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Unit 4: Concept of Economic Value Added




            and adjustments that should be made to financial accounting practices  to  derive  managerial  Notes
            information that is closer to economic reality.

                   EVA = [Profit after Tax + Interest (1 – marginal tax rate of the firm)] – Cost of capital
                          × Economic book value of the capital employed in the firm

                   EVA = Profit after Tax – Cost of equity × Equity employed in the firm
                          EVA is essentially the surplus left after making an appropriate charge for the
                          capital employed in the business. It may be calculated in any of the following
                          apparently different but essentially equivalent ways:

                   EVA = Net operating profit  other tax – Cost  of capital × Economic  book value of
                          capital employed in the firm.

                   EVA = Economic book value of capital employed in the firm (Return in capital – Cost
                          of capital)

            Self Assessment

            Fill in the blanks:
            1.   …………………is the amount in rupees that remains after deducting an “implied” interest
                 charge from operating income.

            2.   EVA is  essentially the ………….left after  making an appropriate charge for the capital
                 employed in the business.
            3.   The implied interest charge reflects a …………………cost.

            4.   The rate of interest charge is equal to the minimum rate on ……………..specified by top
                 management as part of the corporate strategic plan.

            4.2 Advantages of EVA


            1.   EVA combines profit centre and  investment centre concepts. With EVA,  management
                 establishes a target profit or target rate of return for the business segment. Any income in
                 excess of the target level is the residual income/EVA. To illustrate, the target rate of return
                 for DD Ltd., is 20 per cent on total net assets. Total net assets are   800,000 and actual net
                 income   200,000 so the target net income is 800,000 × 0.20 =   160,000. The EVA for the
                 company is actual net income minus target net income =   200,000 –   160,000 =   40,000.
            2.   In case of EVA, different interest rates may be used for different types of assets e.g., low
                 rates can be used for inventories while a higher rate can be used for investments in fixed
                 assets. Furthermore, different rates may be used for different of fixed assets to take into
                 account different degrees of risk.
            3.   With EVA all business units have the same profit objective for comparable investments.
                 The ROI approach, on the other hand provides different incentives for investments across
                 business units.

            4.   The EVA in contrast to ROI has a stronger positive correlation with changes in company’s
                 market share. Shareholders are important stakeholders in a company’s market value.
            5.   EVA eliminates economic distortions of GAAP to focus decisions on real economic results.
            6.   Provision of correct incentives for capital allocations.




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