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: Gourav Sharma 94512236916 1
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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:
Gourav Sharma
94512236916
Submitted To:
Dr. Navjot Kaur
(2009-2011)
1
ACKNOWLEDGEMENT
I am extremely thankful to Dr. NAVJOT KAUR, Faculty Guide,
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.
Name of the Student: Gourav Sharma
Enrollment No.: 94512236916
2
Introduction
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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 investments
and 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 prime
performance measure for companies (Makelainen, 1998). However, in the 1990’s,
the creation of shareholder value has become recognized as the ultimate economic
purpose of a corporation. Firms focus on building, operating and harvesting new
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businesses and/or products that will provide a greater return than the firm’s 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 firm’s 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
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 of
Stern 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
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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
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
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, Need for marketing infrastructure
38
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;
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 economy’s 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.
1.9.1 Scope 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 entrepreneur’s 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. Individual’s 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 amount
of 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:
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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
.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
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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
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, there’s 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
44
efficiency within their organization, such as reducing inventory costs and
improving operational processes.
7. EVA-based budgets. Traditional budgets impede EVA’s effectiveness by,
essentially, saying, "We have X dollars, and all of that money needs to go
someplace." If a company’s calculations indicate that only 60 percent or 75
percent of that money can be spent within its EVA parameters, then that company
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
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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:
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.
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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
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
47
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
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
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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 to use that
to shape our financial decision-making?"
There is a lack of quality training. It is important that the fundamentals of EVA be
communicated throughout the organization because even those with the smallest jobs can
create value. This means things like linking EVA to such key operating metrics as cycle
time or inventory turns and making certain the people involved know how economic
value added fits in. After all, the faster you turn inventory, the greater the reduction of
needed capital, resulting in increased EVA.
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Objectivesof the Study
50
1.11 Objectives of the Study
Whenever a study is conducted, it is done on the basis of certain objectives in mind. A
successful completion of a project is based on the objectives of the study that could be
stated as under:
1) To determine how to calculate EVA of a company.
2) To develop an EVA model for SME’s.
3) To determine how EVA as a tool act as a financial performance measure in SME’s.
4) To examine how EVA is different from other performance measures i.e. pitfalls of
traditional performance measures are discussed here.
1.12 Limitations of the study
Though every care has been taken to make this report authentic in every sense, yet there
were a few uncomfortable factors, which might have their influence on the final report.
Linking factors can be stated as:-
There were many problems regarding the collection of secondary data internally
i.e. Income Statement and Balance Sheet of the firm.
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None of the owner managers and employees of the firm is keeping a proper record
of Sales, Inventory, costs associated and other facts required for the purpose of
research.
Nobody was willing to share any kind of information and it was hard to get the
real fact about the firm’s profitability.
Lack of resources available on Economic Value Added (EVA) model for SME.
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Reviewof
Literature
Review of Literature
2.1 Bartoloma Deya Tortella and Sandro Brusco (2001) examined that Economic
Value Added (EVA) is a widely adopted technique for the measurement of value
creation. Using different event study methodologies they test the market reaction to the
introduction of EVA. Additionally, they analyze the long-run evolution before and after
EVA adoption of profitability, investment and cash flow variables. They first show that
the introduction of EVA does not generate significant abnormal returns, either positive or
negative. Next, they show that firms adopt EVA after a long period of bad performance,
and performance indicators improve only in the long run. With respect to the firm
53
investment activity variables, the adoption of EVA provides incentives for the managers
to increase firm investment activity, and this appears to be linked to higher levels of debt.
Finally, they observe that EVA adoption affects positively and significantly cash flow
measures.
2.2 Andrew Worthington and Tracey West (2003) noticed that with increasing
pressure on firms to deliver shareholder value, there has been a renewed emphasis on
devising measures of corporate financial performance and incentive compensation plans
that encourage managers to increase shareholder wealth. One professedly recent
innovation in the field of internal and external performance measurement is a trade-
marked variant of residual income known as economic value-added (EVA). This paper
attempts to provide a synoptic survey of EVA’s conceptual underpinnings and the
comparatively few empirical analyses of value-added performance measures. Special
attention is given to the GAAP-related accounting adjustments involved in EVA-type
calculations.
