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Economic Value Added: Definition, Formula & Examples

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  • 0:03 What Is Economic Value Added?
  • 0:49 Cost of Capital
  • 1:47 Economic Value Added Formula
  • 3:10 An Example of Economic…
  • 4:47 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

Firms and investors use a number of financial metrics to measure profitability, effectiveness, and efficiency. In this lesson, we'll discuss one of the more complicated metrics, known as economic value added, or EVA.

What Is Economic Value Added?

Economic value added, or EVA, is a metric that reports a firm's economic profit (which means its net profit), less its cost of capital. Sometimes, EVA is called economic profit. To really understand EVA, we need to understand the cost of capital. Every dollar that a business invests into its operations or into a new product line, or even that just sits in a bank, comes at a cost.

EVA is an attempt to not just figure out the accounting profit of an organization, but to put a dollar amount on the actual economic value created by the company. This takes into account how well management is doing at obtaining capital investments as cheaply as possible, and how well it is doing at selecting the right uses of that capital.

Cost of Capital

The cost of capital might be the interest rate the company pays on a loan. Or, if the company issues stock, it could be the return the market expects on the shares. Even if the company generates profit, this capital has a cost, called the opportunity cost. This is the profit a company could be making if it had used money for a different reason.

For example, if the company is considering a $100,000 investment, paid for from net profit, and the only other alternative is letting that money sit in a CD at a local bank for 1% interest, the cost of capital, or opportunity cost, for that $100,000 is $1,000 ($100,000 * 1%). Often the exact opportunity cost is unknown, since the alternative investment might be another new project with an unknown future rate of return. That's why companies have financial analysts who work hard to project forecasts - their best, educated guess.

Economic Value Added Formula

But before we talk about the formula for EVA, there's one more important thing to understand. Part of the formula is the weighted average cost of capital, or WACC, for the company. This is exactly what it says: a weighted average of all the company's sources of capital, like debt, opportunity costs, and equity markets. Calculating the WACC is complicated and involves a lot of information about different sources of capital. So when we talk about the WACC in our examples, we'll just use a reasonable estimate, but you should know - if this were a real-world analysis, coming up with that number would be a project in itself!

With that being said, the formula for EVA is:

Net Operating Profit After Tax - (Capital Invested * WACC)

Let's walk through this formula. The first thing we do is take the net profit, after tax. In accounting terms, we'd just call that profit. If you were talking about your own business, this is the money that you would take home after your bills are paid.

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