FYP Final Project Report EVA

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A

FINAL PROJECT REPORT

ON

EVA AS A FINANCIAL PERFORMANCE

MEASUREMENT TOOL IN CASE OF SMALL

MEDIUM SCALE ENTERPRISES

In partial fulfillment of the requirement for the degree

Of

Master of Business Administration

Specialization- Finance

Submitted By:

Submitted To:Dr. Navjot Kaur

GIAN JYOTI INSTITUTE OF MANAGEMENT & TECHNOLOGY

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ACKNOWLEDGEMENT

I am extremely thankful to Dr. Navjot Kaur, Project Guide, faculty

member, Gian Jyoti Institute of Management and Technology, for her timely

guidance and support throughout the Final Report work. In the course of

carrying out the Project work she help me out to understand the various

terms and working of economic value added as performance measurement

tool for small & medium scale enterprises.

Finally I am indebted to our other faculty members, my friends who

gave their full-fledged co-operation for successful completion of my project.

It was an indeed a learning experience for me.

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TABLE OF CONTENTS

CHAPTERS PAGE NO.

1. INTRODUCTION 4- 44

2. REVIEW OF LITERATURE 45-51

3. RESEARCH METHODOLOGY 52-61

4. ANALYSIS & DISCUSSION 62-71

5. CONCLUSION 72-73

6. SUGGESTIONS 74-75

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Chapter - 1Introduction

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1.1 Introduction

EVA is a value based financial performance measure, an investment decision tool and a

performance measure reflecting the absolute amount of shareholder value created. It is

computed as the product of the excess return made on an investment or investmentsand the capital invested in that investment or investments. EVA is the net operating

profit minus an appropriate charge for the opportunity cost of all capital invested in an

enterprise or project. It is an estimate of true economic profit, or the amount by which

earnings exceed or fall short of the required minimum rate of return investors could

get by investing in other securities of comparable risk (Stewart, 1990).

EVA is not new. Residual income, an accounting performance measure, is defined to be

operating profit with a capital charge subtracted. Thus, EVA is a variant of residual

income, with adjustments to how one calculates income and capital. Stern Stewart

& Co, a consulting firm based in New York, introduced the concept of EVA as a

measurement tool in 1989, and trademarked it. The EVA concept is often called

Economic Profit (EP) to avoid problems caused by the trade marking. EVA is so popular

and well known that all residual income concepts are often called EVA even though they

do not include the main elements defined by Stern Stewart & Co (Pinto, 2001). Up to

1970 residual income did not get wide publicity and it was not the primeperformance measure for companies (Makelainen, 1998). However, in the 1990s,

the creation of shareholder value has become recognized as the ultimate economic

purpose of a corporation. Firms focus on building, operating and harvesting new

businesses and/or products that will provide a greater return than the firms cost of

capital, thus ensuring maximization of shareholder value. EVA is a strategy

formulation and a financial performance management tool that helps companies make a

return greater than the firms cost of capital. Firms adopt this concept to track their

financial position and to guide management decisions regarding resource allocation,

capital budgeting and acquisition analysis.

Economic Value Added simply balances a company's profitability against the capital it

employs to generate this profitability. If a company's earnings, after tax, exceed the cost

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of the capital employed in the business, EVA is positive. Market studies have indicated

that a company that continually generates an increasingly positive EVA will be rewarded

by a higher stock price. A definition of EVA is net operating profit after taxes (NOPAT),

less an internal charge for the capital employed in the business (i.e., opportunity cost of

capital).

Many of the traditional corporate performance measures have been found to poorly

correlate, or even conflict, with management's primary objective of maximizing the

market value of a firm's stock. Now, there are several new measures in the financial

world that attempt to align the behaviors of an organization with its stockholders'

interests. One measure that has received a great deal of notice and acceptance is

Economic Value Added (EVA), developed by Joel M. Stern and G. Bennett Stewart III ofStern Stewart & Co.

Implementation of one of these measures, such as EVA, can fundamentally change the

behavior of an entire organization. The new measure focuses the behavior of individuals

throughout all parts of the organization in a way that is better aligned with creating

stockholder wealth. Because performance compensation incentives are based upon the

new measure, employees and stockholders mutually benefit.

The financial function is uniquely qualified to take a leadership role in communicating an

understanding of the new measure. Main challenge is to gain a deep understanding of the

underlying principles of the measure and to communicate them in a meaningful way to all

parts of the organization. There can be pitfalls in translating the theory to practice, but

there is an opportunity to provide the appropriate counsel.

Economic Value Added (EVA) has become all the rage in the investing world. Stern

Stewart has gone so far as to trademark the concept, though many academics challenge it

as a knock-off of residual income. Stern Stewart has, however, been very successful

touting the measure as the best measure of business performance and management

discipline. Fortune Magazine annually publishes a list of top companies complete with

and EVA numbers and rankings, crediting the measures for the creation (or destruction)

of shareholder wealth. The Journal of Applied Corporate Finance annually publishes the

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EVA for the Stern Stewart Performance 1000, citing EVA as "the critical driver of a

company's stock performance". Successful corporations are increasingly turning to EVA

to measure performance. General Electric, AT&T, Chrysler, and Compaq use EVA for

financial analysis. Coca Cola's late CEO, Roberto Goizueta, acknowledged the value of

EVA and declared "You only get richer if you invest money at a higher rate than the cost

of the money to you" (Fisher, 1995). In turn, investors and analysts are now scrutinizing

company EVA just as they have historically observed EPS and PE ratios. Academic

articles relating EVA success stories and promoting adoption of the measure abound

(Blair, 1996; Byrne, 1994; Carr, 1996; Copeland and Meenan, 1994; Gressle, 1996; Tully

1993; Stern 1990; Rice, 1996; Pallerito, 1997; Martin, 1996).

As described by Stern Stewart, EVA is net operating profit minus an appropriate chargefor the opportunity cost of all capital invested in an enterprise. In effect, it estimates the

economic profit (or loss) of a company's operations. Traditional accounting measures

such as EPS and ROA measure economic performance, but ignore the cost of the capital.

Including the cost of capital, as EVA does, reveals whether any economic value was

created. This forces management to focus on managing the company's assets as well as

creating income.

How does EVA promote shareholder interests? First, it clearly specifies to management

that the primary financial objective of the company is to create shareholder wealth.

Secondly, it emphasizes continuous improvement in the company's EVA as the basis for

increased shareholder wealth. Assuming the efficient market hypothesis holds, stock

price reflects the company's current performance; therefore, the level of EVA isn't

important, but changes in that level are. Management focus on these two issues can result

in dramatically increasing EVA.

Rising EVA has been purported to cause stock price to rise, therefore satisfying

shareholder interests. Does a relationship between EVA and stock return really exist?

James Meenan, CFO of AT&T's long distance business believes that it does. According

to Meenan, his company's EVA and stock price have had an almost perfect correlation

since 1984 (Fortune, 1993). Detractors are not as enthusiastic. Corporate strategy expert

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Gary Hamel argues that while EVA is a good place to start, it is not an adequate way to

measure a company's wealth creation (Hamel and Lieber 1993). In 1995, Daniel Saint of

Chrysler stated, "as a single period measure of financial performance, I believe EVA's

contribution is minimal and not much different from return on equity or other traditional

accounting measures" (Kramer and Pushner, 1997). In truth, empirical evidence

supporting the relationship between EVA and stock return is sketchy at best.

