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Understanding Economic Value Added (EVA) as an Alternative Valuation Technique

Economic Value Added (EVA) is a key tool in corporate finance aimed at maximizing firm value through effective investment, financing, and reinvestment decisions. EVA quantifies the surplus value a project contributes beyond its cost of capital, quantified as EVA = (Return on Capital Invested - Cost of Capital) x Capital Invested. By focusing on true cash flows and minimizing the cost of capital, firms can enhance shareholder value. This approach also aids in evaluating project viability and in performance measurement over time.

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Understanding Economic Value Added (EVA) as an Alternative Valuation Technique

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  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

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