Economic Value Added (EVA): NOPAT, Capital Charge and Interpretation

A listed food company in Nigeria reports profit after tax of ₦48 million and its shares do not move. A rival reports a smaller profit and its shares rise. The first company used ₦450 million of capital to earn its profit; the second used ₦200 million. Accounting profit does not tell the owners whether the business has created value, because it does not charge for the capital used.

Residual income takes a step towards doing so by deducting a notional interest charge, but it still relies on accounting figures that distort economic reality: research and training are written off as expenses, leases may be kept off the statement of financial position, provisions reduce profit without a cash outflow. Economic value added (EVA) goes further.

It adjusts profit and capital to economic values and deducts the cost of all the capital used.

This topic explains why profit is not a good measure of value, the benefits of EVA, the formula, the adjustments to get NOPAT (net operating profit after tax), the valuation of capital employed, the weighted average cost of capital (WACC), a full calculation, how to interpret EVA, how it differs from residual income, and its problems. It builds on the earlier topic on divisional performance: ROI and residual income.

The next topic covers transfer pricing methods and the optimal transfer price.

Why profit does not show value

Profit and the cost of capital

In theory, if a company makes a profit, the value of its shares should rise by the profit less dividends. In practice it does not. One reason is that to earn the profit, capital was invested, and capital has a cost. The value created is the profit less the cost of the capital invested.

As Peter Drucker wrote, until a business earns a profit greater than its cost of capital, it operates at a loss. A company with ₦10 million in a bank deposit earning 2% reports interest income of ₦200,000, which adds to accounting profit. But it does not add value, because the cost of the capital that finances the cash is higher than 2%.

A second, more important reason is that profit measured by accounting conventions is not a proper measure of real economic profit. Stern Stewart, a consulting firm, devised economic value added (EVA), a trademarked measure of economic profit, to give a better measure of the increase in the value of a business in a period.

Benefits of EVA

• It measures value creation, and is a more accurate measure of performance than accounting profit.
• Economic value can be measured as the net present value of future profits, so EVA recognises the benefit of new investments that add to long-term profitability. It is not focused only on the short term.
• It encourages management to focus on creating value, which is in the long-term interests of shareholders.
• Reward schemes based on EVA align the interests of management and shareholders better than bonuses linked to annual accounting profit.
• It is a simple measure, like profit, which line managers can understand.

Measuring EVA

EVA = NOPAT − (capital employed × WACC), where NOPAT is the net operating profit after tax and WACC is the weighted average cost of capital. In practice, EVA needs many adjustments to accounting profit and accounting asset values, which can be complex; an examination question will give simplified data.

NOPAT

NOPAT is an estimate of economic profit before deducting a cost for the capital employed; it is similar to free cash flow. Start with profit after tax and adjust:

• Interest. Interest on debt is not deducted, because debt is part of the capital employed and will be charged for in the capital charge. Add back the interest cost less the tax relief on it: NOPAT = profit after tax + interest × (1 − tax rate).
• Depreciation. Non-cash expenses should not be deducted, but there should be a charge for the economic consumption of non-current assets. Add accounting depreciation and deduct economic depreciation. If the two are taken to be equal, they cancel.
• Other non-cash expenses, such as additions to provisions and to allowances for irrecoverable debts, are added back.
• Investments in intangibles. Spending on promotion, brand-building, research and development and training adds to the value of the business but is written off as an expense in conventional accounts. It should be added back and the amount treated as capital, then charged for through economic depreciation in later years.
• Other adjustments listed in practice: deferred tax provision added, and cash tax deducted in place of the accounting tax charge.

Capital employed

The capital charge should be based on the economic value of capital, so non-current assets should be valued close to current values, not historic cost. A simple version starts with the book value of net assets at the beginning of the year (non-current assets plus net current assets) and adjusts it by adding:

• the net book value of intangibles whose cost was added back to NOPAT;
• the total of provisions and allowances (irrecoverable debts, deferred tax and other provisions) whose additions were added back;
• the estimated value of assets held under operating leases and other off-balance-sheet finance, which are a form of debt provided by the lessor.

WACC

The capital charge applies the WACC to capital employed. WACC is the weighted average of the costs of equity and debt in the company’s target capital structure. If the current structure is close to the long-term target, current values can be used; if not, use the target proportions. Costs of equity and debt change from year to year, so WACC may be recalculated annually.

WACC = k_e × E÷(E+D) + k_d × (1 − t) × D÷(E+D). For example, with equity at 15% and debt at 10% before tax, a 50:50 target structure and tax at 30%, WACC = 15% × 50% + 10% × (1 − 0.3) × 50% = 11%.

Interpreting EVA

A positive EVA means the company has earned more than the cost of the capital it uses and created value for shareholders. A negative EVA means it has not covered the cost of capital, and so it has destroyed shareholder wealth, even if its accounting profit is positive. An increase in EVA from one year to the next shows improvement.

EVA should be considered together with the trend, the cause (higher NOPAT or lower capital) and non-financial factors.

