Residual Income (RI) or Economic Value Added (EVA)

Residual Income (RI) or Economic Value Added (EVA):

In the field of corporate finance, economic values added is a way to determine the value created, above the required return, for the shareholders of a company. Shareholders of the company will receive a positive value added when the return from the capital employed in the business operations is greater than the cost of that capital. The goal of all companies is to create value for the shareholder. But how is value measured? Wouldn’t it be nice if there were a simple formula to figure out whether a company is creating wealth? A growing number of analysis and consultants think there is an answer – Economic Value Added (EVA). EVA is a performance metric that calculates the creation of shareholder value. It distinguishes itself from traditional financial performance metrics such as net profit and EPS. EVA is the calculation of what profits remain after the costs of a company’s capital – both debt and equity – are deducted from operating profit. The idea is simple but rigorous: true profit should account for the cost of capital. In corporate finance, Economic Value Added or EVA is an estimate of true economic profit after making corrective adjustments to accounting, including deducting the opportunity cost of equity capital. The concept of EVA is in sense nothing more than the traditional, commonsense idea of “profit”, however, the utility of having a separate and more precisely defined term such as EVA or Residual Cash Flow is that it makes a clear separation from dubious accounting adjustments that have enabled business such as Enron to report profits while in fact being in the final approach to becoming insolvent. EVA can be measured as Net Operating Profit After Taxes (NOPAT) less the money cost of capital. EVA is similar to Residual Income (RI), although under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula). Another, much older term for economic value added is Residual Cash Flow. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital). The amortization of goodwill or translations that can be made to Economic Profit to make it EVA.

The Calculation of EVA:

There are four steps in the calculation of EVA:

1. Calculate Net Operating Profit After Tax (NOPAT)
2. Calculate Total Invested Capital (TC)
3. Determine a Cost of Capital (WACC)
4. Calculate EVA = NOPAT – WACC% × (TC)

Formula:

The formula for the calculation is EVA i.e. residual income equals to income earned minus cost of capital on investment.

Economic profit – [ROIC × Invested Capital] – [WACC × Invested Capital]

For example, suppose that the cost of capital is 12%. Then the cost of capital for the company is 12% on Rs. 1,000 Lakhs capital invested = Rs. 120 Lakhs. It the net gain is Rs. 130 Lakhs, therefore RS. 130 Lakhs. Rs. 120 Lakhs = Rs. 10 Lakhs. This is the addition to shareholder wealth due to management’s hard work (or good ludk). But if the cost of capital were 20%, then EVA would be negative by Rs. 70 Lakhs.

According to Stern Stewart, literally dozens of adjustments to earnings and balance sheets – in areas like R & D, inventory, costing depreciation and amortization of goodwill – must be made before the calculation of standard accounting profit can be used to calculate EVA. To product its trademark, Stern Stewart doesn’t fully disclose the adjustments – making the job of using the metric even more difficult. Figuring out the cost of capital (WACC) is even more thorny. WACC is a complex function of the capital structure (proportion of debt and equity on the balance sheet), the stock’s volatility measured by its beta, and the market risk premium. Small changes in these inputs can result in big changes in the final WACC calculation.

This method calculates a net return to shareholders. It considers the earnings after deducting a charge for the cost of capital. When firms calculate income, they start with revenues and then deduct cost, such as wages, raw material costs, overheads and taxes. But there is one cost that they do not commonly deduct i.e. the cost of capital. They even allow for depreciation of the assets financed by investors’ capital, but investors also expect a positive return on their investment. A business that achieves the break even point in terms of accounting profits is really making a loss; it is failing to cover the cost of capital. In order to judge the net contribution to value, it is necessary to deduct the cost of capital contributed to the company by its stockholders. Net income after deducting the return required by investors is called residual income or economic value added (EVA). Net return on investment and EVA are focusing on the same question. When return on investment equals the cost of capital, net return and EVA are both zero. But the net return is percentage and ignores the scale of the company. EVA recognizes the amount of capital employed and the amount of additional wealth created. A growing number of firms now calculate EVA and tie management compensation to it. They believe that a focus on EVA can help managers concentrate on increasing shareholder wealth.

The EVA is a registered trademark (EVA) by its developer, Stern Stewart & Company. The term EVA has been popularized by the consulting firm Stern-Stewart. But the concept of residual income has been around for some time, and many companies that are not Stern-Stewart clients use this concept to measure and reward managers’ performance. Other consulting firms have their own versions of residual income. Mckinsey & Company uses Economic Profit (EP), defined as capital invested multiplied by the spread between return on investment and the cost of capital. This is another expression of the concept of residual income.