Economic Profit Model and

Adjusted Present Value

Model
 Economic Profit Model ( Residual Income Valuation)
Economic Profit is the surplus profit over an appropriate cost of capital.

Thus EP = Actual Profit – Expected Profit

= [EBIT (1-T)] – [WACC * TCE ]

For Company : EBIT(1-t) – (WACC * Total Capital Employed)

For Equity Share : [PAT – Preference Dividend] – [ke*Equity]
KE = 144 CRS 18% ----EXPECTED RETURN
PAT – 200 CRS 20% --- ACTUAL RETURN
EP FOR FIRM = [EBIT (1-T)] - [WACC*TCE]
EP FOR EQUITY = [PAT] - [KE*ESHFS]
Value of the business using EP
∞
Total Capital Employed t=0 + ∑ NOPAT – (WACC* Capital Employed)
t=1 (1+WACC)^t

Value per Equity share using EP

∞
Book value of equity /share t=0 + ∑ EPS – (ke* BV /share) or
t=1 (1+ke)^t
∞
BV/share + ∑ (ROE-Ke)* BV/share (i)PAT/share = ROE * BV/share
t=1 (1+ke)^t (ii)required return per share = ke* BV/share
Decoding the model

VALUE PER SHARE = BV/SHARE + PV OF EP FROM YEAR 1- PERPETUITY

= BV/SHARE ( year 0) + [ ( PV OF EP FOR FORECASTED PERIOD) + (PV OF CV OF EP)]

VALUE OF BUS = TCE + PV OF EP FROM YEAR 1- PERPETUITY

= TCE (year 0) + [ ( PV OF EP FOR FORECASTED PERIOD) + (PV OF CV OF EP)]
You are evaluating the expected residual income of Aura Fibres as at the end of
Aug 2022. Using the adjusted beta of 1.50 relative to NIFTY index, , 10 year govt
bond yield of 6% and an estimated equity risk premium of 7% to determine the
required rate of return.
You collect the following data as at the close of Aug 26
1. CMPS Rs.27.70
2. BV/share as at the end of March 2022 – Rs.8.77
3. Annual earning estimates : FY 2023 – Rs.1.40, FY 2024 – Rs.1.60
4. Annual DPS: FY 2023 Rs.0.52 , FY 2024-0.60
Forecast the residual income per share for 2023 and 2024
KE =6+1.5*7 = 16.5%
BV 2023 - 8.77+1.4-0.52 = 9.65, BV 2021 = 9.65+1.60-0.60 = 10.65
EP ( 2023) = 1.40 – 16.5% *8.77 = - 0.04
EP ( 2023) = 1.60- 16.5% * 9.65 = 0.007
Two stage EP model
n
BV/share + ∑ EPSt – (ke* BV /share)t + EPn (1+g)
t=1 (1+ke)^t ke-g
G Ltd has an invested capital of Rs.50 million. Its ROCE is 12% and WACC is 11%. The growth rate in
invested capital will be 20% for the first three years and 12% for the next two years and 8%
thereafter. Determine the value
1 as per2 EP model
3 and4 FCFF 5 6 TV
Capital Employed 50 60 72 86 96.77 108.38 117.05
(opening)
EBIT(1-t) [Actual Profit] 6 7.2 8.64 10.37 11.61 13.00 14.05
WACC 11% 11% 11% 11% 11% 11% 11%
WACC*Capital Employed 5.5 6.6 7.92 9.5 10.64 11.92 12.88
[Expected profit]
EP 0.50 0.60 0.72 0.87 0.97 1.08 1.17
PV of EP ( discounted at 0.45 0.49 0.53 0.57 0.58 0.58
WACC)
Sum PV of EP = 3.2
Continuing Value = [0.97 ]/ (11%-8%) = 32.33, PV of CV = 19.19
1.17/(0.11-0.08)= 39
PV Terminal Value = 20.85 39/
(1+11%)^
6
Value of G Ltd = 50+3.2+20.85= 74.05 v/s 200 mps
Roce = 15% post tax [ebit (1-t)/tce] ebit/tce – not adjusted for tax
Ebit ----- [int + profit] + tax
Tce = 100 crs , ebit ( 1-t) = 15 crs
= 120 crs , ebit (1-t) = 18 crs

Increase in capital employed ===increase in net assets ( fixed assets ( capex) +

wcap)

No depn
ebit ( 1-T) – EP MODEL = ocf - FCFF MODEL
 1 2 3 4 5 6 7

Net Asset value 50.00 60.00 72.00 86.40 96.77 108.38 117.05
NOPAT (ocf) 6.00 7.20 8.64 10.37 11.61 13.00 14.05
Net Invt. 10.00 12.00 14.40 10.37 11.61 8.67 9.36

FCF (4.00) (4.80) (5.76) nil nil 4.33 4.69

pvfcff
Terminal value 4.69 = 156 CAPEX+WCAP = ADDNL INVESTMENT
0.11 -0.08

PV ( FCF+TV) = (9.39 ) + 83.46 = 74.07

You are evaluating a purchase of Canon Inc. Current book value per share is
Rs.26.24 and the CMPS is Rs.34.68. You expects that the long term ROE would be
11% and long term growth to be 5.5%. Assuming a cost of equity of 9.5%,
determine the intrinsic value of Canon using EP model.

You are curious about the market perceived growth rate as you are comfortable
with other inputs. Determine the same.
You want to apply FCFF and EP method to value A Ltd. Its
current book value of assets is 120 crs. The company’s has a
ROCE of 20% and required rate of return of 12%. The company
plans to increase its invested capital by 15% every year for the
the next 3 years. Post which it expects a long term growth rate
in assets of 5%. Determine the value of A Ltd.
Critical Evaluation of EP model ( Residual Income model)

In FCFF and DDM a large portion of the firms value is derived from ‘Terminal Value’ which is fraught
with uncertainty owing to distant cash flows.

However in EP model, larger part of the value is derived from current book value. Thus derivation of
larger value from the earlier part of forecasting makes it useful.
However the EP model used profits and not cash to derive value.

Ep == tce + ep forecasted period+ ep terminal value = 50+3.25+20.85 = 74.05

Fcff = fcff forecasted period + fcff terminal value = (9.39) + 83.25 = 74.05
 Adjusted Present Value method
The FCFF model uses a constant discount rate (WACC) to value the enterprise
thereby assuming that the capital structure will remain constant. If it is believed
that capital structure would change over time, Adjusted PV method can be used
EV = Value of unlevered equity FCFF + Value of interest tax shields
Hence instead of discounting FCFF with WACC, unlevered cost of equity is used as
discounting factor.
n
Value of unlevered equity FCFF = ∑ FCFF
t=1 (1+keul)^t
n
Value of interest tax shields = ∑ Interest * Tax rate
t=1 (1+kd)^t
Terminal value = FCFF(1+g)/WACC-g ( After the planning period, the capital
You have developed the following estimates for Rotor Corpn
1 2 3 4 5
FCFF 200 250 300 340 380
Interest bearing debt 500 400 300 200 100
Interest expense 60 48 36 24 12

FCFF is expected to grow @ 10% beyond year 5

The firms unlevered cost of equity is 14%
After year 5 the company will maintain its target D/E of 4:7
Tax rate is 30%. Borrowing rate is 12%
Rf = 8%, risk premium = 6%
bL = bu[1+(1-t)(D/E)] or bu =bL/ [1+(1-t)(D/E)]