1.2 Performance Measurement (PM)

Investors measure overall performance of a firm as a whole to decide whether to invest in

the firm or to continue with the firm or to exit from it. In order to achieve goal

congruence, managers compensation is often linked with the performance of the

responsibility centers and also with firm-performance. Therefore selection of the right

measure is critical to the success of a firm. To measure performance of a firm one needed

a simple method for correctly measuring value created/ enhanced by it in a given

time frame. All the current metrics trade off between the precision in measuring the value

and its cost of measurement. In other words, each method takes into consideration the

degree of complexities in quantifying the underlying measure. The more complex is the

process, the more is the level of subjectivity and cost in measuring the performance of

the firm. There is a continuous endeavor to develop a single measure that captures

the overall performance, yet it is easy to calculate.

Each metric of performance claims its superiority over others. Performance of a firm is

usually measured with reference to its past record and the performance of other

firms with comparable risk profile. The various performance metrics currently in use are

based on the returns on investment generated by the business entity . Therefore to

reach a meaningful conclusion, returns generated by the firm in a particular yearshould be compared with returns generated by assets with similar risk profile

(cross sectional analysis). Similarly return on investment for the current period should be

compared with returns generated in past (time series analysis). A firm creates value only

if it is able to generate return higher than its cost of capital. Cost of capital is the

weighted average cost of equity and debt (WACC).

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The performance of a firm gets reflected on its valuation by the capital market. Market

valuation reflects investors perception about the current performance of the firm

and also their expectation on its future performance. They build their expectations

on the estimated growth of the business in terms of return on capital. This

results in incongruence between current performance and the value of the firm. Even

if the current performance is better in relative terms, poor growth prospects adversely

affects the value of the firm. Therefore any metric of performance, to be effective,

should be able to not only capture the current performance but also should be able to

incorporate the direction and magnitude of future growth. Therefore the robustness of a

measure is borne out by the degree of correlation the particular metric has with respect

to the market valuation. Perfect correlation is impossible because as shown by empirical

researchers, fundamentals of a company cannot fully explain its market capitalization;

other factors such as speculative activities, market sentiments and macro-economic

factors influence movement in share prices. However the superiority of a performance

metric over others lies in providing better information to investors.

Metrics of performance have a very important and critical role not only in evaluating the

current performance of a firm but also in achieving high performance and growth in the

future. The metrics of performance have a variety of users, which include all thestakeholders whose well being depends on the continued well being of the firm. Principal

stakeholders are the equity holders, debt holders, management, and suppliers of material

and services, employees and the end-users of the products and services. Value creation and

maximization depends on the alignment of the various conflicting interests of these

stakeholders towards a common goal. This means maximization of the firm value without

jeopardizing the interests of any of the stakeholders. Any metric, which measures the

firm value without being biased towards any of the stakeholders or particular class

of participants, can be hailed as the true metric of performance. However it is difficult, if

not impossible, to develop such a metric. Most of the conventional performance measures

directly relate to the current net income of a business entity with equity, total assets, net

sales or similar surrogates of inputs or outputs. Examples of such measures are return on

equity (ROE), return on assets (ROA) and operating profit margin. ROA measures the

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asset productivity and operating profit margin reflects the margin realized by the firm

at the market place. The net income figure in itself is dependent on the operational

efficiency, financial leverage and the ability of the entity to formulate right strategy

to earn adequate margin in the market place.

It is important to note that none of these measures truly reflect the complete picture

by themselves but have to be seen in conjunction with other metrics. These

measures are also plagued by the firm level inconsistencies in the accounting

figures as well as the inconsistencies in the valuation methods used by

accountants in measuring assets, liabilities and income of the firm. Accounting

valuation methods are in variance with the methods that are being used to value

individual projects and firms. The value of an asset or a firm, which is a collection

of assets, is computed by discounting future stream of cash flows. The net present

value (NPV) is the surplus that the investment is expected to generate over the cost of

capital. Measures of periodical performance of a firm, which is the collection of assets

in place, should follow the same underlying principles. Economic value added (EVA)is

a measure that captures the valuation principles.

Historically, PM systems was developed as a means of monitoring and maintaining

organizational control, which is the process of ensuring that an organization pursues

strategies that lead to the achievement of overall goals and objectives (Nanni, et al 1990).

PM plays a vital role in every organization as it is often viewed as a forward-looking

system of measurements that assist managers to predict the company's economic

performance and spot the need for changes in operations. In addition, PM can provide

managers, supervisors and operators with information required for making daily

judgments and decisions. PM is increasingly used by organizations, as it enables them to

ensure that they are achieving continuous improvements in their operations in order to

sustain a competitive edge, increase market share and increase profits.

1.3 EVA (Economic Value Added)

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EVA (Economic Value Added) was developed by a New York Consulting firm, Stern

Steward & Co in 1982 to promote value-maximizing behaviour in corporate managers

(O'Hanlon. J & Peasnell. K, 1998). It is a single, value-based measure that was intended

to evaluate business strategies, capital projects and to maximize long-term shareholders

wealth. Value that has been created or destroyed by the firm during the period can be

measured by comparing profits with the cost of capital used to produce them. Therefore,

managers can decide to withdraw value-destructive activities and invest in projects that

are critical to shareholder's wealth. This will lead to an increase in the market value of the

company. However, activities that do not increase shareholders value might be critical to

customer's satisfaction or social responsibility. For example, acquiring expensive

technology to ensure that the environment is not polluted might not be of high value from

a shareholder's perspective. Focusing solely on shareholder's wealth might jeopardize a

firm reputation and profitability in the long run.

EVA sets managerial performance target and links it to reward systems. The single goal

of maximizing shareholder value helps to overcome the traditional measure problem,

where different measures are used for different purposes with inconsistent standards and

goal. Rewards will be given to managers who are able to turn investor's money and

capital into profits efficiently. Researches have found that managers are more likely to

respond to EVA incentives when making financial, operational and investing decision

(Biddle, Gary, Managerial finance 1998), allowing them to be motivated to behave like

owners. However this behaviour might lead to some managers pursuing their own goal

and shareholder value at the expense of customer satisfaction.

Unlike simple traditional budgeting, EVA focuses on ends and not means as it does not

state how manager can increase company's value as long as the shareholders wealth are

maximized. This allowed managers to have discretion and free range creativity, avoiding

any potential dysfunctional short-term behaviour. Rewards such as bonuses from the

attainment of EVA target level are usually paid fully at the end of 3 years. This is because

workers' performance is monitored and will only be rewarded when this target is

maintained consistently. Hence, leading to long-term shareholders' wealth.

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For example: Coca-Cola is one of the many companies that adopted EVA for measuring

its performance. Its aim, which was to create shareholders wealth, was announced in its

annual report. Coca-Cola CEO Roberto Goizueta accredited EVA for turning Coca-Cola

into the number one Market Value Added Company. Coca-Cola's stock price increased

from $3 to over $60 when it first adopted EVA in the early 1980s. In 1995, Coca-Cola's

investor received $8.63 wealth for every dollar they invested.

Most companies refer to stock price increase as an outcome of implementing EVA.

However, empirical studies have found that traditional accounting measure have provided

a similar, or even better result in increasing stock performance (Dodd J and Johns J 'EVA

reconsidered').

EVA is a financial measure based on accounting data and is therefore historical in nature.

It has the same limitations as other traditional accounting measures and cannot

adequately replace all measures within the company especially the non-financial ones.

Due to the historical nature of EVA, manager can benefit in terms of rewards or be

punished by the past history of the organization (Otley, David Performance management

1999). Dodd J and Johns J see the balanced scorecard as one approach to overcome the

potential problem of using a single financial measure such as EVA.

