How does Economic Value Added (EVA) measure true economic profit, and how does it relate to residual income?

Economic Value Added (EVA) measures the economic profit a company generates above its total cost of capital, including the opportunity cost of equity. Unlike accounting profit, which only deducts interest (debt cost), EVA charges for all capital employed, revealing whether management truly creates value.\n\nEVA Formula:\n\nEVA = NOPAT - (WACC x Invested Capital)\n\nOr equivalently:\nEVA = (ROIC - WACC) x Invested Capital\n\nwhere NOPAT = Net Operating Profit After Taxes, ROIC = Return on Invested Capital.\n\nRelationship to Residual Income:\n\nResidual Income (generic) = Net Income - (r_e x Book Equity)\nEVA = NOPAT - (WACC x Total Invested Capital)\n\nEVA is a specific, refined version of residual income with important adjustments:\n- Uses NOPAT (removes financing effects) rather than net income\n- Charges WACC on total capital, not just equity\n- Applies accounting adjustments to reduce distortions\n\nWorked Example:\n\nPalmetto Industrial Corp financial data:\n\n| Item | Value |\n|---|---|\n| Revenue | $85M |\n| EBIT | $14.2M |\n| Tax rate | 27% |\n| Total debt | $30M |\n| Equity (book) | $45M |\n| Invested capital | $75M |\n| WACC | 10.5% |\n\nNOPAT = EBIT x (1 - t) = $14.2M x 0.73 = $10.366M\n\nCapital charge = WACC x Invested Capital = 10.5% x $75M = $7.875M\n\nEVA = $10.366M - $7.875M = +$2.491M\n\nROIC = $10.366M / $75M = 13.82%\nEVA = (13.82% - 10.50%) x $75M = 3.32% x $75M = $2.49M (same result)\n\nPalmetto creates $2.49M of value above its capital costs -- shareholders are better off.\n\nContrast with accounting profit:\n- Accounting net income: $14.2M - $1.8M interest - $3.35M taxes = $9.05M\n- Looks profitable, but ignores the $4.725M cost of equity capital (10.5% x $45M)\n- EVA tells the full story\n\nCommon EVA Adjustments:\n1. Capitalize R&D and amortize (rather than expense immediately)\n2. Add back goodwill amortization to capital\n3. Use FIFO inventory consistently\n4. Add operating lease assets to invested capital\n5. Remove non-recurring charges\n\nInterpretation:\n- EVA > 0: Management creates value beyond capital costs\n- EVA = 0: Management earns exactly the required return\n- EVA < 0: Management destroys value (earns below cost of capital)\n\nExplore corporate performance metrics in our CFA Corporate Issuers course.