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.














COMPUTATION OF EVA

Stewart has used NOPAT( net operating profit after taxes) as a basis for calculating Eva. it is computed by taking the spread between the rate of return on capital & cost of capital & than multiplying it by the economic book value of the capital committed to the business. However many adjustments are required to convert accounting profits to economic measures of profits used in EVA.

STEPS IN INVOLVED IN COMPUTATION OF EVA

EVA is a financial measure that has received a lot of coverage along the style pf ' better than return on investment'.

EVA = Net operating profit after taxes - ( capital x cost of capital)

The ' cost of capital' comes from the weighted average of equity and debt.

EVA is thus net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA aims to estimate the true "economic profit", or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other companies of comparable risk.


NOPAT: (Net operating profit after tax)

NOPAT is an operating performance measurement after taking account of taxation but before financing cost.( interest is excluded). NOPAT requires further adjustments for non cash accounting entries. These adjustments are known as equity equivalents, which are applied in the calculation of NOPAT. Equity equivalents adjust reported earnings to show true economic earnings. NOPAT provides a more realistic measurement of the actual cash yield generated from recurring business activities.

NOPAT is EBIT adjusted for the impact of taxation. The purpose of this is to arrive at taxation on operating income, which is then deducted from EBIT. Interest is totally excluded, as the concept of separating finance from operations must be taken into account.

COST OF CAPITAL

The cost of capital is the combined rate of return required by both lenders and shareholders. It is the minimum acceptable return on economic investments as a cut off rate required for value creation. The cost of capital has four primary applications.

As the discount rate to bring projected free cash flows to its present value.

As the capital charge rate for calculating economic profit (or economic value added).

As a hurdle rate for assessing return on capital employed.
As a minimum target rate for accepting new projects.
The cost of capital is all about the trade off between risk and reward. The greater the risk the greater the required return and the cost of capital.

In short, the cost of capital is the return on capital required to have sufficient funds to pay interest after tax on debt & provide an acceptable return on equity.

COST OF DEBT

The after tax rate the business would have to pay in the current market to obtain new long term debt capital.



COST OF EQUITY
This component of cost of capital is more abstract as it is based upon alternative investment yield of comparable risk. The leading question is how much compensation do investors require over and above the return provided by government bonds to compensate them for bearing the risk.