EVA – Economic Value Added

Economic Value Added (EVA)

EVA or Economic Profit is a measure based on the Residual Income technique that serves as an indicator of the profitability of projects undertaken and its underlying premise consists of the idea that real profitability occurs when additional wealth is created for the shareholders and that projects should create returns above their cost of capital.

 

EVA Formula

It adopts almost the same form as residual income and can be expressed as follows:

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

 

Calculating NOPAT

One key consideration for this item is the adjustment the cost of interest. The cost of interest is included in the finance charge (WACC*capital) that is deducted from NOPAT in the EVA calculation and can be approached in two ways:

  • Starting with operating profit, then deducting the adjusted tax charge (because tax charge includes the tax benefit of interest). Therefore, we should multiply the interest by the tax rate and add this to the tax charge, or
  • Start with profit after tax and adding back the net cost of interest. Therefore, we should multiply the interest charge by (1-tax rate)

 

 

Adjusting for Calculations in EVA

Accounting adjustments. Three main adjustments should be made, amongst the most common and important, are:

  • Expenditures on R&D, promotion and employee training should be capitalized.
  • Depreciation charge is added back to profit and instead, a charge for economic depreciation is made. This reflects the true change in value of assets during the period, unlike accounting depreciation
  • Accounts such as provisions, allowances for doubtful debts, deferred tax provisions and allowances for inventory should be added back to capital implied,
  • Non-cash expenses should be added back to profits and to capital employed
  • Operating leases should be capitalized and added back to capital employed
  • Tax charge will be based on cash taxes, rather the accruals based methods used in financial reporting and will be calculated as follows:

 

Tax charge per income statement – increase (or + if reduction) in deferred tax provision + tax benefit of interest = Cash taxes

 

 

Calculating Finance Charge

Capital invested * WACC
and WACC = Ke*E/ (E+D) + Kd (1-t)*D/ (E+D),
where Ke = required return on equity and Kd (1-t) = after tax return on debt

Thus, given the adjusted taxes, we can write the EVA formula as follows:

EVA = NOPLAT – (WACC * capital invested)      

 

 

The properties of using EVA can be compared with other approaches in the following table:

Valuation modelMeasureDiscount FactorComments
Enterprise discounted cash flowFree cash flowWACCWorks best for projects, business units and companies that manage their capital structure to a target level
Discounted economic ProfitEVAWACCExplicitly highlights when a company creates value
Adjusted present valueFree cash flowUnlevered cost of equityHighlights changing capital structure more easily than WACC-based models.

 

 

Example 1.  Calculating EVA for XX Company
201420152016
Capital invested (beginning of year) $ 54,236.00 $  50,323.00 $   55,979.00
xWACC8.22%8.28%8.37%
Finance Charge $   4,459.56  $    4,168.90  $     4,682.80
NOPLAT $   7,265.00 $    5,356.00 $     4,336.00
Finance Charge $   4,459.56 $    4,168.90 $     4,682.80
Economic Value Added $   2,805.44  $    1,187.10 -$        346.80

 

In conclusion, this measure highlights when does the company create value and is helpful to understand the company’s performance in a given year and to determine when value is created.