Description
A report explaining the concept of Economic Value Add (EVA) with respect to Cement Industry.
• Value added in Industry is sum total of its constituent firm’s value addition • As per Adam Smith, an “invisible hand” will work to add value to the interest of the public by adding value to self. • The primary objective of any business is to create wealth for its owners. • The quest for value directs scarce resources to their most promising uses and most productive users. • Economic Value Added (EVA) measures the firm’s ability to earn more than the true cost of capital. It is a measure of the profit that remains after earning a required rate of return on capital. If a firm’s earnings exceed the true cost of capital it is creating wealth for its shareholders. • EVA is defined as net operating profit after taxes and after the cost of capital. The cost of capital is the rate of return required by the shareholders and lenders to finance the operations of the business. When revenue exceeds the cost of doing business and the cost of capital, the firm creates wealth for the shareholders. • EVA = Net Operating Profit – Taxes – Cost of Capital • Here, the costs include full opportunity cost of the factors of production. Net Operating Profit after Taxes (NOPAT) It considers cost of ‘Land’ and ‘Labor’. Cost of Capital The opportunity cost of capital invested in a business is not included when calculating accounting profits. So, this takes care of the cost of ‘Capital’ and ‘Entrepreneur’. Weighted Average Cost of Capital Weighted average cost of capital examines the various components of the capital structure and applies the weighting factor of after-tax cost to determine the cost of capital. Long Term Financing Costs Considering Long term rate from bank is two points above PLR (here 11%), so effective lending rate is at 13%. With a 30% tax rate it comes to a 9.1% cost. So, the cost of long term debt is 9.1% and multiplying the long term debt of xxxxxx by 9.1% will give a weighted average cost of LTD of yyyyy. Common Equity Costs It has three components – common stock, paid in surplus and retained earnings. From the shareholder’s viewpoint, all three are costs. If retained earnings are used in the business, the stockholders cannot use them elsewhere to earn money and therefore they carry an opportunity cost. Stockholders expect two benefits from common stock, dividends present and future and capital appreciation from growth. The valuation of common equity must take into consideration both the present and future earnings of the stock.
To calculate the weighted cost of common equity we consider the present market price of the stock less issuing costs. For example we issue common stock for 10 a share less 1.0 issuing cost or proceeds of 9.00 per share. This is divided into the future earnings per share estimate by investors or reliable analysts. If we use 2.00 per share, then the weighted cost will look like this: 2.00/9.00 = 22.22%. Using the 22.22% and the total common equity of $700,000 our cost of common equity is $98,700.
Total Weighted Average Cost of Capital
A summary of the three components gives us the weighted average cost of capital. XYZ Company Long Term Debt $500,000 * 7.48% = $37,400
Preferred Stockholders’ Equity $200,000 * 11.2% = $22,400 Common Equity $700,000 * 14.1% Total cost of Capital = $158,500 = $98,700
Calculating EVA
After tax operating earnings less the cost of capital is equal to EVA. From the above example we can calculate XYZ Company’s EVA and determine if this business is creating wealth for its owners. XYZ Company NOPAT $202,000 cost of Capital = $158,500 ECONOMIC VALUE ADDED $32,500
Ambuja Cements Ltd.
Jun 2004 12 mths Jun 2005 12 mths 1127.45 270.44
30% Div
Dec 2006 18 mths 865.38 303.43 Mar 2004 12 mths 1442.72 178.24
A C C Ltd.
Mar 2005 12 mths 1509.07 179.58 Dec 2005 9 mths 1071.42 185.56
30% Div
Dec 2006 12 mths 771.16 188.33
LTD
Equity Capital
1269.68 179.45
Cost of LTD Cost of Equity Cost of Capital NOPAT Interest paid Earnings Value Added
115.54 59.81 175.35
336.79 111.49
102.60 90.14 192.74
468.29 89.63
78.75 151.70 230.45
1503.25 111.63
131.29 59.41 190.69
200.24 112.17
137.33 59.85 197.18
378.39 96.32
97.50 46.39 143.88
544.18 66.19
70.18 62.77 132.95
1231.84 75.19
448.28 272.93
557.92 365.18
1614.88 1384.43 10% Div
Mar 2006 12 mths 1451.83 124.4
312.41 121.72
474.71 277.53
610.37 466.49
1307.03 1174.08
Ultratech Cement Ltd.
Mar 2004 12 mths Mar 2005 12 mths 1531.38 124.4
LTD
Equity Capital
1635.64 124.4
Total Value Added
Cost of LTD Cost of Equity Cost of Capital NOPAT Interest paid Earnings Value Added
148.84 13.82 162.66
38.83 135.35
139.36 13.82 153.18
2.85 112.47
132.12 13.82 145.94
229.76 95.16
4215.00
174.18 11.52
115.32 -37.86
324.92 178.98
doc_726127434.doc
A report explaining the concept of Economic Value Add (EVA) with respect to Cement Industry.
