Excerpt

## List of content

Executive Summary

List of content

List of figures and tables

List of abbreviations

1 Introduction

2 Theoretical conception of EVA

3 Calculation of the measurement

3.1 Rate of return - r

3.2 Cost of capital - WACC and CAPM

3.3 Conversions in the measurement

4 Application of EVA - example Fresenius

4.1 Indicating the critical parameter for Fresenius

4.2 Calculation of the measurement EVA

4.3 EVA compared to other measurements

5 Evaluation of the concept

5.1 Strengths of EVA

5.2 Weaknesses of EVA

6 Summary

List of literature

Appendix

Integral Total Management (ITM)

## Executive Summary

Creation of shareholder value; this simple Idea has become a principle of corporate governance over the past fifty years (Lazonick et al, 2000). Managers shall maximize the value of their business by efficiently allocating resources and hence increase the wealth of shareholders (Worthington et al, 2001). The operationalization of this objective is done by various indicators. Shareholders, managers and other interested parties strongly follow these in order to assess business and predict future performance. EVA is one of these indicators.

The following paper presents the concept and measurement behind the trademark EVA. It is practically applied for the company Fresenius in a simplified way. Theoretical and practical analyses reveal strengths and weaknesses of measurement and concept. In general it can be said that EVA is one approach to identify value creation and degrading. The concept can be used for investment decisions as well as performance appraisal. Main disadvantage has been identified to be a high degree of complexity in order to derive the true EVA. If adjustments are not made the measurement appears to be similar to other residual income indicators.

## List of figures and tables

Figure 1 : Summarizing financial and operating approach to rate of return

Figure 2: Break down of key measures

Table 1 : Calculation of NOPAT

Table 2: Calculation of capital employed

Table 3: Calculation of rate of return

Table 4: Calculation of cost of capital

Table 5: Calculation of EVA for Fresenius

Table 6: Calculation of EVA for Fresenius with conversion R&D

Table 7: Comparison of value indicators

## List of abbreviations

illustration not visible in this excerpt

## 1 Introduction

Economic Value Added, that is EVA standing "well out from the crowd as the single best measure of wealth creation on a contemporaneous basis [and] is almost 50% better than its closest accounting-based competitor in explaining changes in shareholder wealth” (Stewart, 1994, p.75). Within a short period the registered trademark EVA and the concept behind have gained significant presence internationally with "literally hundreds of firms adopting EVA to some degree, among them Coca-Cola Co., Eli Lilly and Co., and the Postal Service in the US” (Biddle, 1998, p.62). Some researchers, such as Lehn and Makhija (1996), claim that EVA would be the superior tool compared to other performance measurement tools. Other examiners argue that the usage of EVA has no significant impact on changes of the economic value of a business (Worthington et al, 2001 ).

The paper on hand aims at exploring the concept EVA and its measures. Strengths and weaknesses of Stern and Stewart’s concept shall be identified in order to proof respectively refute the image of a superior financial performance measure and value creation tool compared to conventional methods. Six chapters will guide the analysis. The second section gives an outline of the theoretical base of the concept. Thereupon the measurement will be presented by breaking down its components for calculation. Chapter four offers an application example, using a globally well-known business within the medical care sector, Fresenius. Strengths and weaknesses of the concept will be discussed in section five. The last chapter summarizes the findings.

Information on this topic has been gathered from secondary sources. The theoretical part as well as evaluation points was drawn from Stewart and Stern et all as well as researchers on the field. Annual reports of Fresenius built the basis for the practical application of EVA.

## 2 Theoretical conception of EVA

"Investors are looking at the cash to be generated over the life of a business and the risk of the cash receipts” instead of earnings as Stewart emphasizes (1991, p. 22). Hence the ultimate target of the EVA concept is the evaluation of investments and its creation of shareholder value. Value will be created if the allocated return will exceed the cost of capital of this investment (Fackler et al, 2009). EVA is built upon a residual income measurement and reveals the performance of the business over a defined period of time in the past by the result of an absolute value (Baumgartner, 2012).

The implementation of an EVA based performance measurement tool is the central challenge of the concept (Stewart, 1991). It supports all decision making processes starting from investment correspondingly divestment plans, acquisitions and valuation of individual business operations (Hostettler, 2003). Valuation of business and individual operations is possible with the EVA measurement: future EVA measures will be discounted and determine the market value added, MVA. Capital employed from the current period will be charged up (Hoke, 2002).

The transfer to performance appraisal is part of the success of EVA. Stewart calls this "value sharing: making everyone a meaningful partner in the process of adding value” (1991, p.223). All levels of management shall transform their behavior from employees towards owners. Thus Stewart concluded to involve a reward system that would employ a bonus plan based on EVA improvements over time, which can be measured yearly, quarterly and monthly (1991). The bonus should not be capped at a certain level as this would slow down further value creation once reached. On the other hand negative EVA should be penalized thereby incentivizing managers to decrease value losses to a minimum if the target is not reachable (Hostettler, 1997). A long term bonus bank will keep track of positive and negative bonus developments (Pullmann, 2011).

## 3 Calculation of the measurement

Stern et all define the EVA measurement as "the after-tax cash net operating profit less a charge for capital employed to produce those profits [...] The capital charge is the required or minimum rate of return necessary to compensate all the firm’s investors [...] for the risk of investment” (1996, p.236). There are two calculation ways leading to the same result (Stewart, 1991): the first calculation (1) measures the spread between rate of return, r, on the capital and the cost of capital, WACC, then multiplying by book value of capital employed. It is called "value spread” approach (Fackler et al, 2009, p.316).

