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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. Decision-making based on EVA 2
II. Decision-making 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 value-oriented incentive compensation schemes.
2. EVA can be integrated in all key processes
Typically, companies use a variety of conflicting measures such as earnings growth, earnings per share, return on equity, market share, gross and net margin, cash flow, NPV and ROIC.
Using a number of different measures leads to conflicting goals. This is why we will use EVA as a single major performance measure.

The EVA financial management system supports and motivates value-based decision-making for day-to-day operating decisions, budgeting and capital planning and strategic initiatives. By using EVA for all of these processes, as well as for performance measurement and incentives, managers of XY will focus on the goal of creating value.

3. Decision-making based on EVA
Although there are countless individual activities people can pursue to create value, ultimately they all fall into one of four categories: EVA can be increased by enhancing operating efficiency (“performance”), investing in value-creating projects (“growth”) or divesting capital from uneconomic assets or activities (“asset management”). EVA can also be increased by the financing strategy of minimising the cost of capital by optimising the capital structure.

- 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. Decision-making 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 decision-making.

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 non-consolidated and equity companies
As operating management is responsible for the performance of investments in and loans to non-consolidated companies, the results from these assets are included in the operating performance measure.

- Separation of financing results
To exclude any financing costs from NOPAT, some financial charges that are included in operating income (e.g. interest related to pensions, which are part of personnel costs, or interest related to operating leases, which is implicit in the leasing rates) are added back to operating income. Foreign currency results are included in NOPAT (and not in financing costs) as they are regarded as being part of the operating activities.

3. Invested 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 (e.g. 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 non-consolidated and equity companies (including cash) are part of the invested capital, as operating management is responsible for the performance of these activities.

- Net working 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 non-interest bearing and are therefore deducted from invested capital. Provisions for pensions and provisions for deferred taxes are treated differently and will not be deducted from invested capital.

- Adjustments

- Goodwill 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 2023, 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 debt/equity ratio.

WACC = %debt * Net Cost of Debt + %equity * Cost of Equity

Using this approach country-specific WACC’s are calculated. To illustrate the formula the WACC calculation for one country is shown. The cost of debt is 3,9% after-tax. The shareholders expect a return of 10,5%, a higher figure because the risk is higher than for a debt investment. The debt-to-market value (leverage) ratio is 52%:

Cost Weight Weighted Cost

Debt after tax 3,9% 52% 2,0%
Equity 10,5% 48% 5,1%

Weighted Average Cost of Capital 7,1% (rounded 7%)

You can find the specific WACC of different countries on the Intranet under Group functions/Reporting, Controlling, Investor Relations (RCI)/WACC.

5. Focus on Delta EVA

If you have calculated EVA for your business, you may have found out that it is not comparable to other units. This is due to the fact that invested capital is stated at book value, which often does not reflect fair value. Does that mean that EVA does not work? No. As absolute values are sometimes not comparable, we focus on Delta EVA, which reflects the change in EVA from one period to another.

EVA is a management tool. It can help managers to evaluate opportunities, set goals, measure results, benchmark performance and deliver incentive compensation.

Delta EVA is the measure because
- management action should always be directed towards the future
- when evaluating opportunities, an increase of EVA gives the right signal
- when setting goals, Delta EVA gives appropriate incentives
- when measuring results, Delta EVA shows a comparable 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

Value-oriented decisions are taken on all corporate levels. The EVA definition applied on the respective level reflects managers’ responsibilities:

As compared to the EVA definition on the operating unit level, the following items are treated differently on the Group and SBU level:
- Taxes
- Goodwill from the acquisition of A and B
- Currency Translation Adjustment (CTA)

For details of the EVA calculation on the group and SBU level, see Appendix B.

C. Use of EVA in the XY management system
From 2023 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.
- Non-consolidated investments increased by 1.500 and did not earn the cost of capital
- Net working capital increased. The payment time for accounts receivable increased, while the time in which the company paid its creditors decreased.

- Additionally, Delta EVA was reduced by non-operating or exceptional losses which resulted in a Delta EVA non-operating of –30 (For details of the adjustment for unusual items, see Appendix chap. 4).

2. Capital expenditures

The EVA system also supports decisions on capital expenditures. Decisions on investments will be based on the following rule: An investment should only be made if the present value of future 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 1.500 is made at the end of year 0 (corresponding to the beginning of year 1). Starting from year 1, the investment creates operating profit. The book value of the investment is depreciated over five years with the book value at the beginning of each period being the basis for calculating the capital charge. The fact that the present value of EVA is positive indicates that the project is creating value.

3. Portfolio 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.