2.3 Roztocki, N. and Needy, K. L. (1999) this paper examines introducing Economic
Value Added as a performance measure for small companies. Advantages and
disadvantages of using Economic Value Added as a primary measure of performance as
opposed to sales, revenues, earnings, operating profit, profit after tax, and profit margin
are investigated. The Economic Value Added calculation using data from a company’s
income and balance sheet statements is illustrated. Necessary adjustments to these
financial statements, that are typical for a small company, are demonstrated to prepare the
data for the Economic Value Added determination. Finally, potential improvement
opportunities resulting from Economic Value Added implementation as a performance
measure in small manufacturing companies is discussed.
2.4 M Geyser & IE Liebenbergn (2003) examines long-term shareholder wealth is
equally important for all profit seeking organizations, regardless of their size. This paper
examines introducing Economic Value Added (EVA) as a performance measure for
agribusinesses and co-ops in South Africa. EVA is an effective measure of the
quality of managerial decisions as well as a reliable indicator of an enterprise’s
54
value growth in future. The question posed is whether South African agribusinesses and
cooperatives are capable of creating shareholder and member value after the deregulation
of the agricultural markets.
2.5 Linda M. Lovata and Michael L.Costigan (2002) found that Economic Value
Added is a new measure of performance that is purported to better align managers’
incentives to that of the shareholders. Accordingly, firms that experience higher agency
conflicts should be more inclined to use this performance evaluation system.
Additionally, the organizational strategy of the firm should influence the likelihood of
employing EVA. Prospector firms are defined as firms that apply a differentiation
strategy while defender firms focus on being cost-leaders. Firms identified as prospectors
should be less likely to use EVA. One hundred and fifteen firms were identified as being
adopters of EVA. Logistic regression was performed to contrast these firms to a control
group of 1271 non-adopters. The results indicate that firms using EVA exhibit a higher
percentage of institutional ownership and a lower percentage of insider ownership than
non-adopters. Prospector firms as defined by a higher ratio of research and development
to sales tend to use EVA less than defender firms. Accounting adjustments are a focal
point of the EVA formulation and the results presented in this study suggest that
providing appropriate incentives may be more complex than the developers of EVA
imply.
2.6 Financial Management Department ;University of Pretoria (2003) studied that
several researchers and practitioners, notably Stern Stewart Consulting Company and
Associates, have claimed that economic value added (EVA) is superior to traditional
accounting measures in driving shareholder value. Other researchers have refuted these
claims by supplying data in support of traditional accounting indicators such as earnings
per share (EPS), dividends per share (DPS), return on assets (ROA) and return on
equity (ROE). This study endeavored to analyses the results of companies listed on the
JSE Securities Exchange South Africa, using market value added (MVA) as a proxy for
shareholder value. The findings do not support the purported superiority of EVA. The
results suggest stronger relationships between MVA and cash flow from operations. The
study also found very little correlation between MVA and EPS, or between MVA and
55
DPS, concluding that the credibility of share valuations based on earnings or
dividends must be questioned
2.7 Raghunatha Reddy (2008) examined that for the past two decades many countries
started transforming their economies from traditional protected ones to those of more
liberalized, globalize and market driven. This period has also seen the economies
becoming more knowledge oriented and Human Resources started assuming more
prominence in the growth of the economies and businesses posing a greater challenge for
companies to acquire and retain talented workforce (especially at the strategic &
managerial levels). The knowledge economy also started witnessing the rapid rise of the
agency problem- conflict of interest between managers and owners. So it is very essential
to align the interests of the mangers and shareholders or at least reduce the difference
between them. In this regard Economic Value Added has been seen as better alternative
to the stock price and traditional performance measures. While successful EVA stories in
the west are quite encouraging, Corporate India is slowly catching up the EVA adoption.
Although not a panacea, EVA based compensation plans will drive managers employ a
firm's assets more productively and EVA should help reduce the difference in the
interests of the managers and shareholders, if not perfectly align them.
