Economic Value Added (EVA). Drivers and Leverages

How Sales can maximize Shareholder Value


Project Report, 2011

28 Pages, Grade: 1,5


Excerpt


Table of Contents

List of abbreviations

List of graphics

1. Introduction
1.1 Introduction to the topic
1.2 Purpose of this paper

2. Definition of Economic Value Added (EVA)
2.1 Short Overview
2.2 NOPAT (Net Operating Profits After Taxes)
2.3 Capital Charge
2.3.1 Basic formula
2.3.2 Net Operating Assets (NOA)
2.3.3 Weighted Average Cost of Capital (WACC)

3. Rationale and purpose of EVA
3.1 Rationale behind EVA
3.2 Purpose of EVA
3.2.1 EVA as capital market-oriented evaluation tool
3.2.2 EVA as performance measure for companies
3.2.3 EVA as a solution for the Principal-Agent approach
3.3 EVA and Shareholder Value

4. Drivers of EVA
4.1 Decisions with impact on EVA
4.1.1 Overview
4.1.2 Operative decisions
4.1.3 Investment decisions
4.1.4 Financing decisions
4.2 EVA driver tree
4.3 Drivers of NOPAT
4.4 Drivers of the Capital Charge

5. EVA in the specific business context
5.3 Importance of EVA for Global Players
5.5 Adapted leverages for a regional Sales department
5.5.1 Overview
5.5.2 Result Management
5.5.3 Working Capital Management

6. Effect-on-EVA
6.1 Purpose of Effect-on-EVA
6.2 Components of Effect-on-EVA
6.2.1 Overview
6.2.2 Effect-on-NOPAT
6.2.3 Effect-on-Capital-Charge
6.2.4 Example
6.3 Implementation

7. Conclusion

Bibliography

List of abbreviations

illustration not visible in this excerpt

List of graphics

Figure 1: Bookkeeping view and shareholder view on profits

Figure 2: Market Value Added (MVA) and Economic Value Added (EVA)

Figure 3: EVA driver tree

Figure 4: Changes in Return and Capital Commitment

Figure 5: Leverages of the department on EVA

Figure 6: Potential for improvement in Working Capital

Figure 7: Effect-on-EVA and its Drivers

Figure 8: Drivers of Effect-on-EVA

Figure 9: Excel Calculation Model for Effect-on-EVA

1. Introduction

1.1 Introduction to the topic

From a general view, the key question for any company should be for which purpose it does exist. There is lot of different thinking on this issue, having led to a strong debate in world economy. “The business of a business is business”[1], stated the well-known economist Milton Friedman who was awarded Nobel Memorial Prize in Economic Sciences in 1976[2]. By these famous words, Friedman outlines the necessity to focus only on things that have direct impact on business itself and to align the objectives and decision-making in a company according to those stakeholders which are considered to be most essential for a company’s success: the investors, or shareholders. Principally, economists share Friedman’s point-of-view and see the basic rationale of a company in maximizing its shareholder value: “It is a standard doctrine […] in much of the business community that firms should maximize the stock market value.”[3] Consequently, this approach does not seem only to be respected by contemporary managers, it seems to be the most essential rationale, “the sole legitimate purpose”[4], of doing business. The importance of shareholder value arises from the fact that its creation enables companies to obtain large amounts of capital from the markets as shareholders hope to gain profits out of their investments. The approach outlined above seems to be a logic consequence of the fact that shareholders obtain also the risk to lose their money when buying shares of a company. The shareholder value approach underlies the fact that risk and the right to participate in decision-making are owned by each single shareholder. Finally, each single operative part of a company should concentrate on its contribution to the performance of the company’s shareholder value. Eventually, this paper elaborates on a possibility to control the contribution to shareholder value from the point of view of a regional Sales department.

