FREE online courses on Financial Management and Creating Value - Chapter 3 - Economic Value Added - EVA

 

Probably the most widely used approach to measuring value-creation is Economic Value Added or EVA. EVA has been popularized by Stern Stewart, a major consulting firm which holds the registered trademark for EVA?. Many large American corporations have adopted EVA: Boise Cascade, Coca-Cola, Whirlpool, Eli Lilly, Monsanto to name a few. EVA like all value-based metrics departs from the traditional accounting model. The basic equation for calculating EVA is:

 

          EVA = NOPAT - Cost of Capital

 

NOPAT: Net Operating Profits After Taxes. This is Operating Profits less taxes but before financing costs and non-cash entries (although not depreciation). NOPAT is the residual income we have generated on the capital invested.

 

Cost of Capital: This is the charge for use of capital. It includes interest on the debt and a charge for the equity capital based on a cash equivalent equity x cost of equity rate.

 

The idea behind EVA is rooted in economic income as opposed to accounting income. As economic income moves up or down, so goes the value of the business. The problem is that calculating economic income is not easy; it requires hundreds of adjustments. For example, under traditional accounting we would expense cash disbursed for research and development (R & D), but in arriving at economic income we would capitalize R & D since it provides a future economic benefit. The list of adjustments from accounting to economic is extensive: depreciation, gains / losses, reserves, deferred taxes, etc. Since EVA is at the center of Value Based Management, it is important to keep the number of adjustments to those material items that significantly distort value. This is important since managers throughout the entire organization will need to understand how EVA is calculated. Keeping EVA simple will go a long way towards successful implementation.

 

 

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