Alternative Valuation Techniques

Economic Value Added (EVA)

Alternative Valuation

The Objective in Corporate

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

Alternative Valuation

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

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

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 noninterest 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

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

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

Example:EVA
Balance Sheet (in thousands)
Assets

Year 0

Current Assets

Year 1

Year 2

$30

$45

$65

65

80

90

15

30

Net Fixed Assets

65

65

60

Total Net Assets

$95

$110

$125

Gross Fixed Assets

Less Acc. depreciation

Liabilities and Equity

Year 0

Non-interest bearing CL

Year 1

Year 2

$20

$25

$40

Interest bearing debt

25

30

25

Shareholders' equity

50

55

60

$95

$110

$125

Total liabilities and net worth

Alternative Valuation

Example: EVA
Income State me nt
Ye ar 1

Ye ar 2

$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

5,000

5,833

Earnings before taxes

40,000

54,167

Taxes @40%

16,000

21,667

Ne t income

$24,000

$32,500

Sales

Interest expense

Alternative Valuation

Example: EVA
Invested Capital
Yr 0

Yr 1

Yr 2

$75,000 $85,000

After-tax operating profit

Yr 0 Yr 1

$85,000
Yr 2

$27,000 $36,000

Return on Capital

Yr 1

Yr 2

36.0%

42.35%

Alternative Valuation

10

Example: EVA
Economic Value Added for years 1 and 2
Yr 0 Yr 1

Yr 2

$19,500 $27,500

Alternative Valuation

11

EVA and NPV

The NPV of a project = PV(EVA by that project
over its life)
n

EVAt
NPV
t
t 1 (1 WACC )
If there is a residual value associated with the
project, then

EVAt
(1 t )( RV BV )
NPV

t
n
(1 WACC )
t 1 (1 WACC )
n

Alternative Valuation

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Example: EVA and NPV

NPV 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)

45,000

60,000

(18,000)

(24,000)

NOPAT

27,000

36,000

+ Depreciation

15,000

15,000

Net Operating Profit (EBIT)

- taxes @ 40%

- 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

NPV @ WACC = 10%

(75,000)
$ 40,454.55

17,000

Alternative Valuation

121,000

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Example: EVA and NPV

Yr 0

Yr 1

Yr 2

27,000

36,000

85,000

85,000

ROC

36.0%

42.35%

EVA w/o residual value

19,500

27,500

NOPAT
Capital Invested

75,000

(RV-BV)

-Taxes on RV

EVA w/ residual value

NPV@WACC=10%

19,500

27,500

$40,454.55

Alternative Valuation

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Example: EVA and NPV

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)

45,000

60,000

(18,000)

(24,000)

NOPAT

27,000

36,000

+ Depreciation

15,000

15,000

Net Operating Profit (EBIT)

- taxes @ 40%

- 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

NPV @ WACC = 10%

(75,000)

17,000

142,000

$ 57,809.92

Alternative Valuation

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Example: EVA and NPV

Yr 0

Yr 1

Yr 2

27,000

36,000

85,000

85,000

ROC

36.0%

42.35%

EVA w/o residual value

19,500

27,500

NOPAT
Capital Invested

75,000

(RV-BV)

35,000

-Taxes on RV

(14,000)

EVA w/ residual value

19,500

NPV@WACC=10%
$57,809.92
Alternative Valuation

48,500

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Treatment of Residual Value

FCF Method

EVA Method

FCF w/o residual

+RV
-taxes on RV
(RV-BV)*t
=FCF with RV

EVA w/o residual

+(difference between RV and BV)
-taxes on RV
(RV-BV)*t
=EVA with RV

Alternative Valuation

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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.

CVn

FCFn (1 g )
WACC g

Alternative Valuation

18

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

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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
Alternative Valuation

20

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

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