1.4 EVA in Indian context

In India EVA is being used with impunity. A case at point is the study published by

Economic times (11th December 2000) ,on corporate performance. While computing

EVA it used a flat rate of 15 percent as the cost of capital of all the enterprises included

in the study. The study explains that an average 15 percent interest for both the

years covered by the study is used as it is almost equal to the prime-lending rate

of the commercial bank and financial institution. It is a basic principle of economics

that higher the risk higher is the expected return. By estimating WACC at 15% this

basic principle is violated. It may be argued that cost of debt should be taken

post-tax and therefore effective cost of equity incorporated in the calculation is higher

than 15 percent. Even if this argument is accepted the computation cannot be defended

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because the cost of capital is estimated without using any accepted economic model.

Moreover by using a flat rate, variation in risk profiles of firms have been ignored.

This shows both the popularity of EVA in India and difficulties in measuring the

same. The study has also ignored adjustments in capital and operating income suggested

by proponents of EVA

1.5 Economic Value Added The Concept

EVA is the most misunderstood term among the practitioners of corporate finance. The

proponents of EVA are presenting it as the wonder drug of the millennium in overcoming

all corporate ills at one stroke and ultimately help in increasing the wealth of the

shareholder, which is synonymous with the maximization of the firm value. The

attractiveness of the EVA lies in its use of cash flow and cost of capital that are

determinant of the value of the firm.

In the process, EVA is being bandied about with utmost impunity by all and

sundry, which includes the popular press. The academic world in its turn has come up

with various empirical studies which either supports the superiority of EVA or questions

the claim of its proponents. Currently the empirical evidence is split almost half way.

EVA is nothing but a new version of the age-old residual income concept recognized by

economists since the 1770's. Both EVA and residual income concepts are based on the

principle that a firm creates wealth for its owners only if it generates surplus over the cost

of the total invested capital. So what is new? Perhaps EVA could bring back the lost

focus on economic surpluses from the current emphasis on accounting profit. In a lighter

vein it can be said that in an era where commercial sponsorship is the ticket to

the popularity of even the concept of god, the concept of residual income has not found a

good sponsor until Stern Stewart and Company has adopted it and relaunched it with a

brand new name of EVA.

Technically speaking EVA is nothing but the residual income after factoring the cost of

capital into net operating profit after tax. But this is only the tip of the iceberg as will be

seen in the next few sections. The paper examines EVA both as a measure of overall

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performance and a management philosophy that helps to improve the productivity

of resources.

Mathematically:

EVA= (adjusted NOPAT - cost of capital) x capital employed----- (I)

Or

EVA = (Rate of return - cost of capital) x capital --------- (II)

Where;

Rate of Return = NOPAT/Capital

Capital = total assets minus non interest bearing debt, at the beginning of the year

Cost of capital = cost of equity x proportion of equity + cost of debt (1-tax rate)

x proportion of debt in the capital.

The above cost of capital is nothing but the weighted average cost of capital (WACC).

Cost of equity is normally estimated using capital asset pricing model (CAPM) that

estimates the expected return commensurate with the riskiness of the assets.

If we define ROI as NOPAT/capital then the above equation can be rewritten as

EVA= (ROI- WACC) x CAPITAL EMPLOYED----- (III)

Capital being used in EVA calculation is not the book capital, capital is defined as an

approximation of the economic book value of all cash invested in going-concern business

activities, capital is essentially a companys net assets (total assets less non-interest-

bearing current liabilities), but with three adjustments:

Marketable securities and construction in progress are subtracted.

The present value of non-capitalized leases is added to net property, plant,

and equipment.

Certain equity equivalent reserves are added to assets:

Bad debt reserve is added to receivables.

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LIFO reserve is added to inventories.

The cumulative amortization of goodwill is added back to goodwill

R&D expense is capitalized as a long-term asset and smoothly depreciated over

5 years (a period chosen to approximate the economic life typical of an investment in

R&D).

Cumulative unusual losses (gains) after taxes are considered to be a long-

term investment.

A firm can motivate its managers to direct their effort towards maximizing the value of the

firm only by, first measuring the firm value correctly and secondly by providing

incentives to managers to create value. Both are interdependent and they complement

each other. Therefore this paper examines the EVA concept from two perspectives, EVA

as a performance measure and EVA as a corporate philosophy.

I shall examine EVA as a performance measure to assess whether it conveys any

additional information to investors over conventional performance measures. In

other words, whether information on EVA leads to better decision by investors.

EVA can lend a helping hand in this connection in two ways: one that it is

inherently flexible and second, it helps generate flexibility within the organization:

1. The EVA concept allows adjustment of various accounting parameters (mentioned in

section on EVA theory) to suit the desired end purpose. There can be various purposes

for which EVA exercise might be carried out such as award of bonus to employees,

relative performance of various divisions, assessment of business as a whole etc. For the

purpose of award of bonus to employees, the focus is on the operational income and

capital employed to generate such income. Various accounting adjustments are made

accordingly. However, for the purpose of assessment of business as a whole, the strategic

investment and its returns also come into picture. While comparing various divisions, the

capital employed and expenses incurred on corporate centre take a back seat Thus, EVA

concept provides flexibility in hands of finance manager in measuring performance. In

the case study discussed later, we have discussed EVA from the point of view of award

of bonus.

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2. Not only is EVA concept inherently flexible, but also it induces flexibility in the

organization. The application of concept forces the organization to release/ free the

excess capital employed. This deployment of excess capital provides the much-required

flexibility to finance manager to improve performance. Since application of concept

questions every decision harder, it forces the managers to keep exploring options and

encourages keeping the system flexible. This effect is more pronounced in companies

which are in distress, and where restructuring is being carried out.

1.5.1 Implementing EVA

Implementing EVA should be more than just adding one line in the monthly profit report.

EVA affects the way capital is viewed and therefore, it might create some kind of change

in management's attitude. Of course this depends on how shareholder-value-focused the

management is and how the company has been in the past. While implementing EVA

represents some kind of change in the organization, it should be implemented with care in

order to achieve understanding and commitment.

It is vital that group level managers thoroughly understand the characteristics of the

concept, how these characteristics affect control and above all where the Strategic

Business Units (SBUs) stand currently from the viewpoint of these characteristics. Beforeimplementing EVA to any SBU, the group management ought to assess whether the

business units are currently cash flow generators in mature businesses or companies in

rapidly growing businesses. This assessment should absolutely include careful estimation

of relative age and structure of assets in order to know whether the current accounting

rate of return is over or under estimating the true rate of return. Only then can the concept

be properly tailored to the unique situation of each individual business unit. Group level

managers should also know how to support strategic goals of SBU with EVA and how to

create value with EVA in individual SBU.

At the level of SBU, gaining understanding and commitment are also the most important

issues. First task is to get the support of all the managers, not only of the Managing

Director but also of directors of production and marketing etc. This is achieved with

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intense and thorough training. For managerial level, attaining thorough commitment can

be facilitated very much by introducing good incentive plan based on EVA.

Gaining commitment of middle level managers and other employees below the top

management of business unit is also important. Training and some kind of EVA based

compensation plans should also be considered with these target groups. Keeping EVA

simple is also viewed as an important feature in successful implementation. In principle,

EVA is simple concept and it should be offered to business units as such.

1.5.2 How Companies Have Used EVA

Name Timeframe Use of EVA

The Coca-Cola

Co.

Early 1980sFocused business managers on increasing shareholder

value

AT&T Corp. 1994 Used EVA as the lead indicator of a performance

measurement system that included "people value added"

and "customer value added"

IBM 1999 Conducted a study with Stern Stewart that indicated that

outsourcing IT often led to short-term increases in EVA

Herman Miller

Inc.

