EVA, OVA, MVA, CFROI, CVA & TBR

Organisational Performance Measures. This is only for study purpose, The content is refereed from various available sources. Through this, the learner, decision makers are may got benefited.

1. Organizational Performance Measures Economic Value Added (EVA) Owners Value Added (OVA) Market Value Added (MVA) Cash Flow Return on Investment (CFROI) Cash Value Added (CVA) Total Business Return (TBR) Dr. K. Balanaga Gurunathan Professor in Finance, Amity Business School,  Amity University,   Gurgaon ( Manesar), Haryana  , 122413 India

2. Organizational Performance Measures Economic Value Added Economic Value Added (EVA) is a financial performance method to calculate the true economic profit of a corporation. “Is the quantum of economic value (or profits) generated by a company in excess of its cost of capital.” EVA can be calculated as Net Operating Profit After Tax minus a charge for the opportunity cost of the capital invested.

3. Economic Value Added (EVA) A measure reflecting the absolute amount of shareholder value created or destroyed during each year. A measure highly correlated with stock prices. A useful tool for choosing the most promising financial investments. A registered trademark owned by Stern Stewart &Co . supporting more than 250 large companies around the world.

4. EVA: Basic Premise Managers are obliged to create value for their investors Investors invest money in company because they expect returns. Capital charge(CC) is the average equity return on equity Thus creating less return than the CC is economically not acceptable

5. EVA: Application EVA reflects company’ performance Positive EVA indicates value creation Negative EVA indicates value destruction Series of negative EVA is a signal that restructuring in a company may be needed. EVA can be calculated on the basis of the Profit/loss account and Balance sheet.

6. USAGE of the EVA method: Aligning decisions with shareholder wealth The primary financial objective of any company should be to maximize the wealth of its shareholders. The value of a company depends on the extent to which investors expect that future profits will differ from the cost of capital. By definition, a sustained increase in EVA will result in an increase in the market value of a company. This approach has proved valid and effective for many types of organizations. This is because the level of EVA isn't what really matters. Current performance already is reflected in share prices. It is the (continuous) improvement in EVA that brings (continuous) increases in shareholder wealth. Some specific usages of EVA include : To set organizational goals. * Performance measurement. Determining of bonuses. * Communication with shareholders and investors. Motivation of managers. * Capital budgeting. Corporate valuation. * Analyzing equities .

7. Computation of EVA EVA is the profit that remains after deducting a charge for the capital employed by a company from the profit after tax. It is calculated as follows: EVA per annum = PAT but before Interest - Total cost of capital including notional cost of reserves Or EVA = NOPAT – (Weighted Avg.Cost of Capital * Invested Capital) NOPAT = Net operating PAT - NOPAT = Operating Income x (1 – Tax Rate)

8. EVA should be a real growth, after discounting for inflation and other negative factors. To  calculate EVA D etermine the difference between the actual rate of return on assets and the cost of capital, and multiply this difference by the net investment in the business. To analyse the impact of inflation we may take the following numerical example

9. Illustration The Capital Works out = 24 /50 = 0.48 or 48% 20 * 12% of opportunity cost = 20 + 4 = 24 EVA = NOPAT – (Weighted Avg.Cost of Capital * Invested Capital) = 24 – (0.132 * 50) = 17.4 Million Workings: NOPAT = PBIT (1-Tax rate) = (30 (1-0.2)) = 30 * 0.8 = 24 Million WACC = (20/50 * 15) + (12/50 *15%) + (18/50*10%) = 6 +3.66+3.66 = 13.2 % Rs.in Million Total Asset Value of the Enterprise 100 Operating Profit 30 Sources of Funds used: Capital Reserves 10% loans Total 20 12 18 50 Dividend Expectation 15% Opportunity cost of Funds in the Industry 12% Average Annual Rate of Inflation 5% Tax Rate 20%

10. Owners Value Added OVA considers cost of each component of Capital Separately. It can be computed as: = [PAT+ Interest Cost + Asset Appreciation] – [Opportunity cost of Reserves + Actual Int. + Appropriate cost of share capital*] Appropriate cost of owners capital should comprise of following 3 components :– Rate of int. at which, the owners raise their funds Disposable Income for consumption Moderate rate of growth.

