Measuring Corporate Measuring Corporate Performance Performance –– An EVA An EVA ApproachApproach

Prof. Sarbesh MishraProf. Sarbesh MishraM.Com, M.Phil. PhDM.Com, M.Phil. PhD

Assistant Professor, FinanceAssistant Professor, FinanceNICMAR’s CISC, Hyderabad NICMAR’s CISC, Hyderabad –– 84.84.

BackdropBackdrop“If we don’ t know where we’re “If we don’ t know where we’re going, it doesn’t matter how we going, it doesn’t matter how we get there” (Attitude = 100%)get there” (Attitude = 100%)

Recent Buzzword in IndustryRecent Buzzword in Industry::TransparencyTransparencyAccountabilityAccountabilityBusiness EthicsBusiness EthicsSocial ResponsibilitySocial ResponsibilityShareholder’s interest protectionShareholder’s interest protection

Necessity of Corporate GovernanceNecessity of Corporate Governance1.1. Too much of power with few individual.Too much of power with few individual.2.2. Large scale diversion of funds to Large scale diversion of funds to

associated companies & risky ventures.associated companies & risky ventures.3.3. Unfocussed business decisions leading to Unfocussed business decisions leading to

losses.losses.4.4. Preferential allotment of sweat equity at Preferential allotment of sweat equity at

low prices.low prices.5.5. Spinning off profitable business Spinning off profitable business

operations to subsidiary companies.operations to subsidiary companies.

Recent HappeningsRecent HappeningsWorld ComWorld Com –– Improper accounting of Improper accounting of $3.9bn in expenses leading to bankruptcy.$3.9bn in expenses leading to bankruptcy.Enron Enron –– Off balance sheet deals used to Off balance sheet deals used to hide the debt.hide the debt.AOL WarnerAOL Warner –– AOL division accused of AOL division accused of improperly accounted for some advertising improperly accounted for some advertising revenues.revenues.XEROXXEROX –– Financial Fraud.Financial Fraud.UTIUTI –– Indiscriminate investment by UTI.Indiscriminate investment by UTI.

OriginOriginThe Sarbanes The Sarbanes –– Oxley Act, 2002, a Oxley Act, 2002, a recent enactment in USA which deals recent enactment in USA which deals with the Corporate Governance & with the Corporate Governance & Corporate Social Responsibilities has Corporate Social Responsibilities has emphasized audit functions & emphasized audit functions & financial disclosures. (Mandatory as financial disclosures. (Mandatory as per NYSE listing Norms)per NYSE listing Norms)(Benchmark practices in this regard is calculation (Benchmark practices in this regard is calculation of EVA apart from Annual Accounts)of EVA apart from Annual Accounts)

Indian ContextIndian Context

Kumara Mangalam Birla Committee on Kumara Mangalam Birla Committee on Corporate Governance (2000) Corporate Governance (2000) (SEBI Sponsored)(SEBI Sponsored)

Naresh Chandra Committee on Corporate Naresh Chandra Committee on Corporate Governance (2002)Governance (2002)Narayana Murthy Committee on Corporate Narayana Murthy Committee on Corporate GovernanceGovernance

What is EVA?What is EVA?New York based financial advisory New York based financial advisory Stern Stewart Stern Stewart & Co.& Co. postulated the very concept of Economic postulated the very concept of Economic Value Added (EVA) in 1990.Value Added (EVA) in 1990.

EVAEVA: Maximum amount which the : Maximum amount which the business is capable of distributing to its business is capable of distributing to its shareholders while remaining in the same shareholders while remaining in the same position at the end of the period as it was position at the end of the period as it was at the beginning with fair practices.at the beginning with fair practices.

EVA FormulaEVA Formula

EVA = NOPAT - Cost of Capital1.1. NOPAT = Net operating Profit after TaxNOPAT = Net operating Profit after Tax2.2. The The project’s cost of capitalproject’s cost of capital is the minimum is the minimum

required rate of return on funds committed to required rate of return on funds committed to the project, which depends on the riskiness of the project, which depends on the riskiness of its cash flows.its cash flows.The firm’s cost of capitalThe firm’s cost of capital will be the overall will be the overall (WACC), or average, required rate of return on (WACC), or average, required rate of return on the aggregate of investment projectsthe aggregate of investment projects..

Summary of DefinitionSummary of Definition

Thus EVA measures the Operating Thus EVA measures the Operating Profit, which should be fair enough to Profit, which should be fair enough to meet the cost of capital. So excess of meet the cost of capital. So excess of returns over cost of capital is otherwise returns over cost of capital is otherwise referred as EVA.referred as EVA.

