Impacts of inflation on the effectivess of economic value added scale

1. Introduction there are a lot of scales to measure the busi- ness performance of a company and each will pro- vide different information useful for forming and assessing projects and evaluating the business performance. We may exemplify some such as the return on assets (roa), the return on equities (roe) and the economic value added (eVa) which is described as a multi-functional scale that can serve as a replacement for others (tröôøng, 2007). the most striking strength of eVa is that it also considers the cost of capital which may be con- strued as the opportunity cost. through that, we can exactly identify the true return on invest- ments. Yet, when inflation surges ahead, it may distort eVa and result in the inefficient allocation of resources and compensation. Hence, this study will investigate impacts of inflation on the signif- icance of eVa to assessment of business perform- ance, thereby helping investors and managers set up and review projects precisely, assess the busi- ness performance and design policies on rewards. 2. Theoretical framework a. The Economic Value Added: Since the 18th century, the term eVa has been employed by economists to estimate the net profit of a company (ali & nooredin, 2010). However, it was not much attended to until September 2003 when Stern Stewart had a detailed paper on For- tune in light of the so-called eVa and its success- ful application in some american big corporations. Since then, many empirical researches on eVa have been conducted with a view to estimating the business performance, deciding investments and designing policies on rewards. as Stern Stewart put it, eVa is just a measure of economic profit; it is calculated as the difference between the net op- erating Profit after tax (noPat) and the oppor- *HCMC University of Technology Economic Development Review - December 2010 14 Inflation control in Vietnam This study is to investigate the influence of inflation on the effectiveness of the Economic Value Added (EVA) which an investor may employ to quantify the value generated by a company. However, inflation can distort EVA and potentially re- sult in inefficient allocation of resources and policy on rewards. This study will look into the adjusted and nominal EVA in order to measure the business per- formance as reflected in stock returns, stock market prices and operating cash flows. Some 142 non-financial companies have been invited to join this study and 332 observations were undertaken from 2007 to 2009. The findings have shown that the adjusted EVA seems more sensitive to inflation than the nominal EVA. In other words, the latter is distorted by inflation. Thus, Vietnamese business managers should consider thoroughly before integrating EVA into measuring the business performance, especially when inflation rate has galloped over the past few years. Keywords: Economic Value Added (EVA), inflation, business performance tunity cost of invested capital which is determined by the Weighted average Cost of Capital (WaCC) and the amount of capital employed. eVa is calculated according to the basic for- mula as follows: eVa = noPat – WaCC x capital employed b. Empirical researches on EVA: Biddle et al. (1997) compared information con- tent of eVa, the operating cash flow and the net profit; and found that eVa is not superior to the net profit for explaining changes in stock returns. De Villiers (1997) examined the effect of inflation on eVa in a modeling framework. He concluded that a major disadvantage of eVa is that it is based on accounting profits, which, indeed, there exists a discrepancy between the accounting profit and the true economic profit. thus, under the con- ditions of inflation, the nominal eVa cannot be employed to estimate the actual business perform- ance; and an adjusted eVa is required. Warr (2005) investigated the sensitivity of eVa to the level of inflation in a hefty number of the USa companies. His results indicated that within a period of 28 years (1975 to 2002), the nominal eVa has been significantly distorted by inflation. During this period, inflation escalated from 1.13 to 9.7 percent. then, he just analyzed part of his samples from 1990 onwards during which inflation ranged from 1.13 to 4.15 percent; and found that the identical results to the full samples were remained. this is to say, even in the low inflation environment, inflation is also able to distort eVa. Hence, for companies relying on the nominal eVa as a measure of business perform- ance, the distorting impacts of inflation will result in the misallocation of capital and wrong design of reward policies. ali and nooredin (2010) have compared the ca- pability of nominal eVa and eVa adjusted to in- flation to explain the business performance. they found that inflation does not change the signifi- cant impacts of eVa on stock prices, stock returns and