Economic value added and Reducing balance: Difference between pages

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(EVA).
1.
1.
The periodic addition to shareholder value resulting from the efficient management and allocation of a firm's resources.


EVA can be quantified at a whole-firm level as:
A basis of allocating costs or allowances across successive time periods by applying a consistent periodic percentage charge to - for example - the reducing net book value of a fixed asset.
EVA = [Return on book capital LESS Market cost of capital] x Book capital.


Taking a simplified example, for an all-equity financed firm with a market capitalisation (P<sub>0</sub>) of $130m, book value of equity $100m, and annual after tax returns of $13m.


[To keep the illustration simple, we will assume no growth, in other words the whole of the annual after tax returns of $13m are paid out as dividends (D<sub>1</sub>).]
'''Example'''


Return on book capital = 13/100 = 13%.
A fixed asset has a cost of $12m,
Market cost of capital = 13/130 = 10%
(Using Ke = D<sub>1</sub>/P<sub>0</sub>).
EVA = [13% - 10% = 3%] x $100m = $3m.


''In practice a number of adjustments would be made both to the market values and to the book values used in the calculation of the EVA. So the application of EVA analysis is both more complicated, and arguably more subjective, than the simple calculation illustrated above.''
to be depreciated on a reducing balance basis at a rate of 40% per year.


Turning back for now to our simple example, EVA is also closely related to Market value added (MVA).  MVA is the total present value of the expected EVA in the current and future periods.


For example in this case it is a simple fixed perpetuity of $3m, which is evaluated using the simple fixed perpetuity formula 1/r at the market cost of capital 10%:
The depreciation charge for Year 1 would be:
MVA = $3m/0.10 = $30m.
 
= $12m x 40%
 
= $4.8m.
 
 
The net book value at the end of Year 1 (and the start of Year 2):
 
= 12 - 4.8
 
= $9.2m.
 
 
The depreciation charge for Year 2:
 
= $9.2m x 40%
 
= $3.68m.
 
 
The net book value at the end of Year 2 (and the start of Year 3):  
 
= 9.2 - 3.68
 
= $5.52m.
 
 
And so on.
 
Using a reducing balance basis of depreciation, the net book value never falls to zero (unless the asset is disposed of).
 


2.
2.
It is also possible to calculate and analyse EVA at the individual project level.
In simple terms, EVA is positive when the project Internal rate of return exceeds the (appropriately risk-adjusted) Weighted average cost of capital.


A simple decision rule when using EVA at the project level is to reject all negative EVA projects.
''UK tax.''
Positive EVA projects would be considered further.
 
UK Writing Down tax Allowances are normally available to be claimed on a reducing balance basis.


The important insight from EVA analysis is that a project or division is <u>destructive</u> of shareholder value when its returns are inferior to the relevant economic cost of capital, even if it appears to be profitable when measured on an accounting basis (for example on an Earnings per share basis).


== See also ==
== See also ==
* [[Book value]]
* [[Depreciation]]
* [[Cost of capital]]
* [[Straight line]]
* [[Earnings per share]]
* [[Sum of the digits]]
* [[Excess Return]]
* [[Writing down allowance]]
* [[Market value added]]
* [[Return on capital employed]]
* [[Shareholder value]]
* [[Wealth Added Index]]


[[Category:Accounting,_tax_and_regulation]]

Revision as of 12:35, 18 March 2015

1.

A basis of allocating costs or allowances across successive time periods by applying a consistent periodic percentage charge to - for example - the reducing net book value of a fixed asset.


Example

A fixed asset has a cost of $12m,

to be depreciated on a reducing balance basis at a rate of 40% per year.


The depreciation charge for Year 1 would be:

= $12m x 40%

= $4.8m.


The net book value at the end of Year 1 (and the start of Year 2):

= 12 - 4.8

= $9.2m.


The depreciation charge for Year 2:

= $9.2m x 40%

= $3.68m.


The net book value at the end of Year 2 (and the start of Year 3):

= 9.2 - 3.68

= $5.52m.


And so on.

Using a reducing balance basis of depreciation, the net book value never falls to zero (unless the asset is disposed of).


2.

UK tax.

UK Writing Down tax Allowances are normally available to be claimed on a reducing balance basis.


See also

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