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Economic Value Added (EVA) And Net Present Value (NPV)

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Published in: Finance: Banking
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The ppt provides insights on two most common indicators to assess corporate value and shareholder wealth i.e. EVA and NPV

Muhammed A / Dubai

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  1. 44 E (ÄOVIICVAILE By: Muhammad Azhar Baig NPV
  2. WHAT IS VALUE BASED MANAGEMENT (VBM)? Value creation became a deep rooted belief that any corporate's economic goal is to maximize shareholder wealth. V BM is based on the belief that the value of a company is determined by its discounted future cash flows. Value is created only when companies invest capital at returns that exceed the cost of that (Kolier, 1994) capital There are a number of value based measures in the economic framework. Two most commonly used indicators are Economic Value Added (EVA) and Net Present Value (NPV).
  3. et Present Value (NPV) is discounted cash flow technique that determines whether an investment will be profitable (Farlex Financial Dictionary). > NPV is the difference between the present value of cash inflows and the present value of cash outflows. Net Present Value How is it calculated Where: Net cash inflow during the period t Total initial investment costs Discount rate, and Number of time periods
  4. NPV RULE ?resenf Fv+ore If... NPV > O NPV < O NPV 0 It means... the investment would add value to the firm the investment would subtract value from the firm the investment would neither gain nor lose value for the firm Then... the project may be accepted the project should be rejected We should be indifferent in the decision whether to accept or reject the project This project adds no monetary value. Decision should _be based on other criteria, e.g., strategic positioning or other factors not explicitly included in the calculation. Positive NPV PV of outputs > PV of inputs. Positive NPV economic return > economic cost. According to Dr. Boehme there is a strong correlation between the stock market and capital budgeting, as well as merger/acquisition activities. Mergers that create value (+NPV) will increase stock prices; e.g., the Exxon and Mobil merger. McConnell and Muscarella (1985) found that on average for non-regulated firms, the acceptance of capital projects led to increases in stock price.
  5. ADVANTAGES OF NPV Recognizes time value of money Solely depends on forecasted cash flows from the project and not book returns. NPV has an adding up property that facilitates choice in accepting a project. Example: NPV(B). Lets say project B has negative NPV. The joint investment will have lower NPV than taking project A alone ISSUES wrrH NPV Element of uncertainty . Assumes perfect market conditions Does not take in to account capital constraints for investors. Ignores the impact of diversifiable risk on asset valuation (Sheri 12013) Investment have inherent rights connected with respective interest rates ignored by NPV
  6. ECONOWC VALUE ADDED (EVA) Background ofEVA: In 1950's concept of residual income (RI) was adopted by General Motors as a performance (Worthington & West,2001) measure but soon ignored. In 1980's Stewart adjusted the RI computation by adding a series of accounting measures in accordance (Geyser & Liebenberg, 2003). with GAAP In 1982, New York based management consulting firm Stern Stewart Co. named this concept as EVA for measuring and creating value in business.
  7. The Concept ofEVA: The concept of EVA is not a new revelation. It was first introduced by Alfred Marshall in 1890. (Wallace, 1997) EVA is a financial performance measure that highlights the true profit of a company or Economic Profit. (Stewart, 2000) It takes into account the economic reality & not just the numbers from traditional accounting measures, Based on the idea that company does not earn true profit until all costs such as opportunity costs & cost of a capital have been recovered. EVA? Financial indicator Develops a system of financial goals Motivates personnel Createsthe right mind set va/ueAdded
  8. CONWONENTS & FORMULA OF EVA EVA includes three components: NOPAT: Net operating profit after tax is profits derived from a company's operations after deducting taxes. Cost ofCapita1 or Capital Employed: It is the capital investment which is necessary to run the business. It is usually represented as fixed assets and working capital. EVA NOPAT Operating Profit Costs of Capital Sales Costs Formula: EVA = (r -WACO C WACC is the weighted average cost of capital at t = 0. Therefore, if EVA > 0 value has been created EVA < 0 investment rejected
  9. ADVANTAGES OF EVA v/ Helps in eradicating the agency problem. v/ Universal applicabilty. v/ Predicts stock performance of the organization (see next slide). DRAWBACKS OF EVA X Ignores time value of money. X Implementation of EVA. X Short term performance measure.
