The present chapter discusses the conceptual framework of Economic Value Added, a value based management tool, used to measure the corporate financial performance. It is also used as a yardstick to pay compensation and provide incentives to the managers. The chapter focuses on the conceptual framework and computational aspects of EVA alongwith its superiority over the traditional performance measures.
This chapter is divided into nine sections. Section 2.1 gives the introduction of the performance measurement. The traditional performance measures are discussed in section 2.2. After giving an overview of value based management in section 2.3, the value based measures like SVA, MVA, CVA, CFROI, and WA have been discussed in section 2.4.
Section 2.5 covers the concept and methodology of computing EVA and the accounting adjustments necessary to convert the accounting profit into the economic profit to arrive at the EVA value. Also, the different measurement challenges faced while computing EVA are discussed. It also covers the uses, benefits, limitations of EVA besides the strategies which can be used to increase EVA.
Section 2.6 explains the superiority of EVA over the traditional performance measures. Various aspects related to the implementation of EVA are discussed in section 2.7.Section 2.8 deals with the implementation process of EVA.
Various mistakes related to the implementation of EVA are outlined in section 2.9 followed by the conclusion in section 2.10.
2.1 PERFORMANCE MEASUREMENT
Potential investors measure overall performance of a firm as a whole to decide whether to invest in the firm or not. Existing investors measure the performance to decide whether to continue with the firm or to exit from it. Metrics of performance play a very important role not only in evaluating the current performance of the firm but also in achieving high performance and growth in the future. Value creation and maximization for the stakeholders depends on their various conflicting interests towards a common goal.
The performance of a firm gets reflected on its valuation by the capital markets. This evaluation reflects existing and potential investors’ perception about the current and the future performance of the firm. The major problem, which can destroy value, is the fact that some managers focus and pursue other goals such as market share, customer satisfaction, employment satisfaction and jobs rather than the goal of value creation.
Young and O’Byrne explained the importance of shareholders’ value creation as well as stakeholders’ value creation on the claim of Coca – Cola in its 1995 annual report: “Coca- Cola provides value to everyone who touches it.” In other words, this claim presents the philosophical approach of Coke’s managers. According to their opinion, the shareholders’ value can be delivered only by delivering value to everyone, because if customers or employees are not satisfied, they can easily change the company. On the other hand, Neumaierova and Neumaier has emphasized that the company should prefer shareholders’ value creation because shareholders comprise the main group of stakeholders and also bear the highest level of risk. In order to create stakeholders value in long run, first of all the company has to satisfy the requirements of the shareholders.
Performance measures are used to deliver information to support the corporate decisions and to deliver information to assess the divisional performance. Business world becomes extremely complex due to the technological development and innovation in the field of operations along with the logical demand of the consumer groups for the quality product at a minimum price. The companies are getting serious to incorporate all of these in a single package. Employee motivation is also getting preference since a highly motivated employee will work hard towards achieving the performance goals. Along with motivation, performance evaluation comes up to evaluate the extent of motivation. People are searching for the better performance measurement tool that will help them to rightly judge the employees. Thus, the performance measurement has become a continuous effort and a challenging style on part of the management to drive the workforce towards the goal congruence.
Since there are different approaches to measure the performance, it is very important for the company to identify and choose such a metric, which measures the firms’ value as much as possible without being biased towards any of the stakeholders. The selection of the appropriate measurement tool is critical for the success of the firm. Most of the currently used performance measures are based on the current net income, total assets, and net sales or similar inputs or outputs of the business unit. Examples of such metrics are EBIT, ROE, ROA, ROI, FCF, EPS and P/E ratio. Though these metrics measure various aspects of the company’s performance, they have certain limitations also.
All the accounting based performance measures likes EBIT, ROE, ROA, ROI etc. fail to assess the true or economic return of a company as they are based on the historical asset values, which in turn are distorted by inflation and other factors. This led to the immense popularity of value based performance measures.
