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EVA ManualGeneral ConceptTable of ContentsGeneral ConceptI.Introduction11.EVA is a management tool that measures true economic profit12.EVA can be integrated in all key processes13.Decision-making based on EVA2II.Decision-making with EVA3A.How to build up EVA on operating unit level31.Overview32.NOPAT (Net operating profit after tax)33.Invested capital44.Cost of capital65.Focus on Delta EVA7B.How to build up EVA on the Group and SBU level8C.Use of EVA in the XY management system91.Management reporting92.Capital expenditures103.Portfolio analysis11Details of the EVA CalculationIII. Appendix.I. Introduction 1. EVA is a management tool that measures true economic profitAll managers of XY should focus on improving the Groups overall value. With EVA, for the first time, there is a tool that reflects not only the operating performance, but also the expected return on the invested capital of XY. The EVA system encourages managers to think and act like owners, treating the companys resources as if they were their own.EVA reflects not only operating profit after taxes, but also takes into account costs for debt and equity capital. Creating shareholder value may be achieved by improving performance, growth, portfolio management and optimisation of capital structure. EVA provides a tool for all of these aspects.EVA is a management tool. It helps managers to evaluate opportunities, set goals, measure results, and benchmark performance. EVA is also an accurate basis for value-oriented incentive compensation schemes.2. EVA can be integrated in all key processes Typically, companies use a variety of conflicting measures such as earnings growth, earnings per share, return on equity, market share, gross and net margin, cash flow, NPV and ROIC. Using a number of different measures leads to conflicting goals. This is why we will use EVA as a single major performance measure.The EVA financial management system supports and motivates value-based decision-making for day-to-day operating decisions, budgeting and capital planning and strategic initiatives. By using EVA for all of these processes, as well as for performance measurement and incentives, managers of XY will focus on the goal of creating value.3. Decision-making based on EVA Although there are countless individual activities people can pursue to create value, ultimately they all fall into one of four categories: EVA can be increased by enhancing operating efficiency (“performance”), investing in value-creating projects (“growth”) or divesting capital from uneconomic assets or activities (“asset management”). EVA can also be increased by the financing strategy of minimising the cost of capital by optimising the capital structure. - PerformanceImproving operating profits without tying up more capital in the business will directly increase EVA. - GrowthInvestments in new equipment and working capital may be required to increase sales, develop new products, services, markets and customers, all of which results in higher profits. As long as these investments generate a higher return than the cost of capital, shareholder value will increase. EVA is a perfect indicator of this value creation.- Asset ManagementRationalising, liquidating or curtailing investments in operations may be necessary if a business or asset cannot generate returns higher than the cost of capital. Thus, EVA encourages active asset portfolio management. Additionally, working capital management is a means of increasing EVA by optimising inventory levels and managing payables and receivables.- Capital StructureLenders and shareholders expect different rates of return according to the risk they are taking. Improving EVA by optimising the capital structure is an action that can primarily be taken on the Group and SBU level.II. Decision-making with EVA A. How to build up EVA on the operating unit level1. OverviewEVA is a transparent measure that is easy to calculate:2. NOPAT (Net operating profit after tax) a) IntroductionNOPAT is the adjusted operating income after standard taxes.If you want to know how to manage operating performance, use NOPAT. It includes standard taxes because they are an important cost factor. Some specific adjustments are incorporated to reflect economic reality better and to motivate correct decision-making.b) CalculationThe following positions will be adjusted: (For a detailed description of the adjustments and the accounts involved, see Appendix):- Goodwill amortisationGoodwill amortisation of the period is added back to operating income as from an economic point of view the value of the acquisition reflected in goodwill does not diminish, in contrast to standard accounting treatment. - Results from loans to and shareholdings in non-consolidated and equity companiesAs operating management is responsible for the performance of investments in and loans to non-consolidated companies, the results from these assets are included in the operating performance measure.- Separation of financing resultsTo exclude any financing costs from NOPAT, some financial charges that are included in operating income (e.g. interest related to pensions, which are part of personnel costs, or interest related to operating leases, which is implicit in the leasing rates) are added back to operating income. Foreign currency results are included in NOPAT (and not in financing costs) as they are regarded as being part of the operating activities. 3. Invested capitala) IntroductionCapital is not free since both lenders and equity investors expect a return on their investments. The concept of EVA is based on a simple rule:A business only creates value if in the long term it earns at least the cost of the invested capital. Invested capital includes all assets that can be attributed to a business minus provisions and liabilities for which no financing costs are charged (e.g. trade payables). b) CalculationIn addition to tangible and intangible assets, the following positions are included in invested capital (For a detailed description of the adjustments and the accounts involved, see Appendix):- Investments and loansInvestments in and financial loans to non-consolidated and equity companies (including cash) are part of the invested capital, as operating management is responsible for the performance of these activities.