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

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: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

Alternative Valuation Tools - EVA 9

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

Alternative Valuation Tools - EVA 10

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%

Alternative Valuation Tools - EVA 11

Example: EVA

• Economic Value Added for years 1 and 2

Yr 0 Yr 1 Yr 2

$19,500 $27,500

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

1 (1 )

nt

tt

EVANPV

WACC

1

(1 )( )

(1 ) (1 )

nt

t nt

EVA t RV BVNPV

WACC WACC

Alternative Valuation Tools - EVA 13

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$

Alternative Valuation Tools - EVA 14

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

Alternative Valuation Tools - EVA 15

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$

Alternative Valuation Tools - EVA 16

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

Alternative Valuation Tools - EVA 17

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

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.

(1 )nn

FCF gCV

WACC g

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.