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Economic Value Added (EVA) was original based on the work of Professors Franco Modigliani and Merton H. Miller.These two finance professors published "Dividend Policy, Growth and the Valuation of Shares",in the Journal of Business in October 1961. The ideas of free cash flow and the evaluation of business on a cash basis were developed in this article. These ideas were extended into the concept of EVA by Bennett Stewart and Joel Stern of Stern, Stewart & Company. Stern Steward has been particularly aggressive in marketing EVA, bold claim concerning merits of EVA, as belows :
"Forget about earnings, earning per share, earning growth, rate of return, dividends and even cash flow. All of them fundamentally flawed measures of performance and value. EVA is all that realer matters" Stewart (1991)
" EVA is almost 50% better than its closest accounting-based competitor in explaining changes in shareholder wealth" Stewart (1994)
"The adoption of EVA is a proven and potential way to increase corporate performance, motivation and market value" Stewart (1997)
Economic value added (EVA) has been getting years using as tool of performance measurement. In a Fortune article entitled "The Real Key to Creating Wealth," the author claims that using EVA can "give you a marked competitive advantage" over the competition (Tully, 1993). Furthermore, the author states that EVA is "today's hottest financial idea and getting hotter." An increasing number of companies are responding to this kind of hype by relying heavily upon EVA to evaluate and reward managers from all functional departments. Hundreds of firm adopting this system like Coca Cola and Postal Service
How important is it to deliver the project on time? Know project progress in real
time? Identify schedule and cost issues before they become problems? Put your
time into project management, not your tracking tools. Earned Value Analysis is the solution: it is the only project management tools that can objectively status schedule and cost performance in real time. EVA creates a "dollars in time" paradigm tracking costs and schedule in an objective, reliable and easy to use model replacing the complex and confusing project deliverables
"Dependent-milestone-antecedent" subjective model. EVA creates a "project at a glance" paradigm with readily understood visual display of quantitative information. (Pierdesign.ca)
2.0 Definition of Economic Value Added (EVA)
Economic Value Added is defined as net operating profit after taxes and after the cost of capital.
(Tully, 1993) Capital includes cash, inventory, and receivables (working capital), plus equipment, computers and real estate. The cost of capital is the rate of return required by the shareholders and lenders to finance the operations of the business. When revenue exceeds the cost of doing business and the cost of capital, the firm creates wealth for the shareholders.
Shareholder value, a key corporate objective of many companies, is achieved when the return from capital employed in the business is greater than the cost of obtaining funds. Traditionally it been measure using accounting ratios such as earnings per share, return on capital employed and return on investment. However, these formulas have been criticized for many reasons, including being backward-looking, open to manipulation or prone to difficulties due to different accounting procedures. EVA has been proposed as a better measure than traditional ratios to assess corporate performance and shareholder wealth creation.Â
EVA = Net Operating Profit - Taxes - Cost of Capital
Economic Value Added (EVA) also can describe as a measure of economic profit. It is because Economic Value Added calculated as the difference between the Net Operating Profit after Tax and the opportunity cost of invested Capital. This opportunity cost is determined by the weighted average cost of Debt and Equity Capital ("WACC") and the amount of Capital employed.
Net Operating Profit After Taxes (NOPAT) is easy to calculate. From the income statement we take the operating income and subtract taxes. Operating income is sales less cost of sales and less selling, general and administrative expenses.
Weighted Average Cost Of Capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources such as common stock, preferred stock, bonds and any other long-term debt are included in a WACC calculation. All else equal, the WACC increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk. Â WACC also describe as average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.Â
Capital EmployedÂ is a total amount of capital used for the acquisition of profits.Â Capital employed is determine as fixed assets plus working capital , equal to total assets less current liabilities and it will show the value of all assets employed in a firm. By "employing capital" it means making investment.
3.0 Unique of Economic Value Added
EVAÂ as the soundest performance metric. What separates EVAÂ®Â from other performance metrics is that it measures all of the costs of running a business-operating and financing. EVA the one most closely aligned with the creation of shareholder value. The fact is EVA and Net Present Value arithmetically tie, so companies can be assured that increasing EVAÂ is always a good thing for its investors and shareholders.
Many firm think that EVAÂ is a better decision tool because it captures the period-by-period value creation or destruction of a given firm or investment, and makes it easy to audit performance against management projections. Given the usefulness of the measure, companies have adopted it as part of a comprehensive management and incentive system that drives their decision processes. Such focus on value creation has served the shareholders of these companies well. Between 1997 and 2007, Stern Stewart & Co.'s EVAÂ®Â adopters have beat broader market indices by a significant margin:
2.1 Relationship Between Economic Value Added and Market Value Added
Market Value Added (MVA) is a tool to measures the difference between the market value of the firm -Debt and Equity, and the amount of Capital invested. The MVA equals the present value of future expected EVA. Firms that trade at premiums to invested Capital have positive MVA, meanwhile those trading below invested Capital have negative MVA. MVA used for measure performance for long run period as using EVA as short-run concept.
Lehn and Makhija (1996), conducted study to see how well EVA and MVA related to share price performance with selected 241 larges USA companies and conducted measures per company for four year. They found out and prove that a greater focus on business activities leads to higher
levels of EVA and MVA and concluded that EVA and MVA are effective performance measures that contain information about the quality of strategic decisions and that serve as signals of strategic change.
Milunovich and Tsuei (1995), investigated the correlation between frequently used financial measures including EVA and the MVA of companies in the US computer technology industry for 5 years since period 1995. The results clearly shows EVA demonstrated the best correlation and it would be fair to infer that a company and able to boost its MVA if consistently improve its EVA therefore its shareholder value.
