Definition
Economic Value Added (EVA) is a measure of a company’s financial performance that reflects the value created over a specific period. It is derived by calculating the net operating profit after taxes and subtracting the cost of capital employed in the business. Essentially, EVA highlights the true economic profit of a business by factoring in the cost of capital, thereby providing a clear picture of whether the company is truly generating value beyond its capital costs.
Examples
-
Example 1: Company A
- Net Operating Profit After Taxes (NOPAT): $500,000
- Capital Employed: $2,000,000
- Cost of Capital: 10%
- EVA = NOPAT - (Capital Employed * Cost of Capital)
- EVA = $500,000 - ($2,000,000 * 0.10)
- EVA = $500,000 - $200,000
- EVA = $300,000
- Result: Company A created an additional value of $300,000.
-
Example 2: Company B
- Net Operating Profit After Taxes (NOPAT): $100,000
- Capital Employed: $1,000,000
- Cost of Capital: 8%
- EVA = NOPAT - (Capital Employed * Cost of Capital)
- EVA = $100,000 - ($1,000,000 * 0.08)
- EVA = $100,000 - $80,000
- EVA = $20,000
- Result: Company B generated a positive EVA, meaning it created $20,000 of value above the cost of capital.
Frequently Asked Questions (FAQs)
What is the purpose of using EVA as a performance measure?
EVA is used to assess whether a company is generating sufficient profits to cover its cost of capital. It helps in identifying the true economic profit and whether the business is creating value for its shareholders.
How is EVA different from net profit?
While net profit only accounts for the operating expenses, EVA includes the cost of capital, providing a more comprehensive measure of true economic profitability.
How can EVA be improved?
EVA can be improved by increasing net operating profit or reducing the cost of capital. Efficient capital allocation, cost reduction, and revenue enhancement are typical strategies to boost EVA.
Why is the cost of capital important in EVA calculation?
The cost of capital represents the return expected by investors for providing capital. Subtracting this cost ensures that EVA reflects the actual profit generated after compensating investors adequately.
Related Terms
Net Operating Profit After Taxes (NOPAT)
The profit a company generates from its operations after accounting for taxes, excluding any financing costs.
Cost of Capital
The return rate that investors expect on the capital provided for a business. It often includes both debt and equity costs.
Residual Income
Another financial metric similar to EVA, highlighting the net income after deducting the opportunity cost of capital.
Online References to Online Resources
- Investopedia on Economic Value Added (EVA)
- Corporate Finance Institute (CFI) on EVA
- Harvard Business Review on Performance Measurement: EVA
Suggested Books for Further Studies
-
“Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company Inc. This book provides detailed methods for valuing companies with practical applications, including the concept of EVA.
-
“Creating Shareholder Value: A Guide for Managers and Investors” by Alfred Rappaport This book offers insights on how to create shareholder value, with chapters dedicated to understanding and applying EVA.
-
“The EVA Challenge: Implementing Value-Added Change in an Organization” by Joel M. Stern and John S. Shiely A deep dive into EVA implementation in businesses, authored by the pioneers who registered EVA as a trademark.
Accounting Basics: “Economic Value Added (EVA)” Fundamentals Quiz
Thank you for further exploring the term “Economic Value Added (EVA)” through a comprehensive lexicon and a challenging examination. Keep striving for excellence in your financial knowledge!
