Economic Value Added (EVA) Concept
What is Economic Value Added (EVA) Concept?
Economic Value Added (EVA) is a new concept that is used by companies and their consultants as a performance measure. In generic terms ‘value-added’ refers to the additional or incremental value created by an activity or business venture.
Economic Value Added (EVA), or economic rent, is a widely recognized tool used to measure the efficiency with which a company has used its resources. In other words, EVA is the difference between the return achieved on resources invested and the cost of resources. Higher the EVA, the better the level of resource unitization.
EVA can be calculated as Net Operating Profit After Tax minus a charge for the opportunity cost of the capital invested. EVA is based on the idea that a company must cover both the operating costs and capital costs. EVA can be positive or negative. When EVA is negative how to improve and transform it into positive EVA is the concern of the managers.
EVA helps managers to fulfill the following two important objectives while making financial decisions.
- Maximizing the wealth of the shareholders.
- To improve the value of the company by earning excess profit over cost of capital
Therefore, the managers should put their efforts to improve the EVA continuously.
Economic Value Added is a financial measure of what ‘economists’ sometimes refer to as economic profit or economic rent, i.e., it measures the economic rather than the accounting profit created by a business. The difference between the economic profit and accounting profit is essentially the cost of equity capital. A finance manager does not deduct the cost of equity capital in the computation of profit. His/her job is to measure the earnings per share (EPS) to the shareholders. Whereas, an economist computes the earnings by charging all types of costs including the opportunity cost for the equity capital invested in the business. Thus, earnings (profits) for business from the finance manager’s viewpoint are different from that of the economist.
Economic value added in reality does not take into account whether the business is profitable, but it takes into account whether any earnings remain after considering the cost of all resources (including the opportunity cost for equity capital). The opportunity cost for equity capital means the cost that is incurred to compensate the equity shareholders at a market-determined rate of return. If the earnings of the business are able to meet this obligation and some earnings are left for the exclusive use of a business that ‘left over portion’ is called EVA which is ‘positive’. EVA is ‘negative’ if the earnings of the business are not capable of compensating the opportunity cost for equity shareholders. That means the business earnings (profits) are inadequate to compensate the equity capital at its required rate of return as determined by the market.
From the Economic Value Added (EVA) measurement viewpoint, all profitable businesses may not be capable of contributing to EVA (positive). If EVA is consistently negative, the investors may move their funds elsewhere as this company is not capable of generating adequate returns to them.
As every company is interested to know the psychology of their investors and try to retain them, EVA is gaining importance as a good measure.
How to Compute Economic Value Added (EVA)
The computation of Economic Value Added (EVA) is fairly easy. In the normal accounting practice, we subtract the financial charge in the form of interest on debt capital from EBIT to arrive at EBT. From the EBT, the tax on profit is deducted to arrive at EAT and then subtract the dividends payable to preference shareholders to arrive at the earnings (profits) available for distribution to equity shareholders. From these earnings (profits) we should subtract the financial charge (return on investment) to equity shareholders at the market-determined rate.
If the earnings are capable of absorbing fully this charge and some earnings are left in the business, then the leftover balance is treated as EVA (positive). If the market-determined rate of return is not fully absorbed by the earnings (profits) of the business, the unabsorbed portion is treated as EVA (negative). When Economic Value Added (EVA) is negative, the finance managers have to take measures to set right the situation, so that the company will have EVA (positive).
How to Transform Negative EVA into Positive EVA
- More revenue can be generated without using more capital but by improving operating profit margins or asset turnover ratios.
- By selling under-utilized assets, the capital invested in the business can be reduced which will have two-fold positive impact, i.e., it improves asset turnover ratio and reduces capital cost.
- By redeploying the capital invested to projects and activities that have higher operating performance compared to the existing projects and activities.
- By changing the capital structure, the advantage of positive leverage can be obtained, i.e., change the capital structure by substituting lower-cost debt for higher cost equity. Of course, this measure may cause a decrease in net earnings, but it will improve the EVA because the total cost of debt and cost of equity is reduced.
How Economic Value Added (EVA) Helps Financial Managers?
EVA as an economic measure helps financial managers to know the status of their profitability and takes necessary steps to improve the position if the EVA is nil or negative. If the EVA is positive, how to improve it further also is an interesting factor.
Benefits of EVA
- It is very simple and hence any person can understand the EVA concept.
- EVA figure is a powerful representation of corporate performance.
- It can be used as a powerful motivational and communication tool.
- The power of EVA is derived from its focus on shareholders’ value and its expression of performance as a relative term.
- EVA adapters tend to have greater asset dispositions and faster turns
According to Stern, Stewart & CO’s (the developers of Economic Value Added (EVA) concept) ‘Equity market values tend to be more highly correlated with annual EVA levels than with most other performance measures of return on equity, cash flow growth, EPS growth or growth in sales or capital’.
Limitations of EVA
- The major weakness is its single period focus, i.e., its value can be calculated only for a single period at a time.
- It cannot capture all the long-term implications of decision making.
- Very strict reliance on Economic Value Added (EVA) can distract the manager from other pertinent business
How Does EVA Work
In EVA calculation, the following three factors should be taken into account:
- Net operating profit after tax (NOPAT): This is nothing but the annual cash flow that is available to cover the cost of raising all equity and debt capital on an after tax basis.
- Economic book value (EBV) capital: This is an estimate of total capital utilized by an enterprise for a period including debt and equity.
- The enterprise’s cost of capital: This is the appropriate risk-adjusted rate applied to any one of the divisions or to the entity.
There is a need to effect adjustments to arrive at NOPAT and EBV. These adjustments are necessary to ensure the accurate figures which will form a base for calculations. According to Stern and Stewart & Co., there are over 160 and more different adjustments that can be made. The use of different types of adjustments, ‘which one to be used and where’ depends on the industry, technology and value creation process. If this tool is prudently used by the managers, the decisions would be more effective and result-oriented.
How to calculate Economic Value Added (EVA)?
There can be three approaches to EVA:
- Based on the Return on Asset which is calculated by using the formula:
EVA = NOPAT – Required Return on Assets
required Return on Assets = Assets Employed x cost of capital
- Based on capital structure theories which assume that the capital structure consists of only debt and equity and there is no corporate tax (generally this approach is followed).
- A new dimension can be attributed to calculate EVA by considering preference dividend also as financial charge.
Note: In case of approaches (2) and (3) the return to equity shareholders is based on the market-determined rate of return.
The new dimension is explained by using the following format:
Format for calculating Economic Value Added (EVA)
- EVA is positive, if the earnings available to shareholders are more than market determined rate of returns.
- EVA is Negative, if the earnings available to shareholders are less than the market determined rate of returns.
- EVA is Nil (undefined), if the earnings available to shareholders are equal to market determined rate of returns.
The EBIT of EREHWON Company is $50,000. Its capital structure consists of 50,000 equity shares of 10 each, 10,000 5% preference shares of $10 each, and 6% debentures to the extent of $400,000. The company comes under the tax bracket of 30%. The market rate of return on equity shares is 40%. Calculate EVA and comment.
Calculation of EVA for EREHWON Company
- EREHWON Company has been able to absorb the market rate of return to equity shareholders (40%) fully and there is excess earning left over after charging all costs including the opportunity cost of capital. Hence, this is not only a profitable company but also a thriving company with high prospects. Therefore, financial manager has no problem continuing with the same strategic operations.
- Had the earnings available to equity shareholders was less than the EVA would be negative or it was equal to $200,000, EVA would be undefined or NIL.
- If the EVA is either negative or undefined, the financial manager should think in terms of corrective measures to transform EVA to positive to make the company prosperous.