Alternative Valuation Techniques
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Transcript of Alternative Valuation Techniques
Alternative Valuation Tools - EVA 1
Alternative Valuation Techniques
Economic Value Added (EVA)
Alternative Valuation Tools - EVA 2
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 - EVA 3
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 R&D expense provides for future growth, omit R&D 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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Example:EVABalance Sheet (in thousands)
Assets Year 0 Year 1 Year 2
Current Assets $30 $45 $65
Gross Fixed Assets 65 80 90
Less Acc. depreciation 0 15 30
Net Fixed Assets 65 65 60
Total Net Assets $95 $110 $125
Liabilities and Equity Year 0 Year 1 Year 2
Non-interest bearing CL $20 $25 $40
Interest bearing debt 25 30 25
Shareholders' equity 50 55 60
Total liabilities and net worth $95 $110 $125
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Example: EVA
Income Statement
Year 1 Year 2
Sales $150,000 $175,000
Operating costs 90,000 100,000
EBITD 60,000 75,000
Depreciation 15,000 15,000
EBIT 45,000 60,000
Interest expense 5,000 5,833
Earnings before taxes 40,000 54,167
Taxes @40% 16,000 21,667
Net income $24,000 $32,500
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Example: EVA• Invested Capital
• After-tax operating profit
• Return on Capital
Yr 0 Yr 1 Yr 2
$75,000 $85,000 $85,000
Yr 0 Yr 1 Yr 2
$27,000 $36,000
Yr 1 Yr 2
36.0% 42.35%
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Example: EVA
• Economic Value Added for years 1 and 2
Yr 0 Yr 1 Yr 2
$19,500 $27,500
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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
1 (1 )
nt
tt
EVANPV
WACC
1
(1 )( )
(1 ) (1 )
nt
t nt
EVA t RV BVNPV
WACC WACC
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Example: EVA and NPVNPV with RV =$85,000
Year 0 Year 1 Year 2
Sales Revenue 150,000 175,000
- Operating Costs (90,000) (100,000)
- Depreciation (15,000) (15,000)
Net Operating Profit (EBIT) 45,000 60,000
- taxes @ 40% (18,000) (24,000)
NOPAT 27,000 36,000
+ Depreciation 15,000 15,000
- Change in NWC (10,000) (10,000) (5,000)
-Gross CAPEX (65,000) (15,000) (10,000)
FCF (75,000) 17,000 36,000
Residual Value 85,000
-Taxes = (RV-BV)*T -
FCF including Residual Value (75,000) 17,000 121,000
NPV @ WACC = 10% 40,454.55$
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Example: EVA and NPV
Yr 0 Yr 1 Yr 2
NOPAT 27,000 36,000
Capital Invested 75,000 85,000 85,000
ROC 36.0% 42.35%
EVA w/o residual value 19,500 27,500
(RV-BV) -
-Taxes on RV -
EVA w/ residual value 19,500 27,500
NPV@WACC=10% $40,454.55
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Example: EVA and NPVNPV with RV = $120,000
Year 0 Year 1 Year 2
Sales Revenue 150,000 175,000
- Operating Costs (90,000) (100,000)
- Depreciation (15,000) (15,000)
Net Operating Profit (EBIT) 45,000 60,000
- taxes @ 40% (18,000) (24,000)
NOPAT 27,000 36,000
+ Depreciation 15,000 15,000
- Change in NWC (10,000) (10,000) (5,000)
-Gross CAPEX (65,000) (15,000) (10,000)
FCF (75,000) 17,000 36,000
Residual Value 120,000
-Taxes (RV-BV)*T (14,000)
FCF including Residual Value (75,000) 17,000 142,000
NPV @ WACC = 10% 57,809.92$
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Example: EVA and NPVYr 0 Yr 1 Yr 2
NOPAT 27,000 36,000
Capital Invested 75,000 85,000 85,000
ROC 36.0% 42.35%
EVA w/o residual value 19,500 27,500
(RV-BV) 35,000
-Taxes on RV (14,000)
EVA w/ residual value 19,500 48,500
NPV@WACC=10% $57,809.92
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Treatment of Residual Value
FCF Method EVA Method
FCF w/o residual EVA w/o residual
+RV +(difference between RV and BV)
-taxes on RV(RV-BV)*t
-taxes on RV(RV-BV)*t
=FCF with RV =EVA with RV
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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.
(1 )nn
FCF gCV
WACC g
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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.