If EVA is If EVA is +Ve+Ve = Firm is creating shareholder’s wealth= Firm is creating shareholder’s wealth--VeVe = Firm is destroying shareholder’s wealth= Firm is destroying shareholder’s wealth

Computation of NOPATComputation of NOPAT

Profit after tax but before InterestProfit after tax but before Interest+ Increase to Deferred Taxes+ Increase to Deferred Taxes+ Goodwill Amortized in Current year+ Goodwill Amortized in Current year+ Increase to Net Capitalized + Increase to Net Capitalized

IntangiblesIntangibles+/+/-- Unusual loss or (Gains) net of taxUnusual loss or (Gains) net of taxN. B: Some 144 adjustments are thereN. B: Some 144 adjustments are there

Implementation of EVAImplementation of EVA

MeasurementMeasurementManagement SystemManagement SystemMotivationMotivationMindsetMindset

Key Strategies to Enhance EVAKey Strategies to Enhance EVA

Operate: Set targets to Improve ROCE.Build: Invest capital only when return exceeds the cost of the capital.Divest: Divest capital when return fail to achieve cost of capital.Optimise: Restructure capital to reduce the cost of the Capital.

EVA Determination EVA Determination –– A Case StudyA Case Study

Calculation of EVA for Calculation of EVA for NTPC in FY 2005NTPC in FY 2005--0606

Calculation of EVA for NTPCCalculation of EVA for NTPC

1.1. EVA= NOPATEVA= NOPAT-- Cost of CapitalCost of Capital= PAT+ Interest paid = PAT+ Interest paid –– WACC ( Average WACC ( Average

Capital)Capital)

Calculation for NTPC for FY 2004Calculation for NTPC for FY 2004--0505

= (5,500cr+1,000cr) = (5,500cr+1,000cr) -- WACC WACC 1/2(Capital at the beginning of the year 1/2(Capital at the beginning of the year + Capital at the end of the year)+ Capital at the end of the year)

WorkingsWorkings

WACC = Ke* W1 +Kd* W2WACC = Ke* W1 +Kd* W2Debt : EquityDebt : Equity

= 0.14 * 0.7 + 0.8(1= 0.14 * 0.7 + 0.8(1-- Tax) * 0.3 Tax) * 0.3 30 : 7030 : 70= 0.98 + 0.3 * (0.8 * 0.65)= 0.98 + 0.3 * (0.8 * 0.65) W2 : W1W2 : W1= 0.98 + 0.3 * 0.52= 0.98 + 0.3 * 0.52 Ke = 14% as per govt. normsKe = 14% as per govt. norms

= 0.098 + 0.15= 0.098 + 0.15 Kd = Int. paid/Loan Taken Kd = Int. paid/Loan Taken = 0. 254= 0. 254 Tax= 35%Tax= 35%

Calculation of Cost of EquityCalculation of Cost of Equity

Cost of Equity can also be calculated taking CAPM Cost of Equity can also be calculated taking CAPM modelmodel

Ke Ke =Rf + =Rf + B B (Rm (Rm –– Rf)Rf) Rf = Risk Free Rate of ReturnRf = Risk Free Rate of Return

= = 0.08 + 0.8 (0.14 0.08 + 0.8 (0.14 –– 0.08 ) 0.08 ) Rm = Market Rate of ReturnRm = Market Rate of Return= 0.08 + 0.8 * 0.06= 0.08 + 0.8 * 0.06 BB = Beta Coefficient for NTPC= Beta Coefficient for NTPC= 0.134= 0.134

BB = = Covariance of Rm & RfCovariance of Rm & RfVariance of RmVariance of Rm

EVA of NTPCEVA of NTPC

EVA EVA = 6,500 = 6,500 –– 0.254 ( 20,000 )0.254 ( 20,000 )= 6,500 = 6,500 -- 50805080= Rs 1420 Cr EVA= Rs 1420 Cr EVA

A positive EVA indicates that this A positive EVA indicates that this company creates value. It helps company creates value. It helps managers to create value for share managers to create value for share holders.holders.

Strategies for increasing EVAStrategies for increasing EVA

Increase the return on existing project.Increase the return on existing project.Invest in new projects that have a return Invest in new projects that have a return greater than the cost of capital..greater than the cost of capital..Use less capital to achieve the same Use less capital to achieve the same return.return.Reduce the cost of capital.Reduce the cost of capital.Curtail further investment in subCurtail further investment in sub--standard standard operations where inadequate returns are operations where inadequate returns are being earned.being earned.

EVA DeficiencyEVA DeficiencyNot easy to use (for calculation of PAT, Not easy to use (for calculation of PAT, some 144 adjustments are there) too some 144 adjustments are there) too complicated for small business.complicated for small business.Recommends inexpensive debts in order Recommends inexpensive debts in order to reduce cost of capital (COC), is a very to reduce cost of capital (COC), is a very questionable strategy for small business.questionable strategy for small business.A passive accounting tool : measures past A passive accounting tool : measures past performance.performance.

InferenceInference

Thus, A company must strive continuously Thus, A company must strive continuously to increase not only profitability but also to increase not only profitability but also the EVA.the EVA.EVA reflects high net worth of the EVA reflects high net worth of the company, thus it’s credibility increases.company, thus it’s credibility increases.In India, Companies like Dr. Reddy’s Lab, In India, Companies like Dr. Reddy’s Lab, WIPRO, INFOSYS are coming up with their WIPRO, INFOSYS are coming up with their respective EVAs along with their Annual respective EVAs along with their Annual Report.Report.