EVA Manual
General Concept
Table of Contents
General Concept
I Introduction 1
1 EVA is a management tool that measures true economic profit 1
2 EVA can be integrated in all key processes 1
3 Decisionmaking based on EVA 2
II Decisionmaking with EVA 3
A How to build up EVA on operating unit level 3
1 Overview 3
2 NOPAT (Net operating profit after tax) 3
3 Invested capital 4
4 Cost of capital 6
5 Focus on Delta EVA 7
B How to build up EVA on the Group and SBU level 8
C Use of EVA in the XY management system 9
1 Management reporting 9
2 Capital expenditures 10
3 Portfolio analysis 11
Details of the EVA Calculation
III Appendix……………………………………………………………………………………………………………
I Introduction
1 EVA is a management tool that measures true economic profit
All managers of XY should focus on improving the Group’s 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 company’s 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 valueoriented 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 valuebased decisionmaking for daytoday 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 Decisionmaking 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 valuecreating 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
Performance
Improving operating profits without tying up more capital in the business will directly increase EVA
Growth
Investments 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 Management
Rationalising 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 Structure
Lenders 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 Decisionmaking with EVA
A How to build up EVA on the operating unit level
1 Overview
EVA is a transparent measure that is easy to calculate
2 NOPAT (Net operating profit after tax)
a) Introduction
NOPAT 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 decisionmaking
b) Calculation
The following positions will be adjusted
(For a detailed description of the adjustments and the accounts involved see Appendix)
Goodwill amortisation
Goodwill 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 nonconsolidated and equity companies
As operating management is responsible for the performance of investments in and loans to nonconsolidated companies the results from these assets are included in the operating performance measure
Separation of financing results
To exclude any financing costs from NOPAT some financial charges that are included in operating income (eg 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 capital
a) Introduction
Capital 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 (eg trade payables)
b) Calculation
In 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 loans
Investments in and financial loans to nonconsolidated and equity companies (including cash) are part of the invested capital as operating management is responsible for the performance of these activities
Net working capital
Net 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
Provisions
Provisions are regarded as noninterest 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 amortisation
The 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 contracts
The 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 obligations
In 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 progress
Assets 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 2002 this average calculation will be based on the quarterly financial statement
4 Cost of capital
Capital 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 debtequity ratio
WACC debt * Net Cost of Debt + equity * Cost of Equity
Using this approach countryspecific WACC’s are calculated To illustrate the formula the WACC calculation for one country is shown The cost of debt is 39 aftertax The shareholders expect a return of 105 a higher figure because the risk is higher than for a debt investment The debttomarket value (leverage) ratio is 52
Cost Weight Weighted Cost
Debt after tax 39 52 20
Equity 105 48 51
Weighted Average Cost of Capital 71 (rounded 7)
You can find the specific WACC of different countries on the Intranet under Group functionsReporting 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 figure
The 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 level
Valueoriented 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 system
From 2002 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 reporting
The 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
Nonconsolidated investments increased by 1500 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 nonoperating or exceptional losses which resulted in a Delta EVA nonoperating 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 EVA’s 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 1500 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 analysis
The 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 EVA’s 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 Manual
Appendix
Table of Contents
III Appendix Details of EVA calculation 1
A Improve management decisions by adjusting operating income and invested capital 1
1 Selection of adjustments 1
2 Goodwill 1
3 Construction in progress 3
4 Unusual items 4
5 Off balance sheet liabilities 7
6 Operating lease 9
7 Pensions 12
8 Minority interests 14
B EVA on SBU and Group level 16
1 Tax management 16
2 Goodwill for Company A and Company B acquisition 16
3 Currency Translation Adjustment (CTA) 16
C EVA Calculation Schemes 18
1 Calculation of invested capital on the operating unit level 18
2 Calculation of NOPAT on the operating unit level 18
3 Calculation of invested capital on the groupSBU level 22
4 Calculation of NOPAT on the groupSBU level 22
III Appendix Details of EVA calculation
A Improve management decisions by adjusting operating income and invested capital
1 Selection of adjustments
When 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
Materiality
Adjustments should make a material difference in EVA
Motivational Impact
Adjustments should have the potential to influence decisions and behaviour
Practicality
Adjustments should be made subject to data being available
Understandability
Adjustments should not be unnecessarily complex
2 Goodwill
Description of the Adjustment
Goodwill amortisation is not included in NOPAT
The full historic goodwill before amortisation is shown in invested capital
Behaviour ExpectedReason 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 pusheddown to SBU level By including goodwill in the calculation of capital below group level the responsibility for the profitability of acquisitions is decentralised Pushdown accounting brings in line the absolute amount of EVA on group level and on subunit level Otherwise a negative EVA on the group level might correspond to positive EVA’s 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 capital 600
+ Accumulated goodwill amortisation 60
Invested capital (adjusted) 660
NOPAT Calculation
Operating Income 100
+ Goodwill amortisation 15
Operating Income (adjusted) 115
Operating Taxes (38) 44
NOPAT 71
If goodwill is amortised due to an impairment test the respective amount of goodwill will be excluded from invested capital and treated as an unusual item (see chap 4)
3 Construction in progress
Description of the Adjustment
Construction in progress (CIP) is not included in invested capital
Behaviour ExpectedReason for the Adjustment
In order not to discourage valuecreating new investments capital charges are not imposed on CIP until it starts operations and is taken out of the CIP account Managers will be accountable for generating a return once the assets are placed in service
To maintain the consistency between the present value of cash flows and EVA we need to recognise the time value of this money during construction Technically this means that the capital charges for the construction period should be accumulated and capitalised as part of the investment when the asset is in use However this is complex to do For major projects regular financial accounting practices accomplish almost the same result as XY capitalises borrowing costs (pretax cost of interest) in CIP Therefore in order to keep the calculation simple no additional capital charges are capitalised for EVA For all other construction in progress items capital charges for the periods during construction are neglected because of materiality reasons
Mechanics of Adjustment Reduce invested capital by the construction in progress balance
