AccountingFinance

How To Calculate Economic Value Added (EVA)

Economic value added (EVA) is a variation of the RI (Residual Income) calculation. It (EVA) is generally the net profit less the opportunity cost of the organization’s capital. Economic value added is calculated i.e. after-tax operating income minus the product of (after-tax) weighted-average cost of capital and total assets minus current liabilities.

Economic value added (EVA)=After Tax Operating Income-[After Tax Weighted Avg. Cost of Capital* (Total Assets-Current Liabilities)]

EVA is net operating profit after taxes (or NOPAT) less a capital expenses which  is the product of the cost of capital and the economic capital. Where, NOPAT is the net operating profit after tax, with adjustments and translations, generally for the amortization of goodwill, the capitalization of brand advertising and other non-cash items.

NOPAT is profits derived from operations after cash taxes but before financing costs and non-cash journal entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm.

Financial measures such as return on investment and residual income measure the aspects of both managerial and organizational performance.  EVA is the net profit minus the opportunity cost of the firm’s capital.

Return on investment (ROI) is the product of two components: income divided by revenues (return on sales) and revenues divided by investment (investment turnover).

Return on investment formula is: 

ROI = (Income/Revenue) x (Revenue/Investment) 

          =Income/Investment

Managers can easily escalate ROI by simply escalating sales revenues, shrinking costs , and reducing unnecessary investment. But, ROI may tempt managers of highly profitable divisions,  to unwelcome projects that are in the firm’s best interest because accepting the project decreases divisional ROI which the manager would not like.

Residual income (RI) is income less a monetary amount of required return on  the investment.

RI=Income- (Investment*ROI)

RI is more likely than ROI to promote goal congruence. Evaluating managers on RI is also consistent with the use of discounted cash flow to choose long-term projects.

 

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