CHAPTER IV ECONOMIC VALUE ADDED IMPLEMENTED IN INDIA AND OTHER COUNTRIES IN THE WORLD

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1 CHAPTER IV ECONOMIC VALUE ADDED IMPLEMENTED IN INDIA AND OTHER COUNTRIES IN THE WORLD 4.1 INTRODUCTION: EVA was a new metric recognized by an economist since the 1770s and it was called Residual Income. Alfred Marshall has defined Residual Income as a total net profit minus the interest on invested capital in 1917 and EVA is modified version of residual income. Residual Income is old concept and it is included in accounting theory since 1917 and Residual income theory was reuse in management accounting literature in the Before 1970s residual income or the new concept EVA did not get wide publicity. A global consulting firm was established in 1982, by Joel M. Stern and Bennett Stewart. They have put EVA on the world map in 1989, by publishing an article in the Fortune magazine. EVA is the registered trademark of Stern Stewart and company for measuring managerial performance and economic value. EVA is a measure of corporate performance that differs from others by including a charge of profits against cost of all the capital employed. EVA is conversion of accounting information to economic reality that can be readily understood by non-financial managers. EVA is the framework for a complete financial management and incentive compensation system. Recently, EVA is more useful in corporate world and which is to improve the working lives of everyone in the organization by making decision. EVA helps the managers of companies to create shareholders wealth. The concept of EVA is popular particularly in USA, UK and European countries where companies are using EVA as modern measure of performance. It is used as an internal as well as external performance measure because it is consistent with the organizational objective of shareholder s value creation. It is an accounting-based measure of operating performance. Its aim is to provide management with a measure of their success in increasing shareholder s wealth. It is both a measure of value and a measure of performance. The term EVA is registered trade mark of Stern Stewart and Co. USA. It is a strong tool 93

2 for business planning and it is better approach than profit indicator based on profit after-tax. It explains clear surplus of the company. It effectively helps to explain the ability of a company to generate clear surplus. It is spread of the company. It as a performance measure aligns internal process, business strategies and employee behaviour in pursuit of value creation potential. It is useful for making decisions in company which improves the profitability through improving the capital turnover of the company. It is considered as better alternative to the conventional performance measures such as EPS, ROE, ROI, RI, ROCE, MOV, SVA, ROA, EG, Cost of capital, Balanced scorecard, WACC, ESOP, NOPAT, EBIT, ROS, DPS etc. Economic Value Added is an estimate of true economic profit of the company. They found that EVA is reasonably reliable guide to understand the firm s value. Machuga et. al., (2002), in their study highlighted that EVA can be used to enhance future earnings predictions. Lehn and Makhija, (1997), investigated the degree of correlation between different performance measures and stock market returns. The results indicate that EVA is the most highly correlated measure with stock returns. Economic Value Added (EVA) is internal performance measure and modern approach which is useful to measure the real profit of the company. Economic Value Added is measure of corporate performance that differs from conventional measures. Bennett Stewart and Joel Stern founded the New York-based global financial consultancy firm under the name Stern Stewart and Company in EVA is a financial performance tools to capture the economic profit of the company. Growth and development of the corporate sector is based on financial performance. EVA plays significant role for maximization of shareholders wealth. A positive EVA indicates that a business is not only earning, it is earning enough to satisfy the providers of fund Khanka S.S., (2012). A leading pension fund believes that only EVA gives a real picture of value creation Chandra (2001). Shareholders wealth is measured in terms of returns they receive on their investments. Any financial measures used in assessing a firm s performance must be highly correlated with shareholders wealth, but on the other hand should not be subjected to randomness inherent in it Sharma and Kumar, (2010). O Byrne, (1996), concluded that EVA explains more than 94