2.2 TRADITIONAL PERFORMANCE MEASURES
Earnings before Interest and Taxes (EBIT) – EBIT is a measure of the firm’s profit that includes all expenses except interest and taxes. It is the difference between operating revenues and operating expenses, excluding interest and tax. It is often used to compare the performance of the companies employing different capital structure and/or using different tax rates. It eliminates the effects of interest and taxes. It is most suitable for the cross-company comparisons as it represents the operating profit.
EBIT = Revenues – Operating Expenses
Return on Equity (ROE)
ROE expresses the volume of net income returned as a percentage of shareholders equity. Return on equity reflects how much profit is generated with the money which the shareholders have invested into the company. It is expressed as a percentage of net income after taxes by equity. Net income is for the full fiscal year (before dividends paid to the common stockholders but after dividends to preferred stock) and shareholders’ equity does not include preferred shares. It can be used for comparing two or more companies in the same industry.
Return on Equity = Net Income/Shareholder Equity
Return on Assets (ROA)
ROA measures the assets’ productivity. It is expressed as a percentage that indicates how efficiently the management of the company employs its assets to generate the earnings. It is computed by dividing annual earnings (net income for the full fiscal year) by total assets.
Return on Assets = Net Income/ Total Assets
Return on Investment (ROI)
The efficiency of an investment is measured in terms of ROI. It is frequently used to compare the efficiency of various investments. It is calculated by dividing earnings after taxes by invested capital.
ROI = EAT / Invested Capital
Total Cash Flow (TCF)
Cash flow refers to the movement of cash in or out of a business, a project, or a financial product. It is usually measured during a certain period of time. Its value is used to analyze the financial stability of the company alongwith its performance; for short term planning of revenues and expenses and to evaluate and compare the investments.
Cash and Cash Equivalents at the beginning of the year
+ Cash Earnings in time period
(-) Cash paid in time period
= Cash and Cash Equivalents at the end of the year
Free Cash Flow (FCF)
Free cash flow is a measure to calculate the amount of cash that the business unit is able to create after spending the money required to maintain or expand its assets base. It is computed as operating cash flow minus capital expenditures.
Net Income
+ Amortization/Depreciation
(-) Changes in Working Capital
(-) Capital Expenditures
= Free Cash Flow
FCF plays a very important role in running the company as it presents the source of money that can be used to develop a new product, make acquisition or reduce the debt. It is the engine which enhances the shareholders’ value. In case of large investments, the FCF could also be negative, but it is not so bad if the investments earn a higher return.
Earnings per Share (EPS)
EPS presents the portion of a company’s profit which is allocated to each outstanding share of common stock. In other words, it is the conversion of amount of profit to per share basis.
EPS = (Net Profit after Taxes – Preference Dividends) / Average Outstanding Shares
Earnings per share is generally considered to be the single most important variable in determining the share prices of the companies. However, an important aspect of EPS often ignored is the amount of capital required to generate the earnings in the calculation i.e. it ignores the amount of accumulated reserves and surplus. Two companies could generate same EPS number, but one could do so with less amount of equity capital. The company would be more efficient at using its capital to generate income and, all other things being equal it would be a better company. Investors also need to be aware of the earnings manipulation that will affect the quality of the earnings. Hence, it is important not to rely on any one financial performance measure, but to use it in conjunction with the statement analysis and other performance measures.
Price – Earnings Ratio (P/ E Ratio)
P/E ratio is a valuation ratio of a company’s current share price compared to its earnings per share. A high P/E ratio suggests that the investors are expecting higher earnings growth in the future as compared to the companies with a lower P/E within the same industry.
P/E = Market Value per Share / Earnings per Share (EPS)
Critique of traditional performance measures
It is very important to realize that none of the traditional performance measures present the true and complete picture of the company’s performance by themselves. They are based on the accounting figures and earnings of the firm. Moreover, they are influenced by the firms’ level of divergence in the accounting figures and in the valuation methods used by the firm to evaluate its assets, liabilities and income. These measures do not take into consideration the influence of inflation, the risk level and the time value of money. Though these measures are easy to calculate, but they do not include the cost of capital. The limitation of ROA is that it reflexes only short run profit and therefore the investment which is profitable in the long run can be rejected as non-profitable.