2.8 Girotra, Arvind; Yadav, Surendra S (2001) noted that with increased competition
and greater awareness among investors, new and innovative ways of measuring corporate
performance are being developed. New tools/techniques provide flexibility to managers
in their functions, be it in terms of operational aspects or evaluation parameters.
Economic Value Added (EVA) is one such innovation. Besides the measures like Return
on Equity (ROE), Return on Net Worth (RONW), Return on Capital Employed (ROCE)
and Earnings per Share (EPS), EVA is a new measure available to the corporate
managers
2.9 Michael F. Shivey and Jeffery J. McMillan (2002) This paper first provides an
overview of the standard asset ; market and income valuation methods that are used to
estimate the value of small businesses. It then discusses economic value added (EVA)
and demonstrates its potential use inn the valuation of small business.
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2.10 Gary C. Biddle, Robert M. Bowen, James S. Wallace (1998) Traces the growth in
the use of economic value added (EVA, previously known as (residual income) and uses
two previous research studies to assess some claims for its merits. Compares EVA’s
ability to explain stock returns with that of earnings before extraordinary items (EBEI)
and cash flow using 1984-1993 US data; and finds EBEI is most closely related.
Examines EVA’s incentive effects on management investing, financing and operating
decisions and shows that, although EVA users decreased new investment, increased
dispositions of assets, increased share repurchases, used assets more intensively and
increased residual income, market reactions to this were weak. Suggests possible reasons
for this and concludes that EVA may align management incentives with shareholders’
interests but this does not necessarily increase shareholder value.
2.11 Samuel C.Weaver (2001) analyzed that over the past decade, consultants, the
popular business press, a number of companies and a few investment analysts have
heralded Economic Value Added (EVA). In theory, EVA is net operating profit after tax
(NOPAT) less a capital charge for the invested capital (IC) employed in the business.
This survey bridges the gap between "theory" and "practice" by detailing how EVA
proponents measure EVA. This survey is important because its fieldwork identifies
significant inconsistencies in the measurement of EVA and its major components
2.12 Storrie & Sinclair (1997) present that EVA based on historical values can be
somewhat misleading. They first demonstrate that the valuation formula of EVA is
theoretically exactly the same as the valuation formula of discounted cash flow (DCF)
(Proved also by Kappi 1996). After that Storrie & Sinclair also prove mathematically that
this equivalence is due to the fact that the book value in EVA valuation formula is
irrelevant in determining value. That is because an increase in "book value of equity"
decreases the periodic EVA-figures ("present value of future EVA") and these changes
cancel each other out.
2.13 Stewart, (1991) explained that by explicitly assigning a cost of equity capital and
removing the distortions of accounting conventions, EVA allegedly better measures the
wealth that a firm has created during a period than does traditional accounting earnings.
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In other words, EVA allows investors to evaluate whether the return being earned on
invested capital exceeds its cost as measured by the return from alternative capital uses.
Since wealth (or value or return) created is a primary concern to investors, proponents
claim that EVA® is the only measure that ties directly to the intrinsic value of a
company’s stock As mentioned earlier, all anecdotal EVA stories allude to this as the
primary advantage of adopting EVA.
2.14 Weissenreider (1998) criticized EVA because it is based on accounting items only.
He opined that financial managers might be compelled to act on information that is
accounting in disguise and might have serious consequences. Weissenreider (1998)
compared EVA with Cash Value Added (CVA) and concluded that the latter is a better
performance measure.
2.15 Tully, (1993) In contrast, in this paper EVA has been hailed as the most recent and
exciting innovative measure of corporate performance that corrects both types of errors in
accounting earnings and that EVA should, therefore, replace earnings in both security
analysis and performance evaluation
2.16 Asish K Bhattachary and B.V. Phani (2004) this paper explains the concept of
Economic Value Added (EVA) that is gaining popularity in India. The paper examines
whether EVA is a superior performance measure both for corporate reporting and for
internal governance. It relied on empirical studies in U.S.A. and other advance
economies. It concluded that though EVA does not provide additional information to
investors, it can be adapted as a corporate philosophy for motivating and educating
employees to differentiate between value creating and value destructing activities.
