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Unit 4: Economic Value Added (EVA)

relative to target. The EVA target is set for every year on the basis of a standardized acceptable Notes
formula. At the beginning of each year, the list of participating employees for the EVA bonus
plan is disclosed along with the formula for calculating bonus on the basis of EVA. The formula
is so transparent that each eligible employee can calculate his or her bonus without waiting for
the authority to announce the same. The success of EVA lies only in its linking with the
compensation plan. EVA would be effective only when the corporate decision-makers and even
the rank and file officers get bonus linked to improvement in EVA.

4.4 Superiority of EVA

EVA is a superior measure of corporate performance and reflects all the dimensions by which
management can increase value. It helps in creation of wealth in the following ways:

EVA is most directly linked to the creation of shareholder’s wealth over time. The term
‘maximising value’ in the EVA context, means maximising long-term yield on shareholders
investment and not just the absolute amount of earnings/profits.
The mechanism of EVA forces management to expressly recognize is cost of equity in all
its decisions from the boardroom to the shop floor. The inclusion of this element in
overall cost of capital results into the goal congruence of the managers and owners.
An EVA financial management system removes all the inconsistencies resulting from the
use of different financial measures for different corporate functions under the typical
traditional financial management system, as it ties all the functions; for instance:
Reviewing a capital budgeting process,
Valuing an acquisition,
Considering strategic plan alternatives,

Assessing performance,
Communicating,
Rewarding management.
To one single measure - the effect on shareholder value and thus provides a meaningful
target to pursue for both internal and external-oriented decisions.

EVA compensation system ties management’s interest with those of shareholders.
EVA captures the performance status of corporate system over a broader canvas i.e., to
arrive at true profits, cost of borrowed capital as well as cost of equity capital should be
deducted from net operating profits. Further, to maximize earnings is not sufficient, at the
same time consumption of capital should be minimum optimum under an EVA-based
system.
EVA framework provides a clear perception of underlying economics of a business and
enables managers to make better decisions.

A regular monitoring of EVA emphasises on problem areas of a company and helps
managers to take corrective actions.
It is used to assess the likely impact of competing strategies on shareholder’s wealth and
thus helps the management to select the one that will best serve shareholders.
It also fits well with the concept of corporate governance. EVA bonus systems do this by
giving employees an ownership stake in improvements in the EVA of their divisions or
operations. This causes employees to behave like owners and reduces or eliminates the
need for outside interference in decision-making.

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