What is ‘economic value added?

Economic value added also referred as residual income (RI) or economic profit is basically net income less a charge (deduction) for the cost of equity for common shareholders. RI is the residual after deducting all the costs of company’s capital, which is why it is also referred as residual income. Traditionally, in income statement only the cost of debt/ borrowing is officially recognized as interest cost. However, the cost of equity is not considered in the accounting books even though it is costlier than cost of debt. A company may be profitable and have positive net income in the books, but still might not be adding economic value for its shareholders if it does not earn more than the cost of equity. 

Cost of debt vs cost of equity 

Before understanding RI, let us have a look at costs of capital. Major two costs are cost of debt and cost of equity. Debt as we know, can be raised through banks or bonds. It has a regular fixed payment in the form of interest and principal. Since, there is lower risk with the capital and interest is tax deductible, the cost of debt is also lower. On the other hand, the cost of equity is relatively higher since equity investment is riskier than debt investment. It does not involve repayment like debt, but the company is expected to grow in such a way that it provides minimum required return which is cost of equity.  

Equity charge 

Equity charge is just the cost of equity in money terms. It is calculated by multiplying cost of equity with the equity capital. For example, if the cost of equity is 15% and the equity capital stands at Rs 1,00,000 then the equity charge will be: Rs 1,00,000 x 15% = Rs 15,000. 

Calculating RI 

It is calculated by simply deducting equity charge from net income.  In the above example, if the net income is Rs 12,000 then, 

Residual income = 12,000 – 15,000 = (3,000) 

In above we can see that the company had positive earnings and we ended up having negative RI. We can say that the company has not added economic value for the shareholders and as an investor perhaps you should review the company fundamentals in investment process. RI is gaining attention and importance in the finance world and some companies are providing it in their annual reports as well.