Economic value added (EVA) is a financial measurement of the return earned by a firm that is in excess of the amount that the company needs to earn to appease shareholders. In other words, it is a measure of an organization’s economic profit that takes into account the opportunity cost of invested capital and ultimately measures whether organizational value was created or lost.
EVA compares the rate of return on invested capital with the opportunity cost of investing elsewhere. This is important for businesses to keep track of, particularly those businesses that are capital intensive. When calculating economic value added, a positive outcome means that the company is creating value with its capital investments.
Conversely, a negative outcome would mean that the company is destroying value with its capital investments and the capital would be better spent elsewhere. Businesses can use economic value added to assess managerial performance as it serves as a measure of value creation for shareholders.
The EVA formula is calculated using the following equation:
EVA = NOPAT – (Capital x Cost of Capital)
EVA = NOPAT – (WACC * capital invested)
Where NOPAT = Net Operating Profits After Tax
WACC = Weighted Average Cost of Capital
Capital invested = Equity + long-term debt at the beginning of the period
and (WACC* capital invested) is also known as finance charge
Components of EVA:
These three components of EVA are described below:
NOPAT is defined as follows:
(Profits before interest and taxes) (1- tax rate)
(ii) Cost of capital:
Providers of capital (shareholders and lenders) want to be suitably compensated for investing capital in the firm. The cost of capital reflects what they expect.
The formula employed for estimating cost of capital is:
Cost of capital = (Cost of equity) (Proportion of equity in the capital employed) + (Cost of preference) (Proportion of preference in the capital employed) + (Pre-tax cost of debt) (1- tax rate) (Proportion of debt in the capital employed)
(iii) Capital employed:
To obtain capital employed, we have to make adjustments to the ‘accounting’ balance sheet to derive the ‘economic book value’ balance sheet. These adjustments are meant to reflect the economic value of assets in place of value determined by historical cost.
Paul is the CFO of an organization in Boston. In order to assess the organization’s value creation or destruction, Paul would like to calculate economic value added for 2015. The organization’s NOPAT is $3,500,000, cost of capital is 5%, and the organization employed 1,000,000 in capital in 2015.
By plugging the values into the EVA calculation above, we can compute the value that Paul needs:
$3,500,000 – ( 1,000,000 x 5% ) = $3,450,000
Paul’s organization had a total added value amount of $3,450,000 in 2015.
Advantages of EVA:
(i) EVA is a tool which helps to focus managers’ attention on the impact of their decisions in increasing shareholders’ wealth.
(ii) EVA is a good guide for investors; as on the bias of EVA, they can decide whether a particular company is worth investing money in or not.
(iii) EVA can be used as a basis for valuation of goodwill and shares.
(iv) EVA is a good controlling device in a decentralised enterprise. Management can apply EVA to find out EVA contribution of each decentralised unit or segment of the company.
(v) EVA linked compensation schemes (for both operatives and managers) can be developed towards protecting (or rather improving) shareholders’ wealth.