• Value added in Industry is sum total of its constituent firm’s value addition • As per Adam Smith, an “invisible hand” will work to add value to the interest of the public by adding value to self. • The primary objective of any business is to create wealth for its owners. • The quest for value directs scarce resources to their most promising uses and most productive users. • Economic Value Added (EVA) measures the firm’s ability to earn more than the true cost of capital. It is a measure of the profit that remains after earning a required rate of return on capital. If a firm’s earnings exceed the true cost of capital it is creating wealth for its shareholders. • EVA is defined as net operating profit after taxes and after the cost of capital. The cost of capital is the rate of return required by the shareholders and lenders to finance the operations of the business. When revenue exceeds the cost of doing business and the cost of capital, the firm creates wealth for the shareholders. • EVA = Net Operating Profit – Taxes – Cost of Capital • Here, the costs include full opportunity cost of the factors of production. Net Operating Profit after Taxes (NOPAT) It considers cost of ‘Land’ and ‘Labor’. Cost of Capital The opportunity cost of capital invested in a business is not included when calculating accounting profits. So, this takes care of the cost of ‘Capital’ and ‘Entrepreneur’. Weighted Average Cost of Capital Weighted average cost of capital examines the various components of the capital structure and applies the weighting factor of after-tax cost to determine the cost of capital. Long Term Financing Costs Considering Long term rate from bank is two points above PLR (here 11%), so effective lending rate is at 13%. With a 30% tax rate it comes to a 9.1% cost. So, the cost of long term debt is 9.1% and multiplying the long term debt of xxxxxx by 9.1% will give a weighted average cost of LTD of yyyyy. Common Equity Costs It has three components – common stock, paid in surplus and retained earnings. From the shareholder’s viewpoint, all three are costs. If retained earnings are used in the business, the stockholders cannot use them elsewhere to earn money and therefore they carry an opportunity cost. Stockholders expect two benefits from common stock, dividends present and future and capital appreciation from growth. The valuation of common equity must take into consideration both the present and future earnings of the stock.
To calculate the weighted cost of common equity we consider the present market price of the stock less issuing costs. For example we issue common stock for 10 a share less 1.0 issuing cost or proceeds of 9.00 per share. This is divided into the future earnings per share estimate by investors or reliable analysts. If we use 2.00 per share, then the weighted cost will look like this: 2.00/9.00 = 22.22%. Using the 22.22% and the total common equity of $700,000 our cost of common equity is $98,700.
Total Weighted Average Cost of Capital
A summary of the three components gives us the weighted average cost of capital. XYZ Company Long Term Debt $500,000 * 7.48% = $37,400
Preferred Stockholders’ Equity $200,000 * 11.2% = $22,400 Common Equity $700,000 * 14.1% Total cost of Capital = $158,500 = $98,700
Calculating EVA
After tax operating earnings less the cost of capital is equal to EVA. From the above example we can calculate XYZ Company’s EVA and determine if this business is creating wealth for its owners. XYZ Company NOPAT $202,000 cost of Capital = $158,500 ECONOMIC VALUE ADDED $32,500
Ambuja Cements Ltd.
Jun 2004 12 mths Jun 2005 12 mths 1127.45 270.44
30% Div
Dec 2006 18 mths 865.38 303.43 Mar 2004 12 mths 1442.72 178.24
A C C Ltd.
Mar 2005 12 mths 1509.07 179.58 Dec 2005 9 mths 1071.42 185.56
30% Div
Dec 2006 12 mths 771.16 188.33
LTD
Equity Capital
1269.68 179.45
Cost of LTD Cost of Equity Cost of Capital NOPAT Interest paid Earnings Value Added
115.54 59.81 175.35
336.79 111.49
102.60 90.14 192.74
468.29 89.63
78.75 151.70 230.45
1503.25 111.63
131.29 59.41 190.69
200.24 112.17
137.33 59.85 197.18
378.39 96.32
97.50 46.39 143.88
544.18 66.19
70.18 62.77 132.95
1231.84 75.19
448.28 272.93
557.92 365.18
1614.88 1384.43 10% Div
Mar 2006 12 mths 1451.83 124.4
312.41 121.72
474.71 277.53
610.37 466.49
1307.03 1174.08
Ultratech Cement Ltd.
Mar 2004 12 mths Mar 2005 12 mths 1531.38 124.4
LTD
Equity Capital
1635.64 124.4
Total Value Added
Cost of LTD Cost of Equity Cost of Capital NOPAT Interest paid Earnings Value Added
148.84 13.82 162.66
38.83 135.35
139.36 13.82 153.18
2.85 112.47
132.12 13.82 145.94
229.76 95.16
4215.00
174.18 11.52
115.32 -37.86
324.92 178.98
doc_726127434.doc