  10. EMPIRICAL EVIDENCE ON EVA In retail industry, Best Buy adopted EVA in 1998. From 1998 -2002 the company averaged returns of 39.1 % where as its competitors average 10.4 % to shareholders. In pharmaceutical industry, Bradley pharmaceuticals since adopting EVA in 1998 achieved annualized returns of 62.2% In manufacturing, SPX corporation adopted EVA in 1995 from then its stocks returns averaged 14.2% each year through 2002 Source: Stewart; Budington, 2002
  11. SDvflLARITIES BETWEEN EVA & NPV Both these methods are frequently applied in company's valuation and investment project valuation. o EVA is the long term counter-part of the discounted NPV. Abate et al (2004) presented finance perspective where EVA is related to NPV = Present value of expected EVA, This in turn relates EVA to wealth creation. o McClatchey and Clinebell (2011) demonstrated that NPV and EVA will give identical solutions if economic life of project is equal or extend beyond depreciable life (see illustration next slide)
  12. Cost= $400 t=6 Sales=$70 per year Tax=20% WACC=100/0 Depreciation= MACRS Economic life =8 years t=6 t=6 t=6 Economic life =DepreciabIe life • Sales Depreciation EBIT Tax NOPAT cc EVA DCF 10% PV of EVA NOPAT Add Depreciation Cash flows DCF 10% NPV Sales Depreciation EBIT Tax NOPAT cc EVA DCF 10% PV of EVA NOPAT Add Depreciation Cash flows DCF 10% NPV 70 100 -30 -6 -24 — 34.4 -58.4 0.826 — 48.24 — 24 100 76 0.826 62.78 70 68 2 0.4 1.6 — 24.4 -22.8 0.751 -17.12 1.6 68 69.6 0.751 52.26 70 52 18 3.6 14.4 -17.6 -3.2 0.683 -2.18 14.4 52 66.4 o. 683 45.33 70 36 34 6.8 27.2 -12.4 14.8 0.621 9.18 27.2 36 63.2 0.621 39.22 -400 -400 70 56 14 2.8 11.2 -28.8 0.909 -26.18 11.2 56 67.2 o. 909 61.08 70 56 14 2.8 11.2 -28.8 0.909 -26.18 11.2 56 67.2 0.909 61.08 70 36 34 6.8 27.2 -8.8 18.4 0.564 10.38 27.2 36 63.2 0.564 35.66 70 36 34 6.8 27.2 -8.8 18.4 0.564 10.38 27.2 36 63.2 0.564 35.66 70 36 34 6.8 27.2 -5.2 22 0.513 11.28 27.2 36 63.2 0.513 32.41 70 36 34 6.8 27.2 -5.2 22 0.513 11.28 27.2 36 63.2 0.513 32.41 70 16 54 10.8 43.2 -1.6 (book value -depreciation *WACC) 41.6 0.466 19.40 Using book values at the beginning of the year for 43.2 16 59.2 0.466 27.60 70 16 54 10.8 43.2 -1.6 41.6 0.466 19.40 43.2 16 59.2 0.466 27.60 -43 Economic life is more than Depreciable life 70 100 -30 -6 — 24 -34.4 -58.4 0.826 — 48.24 — 24 100 76 0.826 62.78 70 68 2 0.4 1.6 — 24.4 -22.8 0.751 -17.12 1.6 68 69.6 0.751 52.26 70 52 18 3.6 14.4 -17.6 -3.2 o. 683 -2.18 14.4 52 66.4 o. 683 45.33 70 36 34 6.8 27.2 -12.4 14.8 0.621 9.18 27.2 36 63.2 0.621 39.22 70 o 70 56 o 56 0.424 23.74 56 o 56 O. 424 23.74 the capital charge t=10 70 o 70 14 56 o 56 0.385 21.58 t=10 56 o 56 0.385 21.58 2 2
  13. EVA is based on accounting figures whereas NPV approach is based on market value (Modesti, 2007) Valuation differences Time value of money Two opposite routes Discount Factor choices
  14. EVA & MVA Shawn Tully (1994) of Forbes magazine describes M VA : Value the market places on future stream of annual EVAs. Usually there's a positive relationship between EVA and M VA but not always as the case for example Exxon and Mobile 1993 MVA= Company's market value — invested capital , where market value is debt +equity Result will show how much wealth has been created or destroyed Companies that destroy wealth will not be rewarded even if they have positive EVA Source: Economic Value Added Residua/ Income: The Rea/ Margin: Economic Value Added (EVA), 2010 Added {MVAI Market Value EVA EVA EVA EVA (Oebt Equity) EVA Capital
