Another measure of profitability for performance evaluation of investment centers is economic value added.6 Economic value added (EVA) is after-tax operating income minus the total annual cost of capital. If EVA is positive, the company is creating wealth. If it is negative, then the company is destroying capital. Over the long term, only those companies creating capital, or wealth, can survive. Many companies today are passionate believers in the power of EVA. When EVA is used to adjust management compensation, it encourages managers to use existing and new capital for maximum gain. The Coca-Cola Company, General Electric, Intel, and Merck are a few of the companies that have seen increasing EVA during the past fifteen years
Calculating EVA
EVA is after-tax operating income minus the dollar cost of capital employed. The equation for EVA is expressed as follows:
Calculating EVA
EVA is after-tax operating income minus the dollar cost of capital employed. The equation for EVA is expressed as follows:
The difficulty faced by most companies is computing the cost of capital employed. Two steps are involved: (1) determine the weighted average cost of capital (a percentage figure) and (2) determine the total dollar amount of capital employed.
To calculate the weighted average cost of capital, the company must identify all sources of invested funds. Typical sources are borrowing and equity (stock issued). Any borrowed money usually has an interest rate attached, and that rate can be adjusted forits tax deductibility. For example, if a company has issued 10-year bonds at an annual interest rate of 8 percent and the tax rate is 40 percent, then the after-tax cost of the bonds is 4.8 percent [0.08 - (0.4 x 0.08)]. Equity is handled differently. The cost of equity financing is the opportunity cost to investors. Over time, stockholders have received an average return that is six percentage points higher than the return on longterm government bonds. If these bond rates are about 6 percent, then the average cost of equity is 12 percent. Riskier stocks command a higher return; more stable and less risky stocks offer a somewhat lower return. Finally, the proportionate share of each method of financing is multiplied by its percentage cost and summed to yield a weighted average cost of capital.
Read behavioral aspects of eva
Suppose that a company has two sources of financing: $2 million of long-term bonds paying 9 percent interest and $6 million of common stock, which is considered to be of average risk. If the company’s tax rate is 40 percent and the rate of interest on long-term government bonds is 6 percent, the company’s weighted average cost of capital is computed as follows:
To calculate the weighted average cost of capital, the company must identify all sources of invested funds. Typical sources are borrowing and equity (stock issued). Any borrowed money usually has an interest rate attached, and that rate can be adjusted forits tax deductibility. For example, if a company has issued 10-year bonds at an annual interest rate of 8 percent and the tax rate is 40 percent, then the after-tax cost of the bonds is 4.8 percent [0.08 - (0.4 x 0.08)]. Equity is handled differently. The cost of equity financing is the opportunity cost to investors. Over time, stockholders have received an average return that is six percentage points higher than the return on longterm government bonds. If these bond rates are about 6 percent, then the average cost of equity is 12 percent. Riskier stocks command a higher return; more stable and less risky stocks offer a somewhat lower return. Finally, the proportionate share of each method of financing is multiplied by its percentage cost and summed to yield a weighted average cost of capital.
Read behavioral aspects of eva
Suppose that a company has two sources of financing: $2 million of long-term bonds paying 9 percent interest and $6 million of common stock, which is considered to be of average risk. If the company’s tax rate is 40 percent and the rate of interest on long-term government bonds is 6 percent, the company’s weighted average cost of capital is computed as follows:
Thus, the company’s weighted average cost of capital is 10.35 percent. The second datum necessary to calculate the dollar cost of capital employed is the amount of capital employed. Clearly, the amount paid for buildings, land, and machinery must be included. However, other expenditures meant to have a long-term payoff,such as research and development, employee training, and so on, should also be included. Despite the fact that these latter are classified by GAAP as expenses, EVA is an internal management accounting measure, and therefore, they can be thought of as the investments that they truly are.
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