Economic value added (EVA) – The concept

Economic value added (EVA) is a measure of a company's financial performance base on the residual wealth calculate by deducting its cost of capital from its operating profit, adjust for taxes on a cash basis. Financial Management Courses.

The EVA concept is a concept of performance appraisal of financial companies. That develop by Stem Stewart & co., a management consulting firm finance in the United States. The concept of EVA makes a company more focus attention to the company's value. Creation efforts and assess the financial performance of the company fairly measure using a weight of the structure of the initial capital.

EVA calculation Basics

With the counting of the EVA is expect to obtain the results of the calculations on the efforts of the company's value creation. Creating a Firms value is more realistic. Value can be take to mean. The value, effectiveness as well as the benefits enjoy by Stakeholders".

This is because EVA is calculate base on the interests of creditors and shareholders. Especially not base on the historical nature of the book value. Because a rational investor would base his decision on financial data are the most up to date, rather than on the nature of the historical data.

Introduction

The concept of EVA is a new approach in assessing the company's performance fairly. That the meaning of the concept of EVA fully mindful. Its funder in interests, expectations and degree of fairness. As measure by applying size (weight) and the structure of the initial capital.

While the notion of Economic Value Add according to are:

EVA is base on the concept that in the measurement of profit a company. We must fairly consider the expectations of every financial. The degree of Justice express by weight size (weight) of the existing capital structure.

For that reason, it needs to be an understanding of the concept of capital expenses (cost of capital). Because indeed depart from here.  Thus it can be said that EVA is a financial analysis tools. To assess the profitability of the company's operations are realistic and EVA use the cost of capital in the calculation.

Cost of Capital

Besides EVA also consider fairly the expectations of funders. Through the calculation of a weight cost of capital of a company's capital structure. The EVA concept is a new concept which leaves from the old concept IE capital costs (cost of capital).

This concept is a concept that is use to find out how much. It costs that must be incur by the company as a result of the use of funds for the purchase of goods and capital or working capital.

The concept

Understanding capital costs itself is: "the Cost of Capital is the require rate of return on the various types of financing".

This definition identifies that the cost of capital is the rate of return to be achieve by the company. In order to close the financial burden for the use of long-term source of funding.

The concept of cost of capital (COC) is a very important concept in the company's operations. Because of concerns the three (3) things. First, with regard to the decision of the budgeting capital that require cost estimates for capital budgeting. Secondly, with regard to the company's financial structure that affect the level of risk and magnitude of the revenue streams.

Determination of cost of capital

So that also affect the determination of cost of capital, and the third, with regard to other decisions that require cost estimates capital.

View from the angle of corporate spending, the cost of capital is intend. To be able to determine the magnitude of the real cost to be borne by the company to earn a profit.

Such opinion that the concept of cost of capital were mean to be able to determine. The magnitude of the real cost of using capital from each source of funds.

Capital Assessment

This cost of capital Assessment should be conduct quickly and thoroughly, because the company's valuation is very sensitive to the use of capital costs. Calculation of cost of capital is calculate from the way of financing use in the outposts. There were decisions and the right balance of such debt, prefer stock and a sham.

The magnitude of the capital costs to determine the magnitude of the real cost to be borne by the company in order to obtain funds from a source. If this is associate with the calculation of the average cost of capital is calculate from the weight cost of capital components is multiply with the composition of each component.

Purchasing power of a kind of investment will also affect the cost of capital. Purchasing power is influence by their macro economy is going on if economic circumstances the public good. Then the purchasing power is going up, so the rate of return will go down, and will be pressing charges.

The factors that determine the cost of capital is:

The general circumstances of the economy of these factors determine. The demand and supply of capital in the economy as well as the rate of inflation, variables of the economy reflect on the results of the risk-free rate. This rate illustrates the level of results of a risk-free investment such as the short-term securities interest.

The circumstances of the market

If investors increase the level of the results of the minimum. This will cause the cost of capital is rising catastrophically. If no securities market when investors want to sell it or even if it is a continuous demand for the letter is there. But the price is change significantly, investors will require a level results are relatively higher.

On the other hand, built an easily marketable securities and the price is relatively stable investors will require a lower level of results and the company's cost of capital would be low.

The decision of the company's operations and financing

Risk or rate of change of the results is also cause by decisions taken within the company. The risk cause by this decision is generally divide into two types, namely. First, the financial risk is the increase variability of results to public shareholders. The level of the minimum yield investors (and also capital costs) will be moving in the same direction.

Second, the business risk is the level of variation results from the assets-assets. It is cause by the company's investment decisions.

The magnitude of the financing.

