Economic Value Added - Assignment Example

There are two main types of financing for a business, debt and equity financing. When accountants calculate net income, they deduct the interest expense (which is the cost of the debt capital). However, the cost of equity is not taken into account. Therefore, the net income exaggerates the ‘true’ net income in economic terms. This flaw is overcome by the EVA method.A positive EVA indicates that value is being created i.e. value of the company increases by that amount. On the other hand, a negative EVA indicates that value is decreased and the company is now worth less than the initial capital employed (which is the assets from which earnings for the year are generated). (Russell) A value of zero means a sufficient achievement because shareholders have earned a return that just compensates for their risk.

Calculating EVAThe EVA method basically focuses on the effectiveness of management in a given year. The basic formula for calculating EVA is:EVA = NOPAT (Net Operating Profit after Taxes) – Financial requirements= NOPAT – (WACC * Operating Capital), where WACC is the weighted average cost of capital.From the formula above, we can see that EVA is the difference between the Operating Profit and Capital charge of both, debt and equity (i.e. the overall cost of capital). (Misra and Anil)The term “Operating Capital” used in the EVA formula on the last page accounts for the interest-bearing debt, preferred and the common stock used to acquire the company’s net operating assets.

In easy terms, it is the capital that was used to acquire net plant and equipment plus the net current assets.Another way of calculating the EVA is: EVA = (Operating capital) * (ROIC – WACC) i.e. a firm adds value if it’s ROIC – Return on Invested Capital is greater than the WACC – Weighted average Cost of Capital. However, if WACC goes beyond the ROIC, then new investments in the operating capital will actually reduce the firm’s value.Concluding remarksEVA is an estimate of a business’s true economic profit for the year, and if differs sharply for accounting profit.

Accounting profit is basically determined without imposing any charge for the cost of equity capital and is therefore an overstatement in economic terms. However, EVA determines the residual income after accounting for all the cost of capital (debt and equity both) and provides a much better performance measure to the stakeholders.