This would lead to direct all efforts in creating shareholder value. The paper brings to
attention the dangerous trend of reporting EVA casually that might mislead investors.
2.17 Mahfuzul Hoque and Mahmuda Akter (2004) this paper examines performance
measurement matters in today’s complex business arena irrespective of the type, nature,
and volume diversity in business. If the result of performance measurement goes wrong
due to the faulty or inaccurate selection of tool(s), then the total process will prove wrong
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in due time. This paper evaluates Economic Value Added (EVA) as a smart and powerful
alternative to traditional performance measures like gross margin, percentage change in
sales, net margin etc. in a small manufacturing company perspective. Small
manufacturing companies are the focus of the study, as most of the people in such
companies believe that EVA is truly designed for large companies and the equation of
EVA cannot be applied in small companies due to the non-availability of required data.
This paper results in a typical model applicable to small manufacturing companies where
all adjustments and other technicalities are discussed with a real life example. Finally, the
possible advantages and opportunities of using EVA as a performance measurement tool
is discussed that may encourage the users/readers to incorporate EVA with their current
setup to reap the potential benefits from it.
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Research
Methodology
Research Methodology
Research by the name itself means re-search i.e. to search again. The task of research is
to generate accurate information for the use of decision making. Research is a systematic
and objective process of gathering, recording and analyzing data for the aid of making
decisions relating to a particular problem.
3.1 Need and Focus of the Research
The study consists of three main chapters. The first discusses the general theory behind
EVA. This chapter presents the background and basic theory of EVA as well as main
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findings about EVA in financial literature. The chapter also explains in general what
EVA has to give to corporate world. This chapter also focuses on the use of EVA in
group-level controlling. It discusses how EVA could be defined in controlling and
reporting, how it can be used in any company as a financial performance tool and what
are the problems faced in implementing EVA. The second chapter consists of review of
literature mentioning findings of various research papers and various other studies
conducted on the use of EVA as a financial performance tool. Third and final main
chapter deals with EVA more practically inside and for this the case of SME has been
taken from Ludhiana city, Punjab. (Name of the firm has not been disclosed due to
ethical reasons just to hide their explicit identity). The chapter presents with numerical
example the calculation of EVA and its impacts as a financial performance tool.
3.2 Research design
The research design is a master plan specifying the method and procedures for
collecting and analyzing needed information. The research design in this project is
exploratory in nature. Secondary data was used in doing the study “Economic Value
Added (EVA) as a financial performance tool: A case of SME’s”
Sampling plan:
Sampling plan is an effective step in collection of different data from different sources
and has a great influence on the quality of results. Mainly secondary data i.e. Income
Statement and Balance Sheet of the firm was used in doing this study to develop an EVA
model for small manufacturing firms. The sampling plan includes the population, sample
size and sampling technique.
Population:
The study is aimed to include any SSI / SME from Punjab state.
Sample Size:
To conduct this study and to develop an EVA model a case of one small manufacturing
firm has been taken from Ludhiana; Punjab.
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Sampling Technique:
The sample was drawn from the population using convenience sampling.
Data Sources:
Secondary data was used in doing the study which has been collected internally as
Income statement and Balance sheet of the firm and externally from published materials
like research papers and from the internet.
3.3 Data Analysis Technique
How to calculate EVA
The EVA is a measure of surplus value created on an investment. Here, surplus value
simply stands for the difference between return and cost of capital. In a small
manufacturing firm, the EVA model is modified, or more appropriately, simplified to
some extent. This simplification comes due to the less complexity of operation, non-
availability of required information and comparatively lower amount of financial
involvement. This proposed EVA model seeks six sequential steps to be followed
before getting a periodic EVA, i.e., to what extent the owners‘ equity or wealth
is changed (increased/decreased). These steps are outlined below followed by an
illustration with one of my sampled small manufacturing firm.
Step 1: Review the company‘s financial data
EVA is based on the financial data. Most of these data are available from the general-
purpose financial statement consisting of at least income statement and balance sheet.
Sometimes additional data from the notes to financial statements may also be required.