Also, ROE has its own limitations. One of the limitations is that the ROE can be artificially inflated by the borrowing of funds, instead of issuing stocks. As a result, the ROE is increased and at the same time the profits are not improved. In case the company increases the proportion of liabilities, ROE increases, but it does not reflect the risk coming from the increased level of indebtedness. Return ratios evaluate the company’s performance for the previous periods onlyand they do not consider the future incomes.
In case of Price – Earnings Ratio, the stock price is driven by number of factors which cannot be influenced by the company. Thus, P/E ratio also, cannot truly reflect the performance of the company.
Hence, it can be said that the traditional metrics reflect current and past trends, but not the future trends. As most of the figures are taken at historical values, the impact of inflation is also not properly reflected. At the same time, the financial analysts have differences in their approach towards the treatment of certain items and in interpreting the ratios. The ratios are only as good or bad as the underlying information used to calculate them.
2.3 VALUE BASED MANAGEMENT
Value based management (VBM) offers another approach to the performance measurement and metrics. It is a consistent framework that aligns the management actions and strategic objectives with the shareholders’ value creation. It instills a mindset where everyone in the organization learns to prioritize the decisions based on their understanding of how those decisions contribute to the corporate world, to create a corporate mindset in which the management decision making and execution are focused on the creation of shareholder value keeping into mind the fundamental drivers of shareholder value i.e. returns and growth.
The components of VBM programme are:
• Strategic planning
• Capital allocation
• Operating budgets
• Performance measurement
• Management compensation
• Internal as well as External communication
The successful value management requires a mindset of managing for value be integrated into the way decisions are made. James A Knight discusses the issue of value management in five categories viz. goal, strategy, measures, processes and decisions. To make the value based management a reality, the management of a company should agree that the main objective of the company is to create and maximize the shareholders’ value. Managing a company for the value requires delivering maximum return to the investors while balancing the interest of other stakeholders including customers and employees. Management must develop a business strategy in such a way so that they can achieve the objective of maximizing the shareholders’ value.
Value creation is the wealth created for a company’s shareholders through price appreciations and dividends. It can be calculated in different ways wherever the information on stock price and dividends is readily available. Calculating value is a trivial exercise as it involves the tedious calculations in the computation of the future value. In the present study, value stands for economic value added i.e., how much value has been added to the wealth of the shareholders; whether the company has created/destructed the value. An attempt has been made in the study to find out whether the share prices of the value adding companies are high as compared to those of destroying the value.
By incorporating the value based management, a company’s ability to effectively manage for the value could become a source of competitive advantage in and of itself. The focus of value managed companies is on the value oriented decision making in the management processes of planning, budgeting, compensation and management reporting. When taken together, the results of value management can help the company build and maintain the competitive advantage over its competitors.
However, the value based management can only be successful in a company where the decision makers understand its concept and know well how they can affect the value creation through their decisions. To achieve the success, the company needs to integrate the value based decision making throughout the organization by translating its principles, policies, strategies, concepts and practices into the language of the business. The management must be well aware of the program and acknowledge its importance among company’s other priorities. The availability of sufficient resources in the organisation should also be ensured for the success of the value based management program.
A combination of educational, training and development programs need to be developed in order to build the awareness of the value concepts and to integrate them into the day-to-day decision-making process of the company. To be effective, the programs should be introduced to all the managers who are closely related to the business issues faced by the company.
Communication, another important variable, is essential for the people to understand value creation and discover how their decisions influence the amount of value created. A successful communication program requires repeated delivery of messages alongwith their periodic reinforcement and effective translation, thereby, helping the managers understand the concept of value addition.
