market value is dependent on market implications of all

future performance, market values are sensitive to the changes in current
EVA as well as expected EVA improvement. This results in an
interesting problem for the managements. They need to decide the level
of focus on generating current results and future prospects. The solution
seems to be clear. Management must focus on producing best results
today a while making significant efforts for future simultaneously. The
stress has to be on long term and short term perspective both.
Relationship between MVA and EVA is reflected in Chart 4.3.
 314

Chart : 4.3
Relationship between EVA and MVA

Total Market
Value

In a nutshell, relationship between EVA and MVA can be

summarized as follows:

1. The relationship between EVA and MVA is more complicated

than the one between EVA and he firm value.

2. MVA of a firm reflects not only expected EVA of assets in

place but also expected EVA from future projects.

3. To the extent that the actual EVA is smaller than expected

EVA, the market value can decrease even if EVA is higher.

MVA is, thus, in a way best performance measure because it

focuses on cumulative value added or lost on invested capital. It is the
difference between the capital investors have put in business (cash in)
and the value they could get by selling their claims (cash out). It is a
focus on wealth in dollar or rupees rather than rate of return in
percentage. It, therefore, recognizes all value adding investments even if
than original rate of return.
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PROBLEMS WITH EVA AS PERFORMANCE MEASURE

A better understanding of the concept of EVA requires

understanding of the problems it faces in measuring operating
performance of the company. No performance measure is perfect.
Likewise, EVA has its weaknesses and it is for the companies to realize
that EVA is not the ultimate truth and it does not always tell the amount
of shareholders value created or destroyed. Table gives the overview of
these measurement problems faced by the companies in computation of
EVA.

Table 4.7
Some Measurement Issues in EVA
S. Measurement Issues
No.
1. How to measure the capital invested in assets in place:
Many firms use book value of capital invested. To the degree that book values
reflect accounting choice made over time, this may not be true.
In case where firms alter their capital invested through their operating
decisions (for example, by using operating leases), the capital and after tax
operating income have to be adjusted to reflect true capital invested.
2. How to measure return on capital:
Again, the accounting definition of return on capital may not reflect the
economic return on capital.
In particular, the operating income has to be cleansed of any expenses which
are really capital expenses (in the sense that they create future values). One
example would be R&D.
The operating income also has to be cleanse of any cosmetic or temporary
effects.
3. How to estimate cost of capital:
DCF valuation assumes that cost of capital is calculated using market values of
debt and equity.
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If it is assumed that both assets in place and future growth are financed using
the market value mix, the EV A should also be calculated using the market
value.
Instead, if the entire debt is assumed to be correct by assets in place, the book
value debt ratio will be used to calculate cost of capital. Implicit is then the
assumption that as the firms grow, its debt ratio will come close to book value
debt ratio.

In addition to these measurement problems, EVA computation is

subject to two limitations:

1. Wrong Period sing

EVA is poor in period sing returns of a single investment for. It

under - estimates the return in the beginning and over-estimates at the
end of the period. The companies in the growth phase or business units
with heavy new investments are likely to have current negative EVA
although their true rate of return may be good and so long term
shareholders wealth added (TRUE long term EVA) would be positive.
This is the main criticism of EVA being a short term performance
measure.

2. Distortions caused by inflation, asset structure

EVA, on an average, is also a poor estimator of true underlying rate

of return because historical asset values cannot describe accurately the
current value of assets tied into the business. Being distorted by inflation
and different depreciation schedules etc. Historical values distort EVA
and ROI also. As ROI fails (on an average) to estimate the true return, so
periodic EVA fails to estimate the value added to shareholders.
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Distortions of EVA are more pronounced in cyclic businesses where

peaks and valleys feature in EVA figures. Further, projects in
infrastructure, new product launches with high gestation period have
negative initial EVA figure through NPV of the project may be positive.
Thus, it gives wrong signals about the aggregate company performance.
However, industries with lots of current assets (instead of fixed assets
and with short investment period e.g. banking, food and beverages,
personal computers, retailing and publishing ect.) do not get affected by
these pitfalls since current assets represent the majority of total amount
of assets; so value of assets would be close to current value of capital
tied into the business.

To cope with distortions and eliminate this problem, DE Villiers

(1997) suggests using the current value of assets instead of book value.
The extent of this problem depends very heavily on the assets structure
(how relatively big are the proportions of current, depreciable and non
depreciable assets) and on the average project duration. Thus, the extent
and direction of this problem can be estimated. The EVA targets can be
adjusted accordingly, although it is not an easy task. Also, this problem
is generally small though it does not require too many adjustments. EVA
can be and has been successfully applied in many companies without
any special adjustment to capital base (Birchard 1996). This is also the
way the companies have calculated their ROI for decades without
massive criticism. So far, this distortion in ROI has been widely ignored
 318

although the theoretical weakness in using historical values in

calculating ROI has been acknowledged.

CONCLUSION

In spite of these shortcomings, EVA has turned out to be a better

shareholder’s performance measure than the traditional accounting based
performance metrics. In fact, EVA is regarded as the most accurate
measure of shareholder value creation around the world. Ii is an accurate
reflection of the quantum of incremental value a company generates for
its shareholders after accounting for its cost of operations including cost
of capital. Since creating shareholders value is the basic objective of
every organization, hence the present study has employed this metric for
analyzing post-merger performance of merged firms.
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· Bhalla, V.K. 2000: International Financial Management; Text
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· Bhalla, V.K. 1997: Financial Management and Policy, Anmol

Publication Pvt. Ltd., New Delhi.

· Cowling, Keith, Paul Stoneman and John Gubbin 1980. Mergers

and Economic Performance (UK: Cambridge University Press).

· Ehrbar, A.L. 1998. EVA: Real Key to Creating Wealth, 1st edn.
(New Yourk : John Willey and Sons).

· Kaveri, V.S. 1986. Financial Analysis of Company Mergers in

India (New Delhi: Himalaya Publishing House).

· Kothari, C.R. 1992. Research Methodology: Methods and

Techniques, 2nd edn. (UK: Wiley Eastern Ltd.).

· Rapport Alfred 1986. Creating Shareholders Value: The New

Standard for Business Performance (New York: The Free Press).