subject: Economic Value Added Strategy Among Businesses [print this page] Economic Value Added Strategy Among Businesses
Economic Value Added is the approximation of an organization's economic profit which is entirely based on the excesses of the required returns of the organization's capital. In corporate finance, EVA plays a very crucial role in approximating the organizations or firm's capital productivity and efficiency. Basically, economic value added is usually accrued when the firm's returns on the employed capital is higher than the cost of the capital incorporated in running the organization's processes. Generally, the EVA in an organization is acquired through strategic working capital management in order to realize higher returns on the capital employed, while retaining the costs incurred at lower levels. This strategy involves the making of various adjustments to the GAAP. More specifically, this is usually done by subtracting the "opportunity cost of the entire capital equity" (Stewart 2001).
Calculation of EVA
It should be note that, EVA is the ultimate operating profit after deducting taxes and the costs incurred on capital. In this case, any value got by the workers of the organization or by the consumers is excluded while calculating the Economic Value Added. Basically, EVA is calculated using the following general formula (Stern 2003):
EVA = (r-c) . K = NOPAT c.K
Key: r = (Returns on invested Capital)
C = (Weighted Average Cost of Capital)
K = Net capital employed in the firm/organization
NOPAT Net Operating Profit After Tax
In this case, the Returns on the Invested Capital is calculated by dividing the NOPAT, by the net capital employed (NOPAT/K). Certainly, when calculating the NOPAT, there should be adjustments and re-organizations of the expenses incurred on the capital in order to eliminate any chances of double counting expenses. By so doing, accuracy on the calculation of the EVA would be enhanced since it is a complicated operation. When calculating EVA, NOPAT is very crucial component of the operation since it measures the efficiency on capital employed in the business. Being deduced from company's profits after removing tax, the NOPAT is the total pool of revenues accrued in the organization, and is necessary to determine the rate of cash inflows with respect to the expenses incurred on capital (depreciation and interests) (Stern 2003).
In this case therefore, it is usually very important for organizations to evaluate their net worth and productivity on the basis of EVA values and trends. On the process of calculating Eva, it is essential to consider the capital charge within the company or the firm. Capital charge can be defined as the cash flow, necessary to compensate firm or organization owners and other capital contributors for the riskiness of the organization/ firm with regard to the amount of capital invested. Importantly, the cost of capital is the lowest return rates on the capital essential to compensate equity investors for taking the risks involved in particular investment. The main reason as to why organizations should consider EVA as their main tool to asses the performance of the business is the way it takes into account all the risks involved, together with the revenues acquired from a certain investment (Stewart 2001).
More so, Eva can be approached on another perspective in which net investments and required minimum returns on capitol would be required in its calculation. Required minimum return (RONA) is a ration taken by dividing the organizations'/firms' NOPAT with the net capital employed in the organization/form. This is represented as: RONA = NOPAT/K. Afterwards, adjustments are done on value of RONA acquired by deducting any unpaid taxes or depreciations of other assets which do not belong to the organization, but were used in the production process. In this case, the amount obtained would reflect the ultimate company's EVA at its net value (Ehrbar 1998).
EVA = K/RONA
Where K= Net Investments or capital values employed, While RONA = Returns on Net Assets.
It should be noted that, if RONA is above the threshold expected, then EVA would have positive value. Conversely, if RONA will be below the expected threshold value, definitely the EVA acquired will have negative value. This means that, if the company has positive EVA, its capital productivity and efficiency is well and high, while its performance remains excellent. On the other hand, if the EVA is negative, then the company's productivity and efficiency on capital is low and poor, reflecting mismanagement or resources in the organization. Basically, the organizations' managers and other corporate seniors in the top management level should ensure strategic management of the organizations' capital assets in order to enhance its proficiency and efficiency (Ehrbar 1998).
The role of EVA in Businesses in the Short-run
As it has been observed, EVA is the ultimate reflection of the organizations' capital productivity and efficiency. Being based on the cost of capital equity, EVA plays a very important role of presenting the ultimate network of the business by reflecting the organization's discounted valuations. As opposed to traditional methods of determining the productivity of organizations like NPV and DCF, the EVA theoretically gives the best and accurate results by encompassing all the factors affecting capital productivity. More specifically, EVA fits the best in presenting performance evaluation of the capital employed in an organization or firm. On this basis therefore, EVA acts as a real presentation of the organization's or firms equivalence in terms of the efficiency acquired in the capital employed, with regard to the expected returns (Stern & Shiley 1999).
Being based on common accounting elements like interest, risk bearing, capital equity and NOP among other, EVA enhances for the forecasting of the firms net worth. This would thereafter form a basis for development of long-term goals and strategies to ensure higher productivity in the organization or the firm. On this basis, EVA enhances for the planning of the organizations' capital assets, since its productivity would be established through the calculation of EVA. More importantly, EVA plays a crucial role in facilitating for any adjustment within the organization in terms of capital allocation and distribution. Certainly, EVA enhances for the establishment of a basis for the organization to reinstate its performance and productivity through facilitating for various adjustments (Stewart 2001).
More so, EVA gives investors a real reflection of the organization's or firm's capital productivity, which can be used to borrow loans and other capital requirements from other sources. In this case, the EVA of an organization or affirm can be used by its loaners to facilitate the procession of various transactions between the organization and the financing body. Being a real reflection of the capital productivity in an organization/firm, EVA can form a credential for loaners and any other financing body to assess for the performance of the organization before giving out the loan. Further, the value of the EVA of EVA can act as a form of assurance for the productivity of the firm/organization (Stern & Shiley 1999).
In this case, the financing body would determine on whether to offer for the funds required or not, depending on what the EVA reflects. For instance, if the EVA of the organization is negative, the financing body may not be willing to offer its assistance since this would reflect the mismanagement and poor strategic planning within the organization. On the other hand, if the EVA of the organization is positive, it would be easier for the financing body to offer its assistance; as the organization would be reflected as being well performing and having competent management team, which can plan strategically and efficiently (Stewart 2001).
Further, EVA of an organization can be used by investors to determine on whether to buy shares or venture into the existing business or not. By observing the value of the company's net worth after deducting capital expenses, the investors will have a clear picture of the performance of the organization or the firm. On this basis, it would be quite important for the investors to understand the ultimate performance of the organization well before making full ventures into the business. On this basis therefore, the EVA of the organization would be very useful in determining the ultimate productivity and efficiency of the organization on the basis of the capital equity.
Merits EVA Calculations in Evaluating the Performance of a Firm in the Short-run
Being based on capital equity, EVA of any organization gives the overview of the company's internal productivity and efficiency. This is reflected on the way the calculation of EVA considers simple elements in accounting, which determine a lot I the overall capital's productivity and efficiency. More specifically, the EVA of any organization is very useful in enhancing for any adjustments within the organization. In fact, the true rate of returns on capital investments is best reflected in the organization by calculating its EVA. Holding other factors constant (at ceteris paribus) an organization is capable of assessing its overall productivity by calculating its EVA (Stern & Shiley 1999).