Other important considerations are time horizon and risk sequencing of the programs. It is necessary that the organizations must choose realistic time horizon and correct sequence of the tasks, which could otherwise be the death knell of an implementation programme. This is so because the managers view the program as a failure, if the expectations are not met.
Finally, the most critical variable to the success of a value program is the managers in the company, implementing the program, because their role is to understand the company’s business issues and their implications on decision-making, performance measurement and incentive design.
It is thus evident that the value based management is a very powerful tool. It drives dramatic improvements in the decision-making process, if it is used correctly to focus the managers. However, it can also be misused like any other tool. Therefore, the organizations should take time to understand what they are trying to achieve and how their business issues should drive a customized approach to the value based management.
2.4 VALUE BASED PERFORMANCE MEASURES
There are six main metrics used within Value Based Management framework –Market Value Added (MVA), Cash Value Added (CVA), Shareholder Value Added (SVA), Wealth Added (WA), Cash Flow Return on Investments (CFROI) and Economic Value Added (EVA).
2.4.1 Market Value Added (MVA)
MVA is the difference between the market value and capital invested by the investors. Market value includes the market value of equity as well as debt. Market value reflects how the market evaluates the success of managers in managing the investors’ money and also its trust in the future growth and development of the company. The company has managed to create shareholder value, if the total market value of the company exceeds the amount of capital invested in it and vice-versa.
MVA = Market Value – Invested Capital
The main limitation of this metric is to recognize who is the real value creator, what is the result of the working of the company and its managers and what is the impact of the different factors influencing the market value, as MVA is the external measure of corporate performance.
2.4.2 Cash Value Added (CVA)
CVA is a Net Present Value model classifying the investments into two groups- strategic and non-strategic. Strategic investments create new value whereas non–strategic investments maintain the value created by the strategic investments.
Cash value added is calculated as follows:
Sales
– Costs
= Operating Surplus
+/- Working Capital Movements
(-) Non -Strategic Investment
= Operating Cash Flow
(-) Operating Cash Flow Demand
= Cash Value Added
Operating Cash Flow Demand is calculated from each strategic investment made by a company discounted at appropriate cost of capital. Operating Cash Flow presents cash flow before strategic investments, but after non- strategic investments, it has to cover Operating Cash Flow Demand. The measure helps the investors in getting an idea of the company’s ability to generate cash from one period to another.
2.4.3 Shareholder Value Added (SVA)
SVA, a creation of Dr. Alfred Rappaport of Alcar Consulting Group, is based on the strategic approach of generating returns to the shareholders. SVA is the economic value of an investment estimated by discounting future cash flows by cost of capital. The total economic value of a firm is the sum of the values of its debt and equity. The value of the equity represents the shareholder value.
2.4.4 Wealth Added (WA)
It encompasses increase in the market value of equity, dividends and share buy backs, net of new equity issuances in excess of investors’ expected return.
WA= Change in market capitalization-Required return + Dividends – New equity issues
2.4.5 Cash Flow Return on Investments (CFROI)
CFROI for a company is the internal rate of return on the existing investments, based on the real cash flows. It has to be compared to an inflation-adjusted cost of capital in order to judge the quality of the investment. If the CFROI is higher than the cost of capital, the company creates value for its shareholders and vice-versa. In order to calculate CFROI four necessary inputs are required namely: the gross investment of the company, the gross cash flow earned in the current year on the assets, the expected life of the assets, and the expected salvage value of the assets. CFROI removes the influence of accrual accounting and makes the adjustments on account of inflation.
Superiority of Modern Performance Measures
Modern performance measures are closely linked to the shareholders’ value. They reflect future trends, the expectations of the investors as well as the market, the impact of inflation, the risk level and the time value of money. These measures create the connection between the value creation and incentive compensation system that makes the managers more responsible for their decisions.
The modern metrics remove the influence of accrual accounting and provide the investors an idea of the ability of the company to create shareholder value from one period to another.
