What is EVA?

EVA is simply net operating profits after tax, minus a charge for the use of capital employed in the business. The capital charge is the minimum rate of return necessary to compensate shareholders, and lenders for the risk of their investments in a company. Research shows that changes in EVA has a closer correlation to changes in shareholder value, when compared to other metrics like Earnings Per Share (EPS), Earnings Growth, Return on Equity (ROE), and Return on Assets (ROA).

To improve EVA

• Invest in projects that earn more than the cost of capital will help in achieving growth to improve EVA
• Increase profits without using additional capital will help in increasing EVA through productivity improvement.
• Divesting non-strategic assets that do not generate operating profits greater than the cost of capital.

Steps increase EVA

By focusing on EVA, employees throughout an organisation have to make strategic and operating decisions that would increase EVA and in turn, shareholder value. Consider a company ABC Ltd. The significant actions the company has taken in the last 2-3 years include the following:

• Sale of its Metal Services company
• Acquisition of the Kerr brand of home canning products
• Improved operating efficiencies at Plastic Packaging

Operating profits in the Metal services unit had been well below the cost of capital. Long-term prospects in this industry did not show signs of a turnaround. On the other hand, the acquisition and integration of the brand of home canning products provided an opportunity to increase EVA significantly. Improved operating efficiency, combined with reduction in capital employed in Plastic packaging operation in the last two years has contributed to ABC’s recent EVA improvement.

EVA- related incentive compensation

To assure that the management’s interest is in line with that of ABC’s shareholders, the management’s incentive compensation is tied to EVA. ABC’s incentive compensation plan is based on a specific formula. Annual EVA targets are established for each operation based upon the previous year’s actual performance. This target setting approach rewards managers for continuous EVA improvement. It is also consistent with ABC’s long-term value creation strategy.

The Importance of EVA and its Indian Implication

This concept has been picking up in India. Some companies have already made EVA a part of their annual reports-- Infosys Technologies, Hindustan Lever Limited and Dr. Reddy laboratories, to name a few. The reasons for EVA being adopted by only a few companies in India are: -

• There is more than one set of shareholders for Indian companies and the company cannot satisfy one set without displeasing other
• Lack of transparency and consistency in reporting

Calculation of EVA

For calculation of EVA the following elements are needed as inputs: -

Beta (b)

Market Return (Rm)

Risk free rate of return (Rf)

Cost of equity (Ke)

Cost of Debt (Kd)

Weighted average cost of capital (WACC)

Total borrowings

Weightage of debt in total capital employed (Wd)

Weightage of networth in total capital employed (We)

Capital employed = debt + networth (equity + reserve and surplus)

Operating profit before interest and tax (OPBIT)

EXAMPLE

Say,

ß = 0.90

Rm = 19 % = 0.19

Rf = 11 % = 0.11

Using CAPM we can get cost of equity (Ke) = (Rf + b(Rm – Rf))

Ke = 0.11+0. 9 (0.19 - 0.11) = 0.18

Ke = 18 % = 0.18

Kd = 3 % = 0.03

Wd = 11 % =0. 11

We = 89% = 0.89

Now WACC = Ke * We + Kd * Wd

= 0.18 * 0.89 + 0.03 * 0.11

= 16 % = 0.16

Capital employed = 2165 crores.

Tax = 225 crores.

Now, calculation of EVA

Crores

Sales = 1000

Less: crores

Manufacturing cost = 200

Operating cost = 100

Depreciation = 4

304

OPBIT = 696

Less:

Tax = 225

471

WACC (2165 Cr. * .16)= 346

EVA =125