Firms compete with each other for getting the scarce capital from the shayerholders. To be able to get the capital, firm must perform better than those of the competitor. It must earn more than that earned by similar risk seekers. If it can achieve this objective it has created value for the shayerholders and its stock price will command a higher premium in the market. In using the eva system employees on how the capital is being used on the cash flows generated to it. EVA makes managers care about managing assets as well as income, and helps them properly assess the trade off between the two. EVA forces managers to focus on value creating activities rather than wasting time and energy on playing with the accounting principles. EVA based bonus system is based on performance of employees and managers and they rewarded for increasing eva relative to target and they are penalised for falling short. There is no upper limit of bonus. Incentive of employees and managers increase as they keep on increasing EVA relative to target. The EVA is target to set for every year on the basis of a standard acceptable formula. At the beginning of each year, the list of participating employees for the EVA bonus plan is disclosed along with the formula for calculating bonus on the basis of EVA. The formula is so transparent that each eligible employee can calculate his or her bonus without waiting for the authority to announce. The success of EVA lies only when it is linked with compensation plan. EVA would be effective only when the corporate decision makers and even rank and file officers get bonus linked to improvement in EVA.
EVA as a performance measure in corporate world:-
EVA might in some occasions give somewhat misleading signals of the true value added to shayerholders. In spite of this fact EVA has become a very popular performance measure, perhaps because applying it has some powerful impacts on organizational behaviour.
Unlike conventional profitability measures EVA helps the management and also other employees to understand the cost of equity capital. At least in big public companies, which do not have a strong owner, shayerholders have often been conceived as a free source of funds.Similarly, business unit managers often seem to think that they have the right to invest all the retained earnings that their business unit has accumulated although the group wouls have better investment oppoutunities elsewhere. EVA might change the attitude in the sense because it emphasize on the requirement to earn sufficient return on all capital employed.
At best EVA can approach to view business, Perhaps the biggest benefit of this approach is to get the employees and managers to think and act like shayerholders. It emphasize that that in order to justify investments in the long run they have to produce at least a return that covers the cost of capital. In other case the shayerholders would be better off investing elsewhere. This approach includes that the organization tries to operate without lazy or excess capital and it is understood that the ultimate aim of the firm is to create shayerholders value by enlarging the product of positive spread (between return and cost of capital) multiplied with the capital employeed.
Than it would have been without the bonus system. With well designed bonus plan, the higher the bonus that are paid and better it is for the shayerholders. EVA bonus paid is far from a cost to shayerholders because it is often a shayer in the discretionary value created.
STEPS IN IMPLEMENTING EVA
The implementation of EVA are a four step process which includes:
. measurement
management system
motivation
mind set
MEASUREMENT Any company that wishes to implement EVA should institutionalize the
process of measuring the metric, regularly. This measurement should be carried out after carried out the prescribed accounting adjustments.
Management
System The company should be willing to align its management system to the EVA process. The Eva based management system is the basis on which the company should take decision related to the choice of strategy, capital allocation, merger and acquisition, divesting business and goal setting.
Motivation The companies should decide to to implement EVA only if they are prepared to implement the incentive plan that goes with it. An EVA based incentive system, however, encourages managers to operate in such a way as to maximize the EVA, not just of the operations they oversee but of the company as whole.
Mind-set The effective implementation of EVA necessitates a change in the culture and mind set of the company. All constituents of the organization need to be taught to focus on one objective –maximizing EVA. This singular focus leaves no room for ambiguity and also it is not difficult for employees to know just what action of their will create EVA and what will destroy it.
ECONOMIC VALUE ADDED( EVA ) ASSUMPTIONS:
(1) It is assumed that when changing any of the variable (NOPAT), capital investment or cost of capital, the remaining variables remain unchanged.
(2) In the calculation of the change in the earning before interest and tax(EBIT) required to achieve the change in NOPAT as predicted by the model, the income tax rate is assumed to be constsnt. The income tax rate is equal to the income tax divided by EBIT.