Late 1990s Tied EVA measure to senior managers' bonus and

compensation system

4 Ms of EVA

As a mnemonic device, Stern Stewart describes four main applications of EVA with four

words beginning with the letter M.

Measurement

EVA is the most accurate measure of corporate performance over any given period.

Fortune magazine has called it "today's hottest financial idea," and Peter Drucker rightly

observed in the Harvard Business Review that EVA is a measure of "total factor

productivity" whose growing popularity reflects the new demands of the information age.

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Management System

While simply measuring EVA can give companies a better focus on how they are

performing, its true value comes in using it as the foundation for a comprehensive

financial management system that encompasses all the policies, procedures, methods andmeasures that guide operations and strategy. The EVA system covers the full range of

managerial decisions, including strategic planning, allocating capital, pricing acquisitions

or divestitures, setting annual goals-even day-to-day operating decisions. In all cases, the

goal of increasing EVA is paramount.

Motivation

To instill both the sense of urgency and the long-term perspective of an owner, Stern

Stewart designs cash bonus plans that cause managers to think like and act like owners

because they are paid like owners. Indeed, basing incentive compensation on

improvements in EVA is the source of the greatest power in the EVA system. Under an

EVA bonus plan, the only way managers can make more money for themselves is by

creating even greater value for shareholders. This makes it possible to have bonus plans

with no upside limits. In fact, under EVA the greater the bonus for managers, the happier

shareholders will be.

Mindset

When implemented in its totality, the EVA financial management and incentive

compensation system transforms a corporate culture. By putting all financial and

operating functions on the same basis, the EVA system effectively provides a common

language for employees across all corporate functions. EVA facilitates communication

and cooperation among divisions and departments, it links strategic planning with the

operating divisions, and it eliminates much of the mistrust that typically exists between

operations and finance. The EVA framework is, in effect, a system of internal corporate

governance that automatically guides all managers and employees and propels them to

work for the best interests of the owners. The EVA system also facilitates decentralized

decision making because it holds managers responsible for-and rewards them for-

delivering value.

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1.5.3 The EVA Concept of Profitability

EVA is based on the concept that a successful firm should earn at least its cost of capital.

Firms that earn higher returns than financing costs benefit shareholders and account for

increased shareholder value. In its simplest form, EVA can be expressed as the following

equation:

EVA = Net Operating Profit after Tax (NOPAT) - Cost of Capital

NOPAT is calculated as net operating income after depreciation, adjusted for items that

move the profit measure closer to an economic measure of profitability. Adjustments

include such items as: additions for interest expense after-taxes (including any implied

interest expense on operating leases); increases in net capitalized R&D expenses;

increases in the LIFO reserve; and goodwill amortization. Adjustments made to operating

earnings for these items reflect the investments made by the firm or capital employed to

achieve those profits. Stern Stewart has identified as many as 164 items for potential

adjustment, but often only a few adjustments are necessary to provide a good measure of

EVA.

Recently, the Economic Valued Added method has gained attention worldwide. This

method is intuitively appealing and measures profitability in the way shareholders define

it.

Economic Value Added calculates the actual dollar amount of a business's wealth created

or destroyed in each reporting period. It takes into account the opportunity cost (the

minimum acceptable compensation for investing in a risky asset as opposed to a less

risky market instrument like government bonds) of the company's capital investment and

measures the excess returns over this charge.

A positive Economic Value Added indicates that value is being created; so adding to the

intrinsic value of the company by that amount. A negative Economic Value Added, on

the other hand, indicates that value is eroded and the company is now worth less than the

initial capital employed.

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Measurement of EVA

Measurement of EVA can be made using either an operating or financing approach.

Under the operating approach, NOPAT is derived by deducting cash operating expenses

and depreciation from sales. Interest expense is excluded because it is considered as afinancing charge. Adjustments, which are referred to as equity equivalent adjustments,

are designed to reflect economic reality and move income and capital to a more

economically-based value. These adjustments are considered with cash taxes deducted to

arrive at NOPAT. EVA is then measured by deducting the company's cost of capital from

the NOPAT value. The amount of capital to be used in the EVA calculations is the same

under either the operating or financing approach, but is calculated differently.

The operating approach starts with assets and builds up to invested capital, including

adjustments for economically derived equity equivalent values. The financing approach,

on the other hand, starts with debt and adds all equity and equity equivalents to arrive at

invested capital. Finally, the weighted average cost of capital, based on the relative values

of debt and equity and their respective cost rates, is used to arrive at the cost of capital

which is multiplied by the capital employed and deducted from the NOPAT value. The

resulting amount is the current period's EVA.

1.6 There are eight steps involve in applying Economic Value Added to value a

company:

Step 1: Determining a period of financial projection. To calculate returns on capital

employed, we first need to estimate the company's earnings; for instance, in the next five

years to 2016. The earnings projection is based on a set of assumptions for future volume

sales growth, finished product prices, government duties and inflation.

Step 2: Net operating profit after tax (NOPAT): Net operating profit after tax is

equivalent to the after tax earnings generated by the company (excluding interest

expense). The financing of asset (interest expense) is assumed to be independent of

operating results and is instead reflected in the company's cost of capital.

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Step 3: Initial capital employed: The total capital employed at the beginning of each year

is the assets base from which earnings for the year are generated.

Capital employed = Net fixed assets + Working capital

Step 4: Return on capital employed (ROCE) the yearly returns on capital employed are

determined by dividing NOPAT by capital employed at the beginning of each year.

ROCE = NOPAT Capital employed

Step 5: Weighted average cost of capital (WACC) after calculating the Returns on

Investment (ROI), match them to the cost of capital. The most commonly used cost of

capital is the WACC, which is based on the company's debt equity capital structure.

WACC = Weighted cost of equity + Weighted after tax cost of debt

After tax cost of debt = [Interest payment x (1-tax rate)] Total borrowings

How big a risk premium required for investing in a company is dependent on how risky

the stock is relative to the broad market; which known as correlation beta. A high beta

implies the stock price is more volatile than the broad market. Therefore, an investor

should require a higher than market average return to compensate for the additional risks.

Conversely, a low beta implies that the stock returns will lag a market rally but will be

more resilient during a sell down.

Step 6: Excess returns over cost of capital

Excess returns (ER) = ROCE - WACC

Step 7: Economic Value Added and Market Value Added (MVA)

Economic Value Added = ER x Capital employed

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Beyond the projected period of 2016, impute a terminal value (perpetuity); on the basis

that the company is an ongoing business concern (for the stream of future Economic

Value Added, assuming a constant yearly growth of 1%).

The stream of Economic Value Added is then discounted back to present day values

using the WACC calculated previously, the sum of which is the positive value created by

the company's business operations.

MVA = Sum of present value of Economic Value Added stream.

Step 8: Intrinsic value and shareholder value. The intrinsic value for the company is its

initial capital employed enhanced by the positive value created.

Intrinsic market value = Initial capital employed + MVA

And finally,

Shareholder value = Intrinsic market value - Net debt

Fair value per share = Shareholders' value Number of shares

The company's primary objective would be to maximize Economic Value Added; which

is not necessarily the same as maximizing profits. If the return on an investment is below

its cost of capital, then the company prefers not to make the investment at all (even if the

absolute magnitude of profit is increased).