Example
Capital Calculation
Invested capital 600
Construction in progress 30
Invested capital (adjusted) 570
4 Unusual items
Description of the Adjustment
Unusual items are excluded from NOPAT
The Capital charge on unusual items is shown in Delta EVA nonoperating
Behaviour ExpectedReason for Adjustment
Unusual items represent gains and losses that arise from events or activities that are not considered part of XY’s ongoing and recurring business We cannot assess ongoing sustainable profitability if these unusual items are mixed with the operating profit figures Therefore we need to consider unusual items in a way that does not distort ongoing period results and at the same time motivates valuecreating behaviour
Example
An asset generates a profit after tax of 100 The asset which is recorded in the balance sheet at 3000 is now sold for 2000 Selling an asset for a book value loss of 1000 (before taxes) would show the asset reduced to zero on the balance sheet and a loss taken in the profit of the period
EVA Calculation before adjustment
Year 1 Year 2
Operating profit after taxes 100 0
+ Loss on asset sale (after taxes of 38) 620
NOPAT 100 620
Invested capital 3000 0
Capital charge (7) 210 0
EVA 110 620
Delta EVA 510
Without doing any adjustment the sale of the asset results in a decrease in profits of 720 and a decrease in EVA of 510 Thus the normal accounting treatment discourages the manager from selling Nevertheless the asset provides an operating income of only 100 per year which is not enough to earn the cost of capital (negative EVA of 110) Provided that the asset does increase its profitability in the future it is beneficial to sell the asset
The EVA adjustment removes the unusual loss from NOPAT Unusual items are not part of operating activity as NOPAT is an operating measure But does this mean that we should totally ignore these items Of course not The adjustment aims at establishing responsibility for unusual items and at the same time motivating valuecreating behaviour We therefore include capital charges on unusual items in Delta EVA (Capital charges of 7 on the loss after taxes of 620 results in a charge on Delta EVA of –43)
Economic View (after adjustment)
Year 1 Year 2 Year 3
NOPAT 100 0 0
Capital 3000 0 0
Capital charges (7) 210 0 0
EVA 110 0 0
Delta EVA operating +110 0
Delta EVA nonoperating (7 x 620) 43 0
Delta EVA (Total) +67 0
By doing this adjustment the sale of the valuedestroying asset results in an improvement of EVA which is shown in a positive Delta EVA In the following periods there is no influence on EVA or Delta EVA
Decisions concerning unusual items should not be made by looking at the shortterm impact on the income statement In this way the adjustment motivates the right decisions since valuecreating sales are not forfeited when they would cause an accounting loss and valuereducing sales are not encouraged when they would create an accounting gain
Mechanics of the adjustment
The definition of unusual items follows XY’s financial reporting policies as it makes reference to nonoperating income and charges in the income statement
As a general rule the classification of items as unusual or nonoperating should be restrictive Examples include restructuring charges (eg severance facility relocation legal costs intangible writeoffs etc) gains and losses on businesssubsidiary divestments asset sales and asset writeupswritedowns
Taking into account the materiality level of 500 TEUR for the recognition of nonoperating results only items exceeding this amount can be considered unusual
In the income statement nonoperating results are included in the profit of the year but are not part of the operating income As we calculate NOPAT starting from operating income these items are automatically excluded from NOPAT
However unusual items must be included in the EVA calculation somehow in order to create accountability for the unusual results Therefore the effect of the adjustment for unusual items is shown in Delta EVA in the period in which the unusual gain or loss occurs As EVA is an aftertax measure only the net effect of the unusual items is taken into account
Delta EVA nonoperating
Unusual gain (+)loss () before tax 1000
Taxes (38) +380
Unusual gainloss after taxes 620
x WACC (7)
Delta EVA nonoperating 43
Delta EVA nonoperating resulting from an unusual loss is negative whereas Delta EVA nonoperating resulting from an unusual gain is positive
5 Off balance sheet liabilities
Description of the Adjustment
Off balance sheet liabilities are included in invested capital
Theoretical interest income on off balance sheet liabilities is included in NOPAT
Behaviour ExpectedReason for the Adjustment
In the case of off balance sheet liabilities the investors have capital at risk although no entry is made on the balance sheet To promote correct decisionmaking the costs associated with exposing investors to additional risk needs to be accounted for This is done by calculating a risk premium on off balance liabilities which is the difference between the capital charges on the off balance sheet liability and a theoretical interest income in NOPAT
Mechanics of the Adjustment
Types of off balance liabilities to be considered at XY are
Guarantees sureties in favour of nonconsolidated companies
Financial fixed contracts (option contracts for acquiring additional stakes in investments)
Selected commitments to invest
Types of items not to be considered in the calculation are
Obligations that are already subject to provisions (eg guarantees for service replacement)
Obligations that are of a purely operating nature that cannot be avoided when being in the business Those risks are already incorporated in the cost of capital assumptions (eg obligation to restore exploitation site after usage)
Commitments that are not legally binding (eg letters of comfort only stating intentions)
Off balance sheet obligations carry a risk that is comparable to the risk of an investment already made because there is no possibility to step out However off balance sheet obligations do not result in an immediate payout Thus they do not have to carry the full cost of capital but only a reduced part (risk premium) representing the incorporated risk Therefore the adjustment is done as follows The off balance sheet obligation is added to invested capital and cost of capital is charged on the obligation A theoretical interest income is added to NOPAT The theoretical interest income is calculated by multiplying the countryspecific cost of debt before taxes (see WACC calculation in the Intranet under Group functionsReporting Controlling Investor Relations (RCI)WACC) by the off balance sheet liability
Example
Risk premium in included in EVA
WACC 70
Cost of Debt before taxes 63
Cost of Debt after taxes (38) +39
+ Risk premium (after taxes) effective in EVA 31
Capital Calculation
Invested capital 1000
+ Guarantee 1000
Invested capital (adjusted) 2000
NOPAT Calculation
Operating income 100
+ Theoretical interest income 63
(1000 x 63)
Operating income (adjusted) 163
Taxes (38) 62
NOPAT 101
6 Operating lease
Description of the Adjustment
The present value of operating lease and rental obligations is included in invested capital A theoretical interest component is added back to NOPAT so that only the depreciation part of the leasing charge remains in NOPAT
Behaviour ExpectedReason for the Adjustment
In accounting operating leases and rents are simply expensed without recognition of the underlying commitment To optimise income managers could therefore strive for the lowest possible annual payment which normally goes together with a very long commitment period However these long commitments represent a risk to shareholders as the payments have to be made whether the asset is needed or not
The time period of rental and leasing contracts effectively alters the annual rental lease payments The longer the rental period the more risk is borne by the user of the asset and the smaller are the annual lease payments Therefore contracts over a longer period will look more favourable in operating result even when the financing conditions underlying the contract are far less favourable than a company’s usual terms The EVA adjustment is made to accurately reflect all risks and costs associated with those contracts and to treat purchases and rent leases the same way