1.2 Purpose of this paper

From the contemporary dominance[5] of the shareholder value approach arises more and more the necessity to precisely detect its performance as shareholder value is broadly seen as a significant indicator determining a company’s success or failure[6]. However, measuring the performance of a company’s shareholder value can be very challenging. Hence, the purpose of this paper is to deal with a well-known approach that enables businesses to detect its shareholder value performance: Economic Value Added (EVA)[7]. The thesis discusses the correlation between EVA and shareholder value, it further outlines its main drivers. In the second part, the paper elaborates on the specific links of the EVA approach to a regional Sales department and identifies the department’s main leverages on EVA. In order to detect the influence of the main operative decisions on EVA, the thesis introduces the key figure Effect-on-EVA. The applicability of Effect-on-EVA is shown in a model calculation. Above all, this project thesis shall create a profound practical value by sharpening the awareness of how to influence EVA in a positive way. In order to meet the recommended scope, the paper does not elaborate Asset Management, Accounts Receivable Management and Incentive Compensation in detail, but strives to point out the respective links to EVA.

2. Definition of Economic Value Added (EVA)

2.1 Short Overview

As outlined in the introduction, the performance of a company’s shareholder value is a decisive factor determining whether a business can succeed or not. However, despite managers are aware of this circumstance, economists observe the trend that shareholder value is rather interpreted as a buzzword[8] than as a fundamental approach coming up with the challenge to implement dedicated controlling frameworks. For this purpose, in 1991 the US consultancy Stern Stewart & Co. developed[9] “a fully-integrated framework for financial management and incentive compensation. The heart of this framework is ‘Economic Value Added’, or ‘EVA’.”[10] EVA (Economic Value Added) is the Net Operating Profit After Taxes (NOPAT) reduced by the Capital Charge that is employed to produce those earnings.[11] The term EVA is a registered trademark.[12]

The formula is: EVA = NOPAT – Capital Charge

Consequently, EVA shows only that part of the total earnings after taxes that exceeds the Capital Charge. To sum up, EVA measures by which amount the earnings of a company top the return that shareholders could gain from other investments with similar risks.[13]

2.2 NOPAT (Net Operating Profits After Taxes)

“NOPAT is the profits derived from the company’s operations after taxes but before financing costs and non-cash-bookkeeping entries”[14]. It is calculated as the profit after deduction taxes, but before deduction of financing costs.

The formula is: NOPAT = EBIT – Adjusted Taxes

2.3 Capital Charge

2.3.1 Basic formula

In order to calculate the Capital Charge, both Net Operating Assets (NOA)[15] and the Weighted Average Cost of Capital (WACC)[16] have to be considered.

The formula is: Capital Charge = NOA * WACC

2.3.2 Net Operating Assets (NOA)

The basis of Net Operating Assets is the active side of the balance sheet. NOA include Fixed Assets and the Net Working Capital. However, further corrections are often necessary: Capitalized and not operationally used assets and also non-capitalized and operationally used assets must be treated specifically.[17]

The formula is: NOA = Fixed Assets + Net Working Capital

The Net Working Capital is calculated by the following scheme: Stock-in Trade plus Accounts Receivable, reduced by Accounts Payable and Advances Received.[18]

The formula is: Net Working Capital = + Stock-in Trade

+ Accounts Receivable

– Accounts Payable

– Advances Received

2.3.3 Weighted Average Cost of Capital (WACC)

For the calculation of WACC (Weighted Average Cost of Capital), the cost of debt and the cost of equity are added up relative to the capital structure of the company. The cost of debt cd is cost that incurs when borrowing money from external providers of debt capital, whereas the cost of equity ce represents the returns that are expected by the shareholders.[19] Concerning the calculation of cost of equity, three factors are to be considered: Firstly, investors expect a time-based and fixed return if from their investment; secondly, a risk-based return, determined by a market risk percentage mr, and thirdly there is the so-called business-specific β -factor, representing any further business-related risks.[20] “The β -factor of a share expresses the responsiveness of a share regarding the trend of the market. A share with β -factor 1.2 gave reason to expect an appreciation of value by 12 percent, if the market index would rise by 10 percent.”[21] In fact, β determines the so-called risk premium, which is (mr - if) * β. Note, that all these findings are based on the Capital-Asset Pricing Model (CAPM).[22]

The formula is: ce = if + (mr - if) * β

In order to calculate WACC, it is now necessary to detect the relation of equity (E) and debt capital (D) in a company. The cost of equity ce is calculated as set out above, the cost of debt cd (after taxes) is usually predetermined by the total interest burden.

