Monday, June 16

Economic Value Added (EVA)

Economic Value Added (EVA) is another sophisticated modification of cash flow that looks at the cost of capital and the incremental return above that cost as a way of separating businesses that truly generate cash from ones that just eat it up.

EVA is the financial performance measure that captures the true economic profit of an enterprise. It is also directly linked to the creation of shareholders wealth over time. Economic profit is NOPAT minus a capital charge, which represents a sort of rental fee charged to the company for its use of capital. In other words, economic profit is the profits (or returns) our company must generate in order to satisfy the lenders and shareholders who have "rented" capital to the company. Keep in mind that economic profit is a period metric, like earnings or cash flow.

EVA = Net Operating Profit After Tax – (Capital Employed x Cost of Capital)

Net Operating Profit After Tax (NOPAT) is calculated as follows:
Net profit available to Equity Shareholders
Add: Interest Expense (1 - Tax rate)
Add: Preferred Dividends
Add: Minority Interest
Add: Amortisation of Goodwill
Add: Non recurring (unusual) losses or expenses
Less: Non recurring (unusual) gains

Capital Employed is calculated as follows:
Book Value of Equity
Add: Debt
Add: Preferred Stock
Add: Minority Interest
Add: Equity Equivalents

Getting to Invested Capital or Capital Employed, we use the following three-step method:
1. Get invested book capital from the balance sheet. (Total assets – Current Liabilities)
2. Make adjustments that convert accounting accruals to cash. (Eg. Add Provision for Bad Debts)
3. Make adjustments that recognize off-balance-sheet sources of funds. (Eg. Add PV of Operating leases and Capitalised expenses)

Getting to the Cost of Capital involves the following steps.
Calculate Cost of Equity using CAPM viz. Re = Rf + (Rm - Rf) x Beta
Calculate After Tax Cost of Debt viz. Kd = Cost of Debt x (1-tax Rate)
Calculate Weighted Average Cost of Capital based on the weights of Debt and Equity.
WACC = [ E / ( E + D ) x R e ] + [ D / ( E + D ) x K d ( 1 - t ) ]

A simplistic example of calculation of EVA would be:

EBIT = Rs 5 million
Tax rate = 40%
WACC = 12%
Debt = 10 million
Equity = 10 million

EVA = [EBIT x (1 - Tax Rate)] - [WACC x Capital Employed]
EVA = [5 x ( 1 - 0.40)] - [0.12 x (10 + 10)]
EVA = 3.0 - 2.4
EVA = 0.6 million

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