Economic Value Added

Economic value added is the incremental difference in the rate of return over a company's cost of
capital. In essence, it is the value generated from funds invested in a business. If the economic value
added measurement turns out to be negative, this means a business is destroying value on the funds
invested in it. It is essential to review all of the components of this measurement to see which areas of
a business can be adjusted to create a higher level of economic value added. If the total economic
value added remains negative, the business should be shut down.
To calculate economic value added, determine the difference between the actual rate of return on
assets and the cost of capital, and multiply this difference by the net investment in the business.
Additional details regarding the calculation are:
Eliminate any unusual income items from net income that do not relate to ongoing operational

results.

The net investment in the business should be the net book value of all fixed assets, assuming
that straight-line depreciation is used.

The expenses for training and R&D should be considered part of the investment in the
business.

The fair value of leased assets should be included in the investment figure.

If the calculation is being derived for individual business units, the allocation of costs to each
business unit is likely to involve extensive arguing, since the outcome will affect the calculation for
each business unit.
The formula for economic value added is:
(Net investment) x (Actual return on investment Percentage cost of capital)
For example, the president of the Hegemony Toy Company has just returned from a management
seminar in which the benefits of economic value added have been trumpeted. He wants to know what
the calculation would be for Hegemony, and asks his financial analyst to find out.
The financial analyst knows that the company's cost of capital is 12.5%, having recently calculated it
from the company's mix of debt, preferred stock, and common stock. He then reconfigures
information from the income statement and balance sheet into the following matrix, where some
expense line items are instead treated as investments.
Account Description

Performance

Net Investment

Revenue

$6,050,000

Cost of goods sold

4,000,000

General & administrative

660,000

Sales department

505,000

Training department

$75,000

Research & development

230,000

Marketing department

240,000

Net income

$645,000

Fixed assets

3,100,000

Cost of patent protection

82,000

Cost of trademark protection

145,000

Total net investment

$3,632,000

The return on investment for Hegemony is 17.8%, using the information from the preceding matrix.
The calculation is $645,000 of net income divided by $3,632,000 of net investment. Finally, he
includes the return on investment, cost of capital, and net investment into the following calculation to
derive the economic value added:
($3,632,000 Net investment) x (17.8% Actual return 12.5% Cost of capital)
= $3,632,000 Net investment x 5.3%
= $192,496 Economic value added
Thus, the company is generating a healthy economic value on the funds invested in it.
The measurement has benefited from the marketing efforts of consulting firms that want to install an
economic value added measurement system; whether the metric will have standing over the long term
is difficult to say.

Advantages of EVA
1. EVA is closely related to NPV. It is closest in spirit to corporate finance theory that
argues that the value of the firm will increase if you take positive NPV projects.
2. It avoids the problems associates with approaches that focus on percentage spreads
- between ROE and Cost of Equity and ROC and Cost of Capital. These approaches
may lead firms with high ROE and ROC to turn away good projects to avoid lowering
their percentage spreads.

3. It makes top managers responsible for a measure that they have more control over the return on capital and the cost of capital are affected by their decisions - rather than
one that they feel they cannot control as well - the market price per share.
4. It is influenced by all of the decisions that managers have to make within a firm the investment decisions and dividend decisions affect the return on capital (the
dividend decisions affect it indirectly through the cash balance) and the financing
decision affects the cost of capital.
When focusing on year-to-year EVA changes has least side effects
1. Most or all of the assets of the firm are already in place; i.e, very little or none of
the value of the firm is expected to come from future growth.
[This minimizes the risk that increases in current EVA come at the expense of future
EVA]
2. The leverage is stable and the cost of capital cannot be altered easily by the
investment decisions made by the firm.
[This minimizes the risk that the higher EVA is accompanied by an increase in the cost
of capital]
3. The firm is in a sector where investors anticipate little or not surplus returns; i.e.,
firms in this sector are expected to earn their cost of capital.
[This minimizes the risk that the increase in EVA is less than what the market
expected it to be, leading to a drop in the market price.]
When focusing on year-to-year EVA changes can be dangerous
1. High growth firms, where the bulk of the value can be attributed to future
growth.
2. Firms where neither the leverage not the risk profile of the firm is stable, and
can be changed by actions taken by the firm.
3. Firms where the current market value has imputed in it expectations of
significant surplus value or excess return projects in the future.

 Note that all of these problems can be avoided if we restate the objective as
maximizing the present value of EVA over time. If we do so, however, some of
the perceived advantages of EVA - its simplicity and observability - disappear.