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Hello John,
Please, explain why do we add interest expenses LESS tax relief on the interest costs? So, we adding back interest costs as if they didn’t exist, then why do we subtract tax on non-existing costs? I don’t get it.
NOPAT – net operating profit after tax. This is before interest therefore all interest effects have to be removed from post tax profits.
EG1: OP = 100, Tax = 30%, no interest. NOPAT = 70
EG2: OP = 100, interest = 20, Tax at 30% = 30% x 80 = 24.
Profit after tax = 100 – 20 – 24 = 56.To remove the interest effect, you have to add back the interest after tax, because the 56 has had two interest effects: the original interest and a lower tax bill because of interest.
56 + 20 (1 – 0.3) = 70 as in EG1.
For your second point, the assumption is that non-cash based costs would not have attracted tax relief in the first place. Think general provision for bad debts and depreciation.
Thanks for the explanation!
I have another question re EVA:
3) we calculate EVA at the particular moment using NOPAT for a particular period. Then why do we use capital employed AT THE BEGINING of THAT PERIOD? That data is outdated? Why don’t we use capital employed at the end or at least average capital employed (beginning+end)/2)?I agree that there is an argument for using the capital employed as the average.
However, EVA is a trade-marked, specific approach developed by a New York consulting company called Stern Stewart & Co, so you have to do it their way. Their argument is that it is the capital at teh start of the year that you use for the to create value.
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