operating cash flows. in their research, they utilize the linear monovariable regression model, in which eVa is labeled as the independent vari- able and the dependent ones include stock prices, stock returns and operating cash flows. c. Hypotheses: in this research, we will examine the discrep- ancy in the significance of the nominal eVa and the adjusted eVa for the business performance. accordingly, we have developed three hypotheses as follows: H1: the association between rates of return on stock and the adjusted eVa is stronger than that of the nominal eVa. H2: the association between stock prices and the adjusted eVa is stronger than that of the nominal eVa. H3: the association between operating cash flows and the adjusted eVa is stronger than that of the nominal eVa. 3. Data and methodology a. Data: Data are collected from companies listed in the HCmC Stock exchange in the years 2007-2009. Economic Development Review - December 2010 15 Inflation control in Vietnam Fields 2007 2008 2009 Percent Total Realty 4 8 8 6.00% 20 Technology 2 5 6 3.90% 13 Manufacturing 27 39 41 32.20% 107 Petroleum 3 3 3 2.70% 9 Public services 5 6 7 5.40% 18 Consumer services 2 5 5 3.60% 12 Consumer goods 2 5 5 29.20% 97 Basic materials 11 17 5 13.60% 45 Healthcare 3 3 5 3.30% 11 Total 81 122 129 100% 332 Table 1: Description of observed samples in the table 2, it is apparent that although the variables have a quite high kurtosis, i.e. the peakedness of probability distribution of a real- valued random variable, most of them have the low skewness. this is to say, probability distribu- tions of a real-valued random variable are nearly symmetric. eVa variables have the mean smaller than zero. this may be explained that the cost of capi- tal, which has appreciated over the past few years according to the rise in inflation rate, is got into calculating eVa. moreover, the cost of equity also goes up in accordance with the rate of return on stock (capital asset pricing model). the Vietnam’s economy has just undergone a rough period, caus- ing the market rate of return to fluctuate pro- foundly, especially in 2009 when the stock market rate of return rose over 54%. Due to the fact that the cost of capital goes up, the mean of the nomi- nal eVa and the adjusted eVa goes down. this is to render that the calculation of eVa produces the smaller-than-zero mean. b. Research variables: - the nominal eVa: the basic formula for the calculating the nom- inal eVa is as follows: eVanom,t = noPatt –WaCCnom,t x Capitalt-1 Where, eVanom,t: the nominal economic Value added noPatt: the net operating profit after taxes WaCCnom,t: the weighted average cost of capi- tal Capitalt-1: the invested capital by the company in the year t-1. - the adjusted eVa: according to Warr (2005), the adjusted eVa is as follows: Where, eVaadj,t: the adjusted economic Value added Pt: the annual inflation rate pDt-1: the gain from depreciation of debt Dat: the depreciation adjustment according to the GDP deflator (DGDP) - the weighted average cost of capital (WaCC): the WaCC is calculated as follows: WaCC = [Wd x Kd (1-t)] + (We x Ke) Where, Wd: the weight of debt capital Kd: the cost of debt t: corporate income tax We: the weight of equity capital Ke: the cost of equity capital which is estimated by the capital asset pricing model (CaPm) in the CaPm, the rate of government bonds is utilized for the risk-free rate of return. c. Regression model: like the research by ali and nooredin (2010), this research also runs the linear monovariable re- gression model as follows: H1 testing models: retit = a + b.eVaadj.it + eit (model Y1) retit = a + b.eVanom.it + eit (model Y2) Where, retit is the annual rate of return on stock; eVaadj,it the economic value added adjusted for inflation, and eVanom,it the nominal economic value added. EVA P NOPAT P WACC x Capital pD DA 1 1,adj t t t t t t t t1 1= + + - + -- - Minimum Maximum Mean Standard Deviation Skewness Kurtosis EVAnom -2073.435 1306.537 -92.29 323.728 -2.542 14.408 EVAadj -1730.71 1084.411 -30.328 300.373 -1.944 11.247 RET -92.82% 508.41% 5.28% 0.8201 1.536 4.616 PRICE 5.8 340 42.258 44.022 2.718 10.117 OCF -607.881 3155.166 125.291 378.289 4.976 31.906 Table 2: Descriptive stat of variables NB: EVAnom, EVAadj and OCF are calculated in million dongs; PRICE in thousand dongs; and RET in percentage. Economic Development Review - December 2010 16 Inflation control in Vietnam H2 testing models: PriCeit = a + b.eVaadj.it+ eit (model Y3) PriCeit = a + b.eVanom.it+ eit (model Y4) Where PriCeit is the stock market value. H3 testing models: oCfi,t+1 = a + b.eVaadj.it+ eit (model Y5) oCfi,t+1 = a + b.eVanom.it+ eit (model Y6) Where oCfit is the operating cash flow. d. Model evaluation: this study is about to investigate the appropri- ateness of the nominal eVa and the adjusted eVa, and these two are the non-nested models ex- plaining the same dependent variable. Some re- cent model selection techniques have been developed and employed widespread, for example, Vuong test (1989), and the J-test by Davidson macKinno (1981), etc. this study utilizes the J- test via the r software to compare the significance of models. 