Without this adjustment saleandlease back proposals would be common even when the underlying economics are undesirable With the adjustment managers will be relatively neutral to salelease back transactions unless a very desirable financing opportunity is presented Additionally they will be willing to pay more per year to negotiate shorter commitments and transfer risk onto the landlord This is helpful because it avoids onerous cancellation charges if a lease is to be discontinued
Example Comparison lease and purchase
To illustrate the significance of this we can look at the purchase and the lease of an asset having a five year life and a salvage value equal to its removal cost If the purchase price of 100 is financed at 63 it will be paid off with 5 annual payments of 24 per year The lease calls for payments of 24 per year for five years These are economically equivalent situations since the payments are the same the commitments to future payments are the same and the use of the asset is the same
Purchase
Lease (before adjustment)
Although these are economically equivalent situations we get signals that strongly favour leases when comparing the present values of the two options Why is this Because we are ignoring the impact of the future commitments in the lease case
To adjust the lease to a consistent basis we calculate the present value (PV) of future commitments at the (marginal) pretax cost of debt (in this case 63) and include the amount in invested capital Thus we apply a capital charge at the prevailing cost of capital rate just as we do in the purchase case Since the present value of an operating lease commitment will be reduced each year as the lease expiration comes nearer the capital charge that is attributable to capitalised operating leases will vary over time as leases expire and new leases are signed
However the lease payment includes an implicit interest cost which is now redundant We therefore need to add back the interest portion of the rental payment to NOPAT We multiply the capitalised lease by the marginal pretax cost of debt to determine the implied interest Thus the total rent is charged to NOPAT but the implicit interest charge is added back leaving only the depreciation in NOPAT
Lease (after adjustment)
Thus by capitalising the leases and adding back the interest to NOPAT we get a more consistent basis as a lease is treated in the same way as a purchase In fact other than possible timing differences on taxes the net present value of EVA with the capitalised lease versus the purchase is identical Leasing is the same as borrowing money and buying the asset This is not to say that leases are bad Sometimes leases are superior financing vehicles This is particularly true when only a short portion of the life of the asset is needed Comparison models need to be used in order to make decisions on leasebuy and short termlong term Operating managers should focus primarily on whether the asset is needed rather than how it is financed
Mechanics of the Adjustment
Calculate the present value (PV) of future commitments at the marginal cost of debt and include this in capital Multiply the capitalised lease by the marginal cost of debt to determine the implied interest and add this back to NOPAT
Example
Capital Calculation
Invested capital 600
+ PV of operating leases 27
Invested capital (adjusted) 627
NOPAT Calculation
Operating income 150
+ Implied interest expense on operating leases 2
(27 x 63)
Operating Income (adjusted) 152
Operating Taxes (38) 58
NOPAT 94
7 Pensions
Description of the Adjustment
Provisions for pensions recorded in the balance sheet are not deducted from invested capital Theoretical interest on provisions for pensions is added to NOPAT
External pension plan Overfunding of pension plans is not included in invested capital
Behaviour ExpectedReason for the Adjustment
Pension obligations represent a form of debt financing The obligations are stated in the balance sheet at the present value of future obligations The expenses for pensions included in personnel costs contain interest costs In the EVA system operating items are clearly separated from financing items All financing costs are already covered by the capital charges on invested capital In order to reflect only the operating part of pension cost the interest cost needs to be excluded from personnel costs
Provisions for pensions recorded in the balance sheet represent the net amount of plan assets and liabilities When plan assets partly cover the pension obligations only the amount of obligations exceeding the plan assets is recorded in the balance sheet and used for calculating the interest charge which is added back to NOPAT All other interest costs that are recorded under personnel costs of pensions are more than compensated by the anticipated earnings from fund’s assets (see Provisions for pensions’ in the notes of the annual report)
In case of overfunding of plan assets those plan assets are not included in invested capital Nevertheless pension schemes have to be controlled incorporating all risk aspects Therefore detailed calculations capturing the risk impact of plan asset management must be performed However these calculations are used for controlling purposes only Performance measurement of operating units is not affected by these additional considerations
Mechanics of the adjustment
A countryspecific interest rate defined as the cost of debt of the country is applied for the calculation of theoretical interest costs on pensions
Example
Balance Sheet
Tangible assets 4000 Equity 1000
Overfunding of plans 1000 Provisions 2000
Receivables 1000 Pension obligations 3000
Total assets 6000 Total liabilities 6000
Cost of Capital
WACC 70
Cost of Debt before taxes 63
Cost of Debt after taxes (38) +39
Capital Calculation
Tangible assets 4000
Net working capital 1000
Provisions 2000
Invested capital 3000
NOPAT Calculation
Operating income 1000
+ Theoretical interest costs +189
(3000 x 63)
Operating income (adjusted) 1189
Taxes (38) 452
NOPAT 737
8 Minority interests
Description of the Adjustment
For fully consolidated companies minority interests in NOPAT and invested capital are calculated and deducted from NOPAT and from invested capital
Behaviour ExpectedReason for the Adjustment
Minority interests indicate that parts of the income and of the capital do not belong to the shareholders of the group Minority interests have to be taken into account in order to reflect the true ownership In group accounting the minority interests refer to income after tax and to equity As the EVA calculation is based on NOPAT and on invested capital minority interests have to be calculated separately on both items
The adjustments to NOPAT and invested capital are made to reflect economic reality and to improve decision making Calculating minority interests in NOPAT and invested capital leads to the right decision if management intends to acquire additional stakes from minority shareholders
In this case
EVA changes due to the higher cost of capital on the additional equity but
on the other hand the minority part included in NOPAT decreases which improves EVA
Example
Mechanics of the adjustment
The minority interests in NOPAT and invested capital reflect proportional values and are calculated as follows
Example
Capital calculation
Fully cons Calculation
75 of minority
acquisition interests
Goodwill 400
Fixed assets 100 25
LoansInvestments 55 14
Net working capital 75 19
Provisions 100 +25
EVA adjustments 20 5
Invested capital before minority interests 550 38
Minority interests 38
Invested capital after minority interests 613
Minority interests are calculated on all positions of invested capital except goodwill The goodwill already reflects the ownership part of the mother company and therefore includes no minority interests
NOPAT
Full cons Calculation
75 of minority
acquisition interests
NOPAT before minority interests 60 15
Minorities 15
NOPAT after minority interests 45
Minority interests are calculated on full NOPAT
Also indirect minority interests are taken into account by always looking at the stake from a group perspective
B EVA on SBU and Group level
1 Tax management
On the operating unit level NOPAT is calculated using a standard tax rate As the responsibility for tax management lies mainly on SBU and Group level effective taxes are only used at this level
