Management
Accounting
Economic Value Added
(EVA)
Introduction
In corporate finance, Economic Value Added or EVA is a value based financial performance
measure, an investment decision tool and it is also a performance measure
reflecting the absolute amount of shareholders’ value created. It is computed
as the product of the “excess rate of return over the overall cost of capital”
made on an investment or investments and the “capital employed” in that
investment or investments. EVA was developed by the US consulting firm Stern Stewart & Co., and it has
gained widespread use among many well-known companies such as Siemens, Coca
Cola and Herman Miller. EVA is an estimate of a firm's economic profit − being
the value created in excess of the required return of the company’s investors
(i.e. shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less
the cost of financing the firm’s capital. The idea is that value is created when
the return on the firm's economic capital employed is greater than the cost of
that capital.
EVA measures the firm’s ability to earn more than the true cost of capital.
EVA is a measure of economic profit that exceeds investors’ expectations.
Capital is not free. There is an opportunity cost of capital in that
investors can put their money in many places (for instance, into government
bonds, the bank or stock markets). Therefore, it is important to deduct the
cost of capital from the operating profit in order to see the actual
profitability of the enterprise. Capital accounts for both debt and equity.
Capital is a measure of all the cash that has been deposited in a company over
its lifetime, irrespective of its financing source.
Calculating EVA
EVA is net operating profit after taxes (or NOPAT) less a capital
charge, the latter being the product of the cost of capital and the economic
capital. The basic formulas are:
|
EVA = |
(r – c) × K = |
NOPAT – (c × K) |
|
Where: |
|
|
r = |
NOPAT ÷ K [i.e. the rate of return on
capital employed (ROCE)] |
|
c = |
The weighted average cost of capital
(WACC) |
|
WACC = |
[ke × {Ve ÷ (Ve + Vd)}] + [kd × {Vd ÷ (Ve
+ Vd)}] |
|
ke = |
Cost of equity |
|
kd = |
Cost of debt after tax |
|
Ve = |
Book Value of equity |
|
Vd = |
Book value of debt |
|
K = |
The economic capital employed |
|
NOPAT = |
The net operating profit after tax = EBIT × (1 – t) = EAT + [Interest expenses × (1 – t)] |
|
t = |
Tax rate |
|
EBIT = |
Earnings before interest and tax |
|
EAT = |
Earnings after tax |
Positive EVA
indicates that a company surpassed the expectations of its shareholders. On the
other hand, if the EVA is zero, this should be treated as sufficient
achievement of the company because the shareholders have earned a return that
compensates the risk.
NOPAT is
profits derived from a company’s operations after taxes but before financing
costs. It is the total pool of profits available to provide a cash return to
those who provide capital to the firm.
Capital is the amount
of cash invested in the business, net of depreciation. It can be calculated as
the sum of interest-bearing debt and equity or as the sum of net assets less
non-interest-bearing current liabilities (NIBCLs). The cost of capital is the
minimum rate of return on capital required to compensate investors (debt and
equity) for bearing risk.
