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Economic Value Added

Economic Value Added

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What is economic value adeded is explained
What is economic value adeded is explained

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Published by: api-26923473 on Oct 14, 2008
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03/18/2014

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Free Cash Flow (FCF), Economic Value Added (EVA ), and Net Present Value(NPV):
A Reconciliation of Variations of Discounted-Cash-Flow (DCF) Valuation
Ronald E. Shrieves, Ph.D.
SunTrust Bank Professor of Finance
John M. Wachowicz, Jr., Ph.D., CPA
Professor of Finance
Department of Finance
College of Business Administration
The University of Tennessee
Stokely Management Center
Knoxville, TN 37996
865.974.3216 Department
865.974.1716 Fax
rshrieve@utk.edu
jwachowi@utk.edu
June, 2000
Abstract:
The paper assists the user ofDCF methods by clearly setting forth the relationship of free-cash-
flow (FCF) and economic value added (EVA ) concepts to each other and to the more traditional applications of
DCF thinking. We follow others in demonstrating the equivalence between EVA and NPV, but our approach is

more general in that it links the problems of security valuation, enterprise valuation, and investment project selection, and additionally, our approach relates more directly to use of standard financial accounting information. Beginning with the cash budget identity, we show that the discounting of appropriately defined cash flows under the free-cash-flow valuation approach (FCF) is mathematically equivalent to the discounting of appropriately defined economic profits under theEVA

approach. The concept of net operating profit after-tax (NOPAT), found by adding after-tax interest payments to net profit after taxes, is central to both approaches, but there the computational similarities end. TheFCF approach focuses on the periodic total cash flows obtained by deducting total net investment and adding net debt issuance to net operating cash flow, whereas theEVA approach requires defining the periodic total investment in the firm. In a project valuation context, bothFCF andEVA

are conceptually equivalent toNPV. Each approach necessitates a myriad of adjustments to the accounting information available for most corporations.

1
Free Cash Flow (FCF), Economic Value Added (EVA ), and Net Present Value (NPV):
A Reconciliation of Variations of Discounted-Cash-Flow (DCF) Valuation
Introduction

The use of discounted-cash-flow (DCF) methods for investment decision making and valuation is well entrenched in finance theory and practice. This rigorous treatment dates back at least to the Old Babylonian period of 1800-1600 B.C. [11]. Relative newcomers with profound conceptual insights are Irving Fisher [6] and Jack Hirshleifer [9, 10], who provided concise, rigorous utility-theoretic foundations.

While originally conceived primarily in response to compound interest problems, the modern literature has broadened application ofDCF techniques, most notably to capital budgeting and security valuation problems. More recent extensions of theDCF concepts to security valuation using so-called \u201cfree-cash-flow\u201d techniques [3, 4] and to managerial performance evaluation using an \u201ceconomic value added\u201d concept [13], have stirred interest in the application ofDCF methods to a broader range of practical business problems. Financial performance assessment using the concept of residual income known as economic value added, has received much attention in the recent academic literature [1, 2]. These extensions, however, have also raised a number of concerns related to puttingDCF theory into practice.

The last few years have witnessed a tremendous growth in writing onEVA , in the financial press, practitioner publications, and numerous unpublished working papers. Printed and web-published lecture notes on the subject abound. The primary purpose of this paper is to assist users ofDCF methods by clearly setting forth the relationship of free-cash-flow (FCF) and economic value added (EVA ) concepts to each other and to the more traditional applications ofDCF thinking such as net present value (NPV). Although we follow others [7, 8] in demonstrating the equivalence between EVA and NPV, we feel that our approach is more general in that it links the problems of security valuation, enterprise valuation, and investment project selection. Additionally, our approach relates more directly to use of standard financial accounting information. Though theFCF approach discounts cash flow, whereas theEVA

approach discounts profits, we demonstrate in the familiar terminology of cash flow analyses that the two approaches are conceptually equivalent. We do not claim that any of the conclusions presented herein are new, but we do hope that the presentation of ideas in the manner we have chosen will provide a useful synthesis in a theoretically rigorous format. The paper also briefly summarizes some implications of the analysis for problems encountered in translating the theoretical concepts into practice. These are primarily related to issues of adjustments to accounting information that are required to implement theFCF andEVA

methods.
2
1.
Cash Flow
1.a.
The cash budget identity.

Consider the single-period cash budget identity. The components are operating revenues and costs, net security issuance, interest payments, dividend payments, taxes paid, and net investments. Investments may be divided into working capital (i.e., current assets net of \u201cspontaneous\u201d changes in current liabilities such as payables and accrued wages) and so-called long-term investments such as plant and equipment. For now, our discussion assumes that the listed components of the cash budget correspond to items found in the firm's financial statements. In practice, use of accounting information for economic analysis requires a number of adjustments to bring the accounting numbers into conformity with economic reality. In Section 3, we briefly comment on measurement issues that arise due to "distortions" introduced by use of generally accepting accounting principles. The single-period cash budget identity may be expressed as follows:

Sources= Uses
Rt+\u2206Bt= Ot+ Intt+ Divt+ Taxest+\u2206It+ \u2206WCt,
(1)
where subscript (t) is used to index these components of cash flow according to date, and
Rt= operating revenue
\u2206Bt= net debt issuance(i.e., new borrowing net of repayment)
Ot= out- of- pocket operating costs
Intt= int erest payments on debt, less any interest income
Divt= dividendson common stock(defined here as net of equity issuance and repurchase)
Taxest= total taxes paid
\u2206It= net investment in non-current assets (i.e., net of asset sales)
\u2206WCt= net investment in working capital, inclusiveof cash and marketablesec urities.
1.b.
Dividends.
Solving Eq. (1) for dividends paid in periodt gives:
Divt=[Rt\u2212 Ot\u2212 Intt\u2212 Taxest]\u2212 [\u2206 It+\u2206WCt]+\u2206Bt.
(2)
After simultaneously subtracting, then adding, tax depreciation (Deprt ) from the right-hand side of Eq. (2),
dividends paid can now be expressed as follows:
Divt=[Rt\u2212 Ot\u2212 Deprt\u2212 Intt\u2212 Taxest]+ Deprt
{
}\u2212[\u2206It + \u2206WCt] +
\u2206Bt
=
NPATt+ depreciationt
{
}
\u2212total net investmentt + net debt issuancet,
(3)
whereNPATt is net profit after tax.

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