Economic value added (EVA) and Value added statement

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Value Added is the wealth generated by the entity through the collective efforts of capital providers, management and employees.

Economic Value Added or EVA can be considered as an indicator of a firm's economic profit. It is the excess added to the profit after the consideration of shareholders expected return. Mathematically we can state that EVA=(Rate of Return on Investment - Cost of capital) x Investment Or EVA = Net operating profit after tax Investment x Cost of capital Net operating profit after tax is the profit that is generated from a companys all operations after the reduction of taxes. It is the total earnings available to the investors of capital in the firm. It is important to note that in this case the profit after tax does not consider the interest that is paid; which means Net operating profit after tax = Earnings before interest and Tax Tax The total capital invested by the investors is termed as investment. Cost of capital is calculated from any method of capital budgeting, the most widely used being the weighted average cost of capital method.

EVA is a registered trademark of Stern Stewart & Company.

Value Added Statement is a financial statement which shows how much value (wealth) has been created by an enterprise through utilization of its capacity, capital, manpower, and other relevant resources, and how it is being allocated among the different stakeholders (employees, lenders, shareholders, government, etc.) in an accounting period. It also shows how much value has been retained by the firm.

No business organization works with a motive of charity. The shareholders do not invest in the company if the company cannot give them the required return they wish to have. To facilitate the investors to know about the companys stand that whether there is a good return or not, the method of economic value added is essential.

Steps to calculate Economic Value Added Step 1. Calculation of Net operating profit after taxes(NOPAT) Revenue Gross profit EBIT Cost of sales Expenses + Other income Operating tax = = = Gross profit EBIT NOPAT

Step 2. Calculating Capital Charge Capital Charge is the total cost that has to be incurred to raise capital through debt or equity. Capital charge can also be explained as the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested. So we calculate the cost of capital, mostly using the weighted average cost of capital method. Step 3. Calculating EVA EVA = NOPAT - Capital Charge

Example Total Revenue Operating Expenses EBIT Interest EBT Tax @ 30% EAT Rs Rs Rs Rs Rs Rs Rs 5,00,000 3,50,000 1,50,000 50,000 1,00,000 30,000 70,000

Also given : Capital Rs 2,50,000 consists of Rs 1,50,000 equity funds having 15% cost and debt of Rs 1,00,000 having 12% interest. Step 1: Calculating Net operating profit after tax Total revenue Rs 5,00,000 Less: Operating expenses Rs 3,50,000 EBIT or Operating profit Rs 1,50,000 Less: Tax @ 30% Rs 45,000 NOPAT Rs 1,05,000 ( Alternatively EAT, Rs 70,000 + interest, Rs 50,000 tax savings on interest, Rs 50,000 x 0.3 = Rs 15,000 Thus, NOPAT = Rs 1,05,000 ) Step 2: Calculating Capital charge Equity (Rs 1,50,000 x 15%) Debt (Rs 1,00,000 x 12%(1 - 0.3) ) Total capital charge Rs 22,500 Rs 8,400 Rs 30,900

Step 3: Calculating EVA Economic value Added = = Rs 1,05,000 Rs 30900 Rs 74,100

Implications in an industry EVA approach is a modified accounting approach to determine profits earned after meeting all financial costs of all the providers of capital. It considers independent projects, thus the analysis of projects which are capital intensive is very essential as the cost of capital of such projects are usually very high. So an EVA is a better indicator of the returns of the firm rather than a profit statement.

Advantages of Economic value added 1. It explicitly considers the cost of capital for measuring the firms performance. 2. It views projects independently, hence when a management wants to focus more on singular projects, EVA is very helpful. 3. The most important advantage is that it provides the true measure of the economic profit and not just profit derived from profit and loss statement. Disadvantages of Economic value added 1. Difficult to calculate. 2. EVA is difficult to distribute among employees, shareholders etc. hence difficult to create a value added statement also. 3. EVA does not involve forecasts of future cash flows and does not measure present value. Instead, EVA depends on the current level of earnings.

Advantages of Value added statement 1. It enables the investor to compare his companys prospects with other companies. 2. The distribution and division of wealth is useful for a company to see how much wealth is going where and hence they can take measure to see if something can be done to increase or decrease the value. 3. It gives the actual value added rather than just calculating the profit. Because value added is what actually the firm has done in the business. Disadvantages of value added statement 1. A value added statement is not very popular as mostly the P&L statement is used by financial analysts. Still most people believe in the profits rather than the value added. 2. There is no standard format for a value added statement but there is a proper format for a profit and loss statement.