Normally, the
equity cost of capital for an organisation is measured through the Capital
Asset Pricing Model (CAPM). A firm’s equity cost of capital is the return
investors are seeking to achieve when buying a company’s common (i.e. equity)
shares. As per CAPM, this is expressed as the firm’s equity investors’ expected
future return. Therefore, as per CAPM, the equity cost of capital (ke)
= Risk-free rate of return + the firm’s beta × equity risk premium. Here, beta
(β) is a relative measure of volatility in the market price of the firm’s
equity share, and the equity risk premium represents the excess rate of return
above the risk-free rate of return that the investors demand for holding risky
securities. Therefore, formula for calculating cost of equity share capital
under CAPM can be given as follows:
Formula for calculating cost of equity
share capital under CAPM
|
ke |
= Rf + β (Rm – Rf) |
Where,
|
ke |
= Cost of equity share capital |
|
Rf |
= The rate of return on a risk-free
capital asset or investment like the Treasury Bill / Government Bonds |
|
Rm |
= The expected rate of return on the
market portfolio of equity shares |
|
β |
= The beta
coefficient or, as may be called, beta factor representing the relative measure of volatility in
the market price of the firm’s equity share |
Here, (Rm – Rf) =
Equity market risk premium
So, with a
risk-free rate of 7%, a beta of 1.1 and an assumed equity risk premium of 4%, a
company would have the following cost of equity:
|
Cost of equity (ke) = |
Rf + β(Rm – Rf) = 7% + (1.1 × 4%) = 11.4% |
The cost of debt is the rate of return that the debt-holders require in
order to hold the debts. The cost of debt should be calculated after tax as
follows:
Formula for calculating cost of debt
|
kd |
= (Cost of debt before tax) × (1 – t) |
Where,
|
kd |
= Cost of debt capital |
|
t |
= Tax rate |
Calculation of MVA
The calculation
of MVA is relatively straightforward. It involves subtracting the total capital
invested in the company (equity capital and debt capital) from the current
market value of the company. Therefore, the formula for MVA is as follows:
MVA = Market
Value of the Company − Capital Invested in the Company
The market value
of the company is the total value of the company's equity (market
capitalization) and its debt. The capital invested in the company is the total
equity capital and debt capital provided by investors.
MVA is also the present value of a
series of EVA values discounted using the WACC as the discount rate.
Therefore, the firm's market value added, or MVA, can be calculated
using the following formulas:
|
MVA = |
V – KO = |
∑(t = 1 to ∞)[EVAt
÷ (1 + c)^t] |
|
Where: |
|
|
V = |
Current market value of the company
[i.e total value of the company's equity (market capitalization) and its
debt] |
|
KO = |
Initial investment [i.e. total capital invested in the company (equity capital and debt capital)] |
|
EVA = |
The economic value added |
|
c = |
The weighted average cost of capital
(WACC) |
|
t = |
Time period or a specific year for which
a particular EVA is calculated |
Summary
EVA is a
measure of a company's financial performance based on the residual
wealth calculated by deducting cost of capital from its operating
profit (adjusted for taxes on a cash basis). It is also referred to as economic profit. The formula for
calculating EVA is as follows:
EVA = Net
operating profit after taxes (NOPAT) − (capital employed x cost of capital)
= (ROI − WACC) x
Invested capital
This measure was devised by Stern Stewart &
Co. Economic value added attempts to capture the true economic profit of a company.
MVA as Present value of future EVA
Market value of
a company = Book value of equity (i.e. Capital Invested in the Company) + Present value of future EVA with WACC
as the discount rate
Therefore,
MVA = Market
value of a company − Book value of equity
= (Book value
of equity + Present value of future EVA) − Book value of equity
= Present value
of future EVA with WACC as the discount rate
Part B
Management Accounting
Economic Value Added (EVA)
Selected Problems and Solutions
Illustration: 1
The following
information is available of a concern. Calculate Economic Value Added (EVA).
|
1 |
12%
Debt (Rs) |
2,000
Crores |
|
2 |
Equity
Capital (Rs) |
500
Crores |
|
3 |
Reserves
and Surplus (Rs) |
7,500
Crores |
|
4 |
Risk-free
rate of return |
9% |
|
5 |
Beta
factor |
1.05 |
|
6 |
Market
rate of return |
19% |
|
7 |
Equity
(Market) Risk Premium |
10% |
|
8 |
Operating
profit after tax (Rs) |
2,100
Crores |
|
9 |
Tax
rate |
30% |
Illustration: 2
H Ltd’s
current financial year’s income statement reports its net income as Rs 15,
00,000. H Ltd’s marginal tax rate is 40% and their interest expense for the
year is Rs 15, 00,000. The company has Rs 1, 00, 00,000 of invested capital, of
which 60% is debt.
In addition, H
Ltd tries to maintain a weighted average cost of capital (WACC) OF 12.6%.