When the purposes of financing a company enlarges, weighs the cost of capital will be increase by a variety of reasons. As for example, when a growing number of securities issue. The cost of the establishment (flotation cost) of the company will affect a percentage of the cost of capital for companies.

Cost of capital is a concept that can determine the magnitude of the costs that are to be cover by real companies. As a result of the use of the Fund. The components of the cost of capital can be distinguish at the expense of capital borrowings demonstrating. How great the costs to be borne by the company. There are different types of debt, but that became a point of discussion here is the cost of debt capital over bonds.

This is because this type of debt is another magnitude is determine by the lender. The opinion of concerning the cost of debt capital are:

"The cost of debt component is use for the calculation of the cost of the module is the weight average interest rates of debt (Kd) multiplied by (l-t). Where it is the tax rate the company in question ".

Capital Cost

The capital cost of prefer stock is a combination of common stock and debt (bonds). This burdensome obligation prefer stock company to make payments to the holder on a periodic basis. Cost of prefer stock component use to calculate the weight cost of capital. It can be calculate from the prefer dividend (Dp) and net prices (Pn). Capital costs the enormity of the common stock dividend on common stock is not determine by the time investors steer funds. But are not necessarily the (uncertain) depending on the performance of the company in the future.

This contrasts with debt capital, because there is already an agree interest rate certainty. To estimate the cost of ordinary share capital need to approach base on the rate of return expect by shareholders (owners Expectation).

Expectations

That is then to determine the cost of capital common stock should be base on the prevailing market value rather than the book value. The first three models in determining the cost of capital stock of the company Dr. over base on data in the capital markets. For calculating the cost of capital shares the author using CAPM approach. Cost of capital earnings withheld is part corporate earnings. That are not distribute as dividends, but withheld by the company and re-invest to strengthen corporate.

Level of recovery

Although these funds are retrieve with ease, but that does not mean there are no funds should be issue. Reason need to he calculates capital costs for profit was detain is because the principle of Opportunity cost. In that it is proportional to the level of recovery that will accrue. To shareholders if part of this profit distribute as dividends.

Capital costs the weight average EVA is a concept base on the principle. That in the measurement of profit the company we should fairly consider. The expectations of each of the funders (creditors and shareholders). The degree of the justice weight by the size of the stat capital structure that exists within the company.

After all the costs of different types of capital specify individually. Which is the consideration require to take some decisions need to be taken into account. Further funding of the cost of capital of the company as a whole.

Determination of EVA

Measures to determine the EVA are:

1. To calculate the cost of debt.


2. Calculate the cost of common stock.


3. The calculate the capital structure of the balance sheet of.


4. To Calculate NOPAT


5. Calculate the rate of return (r)


6. A calculate the cost of capital weight average


7. Calculating EVA

Steps that need to be done to get the size of EVA according are as follows:

Calculate or estimate the cost of debt module (cost of debt)

Cost of debt (cost of debt) is the rate to be paid by the company in the market right now to get a new long-term debt. Meant here is the debt bonds. The calculations can be complete by calculating the cost of debt before tax. Where the magnitude of the cost of capital is equal to the level of coupon, i.e. The interest rate payable for each sheet of the bond. Another calculation is by calculating the cost of debt after tax. By multiplying the interest rate debt (1-t), where is the tax rate of the company in question.

Estimate cost of capital stock (cost of equity)

Calculation of capital costs (cost of equity) can be done using several approaches, including CAPM which saw the cost of equity as the sum of the interest rate without risk and difference in the level of the expect return of the market portfolio with no risk level interest multiply by the systematic risk of the company (the company's beta value). The dividend approach sees the cost of equity as dividends per share price plus a percentage of the dividend growth or price approach to learning that saw the cost of equity as the value of the action per share divide by the share price now.

Calculate the capital structure (from the balance sheet)

Capital or capital is the amount of funds available for the company to finance his company which is the sum of total debt and capital stock. Calculate capital costs weight average (weight average cost of capital-WACC)

WACC is the weight average cost of debt and own capital, describe the level of minimum investment to get refund rate of return expect by investors. Thus the calculation will include the calculation of each of its components, namely, the cost of debt (cost of debt), the cost of capital stock (cost of equity), as well as their respective proportions in the capital structure of the company.

Calculate the EVA

Was done by reducing the operating profit after tax cost of capital which has been issue by the company. To see if the company has occur or not, EVA can be determine with the criteria express by as follows:

1. EVA > 0, then it has value add economic within the company, so that the larger the EVA generate then the expectation of its funders can be fulfill properly, IE the get return on investment that is equal to or more than the invest and creditors get interest. This state indicates that the company manage to create value (create value) for owners of capital so as to indicate that his performance has been good.


