Table of Contents
- What is Economic Value Added?
- Economic Value Added Formula
- Calculation of EVA
- EVA Advantages
- EVA Disadvantages
- Examples of EVA Examples
- Lesson Summary
Economic value added, or EVA, is the measure of extra money earned by a company based on what remains after the cost of capital is removed from operating profits. This is also known as the economic profit or net profit. Companies can use economic value added as a way to measure how effective they are at attracting investments that do not require a larger return for their money. This return is the cost of capital and is what investors expect in exchange for putting money into a company. There are many different ways a company measures its efficiency and ability to earn as much as possible. The economic value added metric is a way to consider how well investments are used and undertaken versus how much a company will profit based on them.
The economic value added formula is used to calculate the economic profit of a company. The EVA formula is:
EVA = net operating profit after taxes - (invested capital x WACC)
WACC stands for weighted average cost of capital. It is a calculation of several different factors in a company that go into what it costs to raise money. The factors considered include the interest rate on the debt that is owed, the expected return on a stock, and opportunity cost. Opportunity cost would be the money a company could be making if it spent it elsewhere in the organization, hence the opportunity. Establishing the Weighted average cost of capital could be seen as the cost of putting existing money into other investments.
Calculating WACC is something that is left to programs such as excel since there is a lot of information needed for the formula and the formula itself is quite complicated. The answer for WACC is a percentage.
Putting the economic value added formula into practice, an EVA calculation could look like the following:
A company has a net profit of $250,000 after taxes. They raised a total of $75,000 for a project that year with a weighted average cost of capital of 8%.
EVA = 250,000 - (75,000 x .08)
EVA = 250,000 - 6,000
EVA = $244,000
This is the company's economic profit for the year.
The advantages of economic value added include:
There are disadvantages to using economic value added as a metric as well:
Economic value added is an economic metric that measures the economic value created by a company, profitability, and management's ability to attract cheap capital for profitable investments. An economic value added formula is used to find this metric. The EVA formula is (net profit after tax - (capital invested x WACC)). WACC stands for weighted average cost of capital, which is a formula that includes expenses owed to investors such as expected return on a stock, interest on debt owed, and the opportunity cost of alternate investments. Opportunity cost is the profit a company could be making if it used the money for a different reason. As an example of EVA, if a company has a net profit of $100,000, an invested capital of $50,000, and a weighted average cost of capital of 10%, the economic value added would be $95,000.
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Economic added value is the measure of how a company has profited after subtracting what is owed to investors. This is known as economic profit.
Economic added value is important because it can show how a company is increasing wealth. It also can show how effective management is at securing low-cost capital.
Economic value added is calculated by a few items. It is the net profit after taxes subtracted by investment capital and the weighted average cost of capital.
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