Besides the above discussed value based performance measures, one of the today’s hottest financial measure is Economic Value Added (EVA). In this direction, a number of studies have been done for the corporate sector of the developed countries. But the researches are insufficient with respect to the Indian corporate sector. Thus, a need has been felt to investigate some vital issues regarding EVA. Through this study, an attempt has been made to explain how effectively the Indian corporate sector has been at creating the shareholder value.
2.5 EVA-A TOOL OF CORPORATE PERFORMANCE MEASUREMENT
Performance measures are used to deliver information to support the corporate management decisions and to assess the divisional performances. Business world becomes extremely complex due to the technological development and innovations in the field of operations along with the logical demands of the consumers for the quality product at a minimum price. The companies are getting serious and trying to incorporate all of these into a single package. At the same time, employee motivation is getting preference since a highly motivated employee will work hard towards the achievement of organizational goals. The extent of motivation can be evaluated using the performance measures. Thus, the performance measurement has become a continuous effort and challenging style on the part of the management to drive the workforce towards the goal congruence.
All traditional performance measures fail to assess the true or economic return of a firm as they are based on the historical asset values, which in turn are distorted by inflation and other factors (Villiers, 1997). In the 1990’s, one of the value based performance measures EVA was introduced by Stern Stewart & Co. and has gained immense popularity in developed countries: UK, USA, France, Germany etc.
EVA is the surplus (or deficit) that remains after levying a charge against after-tax operating profit for the opportunity cost of all capital, equity as well as debt, used to generate those profits.
Pioneered and advocated by US based consulting firm, Stern Stewart and Company in 1982, EVA can be used as a measure of both internal and external performance. “Abandon earnings per share”, “Earnings, earnings per share and earnings growth are misleading measures of corporate performance” and “The best practical periodic performance measure is EVA” (Stewart 1991). Further, Stewart (1994) cites in-house research which indicates that “EVA stands well out from the crowd as the single best measure of value creation on continuous basis”. He further remarks that ‘EVA is almost 50% better than the accounting based measures in explaining the changes in the shareholders’ wealth”.
Using these findings, Stern Stewart has built a significant presence in the highly competitive value based performance consulting market with literally hundreds of firms adopting EVA to some degree, among them Coca-Cola Co., Eli Lilly & Co., AT & T, Postal Services in the US.(Biddle et al., 1998).
The concept of EVA has been heavily promoted in various countries of the world. Prominent among these are USA, UK, Australia, Canada, France, Germany, Mexico, Turkey and Brazil. EVA figures are used to provide published rankings of the managerial performance. Several international companies have adopted EVA for the performance measurement and/or incentive compensation packages. For example, in Australia the ANZ Banking Group, Fletcher Challenge Limited, James Hardie Industries and the Wrightson Group, have implemented EVA financial management systems in recent years.
Apart from this, support for EVA has been acknowledged from other sources. Fortune, which regularly publishes EVA performance rating since 1993, has called EVA under different notations “today’s hottest financial idea”, “The Real way to creating wealth” and “A new way to find Bargains”.
Peter Drucker (1995) suggested that EVA’s growing popularity reflects, amongst other things, the demands of the information age for a measure of ‘total factor productivity’. Also, there has been a widespread adoption of EVA by security analysts since “instead of using a dividend discount approach, these models measure value from the point of the firms’ capacity for ongoing wealth creation rather than simply wealth distribution” (Herzberg, 1998).
Proponents of EVA have made following principles claiming about EVA:-
1) EVA and Market Value are correlated (O’Byrne, 1996; Uyemura, 1996; Peterson and Peterson, 1996; Lefkowitz, 1999).
2) EVA adds more informational content in explaining the stock returns of a company (Chen and Dodd, 1997; Erasmus, 2008).
3) EVA helps in reducing the conflicts and improve the decision making process (Biddle et al. 1999; Costigan & Lovata, 2002).
4) EVA improves the stock performance (Ferguson et al., 2005).
5) EVA is more strongly associated with stock returns as compared to the other measures (Maditinos et al., 2006).
