keymodels
Economic value added (EVA) and weighted average cost of capital (WACC)
How can economic value added (eva) and weighted average cost of capital (wacc) improve people, teams, or organisational effectiveness?
Contents
The economic value added (EVA) is a method to express the financial performance of an organisation.
Economic value added, or EVA, expresses performance after charging an organisation for the capital required to produce that performance. Value is created only when after-tax operating profit exceeds the required return of lenders and shareholders. Stern Stewart & Co. popularised the branded measure in 1990.
When to use it
EVA brings two principles into investment and operating decisions:
- Management should allocate capital in ways that increase owner value over time.
- A business creates value only when expected operating profit exceeds the cost of the capital employed to generate it.
Use the measure to compare projects, business units or companies with similar risk, and to understand whether a higher accounting profit justifies its larger capital requirement.
WACC = Cost of equity + Cost of debt (after tax)
Weighted by the proportion of debt and equity in the capital structure
- where:
- r_d
- is the cost of foreign capital (interest)
- t
- is the tax rate on corporate income
- D (Debt)
- is a foreign capital
- C
- is the total long-term capital invested
- r_e
- is the cost of own (share) capital (equity) – expected return on equity
- E
- is the Equity
EVA complements value-based management and capital budgeting. WACC can also supply the discount rate for a net-present-value analysis when its financing and risk assumptions match the project. It blends the after-tax cost of debt with shareholders’ required return according to their proportions in the financing structure.
Origins
Residual-income thinking predates the trademark, but Stern Stewart systematised accounting adjustments and management incentives around Economic Value Added. G. Bennett Stewart presented the approach in The Quest for Value in 1990. WACC developed from modern corporate-finance theory as a blended opportunity cost for debt and equity capital.
What it is
EVA is:
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