An EVA with Debt QuickBooks Example

By Stephen L. Nelson

Here’s an example of a modified EVA approach in QuickBooks. Suppose that you, the business owner, go down to the bank and take out another $100,000 loan. Then suppose that the business pays this amount out to the business owner (you) in the form of a dividend. If this transaction occurred at the beginning of the year, you get this income statement and balance sheet.

A Simple Income Statement
Sales revenue $150,000
Less: Cost of goods sold 30,000
Gross margin $120,000
Operating expenses
Rent 5,000
Wages 50,000
Supplies 5,000
Total operating expenses 60,000
Operating income 60,000
Interest expense (20,000)
Net income $40,000

This table reflects the additional loan.

A Simple Balance Sheet
Assets
Cash $25,000
Inventory 25,000
Current assets $50,000
Fixed assets (net) 270,000
Total assets $320,000
Liabilities
Accounts payable $20,000
Loan payable 200,000
Owner’s equity
S. Nelson, capital 100,000
Total liabilities and owner’s equity $320,000

In other words, the only differences between the description of the business in Tables 2-1 and 2-2 and its description in these two tables are that the firm has $100,000 more debt and $100,000 less owner’s equity, and the extra debt produces another $10,000 a year of interest expense. That’s pretty straightforward, right?

This table estimates the capital charge for this new, more highly leveraged firm. Once again, check out the components of the capital charge. The trade vendors, who supply $20,000 of trade credit in the form of accounts payable, don’t charge anything, so there’s no capital charge for their contribution to the firm’s capital structure. In the new, more highly leveraged firm, the bank loan charge has gone way up. Now the firm is carrying a $200,000 loan. With 10 percent interest, the capital charge on the loan rises to $20,000 annually.

Estimating the New Capital Charge
Trade vendors ($20,000 @ 0 percent) $0
Bank loan ($200,000 @ 10 percent) 20,000
Owner’s equity ($100,000 @ 20 percent) 20,000
Adjusted capital charge $40,000

The final owner’s equity capital charge also changes: It drops. With the decrease in owner’s equity to just $100,000, the 20 percent capital charge decreases to $20,000 a year.

When you add up all the bits and pieces, you come up with an adjusted capital charge of $40,000. Remember that this is the capital charge for the new, more highly leveraged business.

For this new, more highly leveraged business, the EVA changes. The adjusted income for the business is $60,000 (calculated as the $40,000 of net income plus $20,000 of interest expense). You can calculate the EVA by subtracting the $40,000 capital charge from the $60,000 of adjusted income. The result equals $20,000 of EVA. The EVA doubles, obviously, when the business is more highly leveraged.

This example shows why the more complicated EVA formula can be useful. The example recognizes more explicitly how EVA results when a firm produces income in excess of the capital charges.