Residual income is equal to the difference between total revenues and operating expenses.
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Additional value created above the cost of capital Show
What is Economic Value Added?Economic Value Added (EVA) or Economic Profit is a measure based on the Residual Income technique that serves as an indicator of the profitability of projects undertaken. Its underlying premise consists of the idea that real profitability occurs when additional wealth is created for shareholders and that projects should create returns above their cost of capital. EVA adopts almost the same form as residual income and can be expressed as follows: EVA = NOPAT – (WACC * capital invested) Where NOPAT = Net Operating Profits After Tax WACC = Weighted Average Cost of Capital Capital invested = Equity + long-term debt at the beginning of the period and (WACC* capital invested) is also known as finance charge Calculating Net Operating Profits After Tax (NOPAT)One key consideration for this item is the adjustment of the cost of interest. The cost of interest is included in the finance charge (WACC*capital) that is deducted from NOPAT in the EVA calculation and can be approached in two ways:
Accounting AdjustmentsThree main adjustments should be made. Among the most common and important are:
Tax charge per income statement – increase (or + if reduction) in deferred tax provision + tax benefit of interest = Cash taxes Calculating the Finance ChargeFinance Charge = Capital invested * WACC and WACC = Ke*E/ (E+D) + Kd (1-t)*D/ (E+D), where Ke = required return on equity and Kd (1-t) = after tax return on debt Thus, given the adjusted taxes, we can write the economic value-added formula as follows: EVA = NOPAT – (WACC * capital invested) Properties of Economic Value AddedThe properties of using economic value added can be compared with other approaches in the following table:
Example – Calculating Economic Value Added for a Company
Download the Free TemplateEnter your name and email in the form below and download the free template now! EVA Example TemplateDownload the free Excel template now to advance your finance knowledge! Alternative Measures of ValueFinancial analysts typically rely on various different methods of measuring value. Return on invested capital (ROIC) is a common method that also uses a residual income approach. Ultimately, the truest measure of value is the cash flow that’s generated by a business, which can only be measured by internal rate of return (IRR). IRR is used in financial modeling to capture all aspects of a business and its economic performance. Video Explanation of Economic Value Added (EVA)Watch this short video to quickly understand the main concepts covered in this guide, including the definition of Economic Value Added, the formula for EVA, and an example of EVA calculation. Additional resourcesIn conclusion, economic value added (EVA) highlights when a company creates value (or destroys value) and is helpful to understand the company’s performance in a given year. For more resources to help advance your corporate finance career as a Financial Modeling & Valuation Analyst (FMVA), these additional resources will be helpful:
What does residual income mean?Residual income is the income an individual has left after all personal debts and expenses are paid in personal finance. Residual income is the level used to help figure out the creditworthiness of a potential borrower.
What is the difference between total revenue and operating revenue?Revenue is the total amount of income generated by a company for the sale of its goods or services before any expenses are deducted. Operating income is the sum total of a company's profit after subtracting its regular, recurring costs and expenses.
What is the difference between total revenue and total expenses?Net Income: difference between total revenue and expenses when total revenue is greater. Net Loss: difference between total revenue and expenses when total expenses are greater.
How do you calculate residual income?The calculation of residual income is as follows: Residual income = operating income - (minimum required return x operating assets).
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