11. Let us look at the following illustrations to understand OVA Following is the total capital employed by X Ltd., as on 31-12-1998 Share Capital 100 $ Million Reserves 200 $ Million 10% Public Bonds 120 $ Million 9% Institutional Loan 130 $ Million Company Made an Operating Profit of $ 130 million during 1999. For EVA computation cost of total capital is taken at 15%. Shareholders raise their funds at 11%. Moderate rate of growth of the economy is 2%. Company Pays tax at 30%. It was also reported that the fixed assets market price appreciated by $5 million during the year.

12. EVA Computation: $ Million Operating Profit 130.00 Less: Interest 23.70 PBT 106.30 Less: Tax @ 30% 31.89 PAT 74.41 EVA = [PAT + Interest] – [Total Cost of Capital] = (74.41 + 23.7) – (550 * 15%) = 98.11 – 82.5 = $ 15.61.million

13. OVA Computation: OVA = [PAT + Int. + Asset Appreciation] – [Appropriate cost of owners fund + Actual Interest cost of Borrowing] = [74.41 + 23.7 + 5] – [55.5+23.7] = (103.11) – (79.2) = $ 23.91 Million *Appropriate cost of owners capital Cost of Capital raised by owners : 33.00 [ 300 * 11%] + Disposable Income [50% of above : 16.50 cost of capital] + Moderate rate of growth (2%) : 6.00 Total 55.5

14. OVA Advantages It considers cost of each component of capital separately. It also considers “Asset value appreciation”, as part of “Value added” the shareholders wealth. It treats the “Cost of owners funds” more appropriately, from the view point of shareholders. It should be the net retained fund for company’s growth.

15. Market Value Added It is the total value of the company [including debt] reduced by the net assets. Market Value Added (MVA) is the difference between the equity market valuation of a listed/quoted company and the sum of the adjusted book value of debt and equity invested in the company. In other words : it is the sum of all capital claims held against the company; the market value of debt and the market value of equity

16. Calculation of Market Value Added :     MVA = Market Value - Invested Capital . Or MVA = Market capital of the company + Value of outstanding debt –(Total assets of the company – Current liabilities Or MVA = Market value of equity – book value of equity Market Value of equity = (No. shares) * (price per share) + Value of debt Book Value = Total common equity + Value of debt

17. The higher the Market Value Added (MVA) is, the better it is.  A high MVA indicates the company has created substantial wealth for the shareholders. MVA is equivalent to the present value of all future expected EVAs. Negative MVA means that the value of the actions and investments of management is less than the value of the capital contributed to the company by the capital markets. This means that wealth or value has been destroyed. The aim of a firm should be to maximize MVA. The aim should not be to maximize the value of the firm, since this can be easily accomplished by investing ever-increasing amounts of capital.

18. Limitations of Market Value Added 1. MVA does not take into account the opportunity costs of the invested capital. 2. MVA does not take into account the interim cash returns to shareholders. 3. MVA can not be calculated at divisional (Strategic Business Unit) level and can not be used for private held companies.

19. Cash Flow Return on Investment Cash Flow Return on Investment (CFROI), originally developed by HOLT Value Associates (since Jan 2002 CFSB Holt, Chicago), is an Economic Profit (Cash-Flow) based corporate performance/valuation framework, mainly used by portfolio managers and corporations.  

20. CFROI is normally calculated on an annual basis, and it is compared to an inflation-adjusted cost of capital to determine whether a corporation has earned returns superior to its costs of capital. Using Cash Flow Return on Investment, you can compare companies with disparate asset compositions, across borders and time. An advantage of CFROI is that it ties performance measurement to the factor that investors appreciate highly: the ability of a corporation to generate cash flow. Also CFROI is inflation-adjusted.

