Economic Value Added

Definition

Economic Value Added (EVA) is a financial performance measure that calculates the value a company generates from its invested capital, effectively showing how well it is generating profit above the required return of its shareholders. EVA connects closely with various strategy evaluation frameworks and techniques as it helps businesses assess their profitability and make informed decisions to enhance shareholder value. By focusing on the surplus generated over the cost of capital, EVA provides insights into operational efficiency and investment effectiveness.

5 Must Know Facts For Your Next Test

1. EVA is calculated using the formula: EVA = Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital).
2. A positive EVA indicates that a company is creating value for its shareholders, while a negative EVA signifies value destruction.
3. EVA encourages management to consider the cost of capital in decision-making, promoting investments that generate returns above this cost.
4. The concept of EVA was popularized by consultant Alfred Rappaport in the 1980s and has been adopted by many companies as a key performance metric.
5. EVA aligns management's goals with shareholder interests, making it a valuable tool in corporate governance and strategy evaluation.

Review Questions

• How does Economic Value Added serve as a tool for evaluating corporate performance?
  • Economic Value Added acts as a crucial metric for evaluating corporate performance by measuring the real economic profit generated by a company's operations. By calculating EVA, companies can determine whether they are generating returns that exceed their cost of capital. This understanding allows them to identify areas where they can improve efficiency or make better investment decisions, ultimately ensuring alignment with shareholder interests.
• Discuss the relationship between Economic Value Added and shareholder value creation.
  • Economic Value Added has a direct relationship with shareholder value creation since it assesses whether a company is providing returns above the required cost of capital. When EVA is positive, it signifies that the company is successfully generating excess returns for shareholders, which can lead to increased stock prices and dividends. Conversely, a negative EVA indicates that shareholder value is being eroded, prompting management to reevaluate strategies and operations to enhance overall profitability.
• Evaluate how implementing Economic Value Added can influence strategic decision-making within an organization.
  • Implementing Economic Value Added can significantly influence strategic decision-making by shifting focus toward initiatives that create true economic profit. When managers recognize that their performance will be assessed based on EVA, they are more likely to prioritize projects that yield returns exceeding the cost of capital. This shift encourages a culture of accountability and performance measurement, fostering innovative thinking aimed at maximizing shareholder wealth while ensuring that investments align with long-term strategic goals.

Related terms

Return on Investment (ROI): A measure used to evaluate the efficiency of an investment or compare the efficiency of several investments, calculated by dividing the net profit from an investment by its initial cost.

Cost of Capital: The return rate that a company must earn on its investment projects to maintain its market value and attract funds, typically determined by the weighted average cost of capital (WACC).

Shareholder Value: The financial worth that a company provides to its shareholders, usually measured by stock price appreciation and dividends paid.