EVA Example

But very simple example just to round up the idea of whether a company is creating or destroying value. Let us consider a company that is generating a NOPAT of $9 million. Therefore, from an accounting point of view, this company is making money. It is investing $100 million of capital. That capital was raised from capital providers, and these capital providers actually require the return of 10%. So the cost of capital of the company is 10%. So we are dealing with a company that makes, in any given period, $9 million with $100 million of capital invested and the capital providers require a return of 10%. Did this company create value or not? 

Well, to answer this question, we can calculate EVA with the first definition. A NOPAT of 9 million minus $100 million of capital multiplied by the 10% cost of capital, that gives me minus $1 million. Why minus $1 million? Well, remember what the product of capital multiplied by the cost of capital is what we call the capital charge. So, the managers of this company need to be delivering at least $10 million to properly compensate the capital providers, but they have delivered only $9 million. So they have been $1 million short, and that is the negative EVA. So, they generated $9 million. There was a minimum expectation of generating $10 million, the minus one million is the shortage of that provision of profits, provision of cash to the capital providers.

We can use the second formula. The second formula will be remembered, capital multiplied by the return on capital minus the cost of capital. And the return on capital was the NOPAT, in our case $9 million divided by the capital, in our case 100 million. So that gives you 9%. Now, 9% is the return on capital, 10% is the cost of capital, so we have a negative spread. If we put any amount of capital at any negative spread, then we are going to be destroying value. In this case, because we are putting $100 million in an activity that generates a return on capital is 1% that is the point lower than the cost of capital will destroy 1 million of value. So as we said before, you can use formula number one or formula number two. You are going to get numerically exactly the same number, and in this very simple company, in both cases, we are destroying $1 million of value.

Another way of saying that is that this company actually generated an accounting profit of $9 million, but generating an economic loss, a negative economic profit of $1 million. It fell short of compensated capital providers, and therefore, this company had a positive accounting profit but a negative economic profit.