3 twice as much of the variance in market/capital ratio as NOPAT when the EVA model has positive and negative EVA coefficient, and an in (capital) term. He also showed that EVA changes explain significantly more of the variation in market value changes. EVA is a better measure than ROA, ROE, NI and EPS. Lehn and Makhija, (1997), examined the relationship between six performance measures and stock returns. The results revealed that EVA and MVA are effective measures of performance. They found that EVA and MVA are better long-run performance measures than conventional accounting performance measures. EVA is new performance measurement tool, but it is critical for measure the financial performance. EPS and ROI both are used as the most important performance measures, although they do not conceptually correlate with the shareholder value creation very well (Kale and Aurora, 2009). MVA is a cumulative measure of corporate performance of the company but continuous improvement of EVA is useful to increase the MVA Kumar Atul, (1999). Economic Value is better than NPV because EVA is flow measure but EVA is stock measure Todd Milbourn, (1997). EVA is playing vital role in corporate world. In corporate world, various researchers said that Economic Value Added (EVA) is more essential to measure the real financial performance of Indian companies but it popular in outside the country like; USA, UK, France, Canada, Germany, Mexico, Singapore, Bangladesh, Kenyan, New Zealand, Pakistan, England, Iran, Turkey, Landon, South Africa, Italy, Malaysia, Zimbabwe, Argentina, China, Brazil, Greece, Russia, Kuwait, Australia, Spain etc. EVA is useful for manufacturing industry as well as computer industry in India. EVA is a process of measure the real profitability but it is depends upon the value creation of shareholders. Financial performance of the company and its value is correlated. EVA is an internal measure of performance used to quantify the shareholder value or destroyed by operating activities of the company also used to manage the economic resources. EVA is new and applied measure of performance, it is useful to understand and evaluate the real financial performance excluding Dabur India Limited for the period from to But conventional measures are used to calculate financial reports as well as showing through financial chart, financial highlights, ratio analysis, trends analysis etc. 95

4 4.2 ECONOMIC VALUE ADDED (EVA): Economic value Added is calculated on the basis of accounting profit and economic capital. EVA means economic earnings minus economic capital. Economic capital means debt and equity. Recently, Maximization of shareholders wealth is becoming in the present corporate world and it is a necessary to increase the value of the company. The company s view, EVA model is more benefited by maximization of shareholders wealth because no. of investors, shareholders who has contributed to operate the company so, it is necessary to use this model. EVA is modern financial performance measure. Presently, EVA is better than the conventional performance measures because, it is more valuable for showing real profit of the company. Few Indian companies are use EVA concept but majority of the Indian companies which are working in India they have not believe to calculation of EVA concept. EVA helps managers to care about the economic capital and accounting profit and it helps to bring up a balance between economic capital and accounting profit. Economic Value Added is a new and dynamic measure of financial performance. EVA is a complete measure of real profit of the company s. Shareholders are real owners of the company and they are more interested to maximize their wealth in the company and maximize the value of the company for their maximization shareholders wealth, it means creation of maximum value for company s Owners i.e. shareholders which mean maximizing the market price of the shares. So, collection of capital through issuing equity is more valuable than the collection of capital through debt. Dividend is paid on the basis of profit available to equity shareholders. Interest on debt is fixed amount of capital. This fixed amount will provide to whom, who are provide debt to the company. 4.3 EVA IMPLEMENTED BY MULTINATIONAL COMPANIES: EVA is a performance metric and it is used to measure economic profit of the company. In , EVA implemented by 582 American companies for the purpose of shareholders wealth creation Fernandez, (2003). In 2005, 89 industrial firms of South Africa have used EVA to analyse the financial performance of the industry (De Wet, 2005). In 2009, 104 Indian companies 96

5 have used EVA concept for shareholders value creation Kaur and Narang, (2009). Top 10 US companies like; Coca-Cola, IBM, Procter and Gampble Johnson, Microsoft, General Electric Eli Lilly, Monsanto, Bausch and Lonb, AT & T and 8 Indian companies like; Infosys Technologies Limited, BPL, HUL, NIIT, TCS, Godrej consumer product limited, Ranbaxy Labratiries, Samtel India Limited have adopted EVA metric. In India, Infosys Technologies Limited is the first Indian company to report its EVA Sharma Asha, (2013). Infosys Technologies Limited has used EVA concept to measure the real profit EVA Implemented in US: 37 US companies have used EVA new metric to measure companies performance Kaur and Narang, (2012). In 2003, 582 companies used EVA metric to increase the firm value and shareholders value creation through conventional measures Fernandez and Pablo, (2003). 28 Pharmaceutical companies used EVA metric (from to ) to predict MVA Kumar and Pal, (2008). Khan and et. al. (2012), observed that 618 US companies are used to explain the relationship between EVA and MVA EVA Implemented in India: In corporate sector from 2004 to 2008 largest 500 companies have used EVA concept to measure shareholders value Kuar and Narang, (2012). In this year HUL, AT & T, Briggs Stratton, CSX, Quaker Qats, Infosys, Hero-Honda has used EVA new metric to motivate and maximise the shareholders wealth. In , 15 companies (IT companies, Pharmaceutical industry, automobile and textile etc.) have used EVA concept to measure the market value of shares. In 2006, Dabur India Limited has used to analyse financial performance Rakshit, (2006) EVA Implemented in South Africa: 89 industrial firms of South Africa have show strongest correlation between EVA-MVA De Wet, (2005). These industrial firms used EVA to maximise the shareholders value and firms value. 97

