Subject 2. Commercial Implementations of the Residual Income Concept PDF Download
There are several other measures of economic earnings related to residual income model.
EVA = Net Operating Profit after Taxes (NOPAT) - Dollar Cost of Capital MVA = Market value of the company - Total Capital
Economic Value Added (EVA)
This is a commercial implementation of the residual income concept. Economic Value Added (EVA) measures values added to shareholders by management.
where: Dollar Cost of Capital = (Cost of capital % ) x (Total Capital)
In practice, both accounting NOPAT and Total Capital are adjusted to correctly estimate EVA:
- R&D expenses are capitalized and amortized. This increases NOPAT accordingly.
- Charges for capital for strategic investments are suspended if they are not expected to generate a return immediately.
- Goodwill is capitalized. Total Capital is adjusted for accumulated amortization and amortization expense is added back to NOPAT.
- Non-cash tax expense is removed.
- LIFO reserve is added back to the Total Capital and NOPAT is adjusted for the change in LIFO reserve.
- Operating leases are treated as capital leases.
- Nonrecurring items are eliminated from the income statement.
Market Value Added (MVA)
This measures the effect on value of management's decisions since the firm's inception.
where the first term on the right side of the equation is the total market value of all debt and equity issued by the company. A company producing positive MVA should have an excess of market value over book value.
EVA and MVA are related concepts: in theory MVA can be thought of as a sum of capitalized future EVA.
Residual income models are used not only for equity valuation and prediction of stock prices, but also to measure internal corporate performance and to determine management compensation.
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