Economic Value Added (EVA)

The economic value added (EVA) is a more precise version of the residual income (RI).

The residual income computes for the excess of the income earned over the desired income.

When calculating for the EVA, the after-tax operating income is used instead of simply operating income, and current liabilities are deducted from total assets in the computation of desired income.

Economic Value Added (EVA) Formula

The formula in computing for the economic value added is:

EVA = After-tax operating income - Desired income

where:
After-tax operating income = Operating income x (1 - Tax rate)
Desired income = Minimum required rate of return x (Assets - Current liabilities)

Note: In most cases, the minimum required rate of return is equal to the cost of capital. The average of the assets and average of current liabilities are used when possible.

Example: Computation of EVA

Compute for the economic value added of an investment center which had operating income of $380,000, average operating assets of $1,200,000, and average current liabilities of $300,000. The cost of capital is 12%. The company is subject to 40% taxes.

After-tax operating income = Operating income x (1 - Tax rate)
  = $380,000 x (1 - 40%)
After-tax operating income = $228,000
Desired income = Minimum ROR x (Operating assets - Current liabilities)
  = 12% x ($1,200,000 - 300,000)
Desired income = $108,000
EVA = After-tax operating income - Desired income
  = $228,000 - $108,000
EVA = $120,000

The subunit made $120,000 after-tax income above its desired or minimum income. The higher the economic value added, the better.

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