Economic Value Added and Other Value-Based Methods

Understand Economic Value Added and Other Value-Based Methods

Key rules to remember

EVA

EVA = NOPAT − (WACC × Invested capital)

NOPAT = EBIT × (1 − tax rate). Use capital at the start of the year unless the question says otherwise.

Capital charge

Capital charge = WACC × Invested capital

Covers both debt and equity cost.

Spread form of EVA

EVA = (ROIC − WACC) × Invested capital

ROIC = NOPAT ÷ Invested capital.

MVA

MVA = Market value of firm (equity + debt) − Capital invested

Equity-only version: market capitalisation − book equity. Use the same basis on both sides.

MVA from EVA

MVA = Σ EVAt ÷ (1 + WACC)^t

If EVA is a constant perpetuity, MVA = EVA ÷ WACC.

Residual income

RI = Profit − (Required rate × Capital)

For equity: RI = Net profit − (Ke × Book equity).

Residual income valuation

Equity value = Book equity + PV of future RI

Discount RI at the cost of equity.

Excess earnings

Excess earnings = Maintainable profit − (Normal rate × Net tangible assets)

Goodwill = Excess earnings × years' purchase, or Excess earnings ÷ capitalisation rate.

How to solve Economic Value Added and Other Value-Based Methods questions

1. 1Identify what is asked: EVA, MVA, RI, goodwill or total business value.
2. 2Find the profit figure. For EVA, compute NOPAT after tax and add back adjustments the question mentions, such as R&D or interest inside operating profit.
3. 3Fix the capital base. Use the capital employed the question gives; do not add or drop items on your own.
4. 4Find the rate. For EVA compute WACC from weights and after-tax cost of debt. For excess earnings use the normal rate given.
5. 5Compute the charge and subtract it from profit to get the surplus.
6. 6Convert the surplus to value if asked: divide by the rate for a perpetuity, or multiply by years' purchase, or discount year by year.
7. 7Add the value to the base if needed, such as book equity plus PV of RI, or tangible assets plus goodwill.
8. 8State a conclusion in one line: value created or destroyed, and what it means.

Quickest way: Spread shortcut

Common mistakes in Economic Value Added and Other Value-Based Methods

• Deducting only interest instead of a full capital charge in EVA.

  Students carry over the accounting profit idea where only debt has a visible cost.

  Fix: Start from NOPAT before interest and charge WACC on total capital, debt plus equity.

• Using pre-tax cost of debt in WACC.

  The tax shield is overlooked when the rate is given as a simple percentage.

  Fix: Use Kd × (1 − t) in WACC every time.

• Mixing equity-only market value with total capital in MVA.

  Both debt and equity terms appear in the data.

  Fix: Match the basis: firm value against total capital, or market equity against book equity.

• Including goodwill or surplus assets in net tangible assets for the excess earnings method.

  Balance sheet totals are used without adjustment.

  Fix: Use only fairly valued tangible assets used in the business. Remove goodwill and non-trading assets, and adjust profit accordingly.

• Not adjusting profit to maintainable level before finding excess earnings.

  Reported profit is taken at face value.

  Fix: Remove abnormal gains and losses, adjust for fair remuneration and tax if told, then compute excess.

• Discounting residual income at WACC in an equity model.

  WACC is the rate students use most often.

  Fix: Equity residual income uses cost of equity for both the charge and the discounting.

Worked examples