How do you evaluate an operating segment or project using residual income and economic value added?

How do you evaluate an operating segment or project using residual income and economic value added?

Expert Solution

The residual income is defined as :

Investment center operating profits -Capital charge * Investment center assets

The capital charge is the minimum acceptable rate of return which will likely be greater than the company cost of capital.

Economic Value Added is defined as :

After tax adjusted operating profit -Cost of Capital * Capital Employed adjusted

Investment center operating profits can be equated to the after tax operating profits in the EVA formula.Investment center can be equated to capital employed.However the capital charge is not the same as cost of capital.The capital charge is the company minimum acceptable rate of return and cost of capital is the weighted average cost of company debt and equity.While it is possible that these percentages might be same for a given operating segment the terms have different meanings.

More importantly EVA calculations adjust the income and capital numbers from the accounting or book to reflect basic differences between economi results and accounting measurements.

ekkarill92 answered 2 years ago

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