Economic Value Added

In finance, economic value added ((EVA®)) measures the true economic profit of a company for a period determined after taking into account the opportunity cost of both debt and equity capital. It equals net operating profit after tax (NOPAT) minus average dollar cost of capital employed.

Accounting profit is determined by subtracting only the cost of debt capital (i.e. interest) from a company's earnings before interest and taxes (EBIT). But a company's shareholders are interested in finding whether the company earned anything in excess of their required rate of return. Economic value added subtracts a charge for both cost of debt and cost of equity to tell us whether the company has generated any wealth for its owners.

Economic value added is also useful in departmental performance evaluation. It is similar in concept to the economic profit and residual income.

If economic value added (EVA) for a period is positive, it means the management has increased the company's total worth. On the other hand, if the economic value added is negative it means that the cost of capital employed is greater than the profit generated by the company and this means a decline in the company's value over the period.

Formula

Economic value added can be computed using the following formula:

Economic Value Added (EVA) = NOPAT − WACC × Operating Capital

Where NOPAT stands for net operating profit after taxes and it is calculated as follows:

NOPAT = Operating Income × (1 - Tax Rate)

WACC stands for the weighted-average cost of capital and it is a composite measure of a company's cost of capital from both debt and equity. It is calculated by weighing cost of each component of capital based on its share in the company's capital structure.

Operating capital is the total net operating capital of a company.

Economic value added can also be computed using the following formula:

Economic Value Added = Operating Capital × (ROI − WACC)

Where ROI is the return on invested capital.

Example

Stark Industries' earnings before interest and taxes for the financial year 2011 amounted to $5,130 million. Applicable tax rate is 35%. 60% of the company's assets are financed by debt which has an after tax cost of 3.8%, while 40% is financed by equity with a cost of 9.8%. Stark Industries average total capital employed over the period amounted to $50,420 million. Find Stark Industries' economic value added.

Economic Value Added = NOPAT − WACC × Capital Employed

NOPAT = EBIT × (1 − Tax Rate) = $5,130 million × (1 − 35%) = $3,334 million

WACC = 0.6 × 3.8% + 0.4 × 9.8% = 6.2%

Economic Value Added = $3,334 million − 6.2% × $50,420 = $208 million

This tells us that over the financial year 2011, Stark Industries added a total of $208 million to its value.

by Obaidullah Jan, ACA, CFA and last modified on

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