Deferred and current tax assets are included in invested capital on the group and SBU level Additionally tax payables and deferred taxes are deducted from invested capital on group and SBU level
2 Goodwill for Company A and Company B acquisition
Goodwill is pushed down to operating units except for goodwill from the acquisition of Company A and Company B which is only pushed down to SBU level
3 Currency Translation Adjustment (CTA)
Whenever different reporting currencies exist on the operating unit SBU and group level the Cumulative Translation Adjustment (CTA) account records the gains and losses in equity stemming from the translation of foreign currency financial statements into the reporting currency of the Group or the SBU
Translation adjustments in equity will only be included in the EVA calculation on the SBU and on the group level They will not be included on OU and on EBU level as translation differences are not part of the operating responsibility of the operating unitEBU manager (an exception is made for AAT the translation adjustment will be included on EBU level also)
By including the translation adjustments in the EVA calculation the translation adjustment in equity is reversed on group and on SBU level translation losses are added back to invested capital gains are deducted from invested capital
Example
Balance sheet (reporting currency) before revaluation
Assets 100 Equity 50
Debt 50
Total assets 100 Total liabilities 100
Balance sheet (reporting currency) after revaluation (foreign exchange rate change from 1 to 08)
Assets 80 Equity 40
Debt 40
Total assets 80 Total liabilities 80
Translation adjustment in assets 80100 20
Translation adjustment in debt 40+ 50 +10
Translation adjustment in equity 20+ 10 10
Capital Calculation
Invested capital before adjustment 80
+ Cumulative translation loss 10
Invested capital (adjusted) 90
NOPAT Calculation No effect
In the example the balance sheet of a unit is translated into the reporting currency of the Group Due to the devaluation of the foreign currency the value of the assets of this unit is decreasing by –20 Foreign currency debt diminishes the conversion exposure of the unit because it reduces shareholders’ equity exposure to changes in exchange rates by +10 By reversing only the net effect of the translation of assets and debt (+10) the hedging character of foreign currency debt is reflected in the EVA calculation
The adjustment makes transparent the investment before foreign currency fluctuations (net of hedging effects) As a consequence the capital charge is also calculated on the full investment
C EVA Calculation Schemes
1 Calculation of invested capital on operating unit level
Invested capital on the operating unit level is calculated according to the calculation scheme on page 19 As a general rule the calculation of capital within the XY group will be based upon average capital during the year By doing so a misstatement of capital due to seasonal effects investments during the year or yearend window dressing will be avoided From 2002 on capital calculation will be based on the beginning balance sheets of each quarter Invested capital of the year will then be calculated as an average of invested capital at the beginning of each quarter
In the following additional information on specific items is provided
Goodwill
Since goodwill may not be pushed down to the operating unit level in the current accounting system the goodwill pushdown will be included as a manual adjustment in the EVA calculation
Investments and loans
Investments in and loans given to related parties are not included in the invested capital as those are considered a grouptreasury responsibility However investments in and loans to nonconsolidated related companies need to be included For the latter we make a manual adjustment (see next point Loans to and investments in nonconsolidated companies’)
Loans to and investments in nonconsolidated companies
Related party accounts include transactions with both consolidated and nonconsolidated companies As related parties are not included in investments and loans the amount that refers to transactions with nonconsolidated and equity companies needs to be added back to the invested capital Those intercompanies to nonconsolidated related parties are recorded with counterpart OTHER in the accounting system To include those amounts a manual adjustment in invested capital is made
Cash and cash equivalents
If cash is included in invested capital the same rate of return is expected from cash as from operational investments As centralised cash management generally obtains higher rates of return there should be an incentive for operating units to transfer cash to the group Therefore cash is included in invested capital unless it is transferred to an account that is at the disposal of group treasury
Net Working Capital
Receivables from and payables to related parties are included in net working capital as those are part of the responsibility of the operating unit manager
Manual adjustments
Other manual adjustments relate to items for which data is not available not detailed enough incorrectly stated or missing in the accounting system It allows to correct for it in the EVA calculation
2 Calculation of NOPAT on OU level
NOPAT on operating unit level is calculated according to the calculation scheme on page 20
Taxes
A countryspecific standard tax rate is applied on net operating profit before taxes You can find the standard tax rates of different countries on the Intranet under XXX
Calculation Scheme Invested Capital on the operating unit level
Calculation Scheme NOPAT on the operating unit level
3 Calculation of invested capital on the groupSBU level
Invested capital on the groupSBU level is calculated based on the calculation scheme for operating units (page 19) and the following additional adjustments
Calculation Scheme Invested Capital on the groupSBU level
4 Calculation of NOPAT on the groupSBU level
NOPAT on the groupSBU level is calculated according to the calculation scheme for operating units (see page 20) The only difference in the calculation of NOPAT refers to the application of effective taxes on group and SBU level
Calculation Scheme NOPAT on groupSBU level
On the groupSBU level taxes included in NOPAT comprise effective taxes as stated in the income statement and the tax effects of adjustments The tax effect of adjustments is taken into account because NOPAT is an aftertax measure and therefore the adjustments also need to be taken into account on an aftertax basis
In order to show the difference between the application of a standard tax rate and effective taxes the calculation is transformed as follows
Total taxes on income
Total taxes on income comprise effective taxes as recorded in the income statement
Standard taxes
Standard taxes are calculated by applying a standard tax rate on the net operating income before taxes By doing so the standard tax rate is applied on operating income and on the adjustments
Difference between standard and effective taxes
The difference between standard and effective taxes shows the effect of applying a standard taxes on the operating unit level and effective taxes on the groupSBU level
Tax effect of adjustments
For the calculation of the tax effects on adjustments a standard tax rate is applied Taxable income excluded from NOPAT (eg nonoperating and exceptional gains) leads to a positive tax adjustment (taxes included in NOPAT will be reduced) Taxdeductible expenses excluded from NOPAT (eg interest portion in leaserent payments nonoperating and exceptional losses interest expenses) leads to a negative tax adjustment (taxes included in NOPAT increase)
For the calculation of the tax effects on interest expenses the following accounts are taken into consideration
Example
Taxable Calculation
income of tax effect
excluded (38)
Nonoperating gains 200 +76
Taxable Calculation
expenses of tax effect
excluded (38)
Interests expenses 100 38
Interests in rentsleases 50 16
Interests in pensions 10 4
Interest on offbalance liabilities 8 3
Tax Effect (reduction+increase ) 15 +15
In the example the tax effect on adjustment causes a tax reduction of 15 which can be explained by the fact that the positive tax effect of the exclusion of taxable income outweighed the negative effect of the exclusion of taxable expenses
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EVA Manual
