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    Module 3 Responsibility Accounting Economic Value Added

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    Jedi Duenas

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    Module 3 Responsibility Accounting Economic Value Added

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    Jedi Duenas
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    85 views2 pages

    Module 3 Responsibility Accounting Economic Value Added

    Uploaded by

    Jedi Duenas

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 2

    What is Economic Value Added?

    Economic Value Added (EVA) or Economic Profit is a measure based on the Residual Income
    technique that serves as an indicator of the profitability. Profitability ratios are financial metrics used
    by analysts and investors to measure and evaluate the ability of a company to generate income (profit)
    relative to revenue, balance sheet assets, operating costs, and shareholders' equity during a specific
    period of time. They show how well a company utilizes its assets to produce profit of projects
    undertaken. Its underlying premise consists of the idea that real profitability occurs when additional
    wealth is created for shareholders and that projects should create returns above their cost of capital.
    WACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including
    equity and debt.

    EVA adopts almost the same form as residual income and can be expressed as follows:
    EVA = NOPAT – (WACC * capital invested)
    Where NOPAT = Net Operating Profits After Tax
    WACC = Weighted Average Cost of Capital
    WACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital
    including equity and debt.
    Capital invested = Equity + long-term debt at the beginning of the period and (WACC*
    capital invested) is also known as finance charge.

    Calculating Net Operating Profits After Tax (NOPAT)


    One key consideration for this item is the adjustment of the cost of interest. The cost of interest is
    included in the finance charge (WACC*capital) that is deducted from NOPAT in the EVA calculation
    and can be approached in two ways:
    1. Starting with operating profit, then deducting the adjusted tax charge (because tax charge
    includes the tax benefit of interest). Therefore, we should multiply the interest by the tax rate
    and add this to the tax charge; or
    2. Start with profit after tax and adding back the net cost of interest. Therefore, we should
    multiply the interest charge by (1-tax rate).

    Accounting Adjustments
    Three main adjustments should be made. Among the most common and important are:
    ● Expenditures on R&D, promotion, and employee training should be capitalized.
    ● Depreciation charge is added back to profit and instead, a charge for economic depreciation is
    made. This reflects the true change in the value of assets during the period, unlike accounting
    depreciation.
    ● Accounts such as provisions, allowances for doubtful debts, deferred tax provisions, and
    allowances for inventory should be added back to capital implied.
    ● Non-cash expenses should be added back to profits and to capital employed.
    ● Operating leases should be capitalized and added back to capital employed.
    ● Tax charge will be based on cash taxes, rather than the accruals-based methods used in
    financial reporting and will be calculated as follows:

    Tax charge per income statement – increase (or + if reduction) in deferred tax
    provision + tax benefit of interest = Cash taxes

    Calculating the Finance Charge


    Finance Charge = Capital invested * WACC
    and WACC = Ke*E/ (E+D) + Kd (1-t)*D/ (E+D), where Ke = required return on equity
    and Kd (1-t) = after tax return on debt

    Thus, given the adjusted taxes, we can write the economic value-added formula as follows:
    EVA = NOPAT – (WACC * capital invested)

    Properties of Economic Value Added


    The properties of using economic value added can be compared with other approaches in the
    following table:
    Valuation
    Measure Discount Factor Comments
    model

    Enterprise Free cash flow WACC Works best for projects, business
    discounted cash units, and companies that manage
    flow their capital structure to a target level

    Discounted EVA WACC Explicitly highlights when a company


    economic profit creates value

    Adjusted present Free cash flow Unlevered cost of Highlights changing capital structure
    value equity more easily than WACC-based
    models

    Example – Calculating Economic Value Added for a Company


    2014 2015 2016

    Capital invested (beginning of year) $54,236 $50,323 $55,979

    WACC 8.22% 8.28% 8.37%

    Finance Charge $4,460 $4,167 $4,682

    NOPAT $7,265 $5,356 $4,336

    Finance Charge $4,460 $4,169 $4,683

    Economic Value Added $2,805 $1,187 -$347

    Additional resources
    In conclusion, economic value added (EVA) highlights when a company creates value (or destroys
    value) and is helpful to understand the company’s performance in a given year. For more resources to
    help advance your corporate finance career as a Financial Modeling & Valuation Analyst
    (FMVA)Become a Certified Financial Modeling & Valuation Analyst (FMVA)®, these additional
    resources will be helpful:
    ● Return on EquityReturn on Equity (ROE)Return on Equity (ROE) is a measure of a
    company’s profitability that takes a company’s annual return (net income) divided by the
    value of its total shareholders' equity (i.e. 12%). ROE combines the income statement and the
    balance sheet as the net income or profit is compared to the shareholders’ equity.
    ● Return on AssetsReturn on Assets & ROA FormulaROA Formula. Return on Assets (ROA) is a
    type of return on investment (ROI) metric that measures the profitability of a business in
    relation to its total assets. This ratio indicates how well a company is performing by
    comparing the profit (net income) it's generating to the capital it's invested in assets.
    ● Valuation MethodsValuation MethodsWhen valuing a company as a going concern there are
    three main valuation methods used: DCF analysis, comparable companies, and precedent
    ● Financial Modeling GuideFree Financial Modeling GuideThis financial modeling guide covers
    Excel tips and best practices on assumptions, drivers, forecasting, linking the three
    statements, DCF analysis, more

    https://corporatefinanceinstitute.com/resources/knowledge/valuation/economic-value-added-eva/

    Watch https://youtu.be/kv3VWPWqJHk

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