6 Many companies in 18 countries like; US, UK, South Africa,India, Australia, China, Malaysia, Canada, Brazil, Greece, Russia, New Zealand, Kuwait, Turkey and Indonesia, Kazakhstan, Saudi Arabia, Pakistan, Iran etc. have used EVA metric to measure financial performance of the corporate sector. EVA is more useful for the developing country like; India to measure performance of the company. 4.4 MARKET VALUE ADDED (MVA): Stewart has introduced another measure of shareholder value called Market Value Added (MVA). He coined the term Market Value Added in MVA tell us how much value the market adds over the book value of invested capital. MVA offers top-down evaluation of the firm s risk dynamics, provides a simple, easy to measure capital allocation method and can easily unify all financial management activities. MVA is closely related to market value, EVA and wealth creation. Wealth creation is not determined by the market value of a company but by the difference between the market value and the capital of the company. It is the difference between the current market value of all capital elements and the historical amount of capital dollars invested in a company. It provides the stock market assessment of management s efficiency in using capital. A positive MVA indicates that a company is building value for its shareholders and negative MVA indicates that the shareholders value is being destroyed. Maximizing MVA is consistent with the management goal to maximize the shareholders wealth. It is best external measure of performance because; it captures the markets assessment of the effectiveness resources under their control. It depends upon company. It may be expressed as the present value of the economic profits earned by company through its business life, Aminimehr, (2008). Market value Added is the present value of all future value of Economic Value Added, Kumar Vinay et.al., (2001). Vijaykumar A., (2012), has indicated that EVA is strong relationship with MVA and it is superior then conventional measures of performance. He has adopted different statistical measures to evaluate and understand EVA metric. EVA is related to long-term sources of the company i.e. debt and equity. 98

7 4.5 EVA AND SHAREHOLDERS VALUE CREATION: EVA is a measure of corporate value creation. EVA is a measure of financial performance and it helps to measure shareholders value creation after charging cost of capital. Positive EVA helps to create shareholders value but negative EVA destroyed value of the shareholders. Return on equity is more useful to maximize the shareholders value of the company. Equity shareholders are value creator. Kumar Vinay et.al., (2001), they have pointed out that the executive performance does not maximize the shareholders wealth, because risk perception of managers and shareholders are different and executive performance is not contributing to have value creation of the company. Shareholders are investing their money in a company and after that they are getting return. There are two parts of return, one is dividend and second is interest. Particularly interest will be paid to, who are investing their fixed money in the company, and they are giving fixed interest. Black Stanley, (1998), says that economic value added is influenced by strategic management and EVA more help to create value of the shareholders. Rauyani and Joshi et.al., (2011) they have focused on maximization of shareholders wealth and it is measured by returns and they analysed that the market value of the share is useful to create shareholders value and operational decisions of the company. Sirbu Alexei, (2012) noted that EVA improving the shareholders wealth and it helps to take strategic decisions. Bacidore Jeffrey e.al., (1997) introduced EVA as an appropriate financial performance measure and it is required for the measurement of shareholders wealth and rate of return of the company. Kumar and Pal, (2008) state that a shareholder value is concept of capitalist economy but EVA is useful to create shareholder wealth and it is depends upon they receives on their investment. Zabiulla, (2012) focused on shareholders value creation and it helps to take managerial decisions. Shareholders return is based on market value of shareholders. Rakshit Debdas (2006) analysed that ROI does not reflect the value addition to shareholders wealth but value creation or value addition is more benefited for the measurement of performance. NPV and EVA are correlated to shareholders. Managerial decision-making approach is playing vital role to maximize value of the company and shareholders wealth. Sharma Asha (2013) has found that EVA is better than conventional measures like; ROCE, EPS, ROA, PAT, 99