- Net working capitalNet Working Capital consists of inventory and operating receivables less operating liabilities. Efficient management of net working capital reduces invested capital, capital charges and therefore improves EVA.- ProvisionsProvisions are regarded as non-interest bearing and are therefore deducted from invested capital. Provisions for pensions and provisions for deferred taxes are treated differently and will not be deducted from invested capital.- Adjustments- Goodwill amortisationThe full historical goodwill from the time of the acquisition is included in invested capital. Therefore accumulated goodwill amortisation is added back to invested capital.- Rental and leasing contractsThe present value of future rental and operating lease contracts is included in invested capital in order to reflect the risk associated with future payment obligations.- Off balance sheet obligationsIn order to show the true risk associated with off balance sheet obligations, they are included in invested capital. In effect, the capital charges will be reduced by a corresponding item in NOPAT in order to derive an adequate risk premium for those items.- Construction in progressAssets under construction are not included in invested capital because they do not earn operating income. As a general rule, the calculation of capital within the XY Group will be based upon average capital during the year. As of , this average calculation will be based on the quarterly financial statement.4. Cost of capitalCapital is not free, since lenders and shareholders expect a return on their investment. Lenders require a return on debt in the form of interest payment. Shareholders expect a return as well. XY will eventually need new equity from the capital market. Only if shareholders anticipate that XY will be able to meet their expectations will they be willing to invest new capital on favourable terms. This expected return on equity can be measured and is part of the cost of capital.In the Weighted Average Cost of Capital (WACC) the cost of debt and the cost of equity are combined, with weights based on the debt/equity ratio.WACC = %debt * Net Cost of Debt + %equity * Cost of EquityUsing this approach country-specific WACCs are calculated. To illustrate the formula the WACC calculation for one country is shown. The cost of debt is 3,9% after-tax. The shareholders expect a return of 10,5%, a higher figure because the risk is higher than for a debt investment. The debt-to-market value (leverage) ratio is 52%: CostWeightWeighted CostDebt after tax3,9%52%2,0%Equity10,5%48%5,1%Weighted Average Cost of Capital7,1% (rounded 7%)You can find the specific WACC of different countries on the Intranet under Group functions/Reporting, Controlling, Investor Relations (RCI)/WACC.5. Focus on Delta EVA If you have calculated EVA for your business, you may have found out that it is not comparable to other units. This is due to the fact that invested capital is stated at book value, which often does not reflect fair value. Does that mean that EVA does not work? No. As absolute values are sometimes not comparable, we focus on Delta EVA, which reflects the change in EVA from one period to another. EVA is a management tool. It can help managers to evaluate opportunities, set goals, measure results, benchmark performance and deliver incentive compensation.Delta EVA is the measure because- management action should always be directed towards the future- when evaluating opportunities, an increase of EVA gives the right signal- when setting goals, Delta EVA gives appropriate incentives- when measuring results, Delta EVA shows a comparable figureThe following example compares the reporting of a unit that belongs to the Group for a long time to the reporting of a recently acquired unit. Both companies have a NOPAT of 120. Due to depreciation, the book value of assets of the company that has been part of the Group for a long time is much lower than the book value of assets of the recently acquired company. Both units invest in a new project that is equally profitable:Because of different levels of invested capital, the EVA of the existing company is much higher than the EVA of the new company. The example shows that Delta EVA correctly indicates the performance of the units because it reflects the profitability of the new project. B. How to build up EVA on the Group and SBU levelValue-oriented decisions are taken on all corporate levels. The EVA definition applied on the respective level reflects managers responsibilities:As compared to the EVA definition on the operating unit level, the following items are treated differently on the Group and SBU level: - Taxes- Goodwill from the acquisition of A and B- Currency Translation Adjustment (CTA)For details of the EVA calculation on the group and SBU level, see Appendix B.C. Use of EVA in the XY management systemFrom onwards all operating units will report EVA on a quarterly basis. In the following, examples for EVA reporting are shown. Please be aware that this is not the final design, but gives you an impression of the analytical features of the tool.1. Management reportingThe following example shows the EVA analysis for an operating unit:The following conclusions can be derived from this example:- Operating income increased by 300 or 30%. Detailed analysis is provided in the income statement and the variance analysis.- The increase in capital charges outweighed the positive development of NOPAT.- Analysis of the changes in invested capital shows that the increase in the capital charge is due to the following factors:- The book value of tangible assets increased, which means that the investments of the company were higher than the depreciation, and the company could not improve its operating income to the same extent.- Non-consolidated investments increased by 1.500 and did not earn the cost of capital- Net working capital increased. The payment time for accounts receivable increased, while the time in which the company paid its creditors decreased.