Economic Value Added (EVA) is a variation to profit, and it refers to a measure of a firm’s estimated economic profit. It can be calculated by deducting the capital costs from the operating profit to get the residual wealth. This residual wealth will let the firm know how their capital is performing in the market versus their other potential investments.
This will also help companies decide between investments, to know which one will yield the most profit. The equation of the Economic Value Added is simple.
Economic Value Added = Net Operating Profits after Taxes- (Capital x minimum rate of return)
If we put this equation to test, suppose you own a company, and you want to open another branch elsewhere. You have $50,000 to invest in your new branch. You do the math and find out that you will make a profit of around $5,000 per year. You also want at least a 15% return on capital for your contribution. Once you substitute all these numbers into the equation, you will get:
$5,000 – ($50,000 x 15%) = -$2,500
This proves that such an investment would be a loss. The negative answer should let your investment to be a failure, and so, you should invest your $50,000 on something more profitable. As is obvious, the calculation can be quite complicated, so you need to treat with care. That said, it could also be a great help when investing in capital intensive industries, as it could help you make smarter investments.
However, doing just a simple math to figure out the Economic Value Added is not enough. This equation isn’t perfect, and so, you have to keep in mind that it has both advantages and disadvantages.
It recognizes the importance of the use of capital (operating assets) and its associated costs (capital costs). This is important because when considering just profit, you don’t take that into consideration and it can be advantageous, as you can now have a clearer picture of what your cost of capital will be in comparison to your investments/ returns.
It clearly shows the relationship between the use of capital and the operating margin, which will help one see the opportunities and make improvements if needed.
EVA does not take size differences into consideration. A plant or division that is larger in size will obviously have a higher EVA, in comparison to something that is smaller in size, which could distort your calculations and give you an inaccurate result.
EVA can be used for personal gains by the manager, which might not be particularly profitable for the firm.
EVA might overemphasize the immediate need to generate the results. It might put more emphasis on short-term gains than long-term ones.
Since EVA is all about calculations, if the yield is lesser than the one that was expected, the calculation will not take human errors into consideration. Therefore, it might be inefficient.