Since,
creating shareholder value has become the widely accepted
corporate objective nowadays, EVA deals with accounting
for the cost of capital and determines the sufficiency or
insufficiency of earnings generated by the firm to cover
the cost of capital i.e., whether a firm is a value generator
or a value diluter. As such, EVA is an estimate of `true
economic profit', or the amount by which earnings fall short
of the required minimum rate of return that shareholders
and lenders could get by investing in other securities of
comparable risk (Stewart, 2000). EVA differs from traditional
accounting measures of corporate profit by including, EBIT
(Earnings Before Interest and Taxes), EBITDA (EBIT plus
Depreciation and Amortization), net income, and even NOPAT
(Net Operating Profit after Taxes), because it fully accounts
for the firm's overall capital costs.
This analytical difference
is important to the firm's owners because the EVA metric
is the net of both the direct cost of debt capital and the
indirect cost of equity capital, as reflected in the shareholders'
required return on common stock (Grant, 2003). EVA
is the difference between the firm's NOPAT and the stakeholder's
expectations, which is the capital charge for both debt
and equity, i.e., overall cost of capital.
The
idea behind EVA is that the shareholders must get a return,
which compensates the risk taken. Hence, if NOPAT exceeds
CC i.e., capital charge, it means that return is more than
cost and therefore the company's EVA is positive. It indicates
that company has generated value for its shareholders. In
the same way, if NOPAT is less than CC, EVA is negative
and the company is a wealth destroyer. On the other hand,
if NOPAT is equal to CC, it means EVA = 0. However, this
should be taken as sufficient achievement because shareholders
have earned a return, which compensates the risk taken by
them. |