2. EVA < 0, then show the value-added process doesn't happen economically for the company, because the available profits cannot meet the expectations of the funders especially shareholders that is not getting a refund Accordingly with the investment that is embed and the lender still get. So with no value add indicates the financial performance of the company.


3. EVA = 0, then shows a break-even position since all profits have been use to pay obligations to funders both creditors and shareholders.

Measure of EVA

As a matter of fact, this is simply a measure of EVA that can support a forward-looking assessment and capital budgeting procedures with a means by which performance can be evaluate.

For more practice, EVA as a measuring tool can be use to evaluate performance, goal setting, the setting of bonus-bonuses and for capital budgeting. EVA is an approach that can be use to measure the profit/loss financial potential shareholders accept the result in acquisition, management strategies investment and restructuring.

EVA attracts because of three factors, namely:

• In comparing cash flow method that discount would give an expect value at a time of an investment in the future, EVA provides an annual measurement of the actual value creation performance (not a self-fulfilling prophecy).


• EVA Result (positive/negative) tracing closer to well being holders of shares compare to traditional measures of the other.


• EVA rectifying strategies desire organizational performance measurement with the relationship and compensation procedures.

Therefore, each company certainly wants the EVA rose, because EVA is a fundamental benchmark of capital rate of return (return of capital).

There are three ways to raise is as follows:

1. The level of profit (profit) without using any additional capital Cost cutting is a very popular method nowadays. This activity will lead to activities that blindly and not effective in raising.


2. Reduce the use of capital in practice, it is often the most effective method. Coke using plastic packaging for concentration instead of using the metal packaging.


3. Do the investment in projects with a high rate of return? Make sure that the projects could get more just the overall capital cost require.

A variety of exposure above is clearly visible, that EVA is mainly use as a marker of the performance of the company where the focus is on performance assessment creation value (value creation) which is one of the advantages of EVA.

Reveals another advantage of EVA are:

EVA focus assessment on the add value taking into account the capital costs as a consequence of the investment. Eva calculation can be use independently without the need for data comparison such as the industry standard or data of other companies as the concept of assessment by using the analysis of the ratio. The concept of EVA is a measuring device company employees are view in terms of the economical measurement

Having regard to the expectation of its funders in a fair manner, where the degree of Justice express by weight size of structure existing capital and guidelines on market value and not at book value. The EVA concept assessment can be use as bonuses on employees especially in the Division provide more EVA, at a company that has a structure consisting of several divisions of a profit center, so it can be said that EVA is an appropriate benchmark to run Stakeholders Satisfaction Concepts i.e. pay attention to employees, customers, and investors.

EVA deployment that is easy to show that the concept is the measurement of a practical, easily calculate and is easy to use, so that is one consideration in accelerating business decision making.

EVA-oriented operational

Although the concept of EVA-oriented operational performance but very influential to be consider in the determination of strategic development of the company's portfolio.

For example, if a business unit has always had a negative EVA, chances are it’s time the parent company decide to get out of certain businesses. So it can be said that EVA is a method of assessment that accurately and comprehensively is able to provide a reasonable assessment upon condition of a company.

See the various advantages of EVA, it also has the weaknesses disclose as follows:

1. EVA only measures the end result (result), this concept does not measure the decisive activities such as consumer loyalty and retention rate.


2. EVA too rests on the belief that investors rely heavily on the fundamental approach in reviewing and taking decisions to sell or buy a certain stock, whereas other factors sometimes just more dominant. This concept is very dependent on internal transparency in the calculation of EVA accurately.  Although there are a few weaknesses, EVA keep it handy for reference, considering MOUSES give consideration to the expectations of investors against investing them. The returns of an investment, a new will mean when such returns exceed the magnitude of capital costs incur to realize such investments.

Some of the benefits that can be gain from EVA are:

• Performance assessment using the EVA approach led to the attention of management in accordance with the decision of the holders of stocks.


• With EVA managers will think and act just like any shareholders i.e. selecting investments that maximize the rate of return and minimize the rate of cost of capital so that the company's value can be maximize.


• An EVA make managers focusing attention on activities that create value and evaluate performance base criteria maximize the value of the company.


• The EVA can be use for identify it activities or practices that provide a higher return than the cost of capital.


• EVA will cause the company to pay more attention to capital structure policy. EVA is also challenging Method in order for the manager to act from the point of view of the owner of the company because it is base on a research on EVA.

Conclusion

Thus the concept of EVA is able to encourage managers to maximize the EVA. If you want to increase the value of the company. Besides measuring company performance as EVA also directly show. How big companies have been creating value for owners of capital. It is also related to the increasing awareness of the managers. That the task is to maximize the value of the company as well as increasing shareholder value rather than to achieve other goals.