Page 60 - DCOM409_CONTEMPORARY_ACCOUNTING

Unit 4: Economic Value Added (EVA)

1. Measurement: Any company that wishes to implement EVA should institutionalise Notes
the process of measuring the metric regularly. This measurement should be carried
out after carrying out the prescribed accounting adjustments.
2. Management system: The company should be willing to align its management system
to the EVA process. The EVA-based management system is the basis on which the
company should take decisions related the choice of strategy, capital allocation,
merger and acquisitions divesting business and goal setting.

3. Motivation: Companies should decide to implement EVA only if they are prepared
to implement the incentive plan that goes with it. An EVA-based incentive system,
however, encourages managers to operate in such a way as to maximize the EVA
not just of the operations they oversee, but of the company as whole.
4. Mindset: The effective implementation of EVA necessitates a change in the culture
and mindset of the company. All constituents of the organisation need to be taught
to focus on the objective of maximising EVA. This singular focus leaves no room for
ambiguity and it is also not difficult for employees to know just what actions of
theirs will create EVA, and which will destroy it.

Self Assessment

State true or false:

1. EVA is ideally suited to private companies.
2. If a company’s EVA is positive, the firm is destroying shareholders wealth.
3. The excess of returns over cost of capital is simply termed as Economic Value Added
(EVA).
4. EVA measurement also requires a company to be more careful about resource mobilization,
resource allocation and investment decisions.

5. EVA measures whether the operating profit is sufficient enough to cover cost of capital.

4.2 Approaches to Computation of EVA

The pure EVA calculation for the company as a whole is:
Net Operating Profit After Taxes (NOPAT) — Capital Charge (Capital Investment × Cost of
Capital)
But purely speaking, there is no net operating profit after taxes (NOPAT) arising out of an IT
investment, so the net financial benefits of the IT investment are used as a replacement for
NOPAT.

Example: Consider, for instance, a case where the cost-benefit analysis reveals that a
` 50,000 IT investment will return `8,000 in net quantifiable benefits. The ROI is 16% (` 8,000
divided by ` 50,000). The cost of capital in the company is 12%. Using the formula above, the EVA
in this case is ` 2,000.

` 8,000 net benefits - (` 50,000 capital investment × 12% cost of capital) = ` 2,000 EVA
Another way to calculate EVA in this example is to simply deduct the 12% cost of capital from
the 16% ROI, then multiply by the investment:

4% × `50,000 = ` 2,000 EVA

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