The concept of Economic Value Added
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The concept of Economic Value Added (E.V.A.).
Economic Value Added (E.V.A.) can be defined as the measure of the financial performance of a company in relation to the remaining wealth calculated by taking away the cost of capital from the economic profit also known as the operating profit. EVA seeks to show a company’s excess profit over the amount of earnings that the company needs to maintain its capital and whether there is any wealth created. The economic profit is usually adjusted for taxes on the basis of cash. EVA can be deduced as follows:
EVA= Net Operating Profit after Taxes (NOPAT) – [Capital * Cost of Capital]
The cost of capital refers to the yearly return needed by the shareholders as well as the lenders of the business entity in exchange for providing capital. Each of the returns of the contributors is calculated differently. Lenders’ returns are shown in the loan agreement whereas that of the shareholders is shown in the company’s dividend policy. Both returns to the lenders and that of the shareholders are used in the computation of weighted average cost of capital. This is in turn used to derive the amount supposed to be deducted from the NOPAT when calculating EVA.
NOPAT plays a vital role in calculating economic profit because this equation makes an attempt to look at the actual finances that are available to the company from its operations as opposed to the accounting profit only. After establishing the funds available, EVA then deducts a charge that relates to the cost of capital maintenance. This has its basis on the concept of capital having a cost meaning that that cost of maintaining capital must be accounted for as an expense in order to acquire economic profit. Economic profit here is that profit achieved after such outgoings as tax and subtracting the funds