- Additionally, Delta EVA was reduced by non-operating or exceptional losses which resulted in a Delta EVA non-operating of 30 (For details of the adjustment for unusual items, see Appendix chap. 4).2. Capital expenditures The EVA system also supports decisions on capital expenditures. Decisions on investments will be based on the following rule: An investment should only be made if the present value of future EVAs is positive. Essentially, the EVA investment model provides the same result as a Free Cash Flow analysis. The present value of EVA equals the net present value of cash flows. EVA has the advantage that it has a memory for the invested capital and can be used for performance measurement purposes as well as for investment decisions. In contrast to the Free Cash Flow method, the EVA system allows an integrated approach whereby the capital expenditure analysis shows annual contributions that will be managed via the EVA management system. The following example shows an EVA based investment analysis:In the example, an investment of 1.500 is made at the end of year 0 (corresponding to the beginning of year 1). Starting from year 1, the investment creates operating profit. The book value of the investment is depreciated over five years with the book value at the beginning of each period being the basis for calculating the capital charge. The fact that the present value of EVA is positive indicates that the project is creating value.3. Portfolio analysisThe company actively manages its portfolio and will need to take strategic decisions. These decisions include both investment and divestment alternatives. As discussed above, it is often not possible to compare absolute EVAs because the capital charge is based on book value and not on fair value. For active portfolio management it is necessary to analyse the changes in EVA due to different future scenarios. The strategy with the highest increase in Delta EVA will be chosen.In the following example, three strategic alternatives are being discussed:- Sell part of the business (alternative 1)- Increase investment in the business (alternative 2)- Divest the whole business (alternative 3)As the current EVA is negative, the unit does not earn the cost of capital. However, decisions should always refer to the future. The current EVA has a signalling function, but is not sufficient as a basis for making strategic decisions. In the example, projections of Delta EVA show that alternative 2 (increase investment in the business) is the strategy that creates the highest value. This is because the investment leads to profitable growth. EVA ManualAppendixTable of ContentsIII.Appendix: Details of EVA calculation1A.Improve management decisions by adjusting operating income and invested capital11.Selection of adjustments12.Goodwill13.Construction in progress34.Unusual items45.Off balance sheet liabilities76.Operating lease97.Pensions128.Minority interests14B.EVA on SBU and Group level161.Tax management162.Goodwill for Company A and Company B acquisition163.Currency Translation Adjustment (CTA)16C.EVA Calculation Schemes181.Calculation of invested capital on the operating unit level182.Calculation of NOPAT on the operating unit level183.Calculation of invested capital on the group/SBU level224.Calculation of NOPAT on the group/SBU level22III. Appendix: Details of EVA calculationA. Improve management decisions by adjusting operating income and invested capital1. Selection of adjustmentsWhen customising the EVA calculation for XY, the objective was to find the right balance between economic accuracy and functional simplicity and to define a meaningful measure of value creation that is understandable to all users. The process of defining these adjustments focused on:MaterialityAdjustments should make a material difference in EVAMotivational ImpactAdjustments should have the potential to influence decisions and behaviourPracticalityAdjustments should be made subject to data being availableUnderstandabilityAdjustments should not be unnecessarily complex2. GoodwillDescription of the Adjustment:Goodwill amortisation is not included in NOPAT.The full historic goodwill before amortisation is shown in invested capital.Behaviour Expected/Reason for the Adjustment: Goodwill resulting from an acquisition is an investment that does not definitively increase or decrease in value over time. Therefore, we should consider it a permanent investment rather than an eroding investment that needs to be amortised. If we did not make an adjustment and used the accounting amortisation, the full charge for goodwill would be the sum of the amortisation and the capital charge on the net book value. The charge would be at its highest immediately after the acquisition and would decline until the asset is fully amortised; the total charge would therefore decline to zero. This is not consistent with the pattern of profits we generally see after acquisitions. Typically, acquisitions are performed at a premium and the immediate impact is that the profits are inadequate to cover the capital charge. Over time, synergies are realised and the profits improve, hopefully, to more than justify the capital spent on the acquisition. Thus, if we would base the EVA calculation on accounting amortisation we would put the highest charge when the lowest NOPAT is expected. Going forward, the NOPAT improves while the capital charge declines. This provides a poor matching of costs and benefits.By not amortising goodwill, we get a better alignment of costs and benefits. The adjustment also avoids a major increase in EVA when the amortisation period is finished, an effect that cannot be attributed to the value creation in that specific period. By using historical goodwill, EVA will turn positive as soon as the NOPAT covers the capital charge on the tangible assets and the goodwill before amortisation. This helps to encourage good acquisitions while still discouraging bad ones. Goodwill at XY is pushed down to operating units, except for the goodwill from the acquisition of Company A and Company B, which is only pushed-down to SBU level. By including goodwill in the calculation of capital below group level, the responsibility for the profitability of acquisitions is decentralised. Push-down accounting brings in line the absolute amount of EVA on group level and on sub-unit level. Otherwise a negative EVA on the group level might correspond to positive EVAs on the SBU level. Mechanics of the Adjustment:Do not charge goodwill amortisation to NOPAT and include goodwill in invested capital at acquisition cost in order to treat it as a permanent investment.Example:Capital Calculation:Invested capital600+Accumulated goodwill amortisation60
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