(3) The variables that can be controlled for the EVA model are the NOPAT, capital investments(c), and cost of capital(coc). By altering these variables, improvements in EVA can be obtained.
EFFECTIVE STRATEGIC DECISIONS FOR GENERATING EVA
.Establish a clear, unambiguous, definite objective statement, which focuses on generating positive EVA for the firm.
Tapping the various capital resources economically & deciding as to what kind & amount of resources will act as competitive winners for the firm. Key resources are emphasized upon as they act as key contributors to generation of value.
Analysis of present scenario and forecasting the estimation of future environment of financial markets in which the company can procure funds and reinvests itself.
Maximization and protection of returns.
Exhaustive and genuine marketing research to control, estimate and exploit the customer preferences.
Developing the competitive edge for the firm.
Efforts should be taken by the firm to outperform the market.
Overlapping the objectives os the management with that of the investors. Thus the each strategic business decision made by them should focus on value creation achievement.
All business decisions should finally rest on one principle- there should be a trade off between cost of activities & the profits these activities generate.
Create a favourable work environment and work culture for achievement of EVA objectives.
BETTER MEASURE OF FINANCIAL PERFORMANCE
Financial decision making for long has been based on traditional accounting information. For long the financial decision makers estimates & determine the performance of the organization by measuring its profits. These profits are calculated from accounting transactions of the firm for a financial year. Besides financial ratios and other indicators like ROI etc. are also used to indicate the profitability of the firm but as these traditional ratios, profits related to historical earnings they fail to give true picture of the firm in real & futuristic terms. The real picture is that market price of any security issued in the primary market & traded in secondary market is determined by investors & the potential investors perception & expectations of firms securities future earnings. Investors assess the value of any firm on the basis of NPV the firm generates.
Accounting transactions reveal accounting profits. These profits have two major demerits:
. Accounting profits do not add back depreciation. Depriciation is a non cash expense, which is tax deductable hence accounting profits are tax
should add back depreciation to give a real picture of profit.
SIGNIFICANCE OF EVA
The financial innovative technique of Eva is an example of restructuring the traditional economic rationally approach of management decision makers. Term Eva is a registered trademark of stern & stewart &co. It is already understood that business should earn sufficient profits to cover its cost of capital & earn an extra to grow & sustain itself.
According to TULLY:
“EVA is equal to after tax operating profit minus cost of capital”.
Where PAT exceeds cost of capital, positive Eva is created. Where cost of capital exceeds PAT, negative is incurred. Positive Eva is creates economic value for the firm while negative Eva destroy it.
Thus firms positive Eva are making rational decisions& those with negative Eva are destroying capital & are in trouble. Many companies worldwide have adopted this approach such as QUAKER,OATS,AT&T, CSX, COCA COLA, BPL, etc. have even incorporated it into their mission statement.
ADVANTAGES OF EVA
EVA is a superior measure of corporate performance and reflects all the dimensions by which management can increase value. It helps in creation of wealth on the following ground:
.EVA is most directly linked to the creation of sharerholders’s wealth over time.
term “maximizing value” in the EVA context, means maximizing long term yield o on shareholders investment and not just the absolute amount of earnings/ profits.
The mechanism of EVA forces management to expressly recognize its cost of equity in all its decision from the board room to the shop floor. The inclusion of this element in overall cost of capital results into the goal congruence of the managers and owners.
An EVA financial management system removes all the inconsistencies resulting from the use of different financial measures for different corporate functions under the typical traditional financial management system as it ties all the functions for instance.
.Reviewing a capital budgeting process
valuing an acquisition
communicating
EVA compensation system ties management’s interest with those of shareholders.
EVA captures the performance status of corporate system over a broader canvas i.e. To arrive at true profits, cost of borrowed capital as well as cost of equity capital should be deducted from net operating profits. Further to maximize earnings is not sufficient, at the same time consumption of capital should be optimum under an EVA based system.
EVA framework provides a clear perception of underlying economics of a business and enables managers to make better decisions.