In most of the cases, the last two years information prove sufficient to get all the
required information to calculate EVA for any specific year. Income statement is used
to calculate net operating profit after tax (NOPAT) and balance sheet is used to identify
the capital invested in the business. Notes are used to find out the adjustments in
NOPAT and cost of capital (COC) invested.
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Step 2: Identify the necessary adjustments require to be considered
The conventional GAAP income statement and balance sheet are required to be
adjusted to find out net operating profit and the true capital. Companies cannot replace
GAAP earnings with EVA in their public reporting, of course. The first departure from
GAAP accounting is to recognize the full COC (Cost of Capital). EVA also fixes the
problems with GAAP by converting accounting earnings to economic earnings and
accounting book value to economic book value, or capital. The result is a NOPAT figure
that gives a much truer picture of the economics of the business and a capital figure that
is far better measure of the funds contributed by shareholders and lenders. Stern Stewart
identified around 164 potential adjustments to GAAP and to internal accounting
treatments, all of which can improve the measure of operating profits and capital. Now
the question comes, to what extent it can be adjusted.
The “Basic EVA” is the unadjusted EVA quoted from the GAAP operating profits and
Balance sheet. “Disclosed EVA” is used by Stern Stewart in its published MVA/EVA
ranking and computed after a dozen standard adjustments to publicly available
accounting data. “True EVA”, is the accurate EVA after considering all relevant
adjustments to accounting data. However, our interest is at the “Tailored EVA”. Each
company must develop their tailored EVA definition, peculiar to its organizational
structure, business mix, strategy and accounting policies, i.e., one that optimally balances
the trade-off between the simplicity and precision.
Once the formula is set, it should be virtually immutable, serving as a sort of
constitutional definition of performance. According to John Shiely, The CEO of Briggs
and Stratton Corp, —Adopting EVA simply as a performance measurement metric, in
the absence of some ideas as to how you are going to create value, is not going to get you
anywhere“ (Kroll, 1997). The list of potential adjustments is too lengthy to detail here.
Some adjustments are necessary to avoid mixing operating and financial decisions,
others provide a long-term perspective, and some are needed to convert GAAP
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accrual items to a cash-flow basis while others convert cash flow items to
additions to capital.
Step 3: Identify the company‘s capital structure
Because of the deficiency of GAAP in describing a company‘s real financial position
(Clinton and Chen, 1998), Stewart proposes up to 164 adjustments to regain the real
picture of a firm‘s financial performance (Stewart, 1991; Blair, 1997). These
adjustments are needed to eliminate financing distortions in a company‘s NOPAT and
capital (Stewart, 1991). Regarding adjustments, some accounting items such as costs for
research and product development, restructuring charges, and marketing outlays are
considered more as capital investments as opposed to expenses (Stewart, 1991).
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 (Van Horne,
2002). Stewart (1990) defined capital to be total assets subtracted with non- interest
bearing liabilities in the beginning of the period. However, it can be computed by either
of the following methods:
Direct Method: By adding all interest bearing debts (both short and long term) to owner‘s equity.
Indirect Method: By subtracting all non- interest bearing liabilities from total assets.
Step 4: Determine the company‘s COC rate for the individual sources of capital in capital structure
Estimation of COC is a great challenge so far as EVA calculation for a company is
concerned. It becomes more complex when small companies are considered whose
sources of capital are unstructured and varied over the years. The cost of capital
depends primarily on the use of the funds, not the source (Ross et al, 2003). It depends
on so many factors like financial structures, business risks, current interest level,
investors expectation, macro economic variables, volatility of incomes and so on. It is
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the minimum acceptable rate of return on new investment made by the firm from the
viewpoint of creditors and investors in the firms‘ securities (Schall and Haley, 1980).
Some financial management tools are available in this case to calculate the COC. A more
common and simple method is Weighted Average Cost of Capital (WACC)
(Copeland et al, 1996).