Stern Stewart & Co. has compiled MVA RankingsÂ to tally wealth creation across the universe of publicly traded firms.
3.0 Methodology of Increase Economic Value Added
The only way to increase EVA is through the actions and decisions of managers. People make the decisions and changes that create value. Companies that use EVA as their financial performance measure focus on operating efficiency. It forces assets to be closely managed. There are three tactics that can be used to increase EVA. Earn more profit without using more capital, use less capital and invest capital in high return projects ( Tully, 1998 )
The main goal is to increase EVAÂ on a sustainable basis. The formula can be accomplished in 4 ways.
The firm can grow the business by investing where the returns exceed the WACC.
The firm can improve the operating efficiencies on its existing Capital, thereby increasing the return on Capital.
A firm can harvest Capital from its losing investments, where the return is less than the WACC and has almost no hope for improving. The harvest funds is disgorged to the shareholders or it is used to make worthwhile investments elsewhere.
The firm can increase its ratio of debt-to-equity when doing so lowers the WACC and doesn't threaten flexibility or survival.
4.0 Theoretical of EVA
Stern et al (ed 2001) suggest that when fully implemented EVA will be centerpiece of an integrated financial management system that incorporates the full range of corporate finance decision making. It argued that advantages can be gain from adoption of EVA based on approach to performance measurement as follows :
a. Profits are shown in then way share holders count them
b. Company decisions are aligned with share holder wealth
c. A financial measure is used that line managers understand
d. The confusion of multiple goals is ended.
Some typical adjustments to net profit and capital employed are required to calculation of EVA to become more accurate. Firstly, net capitalized intangibles are added. Adjustment also need by adding goodwill written off and accounting depreciation such as promotion, training for staff, R&D and others. Additional increasing in provision such as deferred taxation, to apply prudence under conventional accounting practice. Fourth, add back interest on debt capital will avoids the "double-counting" of interest paid on assets financed by debt capital, also consistent with the adjustment to capital employed
5.0 Benefit of EVA
Economic Value Added can help organization by showing the percentage of value will be added to capital employed by forecasting it every year. It clearly shows the relationship between capital budgeting and strategic investment decision. With methodology for subsequent evaluation of actual performance, it helps managers to make decision making about investment, improve the opportunity and strategic long-run and short run that will bring benefits to company.
With Economic Value Added, it automatically produces a goals for management to achieve in order to justify the valuation. It also will improve profits although managers making a further investment in additional capital. It also will help to decide which project are valuable to invest where earning exceed cost of capital.
By forecasting using EVA, the quality of managerial decisions and indicates the value growth in the future. Managers will have good results in term creating additional value with fund capital if the higher the EVA in any year. This powerful overall measurement of management performance is a ideal method for setting goals and target, management incentives and the payment of performance bonuses.
Compute EVA is really easy, by extracting the data from both the income statement and the balance sheet and adjusting it. EVA is also really the discounted free cash flows of a business. It means that a project to be favorably considered, market value added must be positive. On the other hand free cash flow may fluctuate from positive to negative and back again over the life of the project.
EVA will save managerial by dis-invest from projects where the savings on the capital cost exceeds earnings foregone. It can be readily communicated to and understood by operational management. Clearly, it prove that computation of Economic Value Added amounts Economic Value Added creates a meaningful performance measurement which can be used to judge subsequent performance.
Fundamental benefits of EVA:
Early problem identification
Unlinking project performance from tracking technical deliverables
Incredible data density control with readily understandable visual display of quantitative information
6.0 Limitation of EVA
Economic Value Added still has several limitations. Firm didn't believe when the data looks bad. EVA is a real time performance metric tools, all schedule or cost slippage will be presented and common respond is to explain it away as a local anomaly, expected and known, that is the reason, they don't believe that data is bad. EVA tool limitation is not updating with regular cost and percentage complete work assessments because of entering and up-dated data doing at once.
The major problem is hidden early problem identification and using it as explanation. Works Breakdown Schedule also incomplete, when there is hides early problem and improper mid-budget updates. % complete work assessments not discussed with team members leading to increased subjectivity. If assesses work performance % completes then the EVA subjective, often slanted, report. EVA is become very objective and robust when all shareholders contribute to its data. When EVA become ineffectiveness when it be used with other project tracking tools and even link it or equate them.
Economic Value Added is a ideal method and good tool to determine company financial mission and goal. With results from Economic Value Added calculation, top-level manager can predict and create strategy to use in term to more profit and more value for capital in future.
Economic Value Added is a lightweight, flexible, easy to learn tool adaptable for any company. Managerial will able manage to control them all, requires minimal effort to track and report in real time from task to activity levels up to entire project progress. Because of EVA' s objective dollars in time paradigm is valid whether activities are being or yet to be performed immediately and graphically shows budget status, late or early completion all as it begins to happen.
Economic Value Added has a very powerful application in every business entity, irrespective of size or industry in measure of value and performance. It also methodology can be applied to create wealth for the owners of businesses because Economic Value Added forces the organization to make the creation of shareholder value the number one priority
A sustained increase in EVA will bring an increase in the market value of the company because EVA is changing the way managers run their businesses. The value of performance depends on expectations about the future profits of the enterprise. When business decisions are aligned with the interest of the shareholders, it is only a matter of time before these efforts are reflected in a higher stock , found out that stock prices far more closely than they track earnings per share or return on equity. Under the EVA approach stiff charges are incurred for the use of capital. Using EVA will improve the net cash on invested capital because company will concentrate on it.