How to Use Economic Value Added When Your Business Has Debt
In very large businesses, economic value added (EVA) analysis gets really computationally burdensome. Although there are multiple potential problems, you should be familiar with one common complication: debt.
Here’s the deal: If a business can restructure its debt, bank loans, credit lines, mortgages, and so forth, borrowing can be used to boost EVA. Accordingly, and quite helpfully, another EVA model, which is slightly more complicated, enables you to recognize this extra wrinkle.
If your firm can freely restructure its debts, you may want to make two adjustments to the EVA analysis. First, you may need to use an all-encompassing cost of capital. An all-encompassing cost of capital considers both the cost of equity and the cost of any debt. Second, you use an adjusted net income number that includes not only the amounts paid to the shareholders, but also the amounts paid to lenders.
Calculating an all-encompassing cost of capital is the first step. For the sake of illustration, suppose that a business uses capital from three sources: trade vendors, a bank (which loans money at 10 percent), and the owner’s equity.
|Trade vendors ($20,000 @ 0 percent)||$0|
|Bank loan ($100,000 @ 10 percent)||10,000|
|Owner’s equity ($200,000 @ 20 percent)||40,000|
|Adjusted capital charge||$50,000|
None of the numbers is difficult to figure out:
Trade vendors: The trade vendors provide debt, but the firm doesn’t have to pay a charge to those creditors. So that portion of the capital charge is zero.
Bank loan: This $100,000 bank loan charges 10 percent. That bank loan, then, carries a $10,000 capital charge. In other words, in order to use the bank’s capital, the business pays $10,000 a year.
Owner’s equity: This final component of the capital charge is what the business owes the owners. In this example, the owner’s equity capital charge is shown as $40,000. This capital charge is calculated by multiplying a cost of capital percentage, 20 percent, times the owner’s equity (20 percent of $200,000 equals $40,000). The adjusted capital charge, therefore, equals $50,000.
The second step is to add back the interest charges paid to lenders in order to achieve an adjusted income number. Therefore, if you want to compare the funds that the business generated and that are available to pay capital sources, you need to add back the interest expense.
Finally, there’s a pot of money left over at the end to pay creditors and owners. And the pot of money includes both the $10,000 of interest expense and the $50,000 of net income.
After you’ve figured out an all-encompassing cost of capital and an adjusted income amount, you can calculate the EVA in the usual way. In this example, you use the following formula:
adjusted income ($60,000) - the weighted cost of capital charge ($50,000)
The result equals $10,000, which is the EVA amount.