Study Notes on Economic Value Added, Market Value Added, and Shareholder Value Creation

Economic Value Added (EVA)

  • Definition: Economic Value Added (EVA) is a measure of a company's financial performance based on the residual wealth, calculated by deducting the company's cost of capital from its operating profit, adjusted for taxes on a cash basis.   - Discoverer: This measure was devised by Stern Stewart and Co.   - Alternative Terminology: EVA can also be referred to as economic profit, attempting to capture the true economic profit of a company.   - Purpose: EVA assesses company and management performance by measuring the value generated from funds invested into the company.

  • Interpretation of EVA:   - A negative EVA indicates that the company is not generating value from the funds invested into the business.   - A positive EVA shows that the company is producing value from the invested funds.

  • Formula for Calculating EVA:      extEVA=extNetOperatingProfitafterTaxes(NOPAT)−(extInvestedCapitalimesextWeightedAverageCostofCapital(WACC))ext{EVA} = ext{Net Operating Profit after Taxes (NOPAT)} - ( ext{Invested Capital} imes ext{Weighted Average Cost of Capital (WACC)})

  • Example Calculation: Following are the income statement variables of a hypothetical firm, X Ltd:   - Sales Revenue: ₹500 Lakhs   - Operating Costs: ₹300 Lakhs   - Interest Cost: ₹12 Lakhs   - Earnings Before Taxes: ₹188 Lakhs   - Tax Rate: 40%   - Earnings After Tax (EAT): ₹112.8 Lakhs   - Existing Capital Structure:     - Equity: ₹150 Lakhs     - Cost of Equity: 15%     - Debenture: ₹100 Lakhs     - Cost of Debenture: 12%

Market Value Added (MVA)

  • Definition: The Market Value Added (MVA) approach measures the change in the market value of a firm’s equity relative to its equity investments (which consists of share capital and retained profits).

  • Formula for Calculating MVA:      extMVA=extMarketValueoffirm′sequity−extEquityCapitalInvestmentext{MVA} = ext{Market Value of firm's equity} - ext{Equity Capital Investment}

  • Application Requirement: The MVA approach can only be used for firms whose market price is available.

  • Example - Positive MVA Calculation:   - Firm: Rex Ltd   - Equity Market Capitalization: ₹3400 Crore   - Equity Share Capital: ₹2000 Crore   - Retained Earnings: ₹600 Crore      extMVA=₹3400extCrore−(₹2000extCrore+₹600extCrore)=₹800extCroreext{MVA} = ₹3400 ext{Crore} - (₹2000 ext{Crore} + ₹600 ext{Crore}) = ₹800 ext{Crore}   - Interpretation: Management has created ₹800 Crore of additional value for its equity shareholders.

  • Example - Negative MVA Calculation:   - Firm: Dew Ltd   - Equity Market Capitalization: ₹900 Crore   - Equity Share Capital: ₹1200 Crore   - Accumulated Losses: ₹200 Crore      extMVA=₹900extCrore−(₹1200extCrore−₹200extCrore)=−₹100extCroreext{MVA} = ₹900 ext{Crore} - (₹1200 ext{Crore} - ₹200 ext{Crore}) = - ₹100 ext{Crore}   - Interpretation: The firm has a negative MVA of ₹100 Crore, indicating a loss in value for shareholders.

Shareholder Value Creation

  • Definition: Shareholder value creation is the process through which a company's management utilizes the equity capital contributed by shareholders to make and implement strategic and financing decisions.   - Goal: The goal is to increase the wealth of shareholders in excess of their contributions.   - Drivers of Shareholder Value Creation: This process is driven by the long-term free cash flows to equity holders.

  • Value Creation Dynamics: Total value created during a year includes not only operational revenue of that year but also expectations formed during that year about future operations, indicating that shareholder value creation is influenced by both present conditions and future potential performance.