16.2 Economic Value Added

• also known as economic profit.
• is a measure based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.
• measures the value a company generates from its invested funds.
• EVA relies heavily on invested capital. Hence, more suitable for asset-rich companies, whereas companies with intangible assets, such as technology businesses, may not be good candidates.

$$EVA = NOPAT - (Invested Capital * WACC)$$

where

• NOPAT = Net Operating profit after taxes = Operating Profit x (1-Tax Rate)

• Invested capital = Debt + capital leases + shareholders’ equity = Equity + long-term debt at the beginning of the period

• WACC = Weighted average cost of capital (average rate of return a company expects to pay its investors).

  • $WACC = \frac{Ke \times E}{E+D} + \frac{Kd \times (1-t) \times D}{E +D }$

    • Ke = required return on equity
    • Kd(1-t) = after tax return on debt.

• (WACC* capital invested) is also known as a finance charge

Invested capital can also be calculated as (Total Assets - Current Liabilities). Hence, the modified version of EVA is:

$$EVA = NOPAT - (\text{total assets} - \text{current liabilities}) * WACC$$