Economic Value Added (EVA)

ACCA Director Author

Economic Value Added (EVA)

4.1 Concept of EVA:

EVA: A period-based approach assessing a firm's value creation.
Free cash flow methods evaluate a company at a specific point in time; EVA focuses on a performance period.
While free cash flow factors in the firm's tangible and intangible asset purchases, EVA looks at profit minus associated financial costs with numerous adjustments.

4.2 Calculation:

Formula: EVA = NOPAT - (WACC x Capital Employed)
NOPAT (Net Operating Profit After Tax):

Category	Value (X)
Controllable operating profit	X
- Tax expense adjusted to exclude tax benefits on interest	(X)
Add:
- Accounting depreciation	X
- Increase in provisions	X
- Non-cash expenses	X
- Advertising, research and development, and employee training costs	X
Deduct:
- Economic depreciation	(X)
- Decrease in provisions	(X)
- Amortisation of advertising, research and development, and employee training	(X)
NOPAT (Net Operating Profit After Tax)	X

Calculation example for NOPAT:

	$
Operating profits	1,000
Interest expense	(100)
Profits before tax	900
Tax at 25%	(225)
Profits after tax	675

Required:

Calculate NOPAT.

Answer:

	$
Operating profits	1,000
- Tax expense adjusted to exclude tax benefits on interest (225+(100x25%))	(250)
NOPAT =	750

4.3 Accounting Adjustments for EVA:

Capitalize Expenditures: Expenses like R&D, promotion, employee training are added to profit and capital employed.
Depreciation: Add back accounting depreciation to profit, use economic depreciation instead.
Adjust for Over-prudence: Add provisions, allowances for doubtful debts, deferred tax provisions, etc., to capital employed. Remove related movements from NOPAT.
Non-cash Expenses: Suspect manipulation; add them back to profits and capital employed.
Lease Adjustments: Capitalize operating leases, adjusting both the income statement and capital employed.
Tax Charge: Based on cash taxes, which can differ from accrual-based accounting.

	$
Tax charge (P/L)	x
- Increase/+ decrease in deferred taxes	(x)/x
+ Tax benefit of interest	x
Cash taxes	x

4.4 Summarise the above adjustment in the table below:

Change to Profit	Change to Capital Employed
Advertising, R&D, staff training:
Plus back to increase current year profit	Increase capital employed at the year end
Deduct economic depreciation on previous year's EVA adjustment	Increase capital employed regarding similar add-backs of previous year's investments not treated as such in financial statements, net of economic depreciation
Depreciation:
+ A/C depreciation	Adjust value of non-current assets (and capital employed) to reflect economic depreciation not accounting depreciation
- Economic depreciation
Operating leases:
+ Lease payments to profit	+ Present value of future lease payments to capital employed
- Depreciation on assets
Provisions:
+ Increase in profit	+ Value of provision to capital employed
- Decrease in provision from profits
Non-cash expense:
Add back to profit	- Add to retained profits at the year end

4.5 Finance Charge:

Calculated by multiplying capital employed by the WACC (Weighted Average Cost of Capital).

Illustrative example:

VA Company Financial Data:

Controllable operating profit: $2,000
Tax expense (from P/L): $500
Accounting depreciation: $150
Increase in provisions: $50
Non-cash expenses: $100
Advertising, R&D, and staff training costs: $300
Economic depreciation: $90
Decrease in provisions: $30
Amortization of advertising, R&D, and staff training: $70
Tax charge (from P/L): $500
Increase in deferred taxes: -$50
Interest expense: $200
Lease payments: $150
Present value of future lease payments: $1,000

Required:

Calculate the Economic Value Added (EVA) for VA Company using the given data. Use the tax rate of 25% and WACC of 10%.

Answer:

Component	Amount ($) or Calculation	Result ($)
NOPAT Calculation
Controllable Operating Profit	$2,000
Tax Expense Adjusted (Excl. Interest Benefits)	$500 + ($200 x 25%)	$550
NOPAT	$2,000 - $550	$1,450
Accounting Adjustments
Advertising, R&D, Staff Training	+$300 - $70	$230
Depreciation	+$150 - $90	$60
Operating Leases	+$150	$150
Provisions	+$50 - $30	$20
Non-cash Expense	+$100	$100
Adjusted NOPAT	Sum of Above	$2,010
Capital Employed Adjustments
Original Capital Employed	Given	$10,000
Adjustments:
Advertising, R&D, Staff Training	+$300
Depreciation (Non-current assets effect)	-$90
Operating Leases (Future Lease Payments)	+$1,000
Provisions	+$50
Non-cash Expense	+$100
Adjusted Capital Employed	Sum of Above	$11,360
EVA Calculation
WACC x Adjusted Capital Employed	10% x $11,360	$1,136
EVA	$2,010 - $1,136	$874

Explanation:

1. Calculate NOPAT: Operating profits = $2,000

Tax expense adjusted to exclude tax benefits on interest = [($500) + ($200 x 25%)] = $550 NOPAT = $2,000 - $550 = $1,450

2. Accounting Adjustments for EVA:

Advertising, R&D, Staff Training: Change to Profit = +$300 - $70 = $230 Change to Capital Employed = +$300
Depreciation: Change to Profit = +$150 - $90 = $60 Change to Capital Employed = -$90 (assuming it affects the value of non-current assets)
Operating Leases: Change to Profit = +$150 Change to Capital Employed = +$1,000
Provisions: Change to Profit = +$50 - $30 = $20 Change to Capital Employed = +$50
Non-cash Expense: Change to Profit = +$100 Change to Capital Employed = +$100

Adjusted NOPAT = $1,450 + $230 + $60 + $150 + $20 + $100 = $2,010

3. Calculate Capital Employed Adjustments: Sum of Adjustments = $300 - $90 + $1,000 + $50 + $100 = $1,360 Original Capital Employed (for simplification assume this is given) = $10,000 Adjusted Capital Employed = $10,000 + $1,360 = $11,360

4. Calculate EVA: EVA = Adjusted NOPAT - (WACC x Adjusted Capital Employed) = $2,010 - (10% x $11,360) = $2,010 - $1,136 = $874

4.6 Evaluation of EVA:

Advantages:

EVA aligns closely with the goal of maximizing shareholder wealth and is a more accurate reflection of cash flow than accounting profit.
Using economic depreciation discourages delay in replacing old assets and promotes long-term value addition.
EVA's interpretation is straightforward: a positive EVA indicates a return higher than what finance providers require.

Disadvantages:

EVA calculations are complex and require multiple adjustments, which can be misunderstood by managers.
Comparing EVA across divisions is challenging due to its absolute nature and differing industry-specific factors.
Assumptions in the WACC calculation can be problematic, and it's based on historical data, not reflecting future performance.

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Categories: : Advanced Performance Management (APM)