Page 63 - DMGT405_FINANCIAL%20MANAGEMENT

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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