Use Economic Value Added Analysis When Your Business Has Debt - dummies

Use Economic Value Added Analysis When Your Business Has Debt

By Stephen L. Nelson

In very large businesses, economic value added (EVA) analysis gets computationally burdensome. You can use the information that you create with QuickBooks to help use EVA analysis when your business has 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 that’s 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 lends money at 10 percent), and owner’s equity. Here’s an approach to estimating the capital charge that needs to be compared with the net income when this other debt is considered.

Estimating the All-Encompassing Capital Charge
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
  • Trade vendors: The trade vendors provide debt but the firm doesn’t have to pay a charge to those creditors. In effect, any implicit charge that the firm pays to trade vendors is already counted in the amount that you pay those vendors for the products or services that they supply. 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. The owner’s equity capital charge is shown as $40,000. (This is the same $40,000 capital charge discussed earlier in the chapter.) This capital charge is calculated by multiplying a cost of capital percentage, 20 percent, by the owner’s equity (20 percent of $200,000 equals $40,000). The adjusted capital charge, therefore, equals $50,000.

Okay. So far, so good. The second step in working with this slightly more complicated EVA model is to add back the interest charges paid to lenders in order to achieve an adjusted income number. Think about this for a minute.

The business made $50,000 in income, but this amount has already been adjusted for $10,000 of interest expense. 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 $10,000 of interest expense.

In other words, when you’re looking at paying all the capital sources of return (whether in the form of interest or dividends), you have not only the $50,000 of net income, but also the $10,000 of interest expense. Does that make sense?

Finally, there’s a pot of money left over at the end to pay creditors and owners. And that pot of money, as shown on the income statement, 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.

It’s no coincidence that the simple EVA formula and the more complicated EVA formula return the same result. EVA shouldn’t change because you use a more complicated formula — as long as both the simple and complicated formulas are correct. (They are.) So what’s up? The more complicated formula lets you see how changes in your debt affect the EVA.