Alternative Valuation Tools - EVA1 Alternative Valuation Techniques Economic Value Added (EVA)

Alternative Valuation Tools - EVA2 The Objective in Corporate Finance Maximize the value of the firm Three ways to create value: –Investment Decisions –Financing Mix –Reinvestment Policy

Alternative Valuation Tools - EVA3 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

Alternative Valuation Tools - EVA4 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

Alternative Valuation Tools - EVA5 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.

Alternative Valuation Tools - EVA6 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 R&D expense provides for future growth, omit R&D expense from current operating income.

Alternative Valuation Tools - EVA7 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.

Alternative Valuation Tools - EVA8 Example:EVA

Alternative Valuation Tools - EVA9 Example: EVA

Alternative Valuation Tools - EVA10 Example: EVA Invested Capital After-tax operating profit Return on Capital

Alternative Valuation Tools - EVA11 Example: EVA Economic Value Added for years 1 and 2

12 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

13 Example: EVA and NPV

Alternative Valuation Tools - EVA14 Example: EVA and NPV

Alternative Valuation Tools - EVA15 Example: EVA and NPV

16 Example: EVA and NPV

Alternative Valuation Tools - EVA17 Treatment of Residual Value

Alternative Valuation Tools - EVA18 Continuation Value For an ongoing concern, the continuation value is calculated as a growing perpetuity based on the final year’s cash flow. There is no additional calculation for taxes.

Alternative Valuation Tools - EVA19 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.

Alternative Valuation Tools - EVA20 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

Alternative Valuation Tools - EVA21 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.