How to calculate economic value added |
Calculating economic value added (EVA)Calculating the economic value added by a business unit or a new business opportunity, requires the managers or business owners to take into account the net operating profit, any applicable taxes and the cost of capital employed or to be employed. In other words; EVA = (net operating profit - applicable taxes) - cost of capital Let us assume that your business is planning on expanding to another area. The cost of setting up an operating environment in that area is about $50 000 over the next two years. It is estimated that your return (after paying taxes) over the next two years will be $45 000. EVA in this case can be calculated as: EVA = (net operating profit - applicable taxes) - cost of capital = (45000) - 50000 = -5000 Since the EVA is negative, it means that the return on that investment over the next two years will be lower than the capital used to support the operations. If the operations in that area are expected to only last two years, then the effort is not worth the investment. In other words, you are better off investing your money elsewhere for larger returns. If the business is expected to pick up after the first two years, then the whole equation changes depending on what you are expecting to earn and the amount of resources required to support your operations in subsequent years. Bellow is another formula used to calculate EVA: EVA = (percentage return on invested capital - percentage cost of capital) x Initial capital invested |
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