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Economic value added is a measure of surplus value created on a given investment. When a person is
investing his funds, he does this only because he expects to earn a profit from the investment. Let us
say, gold seems to be a good instrument to invest with a high profit margin.
Economic Value Added = Selling price – Expenses associated with selling the asset – Purchase
price – Expenses associated with buying the asset
If we just see the profit, then the profit on selling gold was $ 1200 – $ 1000 i.e. $ 200. But the actual
creation of wealth is only $ 175 on account of expenses incurred. This is a very crude example of
Economic Value Added (EVA).
#3 – Calculate WACC
Economic value added (EVA) is the economic profit by the company in a given period. It measures the
company’s financial performance based on the residual wealth calculated by deducting its cost of capital
from its operating profit, adjusted for taxes on a cash basis.
It helps to capture the true economic profit of a company like we calculated the Economic Value Added
of investing gold in the above . Economic Value Added example was developed and trademarked by
Stern Stewart and Co. as an internal financial performance measure.
2. Capital Invested
Economic Value Added can be calculated with the help of the following formula:
Economic Value Added EVA formula= Net Operating Profit After Tax – (Capital Invested x WACC)
Here, Capital Invested x WACC stands for the cost of capital. This cost is deducted from the Net
Operating Profit After Tax to arrive at the economic profit or the residual wealth created by the
organization.
This represents how much will be the company’s potential cash earnings without its capital cost. It is
important to deduct tax from the Operating Profit to arrive at the true operating inflow that a company
will earn.
EVA Example for calculating Net Operating Income After Tax is as follows:
ABC Company
Year
Particulars
2016 2015
Revenue:
This represents the total capital invested through equity or debt in a given company.
Continuing with the above EVA example of ABC Company, let us say the company has a total invested
capital of $ 30,000. Of this $ 20,000 is through equity funding and the rest ($ 10,000) is by means of long
term debt.
Weighted Average Cost of Capital is the cost the company incurs for sourcing its funds. The importance
of deducting the cost of capital from the Net Operating Profit is to deduct the opportunity cost of the
capital invested. Formula to calculate the same is as follows:
The formula looks complicated scary but if understood, it is fairly simple. It is much more easier if the
formula is put in words as follows:
Weighted Average Cost of Capital = (Cost of Debt) * (1 – Tax Rate) * (Proportion of debt) + (Cost of
Equity) * (Proportion of equity)
Tc = Tax Rate
RE = Cost of Equity
An important point to note about this formula is that that Cost of Debt is multiplied by (1 – Tax Rate) as
there is tax saving on interest paid on debt. On the other hand, there is no tax saving on the cost of
equity and hence the tax rate is not taken into account.
ABC Company
Year
Particulars
2016 2015
From the above, we have all three factors ready for Economic Value Added calculation for the year 2016
and 2015.
Economic Value Added (EVA) for the year 2016 = Net Operating Profit After Tax – (Capital Invested *
WACC)
Economic Value Added (EVA) for the year 2015 = Net Operating Profit After Tax – (Capital Invested *
WACC)
Now since we have understood the basics of EVA calculation, let us go a bit further to understand what
can be some of the real-life accounting adjustments involved especially at the Operating Profit level:
The operating profit above does contain noncash items like Depreciation and Amortization,
Restructuring costs etc.
In our EVA example, we assume that the book depreciation and economic depreciation are same for
Colgate and hence, no adjustment is needed when we calculated NOPAT.
However, restructuring cost needs to be adjusted for. Below is the snapshot of Colgate’s restructuring
costs from its 10K filings.
Adjusted Operating Profit (2016) = $3,837 million + $228 million = $4,065 million
We can calculate the effecitve tax rates from income statement as per below.
