Economic Value Added – an introduction November 18 th, 2009 Jakub Skavroň

 Adjusted operating profit less the capital charge (weighted average cost of capital multiplied by capital invested) Economic Value Added (EVA ® )  A company with a positive EVA is earning more than its cost of capital, and is thus creating wealth EVA ® is the emerging tool with which to measure shareholder value – EVA ® introduction–

Net Operating Profit After Tax (NOPAT) Capital Charge Economic Value Added (EVA ® ) EVA ® utilizes cash flows, the capital employed and the cost of capital to measure the creation of value – EVA ® introduction–

There are two main categories of value drivers Drivers for defining the economic results of management Drivers for determining the cost of activities used to reach economic results EVA ® – = RevenuesProfit margin Economic result CostsCost of debtCost of equity Capital charge AssetsWorking capital Invested capital x – EVA ® value driver categories –

EVA ® compares the return on invested capital with the cost of capital EVA  = ECONOMIC RESULT - COST OF INVESTED CAPITAL EVA  = NOPAT - (WACC * INVESTED CAPITAL) EVA  = ( NOPAT * INVESTED CAPITAL ) - (WACC * INVESTED CAPITAL) INVESTED CAPITAL EVA  = ( ROIC * IC) - (WACC * IC) EVA  = (ROIC - WACC) * IC.

+ - Invested Capital Limiting Value Creating Value Releasing Value Destroying Value (ROIC – WACC) NegativePositive Disinvesting Investing Value driven by ROIC and Invested Capital – Value matrix –

The calculation of EVA starts with calculation of NOPAT SALES Cost of Sales Depreciation Other Costs EBIT Taxes on EBIT 1 NOPAT – Calculation of EVA – 1 At tax rate of 33,3%

NOPAT is then compared with Cost of Invested Capital, and the result represents Economic Value Added Invested Capital Weighted Average Cost of Capital (WACC) 1 COST OF INVESTED CAPITAL % 150 – Calculation of EVA – NOPAT400 COST OF INVESTED CAPITAL-150 ECONOMIC VALUE ADDED An explanation of how to calculate WACC will follow later

The other approach described earlier is to compare ROIC with WACC – Calculation of EVA – ROIC40% WACC-15% ECONOMIC VALUE ADDED (%) 25% NOPAT Invested Capital RETURN ON INVESTED CAPITAL (ROIC) %

Pros  Recognizes the fact that business units have different risk profiles and should therefore be charged with different costs of capital  Shifts the focus from achieving growth to achieving profitable growth, thus enabling the firm to evaluate better where the firm should tie up its capital  Enables manager bonuses to be linked to the real performance of the business unit  Permits to evaluate company performance in every single period Cons  Fails to look forward, due to difficulties with calculations of terminal value  Does not recognize the potential future value of investment expenses such as R&D, investment in human resources  The lack of financial knowledge in many companies  Risks reduce management strategy to a mere formula  Copyright by Stern Stewart & Co. Use of EVA ® remains a controversial subject which presents its pros and cons

DCF is superior when projecting the future, unless the company has installed an EVA  based accounting system, and data is easily available  In all cases much easier to calculate  While discounted EVA (calculated correctly) is mathematically equivalent to discounted cash flow, it is difficult to make sure you have made all the adjustments correctly, and you are almost guaranteed to make a mistake EVA ® DCF EVA  is a great tool for measuring how well you have done and whether you have:  Exceeded the cost of capital (or not) By how much and during which years  It can highlight strategic insights and motivate action What caused the yearly fluctuations, what can we do about it  Remember that EVA was developed as a compensation tool Stern Stewart’s focus is on issues of corporate governance The general rule is to use Economic Value Added (EVA ® ) for the past and Discounted Cash Flow (DCF) for the future

Back up

WACC calculation requires inputs from several outside sources – Steps to Calculation of WACC – Risk Free Rate Market Risk Premium Stock Beta 6,0% 4,0% 1.1  Current Treasury Bond Rate (Source: Fed, CNB)  Represents the premium required to compensate for extra risk associated with investing in equities  Represents “non-diversifiable risk” or risk due to general market shifts (Source: Bloomberg, Value Line) Cost of Equity 10,4%  Cost of Equity = Risk Free Rate + Beta x Market Risk Premium Cost of Debt Tax Rate 5,0% 30,0%  Each rating level has associated debt cost (eg. BBB+ in 2006 is 5%)  Interest expense is tax deductible Effective Cost of Debt 3,5%  Effective cost of debt = Tax shield * Cost of Debt Weight of Equity Weight of Debt 40,0% 60,0%  Ratio of Equity on Total Capital  Ratio of Debt on Total Capital WACC 6,3%  Weighted Average Cost of Capital