The Economic Value Added
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California Electric has a cost of equity capital of 16 percent. The firm has consistently been authorized a return on equity capital below this cost. Also, the effects of regulatory lag and attrition have further reduced the realized return to the 13-percent range. If the utility expects this problem to continue, what actions would you expect Cal Electric to take or not take as a result?
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Solution Summary
In about 870 words, this solution discusses the concept of the economic value added and describes the calculations associated with this term, along with the advantages and recommendations associated with the connection of this term with the firm in question.
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In this case, California Electric is not making money, as its cost of equity is more than its return on capital. It has a negative -3% return. Thus its economic value addition is in negative. Growth is good if and only if the expected return on invested capital is greater than the WACC. If ROC < WACC, growth is harmful to the wealth of stockholders.
Thus, if ROIC-WACC is positive than it adds positive value to the company and Roic-Wacc is negative than it is destroying value of the company.Thus this concept is EVA = Economic Value Added.
Economic Value Added is often defined as the value of an activity that is left over after subtracting from it the cost of executing that activity and the cost of having lost the opportunity of investing consumed resources in an alternative activity.
In Business terms, one could calculate EVA as Income from Operations - rate of interest in sovereign debt. If sovereign debt can be considered an alternative opportunity to invest working capital and equity.
The basic formula is: EVA = NOPAT - (NOA * WACC)
Where :
NOPAT = Net operating profit after taxes
NOA = Net operating assets
WACC = Weighted average cost of capital
Here NOPAT is assumed to be Net Income= $1.2 million
NOA = Net operating assets = The data is not given. Let us assume it ...
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