Page 66 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes each of which earns a 25 per cent return on its total net assets. However, the EVA of the
divisions is significantly different. Below are the data for three divisions:
Table 4.3: Division

X Y Z
Total net assets 100,000 500,000 1000,000
Net income 25,000 125,000 250,000
ROI on net assets 25% 25% 25%

Target net income (15% of net assets) 15,000 75,000 150,000
EVA (net income – target net income) 10,000 50,000 100,000

Each division earned the same rate of return on net assets, and each has the same percentage
target net income requirement. Still the EVA measures are dramatically different among
the divisions. This approach has a tendency to highlight the divisions that generate the
largest rupee profits for the firm.
2. Most of the problem in measuring the divisional income and divisional investment base
are also present in the measurement of EVA.
3. There is additional risk of selecting a fair and equitable measure of the required cut-off
percentage (i.e., the cost of capital).
4. EVA can be readily transformed into ROI and many firms tend to convert EVA into ROI.
The relationship between EVA and ROI is as follows:

EVA
ROI =  K
1
Where, ROI = Return on investment
EVA = Economic Value Added
I = Investment

K = Cost of capital
The two methods however, may show different results. In face of such a conflict, a question may
arise: which of two must be considered more reliable?

Task Taking the example of different companies, analyze how the corporates have used
EVA model.
Illustration:
Income Statement

Net Sales 2,600.00
Cost of Goods Sold 1,400.00
SG&A Expenses 400.00
Depreciation 150.00

60 LOVELY PROFESSIONAL UNIVERSITY