A regular monitoring of EVA emphasis on problem areas of a company and helps managers to make better decisions.
It is used to assess the likely impact of competing strategies on shareholder’s wealth and thus helps the management to select the one that will best serve shareholders.
It also fits well with concept of corporate governance. EVA bonus systems do by giving employees an ownership stake in improvements in the EVA of their divisions or operations. This causes employees to behave like owners and reduces or eliminate the need for outside interference in decision making.
EVA also helps in brand valuation. The brand equity or value created by a particular business unit for its brand could be equated with the value of wealth that the brand has generated over a period of time.
EVA as a performance measure in corporate world:-
EVA might in some occasions give somewhat misleading signals of the true value added to shayerholders. In spite of this fact EVA has become a very popular performance measure, perhaps because applying it has some powerful impacts on organizational behaviour.
Unlike conventional profitability measures EVA helps the management and also other employees to understand the cost of equity capital. At least in big public companies, which do not have a strong owner, shayerholders have often been conceived as a free source of funds.Similarly, business unit managers often seem to think that they have the right to invest all the retained earnings that their business unit has accumulated although the group wouls have better investment oppoutunities elsewhere. EVA might change the attitude in the sense because it emphasize on the requirement to earn sufficient return on all capital employed.
At best EVA can approach to view business, Perhaps the biggest benefit of this approach is to get the employees and managers to think and act like shayerholders. It emphasize that that in order to justify investments in the long run they have to produce at least a return that covers the cost of capital. In other case the shayerholders would be better off investing elsewhere. This approach includes that the organization tries to operate without lazy or excess capital and it is understood that the ultimate aim of the firm is to create shayerholders value by enlarging the product of positive spread (between return and cost of capital) multiplied with the capital employeed.
Than it would have been without the bonus system. With well designed bonus plan, the higher the bonus that are paid and better it is for the shayerholders. EVA bonus paid is far from a cost to shayerholders because it is often a shayer in the discretionary value created.
STEPS IN IMPLEMENTING EVA
The implementation of EVA are a four step process which includes:
. measurement
management system
motivation
mind set
MEASUREMENT Any company that wishes to implement EVA should institutionalize the
process of measuring the metric, regularly. This measurement should be carried out after carried out the prescribed accounting adjustments.
Management
System The company should be willing to align its management system to the EVA process. The Eva based management system is the basis on which the company should take decision related to the choice of strategy, capital allocation, merger and acquisition, divesting business and goal setting.
Motivation The companies should decide to to implement EVA only if they are prepared to implement the incentive plan that goes with it. An EVA based incentive system, however, encourages managers to operate in such a way as to maximize the EVA, not just of the operations they oversee but of the company as whole.
Mind-set The effective implementation of EVA necessitates a change in the culture and mind set of the company. All constituents of the organization need to be taught to focus on one objective –maximizing EVA. This singular focus leaves no room for ambiguity and also it is not difficult for employees to know just what action of their will create EVA and what will destroy it.
ECONOMIC VALUE ADDED( EVA ) ASSUMPTIONS:
(1) It is assumed that when changing any of the variable (NOPAT), capital investment or cost of capital, the remaining variables remain unchanged.
(2) In the calculation of the change in the earning before interest and tax(EBIT) required to achieve the change in NOPAT as predicted by the model, the income tax rate is assumed to be constsnt. The income tax rate is equal to the income tax divided by EBIT.
(3) The variables that can be controlled for the EVA model are the NOPAT, capital investments(c), and cost of capital(coc). By altering these variables, improvements in EVA can be obtained.
EFFECTIVE STRATEGIC DECISIONS FOR GENERATING EVA
.Establish a clear, unambiguous, definite objective statement, which focuses on generating positive EVA for the firm.
Tapping the various capital resources economically & deciding as to what kind & amount of resources will act as competitive winners for the firm. Key resources are emphasized upon as they act as key contributors to generation of value.
Analysis of present scenario and forecasting the estimation of future environment of financial markets in which the company can procure funds and reinvests itself.
