PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

262 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESexpense projections, investment income projections, tax liabilities,after-tax operating earnings, assets, liabilities, initial capital,and the marginal capital that needs to be invested in the companyto grow the company at the expected annual growth rate. 9The DCF value of the forecast period cash flow iswhereFC 0 +nXx=1OE x ¡ (C x¡1 £ g x )(1 + h) x ,n = the number of years in the forecast period(usually five to 10 years);OE x = after-tax operating earnings in year x(including gains and losses in capital thatdo not flow through earnings);g x = expected growth rate of capital in year x;C x¡1 = capital at the end of year x ¡ 1(this equals capital at the beginning of year x);C x¡1 £ g x = incremental capital required to fund future growth;h = hurdle rate; andFC 0 = free capital at time zero; which representscapital that may be either released from thecompany at the valuation date if the company isovercapitalized or infused into the company at thevaluation date if the company is undercapitalized=SC 0 ¡ C 0 ,the difference between SC 0 , the startingcapital of the entity, and C 0 , the capital needed atthe end of year zero/beginning of year 1.The value of the second component of DCF value is oftenreferred to as the terminal value. The terminal value can be devel-9 Appendix A addresses these earnings forecasts in detail and provides an example.