EVA

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Economic Value Added: A yardstick for performance measurement :

Economic Value Added: A yardstick for performance measurement

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Performance Measure ment Return on investment and Earnings per share was the most important used. Recently EVA also is being used. EVA was developed in 1982 by an American Consultancy firm, Stern Stewart and company as performance tool The value of EPS and ROI is derived from the accounting profit, which is subject to manipulation. it does not consider the cost of capital employed.

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The Calculation There are four steps in the calculation of EVA: Calculate Net operating profit after tax (NOPAT) Calculate Total Invested Capital (TC) 3. Determine a Cost of Capital (WACC) 4. Calculate EVA = NOPAT – WACC% * (TC)

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Calculation of NOPAT Earnings available for common stock +interest (1- tax rate) + preferred dividend + minority interest earnings Adjustment + Increase in deferred taxes+ depreciation of goodwill+increase in allowance for bad debts+ increase in allowance for stock obsolescence +R&D expenses – depreciation of R&D + losses from sale of assets There are more than 160 potential adjustments in GAAP earnings

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The second step is to determine the weighted average cost of capital (WACC) The cost of debt, which is the after-tax interest rate on loans and bonds. The cost of equity according : Rf+  ( Rm-Rf) Where Rf = Riskfree Rate  is a relative measure of volatility that is determined by comparing the return on a share to the return on the stock market as a whole. Rm is the market return

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Why EVA as a performance measurement tool? Greater alignment with shareholder wealth Employees would begin to think like owners. EVA is profit according to the shareholders wish . Make everyone a meaningful partner in the process of value creation Can be calculated at lowest operational Unit It serves as a guide to every decision from strategic planning to business acquisition.

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A Common Focus, Language & Mission Measuring Performance Paying Bonuses Setting Goals Communicating Evaluating Strategies Evaluating Operational Initiatives Analyzing Acquisition Reviewing Capital Projects EVA

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Designing better Compensation Plan Under an EVA bonus plan, the only way managers can make more money for themselves is by creating even greater value for shareholders. This makes it possible to have bonus plans with no upside limits. In fact, under EVA the greater the bonus for managers, the happier shareholders will be. Also, EVA forced everyone to think long-term because it operated with a minimum three-year horizon., EVA seems to have importance for companies as a performance measurement and controlling tool.

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An EVA Incentive Model :

Corporate EVA Performance Unit EVA Performance EVA Incentive Individual Performance Declared Incentive Beginning Bank Balance Ending Bank Balance Incentive Paid Available Bank + = An EVA Incentive Model EVA experience at TCS : Variable Component pay is based on EVA achieved Source: www.tcs.com

Incentive Distribution in TCS:

Incentive Distribution in TCS Corporate Unit Performance Individual Performance Junior Level Average % Minimum % Maximum % Middle Management Average % Maximum % Average % Senior Management Maximum % Minimum % Average % Promote Synergies across Cell Avoid Free Riders Be Good at Basics!

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12 EVA is additive therefore The EVA of all the projects and centers in a region will add up to the region’s EVA The EVA of all the regions in a geography will add up to the geography’s EVA The EVA of all the geographies will add up to NIIT’s EVA. Similarly, The EVA of all the products in a business group will add up to the business group’s EVA The EVA of all the business groups in a Strategic Business Unit will add up to the SBU’s EVA and The EVA of all SBUs will add up to NIIT’s EVA. EVA Practices and Implementation by Indian Companies

Typical EVA Incentive Pay-Off Profile:

Typical EVA Incentive Pay-Off Profile Bonus % Performance Target Ad Infinitum! NO Cap on Bonus! Ad Nauseum To Make Managers Behave like Owners => Unlimited Reward for success and Genuine Penalty for Failure! Thrill of Victory and Agony of defeat are Great Motivators!

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It removes multiple measurement parameters Most companies uses a number of variable to measure the performance and to express financial goals and objectives. Strategic plans often are based on growth in revenues or market share. Companies may evaluate individual products or lines of business on the basis of gross margins or cash flow. Business units may be evaluated in terms of return on assets or against a budgeted profit level. The proper implementation of EVA system overcomes these confusions

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Greater focus on optimal capital structure The lower the WACC, the higher would be the EVA. In the long EVA will lead optimum utilization of capital. EVA can act as an internal system of corporate governance. It can motivate everyone to achieve the best attainable performance

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The Indian Experiences

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Godrej Industries has decided to adopt the economic value addition (EVA) Implementing the EVA framework is a key business performance initiative in support of our efforts to evolve as a world class organization and enhance shareholder value. Our main objective behind implementing EVA is to be driven, measured and rewarded by our ability to create sustainable shareholder value." Adi Godrej, Chairman of Godrej Group. A few weeks after the EVA announcement, Adi declared the half yearly financial results of Godrej Consumer Products Limited (GCPL) for the period ended September 30, 2001. The revenues had grown by 19% to Rs 2.529 bn as against the growth of 15% in the corresponding period in 2000. GCPL reported an EVA of Rs. 0.137 bn for the six months ended September 30, 2001. Announcing the results, Adi said, "Our strong focus on EVA has delivered rising profitability."

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The TCS compensation plan consist of Individual compensation consists of two parts : Fixed pay: Reflects experience/competency. Fixed pay is based on industry survey and cost of living index Performance pay: Forms the Variable Component pay is based on EVA achieved The individual works towards the improvement of the benefit package, which essentially has three components - the Corporate EVA, the Business Unit EVA, and the Individual Performance Factor.

Economic value addition by Indian Banks:

Economic value addition by Indian Banks EVA provides a unique insight into value creation and links theory of finance with the competitive strategy framework as enumerated by Michael Porter. EVA is also a quantifiable driver of value creation for the stock markets. Large number of International banks (such as Citibank, Deutsche Bank, Barclays, ABN AMRO) use value based frameworks such as EVA to run their banking operations. Although EVA an a yardstick in India may be at an evolving stage, banks like HDFC Bank, ICICI Bank etc. have gradually started adapting such measure to cater to the increasingly discerning investor base.

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Conclusion: The EVA is quite similar to standard DCF formula because it is a modified version of DCF. The DCF and NPV are based only on future cash flows and EVA is based also on historical accounting items. One of EVA's most powerful features is its suitability to management bonus systems. It is quite clear EVA can be increased either by increasing NOPAT or by reducing the cost of capital. There can be various ways to increase NOPAT such as depreciating less. There are also many ways of reducing the cost of capital (For example if the interest rate fall) that has nothing to with the executive performance.

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