Economic Value Added (EVA)

While MVA measures the collective consequence of managerial actions and decision on shareholder wealth since the beginning of the organization, economic value added (EVA) focuses on managerial efficiency in a given year. Hence MVA is a longer-term measure of a manager's historical performance, while EVA provides a timelier but temporary calculates of value conception. The basic formula for EVA is:

EVA = operating profit - cost of all capital

= (sales revenue  - operating costs - taxes) - (total capital supplied * cost of capital)

Operating profit is distinct as sales revenues deficiency operating costs and taxes. Hence, it measures the total cash obtainable from operations on an after-tax basis that is available to make payments to the corporation's provider of investment capital while the cost of the capital is predictable as total capital times the weighted average cost of that capital. To demonstrate, sup- pose a firm had $200 million of sales, $160 million of operating costs, and $20 million of taxes, so its operating profits as dissimilar were $20 million. We'll presuppose these results are for the firm's 2002 fiscal year. Suppose also that the firm had $100 million of debt and evenhandedness capital, and the weighted average cost of that capital was 10 percent. The firm's 2002 EVA would thus be $10 million:

EVA = $20 - $100(0.10) = $20 - $10 = $10 million

EVA is an approximation of a business's true economic profit for the year, and it is usually considerably dissimilar from that solid accounting profits. EVA present the enduring income that remainder after the occasion cost of the firm's complete capital base has been deduct, whereas accounting profit is designed without recognizing a cost for equity capital. EVA depends on both operating efficiency and balance sheet management: Without operating efficiency, operating profits will be low, and without efficient balance sheet management, there will be too many assets and too much capital. This results in higher-than-necessary capital costs, which would lower a firm's EVA.

EVA (but not MVA) can be calculated for individual business divisions as well as for the entire company. The cost of capital should reflect the risk of the business unit, either for the whole company or for an operating division. Note also that the precise calculation of EVA for an organization is much more compound than we have accessible here because of the many accounting issues, such as inventory valuation, depreciation, amortization of research and development costs, and lease financing that must be memorable correctly when estimate a firm's true economic operating profit.

EVA is a transitional measure of firm value that starts with the NPV of an entity project and ends with the firm's MVA. Each project's expected economic prosperity, which is originally measured by its NPV, contributes to the firm's EVA for any given year. MVA is the current value of the EVAs that the firm is probable to construct in the future. Thus, the creation of good investment opportunities (positive NPV projects) creates the anticipation of high EVAs, which investors recognize by request up the price of the firm's stock. This, in turn, creates a huge MVA.

Although EVA is a timely and imperative topic for organizations managers today, the underlying conception is not new. Managers have always known that they require earning more than the cost of capital. However, this basic premise is often lost because of a mistaken focus on accounting measures of productivity. EVA provide managers with a comparatively straightforward and precise way to assess the likely impact of a firm's investment, financing, and payment decisions on the wealth of the firm's shareholders. Thus, using it as a tool to assess a manager's presentation can reinforce EVA.