The formula is: WACC = ce * (E/D ) + cd * (1 – (E/D))[23]

3. Rationale and purpose of EVA

3.1 Rationale behind EVA

The rationale behind EVA seems to be clearly pointed out in previous sections: As the operating profits are reduced by the Capital Charge, a “residual income”[24], or EVA, is left over. However, the rationale behind subtracting the Capital Charge from the profits is not elaborated, yet. This occurs since EVA does not show any bookkeeping profit; instead it shows a kind of economic profit[25] (there are various kinds of economic profits, for instance Cash Value Added (CVA) or Added Value[26]). From a bookkeeping view, profit is gained, when the Return on Equity (ROE) is greater than zero. However, the real profit of a shareholder derives from the fact that profits exceed his or her yield expectations.[27] The following figure clearly indicates the difference between the bookkeeping profit and the economic profit: From the shareholders’ point of view, ROE (Return of Equity) should be greater than the cost of equity ce (the target rate of return) in order to cross the economic zero line.[28] The shareholders’ yield expectation is equal to their cost of equity ce.

illustration not visible in this excerpt

Figure 1 : Bookkeeping view and shareholder view on profits

3.2 Purpose of EVA

3.2.1 EVA as capital market-oriented evaluation tool

Receiving capital becomes a more and more crucial element of business administration as the search for new investors is highly competitive. Therefore, companies have to provide profound information about their shareholder value’s performance. EVA can help to identify a business’s attractiveness for investors; some describe it as “the most important leverage for the creation of shareholder value”[29] as it provides clear information whether an investment is profitable or not and thus simplifies benchmarking. When investors have to judge whether an investment is profitable or not, a decision support underlying one single indicator, EVA, seems to be desirable. “The EVA approach is good news for the company’s shareholders because it relates company performance directly to the shareholder value. If a company maximizes EVA, it will improve earnings and all the traditional measures of value”[30]. Hence, a positive EVA clearly indicates that a company creates shareholder value. The better is the performance of its drivers – which are discussed in later chapters – the more significant is the increase of EVA, and thereby of shareholder value. Broadly speaking, this means that companies which set their heart on the drivers of EVA can provide the requested orientation to their shareholders’ interests and objectives. The relation of EVA to shareholder value is outlined more in detail in later sections.

3.2.2 EVA as performance measure for companies

As already stated, EVA indicates the profit that exceeds the Capital Charge. It shows an absolute value, being calculated for a predefined accounting period.[31] In order to interpret an EVA value independently from the company’s size, EVA can be related to NOA. The result of this calculation is the so-called Value Spread[32]. Arithmetically aligned, the value spread is calculated by reducing the rate of return – which is NOPAT divided by NOA – by the WACC.[33]

The formula is: Value Spread = (NOPAT/NOA) – WACC

Thus, the Value Spread indicates, whether the investment can create value or not. For creating value, it is necessary that “…the company is investing at a rate of return greater than that demanded by investors in the security market.”[34] Consequently, if the Value Spread is greater than zero, a business does create value. In addition to that, EVA can also be related to the Return on Sales (ROS) in order to measure the entrepreneurial performance. However, the main underlying idea of EVA being used as a performance measure inside a company is, that “…if a company maximizes EVA, it will improve earnings and all the traditional measures of value.”[35] Vice versa, logically, if a company improves the traditional measures of value, this will have a significantly positive effect on EVA. The drivers of a business’s EVA are identified in later chapters and are discussed in detail in the practical part of this thesis.

3.2.3 EVA as a solution for the Principal-Agent approach

Moreover, EVA corresponds to the Principal-Agent approach which elaborates on the fact that shareholders (principals) transfer their controllership to the management (agents)[36]. As a consequence, a so-called Principal-Agent-relationship emerges, leading to “hidden intention” and/or “hidden action” of managers.[37] In order to manage a company according to the interests of the shareholders and with the aligned objectives, managers need a measure to control themselves and to avoid “hidden intention” and “hidden action”. Efficient incentive systems can ensure the avoidance of effects that derive from a principal-agent-relationship and from the imbalance of information and interests. As EVA is “a superior measure of performance because it charges management for using capital at an appropriate risk-adjusted rate”[38], an EVA-oriented incentive strategy is likely to respond to the issues of the principal-agent approach.