General Concept
Table of Contents
General Concept
I Introduction 1
1 EVA is a management tool that measures true economic profit 1
2 EVA can be integrated in all key processes 1
3 Decisionmaking based on EVA 2
II Decisionmaking with EVA 3
A How to build up EVA on operating unit level 3
1 Overview 3
2 NOPAT (Net operating profit after tax) 3
3 Invested capital 4
4 Cost of capital 6
5 Focus on Delta EVA 7
B How to build up EVA on the Group and SBU level 8
C Use of EVA in the XY management system 9
1 Management reporting 9
2 Capital expenditures 10
3 Portfolio analysis 11
Details of the EVA Calculation
III Appendix……………………………………………………………………………………………………………
I Introduction
1 EVA is a management tool that measures true economic profit
All managers of XY should focus on improving the Group’s 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 company’s 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 valueoriented 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 valuebased decisionmaking for daytoday 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 Decisionmaking 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 valuecreating 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
Performance
Improving operating profits without tying up more capital in the business will directly increase EVA
Growth
Investments 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 Management
Rationalising 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 Structure
Lenders 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 Decisionmaking with EVA
A How to build up EVA on the operating unit level
1 Overview
EVA is a transparent measure that is easy to calculate
2 NOPAT (Net operating profit after tax)
a) Introduction
NOPAT 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 decisionmaking
b) Calculation
The following positions will be adjusted
(For a detailed description of the adjustments and the accounts involved see Appendix)
Goodwill amortisation
Goodwill 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 nonconsolidated and equity companies
As operating management is responsible for the performance of investments in and loans to nonconsolidated companies the results from these assets are included in the operating performance measure
Separation of financing results
To exclude any financing costs from NOPAT some financial charges that are included in operating income (eg 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 capital
a) Introduction
Capital 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 (eg trade payables)
b) Calculation
In 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 loans
Investments in and financial loans to nonconsolidated and equity companies (including cash) are part of the invested capital as operating management is responsible for the performance of these activities
Net working capital
Net 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
Provisions
Provisions are regarded as noninterest 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 amortisation
The 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 contracts
The 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 obligations
In 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 progress
Assets 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 2002 this average calculation will be based on the quarterly financial statement
4 Cost of capital
Capital 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 debtequity ratio
WACC debt * Net Cost of Debt + equity * Cost of Equity
Using this approach countryspecific WACC’s are calculated To illustrate the formula the WACC calculation for one country is shown The cost of debt is 39 aftertax The shareholders expect a return of 105 a higher figure because the risk is higher than for a debt investment The debttomarket value (leverage) ratio is 52
Cost Weight Weighted Cost
Debt after tax 39 52 20
Equity 105 48 51
Weighted Average Cost of Capital 71 (rounded 7)
You can find the specific WACC of different countries on the Intranet under Group functionsReporting 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 figure
The 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 level
Valueoriented 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 system
From 2002 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 reporting
The 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
Nonconsolidated investments increased by 1500 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 nonoperating or exceptional losses which resulted in a Delta EVA nonoperating 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 EVA’s 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 1500 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 analysis
The 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 EVA’s 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 Manual
Appendix
Table of Contents
III Appendix Details of EVA calculation 1
A Improve management decisions by adjusting operating income and invested capital 1
1 Selection of adjustments 1
2 Goodwill 1
3 Construction in progress 3
4 Unusual items 4
5 Off balance sheet liabilities 7
6 Operating lease 9
7 Pensions 12
8 Minority interests 14
B EVA on SBU and Group level 16
1 Tax management 16
2 Goodwill for Company A and Company B acquisition 16
3 Currency Translation Adjustment (CTA) 16
C EVA Calculation Schemes 18
1 Calculation of invested capital on the operating unit level 18
2 Calculation of NOPAT on the operating unit level 18
3 Calculation of invested capital on the groupSBU level 22
4 Calculation of NOPAT on the groupSBU level 22
III Appendix Details of EVA calculation
A Improve management decisions by adjusting operating income and invested capital
1 Selection of adjustments
When 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
Materiality
Adjustments should make a material difference in EVA
Motivational Impact
Adjustments should have the potential to influence decisions and behaviour
Practicality
Adjustments should be made subject to data being available
Understandability
Adjustments should not be unnecessarily complex
2 Goodwill
Description of the Adjustment
Goodwill amortisation is not included in NOPAT
The full historic goodwill before amortisation is shown in invested capital
Behaviour ExpectedReason 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 pusheddown to SBU level By including goodwill in the calculation of capital below group level the responsibility for the profitability of acquisitions is decentralised Pushdown accounting brings in line the absolute amount of EVA on group level and on subunit level Otherwise a negative EVA on the group level might correspond to positive EVA’s 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 capital 600
+ Accumulated goodwill amortisation 60
Invested capital (adjusted) 660
NOPAT Calculation
Operating Income 100
+ Goodwill amortisation 15
Operating Income (adjusted) 115
Operating Taxes (38) 44
NOPAT 71
If goodwill is amortised due to an impairment test the respective amount of goodwill will be excluded from invested capital and treated as an unusual item (see chap 4)
3 Construction in progress
Description of the Adjustment
Construction in progress (CIP) is not included in invested capital
Behaviour ExpectedReason for the Adjustment
In order not to discourage valuecreating new investments capital charges are not imposed on CIP until it starts operations and is taken out of the CIP account Managers will be accountable for generating a return once the assets are placed in service
To maintain the consistency between the present value of cash flows and EVA we need to recognise the time value of this money during construction Technically this means that the capital charges for the construction period should be accumulated and capitalised as part of the investment when the asset is in use However this is complex to do For major projects regular financial accounting practices accomplish almost the same result as XY capitalises borrowing costs (pretax cost of interest) in CIP Therefore in order to keep the calculation simple no additional capital charges are capitalised for EVA For all other construction in progress items capital charges for the periods during construction are neglected because of materiality reasons
Mechanics of Adjustment Reduce invested capital by the construction in progress balance
