24.2.3: Economic Value Added

Economic Value Added

Economic value added (EVA) is a variation of RI used by many companies.^* It is calculated as follows:

$\begin{array}{l} \begin{matrix} Economic value \\ added (EVA) \end{matrix} & = & \begin{matrix} After-tax \\ operating income \end{matrix} & - & [\begin{matrix} \begin{matrix} Weighted \\ average \\ cost of capital \end{matrix} & \times & (\begin{matrix} \begin{matrix} Total \\ assets \end{matrix} & - & \begin{matrix} Current \\ liabilities \end{matrix} \end{matrix}) \end{matrix}] \end{array}$

That is, EVA substitutes the following numbers in the RI calculation:

Income: After-tax operating income
Required rate of return: (After-tax) weighted-average cost of capital
Investment: Total assets minus current liabilities, or, equivalently, long-term assets plus working capital^*

We use the Hospitality Inns’ data in Exhibit 24-1 to illustrate the basic EVA calculations. The weighted-average cost of capital (WACC) equals the after-tax average cost of all the long-term funds Hospitality Inns uses. The company has two sources of long-term funds: (1) long-term debt with a market value and book value of $4.5 million issued at an interest rate of 10%, and (2) equity capital that also has a market value of $4.5 million (but a book value of $1 million).^* Because interest costs are tax-deductible and the income tax rate is 30%, the after-tax cost of debt financing is $0.10 \times (1 - Tax rate) = 0.10 \times (1 - 0.30) = 0.07, or 7 %$ . The cost of equity capital is the opportunity cost to investors of not investing their capital in another investment that is similar in risk to Hospitality Inns. Hospitality Inns’ cost of equity capital is 14%.^* The WACC computation, which uses market values of debt and equity, is as follows:

$\begin{array}{rcl} W A C C & = & \frac{(7 % \times Market value of debt) + (14 % \times Market value of equity)}{Market value of debt + Market value of equity} \\ = & \frac{(0.07 \times $ 4,500,000) + (0.14 \times $ 4,500,000)}{$ 4,500,000 + $ 4,500,000} \\ = & \frac{$ 945,000}{$ 9,000,000} = 0.105, or 10.5 % \end{array}$

The company applies the same WACC to all its hotels because each hotel faces similar risks.

After-tax hotel operating income is

$\begin{matrix} Hotel operating \\ income \end{matrix} \times (1 - Tax rate) = \begin{matrix} Hotel operating \\ income \end{matrix} \times (1 - 0.30) = \begin{matrix} Hotel operating \\ income \end{matrix} \times 0.70$

EVA calculations for Hospitality Inns are as follows:

A table shows economic value added calculations for Hospitality Inns

The table depicts after-tax operating income minus the quantity weighted average cost of capital times the quantity total assets minus current liabilities to equal economic value added for hotels in San Francisco, Chicago, and New Orleans. The details of the table are as follows:

1. San Francisco

After-tax operating income: 240,000 dollars times 0.70

Minus the quantity

Weighted average cost of capital times the quantity total assets minus current liabilities: 10.50 percent times the quantity 1,000,000 dollars minus 50,000 dollars

Equals

Economic value added: 68,250 dollars

2. Chicago

After-tax operating income: 300,000 dollars times 0.70

Minus the quantity

Weighted average cost of capital times the quantity total assets minus current liabilities: 10.50 percent times the quantity 2,000,000 dollars minus 150,000 dollars

Equals

Economic value added: 15,750 dollars

3. New Orleans

After-tax operating income: 510,000 dollars times 0.70

Minus the quantity

Weighted average cost of capital times the quantity total assets minus current liabilities: 10.50 percent times the quantity 3,000,000 dollars minus 300,000 dollars

Equals

Economic value added: 73,500 dollars

The New Orleans hotel has the highest EVA. Economic value added, like residual income, charges managers for the cost of their investments in long-term assets and working capital. Value is created only if the subunit’s after-tax operating income exceeds the cost of investing the capital. To improve EVA, managers can, for example, (1) earn more after-tax operating income with the same amount of capital, (2) use less capital to earn the same after-tax operating income, or (3) invest capital in high-return projects.^*

Companies such as Briggs and Stratton (a leading producer of gasoline engines), Coca-Cola, Eli Lilly, and Infosys Limited use EVA to guide their decisions. CSX, a railroad company, credits EVA for decisions such as to run trains with three locomotives instead of four and to schedule arrivals just in time for unloading rather than having trains arrive at their destination several hours in advance. The result? Higher income because of lower fuel costs and lower capital investments in locomotives. Division managers find EVA helpful because it allows them to incorporate the cost of capital, which is generally only available at the company-wide level, into the decisions they make.

Try It! 24-2

Performance City supplies helicopters to corporate clients. Performance City has two sources of funds: long-term debt with a market and book value of $34 million issued at an interest rate of 10% and equity capital that has a market value of $12 million (book value of $7 million). The cost of equity capital for Performance City is 16%, and its tax rate is 40%. Performance City has divisions in two cities that operate autonomously. The company’s results for 2020 are as follows:

	Operating Income	Assets	Current Liabilities
New York	$2,250,000	$12,000,000	$2,400,000
Chicago	$2,900,000	$10,500,000	$3,600,000

What is Performance City’s weighted average cost of capital?
Compute each division’s Economic Value Added.

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