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Economic Value Added (EVA), which can also be referred to as Economic Profit, is the measure of a company’s financial performance based on its residual wealth. The residual wealth is calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.
The term Economic Value Added was originally developed to describe the incremental difference in the rate of return over a company’s cost of capital. It essentially measures the value a company generates from its investments rather than simply its profit.
If the EVA is negative, it means the company is not generating value from the funds invested in it. A positive EVA shows that the funds invested in a company are providing added value. The underlying premise of Economic Value Added is the idea that real profit is generated when additional wealth is created for stockholders, and that a company’s projects should create returns above their cost of capital.
The formula for calculating EVA is shown below:
EVA = NOPAT – (WACC * Capital Invested)
NOPAT = Net Operating Profits After Tax
WACC = Weighted Average Cost of Capital
Capital Invested = Equity + Long Term Debt at the Beginning of the Period
WACC * Capital Invested is also known as the finance charge
The benefit of using Economic Value Added is that it shows how and where a company created wealth. This ensures that managers are aware of assets and expenses when making managerial decisions. One drawback of using EVA is that because it relies heavily on the amount of invested capital, it is best used for stable and mature asset-rich companies rather than those with intangible assets such as start-ups or software companies.
The tools managers most often used for determining Economic Value Added are spreadsheets.
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