4. Research results and remarks a. Results of testing H1 : the results of the estimation of the two models for H1 show that the r 2 values are not high. this means that the association between the nominal eVa and the rate of return on stock is as weak as that of the adjusted eVa. the J-test points out that the adjusted eVa is superior to the nominal eVa for the year 2008 when inflation rate and GDP deflator reaches 21.7% and 23.1% respec- tively. Table 3: The appropriateness of models in H1 Table 4: The J-test for models of H1 NB: Ŷ1 and Ŷ2 are the average estimation of Y1 and Y2 respectively b. Results of testing H2: in general, the r2 of models in H2 is higher than that in the H1. in other words, the stock market price reflects the business performance better than the rate of return on stocks. the J-test for H2 also produces the same results as H1, i.e. for the year 2008, the association between the stock market price and the adjusted eVa is stronger that of the nominal eVa. for the remain- der, there is not discrepancy in significance of the two models. Table 5: The appropriateness of models in H2 Table 6: The J-test for models of H2 NB: Ŷ3 and Ŷ4 are the average estimation of Y3 and Y4 respectively c. Results of testing H3: the r2 of models in H3 is quite high. thus, eVa can explain well the business performance as reflected by the operating cash flows. for the year 2007, even though the r2 of the adjusted eVa is much higher than that of the nominal eVa, the J-test has shown the unsubstantial discrepancy between them. for the remainder, the H3 is ac- cepted. Table 7: The appropriateness of models in H3 Years Model Y1 Model Y2 R2 P-value R2 P-value 2007 0.0564 0.0328 0.0702 0.0169 2008 0.0356 0.0375 0.0626 0.0055 2009 0.0531 0.0086 0.0486 0.0121 Years Y1 + Ŷ2 Y2 + Ŷ1 H1 results (P-value) (P-value) 2007 0.2534 0.6888 Rejected 2008 0.0301 0.2467 Accepted 2009 0.6768 0.3783 Rejected Years Model Y3 Model Y4 R2 P-value R2 P-value 2007 0.2418 0.0000 0.1720 0.0001 2008 0.0611 0.0060 0.2327 0.0000 2009 0.0125 0.2065 0.0063 0.3730 Years Y3 + Ŷ4 Y4 + Ŷ3 H2 results (P-value) (P-value) 2007 0.0952 0.0019 Rejected 2008 0.0000 0.3662 Accepted 2009 0.0468 0.0293 Rejected Years Model Y5 Model Y6 R2 P-value R2 P-value 2007 0.1107 0.0024 0.3069 0.0000 2008 0.0452 0.0187 0.4724 0.0000 2009 0.3096 0.0000 0.3407 0.0000 Economic Development Review - December 2010 17 Inflation control in Vietnam Table 8: The J-test for models of H3 NB: Ŷ5 and Ŷ6 are the average estimation of Y5 and Y6 respectively 5. Conclusion the estimation results show that when infla- tion rises, the adjusted eVa seems superior to the nominal eVa in estimating the business perform- ance. it is quite apparent for the year 2008 when inflation rose by over 21%, three hypotheses are entirely accepted by J-test. in the event that in- flation is at the mediocre level like in 2007 and 2009, the study does not show that the adjusted eVa is superior to the nominal eVa. the relation- ship between eVa and operating cash flows is stronger than that between the eVa and rate of return on stocks. result of the J-test is quite ap- propriate to the studies by Warr (2005) and De Villiers (1997). However, this result is contrary to findings by ali and nooredin (2010) which show that the nominal eVa is superior to the adjusted eVa. in a word, this study proves that the high in- flation will distort the nominal eVa; and utiliza- tion of an adjusted eVa must be requiredn References 1. Ali S. & A. Nooredin (2010), “Impact of Inflation on the Effectiveness of EVA: Evidence from Iranian Com- panies”, International Research Journal of Finance and Economics, Issue 37 2. Biddle, G. C., R. M. Bowen & J. S.Wallace (1997), “Does EVA Beat Earnings? Evidence on Associations with Stock Returns and Firm Values”, Journal of Account- ing & Economics, 24(3), 301 3. Davidson, R and J. G. MacKinnon (1982), “Some Non-Nested Hypothesis Tests and the Relations among them”, The Review of Economic Studies, XLIX, 1982, pp. 551-565 4. De Villiers, J. (1997) “The Distortions in Economic Value Added (EVA) Caused by Inflation”, Journal of Eco- nomics and Business, 49(3), 285 5. Tröôøng H. D. (2007), “Ñaùnh giaù giaù trò kinh teá gia taêng cuûa doanh nghieäp. Moät phöông thöùc quaûn trò ruûi ro taøi chính” (Estimating the economic value added – a measure of financial risk management), Nghieân cöùu & phaùt trieån. 6. Warr, S. R. (2005), “An Empirical Study of Inflation Distortions to EVA”, Journal of Economics and Business, 57(2), 119 Years Y5 + Ŷ6 Y5 + Ŷ6 H3 results (P-value) (P-value) 2007 0.0000 0.0000 Rejected 2008 0.0000 0.4795 Accepted 2009 0.0053 0.1606 Accepted Economic Development Review - December 2010 18 Inflation control in Vietnam