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Economic Value Added (EVA)

Introduction

The economic value added (EVA) shows the incremental value generated from the cost of total invested funds. It is actually a more complex version of the residual income (RI) as it computes for the real economic profit of a company.

Residual income computes for the excess of the operating income earned above the desired income. In EVA, taxes are taken into account and short-term operating liabilities are not treated as invested funds.

In a Nutshell

Economic-value added is equal to after-tax operating income minus desired income or minimum required income.

Minimum required income is equal to the cost of capital (weighted average cost of capital) multiplied by invested funds.

Invested funds come from both debt acquired and equity contributions.

When calculating for the EVA, the after-tax operating income or net operating income after profit (NOPAT) is used. If total assets is used in the computation, current liabilities are excluded 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 Invested funds

In most cases, the minimum required rate of return is equal to the cost of capital. Invested funds come from debt and equity.

You can also compute for invested funds from average total assets. Assuming all current liabilities are operating obligations only, invested funds is equal to average total assets minus average current liabilities.

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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