EVA approach

Concept of Economic Value Added (EVA) EVA is a value based financial

performance measure, an investment decision tool and it is also a performance
measure reflecting the absolute amount of shareholder value created. It is computed as
the product of the “excess return” made on an investment or investments and the
capital invested in that investment or investments. “Economic Value Added (EVA) is
the net operating profit minus an appropriate charge for the opportunity cost of all
capital invested in an enterprise or project. It is an estimate of true economic profit, or
amount by which earnings exceed or fall short of the required minimum rate of return
investors could get by investing in other securities of comparable risk.”
EVA is a variation of residual income with adjustments to how one calculates income
and capital. Stern Stewart & Co., a consulting firm based in New York, introduced the
concept on EVA as a measurement tool in 1989, and trade marked it. The EVA
concept is often called Economic Profit (EP) to avoid problems caused by the trade
marking. EVA is so popular and well known that all residual income concepts are
often called EVA even though they do not include the main elements defined by Stern
Stewart & Co.
In the 1990’s, the creation of shareholder value has become the ultimate economic
purpose of a corporation. Firms focus on building, operating and harvesting new
businesses and/or products that will provide a greater return than the firm’s cost of
capital, thus ensuring maximization of shareholder value.
EVA is a strategy formulation and financial performance management tool that help
Companies make a return greater than the firm’s cost of capital. Firms adopt this
concept to track their financial position and to guide management decisions regarding
resource allocation, capital budgeting and acquisition analysis.
In its simplest terms, EVA measures how much economic value in Money; the
Company is creating, taking into account the cost of debt and equity capital. The term
EVA, a registered trademark of the consulting firm of Stern Stewart, represents the
specific version of residual income used by the firm.
It is defined as: EVA=NOPAT- (Invested Capital × WACC).
Calculation of Economic Value Added (EVA)
Step 1: Review the Company’s financial data:
Nearly all of the needed information to perform an EVA calculation can be obtained
from the Company’s income statements and balance sheets.
Step 2: Calculate the Company’s Net Operating Profit after Tax (NOPAT).
The NOPAT is a function of Earnings Before Interest payments and Taxes (EBIT) and
the tax rate of the firm.
Step 3: Calculating Invested Capital.
By reviewing of the balance sheet, its basic structure says that total assets are equal to
the sum of debt, plus stockholders' equity.
The major components commonly found in the structure are: • Debt • Preferred
stock • Common stock or partnership interests.
Capital employed is the book value of return on equity together with book value of
liabilities with interest. In other words, capital means all costing financial resources
available to the Company.
Calculated Invested Capital using the operating approach, by subtracting short term
Non-Interest Bearing Liabilities (NIBL's) from the total assets.
Invested capital = Total assets – non-interest-bearing liabilities (NIBLs) Thus
invested capital is as following:
Invested capital =total debt +total shareholder's fund (total equity).
Step 4: Calculating Weighted Average Cost of Capital (WACC):
The WACC is the minimum return that a firm must earn on existing invested capital.
The WACC can be calculated by taking into account the proportionate weights of
various funding sources such as common equity, straight debt, warrants and stock
options, and multiplying them by the cost of each capital component.
Weight average capital of cost (WACC) = (Interest expense / debt) × (debt / capital) ×
(1-tax %) +equity cost × (equity / capital)
WACC = (Ke × We) + (Kp × Wp) + (Kd(pt)[1 – t] × Wd)
Where: WACC = Weighted average cost of capital
Ke = Cost of common equity capital
We = Percentage of common equity in the capital structure, at market value
Kp = Cost of preferred equity
Wp = Percentage of preferred equity in the capital structure, at market value
Kd(pt) = Cost of debt (pre-tax)
t = Tax rate
Wd = Percentage of debt in the capital structure, at market value

Step 5: Calculation of Cost of Equity (Ke):

There are 2 ways to calculate Ke
i) DDM (if given level of dividend and rate of growth)
ii) ii) CAPM (If given the rate of risk and return)
Dividend Discount Model (DDM): The Dividend Discount Model (DDM) is a way
of valuing a Company based on the theory that a stock is worth the discounted sum of
all of its future dividend payments. In other words, it is used to value stocks based on
the net present value of the future dividends. The equation most always used is called
the Gordon’s growth model. The variables in this model are: P is the current stock
price. g is the constant growth rate in perpetuity expected for the dividends. r is the
constant cost of equity for that Company. D1 is the value of the next year's dividends.
There is no reason to use next year's dividend using the current dividend and the
growth rate.
Cost of Equity = (Dividends per share / Price per share) + Dividend growth rate
Ke = D1/P0 + G
Where: Ke=required return on common stock;
D1= per-share dividend expected at the end of year 1;
P0=value of common stock; and
G=constant rate of growth in dividends.

Rate of return on equity method In this approach, retention ratio is multiplied by

the return on equity in order to calculate the expected growth rate.
Growth - exist when there is money retained to be reinvested, indicating growth.
Therefore: g = ROE ×Retention ratio (RR)
Retention ratio: (1− DPS/ EPS)
g = ROE × (1− DPS/ EPS)
Where, g: expected growth rate
ROE: Net income to equity ratio (Return on Equity) Hence, to compute the expected
growth rate based on this approach, information about earnings per share, cash
dividend per share, net income, and equity
Capital Asset Pricing Model (CAPM): CAPM made some assumptions about the
behavior of the investors. The most important is that investors are risk avoiders, and
investors avoid the risks to diversify in other Companies. CAPM is an expectation
model, this model is based on the investors’ expectation, what is going to happen, not
based on what has happened.
The formula is: Ke = Rf + β (Rm – Rf)
Where, Ke = Cost of equity
Rf = Risk-free rate, the amount obtained from investing in securities and considered
free risk, such as government bonds from developed countries.
Rm = Rate of market return, calculated by summing returns in five year period (for
this study)
β = Systematic risk (individual risk), calculated by searching the rate of beta’s stock in
five year period (for this study). Beta, it measures how much a Company's stock price
reacts against the market as a (Rm – Rf) = Equity Market Risk Premium, Equity
Market Risk Premium (EMRP) represents the return investors expected to
compensate them for taking extra risk by investing in the stock market over and above
the risk-free rate.
Step 6: Calculation of cost of debt (Kd):
The rate on debt is calculated by dividing financial expenses with the interest bearing
debt. The interest bearing debt is comprised of construction contracts in progress,
bank loans, credit institutions, mortgage debt and short-term share of long-term debt.
Kd (Cost of Debts) are calculated by dividing between interest expense and total long-
term debts of the Company (total debt in this study).
Kd = (Interest Expense/Total Debts).
Step 7: Calculate the Company’s Economic Value Added (EVA).
The EVA model works with three basic components - Capital, NOPAT and WACC.
EVA can be defined as the firm’s Net Operating Profit After Taxes (NOPAT), less the
cost of capital. EVA proponents assume that any increment in the firm EVA increases
the value of the firm.
EVA =NOPAT - (WACC × IC) or EVA= NOPAT – C x Capital

EVA = NOPAT − (D + Ebv) × WACC

Where,
NOPAT = Net Operating Profits After Taxes or (Profits before interest and taxes) (1- tax
rate).
D = Debt Book Value.
Ebv =Equity Book Value.
WACC = Weighted Average Cost of Capital
IC =Invested Capital