1.6.1 EVA Calculation and Adjustments

As stated above, EVA is measured as NOPAT less a firm's cost of capital. NOPAT is

obtained by adding interest expense after tax back to net income after-taxes, because

interest is considered a capital charge for EVA. Interest expense will be included as part

of capital charges in the after-tax cost of debt calculation.

Other items that may require adjustment depend on company-specific activities. For

example, when operating leases rather than financing leases are employed, interest

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expense is not recorded on the income statement, nor is a liability for future lease

payments recognized on the balance sheet. Thus, while interest is implicit in the yearly

lease payments, an attempt is not made to distinguish it as a financing activity under

GAAP.

Under EVA, however, the interest portion of the payment is estimated and the after-tax

amount from it is added back into NOPAT because the interest amount is considered a

capital charge rather than an operating expense. The corresponding present value of

future lease payments represents equity equivalents for purposes of capital employed by

the firm, and an adjustment for capital is also required.

R&D expense items call for careful evaluation and adjustment. While GAAP generally

requires most R&D expenditures to be expensed immediately, EVA capitalizes

successful R&D efforts and amortizes the amount over the period benefiting the

successful R&D effort.

Other adjustments recommended by Stern Stewart include the amortization of goodwill.

The annual amortization is added back for earnings measurement, while the accumulated

amount of amortization is added back to equity equivalents. Goodwill amortization is

handled in this manner because by "unamortizing" goodwill, the rate of return reflects thetrue cash-on-yield. In addition, the decision to include the accumulated goodwill in

capital improves the real cost of acquiring another firm's assets regardless of the manner

in which the acquisition is accounted.

While the above adjustments are common in EVA calculations, according to Stern

Stewart, those items to be considered for adjustment should be based on the following

criteria:

Materiality: Adjustments should make a material difference in EVA.

Manageability: Adjustments should impact future decisions.

Definitiveness: Adjustments should be definitive and objectively determined.

Simplicity: Adjustments should not be too complex.

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If an item meets all four of the criteria, it should be considered for adjustment. For

example, the impact on EVA is usually minimal for firms having small amounts of

operating leases. Under these conditions, it would be reasonable to ignore this item in the

calculation of EVA. Furthermore, adjustments for items such as deferred taxes and

various types of reserves (i.e. warranty expense, etc.) would be typical in the calculation

of EVA, although the materiality for these items should be considered. Unusual gains or

losses should also be examined and eliminated if appropriate. This last item is

particularly important as it relates to EVA-based compensation plans.

1.6.2 EVA at Work

Although economic value added is considered to be the kingpin of value-based metrics, it

won't work in an organization if a CEO doesn't force implementation throughout the

company or if incentive-based compensation isn't offered. And a pure EVA bonus plan

won't necessarily work at the middle and lower levels of a company, making it difficult to

preach the EVA gospel throughout an organization.

Stern Stewart & Co., a New York-based financial consulting firm which has trademarked

the term EVA, promotes the idea that economic value added is a financial performance

measure that comes closer than any other to capturing the true economic profit of anenterprise. "The formula for EVA looks formidable, but it's really not," says Stern

Stewart vice president Tom Leander. "EVA is net operating profit minus an appropriate

charge for the opportunity cost of all capital invested in an enterprise. In simple terms,

EVA equals net operating profit after taxes we use the acronym NOPAT."

Stern Stewart calculates what the economic value added for a company is and then

decides from what business centers the EVA will be calculated. Once the measurement is

made, the firm works with the finance department to show employees how EVA can be

used as an internal measure. The next and most obvious step is tying that measurement to

incentive compensation.

"Under classic economic theory, a problem exists in that managers' interests are not

aligned with the interests of the owners," Leander says. "But one of the aspects of EVA is

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that managers must think and act like owners of the company. The underlying principle

here is that unless managers are motivated to think and feel like they're owners of the

company, they're not going to create value in a way that benefits shareholders."

EVA is about working smarter, not harder. It's about doing such things as reducing the

number of steps in a work process, reducing cycle times or scrutinizing business

expenses. Economic value added can be improved in three basic ways:

1. Growth: Invest in projects that earn more than the cost of capital. For example,

investing in personal computers, which frequently increase efficiency and justify

a minimal investment?

2. Improved productivity: Increase profits without using additional capital and/or

eliminate business expenses which can help improve income.

3. Divestiture: Eliminate non-strategic assets that do not generate operating profits

greater than the cost of capital. Examples include the reduction of inventory levels

and speeding up cycle times. Many companies which use EVA have found this to

be the most attractive method.

According to Stern Stewart, a key to weaving EVA into the corporate culture is to make

it the focal point for reporting, planning and decision-making. To do that requires twothings: The first is recognizing that, because economic value added is a measure of total

factor productivity, it can and should supersede other financial and operating measures,

resulting in a hierarchy as opposed to a balanced scorecard. The balanced scorecard

results when financial numbers are not the only consideration used to make strategic

decisions. For example, if you're manufacturing a product, a balanced scorecard weighs

factors such as financial impact, quality, customer satisfaction and productivity. If EVA

is merely added to a list of many other performance measures, confusion and unnecessary

complexity will remain. The second requirement is that EVA be incorporated into

decision-making processes.

The fact that such high-profile companies as The Coca-Cola Co. and Briggs & Stratton

have achieved considerable success through the implementation of EVA has prompted a

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wave of companies to at least consider the strategy. "You have thought leaders in the

marketplace who are touting this much as they would reengineering," says Tom Hertog,

manager of Chicago-based Arthur Andersen Global Best Practices.

"When people come to us, they're looking for the magic bullet, but as is the case with

benchmarking and best practices, there is a whole host of approaches and no single

solution. But the appropriate and consistent application of EVA methodology will yield

results, regardless of what size company you are or what industry you're in."

Arthur Andersen promotes a four-step process for organizations that want to undertake an

economic value added program:

1. Calculation or formulation: How does one measure the return on capital minus the

cost of capital? This is where most of the focus is directed. Certain aspects of the

EVA calculation include determining the number of capital adjustments, the

number of cost of capital factors, the number of cost centers calculating EVA, and

the number of NOPAT (net operating profit after taxes) adjustments

2. Application: How does one apply EVA in his/her organization, in that particular

line of business? For example, if you're a service organization and you don't have

a tangible product, you still need a performance measurement tool such as EVA todetermine the increase or decrease of value. It's important to set a goal for

increasing EVA as expressed as a percentage for the next 12 months, the next one

to three years, and the next three to five years.

3. Implementation or integration: How does one make EVA part of their

organizational culture? This step includes determining the extent of training

needed for management and staff, the methods by which EVA will be

communicated throughout the company, and the time it will take for

implementation at various levels in the organization.

4. Interpretation or correlation: How will EVA impact the future of company?

Organizations obviously want to focus on positive change and sometimes use

MVA (market value added) as a measure of interpretation. MVA can be measured

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by taking the current market value placed on the company as reflected in its stock

price and then subtracting the capital invested on the balance sheet.

"It comes down to ABO awareness, buy-in, and ownership," Hertog says. "One or two

people will rise to the champion level and take ownership and drive it. The business unit

controllers will need to get that message from the CFO that they're going to do EVA. The

way you introduce it and integrate it is absolutely critical for it to gain acceptance.

Otherwise, it never happens

1.7 EVA vs. Traditional Performance Measures

The development of the concept of EVA has added flexibility in measurement of

performance. The traditional methods can continue side by side with EVA. Some of the

traditional ways of measuring corporate performance are described here.

1.7.1 Return on Investment (ROI)

Return on capital is a very good and relatively good performance measure. Different

companies calculate this return with different formulae and call it also with different

names like return on invested capital, return on capital employed, return on net assets,

return on assets etc. The main shortcoming with all these rates of return is that in all cases

maximizing rate of return does not necessarily maximize the return to shareholders.