Example
Capital Calculation
Invested capital 600
Construction in progress 30
Invested capital (adjusted) 570
4 Unusual items
Description of the Adjustment
Unusual items are excluded from NOPAT
The Capital charge on unusual items is shown in Delta EVA nonoperating
Behaviour ExpectedReason for Adjustment
Unusual items represent gains and losses that arise from events or activities that are not considered part of XY’s ongoing and recurring business We cannot assess ongoing sustainable profitability if these unusual items are mixed with the operating profit figures Therefore we need to consider unusual items in a way that does not distort ongoing period results and at the same time motivates valuecreating behaviour
Example
An asset generates a profit after tax of 100 The asset which is recorded in the balance sheet at 3000 is now sold for 2000 Selling an asset for a book value loss of 1000 (before taxes) would show the asset reduced to zero on the balance sheet and a loss taken in the profit of the period
EVA Calculation before adjustment
Year 1 Year 2
Operating profit after taxes 100 0
+ Loss on asset sale (after taxes of 38) 620
NOPAT 100 620
Invested capital 3000 0
Capital charge (7) 210 0
EVA 110 620
Delta EVA 510
Without doing any adjustment the sale of the asset results in a decrease in profits of 720 and a decrease in EVA of 510 Thus the normal accounting treatment discourages the manager from selling Nevertheless the asset provides an operating income of only 100 per year which is not enough to earn the cost of capital (negative EVA of 110) Provided that the asset does increase its profitability in the future it is beneficial to sell the asset
The EVA adjustment removes the unusual loss from NOPAT Unusual items are not part of operating activity as NOPAT is an operating measure But does this mean that we should totally ignore these items Of course not The adjustment aims at establishing responsibility for unusual items and at the same time motivating valuecreating behaviour We therefore include capital charges on unusual items in Delta EVA (Capital charges of 7 on the loss after taxes of 620 results in a charge on Delta EVA of –43)
Economic View (after adjustment)
Year 1 Year 2 Year 3
NOPAT 100 0 0
Capital 3000 0 0
Capital charges (7) 210 0 0
EVA 110 0 0
Delta EVA operating +110 0
Delta EVA nonoperating (7 x 620) 43 0
Delta EVA (Total) +67 0
By doing this adjustment the sale of the valuedestroying asset results in an improvement of EVA which is shown in a positive Delta EVA In the following periods there is no influence on EVA or Delta EVA
Decisions concerning unusual items should not be made by looking at the shortterm impact on the income statement In this way the adjustment motivates the right decisions since valuecreating sales are not forfeited when they would cause an accounting loss and valuereducing sales are not encouraged when they would create an accounting gain
Mechanics of the adjustment
The definition of unusual items follows XY’s financial reporting policies as it makes reference to nonoperating income and charges in the income statement
As a general rule the classification of items as unusual or nonoperating should be restrictive Examples include restructuring charges (eg severance facility relocation legal costs intangible writeoffs etc) gains and losses on businesssubsidiary divestments asset sales and asset writeupswritedowns
Taking into account the materiality level of 500 TEUR for the recognition of nonoperating results only items exceeding this amount can be considered unusual
In the income statement nonoperating results are included in the profit of the year but are not part of the operating income As we calculate NOPAT starting from operating income these items are automatically excluded from NOPAT
However unusual items must be included in the EVA calculation somehow in order to create accountability for the unusual results Therefore the effect of the adjustment for unusual items is shown in Delta EVA in the period in which the unusual gain or loss occurs As EVA is an aftertax measure only the net effect of the unusual items is taken into account
Delta EVA nonoperating
Unusual gain (+)loss () before tax 1000
Taxes (38) +380
Unusual gainloss after taxes 620
x WACC (7)
Delta EVA nonoperating 43
Delta EVA nonoperating resulting from an unusual loss is negative whereas Delta EVA nonoperating resulting from an unusual gain is positive
5 Off balance sheet liabilities
Description of the Adjustment
Off balance sheet liabilities are included in invested capital
Theoretical interest income on off balance sheet liabilities is included in NOPAT
Behaviour ExpectedReason for the Adjustment
In the case of off balance sheet liabilities the investors have capital at risk although no entry is made on the balance sheet To promote correct decisionmaking the costs associated with exposing investors to additional risk needs to be accounted for This is done by calculating a risk premium on off balance liabilities which is the difference between the capital charges on the off balance sheet liability and a theoretical interest income in NOPAT
Mechanics of the Adjustment
Types of off balance liabilities to be considered at XY are
Guarantees sureties in favour of nonconsolidated companies
Financial fixed contracts (option contracts for acquiring additional stakes in investments)
Selected commitments to invest
Types of items not to be considered in the calculation are
Obligations that are already subject to provisions (eg guarantees for service replacement)
Obligations that are of a purely operating nature that cannot be avoided when being in the business Those risks are already incorporated in the cost of capital assumptions (eg obligation to restore exploitation site after usage)
Commitments that are not legally binding (eg letters of comfort only stating intentions)
Off balance sheet obligations carry a risk that is comparable to the risk of an investment already made because there is no possibility to step out However off balance sheet obligations do not result in an immediate payout Thus they do not have to carry the full cost of capital but only a reduced part (risk premium) representing the incorporated risk Therefore the adjustment is done as follows The off balance sheet obligation is added to invested capital and cost of capital is charged on the obligation A theoretical interest income is added to NOPAT The theoretical interest income is calculated by multiplying the countryspecific cost of debt before taxes (see WACC calculation in the Intranet under Group functionsReporting Controlling Investor Relations (RCI)WACC) by the off balance sheet liability
Example
Risk premium in included in EVA
WACC 70
Cost of Debt before taxes 63
Cost of Debt after taxes (38) +39
+ Risk premium (after taxes) effective in EVA 31
Capital Calculation
Invested capital 1000
+ Guarantee 1000
Invested capital (adjusted) 2000
NOPAT Calculation
Operating income 100
+ Theoretical interest income 63
(1000 x 63)
Operating income (adjusted) 163
Taxes (38) 62
NOPAT 101
6 Operating lease
Description of the Adjustment
The present value of operating lease and rental obligations is included in invested capital A theoretical interest component is added back to NOPAT so that only the depreciation part of the leasing charge remains in NOPAT
Behaviour ExpectedReason for the Adjustment
In accounting operating leases and rents are simply expensed without recognition of the underlying commitment To optimise income managers could therefore strive for the lowest possible annual payment which normally goes together with a very long commitment period However these long commitments represent a risk to shareholders as the payments have to be made whether the asset is needed or not
The time period of rental and leasing contracts effectively alters the annual rental lease payments The longer the rental period the more risk is borne by the user of the asset and the smaller are the annual lease payments Therefore contracts over a longer period will look more favourable in operating result even when the financing conditions underlying the contract are far less favourable than a company’s usual terms The EVA adjustment is made to accurately reflect all risks and costs associated with those contracts and to treat purchases and rent leases the same way
