SFM(CA)

L-8: Strategic Cost Management (Contd.)

(Shareholders Value Creation: MVA, EVA approaches, etc)

Market Value Added (MVA):

MVA is the difference between the Current Market Value of the firm and the Capital Employed by the firm.

Economic Value Added (EVA):

EVA is the surplus left after making an appropriate charge for the capital employed in the business. The three components of EVA are: Net Operating Profit after Tax (NOPAT), where, NOPAT= PBIT (1-Tax Rate) Cost of Capital (reflects expectations of shareholders & lenders) Capital Employed (based on economic book value, rather than on historical cost based book value). The GAAP or historical accounting concept provides for all possible losses but anticipates no gains, which is a highly conservative approach and does not recognize gains from EVA approach. On the other hand, EVA is a reliable guide to value creation, which requires several adjustments to accounting earnings and accounting book values like intangible assets, strategic investments, goodwill, timing of expense and revenue recognition, off-balance sheet financing, restructuring charges, bad-debt recognition, inventory valuation, foreign currency translation, depreciation, taxes, and non-interest bearing liabilities. In most cases, R & D investments, strategic investments, expense recognition, depreciation, restructuring
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charges, taxes, and marketable securities are the important factors to be considered in EVA. The details are given below:-

1. R & D Expenses and marketing costs for establishing new brands, new markets, etc.
These expenses are for future products/processes. Their treatments are like this: For GAAP it is an expense or deduction from earnings. For EVA- Capitalize and amortize over a period of, say, 5 years.

2. Strategic Investments:
Here, capital charge on strategic investments which have some gestation periods are kept in a suspense account and left out from EVA calculation till they earn profits.

3. Depreciation:
Under GAAP, SLM is used, whereas, under EVA, Sinking Fund method is used, where annual depreciation charge is small initially, which rises over the life of the asset. Since capital charge decreases over a period, the sum of depreciation and capital charge under EVA remains constant.

4. Restructuring Charges:
Under GAAP, restructuring charge on an investment which has turned sour is treated as a loss. Under EVA, restructuring cost is treated as a future gain on likely improvement in shareholders wealth and is considered as a productive deployment of capital.

5. Taxes:
Under GAAP, companies use WDV method for paying tax and SLM for shareholder reporting. Here, book taxes differ from cash taxes which the co. pays. The difference goes into an account called deferred taxes liability account which is presumably payable in future, but is generally never paid. From EVA point, what matters is the tax the co. now pays and not what it may have to pay in future. So, for calculating NOPAT, only cash taxes must be deducted. Consequently, deferred tax liability must be treated as quasi equity & included as a part of shareholders fund.

6. Marketable Securities:
Since marketable securities do not generate operating profit, the investment in them should be excluded from capital employed in the firm. Likewise, the investment from this should not be included in NOPAT.

EVA and its Calculations:

EVA can be calculated through the following different routes, but its value will always be the same:EVA = NOPAT c* x CAPITAL 2. EVA = CAPITAL (r c*) 3. EVA = [PAT + Intt. (1 -t )] c* x CAPITAL 4. EVA = PAT ke x Equity where, NOPAT = Net Operating Profit after Tax. = PBIT (1 t), where, t= Tax Rate c* = Cost of Capital, ke = Cost of Equity r = Return on capital = NOPAT/Capital
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Capital = Economic Book Value of Capital Employed in firm

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Causes for increasing EVA: EVA will rise if Operating efficiency is improved Value adding investments are made Uneconomic activities are curtailed Cost of capital is lowered.

EVA and Capital Budgeting:

As per EVA: NPV = EVAt / (1+c*)t , t= 0,1,2,3n As per DCF: NPV = [Cash Flowt / (1+ c*)t ] - I, t= 0,1,2,3.n I = Investment and c* = Discount Rate The NPV of a project used under both the above methods yields the same results.

EVA and Valuation:

EVA Valuation = Economic BV of Assets + PV of EVA Stream EVA valuation & DCF valuation always leads to same results.

Link between Market Value Added (MVA) & EVA:

MVA is the PV of all future EVAs. MVA = EVAt / (1+c*)t, where c*= WACC , t= 0,1,2,..n

Cash Value Added (CVA):

CVA is superior to EVA because it removes the accounting distortion that may bias EVA. CVA is operating cash flow less

economic depreciation less capital charge on gross investment, given as below:CVA = Cash Flow Economic depreciation Capital Charge on Gross Investment Investment in Fixed Assets Where, Economic depreciation = ----------------------------------FVIFA(r, t)
Capital Charge on Gross Investment = Cash Invested x Cost of Capital

EVA and Incentive Compensation System:

The centerpiece of an EVA financial management system is a unique bonus system which overcomes the anomalies of paying too little compensation to the outstanding performers or too much to inferior performers. The key elements of EVA bonus plan are: Bonus is linked to increase in EVA No floor or ceiling on bonus The target bonus is generous Performance targets are set by formulae, not by negotiations A bonus bank is established

EPS based Financial Management Sytem (FMS) and EVA based FMS:
EPS-based FMS: Management tries to: EVA-based FMS: Management tries to:
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- Report steady increase - Achieve improvement in EVA in EPS -Diversify to achieve stability - Strive for focus -Tight control on allocation - Decentralize investment of capital decision making - Balance the claims of various - Prime value to shareholders stakeholders - Buy companies with low P/E - Acquire cos. that augment multiples to bootstrap EPS value - Negotiate div. profit targets - Define EVA targets

Implementing EVA System:

1. Develop Top Management Commitment 2. Customize Definition of EVA 3. Identify EVA Centers 4. Analyze the Drivers of EVA 5. Tailor an Incentive Compensation System 6. Train all the Employees

Limitations of EVA:
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Though it helps firms in achieving higher business and unit efficiency, it may not encourage collaborative relationship between business unit managers. EVA is not a perfect measure of performance, though it is a better measure than the conventional measures like EPS, PAT and RONW. In fact, perfect measures of capitalized value will never be found because the value cannot be known with certainty until after a project has run its course to competition and shut down.

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