<img class="alignnone size-full wp-image-25687" src="https://cdn.wallstreetmojo.com/wp-
content/uploads/2017/09/Colgate-WACC-Calculation-Step-5.png" alt="Colgate WACC Calculation - Step
5" width="866" height="249" srcset="https://cdn.wallstreetmojo.com/wp-
content/uploads/2017/09/Colgate-WACC-Calculation-Step-5.png 866w,
https://www.wallstreetmojo.com/wp-content/uploads/2017/09/Colgate-WACC-Calculation-Step-5-
300x86.png 300w, https://www.wallstreetmojo.com/wp-content/uploads/2017/09/Colgate-WACC-
Calculation-Step-5-768x221.png 768w" sizes="(max-width: 866px) 100vw, 866px" />
Effective Tax rate = Provision for Income Taxes / Income Before income taxes
Let us now calculate the second item required for calculating Economic Value Added i.e. Invested
Capital.
<img class="alignnone size-full wp-image-25680" src="https://cdn.wallstreetmojo.com/wp-
content/uploads/2017/09/Colgate-EVA-Invested-Capital.png" alt="Colgate EVA Invested Capital"
width="857" height="473" srcset="https://cdn.wallstreetmojo.com/wp-
content/uploads/2017/09/Colgate-EVA-Invested-Capital.png 857w,
https://www.wallstreetmojo.com/wp-content/uploads/2017/09/Colgate-EVA-Invested-Capital-
300x166.png 300w, https://www.wallstreetmojo.com/wp-content/uploads/2017/09/Colgate-EVA-
Invested-Capital-768x424.png 768w" sizes="(max-width: 857px) 100vw, 857px" />
Invested capital represents the actual debt and equity invested in the company.
Total Debt = Notes and Loan Payable + Current Portion of Long-Term Debt + Long Term Debt
Adjusted Equity = Colgate Shareholders Equity + Net Deferred tax + Non Controlling Interest +
Accumulated Other comprehensive (income) loss
Colgate’s Invested Capital (2016) = $6,533 million + $4,252 million = $10,785 million
Current Market Price of Colgate = $72.48 (as of closing 15th September, 2017)
Total Debt = Notes and Loan Payable + Current Portion of Long-Term Debt + Long Term Debt
Let us now find the cost of equity of Colgate using CAPM model
source – bankrate.com
source – stern.nyu.edu
Let us look at the Beta of Colgate. We note that Colgate’s Beta has increased over the years. It is
currently 0.805
source: ycharts
WACC = 6.63%
Economic Value Added formula= Net Operating Profit After Tax – (Capital Invested x WACC)
Colgate’s Invested Capital (2016) = $6,533 million + $4,252 million = $10,785 million
The very basic objective of every business is to maximize the shareholder value. The investor is the key
stakeholder around which all business activities are focused.
The key factors which are important while maximizing shareholder value are:
Organizations tend to focus on profits and ignore the cash flow. This often leads to a liquidity
crunch and can also lead to bankruptcy. Economic Value Added (EVA) focuses on cash flows
more than profits.
By taking the Weighted Average Cost of Capital, it takes into account both short-term as well as
long-term perspectives.
Like any other financial ratio/indicator, even Economic Value Added (EVA) has its own sets of
advantages and disadvantages. Let us have a look at the basic pointers for the same.
1. As discussed above, it helps to give a clear picture about wealth creation as compared to other
financial measures used for analysis. It takes into account all costs including the opportunity cost
of equity and it does not stick to accounting profits.
3. EVA can also be calculated for different divisions, projects, etc. and the appropriate investment
decisions can be taken for the same
4. It also helps to develop a relationship between the use of capital and Net Operating Profit. This
can be analyzed to make the most out of opportunities and also make appropriate
improvements, wherever necessary.
1. There are a lot of assumptions involved in calculating the Weighted Average Cost of Capital. It is
not easy to calculate the cost of equity which is a key aspect of WACC. On account of this, there
are chances that EVA itself can be perceived to be different for the same organization and for
the same period as well. In the above Economic Value Added example, the cost of equity has
changed from the year 2015 to the year 2016. This can be one of the major factors due to a
decrease in EVA.
2. Apart from the WACC, there are other adjustments also which are required to the Net Operating
Profit After Tax. All non-cash expenses need to be adjusted for. This becomes difficult in case of
an organization with multiple business units and subsidiaries.
3. Comparative analysis is difficult with Economic Value Added (EVA) on account of the underlying
assumptions of WACC.