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Strenghs, Weakness and Uses of the Economic Balue Added - Essay Example

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Strenghs, Weakness and Uses of the Economic Balue Added

This paper candidly evaluates the uses of Economic Value Added model in a business as well as its strengths and weaknesses. Uses of EVA EVA is obtained by subtracting the cost of capital from Net Operating Profit After Tax (NOPAT).In this regard, Al Ehrbar (2008) depicts that it is a useful tool for measuring the extent to which value has been lost or added on the business performance. After accounting for the various aspects covered by the balance sheet, EVA indicates the amount of the residual income. There are various factors that cause an increase of EVA. First, if capital employed does not increase and the NOPAT increases. Secondly, EVA increases if the additional capital invested generates more returns than the cost of capital. EVA can also increase if the capital that was earlier invested in a business is divested if it fails to cover the cost of capital used by a business. Economic Value Added=Operating income obtained after tax-(Investment in assets * weighted average cost of capital) (Bennett, 1991). If the EVA figure is negative, it means that a business is consuming more capital instead of creating wealth. On the other hand, a positive EVA indicates that the company has earned more after tax revenue than the costs incurred in generating that revenue. The examples below indicate the procedure of calculating EVA. Example 1 EVA for Pitt Products Company (figures in $000) Income from operations 364 Earnings before interest and taxes 364 Pretax income 320 Net income 192 Net profit after tax 192 Capital employed 1200 Capital Cost Rate 8.7% In this case EVA=NOPAT-Capital Charge NOPAT=Net profit after tax + Total Adjustments-Tax savings on Adjustments =192+ (42-50)-(42+50)*0.4 =248.4 Capital charge = Capital * Capital Cost Rate = 1,200*0.087 =248.4-104.4 =104.4 Therefore EVA =248.4 -104.4=144. This implies that in 1998, Pitt Products had a positive EVA of $ 144,000. Example 2 The information below gives information as depicted by XYZ Company 2000 financial statements (figures in $000). Total Capital $1,400 Weighted Average Cost of Capital =1 1.3% Gross profit 736 Selling, General & Administration Expenses 400 Taxes 134 Sales 2,436 Cost of goods sold 1,700 NOPAT = Operating Profit-Taxes Operating Profit =Gross Profit- Selling, General & Administration Expenses = 736-400=336 Therefore NOPAT=336-134=202 Capital Charge =11.3%*1500=169.5 This implies that EVA of XYZ Company =202-169.5=32.5 XYZ has an EVA of $32,500. This indicates that the company creates wealth for shareholders equity. Evaluation of employee’s performance In addition to measuring of business performance, Baran et al, 2007 argues that EVA is also used in evaluating employee’s performance. In order to effectively evaluate the productivity of the employees, EVA should be accompanied by appropriate measures that entail all the performance attributes that are vital for the achievement of long-term benefits. This involves use of balanced score card that defines the major aspects that contributes to a long term success. These aspects include learning perspective and innovation, customer perspective, financial perspective and internal business activities perspective. In addition, Baran et al, 2007 stipulates that In order to create a balanced scorecard, managers must consider the strategic goals of the firm. This implies that ...Show more

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Running head: STRENGTHS, WEAKNESSES AND USES OF THE ECONOMIC VALUE ADED MODEL Strengths, weaknesses and uses of the Economic Value Added Insert Name Insert Insert 22nd November 2011 Introduction Economic Value Added (EVA) model also referred to as economic profit refers to the value created above the shareholders investment…
Author : terrence61
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