 Hello and welcome to the session in which we would look at economic value added or EVA, also known as the residual income. This measure is a dollar amount rather than a percentage. So every time when we do, when we compute a rate of return on asset, rate of return on equity, what we do is a ratio we'll take X over Y and we'll get some type of a ratio here. In this computation, the economic value added, we're going to be looking at a dollar amount. So it's the measure of the dollar amount of the firm return and access of its opportunity cost. Now we're going to explain this. First, I'm going to show you the simple example to explain this concept that I'm going to go a little bit further into explaining what do we mean by opportunity cost. Before I start, as always, I would like to remind you to connect with me only and then subscribe to my YouTube channel where I have many accounting, finance, audit and tax courses on my website, farhatlectures.com. You will find additional resources, especially if you're studying for your CPA exam and or your accounting courses. Matter of fact, if you don't want to do anything, just visit my website to find out how well is your university doing on the CPA exam. There's I have a pass rate by university by section and average scores. It'll be very interesting to know where your school stand. Let's go ahead and keep going with this economic value computation. So I'm going to show you the simplest example to illustrate the big picture. Then we're going to dig a little bit deeper into this concept. So how do we compute economic value added? Simply put, we're going to take net operating after taxes or operating income. Basically, we call it in many tax books, they call it NOPAT, net operating after tax or simply operating income. We're going to subtract from that the invested capital times the required rate of return. What's the invested capital? How much assets do you have that you are using for the company? For a simple example, I'm going to say we have $100,000 worth of assets. And our required rate of return or WAC, whether you have WAC or required rate of return, we're going to assume they mean the same thing, which they are. It's the cost of capital for the company. And let's assume your required rate of return is 10%. What does that mean? It means the company has $100,000 in assets. The required rate of return, we need to return 10%. So if we take 100,000 times 10%, it's going to give us $10,000. So basically what we are saying is, since we invested 100,000, we expect to return 10%. We expect to have operating income of 10,000. Now what we do is we look at our actual operating income and our operating income happens to be 15,000. Well, guess what? If our operating income or NOPAT, our net income after taxes was 15,000, then we are higher $5,000 higher. So our economic value added is 5,000. So simply put, if you can earn more than what you are expected to earn, which is the required rate of return, then you have what's called a positive EVA or positive economic value added. Notice the answer is a dollar amount. The answer is not a percentage, like 6%, 8%. The answer is a dollar amount. So this is basically from a simplistic, not a simplistic. This is what economic value added is. I just want you to see the big picture. Then I'm going to dig a little bit more into this concept and look at actual companies from the real world to see how this all fits together. So simply put, if we want to consider a firm successful, a firm should be viewed as successful. Well, if the return on its projects, if you can invest the return on your invested capital, is better, is greater than the rate investors would expect to earn for themselves. And what do they expect to earn for themselves? They expect to earn the required rate of return. When you invest, you have a required rate of return. When you can make more money than the required rate of return in that company, then you should consider a company, a firm, a good firm, a successful firm. So to account for this, we measure the success of the firm using the difference between ROA, what should be your return on asset, and the cost of capital. So how much are you actually returning on your asset? So now we're going to be using percentages to find out the dollar amount. So the way we're going to compute this is take an ROA. The reason I'm showing you both formulas, because certain textbooks, they use this number. They rely on accounting figures like NOPAT, and other textbook, an investment textbook, and this course is investments, they rely on percentages. So for this textbook, we're going to be taking return on asset and minus the cost of capital. That's basically what we're doing. Taking those two figures, then multiplying it by the invested capital. So the economic value added is the spread. The spread is the difference between ROA return on asset and the cost of capital, the cost of capital. So the difference between those two ROA minus the cost of capital times the capital invested. Simply put, the formula would look something like this. ROA minus either WAC or K, which is the required rate of return or WAC, times the invested capital. This is how we compute this, and this will give us EVA. Now this formula and this formula are the same formulas. I'm not going to go in here and reconfigure the formulas. Just trust me, they're the same formulas in different textbooks. They use two different formulas, but they're both in front of you. Let's take a look at a real example. In 2016, Walmart has a weighted average cost of capital WAC of 4.59 based on their cost of debt and their capital structure, beta, so