What is ‘Economic Value Added – EVA?’
Performance measures evaluate how well an organization achieves its objectives. Since the primary objective of the organization is to maximize wealth for shareholders. Many organizations perform profit based measurement to evaluate financial performance. Two problems relating profit base measure are:
- Profit calculated according with accounting standard and usually does not represent the true economic wealth.
- In financial statements, the calculation of profit ignores the cost of equity finance.
So Economic Value Added is a performance measurement system aims to overcome above mentioned problems. Quite simply, EVA is the net profit less the opportunity cost of the firm’s capital or Economic Value Added is an estimate of a firm’s economic profit.
Idea behind ‘Economic Value Added – EVA’
The basic concept of EVA is that the performance of a company as a whole, or of investment centre within the company, should be measured in terms of the value that has been added to business during the period. Economic Value Added is also referred to as economic profit.
How it works (Example)
Assume that you have been invested in ABC Company, and you have just attended the seminar on Firm’s Economic Value Added and very curious to know true value or EVS of ABC Company. Firstly, you calculate the weighted average cost of capital of 11.19% (from the company’s mix of debt, preferred stock, and common stock). Secondly, you will get the following information from Company’s financial statements:
Net profit after tax = $ 1,200,000
Capital investment = $ 2,500,000
Economic Value Added = Net profit after tax – (Capital investment * WACC)
Economic Value Added = $ 1,200,000 – ($ 2,500,000 * 11.19%) = $ 920,250
The positive number means that Company ABC is strong in terms of value creation for shareholders. A negative number indicates that the project did not make enough profit to cover the cost of doing business.
Difference between Economic Value Added and Residual Income
- Residual income is computed use accounting profit and an economic value for capital employed.
- EVS is calculated using an estimated value for economic profit and an estimated economic value of capital employed. (Adjustment are made to accounting profit and accounting capital employed to get economic profit and economic value of capital employed)