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Unit 4: Economic Value Added (EVA)

current replacement costs. NOPAT and Equity are adjusted for this change from LIFO to Notes
FIFO by adding the difference between the LIFO and FIFO inventory (or LIFO and FIFO
cost of goods sold) to the equity and NOPAT. This way the tax benefits of LIFO are
retained.

Deferred taxes arise due to the difference in timing of recognition of revenues and expenses
for financial reporting versus reporting for tax purposes. It is basically the accumulation
of the difference between accounting provision of taxes and the tax amount actually paid
under the head ‘Reserve for deferred taxes’. NOPAT is adjusted for the tax actually paid,
instead of the accounting provisions. The reserves for deferred taxes are added to the
equity.
Operating leases are to be capitalized. The net present value of the lease payments is
capitalised.
Restructuring expenses and such other expenses, which will benefit the firm in the long
run, are capitalised and written-off over a period.

Other adjustments like adding back the provision for warranty claims, provisions for bad
and doubtful debts are also made. They are accounted for on cash basis. Similarly, other
non-cash bookkeeping entries are adjusted and accounted for on cash basis.
Provision for gratuity and pension should be recognised and provided for properly.

4.2.2 Adjustment to ‘Capital Employed’

For calculation of correct EVA, the following adjustments are required to be made for capital
employed:

The capital employed can be calculated through the assets side of the balance sheet or the
liability side. From the asset side, capital employed is the current assets less the non-
interest bearing current liabilities, i.e., the net working capital plus and net fixed assets.
From the liabilities side, it is the sum of interest bearing debt (short-term as well as long-
term) and net worth less and non-operating assets.
Use the beginning of the year capital employed for calculating EVA as this was the capital
available to the management to earn the returns and it helps in evaluating capital budgeting
decisions.
It is prudent to use the book value figure in the EVA calculations, as this is the amount that
has been entrusted to the management to employ in the business. The market value of a
firm is the investor’s capital and it is not the same as the firm’s capital. The capital employed
that earns operating profits is the book value of net assets and not the market value of a
firm’s stock.

4.2.3 Adjustment to ‘Cost of Capital’

The third element in EVA calculation is the cost of capital, which is the weighted average of the
cost of debt, cost of equity capital and cost of preference capital, if any.
While the cost of debt is the average interest rate paid by the company on its debt, the cost of
equity can be found out using the Capital Asset Pricing Model (CAPM) and the cost of preference
shares can be taken as the fixed rate of dividend.

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