Economic value added

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In corporate finance, Economic Value Added or EVA is an estimate of a firm's economic profit - being the value created in excess of the required return of the company's shareholders - where EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that shareholders gain when the return from the capital employed is greater than the cost of that capital; see Corporate finance: working capital management. This amount can be determined, among other ways, by making adjustments to GAAP accounting, including deducting the opportunity cost of equity capital.

Contents

Calculating EVA

EVA is Net Operating Profit After Taxes (or NOPAT) less the money cost of capital. Any value obtained by employees of the company is not included in the calculations. The basic formula is:

 \mathit{EVA} \ = \  ( r - c ) \cdot K   \ = \  \mathit{NOPAT} -  c \cdot K

where:

EVA Calculation

EVA = (r-c) x Capital

EVA = (r x Capital) – (c x Capital)

EVA = NOPAT - c x Capital

EVA = operating profits – a capital charge

where:

             r = rate of return, and
             c = cost of capital, or the weighted average cost of capital.

NOPAT is profits derived from a company’s operations after taxes but before financing costs and noncash-bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm.

Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less noninterest-bearing current liabilities.

Capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested.

The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk.

Another perspective on EVA can be gained by looking at a firm’s Return on Net Assets (RONA). RONA is a ratio that is calculated by dividing a firm’s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system.

EVA = (Net Investments)(RONA – Required minimum return)

If RONA is above the threshold rate, EVA is positive.

Comparison with other approaches

Other approaches along similar lines include Residual Income (RI) and Residual Cash Flow. Although EVA is similar to Residual Income, under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual Cash Flow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital); at the same time, the adjustments to NOPAT are unique to EVA.

Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of "profit", the utility of having a separate and more precisely defined term such as EVA is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while actually approaching insolvency.

Other measures of shareholder value include:

Relationship to Market Value Added

The firm's market value added, or MVA, is the discounted sum of all future expected economic value added:

MVA = V - K_0 = \sum_{t=1}^{\infty} { EVA_t \over (1+c)^t }

Note that MVA = NPV of EVA.

See also

References

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