Economic value added and return on investment

economic value added and return on investment

1. Economic value added PRESENTED BY – NEHA STANDARD – M.COM 2

2. Introduction :- EVA was devised by management consulting firm Stern Stewart and co. it is a performance measurement tool. Performance measurement systems was developed as a means of monitoring and maintaining organizational control. Reasons for adopting performance measurement are :

3. Meaning:- In corporate finance, economic value added is an estimate of firms economic profit, or the value created in excess of the required return of the company’s shareholders. The idea is that value is created when the return on firm’s economic capital employed exceeds the cost of that capital. It considers the shareholder’s wealth maximization purpose.

4. Steps in EVA computation:- EVA computation requires some basic steps. The common steps are exemplified here that may be modified due to the typical nature of business or processes where it has been used. STEP 1 :- Collect and review financial statements EVA is based on the financial data produced by traditional accounting system. Most of the data come from either income statement or balance sheet both of which are available from general-purpose financial statements.

5. Step 2:-identify the distortions and adjustments required to make it distortion free Stern S tewart has identified around 164 potential adjustments to GAAP and to internal accounting treatments, all of which can improve the measure of operating profits and capital. As financial statements are mandatorily prepared under GAAP, distortions will be there and identification of distortions is an art that requires a sound understanding of EVA technicalities to identify and to adjust them as well.

6. Step 3:- identify the company’s capital structure:- A company’s capital structure comprises all of the money invested in the company either by the owner or by borrowing from outsiders formally. It is the proportions of debt instruments and preferred and common stock on a company’s balance sheet. However capital employed can be computed under anyone of the following methods: Direct method: by adding all interest bearing debts(both short term and long term) to owner’s equity. Indirect method: by subtracting all non interest bearing liabilities from total liabilities(or total assets)

7. Step 4:- determine the company’s weighted average cost of capital (WACC): Cost of capital refers to the minimum rate of return expected by all the investors in the company. Some financial management tools are available in this case to calculate the cost of capital. A more common and simple method is weighted average cost of capital:- Weighted average cost of capital is the average return that a company is expected to pay to all its different investors or stakeholders. It represents the overall cost of all funds employed in the business.

8. Calculation of weighted average cost of capital: SOURCES COST (K) BOOK VALUE OR MARKET VALUE BOOK VALUE OR MARKET VALUE PROPORTION (W) (KW) PRODUT EQUITY ----- ------ ----- ----- DEBT ------ ------ ----- ----- RETAINED EARNINGS ------ ------ ----- ----- TERM LOAN ------ ----- ------ ----- PREFERENCE CAPITAL ------ ------ ----- ----- TOTAL Weighted average cost of capital = ∑KW/∑W

9. Step 5 : calculate company’s net operating profit after tax (NOPAT):- NOPAT is a measure of a company’s cash generation capability from recurring business activities and disregarding its capital structure. XYZ CO. (INR) Sales 2436000 (-) Cost of goods sold 1700000 Gross profit 736000 (-) Administrative, general and selling expenses 400000 Operating profit 336000 (-) taxes @ 50% 168000 NOPAT 168000

10. step 6 :- calculation of economic value added:- Finally, the EVA can be calculated by subtracting capital charges from NOPAT EVA = NOPAT – Capital employed * WACC

11. EVA V/S ROI:- Meaning of ROI:- Return on investment is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. It is the ratio between net profit and cost of investment resulting from an investment of some sources. A high ROI means the investment’s gains comparably to its cost.

12. Formula of ROI:- to calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or ratio. Example:- An investor buys $1000 worth of stocks and sells the shares two year later for $1200. The net profit from the investment would be $200 and the ROI would be calculated as follows:- ROI = (200/1000) * 100 = 20% Profit after tax ROI = ———————— capital employed

13. Difference between ROI and EVA:- POINT ROI EVA Meaning ROI is the comparison of the income generated with the assets employed. EVA is the residual profit after taking into account the capital charge. Calculation ROI is a ratio. Numerator is income and denominator is assets employed. EVA is a value. It is found by subtracting capital charge from profit after tax. Comparison ROI can be used to compare with the competitors and industry. EVA can not be used for comparison. Concept It is a traditional concept. EVA is a modern concept. Cost of capital ROI does not take the cost of capital into consideration. EVA includes cost of capital.

14. Advantages of ROI over EVA :- it is comprehensive measure as anything that affects financial statement is reflected in this ratio. It is simple to calculate, easy to understand, and meaningful in an absolute sense. ROI data is also available for competitors and can be used as a basis for comparison. The performance of different units may be compared directly to one another.

15. Advantages of EVA over ROI :- With EVA all business units have same profit objective for comparable investments. But ROI provides different profit objective for all business units. It creates a bias towards high profit business units of little or no expansion while, at the same time, low profit units are making investments at rate of return below those rejected by the high profit units . Different interest rate can be used for different type of assets. For more riskier assets, higher rates of cost of capital can be used. With ROI this will not happen.

16. EVA considers the motive of shareholder’s wealth maximization. It indicates that the company with high EVA tend to show high market value added or high gains for shareholders. When used as a performance metric, EVA motivates managers to increase EVA by taking actions consistent with increasing shareholder value.

17. Conclusion :- EVA is both a measure of value and also a measure of performance. The value of a business depends on investor’s expectations about the future profits of the enterprise. As a performance measure, economic value added forces the organization to make the creation of shareholder value the number one priority.

18. Thank you