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Hello
We are told in the EVA article part 2 page 3 that Residual income and EVA are essentially the same. However, RI includes a finance charge and in NOPAT we are asked to exclude it. Moreover, NOPAT can have 160 adjustments as per the article. Surely RI cannot equal to EVA if they have so many differences.
Could you please clarify
Thank you
The last stage in EVA does remove a finance charge from NOPAT based on the company’s WACC.
There are, of course, differences between RI and EVA (eg capitalining R&D in EVA). However the overall ‘shape’ of both calculations are very similar.
thank you for getting back to me
page 2 article part 2 says that directors should only invest in projects where the return of the project exceeds the company’s CE. Should it not be when it exceeds the capital employed for the project. Is this not otherwise too excessive?
Q24 of the BPP does not adjust the CE for depreciation and economic depreciation why not? Should it not add back the accumulated dep balance at beg of the year and deduct the economic depreciation?
Thank you very much
The usual assumption in investment appraisal is that the long-term cost of capital will be maintained and to use a project’s cost of capital is an accident of timing.
However, there are such things as risk adjusted rates costs of capital and this would be suitable in ROI and RI if, say, a particularly risky project were to be taken on. Risk adjusted costs of capital can raise (or lower) the hurdle for investment acceptance.
I do not have the current BPP book. Give the question name and I will see if I can match it to an older book or a past question.
the question referred to was Stillwater services
I don’t understand the accident in timing. Im sure the owners of the project would know when to use the project’s capital.
I do see why EVA can be used in divisional appraisals but fail to see how it can be used to appraise investments when it is expected that managers only invest in projects whos return need to be higher than the cost of capital times the company whole capital employed
What I meant was, and it was badly expressed, was that a company might have a choice of using debt or equity to finance a project. Long-term the company would be expected to maintain these in balance eg to minimise their WACC. Therefore, whether debt or equity is used for a particular project might depend on what was needed to maintain a reasonable gearing ratio so in that respect he finance raised is coincidental to the project it is going to be used for.
Your point about depreciation in Stillwater services is addressed by the line in the question Note 3 where it says that economic and accounting depreciation are the same so you would just be adding and subtracting the same amount. This is a common simplification in EVA questions.
EVA is used to appraise how whole companies or divisions are doing; NPV and IRR are used to appraise individual projects.
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