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Economic Value Added

Also written EVA · Economic Value Added (EVA) · Economic profit

A company's after-tax operating profit less a charge for the capital employed to earn it — the profit that remains after the providers of capital have been paid what they required.

In plain language

Accounting profit charges a company for the debt it uses and nothing for the equity. That is the flaw EVA exists to fix.

Shareholders' money is not free. It has a required return, and a company that earns less than that return is destroying value even while its profit and loss account shows a profit. EVA makes the charge explicit: take the after-tax operating profit, subtract the cost of all the capital tied up in the business, and see what is left.

The workbook calls this the true economic profit produced by a company, and also refers to it simply as economic profit. It is a measure of a company's economic success over a period of time, useful to investors who want to know how well the company has produced value for them.

How it works

The construction is in three parts.

Net after-tax operating profit is the earnings the operations generate, struck before the cost of financing but after tax — so it belongs to everyone who funded the business, lenders and shareholders alike.

Invested capital is what those funders have put in and left in.

Percentage cost of capital is the blended return the funders require, weighted between debt and equity.

Multiply the last two and you get the rupee amount the business must earn just to stand still. Subtract it from the first and you have EVA.

The sign is what matters. Positive EVA means the business earned more than the capital cost, and value was created. Negative EVA means the opposite — and a company can post a large accounting profit and a negative EVA at the same time, which is precisely the situation the measure is built to expose.

The formula

EVA = Net after-tax operating profit - (Invested capital x Cost of capital %)

The second term is the capital charge — the rupee return the providers of capital required for the year.

A worked example

A listed capital goods company, for the year:

LineRs crore
Revenue3,600
Operating profit (EBIT)520
Tax at 25%130
Net after-tax operating profit390
Invested capital (equity Rs 2,000 cr + debt Rs 1,400 cr)3,400
Cost of capital11%
Capital charge = 3,400 x 11%  = Rs 374 crore
EVA            = 390 - 374    = Rs  16 crore

The company earned Rs 390 crore and the market told it that Rs 374 crore of that was simply rent on the money. Rs 16 crore is the genuine surplus — on a business of Rs 3,600 crore of revenue, a margin of value creation of less than half a per cent.

Now grow it. Suppose the board funds a Rs 600 crore expansion at the same 11% cost of capital, and it lifts after-tax operating profit by Rs 54 crore:

New NOPAT          = 390 + 54           = Rs 444 crore
New invested capital = 3,400 + 600      = Rs 4,000 crore
New capital charge = 4,000 x 11%        = Rs 440 crore
New EVA            = 444 - 440          = Rs   4 crore

Profit rose 14% and EVA fell by three-quarters. The expansion earns 9% on capital costing 11%, so every rupee of it destroys value. Nothing in the profit and loss account says so. EVA says so immediately.

Why NISM asks about it

Chapter 8 (Investing in Stocks), section 8.5.5.5, which pairs EVA with MVA as "the most common metrics used to determine a company's value", immediately before the EBIT/EV and EV/EBITDA multiples at 8.5.5.6. Questions are definitional and directional: what is subtracted from what, what a positive or negative EVA signifies, and how EVA differs from MVA.

Common exam traps

  • EVA is a flow, MVA is a stock. EVA measures economic success over a period of time; MVA compares a market value today with capital contributed historically. They are not two names for one thing.
  • The capital charge covers equity too. That is the entire point. A company with no debt still has a cost of capital and still faces a charge.
  • Positive accounting profit and negative EVA coexist routinely. A question that offers "the company is profitable, therefore EVA is positive" is offering a false inference.
  • Start from after-tax operating profit, not profit after tax. PAT is already after interest; using it would charge the debt cost twice, once through interest and again through the capital charge.
  • Growth is not automatically value-creating. Adding capital adds to the capital charge. Only a project earning above the cost of capital raises EVA.
  • EVA is also called economic profit. Both names appear in the workbook, and a question may use either.

Check yourself

  1. 1.Financial planning refers to the process of streamlining which four items of a household or individual?

    1. a)Income, expenses, assets and liabilities
    2. b)Income, savings, insurance and tax
    3. c)Assets, liabilities, goals and returns
    4. d)Salary, business income, rent and dividends
    Show the answer

    Answer: (a) Income, expenses, assets and liabilities

    "Financial planning refers to the process of STREAMLINING THE INCOME, EXPENSES, ASSETS AND LIABILITIES of the household or individual to take care of BOTH CURRENT AND FUTURE NEED FOR FUNDS." It is described as a holistic approach that considers the existing financial position, evaluates future needs, puts a process in place to fund them and reviews progress.

  2. 2.Which of the following is NOT a part of the financial planning process?

    1. a)Setting goals
    2. b)Monitoring
    3. c)Develop financial planning recommendations
    4. d)Financing the investments
    Show the answer

    Answer: (d) Financing the investments

    Module 1 sample question. The six-step process is: establish and define the client-planner relationship; gather client data including goals; analyse and evaluate financial status; develop and present recommendations; implement them; monitor them. Financing the investments is not a step. Chapter 4 in fact warns that financing risky or volatile investment propositions with debt may entail high risk.

  3. 3.What does the chapter say about the role of tax efficiency in investment decisions?

    1. a)It should be the primary basis of investment selection
    2. b)It should not be the basis of investment decisions; the basis should be requirements and risk appetite
    3. c)It is irrelevant to an Investment Adviser
    4. d)It applies only to retirement planning
    Show the answer

    Answer: (b) It should not be the basis of investment decisions; the basis should be requirements and risk appetite

    "To be noted, TAX EFFICIENCY SHOULD NOT BE THE BASIS OF INVESTMENT DECISIONS, it is more about GUIDANCE AND AWARENESS. THE BASIS SHOULD BE THE REQUIREMENTS AND RISK APPETITE." Tax remains highly relevant: post-tax returns, differing taxability of dividends, rents and interest, accumulation versus payout, and holding period all matter.

Where this is taught

Free preparation for NISM Series X-A

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