EVA as a measure of corporate performance differs from most others by charging the profit for the cost of all the capital a company employs. The importance of EVA as a corporate performance measure is very much evidential from the introduction of Harsco Corporate Finance Manual, “EVA is more than a performance measure; it is the focal point of a management system and a mindset. EVA affords the company the ability to establish clear, accountable links between strategic thinking, capital investment, day-to-day operating decisions, and the shareholder value (Singer and Millar, 2003). It is the framework for a complete financial management and incentive compensation system. It can guide the company’s decisions that can transform a corporate culture, improve the working environment and help in creating greater wealth to the shareholders.
EVA is regarded as a single measure that gives a real picture of the shareholders’ wealth creation (Tully, 1998). The reports claim that implementing an EVA policy triggers a company’s stock price to rise (Burkette and Hedley, 1997) and its leading managers to act more like the owners (Tully, 1993). In addition to motivate the managers to create shareholders value and being a basis for the management compensation, the value based performance measurement systems have further practical advantages (Stern et al, 1989). At the operational level, this approach often leads to the increased shareholder value through increased capital turnover (Wallace, 1997).
One of the most powerful features of EVA is its sustainability to management of the bonus systems. It has been empirically proved a good way to increase the shareholder value. It is an effective measure of the quality of the decisions taken by the management (Lehn and Makhija, 1996) as well as a reliable indicator of a company’s future growth in terms of value (Fisher, 1995). EVA is superior to accounting profits as a measure of value creation because it takes into consideration the cost of capital and, hence, the risk involved in the firm’s operations (Lehn and Makhija, 1996).
Last but not the least, a study found that relative to the companies that do not adopt EVA, a sample of companies adopting EVA as a performance measure:
(i) Increased their dispositions of assets and decreased their new investment,
(ii) Increased their payout to shareholders through share purchases, and
(iii) Used their assets more intensively.
2.5.1 Concept of EVA
EVA, patented by New York based consulting firm, Stern Stewart & Co., has emerged as a critical tool to measure and monitor the corporate performance. Today, the EVA concept has got a wider acceptance as a key indicator of performance since industry is shifting from the product centric to a value centric world.
EVA estimates a particular type of economic profit, which has been a part of mainstream economic thinking for more than a century. The concept states that in order to assess whether a company earns a genuine profit, it is not only necessary that the company earns sufficient profit to cover the firms operating costs, but they should also cover the cost of capital i.e. the cost of borrowed money in the business as well as the owner’s funds deployed in the business. Only then, the owner can claim to have earned a profit. In other words, EVA is the surplus (deficit) that remains after levying a charge against after-tax operating profit for the opportunity cost of all capital, equity as well as debt, used to generate those profits i.e.
EVA= NOPAT- (WACC x CE)
Where, NOPAT- Net operating profit after tax,
WACC- Weighted average cost of capital
CE- Capital employed
This formula will give either a positive EVA or a negative EVA. A positive EVA reflects that the company is increasing its value to its shareholders, whereas a negative EVA reflects that it is diminishing the value to its shareholders. EVA is based on the principle that since a company’s management employs equity capital to earn a profit; it must pay for the use of this equity capital. As management consultant Peter Drucker (1998) said, “Until a business returns a profit that is greater than its cost of capital, it operates at a loss…The enterprise still returns less to the economy than it devours in resources…Until then it does not create wealth; it destroys it”.
2.5.2 Computation of EVA
The EVA calculation begins by putting the operating profits on an economic basis rather than on an accounting basis. This requires some accounting adjustments in traditional financial accounting, such as, research and development expenses, provisioning and write-off of expenses like depreciation, goodwill etc. the figure 1 shows the process of EVA computation used by the companies.
Figure 1: Computation of EVA
The EVA measure deducts a charge for the weighted average cost of capital from the operating profit arrived at by adding the interest amount with the profit after tax.
