EVA AN OVERVIEW AND A CASE STUDY

EVA is simply net operating profits after tax, minus a charge for the use of capital employed in the business. The capital charge is the minimum rate of return necessary to compensate shareholders, and lenders for the risk of their investments in a company. Research shows that changes in EVA has a closer correlation to changes in shareholder value, when compared to other metrics like Earnings Per Share (EPS), Earnings Growth, Return on Equity (ROE), and Return on Assets (ROA). To improve EVA - Invest in projects that earn more than the cost of capital will help in achieving growth to improve EVA Increase profits without using additional capital will help in increasing EVA through productivity improvement. Divest non-strategic assets that do not generate operating profits greater than the cost of capital.

EVA vis--vis other Metrics

Sales, NBV, SVOP, growth rates EVA forces Top-line growth to generate sustainable profits in the long run and to also keep an eye on Capital Employed

Cost Ratios, Gross Contribution, NOS EVA compares Returns generated with the cost of Capital Employed to generate these returns

Net Divisional Assets, Asset Turns, ROI Average Net Working Capital, Turns EVA ensures Optimum and Profitable Utilization of all Business Assets Net Funds Flow to Corporate Treasury EVA also includes non-cash costs like Depreciation Measuring and Reporting EVA at G&B -

Basis of EVA:
Objective of maximizing Shareholder Value Value depends on Residual Income (EVA), which includes income left over after providing for adequate returns to Lenders (Interest) as well as Shareholders (Dividend) EVA looks at true or economic earnings instead of Accounting earnings Focus on Profits AND Capital Efficiency

EVA as a Performance Metric

Comprehensive; it integrates the P&L Account (NOSBI) with the Balance Sheet (CE) Aligns Shareholders interests with those of Executives: EVA increases only if shareholder Wealth increases A single number is reported Accesses financial data easily available from the existing MIS Isolates extraordinary / non-recurring items Can be seamlessly integrated with decision making logic, e.g.: positive NPV projects / Capex increase EVA, Optimal Cost and Price decisions based on marginal costing also optimize EVA

The Concept OF EVA

Sources of Funds Application of Funds

LIABILITIES
ShareholdersFun ds

ASSETS Fixed Assets Investments

Assets Employed in Business

Share Capital Reserves/Surplus (Past Profits)

Borrowed Funds

Net Working Capital Long Term Loans (Current Assets Short Term Loans Current (Working Capital) Liabilities)

Funds employed in Business can be supplied by Shareholders or by Lenders (Banks and Financial Institutions) 2

Funds so obtained are invested in Fixed Assets, Investments and Working Capital NOSBI Tax is ignored, since G&B has adequate tax shelter that can be set off against future business profits. Taxes are not relevant to an SBU in G&Bs portfolio of businesses

Capital Employed Divisional Assets include Divisional Fixed Assets, Net Working Capital (Stocks + Debtors Creditors Advances) and apportioned Common Operating Assets

WACC - Cost of Debt is calculated on a monthly basis depending on actual levels of Debt - Cost of Equity is the level of returns expected by shareholders

Calculation of EVA

Fixed Fixed Assets Assets

Investment Investment Net Working Capital Net Working Capital ss

Net Operating Surplus before Interest

EVA
Capital Charge
Funds Employed Cost of Funds Employed

ShareholdersFunds ShareholdersFunds

Borrowed Funds Borrowed Funds

EVA = NOSBI minus CAPITAL CHARGE

A Numerical Example
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Liabilities Equit Capit y al W Loan (7%) C TermLoan 1(12%) TermLoan 2 (14%) 200 50

Assets Fixed Asset s CurrentAsset s 250 350 (150) 40 5

Profit &Loss A ccount Sales Operat Exp. ing N SBI O Int erest NS O 1,000 (800) 20 0 (30) 10 7

75 CurrentLiabilit ies 125 40 5

NOSBI = NOS 170 + Interest 30 = 200 CE = Fixed Assets 250 + Net Working Capital 200 = 450 WACC is a combination of WAC of Debt and WAC of Equity WAC of Debt = (50*7%+75*12%+125*14%) / (50+75+125) = 30 / 250 = 12% We ASSUME WAC of Equity = 20% (how?) WACC = (200*20%+250*12%) / (200+250) = 15.55% Capital Charge = CE 450 * WACC 15.55% = 70 EVA = NOSBI 200 Capital Charge 70 = 130

EVA at Godrej & Boyce

(+)

On the Mend
(Reward for improving)

Star Performer
(Reward for performing)

EVA Business Viability under doubt (-)

(No Reward)

Living on Past Glory

(No Reward)

(-)
-

EVA

(+)

Annual change in EVA, i.e. EVA is measured Mapping EVA and EVA to performance:

What EVA Is not & IS

4

What -

EVA is not A totally new, exotic Performance Metric A complete substitute for all existing Performance Metrics The answer to all Business problems, strategic as well as tactical

What EVA is A more comprehensive Metric that encompasses the broad functionalities of many, but not all, other Metrics A means to align Corporate action with Shareholders interests and sustained Wealth Creation One of the management tools available for Planning and Variance Analysis