The overall COC is the weighted average of the costs of the various components of the
capital structure. WACC, though a good tool to compute accurate cost of capital, is less
useful for a small company. WACC includes both debt and equity part of financing. Each
element in the capital structure has an explicit, or opportunity, cost associated with it
(Block and Hirt, 2002). The cost of each component of the firm‘s capital, debt, preferred
stock, or common stock equity is the return that investors must forgo if they are to invest
in the firm‘s securities (Kolb and DeMong, 1988). Thus, the difficulty arises in both of
the cases. Cost of debt cannot be calculated because the debt instruments in this case are
not traded in the open market. It is measured by the interest rate, or yields, paid to
bondholders (Block and Hirt, 2002). Sometimes, these instruments have no developed
market. Again, cost of equity is also difficult to calculate due to the non- applicability of
the tools developed to this effect. For example, for large companies, the
Capital Asset Pricing Model (CAPM) is a common method in estimating the cost of
equity (Copeland et al, 1996). CAPM postulates that the cost of equity is equal to the
return on risk-free security plus a company‘s systematic risk, called beta, multiplied
by the market risk premium (Copeland et al, 1996). Risk premium is associated
with the specific risks of a given investment (Block and Hirt, 2002).
In our financial environment, even the betas for all large companies are not available. For
large publicly traded companies, betas are published regularly by services such as Value Line
(Reimann, 1988). For small companies, regression analysis may be used in order to
estimate their betas (Ross et al, 1999). The next obstacle is to get a proper value of
market risk premium. For large U.S. companies, the recommended market risk
premium is 5 to 6 percent (Copeland et al, 1996; Stewart, 1991). For publicly traded
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small companies, the market risk premium is significantly higher with values around 14
percent (Ross et al, 1999). These rates are not absolute rather relative as these depend on
time, location, macro economic variables and some other factors. In our environment,
market risk is so volatile that the appropriate premium, demanded by the
owners against their investment, for even the large companies cannot be
accurately estimated. Even no company takes the responsibility to work in this area. For
a small company, it cannot be thought of in current eco-financial setup.
Dividend discount model is another popular model in this case where market price of a
share is equal to the present value of future streams of dividends (Khan and Jain, 1999).
This model presupposes that the company under consideration is matured and normal
growth one that I have assumed in my case. However, in this case also, the presence
of an active market for securities is a must, otherwise, the COC (Equity ) cannot
be determined which is the discount rate (ke) in the following simplified version
of Gordon‘s dividend capitalization model:
P = E (1-b) / ke – br
Where, P = Price of shares E = Earnings per share b = Retention ratio Ke = Capitalization rate/ COC (Equity) br = g = growth rate in i.e., rate of return on investment in an all-equity firm.
Considering all of the obstacles, we suggested a method derived from the WACC
estimation and the CAPM model which have been adapted to the needs of small
companies. We identify this rate as COC rate just to make a distinction between WACC
that is used for large companies with the modified WACC. The COC that is developed
here with the applicability option of small companies as considered here. The COC
Table 4: An estimation of the capital employed by XYZ firm under indirect method or operating approach (in lacs Rupees) Components of Capital 2009 2010
Total Liabilities 50.32 74.94
Accounts Payable/ SundryCreditors
(11.76) (16.89)
Accrued Expenses (0.67) (0.75)
Other current liabilities (0.26) (0.39)
Capital 37.63 56.91
In calculating the capital, I assumed the book value of the liabilities truly
represent the current market value. Furthermore, since the XYZ‘s equity and other debts
are not traded in a financial market, it is assumed that the values on the balance sheet are
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good estimators of market values. Finally, no adjustment is made to convert the
accounting capital to financial capital just to keep the illustration simple and precise.
Step 4: Determine the company‘s COC rate for the individual sources of capital in capital structure
The COC rate has two parts. The prime rate for the cost of debt is 14% for this typical
firm and on an average, they have to pay other charges of 1% of the amount
borrowed. Thus, the pre-tax COC (Debt) will be 15% for the year 2010 if I put the values
in equation
. COC (Debt) = Prime Rate + Bank Charges
= 14 % + 1 % = 15 %
For the COC calculations, I have taken weighted average yield of 91days
government treasury bill rate (ranges between 6.50% - 7.50%) of 7.50% as a
proxy for risk free rate and according to my analysis; the company lies in average
risk area that requires 12% of risk premium. Having this information and equation,