Maximization and protection of returns.
Exhaustive and genuine marketing research to control, estimate and exploit the customer preferences.
Developing the competitive edge for the firm.
Efforts should be taken by the firm to outperform the market.
Overlapping the objectives os the management with that of the investors. Thus the each strategic business decision made by them should focus on value creation achievement.
All business decisions should finally rest on one principle- there should be a trade off between cost of activities & the profits these activities generate.
Create a favourable work environment and work culture for achievement of EVA objectives.
BETTER MEASURE OF FINANCIAL PERFORMANCE
Financial decision making for long has been based on traditional accounting information. For long the financial decision makers estimates & determine the performance of the organization by measuring its profits. These profits are calculated from accounting transactions of the firm for a financial year. Besides financial ratios and other indicators like ROI etc. are also used to indicate the profitability of the firm but as these traditional ratios, profits related to historical earnings they fail to give true picture of the firm in real & futuristic terms. The real picture is that market price of any security issued in the primary market & traded in secondary market is determined by investors & the potential investors perception & expectations of firms securities future earnings. Investors assess the value of any firm on the basis of NPV the firm generates.
Accounting transactions reveal accounting profits. These profits have two major demerits:
. Accounting profits do not add back depreciation. Depriciation is a non cash expense, which is tax deductable hence accounting profits are tax
should add back depreciation to give a real picture of profit.
SIGNIFICANCE OF EVA
The financial innovative technique of Eva is an example of restructuring the traditional economic rationally approach of management decision makers. Term Eva is a registered trademark of stern & stewart &co. It is already understood that business should earn sufficient profits to cover its cost of capital & earn an extra to grow & sustain itself.
According to TULLY:
“EVA is equal to after tax operating profit minus cost of capital”.
Where PAT exceeds cost of capital, positive Eva is created. Where cost of capital exceeds PAT, negative is incurred. Positive Eva is creates economic value for the firm while negative Eva destroy it.
Thus firms positive Eva are making rational decisions& those with negative Eva are destroying capital & are in trouble. Many companies worldwide have adopted this approach such as QUAKER,OATS,AT&T, CSX, COCA COLA, BPL, etc. have even incorporated it into their mission statement.
ADVANTAGES OF EVA
EVA is a superior measure of corporate performance and reflects all the dimensions by which management can increase value. It helps in creation of wealth on the following ground:
.EVA is most directly linked to the creation of sharerholders’s wealth over time.
term “maximizing value” in the EVA context, means maximizing long term yield o on shareholders investment and not just the absolute amount of earnings/ profits.
The mechanism of EVA forces management to expressly recognize its cost of equity in all its decision from the board room to the shop floor. The inclusion of this element in overall cost of capital results into the goal congruence of the managers and owners.
An EVA financial management system removes all the inconsistencies resulting from the use of different financial measures for different corporate functions under the typical traditional financial management system as it ties all the functions for instance.
.Reviewing a capital budgeting process
valuing an acquisition
communicating
EVA compensation system ties management’s interest with those of shareholders.
EVA captures the performance status of corporate system over a broader canvas i.e. To arrive at true profits, cost of borrowed capital as well as cost of equity capital should be deducted from net operating profits. Further to maximize earnings is not sufficient, at the same time consumption of capital should be optimum under an EVA based system.
EVA framework provides a clear perception of underlying economics of a business and enables managers to make better decisions.
A regular monitoring of EVA emphasis on problem areas of a company and helps managers to make better decisions.
It is used to assess the likely impact of competing strategies on shareholder’s wealth and thus helps the management to select the one that will best serve shareholders.
It also fits well with concept of corporate governance. EVA bonus systems do by giving employees an ownership stake in improvements in the EVA of their divisions or operations. This causes employees to behave like owners and reduces or eliminate the need for outside interference in decision making.
EVA also helps in brand valuation. The brand equity or value created by a particular business unit for its brand could be equated with the value of wealth that the brand has generated over a period of time.
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