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Value-Based Management (VBM) with Economic Value Added (EVA): A Simple Explanation

Richard Clarke

Value-Based Management (VBM) with Economic Value Added (EVA): A Simple Explanation

What is VBM with EVA?

Value-Based Management (VBM) aligns business decisions with shareholder value creation. Economic Value Added (EVA), a key VBM metric, measures profit after deducting the cost of capital. In the ACCA APM exam, you’ll calculate EVA to assess performance and recommend strategic improvements.

Let’s apply EVA to a manufacturing division.

Key Components of EVA Calculation

EVA shows whether a business earns more than its capital cost:

  1. Net Operating Profit After Tax (NOPAT): Profit after tax, adjusted for non-cash items.
  2. Capital Employed: Total assets used in operations, minus non-interest-bearing liabilities.
  3. Cost of Capital: Weighted Average Cost of Capital (WACC) × Capital Employed.

Formulae

  • NOPAT = Operating Profit × (1 - Tax Rate) (adjust for distortions if needed)
  • Capital Charge = Capital Employed × WACC
  • EVA = NOPAT - Capital Charge

Numeric Example

A manufacturing division’s performance in 2025:

  • Operating Profit: $500,000 (before tax)
  • Tax Rate: 20%
  • Capital Employed: $2,000,000 (assets - current liabilities)
  • WACC: 10% (blend of 6% debt and 15% equity costs)
  • Adjustments: Add back $50,000 depreciation to reflect economic profit.

Step 1: Calculate NOPAT

  • Pre-Adjustment: $500,000 × (1 - 20%) = $500,000 × 0.8 = $400,000
  • Adjusted NOPAT: $400,000 + $50,000 = $450,000 (depreciation added back)

Step 2: Calculate Capital Charge

  • Capital Charge = $2,000,000 × 10% = $200,000

Step 3: Calculate EVA

  • EVA = $450,000 - $200,000 = $250,000

Step 4: Interpret Results

  • EVA ($250,000): Positive, meaning the division creates $250,000 value beyond capital costs.

What Does This Mean?

  • NOPAT ($450,000): Economic profit exceeds accounting profit by including depreciation.
  • Capital Charge ($200,000): Cost of using $2M in capital.
  • Positive EVA: The division adds value, justifying investment.

Management might ask: Can we reduce capital employed? Should we invest more at this return?

Why It Matters for ACCA APM

EVA in VBM tests your ability to:

  • Measure performance beyond traditional profit metrics.
  • Adjust financial data for strategic insights (e.g., NOPAT adjustments).
  • Link results to management decisions (e.g., cost reduction, investment).

Practice with multi-division scenarios or WACC variations to excel in APM!