Following example will clarify this statement:

Suppose a group has two subsidiaries X and Y. For both subsidiaries and so for the whole

group the cost of capital is 10%. The group has maximizing ROl as its target. Subsidiary

X has ROl of 15% and the other has ROl of 8%. Both subsidiaries begin to struggle for

the common target and try to maximize their respective ROIs. Company X rejects all the

projects that produce a return below the current 15% although there would be some

projects with return 12-13%. Y, in turn, accepts all the projects with return above 8%. For

a reason or another, it does not find very good projects, but the returns of its projects lie

somewhere near 9%.

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Suppose that both subsidiaries manage to increase their ROI. The ROI of subsidiary X

increases from 15 to 16% and that of Y increases from 8 to 8.5%. The company's target

to increase ROI has been achieved, but what about the shareholder value. It is obvious

that all the projects of subsidiary Y decrease the shareholder value, because the cost of

capital is more than rate of return (and so the shareholders money would have been better

off with alternative investments). The actions of the better subsidiary are not optimal for

shareholders. Of course shareholders will benefit from the good projects with return

greater than 15% but also all the projects with returns of 10-14% should have been

accepted even though they decrease the current ROl of subsidiary X. These projects still

create and increase the shareholder value.

Hence, the capital can be misallocated on the basis of ROl. ROl ignores the definiterequirement that the rate of return should be at least as high as cost of capital. Further,

ROI does not recognize that shareholder's wealth is not maximized when the rate of

return is maximized. Shareholders want the firm to maximize the absolute return above

the cost of capital and not to increase percentages.

1.7.2 Return on Equity (ROE)

The level of ROE does not tell the owners if company is creating shareholders' wealth ordestroying it. With ROE, this shortcoming is much more severe than with ROI, because

simply increasing leverage can increase the ROE. In other words, decreasing solvency

does not always make shareholders' position better because of the increased financial

risk.

1.7.3 Earning per Share (EPS)

EPS is raised simply by investing more capital in business. If the additional capital is

equity (retained earnings) then the EPS will rise if the rate of return of the invested

capital is just positive. For example, let us assume that as on March 31, 2009, company A

has net worth of Rs 50 million and 5 million equity shares. At a profit after tax of Rs 100

million for FY 2009, the EPS would work out to be 20. The entire income can be

ploughed back in the business at a marginal return of 5%. Assuming that the return on

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previous net worth remains the same, the profit after tax would be Rs 105 million and

EPS would be 21. Though the performance has gone down, the EPS has increased.

If the additional capital is debt then the EPS will rise if the rate of return of the

invested capital is just above the cost of debt. In reality, the invested capital is a mix of

debt and equity and the EPS will rise if the rate of return on the additional investment is

somewhere between the cost of debt and zero. Therefore EPS is completely inappropriate

measure of corporate performance and still is very common yardstick and even a

common bonus base.

Unlike conventional profitability measures, EVA helps the management and other

employees to understand the cost of equity capital. At least in big companies, which do

not have a strong owner, shareholders have often been perceived as free source of funds.

These flaws are taken care of by the concept of economic value added. The key feature of

this concept is that for the first time any measure takes cares of the opportunity cost of

capital invested in business.

1.8 The Utility of EVA: Better Decision-Making

EVA clarifies the concept of maximizing the absolute returns over and above cost of

capital in creating shareholders' wealth. Hence better investment decisions can be taken

with above aim rather than maximizing percentage of ROl. Understanding of EVA

enables monitoring of investment decisions closely not only at the level of corporate but

at line staff as well.

Fosters New Era of Corporate Control

EVA points / centres can be created within an organization and these centres would have

capital, revenue and expenditure issue attached to them. It helps identify value drivers

and destroyers. Responsibility of positive EVA can be delegated at these centres. It

questions the decisions harder.

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Long-Term Thinking

Perhaps the biggest benefit of this approach is to get employees and managers to think

and act like shareholders. EVA encourages long-term perspective among the managers

and employees of organization. It emphasizes 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 shareholders would be better off investing elsewhere. This approach includes

that the organization tries to operate without the luxury of excess capital and it is

understood that the ultimate aim of the firm is to create shareholder value by enlarging

the product of positive spread multiplied with capital employed. The approach creates a

new focus on minimizing the capital tied to operations. Firms have so far done a lot in

cutting costs but cutting excess capital has been paid less attention.

Capital Allocation Tool

EVA is a capital allocation tool inside a company as it sets minimum level of acceptable

performance with regard to the rate of return in the long run This minimum rate of return

is based on average (risk adjusted) return on equity markets. The average return is a

benchmark that should be reached. If a company cannot achieve the average return, then

the shareholders would be better off if they allocated the capital to another industry oranother company.

Bonus System

EVA has provided a platform on which a flexible bonus payment system can be

based. Employees will be paid bonus only when they earn at least equal to the cost of

capital employed. This links the bonus with the end result and forces employees to act

like shareholders. Proponents of bonus systems based on EVA have suggested thatbonuses for corporate managers should always be tied to the long-term capital because

short-term EVA can sometimes be manipulated upwards to the cost of long run EVA The

long run can be incorporated into EVA-based bonuses, that is, by banking the bonuses.

This would mean that when EVA is good, the managers earn a certain percentage of it,

but the bonus should not be paid out of them entirely. If the periodic EVA is negative,

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then the bonus put in the bank is negative and it decreases the balance already earned.

This exposes the managers partly to the risk the shareholders are used to bear. At the

same time, it gives incentives to good performers and encourages the bad performers to

improve their performance.

For example, manager earns a bonus of an amount X of the annual salary for leading its

centre to a positive EVA to the extent of 10% of capital employed. Out of the entire

bonus, 50% can be paid out and the rest can be banked as entitlement if the next year

EVA is not negative. In case the EVA next year is negative, the banked bonus can be

reduced as disincentive for bad performance.

Flexibility in EVA

Today's business environment is marked by presence of a lot of change drivers like

globalization, an intense competition, etc and the uncertainty surrounding them has

created chaos and confusion in organizations. Consequently, flexibility has assumed key

role in every facet of organization management and finance function, known for its

rigidity, is not too far from application of this paradigm.

1.9 Small and Medium Enterprises (SMEs)

Small and Medium Enterprises (SMEs) are considered engines for economic growth, not

only in India but all over the world. Small and medium enterprises have played a vital

role in the growth of the Indian economy. Small Scale Industry has a 40% share in

industrial output, producing over 8000 value-added products. They contribute nearly 35%

in direct export and 45% in the overall export from the country. They are one of the

biggest employment-providing sectors after agriculture, providing employment to 28

million people. They account for 80% of global economic growth.

Market conditions have dramatically changed for Indian SMEs after economic reforms.

SMEs are regularly facing new challenges in terms of cost, quality, delivery, flexibility

and human resource development for their survival and growth. In the context of a

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dynamic market scenario, they have to formulate their strategies for developing various

capabilities and competencies to satisfy their domestic as well as global customers.

For long-term competitiveness, SMEs have to focus on all aspects of organizational

functions such as assets, strategy development, processes and their performance. In

Punjab the SMEs have not been growing at the pace at which they should have been as

they have been facing a lot of problems.