The second calculation way (2), called "capital charge calculation”, multiplies the capital employed directly by rate of return, resulting into the net operating profit after tax (NOPAT), and cost of capital. Both calculations do not distinguish between equity and debt capital, therefore gives same information to owners as well as investors.

EVA = (r -WACC ) x capital (1)

= (rate of return — cost of capital) x capital employed = NOPAT — (cost of capital x capital employed) (2)

### 3.1 Rate of return - r

The rate of return, r, is computed by dividing the net operating profit after taxes by the total capital employed in operations.

illustration not visible in this excerpt

The net operating profit after taxes, NOPAT, is one measurement of the free cash flow of a business. The NOPAT is the earnings derived from business operations after tax but before financing costs and non-cash bookkeeping entries (Investopedia US, 2012 a).The measurement reflects the potential dividend payouts belonging to all providers of capital (Copeland et all, 1990).

The term capital employed refers to all the cash that has been invested into the business (Investopedia US, 2012 b). In accordance with the usage of NOPAT, capital employed does not respect financing sources. Capital employed comes from debt as well as equity and can be used for working capital as well as fixed assets (Stewart, 1991).

There are two ways to compute r: from a financing and an operating perspective. The financing perspective begins with the adaption or rather the removal of effects from the capital structure. The result of this adjustment reflects both figures as if they were financed solely with equity capital (Fackler et al, 2009). In a second and third step other financial and accounting distortions will be eliminated. Notably for each component of capital, there has to be a corresponding entry for the calculation of the NOPAT (Stewart, 1991).

The operating perspective is also shown in figure 1. From this perspective capital is defined as net working capital plus net fixed assets. Net working capital is derived by current assets minus non-interest bearing current liabilities, NIBCL, such as accounts payable and accrued expenses. Net fixed assets contain all long term capital, such as net property, plant and equipment as well as goodwill. The NOPAT will be derived from sales minus operating expenses minus cash operating taxes (Stern et all, 1996; Fackler et al, 2009).

Figure 1: Summarizing financial and operating approach to rate of return

illustration not visible in this excerpt

### 3.2 Cost of capital - WACC and CAPM

The parameter WACC is the abbreviation for weighted average cost of capital. It represents the average demanded return of all investors. The financing structure of the business is being proportionally weighted with equity capital (EC) and debt capital (DC) at market value (MV) (Rappaport, 1986).

illustration not visible in this excerpt

#### 3.2.1 Cost of equity - CAPM

In order to compute rEC, the expected rate of return from EC, there is a variety of possible approaches. Knüsel and other authors advice the usage of CAPM, standing for capital asset pricing model (1994). The calculation is shown in following equation:

illustration not visible in this excerpt

The equation consists of two components: time value of money and risk. "The time value of money is represented by the risk-free rate rf " (Investopedia US, 2012 c). Risk on the other hand is measured by beta (ß), which is a business specific risk index of the market, and a market risk premium (MRP), which is derived from the expected return of the market portfolio minus the risk free rate (rm - rf ) (Brealey et al, 2000).

#### 3.2.2 Cost of debt

The calculation of the cost of debt, rDC, uses the interest rate that the business has to pay if it would obtain new long-term DC at the current market conditions. Similar to cost of equity, the cost of debt consists of risk free interest rate and a risk premium, called credit spread. In case the business is publicly trading debt, the cost of debt can be derived from the prevailing bond price. Alternatively the cost of debt can be determined by an average of debt positions in past annual statements (Fackler et al, 2009).

Interest payments for DC reduce the tax base, therefore lead to higher cash flows for the equity investors. For calculating EVA, this tax shield has to be subtracted from the cost of debt capital (1-7) (Stern et all, 1996).

### 3.3 Conversions in the measurement

The practical implementation of EVA is accompanied by a number of “conversions”, as Hostettler describes (Hostettler, 1997, p. 97), with the attempt to remove distortions of the economic performance coming from shortcomings in conventional accounting standards and to introduce the characteristics of the business, such as size, risk profile and strategy (Stewart, 1991). Conversions are made in the calculation of the NOPAT in order to preserve an economic performance indicator and in the computing of capital for estimating market value. Stern and Stewart have identified over 164 conversions. Stern et all advise to anticipate between fifteen and twenty-five key conversions in detail with the remark to check for necessity (1996).

One critical conversion is research and development (R&D): under the generally accepted accounting principles these are required to be expensed as if the full value has been returned in the same period. Businesses in pharmaceutics and technology heavily invest in R&D activities; hence do not disclose high earnings per period (PwC, 2010). Yet these investments are aimed at creating future economic value, corresponding to tangible assets, and therefore should be regarded as capital expenditures rather than expenses.

The switch of valuation methods for inventories from ”first in, first out” to “last in, first out”, and vice versa, is another example that will impact reported returns. Further conversions will not be discussed in this paper.

**[...]**

- Quote paper
- Anne-Kristin Rademacher (Author), 2012, Creation of shareholder value by application of EVA , Munich, GRIN Verlag, https://www.grin.com/document/213654

Publish now - it's free

Comments