## Monday, December 8, 2008

### Economic Value Added (EVA)

This is a follow-up to my earlier post: What's Your Profit? I recommend reading that post first to understand the nuts and bolts of Economic Value Added (EVA).

EVA (or economic profit) is found by taking the net operating profit after taxes (NOPAT) for a particular period (such as a year) and subtracting the annual cost of ALL the capital a firm uses. EVA recognizes all capital costs, including the opportunity cost of the shareholder funds.
EVA Example: This example illustrates how a company's economic profit differs from its accounting profit. It also explains application of EVA in calculating "true" profitability of business.
Let us review the formula for EVA:
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EVA = NOPAT - After Tax Cost of Total Capital
= EBIT (1- Tax Rate) - (Total Capital) (After Tax cost of capital)
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Total capital used here is total assets minus current liabilities. Hence, it is long term liabilities plus equity (preferred stock and common stock)

Say, a company with \$100,000 in equity capital (stated at fair value)and \$100,000 in 8% debt (also at fair value) had \$60,000 in earnings before interest and taxes (EBIT). Assume that \$200,000 equals capital employed. The corporate tax rate is 40%. Company's weighted average after-tax cost of capital is 14%.

EBIT =\$60,000
- Taxes (40% x 60,000) = (\$24,000)
NOPAT= \$36,000
- Capital Charge (14% x 200,000) = (\$28,000)
EVA = \$ 8,000
The company's traditional income statement reports income of \$31,200 calculated as follows:
EBIT =\$60,000
- Interest (8% x 100,000) = (\$8,000)
Income Before Taxes= \$52,000
- Income Taxes (40% x 52,000) = (\$20,800)
Net Income After Tax = \$31,200
Initially a 31.2% return on equity (\$31,200 or net income/ \$100,000 of equity capital) seems favourable, but WHAT IS THE COST OF THAT EQUITY CAPITAL?
Given equal amounts of debt and equity, the cost of equity capital is calculated as follows:
14% = (1/2)(4.8%)+"X"(1/2) : after-tax cost of debt capital =8% (1.0-40%)=4.8%
=>Cost of equity capital ("X") = 23.2%
Thus, \$23,200 of \$31,200 of net income is nothing more than the opportunity cost of equity capital. The \$8,000 (31,000 - 23,000) of EVA is the only portion of earnings that has created real value for shareholders. Accordingly, if net income after tax had been only \$20,000 (a 20% return on equity), shareholder value would have been reduced because cost of equity capital exceeded returns.
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