Building Long-term Value: Plan on It
"Everything has a price, as the saying goes, but a lot of p...
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Economic Value Added (EVA) is a complicated formula that provides excellent insight into performance. The goal of calculating EVA is to determine true economic profit, after taking into account the opportunity cost of capital invested.
Here's an example of how it works:
But if you instead invest the $50,000 in a CD yielding 4 percent, you could earn $2,000 a year in interest. So, in EVA terms, $2,000 is the cost of capital and should be deducted from your operating profits to show your true profit. The goal of EVA is to determine whether the company has generated a greater return on a capital investment than it could have received by investing the money elsewhere.
Here's another example. Say you have $8,000 you plan to invest in website upgrades. You feel that investment will generate additional profits of $2,000 a year. That sounds good, since you'll pay off the investment in four years, but let's factor in EVA. Instead, you could invest the money in a CD yielding 4 percent. With a CD there's no risk; you know you'll receive that return.
There is risk investing the money in your website, though, because it's impossible to know whether the upgrades will actually pay off. As a result, you decide you need to make at least 10 percent on your investment because of the risk you incur. (Think of the 10 percent as a quasi-internal rate of return.)
So you make the investment and do generate the $2,000 in additional profits you anticipated.
But wait; your cost of capital is $8,000 x 10 percent, or $800. $2,000 – $800 = $1,200; that's your true economic profit. In those terms, it will take six or seven years to pay back the investment after you factor in the opportunity cost. (Again, these are intentionally rough calculations. If you're an accountant and you want to share a comprehensive example, feel free to do so in the comments.)
The goal of EVA is to answer this question: If I make an investment, will it generate profits that outweigh the risk and truly add value to the company?
Sources: "Should You Track Economic Value Added?" Inc.