3.3 EVA and Shareholder Value

In previous sections, a substantial correlation between EVA and shareholder value is outlined. However, EVA has its limitations and weaknesses and cannot provide completely nonbiased information on a company’s performance with regard to shareholder value.[39] Boston Consulting Group found out that the correlation between EVA, being considered “a beguiling solution”[40], and shareholder value should not be overestimated as it is not that clear as stated in the majority of EVA-related literature. Several weaknesses of EVA are pointed out. Firstly, EVA penalizes betting on growth: When investing in new assets with long-term amortization, the Capital Charge rockets and EVA decreases. Thus, aligning the decision-making in a company only to EVA can even reward antigrowth-strategies.[41] In addition to that, EVA provokes managers “to reduce assets faster than earnings – to milk the business.”[42] Nevertheless, a significant correlation between EVA and shareholder value does exist. According to Rappaport, management can influence the performance of shareholder value by decision-making on three different planes: firstly, operative decisions that have direct impact on the entrepreneurial performance; secondly, investment decisions influencing the assets; thirdly, financing decisions with impact on the liability side of the balance sheet.[43] EVA unites all these different planes in one single KPI. This fact is also elaborated in further chapters.

[...]


[1] Friedman, M. (publication date unknown)

[2] Anon (2012)

[3] Humphreys, M.; Sachs, J.; Stiglitz, J. E. (2007), pp. 28-29

[4] Davis, I. (2005)

[5] cf. Philipp, B.C. (1995), p. 23

[6] cf. Rappaport, A. (1986), p. 1

[7] cf. Stewart, G.B. (1991), p. 1

[8] Volkart, R (1995), pp. 1064-1067

[9] cf. Stewart, G.B. (1991), p. 2

[10] Stern Stewart & Co (1993), p. 2

[11] cf. Stewart, G.B. (1991), p.2

[12] cf. Stern Stewart & Co (2001), p. 9

[13] cf. 2.3.3

[14] Stewart, G.B. (1991), p. 86

[15] cf. Hostettler, S. (2000), p. 111

[16] cf. Hostettler, S. (2000), p. 168

[17] cf. Hostettler, S. (2000), pp. 111-112

[18] cf. Schöning, S.; Rutsch, J.C.; Schmitt, M. (2012), p. 242

[19] cf. Brigham, E.F.; Ehrhardt, M.C. (2011), p. 339

[20] cf. Hostettler, S. (2000), pp. 160-161

[21] English translation; cf. Kleeberg, J.M. (1992), p. 474

[22] Hull, J.C. (2012), pp. 73-74

[23] cf. Hostettler, S. (2000), p. 168

[24] Stern, J.M. (1994), p. 49

[25] cf. Hostettler, S. (2000), p. 38

[26] cf. Hostettler, S. (2000), p.76

[27] cf. Hostettler, S. (2000), pp. 40-41

[28] cf. figure 1

[29] Stern Stewart & Co (2001), p.36

[30] Jones, T.P. (1995), pp. 12-19

[31] Copeland, T.; Koller, T.; Murrin, J. (1994), p. 145

[32] Hostettler, S. (2000), p. 252

[33] Hostettler, S. (2000), p. 252

[34] Rappaport, A. (1986), p. 173

[35] Jones, T.P. (1995), p. 19

[36] cf. Bühner, R.; Weinberger, H.-J. (1991), p. 194

[37] cf. Wöhe, G. (2010), p. 64

[38] Stewart, G.B. (1994), p.74

[39] cf. Boston Consulting Group (1996), p. 1

[40] Boston Consulting Group (1996), p. 1

[41] cf. Boston Consulting Group (1996), p. 1

[42] Boston Consulting Group (1996), p. 1

[43] cf. Rappaport, A. (1986), pp. 76ff

Excerpt out of 28 pages

Details

Title
Economic Value Added (EVA). Drivers and Leverages
Subtitle
How Sales can maximize Shareholder Value
College
University of Cooperative Education Stuttgart; Horb
Grade
1,5
Author
Year
2011
Pages
28
Catalog Number
V212413
ISBN (eBook)
9783656405061
ISBN (Book)
9783656405580
File size
1509 KB
Language
English
Keywords
EVA, Economic Value Added, Shareholder Value, MVA, WACC, NOPAT, Working Capital, Capital Market, Asset Management
Quote paper
Dirian El Amine (Author), 2011, Economic Value Added (EVA). Drivers and Leverages, Munich, GRIN Verlag, https://www.grin.com/document/212413

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