Without this adjustment saleandlease back proposals would be common even when the underlying economics are undesirable With the adjustment managers will be relatively neutral to salelease back transactions unless a very desirable financing opportunity is presented Additionally they will be willing to pay more per year to negotiate shorter commitments and transfer risk onto the landlord This is helpful because it avoids onerous cancellation charges if a lease is to be discontinued
Example Comparison lease and purchase
To illustrate the significance of this we can look at the purchase and the lease of an asset having a five year life and a salvage value equal to its removal cost If the purchase price of 100 is financed at 63 it will be paid off with 5 annual payments of 24 per year The lease calls for payments of 24 per year for five years These are economically equivalent situations since the payments are the same the commitments to future payments are the same and the use of the asset is the same
Purchase
Lease (before adjustment)
Although these are economically equivalent situations we get signals that strongly favour leases when comparing the present values of the two options Why is this Because we are ignoring the impact of the future commitments in the lease case
To adjust the lease to a consistent basis we calculate the present value (PV) of future commitments at the (marginal) pretax cost of debt (in this case 63) and include the amount in invested capital Thus we apply a capital charge at the prevailing cost of capital rate just as we do in the purchase case Since the present value of an operating lease commitment will be reduced each year as the lease expiration comes nearer the capital charge that is attributable to capitalised operating leases will vary over time as leases expire and new leases are signed
However the lease payment includes an implicit interest cost which is now redundant We therefore need to add back the interest portion of the rental payment to NOPAT We multiply the capitalised lease by the marginal pretax cost of debt to determine the implied interest Thus the total rent is charged to NOPAT but the implicit interest charge is added back leaving only the depreciation in NOPAT
Lease (after adjustment)
Thus by capitalising the leases and adding back the interest to NOPAT we get a more consistent basis as a lease is treated in the same way as a purchase In fact other than possible timing differences on taxes the net present value of EVA with the capitalised lease versus the purchase is identical Leasing is the same as borrowing money and buying the asset This is not to say that leases are bad Sometimes leases are superior financing vehicles This is particularly true when only a short portion of the life of the asset is needed Comparison models need to be used in order to make decisions on leasebuy and short termlong term Operating managers should focus primarily on whether the asset is needed rather than how it is financed
Mechanics of the Adjustment
Calculate the present value (PV) of future commitments at the marginal cost of debt and include this in capital Multiply the capitalised lease by the marginal cost of debt to determine the implied interest and add this back to NOPAT
Example
Capital Calculation
Invested capital 600
+ PV of operating leases 27
Invested capital (adjusted) 627
NOPAT Calculation
Operating income 150
+ Implied interest expense on operating leases 2
(27 x 63)
Operating Income (adjusted) 152
Operating Taxes (38) 58
NOPAT 94
7 Pensions
Description of the Adjustment
Provisions for pensions recorded in the balance sheet are not deducted from invested capital Theoretical interest on provisions for pensions is added to NOPAT
External pension plan Overfunding of pension plans is not included in invested capital
Behaviour ExpectedReason for the Adjustment
Pension obligations represent a form of debt financing The obligations are stated in the balance sheet at the present value of future obligations The expenses for pensions included in personnel costs contain interest costs In the EVA system operating items are clearly separated from financing items All financing costs are already covered by the capital charges on invested capital In order to reflect only the operating part of pension cost the interest cost needs to be excluded from personnel costs
Provisions for pensions recorded in the balance sheet represent the net amount of plan assets and liabilities When plan assets partly cover the pension obligations only the amount of obligations exceeding the plan assets is recorded in the balance sheet and used for calculating the interest charge which is added back to NOPAT All other interest costs that are recorded under personnel costs of pensions are more than compensated by the anticipated earnings from fund’s assets (see Provisions for pensions’ in the notes of the annual report)
In case of overfunding of plan assets those plan assets are not included in invested capital Nevertheless pension schemes have to be controlled incorporating all risk aspects Therefore detailed calculations capturing the risk impact of plan asset management must be performed However these calculations are used for controlling purposes only Performance measurement of operating units is not affected by these additional considerations
Mechanics of the adjustment
A countryspecific interest rate defined as the cost of debt of the country is applied for the calculation of theoretical interest costs on pensions
Example
Balance Sheet
Tangible assets 4000 Equity 1000
Overfunding of plans 1000 Provisions 2000
Receivables 1000 Pension obligations 3000
Total assets 6000 Total liabilities 6000
Cost of Capital
WACC 70
Cost of Debt before taxes 63
Cost of Debt after taxes (38) +39
Capital Calculation
Tangible assets 4000
Net working capital 1000
Provisions 2000
Invested capital 3000
NOPAT Calculation
Operating income 1000
+ Theoretical interest costs +189
(3000 x 63)
Operating income (adjusted) 1189
Taxes (38) 452
NOPAT 737
8 Minority interests
Description of the Adjustment
For fully consolidated companies minority interests in NOPAT and invested capital are calculated and deducted from NOPAT and from invested capital
Behaviour ExpectedReason for the Adjustment
Minority interests indicate that parts of the income and of the capital do not belong to the shareholders of the group Minority interests have to be taken into account in order to reflect the true ownership In group accounting the minority interests refer to income after tax and to equity As the EVA calculation is based on NOPAT and on invested capital minority interests have to be calculated separately on both items
The adjustments to NOPAT and invested capital are made to reflect economic reality and to improve decision making Calculating minority interests in NOPAT and invested capital leads to the right decision if management intends to acquire additional stakes from minority shareholders
In this case
EVA changes due to the higher cost of capital on the additional equity but
on the other hand the minority part included in NOPAT decreases which improves EVA
Example
Mechanics of the adjustment
The minority interests in NOPAT and invested capital reflect proportional values and are calculated as follows
Example
Capital calculation
Fully cons Calculation
75 of minority
acquisition interests
Goodwill 400
Fixed assets 100 25
LoansInvestments 55 14
Net working capital 75 19
Provisions 100 +25
EVA adjustments 20 5
Invested capital before minority interests 550 38
Minority interests 38
Invested capital after minority interests 613
Minority interests are calculated on all positions of invested capital except goodwill The goodwill already reflects the ownership part of the mother company and therefore includes no minority interests
NOPAT
Full cons Calculation
75 of minority
acquisition interests
NOPAT before minority interests 60 15
Minorities 15
NOPAT after minority interests 45
Minority interests are calculated on full NOPAT
Also indirect minority interests are taken into account by always looking at the stake from a group perspective
B EVA on SBU and Group level
1 Tax management
On the operating unit level NOPAT is calculated using a standard tax rate As the responsibility for tax management lies mainly on SBU and Group level effective taxes are only used at this level
