Economic Value Added (EVA) for the CPA BAR Exam
Learn how Economic Value Added measures true economic profit for the CPA BAR exam. Covers EVA calculation, capital charges, NOPAT adjustments, and comparison to traditional metrics.
What Is Economic Value Added?
Economic Value Added (EVA) is a performance metric that measures whether a company generates returns above its cost of capital. Unlike traditional accounting measures such as net income or earnings per share, EVA accounts for the full cost of all capital employed, including equity capital. A positive EVA indicates the company is creating value for shareholders; a negative EVA means it is destroying value.
The core idea behind EVA is straightforward: a company truly creates wealth only when its operating profits exceed the cost of the capital used to generate those profits. Earning an accounting profit is not enough if that profit does not cover the opportunity cost of the capital invested by shareholders and creditors.
Calculating EVA
The EVA formula is: EVA = Net Operating Profit After Taxes (NOPAT) − (Capital Employed × Weighted Average Cost of Capital). Alternatively, EVA = (Return on Invested Capital − WACC) × Capital Employed. Both formulas yield the same result.
Net Operating Profit After Taxes (NOPAT)
NOPAT represents the company's after-tax operating profit, calculated as if the company had no debt. It starts with operating income (EBIT) and subtracts taxes on operating income. The formula is NOPAT = EBIT × (1 − Tax Rate). NOPAT excludes interest expense because the cost of debt is already captured in the WACC applied to total capital.
Several adjustments may be made to convert accounting income to economic income. Common adjustments include adding back amortization of goodwill, capitalizing research and development costs (treating them as investments rather than period expenses), adding back restructuring charges, and adjusting for LIFO reserves to approximate replacement cost.
Capital Employed
Capital employed represents the total amount of capital invested in the business, including both debt and equity. It can be calculated from the asset side of the balance sheet (total assets minus non-interest-bearing current liabilities) or from the financing side (interest-bearing debt plus equity). Adjustments to capital employed mirror those made to NOPAT, such as capitalizing operating leases and R&D expenditures.
The Capital Charge
The capital charge is the minimum return the company must earn to satisfy its capital providers. It equals Capital Employed × WACC. This charge represents the opportunity cost of capital: the return investors could earn on alternative investments of similar risk. Only when NOPAT exceeds this capital charge does the company generate positive EVA.
EVA Example
Suppose a company has NOPAT of $15 million, total capital employed of $100 million, and a WACC of 10%. The capital charge is $100 million × 10% = $10 million. EVA = $15 million − $10 million = $5 million. This positive EVA means the company generated $5 million in economic profit beyond what investors required.
Now suppose another division has NOPAT of $8 million with capital employed of $90 million and the same 10% WACC. The capital charge is $9 million. EVA = $8 million − $9 million = −$1 million. Despite being profitable in accounting terms, this division is actually destroying shareholder value because it earns less than its cost of capital.
EVA vs. Traditional Performance Metrics
Return on Investment (ROI)
ROI measures income as a percentage of investment. While useful, ROI can lead to suboptimal decisions. A division manager compensated on ROI might reject a project earning 15% if the division's current ROI is 20%, even though the company's cost of capital is only 10%. EVA avoids this problem because any project earning above the cost of capital increases EVA, regardless of the division's existing returns.
Residual Income
Residual income is similar to EVA in that it deducts a capital charge from operating income. The key difference is that EVA makes specific accounting adjustments to better approximate economic reality, while traditional residual income uses unadjusted accounting numbers. EVA is essentially an enhanced version of residual income.
Benefits and Limitations of EVA
EVA aligns management incentives with shareholder interests by focusing on value creation above the cost of capital. It encourages efficient use of capital and discourages empire building. However, EVA requires numerous accounting adjustments that can be complex and subjective. It also focuses on short-term results and may discourage long-term investments that reduce current-period EVA but create value over time.
Exam Preparation Tips
- Memorize both forms of the EVA formula and be able to calculate EVA given NOPAT, capital employed, and WACC.
- Understand the common accounting adjustments made to calculate NOPAT and capital employed.
- Know the advantages of EVA over ROI, particularly the elimination of the underinvestment problem.
- Be able to compare EVA with residual income and explain the relationship between them.
- Recognize that a positive EVA indicates value creation and a negative EVA indicates value destruction.
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