Page 58 - DCOM409_CONTEMPORARY_ACCOUNTING

Dilfraz Singh, Lovely Professional University
Unit 4: Economic Value Added (EVA)

Unit 4: Economic Value Added (EVA) Notes

CONTENTS
Objectives
Introduction
4.1 Concept of EVA
4.2 Approaches to Computation of EVA
4.2.1 Adjustments to ‘Net Operating Profit after Tax’
4.2.2 Adjustment to ‘Capital Employed’

4.2.3 Adjustment to ‘Cost of Capital’
4.3 Applications of EVA
4.4 Superiority of EVA
4.5 Shortcomings of EVA
4.6 Summary
4.7 Keywords
4.8 Review Questions
4.9 Further Readings

Objectives

After studying this unit, you will be able to:

Define EVA
Illustrate the approaches to compute EVA
Describe the applications and shortcomings of EVA

Introduction

Economic profit is wealth created above the capital cost of the investment. EVA prevents
managers from thinking that the cost of capital is free. In other words, a measure of a company’s
financial performance based on the residual wealth calculated by deducting cost of capital from
its operating profit (adjusted for taxes on a cash basis). The formula for calculating EVA is as
follows:
= Net Operating Profit after Taxes (NOPAT) – (Capital * Cost of Capital)
EVA focuses managers on the question, “For any given investment, will the company generate
returns above the cost of capital?” Companies that embrace EVA have bonus compensation
schemes that reward or punish managers for adding value to or subtracting value from the
company. As with any metric, it’s hard to link precise EVA returns to a specific technology
investment. EVA is ideally suited to publicly traded companies, not private companies, because
it deals with the cost of equity for shareholders, as opposed to debt capital.
If a company invests in manufacturing equipment or a warehouse, how much additional profit
will be required to pay for it? Managers are intuitively aware of the importance of value
creation to their businesses.

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