Compute –
1)
The
operating income or EBIT earned by H Ltd in the current year; and
2)
The
Economic Value Added (EVA) of H Ltd for the current year.
Illustration: 3
The following information
is supplied by ABC Ltd. for the year ended 31.03.2022:
|
Sl.
No. |
Particulars |
Rs
(in Cr) |
Rs
(in Cr) |
|
1 |
Profit
after tax |
|
205.90 |
|
2 |
Interest |
|
4.85 |
|
3 |
Equity
share capital |
40.00 |
|
|
|
Accumulated
surplus |
700.00 |
|
|
|
Shareholders’ Fund |
740.00 |
|
|
|
Loans (Long Term) |
37.00 |
|
|
|
Total Long Term Funds |
|
777.00 |
|
4 |
Market
capitalisation |
|
2,892.00 |
|
|
|
|
|
|
|
Additional Information: |
|
|
|
(a) |
Risk-free
rate of return |
|
12% |
|
(b) |
Long
term market rate of return |
|
15.5% |
|
(c) |
Effective
tax rate for the company |
|
25% |
|
(d) |
Beta (β) for the last few years: |
|
|
|
|
Year
1: 0.48 |
|
|
|
|
Year
2: 0.52 |
|
|
|
|
Year
3: 0.60 |
|
|
|
|
Year
4: 1.10 |
|
|
|
|
Year
5: 0.99 |
|
|
You are
required to calculate the Economic Value Added (EVA) of ABC Ltd. as on
31.03.2022.
Illustration: 4
XYZ Ltd.
furnishes the following information, from which you are required to calculate
the Economic Value Added (EVA) of the company.
|
1 |
Equity
shares of Rs 1,000 each |
No.
1,58,200 |
|
2 |
12%
Debentures of Rs 10 each |
No.
50,00,000 |
|
3 |
Tax
rate |
30% |
|
4 |
Financial
Leverage |
1.1
times |
|
5 |
Securities
Premium Account (Rs) |
Rs
155 lakhs |
|
6 |
Free
Reserves (Rs) |
Rs
154 lakhs |
|
7 |
Capital
Reserve (Rs) |
Rs
109 lakhs |
It is a prevailing
practice for companies in the industries to which XYZ Ltd. belongs to pay a
dividend of at least 15% p.a. to its equity shareholders.
Illustration: 5
ABC Ltd. has
provided the following data for the financial year ending 31.03.2022:
Balance Sheet as at 31.03.2022
|
Liabilities |
Rs
in lakhs |
Assets |
Rs
in lakhs |
|
Share
capital |
1,000 |
Fixed
assets |
3,000 |
|
Reserves
and surplus |
2,000 |
Investments |
150 |
|
Long-term
debt |
200 |
Current
assets |
100 |
|
Trade
payables |
50 |
|
|
|
|
3,250 |
|
3,250 |
Additional information provided is as
follows:
|
1 |
Profit
before interest and tax (Rs) |
1,000
lakhs |
|
2 |
Interest
(Rs) |
20
lakhs |
|
3 |
Tax
rate |
35.875% |
|
4 |
Risk-free
rate of return |
10% |
|
5 |
Market
rate of return |
15% |
|
6 |
Beta
(β) Factor |
1.4 |
Calculate
Economic Value Added (EVA).
Illustration: 6
Prosperous
Bank has a criterion that it will give loans to companies that have an “Economic
Value Added (EVA)” greater than zero for the past three years on an average.
The bank is considering lending money to a small company that has the economic
value characteristics as shown below. The data relating to the company is as
follows:
1)
Average
operating income after tax equals Rs 25, 00,000 per year for the last three
years.
2)
Average
total assets over the last three years equal Rs 75, 00,000.
3)
Weighted
average cost of capital (WACC) appropriate for the company is 10% which is
applicable for all the last three years.
4)
The
company’s average current liabilities over the last three years are Rs 15,
00,000.
Does the
company meet the bank’s criterion of positive economic value added for a loan?
Solution: 6
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