Economic Value Added (EVA) is a financial performance measure that assesses a company's ability to generate value for its shareholders. It calculates the excess return earned by a company on its invested capital, taking into account the cost of capital. Here's an example of how EVA analysis is conducted:
1. Calculate Net Operating Profit After Tax (NOPAT): Start by determining the company's net operating profit after tax, which represents its operating income after deducting taxes. NOPAT is calculated as follows:
NOPAT = Operating Income * (1 - Tax Rate)
2. Determine the Cost of Capital: Calculate the company's cost of capital, which represents the required rate of return that investors expect for investing in the company. The cost of capital is typically calculated by combining the cost of equity and the cost of debt, weighted by their respective proportions in the company's capital structure.
3. Calculate Invested Capital: Determine the total amount of capital invested in the company, which includes both equity and debt. It represents the company's net operating assets and is calculated as follows:
Invested Capital = Total Assets - Total Non-Interest Bearing Current Liabilities + Total Interest-Bearing Debt
4. Determine the Weighted Average Cost of Capital (WACC): Calculate the weighted average cost of capital, which is the weighted average of the cost of equity and the cost of debt. The weights are determined based on the proportions of equity and debt in the company's capital structure.
5. Calculate EVA: Use the following formula to calculate Economic Value Added:
EVA = NOPAT - (Invested Capital * WACC)
If EVA is positive, it indicates that the company is generating value for shareholders above the cost of capital. A negative EVA suggests that the company is not generating sufficient returns to cover its cost of capital.
Here's a simplified example:
Assume a company has an operating income of $10 million, a tax rate of 30%, total assets of $50 million, total non-interest bearing current liabilities of $5 million, total interest-bearing debt of $20 million, a cost of equity of 12%, and a cost of debt of 6%.
1. Calculate NOPAT: NOPAT = $10 million * (1 - 0.30) = $7 million
2. Calculate Invested Capital: Invested Capital = $50 million - $5 million + $20 million = $65 million
3. Calculate WACC: WACC = (Equity Proportion * Cost of Equity) + (Debt Proportion * Cost of Debt) Assuming equity proportion is 60% and debt proportion is 40%: WACC = (0.60 * 0.12) + (0.40 * 0.06) = 0.072 or 7.2%
4. Calculate EVA: EVA = $7 million - ($65 million * 0.072) = $7 million - $4.68 million = $2.32 million
In this example, the company's EVA is $2.32 million, indicating that it is generating positive value for shareholders above its cost of capital.
EVA analysis provides a useful metric for evaluating a company's financial performance and its ability to create value for shareholders. It helps identify areas where improvements can be made to enhance profitability and efficiency.
