ECONOMIC VALUE ADDED
INTRODUCTION
The decision to invest in the equity shares of a company assumes greater risk than investing in any other modes of capital formation because there is no assured periodical return for the equity shareholders and also they have only residual claim on the profit and assets of the business. The investor will be presuming certain opportunity cost while he makes an investment decision. An equity shareholder needs to be compensated sufficiently for accepting the risk and opportunity cost involved in his investment decision.
From the initial phase of studying financial management, we were told that, maximizing shareholders’ wealth is the one and only objective of financial management. In the past, the major tools that were used to analyze financial performance of any business firm are Cash Flow Statement, Fund Flow Statement, Comparative Statements, Common Statements, Break Even Analysis, Budgeting, Ratio Analysis, etc. Most of these performance measures does not give due care for analysing the expectation of an equity shareholder on his investment. Although ratios like Return on Investment (ROI) and Earning per Share (EPS) quantify the amount of return that is available to the equity shareholders on his each rupee of investment, the expectation of equity shareholders is completely ignored.
In this scenario, the performance measurement tools which focused on measuring shareholders’ wealth grabbed attention. Some of them are Residual Income (RI), Economic Value Added (EVA), Market Value Added (MVA), etc.
ECONOMIC VALUE ADDED
Economic Value Added is a performance metric that calculates the value creation of shareholders’ investment. It is calculated as the difference between the Net Operating Profit After Tax (NOPAT) and the opportunity cost of invested Capital. This opportunity cost is determined by the weighted average cost of Debt and Equity Capital (WACC).
EVA = NOPAT – (Capital * WACC)
Or
EVA = NOPAT...