What is EVA?

Economic value added (EVA) is a measure of a 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. EVA can also be referred to as economic profit, and it
attempts to capture the true economic profit of a company.
EVA is the incremental difference in the rate of return over a
company's cost of capital. Essentially, it is used to measure the
value a company generates from funds invested into it. If a
company's EVA is negative, it means the company is not
generating value from the funds invested into the business.
Conversely, a positive EVA shows a company is producing value
from the funds invested in it.
EVA(Economic Value Added)
EVA was developed by a New York consulting firm, Stern Steward & Co. in 1982 to
promote value-maximizing behavior in corporate managers.

Value-based measure to evaluate business strategies, capital projects and to maximize

long-term shareholders wealth.
Implies the difference between net operating profits after taxes and total cost of funds

It offers a consistent approach to setting goals and measuring performance,

communicating with investors, evaluating strategies and allocating capital.

It is the measure that captures the true economic profit of the organization.

Maximizing EVA means the same as maximizing long-term yield on shareholders

investment.

Economic value added is also referred to aseconomic profit

Calculating EVA
EVA = NOPAT Capital Charge

where,
NOPAT = Net Operating Profit After Tax
Capital Charge = (WACC x Capital Employed)
Calculating Net Operating After
Tax
(NOPAT)
NOPAT is easy to calculate. From the income statement
we take the operating incomes and subtract taxes.
Amount
Particulars
(Rs.)
Sales 24,36,000/-
e.g. XYZ Company
Cost of Goods sold (-) 17,00,000/-
Gross Profit 7,36,000/-
Selling, general &
4,00,000/-
Admin Exp. (-)
Operating Profit 3,36,000/-
Taxes (-) 1,34,000/-
NOPAT 2,02,000/-
Cost of Capital
Meaning: The cost of capital is the rate of return
required by the shareholders and lenders to finance the
operations of the business.

Types of Cost of Capital

Equity Capital: Equity Capital is provided by the

Shareholders.

Borrowed Capital: It is the Capital borrowed by the

Weighted Average Cost of
Capital
(WACC)
Weighted Average Cost of Capital examines the various
components of the Capital structure and applies the
weighting factor of after-tax cost to determine the cost
of Capital.
Calculating WACC
Particulars Amount (Rs.)
Long Term Debt e.g. XYZ Company 5,00,000/-

Preferred Stockholders Equity 2,00,000/-

Total Common Equity 7,00,000/-

Total Capital 14,00,000/-

Long Term Debt
Bond Rs. 100/-

Net Return (Deducting discounting & Financing cost) Rs. 96/-

Interest 14% (Rs. 14/-)

Assumed Tax 35% (Rs. 5/-)

Interest After Tax (Rs.14 Rs. 5) 9%

Cost for Bond Financing (9/96 x 100) 9.47%
Preferred Stock Cost
Preference Share (Per share) Rs. 100/-

Net Revenue (Deducting discount & financing cost) Rs. 98/-

Dividend 11% (Rs. 11/-)

Cost for Preferred Share (11/98 x 100) 11.20%

Common Equity Cost
Share Price (Per Share) Rs. 100/-

Net Return (Less issuing cost) Rs. 85/-

EPS (Estimated by investors & reliable analyst) Rs. 12/-

Cost for Common Equity (12/85 x 100) 14.10%

Summarizing
Bond Cost 9.47%

Preferred Stock Cost 11.20%

Common Equity Cost 14.10%

Calculation of WACC
for XYZ Company
Amount Total
Particulars Cost (%)
(Rs.) (Rs.)
Long Term Debt 5,00,000/- 9.47 47,375/-
Preferred Stock Cost 2,00,000/- 11.2 22,400/-
Common Equity Cost 7,00,000/- 14.1 98,700/-
Total Capital 14,00,000/- - 1,68,475/-

