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Financial Tools Of Analysis Economic Value Added _EVA

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					       FINANCIAL TOOLS OF ANALYSIS: ECONOMIC VALUE ADDED (EVA)
                            PART 2 OF 4


               As we enter a new millennium, the quantitative skills employed by credit
managers are becoming more and more sophisticated . Last month we examined the Basic
Defensive Interval (BDI). In this monthly installment we will scrutinize another financial tool
that has been emerging in popularity: The Economic Value Added (EVA).
        EVA is a term that was coined by Stewart Stern & Co. When I first encountered EVA I
made the mistake of passing off on it; I erred in believing that EVA was just another way to
repackage an old tool. However, a corporate credit manager at a Chicago based Fortune 500
company took me to the side and explained the success that she was enjoying by employing
EVA. She was getting more cooperation than ever from non-financial managers.
        Conceptually EVA is similar to a concept stressed in most college level finance courses:
Net Present Value. Years ago, when I was a credit manager at General Electric, we referred to a
measure similar to EVA as residual income. Today, a number of large corporations are using
EVA as a quantitative tool. Companies such as R.R. Donnelley, Coca Cola, Quaker Oats, Eli
Lily, AT&T, CSX, Briggs & Stratton and even the U.S. Postal System, have been able to employ
EVA as a financial tool. EVA appears to be much easier to convey to non-financial managers
than was residual income or net present value.


                              RATIONALE FOR USING EVA

        EVA is the gain or loss that remains after assessing a charge for the cost of all types of
capital employed. What an accountant calls profits in an income statement includes a charge for
the debt capital employed which is commonly referred to as interest expense. However, an
income statement does not include a charge for the equity capital that was employed during the
accounting period. Therefore, EVA goes beyond conventional accounting standards by including
a provision for the cost of equity capital. The cost of equity needs to be factored into business
investment decisions in order to enhance shareholder value.
        Although EVA is couched in financial analysis, its primary purpose is to shape
management behavior. EVA can be used as a performance measure to evaluate an overall
company, a division within a company, a location within a division, or an individual manager. By
setting goals, EVA can become a motivational tool at various levels of management. EVA can
also be used in downsizing decisions.
        Perhaps the real key to appreciating EVA lies in its simplicity. Often times non-financial
managers are hard pressed to understand financial tools; EVA can help to facilitate
communication thereby enhancing coordination within a company. Managers need to trained to
recognize the opportunity to strive for an increase in economic value added. Once properly
trained, managers can then pinpoint key financial focal concerns germane to decisions.
                              THE EVA CALCULATION

               The formula to calculate EVA is fairly simple, The formula is:

       EVA = Net operating profit after taxes less the after tax cost of capital employed

        The operating profit includes deductions from revenues for the cost of goods sold and for
the operating expenses. The interest expense is then subtracted to cover the cost of the debt
capital used, income taxes are then subtracted, and finally, a cost for the equity capital is
subtracted from the net income after tax to obtain the EVA.
        The cost of equity capital can be derived by using any one of several approaches. Perhaps
the simplest approach is to use the interest rate that a company can borrow at and then add a risk
premium. The risk premium is added because investors require a higher return to invest in stock
than they require on bonds. ( This is often called the bond yield plus risk premium approach.) A
typical equity risk premium is about 4%, so if a company can borrow at 10% then its cost of
equity capital would be 14%.
        ( There are other approaches that can be used to calculate the cost of equity capital. Two
such approaches that are commonly used are the Capital Asset Pricing Model Approach and the
Dividend Yield Plus Growth Rate Approach. Most college level finance textbooks will include
thorough discussion of these approaches in the Chapter that covers the cost of capital.)

        EVA Illustration: The Blackhawk Company can borrow on a bond at a 10% interest
rate. The equity risk premium is the bond yield plus 4%. It uses 50% debt and 50% equity. Total
capital employed is $10,000,000. The business is in the 40% tax bracket. Let’s look at the
Blackhawk Company income statement and then calculate the EVA:

       Sales                         $50,000000
       Cost of Sales                   20,000,000
       Gross Profit                    30,000,000
       Operating Expenses              20,000,000
       Operating Profit                10,000,000
       Interest Expenses                  500,000 (10% of $5,000,000 in debt capital employed)
       Profit before tax                9,500,000
       Income tax (40%)                 3,800,000
       Income after tax                 5,700,000
       Charge for equity capital         700,000 (14% of $5,000,000 in equity capital employed)
       EVA                            $ 5,000,000

       As long as the EVA is a positive number the business is creating value.
                              USING THE RESULTS

        EVA can become a management focus at all levels. Individual unit managers may find
ways to cut costs or increase revenue. Corporate managers could focus upon allocating capital to
divisions, units, or profit centers that can generate higher EVAs. . Managers can be rewarded or
replaced based upon EVA. Perhaps a manager will take more time to consider using less capital
which would create efficiency gains for a business.
        EVA tends to work best for old economy companies; e-commerce companies would be
hard pressed to use EVA. There are potential pitfalls. EVA can be used subjectively which could
lead to faulty decisions. Finally , EVA can be subject to manipulation by individual managers
seeking rewards.
        The purpose of EVA is to create value for the owners of a firm. If used properly it can be
an effective tool in the hands of a credit manager. Efficiently managed accounts receivable will
create value for a firm. The challenge to credit managers is to deploy EVA in a most constructive
manner. For the credit manager, the need to increase sales must be balanced off against the days
sales outstanding, costs of collections, and the write-offs to bad debts in order to maximize the
EVA.


       NEXT MONTHS TOOL:             LEVERAGED BUYOUT ANALYSIS


About the author: Dr. Chuck Gahala, CCE can be reached via e-mail at cgahala@ben.edu


       Dr. Gahala is a Finance Professor at Benedictine University which is located in Lisle, Il
where he is the chair of the Undergraduate Business Department. Dr. Gahala specializes in
corporate finance and business credit management. He is the author of Credit Management:
Principles and Practices published by the NACM. He holds NACM’s CBF and CCE
credentials.

				
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