Economic value added is the incremental difference in the rate of return over a company's cost of capital. In essence, it is the value generated from funds invested in a business. If the economic value added measurement turns out to be negative, this means a business is destroying value on the funds invested in it. It is essential to review all of the components of this measurement to see which areas of a business can be adjusted to create a higher level of economic value added. If the total economic value added remains negative, the business should be shut down.
To calculate economic value added, determine the difference between the actual rate of return on assets and the cost of capital, and multiply this difference by the net investment in the business. Additional details regarding the calculation are:
- Eliminate any unusual income items from net income that do not relate to ongoing operational results.
- The net investment in the business should be the net book value of all fixed assets, assuming that straight-line depreciation is used.
- The expenses for training and R&D should be considered part of the investment in the business.
- The fair value of leased assets should be included in the investment figure.
- If the calculation is being derived for individual business units, the allocation of costs to each business unit is likely to involve extensive arguing, since the outcome will affect the calculation for each business unit.
The formula for economic value added is:
(Net investment) x (Actual return on investment – Percentage cost of capital)
This calculation yields more reliable results when the targeted organization has a large asset base. Its results are less certain when a business has a large proportion of intangible assets.
For example, the president of the Hegemony Toy Company has just returned from a management seminar in which the benefits of economic value added have been trumpeted. He wants to know what the calculation would be for Hegemony, and asks his financial analyst to find out.
The financial analyst knows that the company's cost of capital is 12.5%, having recently calculated it from the company's mix of debt, preferred stock and common stock. He then reconfigures information from the income statement and balance sheet into the following matrix, where some expense line items are instead treated as investments.
|Account Description||Performance||Net Investment|
|Cost of goods sold||4,000,000|
|General & administrative||660,000|
|Research & development||230,000|
|Cost of patent protection||82,000|
|Cost of trademark protection||145,000|
|Total net investment||$3,632,000|
The return on investment for Hegemony is 17.8%, using the information from the preceding matrix. The calculation is $645,000 of net income divided by $3,632,000 of net investment. Finally, he includes the return on investment, cost of capital, and net investment into the following calculation to derive the economic value added:
($3,632,000 Net investment) x (17.8% Actual return – 12.5% Cost of capital)
= $3,632,000 Net investment x 5.3%
= $192,496 Economic value added
Thus, the company is generating a healthy economic value on the funds invested in it.
The measurement has benefited from the marketing efforts of consulting firms that want to install an economic value added measurement system; whether the metric will have standing over the long term is difficult to say.