Small Scale industrial undertaking is defined as an industrial undertaking in which the

investment in fixed assets in plant and machinery whether held on ownership terms on

lease or on hire purchase does not exceed Rs.50 million (Subject to the condition that the

unit is not owned, controlled or subsidiary of any other industrial undertaking). Small andmedium-size enterprises (SMEs) in India play an important role in generatingemployment and creating economic wealth. Small-scale industries play a key role in the

industrialization of a developing country. This is because they provide immediate large-

scale employment and have a comparatively higher labor-capital ratio; they need lower

investments, offer a method of ensuring a more equitable distribution of national income

and facilities an effective mobilization of resources of capital and skill which might

other-wise remain unutilized.

Table1: Small Scale Industry of Punjab: A Brief Profile (2009 10)

No. of Registered SSI

Units1,97,340

Employment 8,54,000

Fixed Investment (Rs

mn)34,050

Production (Rs mn) 1,50,000

Predominant

Industries

Metal Products, Leather and Products, Textile and Hosiery, Non-electrical Machine Tools & Parts, Food Products

Major Issues Need for Infrastructural facilities, Need for working capital, Needfor marketing infrastructure

The small scale sector has stimulated economic activity of a far reaching magnitude

and has played a significant role in attaining the following major objectives;

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1. Elimination of economic backwardness of rural and underdeveloped regions in the

country.

2. Attainment of self-reliance

3. Reduction of regional imbalance.

4. Reduction of disparities in income wealth and consumption.

5. Mobilization of resources of capital and skills and their optimum utilization.

6. Creation of greater employment opportunities and increase output, income and

standards of living

7. Meeting a substantial part of the economys requirements for consumer goods and

simple producer goods

8. Provide employment and a steady source of income to the law-income groups living in

rural and urban areas of the country

9. Provide substitutes for various industrial products now being now being imported into

the country.

10. Improves the quality of industrial products manufactured in the cottage industry

sector and to enhance both production and exports.

The development of these industries would be beneficial to the developing countries and

assist them in improving their economic and social well-being. This would create greater

employment opportunities and assist in entrepreneurship and skills development and

ensure better use of the scarce financial resources and appropriate technology. India is

ranked among the ten most industrialized countries in the world. The country has derived

its economic strength from the growth of small-industries throughout its length and

breadth. The pivotal role the small industry play in the economy of India can be judged

by looking at the statistical data; more than 55% of total production in country today is

from small-scale sector.

1.9.1Scope of small-scale industry

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The importance of small-scale enterprises is a global phenomenon encompassing both the

developing and developed countries. Globally, the emphasis is on the small-enterprises

holding the key to growth with equity and proficiency. In India, small industry refers to

manufacturing activity. Recently it has also included servicing activities such as repair

and maintenance shops and few community services. This sector covers over 7500 items

involving very simple to highly sophisticated technologies and offering opportunities for

the utilization of local resources and skills, the sector has emerged as a major supplier of

a variety of products for mass consumption as well as parts and components to the large

industry sector. Apart from handicrafts and other traditional products, small-scale

manufacture some of the high value-added and sophisticated products like electronic

typewriters, survey equipment, security and fire alarm system, television sets and other

consumer durables. Many such products are used as original equipment items by the

manufacturers in the large industry sector. The sector has the flexibility of responding to

varied needs of the economy.

1.9.2 Characteristics of small-industries

1. Capital investment is small

2. Most have fewer than 20 workers

3. Located in rural and semi-urban areas

4. Virtually all of these firms are privately owned and are organized as sole

proprietorships

5. Growing at a faster rate than large scale industry

6. Small-scale industries activity is beehive of entrepreneurship

7. Exploitation of natural resources

8. Human resource is exploited instead of developing it

9. Due to various constraints, cheating is a common feature

10. Organization and management is very poor and negligible in many cases.

11. Financial discipline is very weak and rules and regulation are not adhered.

12. Most of the funds come from entrepreneurs saving.

1.9.3 Importance of small-scale industries

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1. The small-scale sector has a high potential for employment, dispersal of industries,

promoting entrepreneurship and earning foreign exchange to the country. The following

are the points to demonstrate it

2. Symbols of national identity-small enterprises are almost always locally owned and

controlled, and they can strengthen rather than destroy the extended family and other

social systems and cultural traditions that are perceived as valuable.

3. Individuals taste fashion and personalized service-small firms are quick in studying

changes in tastes and fashion of consumers and in adjusting the production process and

production accordingly. For eg: In garment industry the small units have ruled the roost,

big companies delegate responsibility down the line and cannot swiftly change the trace

when necessary. The garment business is personalized, oriented to changing fashions and

has to be tightly controlled.

4. Facilitates capital formation-the development of small industries generated additional

income and additional savings, this helps in capital formation in the economy.

5. Equitable distribution of income and wealth-By creating opportunities for small

business, small enterprises can bring about can bring about a more equitable distribution

of income and wealth which is socially necessary and desirable

6. Balanced regional growth-small-industries make possible transfer of manufacturing

activity from congested cities to rural and semi-urban areas, this helps in regional

development

7. Linkages-the large scale industries create an opportunity for growth of small-scale

industry, the growth of large motor industry will create opportunities for setting up small

service station and repair centers.

8. Export potential-Nearly 20% of the total value of export comes from small-scale

industry. The main items of export includes pharmaceuticals, sports goods, engineering

goods, finished leather, readymade cotton garments, processed foods etc.

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1.9.4 Advantages of small-scale enterprises

1. Small-scale industry do not require as heavy and costly infrastructure as larger

enterprises.

2. They have favorable capital output ratio

3. Helps to create economic stability in society by diffusing prosperity and by checking

the expansion of monopolies

4. Most developing countries are rich in certain agricultural, forest and mineral resources;

small-scale industries can be based on processing of locally produced raw materials

5. It is possible to save and to earn a foreign exchange by producing and exporting goods

process from local resources.

6. Small-scale industries are generally labour-intensive and do not require large amountof capital. The energy of unemployed and under-employed people may be used for

productive purposes in an economy in which capital is scarce.

7. They bring integration with rural economy on one hand and large scale enterprise on

other.

8. They facilitate mobilization of resources of capital and skills which often would

remain inadequately utilized.

1.9.5 Role of small business in national economy

Small business has played a very crucial role in transforming the Indian economy from a

backward agrarian economy to its present stature. Its benefits range from creating job

opportunities for millions of people, including many with low levels of formal education.

It has nurtured the inherent entrepreneurial spirit in far flung corners of the nation

resulting in the growth and development of all regions. It has been instrumental in raising

the standard of living of the multitudes. The small scale sector has contributed

specifically in the following areas:

1. Employment Generation: The SSI sector in India is the second largest manpower

employer in the country next only to the agriculture sector. India is

characterized by abundant labour supply and is plagued by unemployment and

underemployment. Under these circumstances the small-scale sector is a boon

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.For every Rs.0.1million of investment, the small-scale sector provides jobs to

26 people as compared to 4 jobs created in the large-scale sector.

2. Low Initial Capital Investment: Another feature of the Indian economy and

most of the developing economies is the scarcity of capital. The modern large-

scale sector requires colossal investments whereas the small sector is just the

opposite. Not only is the employment capital ratio high for the SSI but the

output capital ratio is also high.

3. Balanced Regional Development: Dispersion of small business in all parts of

the country helps in removing regional imbalances by promoting decentralized

development of industries. It helps in industrialization of rural and backward areas. It

also helps to reduce problems of congestion, pollution housing, sanitation etc

4. Equitable Distribution of Income: This is a natural corollary of the above.

When entrepreneurial talent is tapped in different regions and areas the

income is also distributed instead of being concentrated in the hands of a few

individuals or business families.