The total Weighted Average Cost of Capital (WACC) =

1,68,478 / 14,00,000 = 12.03%
IMPORTANCE OF EVA
Economic Value Added (EVA) is important because it is used as an indicator
of how profitable company projects are and it therefore serves as a
reflection of management performance.
It succinctly summarizes how much and from where a company created
wealth.
It includes the balance sheet in the calculation and encourages managers
to think about assets as well as expenses in their decisions.
Economic value added asserts that businesses should create returns at a
rate above their cost of capital
The EVA calculation depends heavily on invested capital, and it is therefore
most applicable to asset-intensive companies that are generally stable.
EVA is more useful for auto manufacturers, for example, than software
companies or service companies with a lot of intangible assets.
Return on Investment (ROI)
Return on Investment (ROI) is the benefit to an investor resulting from an
investment of some resource.
As a performance measure, ROI is used to evaluate the efficiency of an investment
or to compare the efficiency of a number of different investments.
In purely economic terms, it is one way of considering profits in relation to capital
invested.
If the ROI is less than the rate of return on an alternative, risk-free investment such
as a bank savings account, the owner may be wiser to sell the instrument, put the
money in such a savings instrument, and avoid the daily struggles of small business
management.
Financial statements express only monetary aspects; businesses dont get reflected.
Thus ROI doesnt give a complete picture of the happenings in a business.
ROI leads to excessive focus on improving profitability and not wealth
maximization or shareholder value maximization, recognition, social
wealth etc.
Example
An investor buys $1,000 worth of stocks and sells the
shares two years later for $1,200. The net profit from
the investment would be $200 and the ROI would be
calculated as follows:
ROI= (Net Profit/ Cost ofInvestment)x100
ROI = (200 / 1,000) x 100 = 20%
Importance of ROI
ROI is one of the most used profitability ratios because
of its flexibility.
That being said, one of the downsides of the ROI
calculation is that it can be manipulated, so results may
vary between users.
By calculating ROI, you can better understand how well
your business is doing and which areas could use
improvement to help you achieve your goals.
How to use ROI
ROI calculation gives you numerous advantages. The first and most obvious? Knowing your
investments impact on your business. If you determine youre wasting money on an expense, its a
no-brainer that something needs to change. Many types of ROI can help you make important
business decisions, including but not limited to:

Purchasing a new tool: Adding new tools, equipment and products to your business can be a step in
the right direction, but they must be purchased wisely. Calculating the ROI on an equipment
purchase allows you to gauge how valuable your new tool is and what types of equipment to invest
in in the future.
Hiring new employees: Is your new employee increasing or decreasing your businesss profitability?
Tracking the return on investment of your employees will help you better understand which kinds of
people to hire (or fire).
Adding a new department: Just like hiring a new employee, adding a new department to your
business can be a smart move if it helps increase profits. You dont want to play a guessing game
here calculate return on investment to determine the profitability of your departments and identify
opportunities for expansion.
Sales strategies: Did a particular strategy help lead to a sale? Tracking which kinds of sales strategies
drive results will give you an idea of how to boost profitability for your business.

https://www.callrail.com/blog/importance-of-roi-why-it-matters-for-all-businesses/
Using EVA within a company
EVA can be used as a financial management system
that allows managers and employees to focus on how
capital is used and the cash flow generated from it.
There are two benefits from focusing on growth in EVA :
1) managements focus on primary responsibilities & 2)
distortions are reduced/eliminated

Performance measures of an
Investment center ROI v/s EVA
Point ROI EVA
Meaning ROI is the comparison of the EVA is the residual profit after
income generated with the assets taking into account the capital
employed. charge.

Calculation RoI is a ratio. Numerator is EVA is a value. It is found out by

income and denominator is assets subtracting capital charge from
employed. Profit after Tax.

Superiority Conceptually EVA is superior than Conceptually EVA is superior than

RoI
Popularity As per one survey carried by Vijay
Govindarajan of Fortune 1000
companies, RoI is more popular
than EVA
RoI
As per one survey carried by Vijay
Govindarajan of Fortune 1000
companies, RoI is more popular
than EVA

Simplicity of calculation RoI is comparatively easy to EVA is a bit difficult to calculate

calculate given the problems with
calculating the capital charge
Performance measures of an Investment
center Superiority of EVA over ROI

4 points
EVA offer same profit objective for comparable investments, unlike ROI which may make a
manager reluctant to accept lower ROI (20%) opportunities than the current ROI (30%) levels
despite being more than CoC (10%). ROI creates a bias towards little or no expansion in high-
profit business units while at the same time low-profit units are making investments at rates
of returns well below those rejected by high-profit units.
Units can increase ROI by actually decreasing its overall profits. This thing will not happen if
EVA is measured.
Different interest rates can be used for different types of assets. For more riskier assets,
higher rates of costs of capital can be used. With ROI this is not possible.
EVA as compared to ROI has a stronger positive correlation with changes in a companys
market value. To induce managers at the BU level to enhance shareholders value, managers
can be told to create and grow EVA.