How to calculate Economic Value Added (EVA) :
Note that, as in the traditional computation of earnings, interest on debt capital is subtracted from operating earnings (earnings before interest and taxes (EBIT)) to obtain net income Then, an opportunity cost on equity capital is subtracted to obtain EVA. The opportunity cost on equity capital is computed as the equity or net worth of the business times a rate of return that reflects the rate required by investors in the business. This required rate is in reality an opportunity cost measured by the rate of return that could be obtained on equity funds if they were invested elsewhere. A positive EVA means the firm is generating a return to invested capital that exceeds the direct (i.e. interest) and opportunity cost of that invested capital; a negative EVA means that the firm did not generate a sufficient return to cover the cost of its debt and equity capital.
The under given tables gives a view for how to calculate ‘Economic Value Added (EVA)’
| Earnings before Interest and Taxes (EBIT) | xxx |
| Less : Interest | xxx |
| Net Income | xxx |
| Less : Cost of Equity Capital | xxx |
| Economic Value Added (EVA) | xxx |
Expressed as a formula:
EVA = “Net Operating Profit after Taxes” – (Equity Capital X % Cost of Equity Capital).
Illustration
Balance Sheet of ABC Limited
as at 31st March, 2012
I. EQUITY AND LIABILITIES Rs.
| 1. Shareholder’s Funds | |
| Equity | 40,00,000 |
| 2. Non-Current Liabilities | |
| Long Term Debt | 60,00,000 |
| 3. Current Liabilities | |
| (a) Account Payables | 2,08,000 |
| (b) Bank Overdrafts | 4,84,000 |
| TOTAL | 1,06,92,000 |
| II ASSETS | |
| 1. Non-current assets | |
| (a) Fixed Assets | 1,00,00,000 |
| 2. Current Assets | |
| (a) Inventories | |
| (i) Raw Material | 86,400 |
| (ii) Finished Goods | 1,71,360 |
| (b) Account receivable | 4,29,300 |
| (c) Cash | 4,940 |
| TOTAL | 1,06,92,000 |
Statement of Profit of ABC Limited
| Sales | 28,62,000 |
| Less: Operating Expenses | 11,48,400 |
| EBIT | 17,13,600 |
| Less: Tax Expenses | 6,85,440 |
| NOPAT | 10,28,160 |
The average rate of return on similar types of companies is 20% while risk free return is 12.5%. Rate of return as charged by bank is 18% and the tax rate is 40%. .
Calculate Economic Value Added.
Solution
Step 1: Calculation of Capital Employed
| Equity | 40, 00,000 |
| Long Term Debt | 60, 00,000 |
| Bank Overdrafts | 4,84,000 |
| Total capital employed | 1,04,84,000 |
Step 2: Calculation of Weighted Average Cost of Capital (WACC
| Amount | Expected Return |
| Equity | 40,00,000 | 8,00,000 |
| Long Term Debt | 60,00,000 | 4,50,000 |
| Bank Overdrafts | 4,84,000 | 52,272 |
| Total capital employed | 1,04,84,000 | 13,02,272 |
WACC = 13,02,272/1,04,84,000
= 12.42%
Step 3:
Economic Value Added = NOPAT – Weighted average cost of capital* Capital Employed
= Rs.10,28,160 – Rs.13,02,272
= Rs.2,74,112
What insight does EVA provide about financial performance of a business?
First, like any financial measure, the trend may be more valuable than the absolute value of EVA. Even if EVA is positive, a declining EVA suggests that financial performance is deteriorating over time, and if this trend continues EVA will become negative and financial performance unacceptable. A negative EVA indicates that the firm is not compensating its capital resources adequately, and corrective action should be considered if this negative EVA persists over time.