For an unlevered firm:
NOPAT = EBIT (I-t)
(Without adjustment) = (Sales- COGS- Amortisation-Depreciation) x (1-t)
For a levered firm:
Levered NOPAT = NOPAT + (t x Interest)
The balance is the amount by which after-tax operating profits exceed or fall short of the cost of capital. Thus, EVA measures the difference between the return on a company’s capital and the cost of that capital. A positive EVA indicates that value has been created for the shareholders by the company and a negative EVA signifies the value has been destroyed by the firm during the period.
2.5.3 EVA Measurement Challenges
The basic EVA formulation is helpful in showing how a value-based metric differs from traditional accounting measures of profit such as net income. However, it also introduces the complexities involved in the calculations of the economic profit and capital. In this context, Stem Stewart and Co. has pointed out that there are some 164 accounting adjustments that can be made to a firm’s financial statements to convert them to a value¬ based format, emphasizing the cash operating profit and asset replacement cost considerations. In addition to this, there are significant empirical anomalies and academic issues that embroil the weighted average cost of capital (WACC) primarily the cost of equity. The firm’s EVA is calculated by taking a difference of NOPAT and weighted average cost of capital multiplied by the amount of capital invested in the business. In practice, however, there are numerous accounting items which jointly affect the NOPAT, WACC and CE arising from the accounting-versus-economic treatment of depreciation, intangibles (including research & development and goodwill arising from corporate acquisitions), deferred income taxes, valuation of inventory (LIFO, FIFO, Weighted Average pricing method), and other equity reserve adjustments. Such EVA measurement issues are important because they impact the analyst’s estimate of invested capital and economic profit. A few of the EVA challenges have been discussed below.
NOPAT Adjustments
NOPAT is measured from the Income statement by adding back the interest payment and subtracting and adding non-operating income and expenses, respectively to a Net profit figure and after making certain other adjustments which turns accounting profits into the economic profits.
NOPAT= Profit after Tax + Non-recurring Expenses+ R&D Expenditure + Interest Expense + Provision for Taxes – Non-Recurring Income – R&D amortization – Cash Operating Taxes
Cash Operating Taxes= (Provision for Taxes + Tax Benefit of Non-Recurring Expenses + Tax Benefit of Interest Expense -Tax on Non-Recurring Income).
So far as the adjustments to accounting profit figure are concerned, Stern¬ Stewart has identified as many as 164 adjustments subject to the following criteria.
Materiality: Adjustments should make a material difference in EVA.
Manageability: Adjustments should have an impact on the future decisions.
Definitiveness: Adjustments should be definitive and objectively determined.
Simplicity: Adjustment should be simple and not be too complex.
If an item meets all these four criteria, it should be considered for the adjustments. For example, the impact on EVA is usually minimal for the firms having small amounts of operating leases. Under this condition, it would be reasonable to ignore this item while calculating EVA.
All the potential adjustments can improve the measure of operating profits and capital. But in real practice, the companies make only few adjustments while calculating EVA.
Figure 2: The EVA Spectrum
Figure 2 exhibits the EVA spectrum showing different figures of EVA for a company. The “Basic EVA” is the unadjusted EVA quoted from GAAP operating profits and Balance sheet. Disclosed EVA is used by Stern Stewart in its published MVA/EVA ranking and computed after a dozen standard adjustments to publicly available accounting data. True EVA is the accurate EVA after considering all the relevant adjustments to the accounting data. However, the interest of the companies is at the Tailored EVA. Each company develops its tailored EVA definition, peculiar to its organizational structure, business mix, strategy and accounting policies that optimally balances the trade-off between the simplicity and precision.
Following are the most commonly proposed adjustments out of 164 odd adjustments to have a realistic figure of EVA.
• Research & Development (R&D),
• Deferred taxes,
• Depreciation,
• LIFO reserves,
• Goodwill,
• Restructuring expenses,
• Provisions for warranties and bad debts,
• Leases
Research and Development: Young and O’Byrne has argued that investments in R&D, new technologies, brand names, customer loyalty are still investments because they present going concern activities of the company and in long term they might pay off. Therefore, these investments should be capitalized as long term assets in the balance sheet. After tax R&D expenditure must be added back to NOPAT. Only those R&D expenses that have no future value are charged to the income statement. The amount included in the capital is amortized over a period during which the benefits of the successful R&D projects will be reaped.
