COSTING ASSIGNMENT

ON

ECONOMIC VALUE ADDED

Submitted by:

DIVYA BODDU09020242007

MBA-AB [09-11]

INTRODUCTION:

Economic Value Added (EVA) is a financial performance method to calculate the true economic profit of a corporation. EVA is basically an estimate of the amount by which earnings exceed or fall short of the minimum rate of return for shareholders or lenders at comparable risk.

Unlike market based measures, EVA can be calculated at divisional (SBU) level. Unlike stock measures, EVA is a flow and can be used for performance evaluation

over time. Unlike accounting profits, EVA is economical and is based on the idea that a business

must cover both the operating costs and capital costs.

EVA is a part of performance metric used by various corps and its corresponding wealth metric is Market Value Added. The EVA is a registered trademark by its developer, Stern Stewart & Co.

EVA is generally used for setting organizational goals, performance measures, determining bonuses, communication with shareholders and investors, motivation of managers, corporate valuation and analysing equity securities.

CALCULATION OF EVA:

EVA is calculated in three basic steps:

There are certain adjustments that are to be made while calculation of EVA:

SIGNIFICANCE OF EVA:

The use of above formula will produce either a positive or negative EVA number. A positive EVA reflects that the company is increasing its value to its shareholders, whereas a negative EVA reflects that it is diminishing its value to its shareholders. Also, MVA has a direct relation with EVA.

The market value of a company = Book value of equity + presentvalue of future EVA

The strengths of EVA are as follows:

Because it is a residual performance metric, it conveniently summarizes into a single statistic the value created above and beyond all financial obligations

By applying a capital charge, it corrects the key deficiency of earnings and earnings per share (EPS): they do not incorporate the balance sheet. Economic profit explicitly recognizes - by way of the capital charge - that capital is not free

Generally, they do it either by investing additional capital that produces returns above WACC, by reducing capital employed in a business, by improving returns by growing revenues or reducing expenses or by reducing the cost of capital.

Thus companies try to increase their EVA by:

Increasing the NOPAT generated by existing Capital

Reducing the WACC

Investing in new projects where the Return exceeds the WACC

Divesting Capital where the Return is below the WACC

LIMITATIONS OF USING EVA:

EVA has the limitations of any single-period, historical metric: last year's economic profit will not necessarily give you an insight into future performance

EVA is difficult to use for inter-firm and inter-divisional comparisons because it is an absolute rather than a relative measure.

Due to the calculation being a year-to-year performance metric, the result could be manipulated by, for example, choosing short-term, early yield projects over longer-term, delayed income stream, higher yield projects.

EVA is a short-run concept that deals only with the current reporting period The use of conventional depreciation methods means that there is no guarantee that

the measurement of EVA™ in the short-term will be consistent with the measurement of EVA in the longer-term.

Economic depreciation is difficult to estimate and conflicts with generally accepted accounting principles, which may hinder its acceptance by financial managers

REFERENCES: www.investopedia.com; www.wikipedia.org; www.evanomics.com; www.sternstewart.com