ECONOMIC VALUE ECONOMIC VALUE ADDEDADDED

OverviewOverview EVA

MVA

Value Based Management & Business Strategy

Drivers of Shareholders Value

Linking VBM to Business Strategy

Keys to Success

EVA focuses on Economic Income EVA focuses on Economic Income – the income generated by the – the income generated by the company net of the investors’ company net of the investors’ required required

return on capital return on capital investedinvested

Popular measure being used by several Popular measure being used by several firms to determine whether an existing firms to determine whether an existing proposed investments positively proposed investments positively contributes to the Owners’ / Shareholders contributes to the Owners’ / Shareholders wealthwealth

EVA is equal to after-tax operating profits of a firm less the cost of funds used to finance the investments.

EVA is equal to after-tax operating profits of a firm less the cost of funds used to finance the investments.

•EVA is equal to after-tax operating profits of a firm less the cost of funds used to finance the investments.

• Combines the accounting and finance frameworks for measuring corporate finance

• In other words a firm adds value for its shareholders, if its return on capital exceeds its cost of capital.

EVAEVA

Capital is the amount of cash invested in 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.

NOPAT is profits, derived from the firm’s operations, after tax but before financing costs non-cash expenses.

To determine the EVA adjustments has to be effected on the published accounts – from the investors point of view traditional calculation of the return on capital is distorted due to accounting conventions

1. Calculate the adjusted capital employed – Equity and Debt + adjustment for items such as cumulative good will associated with acquisition - adjust for amounts charged to Reserves unless the underlying economic value has reduced, R & D expenditure to be treated as capital investment as they will produce revenues in future.

2.   Calculate Net Operating Profit after Tax (NOPAT).

3.     Calculate the company’s Weighted Average Cost of Capital – (WACC).

4.     Multiply the cost of capital by the capital employed to produce a capital charge which is then deducted from the company’s profit.

The positive result indicates that organization is adding EVA for the shareholders

This approach is attractive where This approach is attractive where substantial assets are tied up in substantial assets are tied up in projects,because it simplifies the process projects,because it simplifies the process of value creation to one or more of a few of value creation to one or more of a few

actionsactions..

1. Increasing the operating income from assets in place by reducing costs or increasing sales.

2. Reducing the cost of capital by changing the financing mix.

3. Reducing the amount of capital tied up in existing projects, without affecting operating operating income significantly, by reducing working capital investment and selling unutilized or underutilized assets.

LimitationsLimitations

Does not account for real options (growth opportunities) inherent investment decisions, especially in R & D, whereas a firm’s market value does take this into account. Therefore, growth in EVA becomes more relevant.

For firms with fewer assets is place and large growth opportunities, EVA is not likely to explain the changes in market prices.

MARKET VALUE ADDEDMARKET VALUE ADDEDAn External Measure of how much better off the shareholders as a consequence of management’s performance.

MVA seeks to reflect the decisions of the present management team or the period of a major business decision such as an acquisition takes place.

MVA = Rise in Market Capitalization during the period - Increase in capital invested during the period

VALUE BASED MANAGEMENTVALUE BASED MANAGEMENT

A Methodology that involves managing all aspects of the business in accordance with the desire to create and maximize the wealth of shareholders.

1. Growing concern about the diverse of ownership from control

2. Adoption of VBM techniques by investment analysis

3. Emergence of aggressive shareholders

4. Problems assessing the impact of new management techniques

5. Marketing efforts of management consultants

Areas covered by VBMAreas covered by VBM

Strategy SelectionResource AllocationTarget Setting and Performance MeasurementManagerial Reward SchemesValue ReductionImplementation

DRIVERS OF SHAREHOLDERS DRIVERS OF SHAREHOLDERS VALUEVALUE

Business Value = Present Value of free cash flow from operations plus

value of marketable securities

The amount of cash it is generating which could potentially become dividend and will be the basis of the market capitalization of the business.

The securities or investment held by the company which could be disposed of for cash without affecting operations.

The corporations overall value is arrived by

Shareholders Value =

Business Value - Debt Value

To Increase shareholder value, the To Increase shareholder value, the Management should increase Business Value Management should increase Business Value or reduce Debt.or reduce Debt.

Sale Growth RateOperating Profit MarginCash income tax rateIncremental fixed capital investment rateInvestment in working capital ratePlanning PeriodCost of Capital

LINKING VBM TO BUSINESS LINKING VBM TO BUSINESS STRATEGYSTRATEGY

EVA ignores future forecast earnings. Other approaches to VBM take future earnings into consideration on the grounds that the perceptions investors hold of future earnings will influence the share price and hence MVA.

Market Expectations of future earnings

Investor understanding of firm’s strategy

Investor trust in ability of firm to deliver its strategy

Number of years over which earnings are forecast

Size of forecast earnings

Length of time horizon of strategy

Quality of strategic forecasts

Past experience of firm’s ability to implement strategy

Extent of investor understanding of strategy

Achievement and publications of KPIs

Quality of investor relations