Deferred and current tax assets are included in invested capital on the group and SBU level Additionally tax payables and deferred taxes are deducted from invested capital on group and SBU level
2 Goodwill for Company A and Company B acquisition
Goodwill is pushed down to operating units except for goodwill from the acquisition of Company A and Company B which is only pushed down to SBU level
3 Currency Translation Adjustment (CTA)
Whenever different reporting currencies exist on the operating unit SBU and group level the Cumulative Translation Adjustment (CTA) account records the gains and losses in equity stemming from the translation of foreign currency financial statements into the reporting currency of the Group or the SBU
Translation adjustments in equity will only be included in the EVA calculation on the SBU and on the group level They will not be included on OU and on EBU level as translation differences are not part of the operating responsibility of the operating unitEBU manager (an exception is made for AAT the translation adjustment will be included on EBU level also)
By including the translation adjustments in the EVA calculation the translation adjustment in equity is reversed on group and on SBU level translation losses are added back to invested capital gains are deducted from invested capital
Example
Balance sheet (reporting currency) before revaluation
Assets 100 Equity 50
Debt 50
Total assets 100 Total liabilities 100
Balance sheet (reporting currency) after revaluation (foreign exchange rate change from 1 to 08)
Assets 80 Equity 40
Debt 40
Total assets 80 Total liabilities 80
Translation adjustment in assets 80100 20
Translation adjustment in debt 40+ 50 +10
Translation adjustment in equity 20+ 10 10
Capital Calculation
Invested capital before adjustment 80
+ Cumulative translation loss 10
Invested capital (adjusted) 90
NOPAT Calculation No effect
In the example the balance sheet of a unit is translated into the reporting currency of the Group Due to the devaluation of the foreign currency the value of the assets of this unit is decreasing by –20 Foreign currency debt diminishes the conversion exposure of the unit because it reduces shareholders’ equity exposure to changes in exchange rates by +10 By reversing only the net effect of the translation of assets and debt (+10) the hedging character of foreign currency debt is reflected in the EVA calculation
The adjustment makes transparent the investment before foreign currency fluctuations (net of hedging effects) As a consequence the capital charge is also calculated on the full investment
C EVA Calculation Schemes
1 Calculation of invested capital on operating unit level
Invested capital on the operating unit level is calculated according to the calculation scheme on page 19 As a general rule the calculation of capital within the XY group will be based upon average capital during the year By doing so a misstatement of capital due to seasonal effects investments during the year or yearend window dressing will be avoided From 2002 on capital calculation will be based on the beginning balance sheets of each quarter Invested capital of the year will then be calculated as an average of invested capital at the beginning of each quarter
In the following additional information on specific items is provided
Goodwill
Since goodwill may not be pushed down to the operating unit level in the current accounting system the goodwill pushdown will be included as a manual adjustment in the EVA calculation
Investments and loans
Investments in and loans given to related parties are not included in the invested capital as those are considered a grouptreasury responsibility However investments in and loans to nonconsolidated related companies need to be included For the latter we make a manual adjustment (see next point Loans to and investments in nonconsolidated companies’)
Loans to and investments in nonconsolidated companies
Related party accounts include transactions with both consolidated and nonconsolidated companies As related parties are not included in investments and loans the amount that refers to transactions with nonconsolidated and equity companies needs to be added back to the invested capital Those intercompanies to nonconsolidated related parties are recorded with counterpart OTHER in the accounting system To include those amounts a manual adjustment in invested capital is made
Cash and cash equivalents
If cash is included in invested capital the same rate of return is expected from cash as from operational investments As centralised cash management generally obtains higher rates of return there should be an incentive for operating units to transfer cash to the group Therefore cash is included in invested capital unless it is transferred to an account that is at the disposal of group treasury
Net Working Capital
Receivables from and payables to related parties are included in net working capital as those are part of the responsibility of the operating unit manager
Manual adjustments
Other manual adjustments relate to items for which data is not available not detailed enough incorrectly stated or missing in the accounting system It allows to correct for it in the EVA calculation
2 Calculation of NOPAT on OU level
NOPAT on operating unit level is calculated according to the calculation scheme on page 20
Taxes
A countryspecific standard tax rate is applied on net operating profit before taxes You can find the standard tax rates of different countries on the Intranet under XXX
Calculation Scheme Invested Capital on the operating unit level
Calculation Scheme NOPAT on the operating unit level
3 Calculation of invested capital on the groupSBU level
Invested capital on the groupSBU level is calculated based on the calculation scheme for operating units (page 19) and the following additional adjustments
Calculation Scheme Invested Capital on the groupSBU level
4 Calculation of NOPAT on the groupSBU level
NOPAT on the groupSBU level is calculated according to the calculation scheme for operating units (see page 20) The only difference in the calculation of NOPAT refers to the application of effective taxes on group and SBU level
Calculation Scheme NOPAT on groupSBU level
On the groupSBU level taxes included in NOPAT comprise effective taxes as stated in the income statement and the tax effects of adjustments The tax effect of adjustments is taken into account because NOPAT is an aftertax measure and therefore the adjustments also need to be taken into account on an aftertax basis
In order to show the difference between the application of a standard tax rate and effective taxes the calculation is transformed as follows
Total taxes on income
Total taxes on income comprise effective taxes as recorded in the income statement
Standard taxes
Standard taxes are calculated by applying a standard tax rate on the net operating income before taxes By doing so the standard tax rate is applied on operating income and on the adjustments
Difference between standard and effective taxes
The difference between standard and effective taxes shows the effect of applying a standard taxes on the operating unit level and effective taxes on the groupSBU level
Tax effect of adjustments
For the calculation of the tax effects on adjustments a standard tax rate is applied Taxable income excluded from NOPAT (eg nonoperating and exceptional gains) leads to a positive tax adjustment (taxes included in NOPAT will be reduced) Taxdeductible expenses excluded from NOPAT (eg interest portion in leaserent payments nonoperating and exceptional losses interest expenses) leads to a negative tax adjustment (taxes included in NOPAT increase)
For the calculation of the tax effects on interest expenses the following accounts are taken into consideration
Example
Taxable Calculation
income of tax effect
excluded (38)
Nonoperating gains 200 +76
Taxable Calculation
expenses of tax effect
excluded (38)
Interests expenses 100 38
Interests in rentsleases 50 16
Interests in pensions 10 4
Interest on offbalance liabilities 8 3
Tax Effect (reduction+increase ) 15 +15
In the example the tax effect on adjustment causes a tax reduction of 15 which can be explained by the fact that the positive tax effect of the exclusion of taxable income outweighed the negative effect of the exclusion of taxable expenses
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