Alternative Valuation Techniques

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 Alternative Valuation Tools - EVA

4. 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 - EVA

5. 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 - EVA

6. 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 - EVA

7. 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 - EVA

8. Example:EVA Alternative Valuation Tools - EVA

9. Example: EVA Alternative Valuation Tools - EVA

10. Example: EVA • Invested Capital • After-tax operating profit • Return on Capital Alternative Valuation Tools - EVA

11. Example: EVA • Economic Value Added for years 1 and 2 Alternative Valuation Tools - EVA

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

14. Example: EVA and NPV Alternative Valuation Tools - EVA

15. NPV 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 Example: EVA and NPV Alternative Valuation Tools - EVA

16. Example: EVA and NPV

17. Treatment of Residual Value Alternative Valuation Tools - EVA

18. 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 - EVA

19. 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 - EVA

20. 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 - EVA

21. 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. Alternative Valuation Tools - EVA