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Economic Value Added, or EVA, is a measure of financial performance that combines the familiar concept of residual income with principles of modern corporate financespecifically, that all capital has a cost and that earning more than the cost of capital creates value for shareholders. EVA is after-tax net operating profit-NOPAT-minus a capital charge. If a company's return on capital exceeds its cost of capital, it is creating true value for the shareholder. Companies consistently generating high EVAs are top performers that are valued highly by shareholders.
Both EVA and MVA (Market Value Added) have been highly publicized in leading business magazines, but the focus usually is on what EVA and MVA are and how they are used externally to rank companies. Little detail is given on how the numbers in an EVA calculation actually are determined-which we propose to do here. Further, we demonstrate that these techniques have utility within a company in managing a company's operations, in guiding its strategy, and in providing incentives to its employees.
Key components of EVA are NOPAT and the capital charge-the amount of capital times the cost of capital. NOPAT is profits derived from a company's operations after taxes but before financing costs and noncash-bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provided capital to the firm. Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less noninterest-bearing current liabilities.1
The capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested. Reducing the amount of working capital or fixed assets required to run the business while holding profits steady increases EVA.
The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk, e.g., a cut-off rate to create value.
Another perspective on EVA can be gained by looking at a firm's RONA-Return on Net Assets. For a firm, RONA is a ratio that is calculated by dividing its NOPAT by the amount of capital it employs (RONA=NOPAT / Capital) after making the...