Deferred Taxes: Deferred taxes arise due to the difference in the timings of recognition of revenues and expenses for the financial reporting and reporting for the tax purposes. It is basically the accumulation of the difference between accounting provision of taxes and the amount actually paid under the head ‘Reserve for Deferred Taxes’. NOPAT is adjusted for the amount of tax actually paid instead of the accounting provisions. The reserves for deferred taxes are added to the equity.
Depreciation: The straight line method of charging depreciation work acceptably well in the accounting based on GAAP. But in the calculation of EVA, the uses of straight line method of charging depreciation can create a powerful bias against the investment in the new equipment. This is because the EVA capital charge declines in step with the depreciated carrying value of the assets, so that the old assets look much cheaper than new ones. This can make the managers reluctant to replace the “cheap” old equipment with the “expensive” new one. This distortion can be eliminated by changing the method of charging depreciation from the straight line method to the sinking fund method. Under sinking fund method, the amount of annual depreciation follows the same pattern as the principal payment in a mortgage, starting out small amount in the early years and rising rapidly in the later years. The sum of depreciation charge and the EVA capital charge remain constant from year to year, just like a mortgage payment. The switch over to sinking fund method of charging depreciation, which effectively makes owning an asset look just like leasing, eliminates any bias against the new equipment. It also happens to be much closer to the economic reality. So long as the depreciation charges are not excessive, the deviations from the reality are inconsequential ordinarily that they do not distort decisions, no adjustment is needed. It is only in case of excessive depreciation charge that accounting profit needs to be adjusted.
LIFO Reserves: For calculating EVA, the LIFO system of inventory valuation, adopted by the companies during the periods of rising prices to save taxes, is changed to FIFO basis. FIFO system of inventory valuation is a better basis for estimating the current replacement costs. NOPAT and Equity are adjusted for this change from LIFO to FIFO by adding the difference between the LIFO and FIFO inventory valuation to the equity and NOPAT. This way the tax benefit of LIFO is retained.
Goodwill: The annual amortisation is added back for the calculation of NOPAT and the accumulated amount of amortisation is added back to the equity equivalents. The amount is added back because by unamortising the goodwill, the rate of return reflects the true cash-on-yield. In addition, the decision to include the accumulated goodwill in capital improves the real cost of acquiring another firm’s assets regardless of the manner in which the acquisition is accounted.
Restructuring expenses: Restructuring expenses and any other such expenses which will benefit the firm in the long run are capitalized and written off over the time period.
Operating leases: From the accounting point of view, an operating lease is a rental expense and does not appear in the balance sheet. But in economic reality, leasing is a form of debt, which company uses for its operating activities. Therefore, invested capital is undervalued and the present value of the future lease payments discounted by company’s borrowing rate has to be added back to invested capital. Also, NOPAT is undervalued because lease payments should be identified as an interest cost. Interest costs have to be excluded from NOPAT, because they are already reflected in WACC. So if we donot exclude them from NOPAT, interest costs would be used in EVA calculation twice. An adjustment is to be made by adding the capitalized value of the leases multiplied by the borrowing rate to NOPAT. Further, leases have to be smoothly depreciated over the time.
Provision for warranties and bad debts: Young and O’Byrne state that some EVA proponents argue that managers use provisions and reserves to manipulate profit, thereby creating the disparity between the accounting profit and the cash flow. They agree that any increase or decrease in such reserves should be added back to or subtracted from NOPAT. Such reserves and provisions should be added back to invested capital.
While the above adjustments are common in EVA calculations, other items that may require adjustments depend on company specific activities. when the operating leases rather than financing leases are employed, the interest expense is not recorded in income statement.