Economic Value Added Model

Topics: Net present value, Weighted average cost of capital, Free cash flow Pages: 5 (1570 words) Published: September 24, 2009

USING OF THE ECONOMIC VALUE ADDED MODEL FOR VALUATION OF A COMPANY Doc. Ing. Eva Kislingerová, CSc. Prague University of Economics

There is possibility to use, with respect to the object of valuation, several methods for valuation of a company in practice. One of the most important and highly used group of methods are yield methods. They are usually called Discounted Cash Flows (DCF) methods. Value of a company is derived from present value of future incomes connected with the ownership of a company. The core of these models is working with time value of future incomes investor gets in case of realization of an investment. There are several possibilities to work with future incomes in DCF models, like using cash flow, free cash flow or in some cases dividends. These are models with construction and way of using well known to professional public, therefore the aim of this article is to focus on model called EVA – Economic Value Added, which is recently highly used by investors coming from developed market economies.

A basic construction of EVA measure is clear from the following formula: EVAt = NOPATt – Ct x WACCt where NOPATt is Net Operating Profit After Tax, Ct is long term capital, WACC is Weighted Average Cost of Capital. If EVA > 0 than we can say a company is successful. This is the only case wealth of shareholders increases because they gain more than what their original investment was. The service to creditors is included there, too. In case EVA = 0 a company produced just as much as it was invested and EVA < 0 leads to destroying of whealth of shareholders. From above mentioned construction it is clear that EVA concentrates all important aspects of business, like: – the amount of capital involved to business and its internal structure (talking about proportion od D/C and E/C), – cost of capital (shareholders’ and creditors’capital), which is price a company must pay for using resources (WACC), – effective employment of invested resources – NOPAT. Companies which can gain the highest level of profit (NOPAT) while using minimum of „cheap“ capital will experience positive results. It is possible in case investments are consistently driven by criteria of net present value. Therefore EVA represents an interesting measure of judging the performance of companies. It can be also used for measuring the value of a company. However now we have to rise a guestion of filling the parameters of the EVA model. NOPAT can be defined as a result of the following formula: NOPAT = EBIT (1 – t), where EBIT is Earnings Before Interest and t is tax rate. NOPAT derived this way includes both effect reached by using assets of a company (its technical-production base for owners) and interest paid to creditors. Parameter Ct represents long term invested capital. It is sum of equity and invested capital. The other way of defining Ct is to summarize fixed assets and net working capital (net working captal = current assets – short term liabilities). Both approaches offer the same results. In EVA model Weighted Average Cost of Capital (WACC) is used for calculation of economic value added and as a discount rate transferring future values of EVA to present value to the date of valuation.

EVA measure
The basic idea of this criteria is possible to find in microeconomics where it is said that the main goal of a comapny is maximalisation of profit. However it does not mean book profit (the difference between revenues and costs) but economical profit. The difference between economical and book profit is that economical profit is the difference between revenues and economical costs, which are book costs and opportunity costs. Opportunity costs are presented by the amount of money lost by not investing sources (like capital, labour, etc.) to the best alternative use. Opportunity costs are in reality represented mainly by interests from equity capital including risk reward and sometimes lost wage, too....
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