Using EVA, and its problems

If measured with reasonable accuracy, EVA shows how much wealth a business operation has created in a period, so it can be argued that it is a better measure of divisional and company performance than ROCE and profit. It can replace ROI or residual income for divisions, but this makes little sense unless the company as a whole also uses EVA. The problems:

• It is an absolute amount in naira, so inter-firm and inter-divisional comparisons are difficult.
• The adjustments are complex, and economic depreciation in particular is hard to estimate; the result may be unreliable.
• It may be asked whether the cost of calculating it is justified compared with ROI or residual income.
• It depends on a WACC that has to be estimated, and which changes.
• It is still a financial measure and ignores non-financial performance (the balanced scorecard can complement it).

EVA and residual income

Both deduct a charge for capital from a profit figure. Residual income uses accounting profit and accounting capital employed, usually before the adjustments, and a notional interest rate that may be chosen by management. EVA uses NOPAT (adjusted profit after tax), adjusted capital employed and the WACC. EVA is therefore closer to economic reality and less open to accounting distortion, but harder to compute.

Layouts for EVA

1. NOPAT: profit after tax; add interest × (1 − t); add non-cash expenses; add intangibles written off; adjust depreciation if asked.
2. Capital employed (opening): book capital employed; add leases, intangibles, provisions as instructed.
3. WACC: target weights; after-tax cost of debt.
4. Capital charge = capital employed × WACC; EVA = NOPAT − capital charge.
5. Interpret: sign, trend, cause.

Money is in naira millions; percentages to one decimal place; each answer is rounded once, at the end.

Worked examples

1. Interest after tax relief.
   9 × (1 − 0.25) = 6.75.
2. NOPAT.
   48 + 6.75 + 5 + 8 = ₦67.75m.
3. Capital employed.
   400 + 30 + 20 = ₦450m.
4. WACC.
   60% × 14% = 8.4%
   40% × 10% × (1 − 0.25) = 3.0%
   WACC = 11.4%.
5. Capital charge.
   450 × 11.4% = ₦51.3m.
6. EVA.
   67.75 − 51.3 = ₦16.45m, positive.
7. Comment. The company earned ₦16.45m more than its capital cost and created value. Residual income computed on profit after tax of ₦48m with a charge on book capital of ₦400m would give a different figure, because it makes none of these adjustments.

1. EVA.
   30 − 20 = ₦10m, positive.
2. With ₦340m:
   30 − 34 = −₦4m, negative.
   The same NOPAT does not create value on a larger capital base.

Expect variants: a second year to calculate and compare, a statement of which adjustments to make, a requirement to calculate residual income and compare, and discussion of benefits and problems.

Amortised research costs, and a regulated return on capital

Research and development that is written off in the accounts but expected to give long-term benefit is added back to NOPAT and treated as capital, then amortised over its useful life: R&D of ₦6.0bn expected to benefit five years is added back and ₦1.2bn (6.0 ÷ 5) is deducted as amortisation, a net add-back of ₦4.8bn in year one; the unamortised ₦4.8bn is added to capital employed.

Other adjustments in such questions:

• add the provision for doubtful debts charged for the year and add its balance to capital employed
• add the deferred tax provision (tax paid in cash is used)
• add other non-cash items
• add accounting depreciation and deduct economic depreciation (which may be higher or lower)

A regulated utility. Where a regulator sets a target return on capital employed for regulated services, the company must check its regulatory ROCE (regulated operating profit ÷ the regulator’s valuation of capital) against the target: a breach can bring fines.

The constraint changes performance management: in regulated activities profit is capped, so targets focus on cost control, tight budgets, efficiency and variances; in non-regulated activities targets favour revenue growth, margin and innovation, perhaps funded by cash from the regulated business.

A capped return may be too low to create value for shareholders, which a measure such as EVA can show, and extra value created in the regulated part is discouraged unless it outweighs the penalty.

An analyst’s adjustments to profit and capital

The approach measures value added = adjusted profit − a capital charge, with both profit and capital restated to reflect economic reality. Interest and borrowings: interest is added back to profit because the charge for all capital is made through the cost of capital, and borrowings are included in capital employed.

Research and development and advertising: these are treated as investments, so the year’s expense is added back to profit (less any amortisation) and past expenditure still giving benefit is added to capital. Goodwill written off against reserves is added back to capital (it is part of what was invested), and its amortisation added back to profit.

Tax is the cash paid, and the deferred tax provision is added to capital because it is like funding. Example: adjusted profit ₦16.1m, capital ₦146.0m at 12% requires ₦17.5m, so value destroyed ₦1.4m. Comments: the adjustments are judgemental, capitalising past spending needs an estimated life, and the result depends on the cost of capital chosen.

Common mistakes

• Deducting interest in NOPAT. Add it back, net of tax relief.
• Forgetting to add intangibles to capital employed when they are added back to NOPAT.
• Using the cost of debt before tax in WACC.
• Using current rather than target weights when the question gives a target.
• Using closing capital when opening is required.
• Calculating without interpreting.

Quick revision

• EVA = NOPAT − capital employed × WACC. Positive: value created.
• NOPAT: PAT + after-tax interest + non-cash expenses + written-off intangibles.
• Capital employed: opening book + leases + intangibles + provisions. WACC: target weights, after-tax debt.
• Problems: complexity, absolute figure, cost.

How the marks are earned

• NOPAT and capital employed adjustments.
• WACC and EVA, correct.
• Interpretation and comparison with other measures.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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