8 etc to create shareholders wealth. The return is higher than the cost of capital for creating shareholders wealth. Sivakumaran and Saravankumar (2011) concluded that shareholder value is depends upon the maximization of the EVA metrics. EVA is best indicators of maximization of shareholders wealth as compare to conventional measures. Banerjee, (2000) has observed that a shareholder value is depends upon the market value of the equity shares. Thenmozhi M., (2000) introduced, the main aim of every company is maximization of shareholders value creation. Salehi and Yousefi et.al., (2011) state that role of managers in corporate sector is more important of maximization of shareholders wealth. Shareholders value means minus debt. In value creation process, shareholders value is rely on market value of equity shares. Bacidore, (1997) studied that TQM is highly correlated with shareholders wealth. Franklin and Muthusamy (2011) positive EVA increase the shareholders wealth and it relates to market prices of equity. Worthington and West (2001) financial performance of the company encourages managers to create shareholders value. Ghosh and Mukherjee (2006) observed that conventional measures performance focuses on value creation of the shareholders. Lion Kim (2004) suggested that many companies are involved to create shareholders wealth. Ralph Kimball (1998) concluded that market capitalization and other accounting methods do not measure shareholders value created. Sharma and Kumar (2012) shareholders value added is a value based financial performance measures. Kaur and Narang (2010) EVA disclosure is benefited to create shareholders with help of market value of equity shares. Kumar Vinay et.al., (2001), Market Value Added is an ideal and new performance metric of wealth creation in long term period. MVA is fluctuating metrics. Bhasin Madan (2013) corporate managers do not always playing role, to maximize the shareholders value and EVA is the new financial performance measure and it is directly relates to creation of shareholders wealth. Nagar Neerav (2007) EVA was introduced as an indicator of maximization of shareholders wealth. EVA is one of the best motivator of company and it is helps to achieve the goal of sustainable long term value creation for our shareholders. It is a measure of business performance and to set targets through value creation of shareholders. EVA represents the value added to the shareholders by generating operating profits over the cost of 100

9 capital employed in the company. EVA is important measure to evaluate the financial performance as well as maximization of shareholders wealth of the company. EVA is one of the critical factors for the company success and it is focused on creation of shareholders value. EVA is helpful to achieve the objective and accomplish them successfully. Increasing trend of profit from current operations by utilising the current economic resources or current assets in different market place is continuously representing the value creation of the shareholders. 4.6 INCENTIVE PLANS: Performance Linked Variable Remuneration (PLVR) is a scheme and this scheme under company provides rewards to the employee but it based on EVA. The scheme amount is related to actual improvements of the EVA over the previous year. The company provides rewards on two basis. One is actual improvements and second is expected improvements. Actual improvement is more than expected improvement; at this stage company provides incentives i.e. rewards to the company employee. The main objective of the PLVR scheme is to create value the company and to improve the future performance of the company. The Company has a scheme of Performance Linked Variable Remuneration (PLVR) which rewards its employees based on Economic Value Added (EVA). The PLVR amount is related to actual improvements made in EVA over the previous year when compared with expected improvements. The EVA awards flow through a notional bank whereby only pre-specified portion of the bank is distributed each year and balance is carried forward. Only the amount distributed out of notional bank is charged to Profit t and Loss Account. The notional bank is held at risk and charged to EVA of future years and payable at that time if future performance so warrants CONCLUSION: EVA is new performance measure in the corporate world and it is one of the modern approaches. EVA is useful for measuring the financial performance. It is a tool to measure, motivate and also used to manage and new investment decision, to measure the employee efficiency, grant rewards to the employee business strategy, to identify the shareholders value, financial 101

10 highlights, ratios, EVA trends as compare to conventional measures etc. EVA is necessary to measure the real profit of the company. REFERENCES: Aminimehr, (2008), pp Bacidore Jeffrey et. al., (1997), pp Bacidore Jeffrey, op.cit, (1997), pp Banerjee Ashok, (2000), pp Bhasin Madan, (2013), pp Black Stanley, (1998), pp Chandra Prasanna, (2001), pp Fernandez, (2003), pp Franklin and Muthusamy, (2011), pp Ghosh and Mukherjee, (2006), pp Kale and Aurora, (2009), pp to Kaur and Narang, (2010), pp Khanka S.S., (2012), pp Kumar and Pal, (2008), pp Kumar Atul, (1999), pp Kumar Vinay et. al., (2001), pp Kumar Vinay et. al., op. cit., (2001), pp Lehn and Makhija, (1997), EVA, pp Lehn and Makhija, op. cit. (1997), pp Liow Kim, (2004), pp Machuga et. al., (2002), pp Nagar Neerav, (2007), pp O Byrne Stephen, (1996), pp Rakshit Debdas, (2006), pp Ralph Kimball, (1998), pp Rauyani and Joshi et. al., (2011), pp Salehi Mahdi et.al., (2011), pp Sharma and Kumar, (2010), pp Sharma and Kumar, (2012), pp Sharma Asha, (2013), pp

11 Sirbu Alexei, (2012), www. arpapaerss.com/volumes/vol12 Issue1/12/1/06. pdf, pp Sivakumaran and Saravankumar, (2011), pp Thenmozhi M., (2000), pp Todd and Milbourn, (1997), pp Vijaykumar A., (2012), pp Worthington and West, (2001), pp Zabiulla, (2012), pp