Integrating EVA into Business Planning

Strategic Capital Expenditure / Project Analysis - Traditional NPV or IRR evaluations will yield results consistent with EVA; Positive NPV results or IRR values higher than WACC will yield positive EVA - For major Capex (Greenfield projects), certain expenses like depreciation and set-up costs might have to be amortized over a longer period for EVA purposes Operational Decisions - (Pricing, In-house v. Sub-contracting, Volume Discounts, Cash Discounts, Manufacture v. Trade) - Marginal Cost / Marginal Revenue based decisions will yield results consistent with EVA; Costs / Benefits of Marginal Capital Employed need to be considered as well e.g. increase in Debtors or Inventories Business planning focuses on, and rewards - EVA. Managing for Value Creation means rebuilding G&B as an organization of Long term Shareholder Value managers - Does Return on Capital Employed exceed WACC? Firms create Shareholder Value only if they make decisions that consistently earn Economic Profit, i.e., a Return on Capital Employed that exceeds the Cost of financing that Investment. - Strategic Focus for Long Term Survival and Profitable, Sustainable Growth. Review of Strategic Value Drivers. Long term Shareholder Value managers

Managing for Value Creation means rebuilding G&B as an organization of Long term Shareholder Value managers Consistently earn Economic Profit Does Return on Capital Employed exceed WACC? - Firms create Shareholder Value only if they make decisions that consistently earn Economic Profit, i.e., a Return on Capital Employed that exceeds the Cost of financing that Investment Strategic Focus for Long Term Survival and Profitable, Sustainable Growth - Review of Strategic Value Drivers - Profitable growth in Businesses that are Quality / Cost competitive - Capex controls / Working Capital controls - Generation of Free Cash Flows - Prudent Debt for Asset Build-up in Profitable Sunrise Industries for sustained Growth with Economic Profit - Constant Strategic Review / Exit Strategies Profitable growth - Profitable sustained growth in Businesses that are Quality / Cost competitive - Capex controls / Working Capital controls - Generation of Free Cash Flows - Prudent Debt for Asset Build-up in Profitable Sunrise Industries for sustained Growth with Economic Profit - Constant Strategic Review / Exit Strategies.

Integrating EVA into Business

FINANCIAL DRIVERS
Operating Profit NOPAT Taxes Econom ic Profit Capital Em ployed Capital Charge WACC

Gross Contribution

Revenue Material Costs Labour

Overhead

Mfg. Costs

Fixed Assets Working Capital Cost of Debt Cost of Equity

RM, WIP, FG Debtors

Creditors

Ways to raise EVA

Earn more Profit without using more Capital e.g., Cost Cutting in Price-competitive markets Use Less Capital Optimizes the use of Capital, both Equity and Debt Makes Projects and Products compete for Capital Curtails Capital in Businesses that do not cover WACC Capital released can be used to repay Debt, esp. at a highly geared company like G&B Invest Capital in high-return Projects Profitable and Sustainable Growth Invest Capital in high-return Projects

EVA and Managerial Rewards

Managerial Goal-orientation, Motivation and Reward Structure EVA and EVA Focus on twin KPIs of Profits as well as Capital Employed A Key Variable for Performance-based Rewards to senior Managers The Structure of EVA-based Managerial Rewards Rewarding EVA motivates profit-making Divisions even in stagnating markets Rewarding EVA motivates loss-making Divisions to seek constant improvements in performance Rewarding EVA more than EVA forces all Divisions, including those making profits, to earn more profits and/or to use less Capital, rethinking business strategies if needed

EVA and Rewards at Godrej & Boyce

The concept of EVA being explained earlier; Godrej & Boyce has used this as a motivational tool. The concept has been a key calculating method while estimating the profit share being distributed to the employees. The exact value and ratios not being disclosed, an attempt is made to understand conceptually the calculation that is carried out at Godrej & Boyce. If in the year 2007 a division or a SBU of Godrej and Boyce has recorded a profit of Rs.500 & it has been estimated that the Economic Value Addition & Economic Value

Addition in this profit is Rs.100. Then it is decided to distribute this amount, down the organizational chain.

MD Godrej

President Staff Function

President Line Function

VP Corporate HR

Admin VP

VP Service

Aero Space SBU VP

Furniture SBU VP

Soaps SBU VP

If EVA & EVA is 100 Rs then in the organization the distribution done is as follows: MD : Rs. 50 VP-Support Functions : Rs. 25 VP-Line Function (Division) : Rs. 25 Similarly, for every SBU Strategic Business Unit the distribution follows. Of the Rs. 25, distribution is amongst the remaining chain element of the orgainsation. Vice President General Manager Senior Manager Manager DeputyManager Executive Operators : Rs. 1 : Rs. 1.5 : Rs. 2.5 : Rs. 3.5 : Rs. 4.5 : Rs. 5.5 : Rs. 7

Though the amount to the Operators appears high the numbers of divisions are higher, i.e. if 700 operators are there, then Rs. 7 is divided into 700 shares, i.e. Re. 0.01 per operator. Similarly if there are 275 Executives each gets Rs. 0.02 The objective is to distribute the profits and reward every element of the chain or organizational pyramid. 8

COMPILED BY

CHHAYA SEHGAL