Economic Value Added (EVA) and Weighted Average Cost of Capital (WACC)

Economic Value Added (EVA) is a performance metric that measures a company’s financial performance by calculating the residual wealth generated by deducting its cost of capital from its operating profit. It is a comprehensive measure of a company’s profitability and efficiency. Weighted Average Cost of Capital (WACC) is the average rate of return a company expects to pay its investors, taking into account the cost of debt and the cost of equity. WACC is a critical input in calculating EVA.

Key Facts

  1. Determine Net Operating Profit After Tax (NOPAT): NOPAT is the net operating profit of a company after deducting taxes. It can be found in a company’s financial statements or calculated manually.
  2. Calculate Invested Capital: Invested capital represents the total amount of capital invested in a company or project. It includes debt, capital leases, and shareholders’ equity. You can find this information on a company’s balance sheet.
  3. Determine the Weighted Average Cost of Capital (WACC): WACC is the average rate of return a company expects to pay its investors. It takes into account the cost of debt and the cost of equity. The weights are derived as a fraction of each financial source in a company’s capital structure. WACC can be calculated or provided by the company.
  4. Use the EVA formula: The formula for calculating EVA is EVA = NOPAT – (Invested Capital x WACC).

By following these steps, you can calculate EVA using WACC. It is important to note that EVA is a measure of a company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit.

Calculating EVA Using WACC

To calculate EVA using WACC, follow these steps:

Determine Net Operating Profit After Tax (NOPAT)

NOPAT is the net operating profit of a company after deducting taxes. It can be found in a company’s financial statements or calculated manually.

Calculate Invested Capital

Invested capital represents the total amount of capital invested in a company or project. It includes debt, capital leases, and shareholders’ equity. This information can be found on a company’s balance sheet.

Determine the Weighted Average Cost of Capital (WACC)

WACC is the average rate of return a company expects to pay its investors. It takes into account the cost of debt and the cost of equity. The weights are derived as a fraction of each financial source in a company’s capital structure. WACC can be calculated or provided by the company.

Use the EVA Formula

The formula for calculating EVA is:

EVA = NOPAT – (Invested Capital x WACC)

By following these steps, EVA can be calculated using WACC.

Conclusion

EVA is a valuable metric for evaluating a company’s financial performance and efficiency. By considering the cost of capital, EVA provides a more accurate measure of a company’s profitability than traditional accounting measures. WACC is a critical input in calculating EVA, as it represents the cost of financing the company’s operations.

References

FAQs

1. What is EVA?

EVA stands for Economic Value Added. It is a performance metric that measures a company’s financial performance by calculating the residual wealth generated by deducting its cost of capital from its operating profit.

2. What is WACC?

WACC stands for Weighted Average Cost of Capital. It is the average rate of return a company expects to pay its investors, taking into account the cost of debt and the cost of equity.

3. How is EVA calculated using WACC?

EVA is calculated using the following formula:

EVA = NOPAT – (Invested Capital x WACC)

Where:

  • NOPAT = Net Operating Profit After Tax
  • Invested Capital = Debt + Capital Leases + Shareholders’ Equity
  • WACC = Weighted Average Cost of Capital

4. What is the significance of EVA?

EVA is a comprehensive measure of a company’s profitability and efficiency. It considers the cost of capital, which is often ignored in traditional accounting measures.

5. What is the significance of WACC in EVA calculation?

WACC is a critical input in calculating EV It represents the cost of financing the company’s operations. A higher WACC will result in a lower EV

6. How can EVA be used by investors?

EVA can be used by investors to evaluate a company’s financial performance and efficiency. It can also be used to compare companies in the same industry.

7. How can EVA be used by managers?

EVA can be used by managers to make investment decisions and to evaluate the performance of different business units. It can also be used to identify areas where costs can be reduced or efficiency can be improved.

8. What are some limitations of EVA?

EVA is a complex metric that can be difficult to calculate. It also relies on estimates and assumptions, which can affect its accuracy. Additionally, EVA may not be suitable for all companies, especially those with intangible assets or those that are in a rapid growth phase.