5. Promotes Inter-Sectoral Linkages: SSI units are supplementary and

complementary to large and medium scale units as ancillary units. Many small

units produce sub-parts, assemblies, components and accessories for the large-

scale sector especially in the electronic and automotive sectors.

6. Exports: The most significant contribution of the SSI has been in the field of

exports. There has been a significant increase in the exports from this sector

of both traditional and non-traditional goods including jewellery, garments,

leather, hand tools, engineering goods, soft ware etc.

7. Development of Entrepreneurship: Small business taps the latent potential

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available locally. This way they facilitate the spirit of enterprise, which results

in overall growth, and development of all the regions /sectors of the nation

Companies that succeed with economic value added (EVA) initiatives tend to

possess the following characteristics:

1. Strong support from the CEO. If the CEO takes a wait-and-see attitude, EVA

stands a greater chance of failing, because employees are less likely to take it

seriously.

2. Effective EVA education. If employees understand why they should start using

EVA principles in their everyday tasks, theres a greater chance of success in the

implementation phase.

3. Links between EVA performance and employee compensation. Connecting the

performance measure with incentives gives EVA implementation teeth and lets

everyone know how they will be evaluated.

4. Realistic income stream projections. EVA is based on the educated guess of how

much potential a capital asset has to produce a rate of return over and above its

cost. If the people making those estimates are too rosy in their projections, the

number of capital expenditures that produce a positive EVA will shrink

5. An overall attitude of economic efficiency. Successful EVA companies look not

only at the cost of capital, but also at a variety of ways to improve economic

efficiency within their organization, such as reducing inventory costs and

improving operational processes.

6. An overall attitude of economic efficiency. Successful EVA companies look not

only at the cost of capital, but also at a variety of ways to improve economic

efficiency within their organization, such as reducing inventory costs and

improving operational processes.

7. EVA-based budgets. Traditional budgets impede EVAs effectiveness by,

essentially, saying, "We have X dollars, and all of that money needs to go

someplace." If a companys calculations indicate that only 60 percent or 75

percent of that money can be spent within its EVA parameters, then that company

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should allocate its resources only to capital projects that will produce an

acceptable rate of return.

1.10 Strategies for increasing EVA

Increase the return on existing projects (improve operating performance)

Invest in new projects that have a return greater than the cost of capital

Use less capital to achieve the same return

Reduce the cost of capital

Liquidate capital or curtail further investment in sub-standard operations where

inadequate returns are being earned

1.10.1 Advantages of EVA

EVA is more than just performance measurement system and it is also marketed as a

motivational, compensation-based management system that facilitates economic activity

and accountability at all levels in the firm.

Stern Stewart reports that companies that have adopted EVA have outperformed their

competitors when compared on the basis of comparable market capitalization.

Several advantages claimed for EVA are:

EVA eliminates economic distortions of GAAP to focus decisions on real

economic results

EVA provides for better assessment of decisions that affect balance sheet and

income statement or tradeoffs between each through the use of the capital charge

against NOPAT

EVA decouples bonus plans from budgetary targets

EVA covers all aspects of the business cycle

EVA aligns and speeds decision making, and enhances communication and

teamwork

Academic researchers have argued for the following additional benefits:

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Goal congruence of managerial and shareholder goals achieved by tying

compensation of managers and other employees to EVA measures (Dierks &

Patel, 1997)

Better goal congruence than ROI (Brewer, Chandra, & Hock, 1999)

Annual performance measured tied to executive compensation

Provision of correct incentives for capital allocations (Booth, 1997)

Long-term performance that is not compromised in favor of short-term results

(Booth, 1997)

Provision of significant information value beyond traditional accounting measures

of EPS, ROA and ROE (Chen & Dodd, 1997)

1.10.2 Limitations of EVA

EVA also has its critics. The biggest limitation is that the only major publicly-available

sample evidence on the evidence of EVA adoption on firm performance is an in-house

study conducted by Stern Stewart and except that there are only a number of single-firm

or industry field studies. It would be wrong to say that EVA is not beset with any

drawbacks. Though it provides a new tool in the hands of management, it has its own

limitations. For example, EVA does not take into cognizance current market value of

assets and book value is taken into account in calculations. This is of course misleading

and presents distorted picture but estimating the current market value of assets is very

difficult and often impractical.

EVA has established superiority over other measures of performance but that does not

mean that EVA alone can clearly tell how the plans are going and strategic goals being

met. The companies that have invested heavily today and expect positive cash flow only

in distant future are extreme examples that have negative EVA in near future. Their

performance can be better judged by market share, sales growth etc.

For the equity analysts, there is a word of caution. The concept of EVA requires

knowledge of accounts internal to organization to a great extent and their availability to

the external world is a big constrain. This constraint becomes even more pronounced in

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countries like India where even the annual reports published by companies have scanty

disclosures. Moreover, it has to be borne in mind that EVA gives one year snapshot of

company's operational performance.

Brewer, Chandra & Hock (1999) cite the following limitations to EVA:

EVA does not control for size differences across plants or divisions

EVA is based on financial accounting methods that can be manipulated by

managers

EVA may focus on immediate results which diminishes innovation

EVA provides information that is obvious but offers no solutions in much the

same way as historical financial statement do

Also, Chandra (2001) identifies the following two limitations of EVA:

Given the emphasis of EVA on improving business-unit performance, it does not

encourage collaborative relationship between business unit managers

EVA although a better measure than EPS, PAT and RONW is still not a perfect

measure

Brewer et al (1999) recommend using other performance measures along with EVA and

suggest the balanced scorecard system. Other researchers have noted that EVA does not

correlate as strongly with stock returns as its proponents claim. Chen & Dodd (1997)

found that, while EVA provides significant information value, other accounting profit

measures also provide significant information and should not be discarded in favor of

EVA alone. Biddle, Brown & Wallace (1997) found only marginal information content

beyond earnings and suggest a greater association of earnings with returns and firm

values than EVA, residual income, or cash flow from operations.

Finally, a key criticism of EVA is that it is simply a retreated model of residual income

and that the large number of "equity adjustments" incorporated in the Stern Stewart

system may not be necessary (Barfield, 1998; Chen & Dodd, 1997; O'Hanlon & Peasnell,

1998; Young, 1997). The similarity between EVA and residual income is supported by

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Chen and Dodd (1997) who note that most of the EVA and residual income variables are

highly correlated and are almost identical in terms of association to stock return.

1.10.3 Common EVA errors:

They don't make it a way of life. You can't just calculate EVA; you have to adopt

it. Companies must make it the centerpiece of a comprehensive financial

management system. Economic value added must be linked to how companies set

overall financial goals, how they communicate those goals internally and to the

investment community, and how they evaluate opportunities to build the business

and invest capital.

They rush the implementation process. Depending on the size of a company, the

implementation process could take anywhere from three months to two years.

Companies that make the mistake of trying to implement EVA all at once often

find there are too many people to train and disruption results. Top managers must

be able to understand economic value added so they can train those down the line.

There is a lack of conviction from senior management. The CEO must be totally

committed to prevent staff from creating fiefdoms. Direction from the top is

critical because moving to EVA is something not all managers will want to do if

they already can easily meet budget. Approximately 50 percent of the power of

EVA can be lost if the incentive plan is not driven by it.

Managers complain too much. Instead of making economic value added a

philosophical crusade to create shareholder value, communicate a simple message

to employees: "What if we found a measure of financial performance that really

captures all the things a person can do to run the business more efficiently, to

satisfy customers, and to reward shareholders. Wouldn't it make sense t

Documents

FYP Final Project Report EVA