on and so forth. We're dealing with a WAC of weighted cost of capital, 4.59, done. Walmart return on asset ROA is 7.4. Remember, ROA is EBIT divided by average asset. Again, it's given to us, so ROA equal to 7.14. Take the difference between them, it's 2.55. So ROA, we are earning more than our WAC. That's it. Then we have a positive, positive. We should have a positive EVA, okay? So Walmart's return on asset was 7.14. It's 2.55 greater than the opportunity cost. What's the opportunity cost? 4.59. What do we mean by the opportunity cost? Simply put, if you're an investor, you have a required rate of return. Happens to be for Walmart 4.59, which is WAC required rate of return or the opportunity cost. Walmart is earning you more on their invested asset. They're earning 7.14, okay? For the assets that are invested in property, plant, and equipment, and know-how. In other words, each dollar invested by Walmart earned 2.55 cent more than the return that the investor could have anticipated by investing in equivalent risk stocks, because what is K for Walmart is 4.59. The expected rate of return is 4.59. They are earning 7.14. Therefore, if Walmart has assets of 120, almost 124 billion, we will find out that their EVA equal to 3.16 billion. Once again, EVA is a dollar amount, not a percentage. So it's economic value added, that is it's return and access of the opportunity cost. So the difference between, again, ROA minus K or WAC, the required rate of return or WAC, multiplied by the assets. So that's the second formula that I showed you that we will use in this course. Now, to illustrate this concept further, I'm gonna show you few companies and kind of be able to read, how do we interpret EVA in the real world? So let's take a look at this list of companies, Apple, Home Depot, Walmart, Microsoft, Intel, Walt Disney, AT&T, and Honda. This is their EVA already computed for us, their capital, which is the assets invested in the company, ROA, and the cost of capital K. So this is ROA, again, cost of capital, WAC, or K, which is the required rate of return. Now, remember that EVA is affected by size, by firm size, because it's a dollar amount. So if we look at this, the highest EVA is 5.2 billion, which is the EVA, the economic value added of Apple. Well, let's compare Apple to Home Depot and see who really has a better EVA. The difference between Home Depot, ROA, and its cost of capital, so if we look at ROA for Home Depot now, and the cost of capital, 8.5, is equal to 11.71. So investors at Home Depot, they are earning 11.71 more than their expected return. If we look at Apple, Apple is 11.85 minus 9.45. So it's even without doing this computation, you would know that the difference between ROA and cost of capital for Apple is lower. But obviously, Apple has a larger base. Apple has 220 billion. Therefore, if we take, even though it's 11, let's me, 11.85 minus 9.45, 2.4%, 2.4%. Although it's only 2.4%, but you're multiplying 2.4% by 220 billion. That's why the economic value added is affected by size. Home Depot, their way, their EVA percentage, and in quote, percentage is way higher than Apple. So the investors are earning a premium, but they have only almost 28 billion in assets. So Apple is better because it has a larger base. Let's take a look at Honda here. In Honda, they have a negative 4.1 billion economic value added. Now, why would that be the case? Well, let's take a look at their ROA. Their ROA is 2.13. Their cost of capital is 5.14. What is that gonna give us? That's gonna give us a negative, a negative percentage. And we're gonna take this negative percentage and multiply it by 124.56. And it's a large base, too. So that's why it's given us a negative EVA. So that's why it's a negative EVA. So Honda simply put that not cover its opportunity cost of capital, and its EVA was negative. So the EVA treats opportunity cost of capital as real cost that should be deducted from revenue to arrive to a more meaningful bottom line. Here we are talking from an economic perspective. You tell this to an accountant, they will think you are crazy. But from an economic perspective, what we are saying, we are not really utilizing our asset as much as we should do, okay? So this is, remember, EVA is more like, economists use this. Actually, it's called EVA, economic value added. So a firm that's generating accounting profit, but it's not covering its opportunity cost might be able to redeploy its capital a better use. So simply put, Honda will need to take a look at their assets and see if they can redeploy it to earn a higher rate of return on their assets, higher than their cost of capital. And that's why many firms, what they do to compensate managers, to give them bonuses, what they see, they would say, we're gonna rely on EVA rather than accounting numbers because we want to know if we are covering the opportunity cost for the investors. And based on that, you will be rewarded. If you like this recording, please like it and share it in the next session. I'll take a look at, I will decompose return on equity. But again, I'm gonna invite you, especially if you're a CPA candidate to check out my website, farhatlectures.com. I don't replace your accounting courses. I don't replace Bakker, Roger, Wiley or whatever course you are taking. I help you understand the material better. Economic value added is tested on the exam. I spend more time explaining this concept than any of the other CPA firm, because not firm, the other CPA prep companies, because they assume you already know it. I don't assume anything. I explain it to you. Good luck, study hard, and as always, stay.