Finance
Economic value added (EVA) and weighted average cost of capital (WACC)
The economic value added (EVA) is a method to express the financial performance of an organisation.
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Economic value added (EVA) and weighted average cost of capital (WACC) vs Weighted average cost of capital
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Weighted average cost of capital
A firm’s ‘weighted average cost of capital’ (or WACC) is a financial metric used to measure the cost of capital to a firm.
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EVA brings two principles into investment and operating decisions:
Select a discount rate for valuing a business or a project with risk comparable to the company’s existing operations.
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Strengths, limits, and pitfalls.
Economic value added (EVA) and weighted average cost of capital (WACC)
- Use EVA to compare the return from an opportunity with the complete capital charge, then trace the result to operating margin, asset intensity, working capital and financing assumptions that management can inspect.
- Calculate NOPAT from EBIT after correcting items that materially distort operating performance, then apply the appropriate operating tax. Decide whether expenses such as goodwill amortisation, inventory write downs or long lived investments require an economic adjustment and keep the policy consistent.
- Calculate WACC by identifying each financing source, its current required return and its share of the relevant capital structure. Use the after tax cost of debt where interest is tax deductible. Estimate the cost of equity with a defensible method such as CAPM, then weight debt and equity consistently.
Watch for
- Do not substitute RONA or accounting profit when capital sources carry meaningfully different required returns. Conversely, do not add elaborate adjustments whose subjectivity is greater than the distortion they claim to correct.
Weighted average cost of capital
- Match precision to the decision. An estimate within 1–2 per cent may be adequate when project cash flow uncertainty is much larger than 1–2 per cent. Show a sensitivity range and focus scrutiny on market weights, equity cost, debt spread and project risk.
- Gryphon Conglomerate is evaluating investments. Its current financing is 80 per cent equity requiring a 25 per cent return and 20 per cent long term debt costing 6 per cent. The marginal tax rate is 30 per cent. If financing were 100 per cent equity, WACC would be 25 per cent. With the current mix:
- WACC = (0.80 × 0.25 ÷ 1.00) + (0.20 × 0.06 × (1 − 30 per cent) ÷ 1.00)
Watch for
- Do not treat WACC as fixed or universal. Leverage changes required returns, CAPM inputs are estimates and a corporate average can accept risky projects while rejecting safer ones. Re estimate material assumptions and use a risk appropriate rate.
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