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Business Finance

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Explanation & Answer

The EVA calculation starts with operating income. This profit figure can be pre-tax or post-tax, according to taste. Operating income net of tax is called Net Operating Profit after Tax (NOPAT). Capital charges are then subtracted from NOPAT to arrive at EVA. Capital charges equal the cost of capital (for both debt and equity), multiplied by invested capital. A common approach to determining the cost of capital is to use the formula for the weighted-average cost of capital, otherwise known as WACC. WACC is based on the cost of debt and the cost of equity, weighted for their relative proportions in the company's capital structure. However, the cost of debt needs to be adjusted for the tax savings that arise from the deductibility of interest payments. So the interest cost is not double counted. In fact, the tax benefit (= interest expense * the marginal tax rate) has the effect of increasing EVA.

Ghgbe X (29)
Boston College

I was struggling with this subject, and this helped me a ton!