21. CFROI is the equivalent of ROI computed based on cash flows, instead of profits. CFROI compares the sustainable cash flow generated by a firm with the total cash invested [towards both fixed assets and working capital] to generate these inflows. Sustainable cash flow is defined as cash flow less economic depreciation.

22. The calculation of CFROI (formula) is: [Cash Flow – Economic Depreciation] / Cash invested CFROI explained It can be calculated at the level of a Strategic Business Unit, and it can also be used for private held companies.   It is an approximation of the average real internal rate of return earned by a firm on all its operating assets. The inflation-adjusted CFROI method, is calculated from a recurring stream of after-tax cash flows generated by a company's growing base of depreciating and non depreciating assets.

23. Over time, CFROI fades, or regresses, to the long-term corporate average. By applying the ROI to the total assets, a net cash receipt forecast can be calculated. This forecast is discounted back to the present to arrive at a current value for a company. CFSB Holt maintains a CFROI database of over 18.000 companies, consisting of 20 year historical data for American companies and 10 year historical data for non American companies.

24. Cash Value Added CVA is BCG’s metric for measuring economic profit. It is conceptually similar to EVA, but it is based mainly on cash items.

25. The Cash Value Added (CVA) model includes only cash items, i.e. Earnings Before Depreciation Interest and Tax (EBDIT, adjusted for non cash charges), working capital movement and non-strategic investments. The sum of those three items is the Operating Cash Flow (OCF). The OCF is compared with a cash flow requirement, "the Operating Cash Flow Demand " (OCFD). This OCFD represents the cash flow needed to meet the investor's financial requirements on the company's strategic investments, i.e. the Cost of Capital.

26. Opportunity cost of capital in cash terms Instead of measuring the investor's opportunity Cost of Capital in percentage terms, the CVA model uses the investor's opportunity Cost of Capital in cash terms. The difference between the OCF and the OCFD is the "Cash Value Added" - CVA. The CVA for a period is a good estimate of the cash flow generated above or below the investor's requirement for that period. This analysis can be done at each level of the company and the CVA for the company is the aggregate CVA of its Strategic investments.

27. CVA compared with MVA Unlike Market-based measurements, such as MVA , Cash Value Added (CVA) can be calculated at divisional (Strategic Business Unit) level. Unlike Securities measurements, CVA is a flow and can be used for performance evaluation over time.

28. CVA compared with EBIT Unlike accounting profit, such as EBIT , Net Income and EPS , Cash Value Added (CVA) is Economic and is based on the idea that a company must cover both the operating costs AND the Cost of Capital.

29. Formula of Cash Value Added Sales -   Costs -----------------------------------------    Operating Surplus +  Working Capital Movement -   Non-strategic Investments -----------------------------------------     Operating Cash Flow -   Operating Cash-Flow Demand -----------------------------------------Cash Value Added - CVA Operating Cash Flow Demand Economic Depreciation Capital charge on Gross Investments

30. Total Business Return Total Business Return is a forward-looking measurement of CFROI . TBR was designed to imitate the way in which capital markets determine Total Shareholder Return (TSR). In this way we can also use Total Business Return for an internal business unit, division, project or strategy.

31. Calculation of Total Business Return   Terminal Value at the End of the Period - Gross Cash Investments at the Begin of the Period +   Gross Cash Flows in the In-between Period ----------------------------------------------  Total Business Return (TBR) TBR = [(End Business Value – Beginning Business Value / Beginning Business Value ] + [Free Cash flow / Beginning Business Value] OR

32. Total Business Return is very similar to something EVA users call forward looking IRR. TBR can be calculated at divisional (Strategic Business Unit) level and below. Total Business Return can even be observed for privately held companies.

33. BCG Approach – TSR, TBR, CFROI & CVA End Market Value – Beginning Market Value TSR TBR End Market Value – Beginning Market Value Dividend CVA CFROI Cash flow Economic Depreciation Capital Investment Charge on Investment

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