Management Control System Essay

7813 Words Apr 19th, 2016 32 Pages
Q.1 How is RI (EVA) analysis carried out? Explain advantages and disadvantages.
Ans. The EVA method is based on the past performance of the corporate enterprise. The underlying economic principle in this method is to determine whether the firm is earning a higher rate of return on the entire invested funds than the cost of such funds (measured in terms of weighted average cost of capital, WACC). If the answer is positive, the firm’s management is adding to the shareholders value by earning extra for them. On the contrary, if the WACC is higher than the corporate earning rate, the firm’s operations have eroded the existing wealth of its equity shareholders. In operational terms, the method attempts to measure economic value added (or
…show more content…
Determine the economic value added during the year.

Solution

I) Determination of Net Operating Profit After Taxes

Particulars Amt (in lakhs)

Sales revenue 500

Less: Operating Costs 300

Operating profit (EBIT) 200

Less: Taxes (0.40) 80

Net operating profit after taxes (NOPAT) 120

II) Determination of WACC

Particulars Amt (in lakhs)

Equity (150 lakh * 15%) 22.5

12% Debt (100 lakh * 7.2%) 7.2

Total Cost 29.7

WACC (29.7 lakh/ 250 lakh) 11.88%

Cost of debt= 12% (1 – 0.4 tax rate) = 7.2%

III) Determination of EVA

EVA = NOPAT – (Total capital * WACC)

Rs 120 lakh – (Rs 250 lakh * 11.88%)

Rs 120 lakh – Rs 29.7 lakh = Rs 90.3 lakh

During the current year, the firm has added an economic value of Rs.90.3 lakh to the existing wealth of equity shareholders. Essentially, the EVA approach is a modified accounting approach to determine profits earned after meeting all financial costs of all the providers of capital. Its major advantage is that this approach reflects the true profit position of the firm.

RI (EVA) has the following advantages:

i) It avoids suboptimal decisions as investments are not rejected merely because they lower the divisional

Related Documents