  15. CONCLUSION Traditional financial performance measures, such as earnings or earnings growth, are not always good proxies for value creation. First step in adopting V BM is to embrace value creation as ultimate financial objective for a company To focus more directly on value creation, companies should set goals in terms of discounted cash flow value or economic profits, the most direct measure of value creation (Koller,1994) Using EVA or NPV in isolation is no case for good decision. Rather combination of these measures can facilitate effective decision making,
  16. REFERENCES Abate, J. , Grant, J. and Stewart Ill, G.B. (2004) The EVA style of investing. Journal of Portfolio Management 30: 61— 72. a [ONLINE] Available at: http://www.tandfon1ine.com/d0i/abs/10.1080/03031853.2003.9523614#.VjJbtd1rJdg. [Accessed 5 October 2015] Adserå, X., and Vinolas,P., (2003) "FEVA: A Financial and Economic Approach to Valuation ", pp. 80-87. Corporate capital expenditure decisions and the market value of the firm . 2015. Corporate capital expenditure decisions and the market value of the firm . [ONLINE] Available at: http://www.sciencedirect.com/science/article/pii/0304405X85900066. [Accessed 29 October 2015]. Does EVA@ beat earnings? Evidence on associations with stock returns and firm values . 2015. Does EVA@ beat earnings? Evidence on associations with stock returns and firm values . [ONLINE] Available at: http://www.sciencedirect.com/science/article/pii/S016541019800010X. [Accessed 15 September 2015] Modesti, P. , (2007) "EVA and NPV: some comparative remarks* " 2015.. [ONLINE] Available at: http://www.rdboehme.com/MBA_CF/Chap_8.pdf. [Accessed 1 October 2015]. Sherif, M. , (2013) "Advanced issues in Corporate Finance ", McGraw-Hill
  17. REFERENCES Stewart,G.B.,III, Elias,M.& Stern Stewart's EVA clients outperform the market and their peers. EVA1uation Stern Stewart (2000) "EVA & Strategy", [online] Available: http://www.sternstewart.com.br/publicacoes/pdfs/EVA_and_strategy.pdf [Accessed 21 Sep 2015]. Tully, S(1994). America's greatest wealth creators. Fortune 130 (11), 77-91. Using EVA As A Decision Metric In Capital Budgeting I McClatchey I Journal of Applied Business Research (JABR). 2015. Using EVA As A Decision Metric In Capital Budgeting I McClatchey I Journal of Applied Business Research (JABR). [ONLINE] Available at: http://cluteinstitute.com/ojs/index.php/JABR/article/view/2226/2203. [Accessed 9 October 2015]. What is value-based management? I McKinsey & Company . 2015. What is value-based management? I McKinsey & Company . [ONLINE] Available at: http://www.mckinsey.com/insights/corporate finance/what is value- based management. [Accessed 15 October 2015] Worthington, Andrew, West, Tracey (2001) Economic Value-Added: A Review of theTheoretical and Empirical Literature. Asian Review of Accounting 9(1):67—86
  18. Thank You

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