BUS601: Financial Management

Modern financial management emphasizes that a firm must seek to maximize shareholder value. Shareholder wealth creation normally is represented by the market value of the firms' shares. It is the shareholders' appraisal of the firms' efficiency in employing their capital. The capital contributed by shareholders is reflected by the book value of the firms' shares. Market Value Added also known as shareholder value creation is the excess of market value over book value.

MVA = Market Value - Capital Employed

Market value as stated in the equation mentioned above is the total of the firms' market value of debt and market value of equity. Invested capital also known as capital employed is the summation of equity and debt capital supplied by the firms' shareholders and debt holders to finance assets. Positive MVA is the sign of shareholder value creation. Managers must aim at earning higher MVA for shareholders and it can be attained only when the firm earns a return in excess of the cost of capital. MVA would be reduced if the firm invests capital in projects which are having negative NPV

Market Value Added is considered as the best indicator of shareholders' wealth creation from an investor's point of view. MVA presents a coherent image that growth for its own sake does not generate value. Value can only be created when the growth stratagem paves way to additional value that surpasses the additional capital provided. The value will be demolished if the net present value of the strategy is negative. It emphasizes that only if managers invest in projects which have positive net present values, value will be created.

Economic Value Added also known as economic profit is explained as net earnings (profit after tax) in surplus of the charges for capital employed.

Economic Value Added = Net Operating Profit after Tax (NOPAT) - Charges for Capital Employed

Profit after depreciation and taxes denoted by NOPAT is calculated by disregarding interest on debt. In other words NOPAT is Profit before Interest and Taxes (PBIT) minus tax without any adjustments for interest. It can also be calculated as Profit after Tax (PAT) plus after tax interest.

NOPAT = PBIT (1-T)

EVA is an assessment of an annual profit of a firm and it differs substantially from accounting profit. It exemplifies the residual income remaining after all opportunity cost of capital is covered. The change between the return on a company's capital and the cost of capital employed is measured by EVA. Negative EVA signifies value demolition whereas value creation is represented by positive EVA.

MVA is the present value of the firm's expected future EVAs. Thus, the connectivity between EVA and MVA is justified.

MVA = Present value of all future EVA

Example

At the commencement of the year, the company named "X" employed capital worth of LKR 10 million, which consists of 70% equity and 30% debt. The interest charged on debt is 15% before tax. The tax rate is 20% and the Weighted Average Cost of Capital (WACC) is 18%. The profit before the deduction of interest and tax is LKR 6 million.

The return on invested capital after tax is 6m/10m x ( 1 - tax rate of 20%) = 48%.

If the future EVAs are anticipated to remain for an indefinite period at LKR 3 million per annum then the calculation of MVA will be in the following manner:

MVA of a firm can be maximized via the following ways (Stewart 1991:137; Ernst & Young 1994:10; Firer 1995:57; Davidson 2003:49).

• By eliminating projects that have a negative EVA;
• By making new investments in projects that have positive EVA;
• By broadening existing projects with positive EVA.

As compared to other accounting measures, EVA is the better prognosticator of market value, several studies emphasize. According to Misra and Kanwal (2007), EVA is the key determinant of MVA as it better reveals the variations in share value than the traditional accounting measures. All the future EVAs which will be generated by a company is represented by MVA. Hence an organization can maximize its MVA by maximizing EVA.