Page 59 - DCOM409_CONTEMPORARY_ACCOUNTING

Contemporary Accounting

Notes
!
Caution EVA is a management philosophy and performance metric that elevates those
goals from intuition to rigorous analysis and ensures that no investment escapes scrutiny.

4.1 Concept of EVA

The New York-based financial advisory Stern Stewart and Co. postulated a concept of economic
income in 1990 in the name of ‘Economic Value Added’ (EVA). EVA is a modified version of
residual income concept. EVA has provided financial discipline in many US companies,
encouraged managers to act like owners and has boosted shareholders returns and the value of
their companies. The company creates shareholder value only if it generates returns in excess of
its cost of capital. The excess of returns over cost of capital is simply termed as Economic Value
Added (EVA).

Did u know? What is the role of EVA?
EVA measures whether the operating profit is sufficient enough to cover cost of capital.
Shareholders must earn sufficient returns for the risk they have taken in investing their money
in company’s capital. The returns generated by the company for shareholders have to be more
than the cost of capital to justify risk taken by the shareholders. If a company’s EVA is negative,
the firm is destroying shareholders wealth even though it may be reporting positive and growing
EPS or return on capital employed EVA is just a way of measuring an operation’s real profitability.
EVA holds a company accountable for the cost of capital it uses to expand and operate its
business and attempt to show whether a company is creating a real value for its shareholders.
EVA is a better system than ROI, to encourage growth in new products, new equipment and new
manufacturing facilities. EVA measurement also requires a company to be more careful about
resource mobilization, resource allocation and investment decisions. It effectively measures the
productivity of all factors of production. EVA can be calculated as follows:
EVA = NOPAT (TCE x WACC)

Where,
NOPAT = Net operating profit after tax
TCE = Total capital employed

WACC = Weighted average cost of capital
The fundamental proposition of EVA is that capital isn’t free and its cost must be factored into
every benefit analysis or return-on-investment model when an investment in a plant, equipment
or a new customer relationship management system is contemplated. Putting a finer point on
this concept, EVA targets equity capital as opposed to debt capital. Managers often treat equity
capital as free when it’s not—shareholders could have invested elsewhere.

Notes Steps in Implementing EVA
The implementation of EVA is a 4-step process that includes: (a) Measurement,
(b) Management System, (c) Motivation and (d) Mindset.

Contd...

54 LOVELY PROFESSIONAL UNIVERSITY