Alternative Valuation Techniques

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Alternative Valuation Techniques

• Economic Value Added (EVA)

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The Objective in Corporate Finance

• Maximize the value of the firm
• Three ways to create value
• Investment Decisions
• Financing Mix
• Reinvestment Policy

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Classical DCF Valuation

• The Investment Decision invest in projects that
  yield a return greater than the minimum
  acceptable risk-adjusted hurdle rate. (Accept
  positive NPV projects)
• The Financing Decision Choose a financing mix
  that minimizes the cost of capital
• The Reinvestment Decision Return cash to
  shareholders if you do not have positive NPV
  projects

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Alternative Approach to Valuation EVA

• Economic Value Added (EVA) measures the surplus
  value created by an investment
• EVA (Return on Capital Invested - Cost of
  Capital) ? Capital Invested
• Return on Capital Invested the true cash flow
  return on capital earned on an investment
• Cost of Capital the WACC

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How Much Capital is Invested?

• The market value of the firm includes capital
  invested in both assets-in-place and future
  growth.
• To calculate the invested capital add net fixed
  assets plus net working capital as of the
  beginning of the year.
• Net working capital is calculated as Current
  Assets (not including excess cash and marketable
  securities) less non-interest bearing current
  liabilities (omit notes payable, current portion
  of long-term debt).
• Alternatively, you can estimate the market value
  of the assets owned by the firm.

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What if the Return on Capital Invested?

• To measure ROC, you need to estimate after-tax
  operating income.
• As in our DCF analysis, we may need to make
  adjustments to get at a true measure of economic
  return (versus accounting return.)
• For example, omit any one-time charges. Or, if
  RD expense provides for future growth, omit RD
  expense from current operating income.

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What is the Cost of Capital?

• The cost of capital is the weighted average cost
  of capital.
• Use the market values of debt and equity to
  calculate the weights. As is DCF, many firms use
  the book value of debt.

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ExampleEVA
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Example EVA
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Example EVA

• Invested Capital
• After-tax operating profit
• Return on Capital

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Example EVA

• Economic Value Added for years 1 and 2

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EVA and NPV

• The NPV of a project PV(EVA by that project
  over its life)
• If there is a residual value associated with the
  project, then

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Example EVA and NPV
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Example EVA and NPV
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Example EVA and NPV
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Example EVA and NPV
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Treatment of Residual Value
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Continuation Value

• For an ongoing concern, the continuation value is
  calculated as a growing perpetuity based on the
  final years cash flow. There is no additional
  calculation for taxes.

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Continuation Value

• In the FCF method, the entire continuation value
  at time n is discounted back to time 0.
• In the EVA method, the continuation value less
  the book value at time n is discounted back to
  time 0.

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Summary

• Both EVA and DCF valuation should provide the
  same estimate for the value of a firm.
• Both approaches require the same information.
• Maximizing the present value of EVA over time
  should be equivalent to maximizing the value of
  the firm

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EVA In Use

• Firms often evaluate year-to-year changes in EVA
  rather than the present value of EVA over time.
• The advantage is that it is simple and does not
  require making forecasts of future earnings
  potential.
• EVA can be broken down by any unit - manager,
  division, etc. provided you can assign capital
  and earnings across these units.
• EVA is often used in determining compensation.