CIMA P2 Syllabus C. Managing Performance Of Organisational Units - Economic Value Added - Notes ^{3 / 4}

Uses economic profits (NOPAT)

NOPAT = net operating profit after tax

EVA = NOPAT - (Adjusted invested capital (Capital employed) x WACC)

There are some differences in the way that NOPAT is calculated

• Future Investments ADDED back

  Costs which would normally be treated as expenses in the FS, but which are considered within an EVA calculation as investments building for the future, are added back.

  These costs are included instead as assets in the figure for net assets employed (Capital employed)

   Examples:
  - Research and development expenditure
  - Advertising costs
  - Staff training

• Non-cash items ADDED back 

  Investors are primarily interested in cash flows, so accounting adjustments for non-cash items.

  Therefore they should all be added back to capital employed.

  Any movements in provisions recognised as income or expenses in the income statement also need to be removed from NOPAT.

  Examples
  - Allowances for doubtful debts
  - Provisions
  - Inventory write-downs
  - Deferred tax provisions 
  - Goodwill

• Depreciation ADDED back

  The charge for depreciation in the income statement should be added back to profit, and a charge for economic depreciation made instead. 

  The value of non-current assets (and therefore capital employed) should also be adjusted to reflect the revised charge.

  Economic depreciation reflects the true change in the value of assets during the period. 

  Note: if no detail is given about economic depreciation in a question scenario, then you should assume that accounting depreciation is a reasonable approximation for it, and therefore you do not need to make any change to the depreciation figure.

• Operating leases

  Operating leases should be capitalised and added to capital employed. 

  Otherwise, the inconsistency in treatment between operating and finance leases means that firms can take advantage of operating leases to reduce the capital employed figure, and in doing so increase EVA. 

  In effect, EVA treats all leases as finance leases.

  Any operating lease charges in the income statement should be added back and removed from NOPAT.

  In principle, depreciation should then be charged on the assets acquired under finance leases. 

  However, remember that accounting depreciation is replaced with economic deprecation when calculating EVA.

Example: calculating EVA

A company has reported operating profits of $30 million. 

This was after charging $10 million for the development and launch costs of a new product that is expected to generate profits for 5 years.

Taxation is paid at the rate of 30% of the operating profit.

The company has a risk-adjusted weighted average cost of capital of 15% per annum and is paying interest at 10% per annum on a substantial long-term loan.

The company's non-current asset value is $50 million and the net current assets have a value of $20 million. 

The replacement cost of the non-current assets is estimated to be $80 million.

Required

Calculate the company's EVA for the period.

The capital charge is based on the weighted average cost of capital, which takes account of the cost of share capital as well as the cost of loan capital.

Therefore the correct interest rate to use is 15%.