Residual Value We use the term, residual value to correspond to the value of the firm at that point in time

when the company's return on its investment just equals the company's Weighted Average Cost of Capital (WACC). Investors are just compensated for the risk that they are taking in owning the company's stock and no additional value is created from new business investments. The stock price is still growing in value, but only at the company's cost of equity. At this point in time, the after-tax earnings of the company are treated and valued as a cash flow perpetuity--which is equal to the company's NOPAT divided by its WACC. This number is discounted to the present also at the company's WACC. In calculating residual value, it is assumed that there is no net new investment (i.e., investment = depreciation) and that no additionl working capital is required. For example, at the end of an excess return period of 10 years, if the company's NOPAT = $1 million and its WACC = 10%, the company's future residual value is $1 million/(.10) = $10 million, which amount would be discounted to the present at the discount factor equal to 1.0/ (1.0 + WACC)^t = 1.0/(1.0 + .1)^10 = (.3855). Residual value is therefore $10 million * .3855 = $3.855 million. WACC The company's WACC is a very important number, both to the stock market for stock valuation purposes and to the company's management for capital budgeting purposes. In an analysis of a potential investment by the company, investment projects that have an expected return that is greater than the company's WACC will generate additional free cash flow and will create positive net present value for stock owners. These corporate investments should result in an increase in stock prices. These projects are good things! Investments that earn less than the firm's WACC will result in a decrease in stockholder value and should be avoided by the company.