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

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 267In the valuation formula ANW + PVFE ¡ COC, the termPVFE ¡ COC represents these “excess returns.”Excess returns have positive value only when the future earningsexceed the cost of capital. In this case, the cost of capitalrepresents the present value of the product of the hurdle rate andthe starting capital for each period for which earnings are projected.If investment earnings on the capital are excluded fromfuture earnings, then the cost of capital calculation will be thepresent value of the product of the hurdle rate and the startingcapital less the investment earnings on the capital.While the two calculations of excess returns should be mathematicallyequivalent, there are numerous practical advantagesto including earnings on the capital in future earnings. First, theearnings projections will be more in line with historical earningsso one can review the reasonableness of the projections relativeto past experience. Second, allocation of assets between capitaland liabilities is unnecessary. Third, one does not need to allocatetaxes, tax loss carryforwards, and other factors betweeninvestment earnings on capital and all other earnings.In Appendix A, this paper will demonstrate that the twomethodologies, DCF and EVA, produce equivalent values whenspecific conditions hold [7]. These conditions are the following:1. The starting capital and the after-tax operating incomethat is used to estimate free cash flows to the firm for aDCF valuation should be equal to the starting capital andthe after-tax operating income used to compute EVA.(For insurance company valuations, after-tax operatingincome should include “below the line” gains and lossesin capital that do not flow through earnings.)2. The capital invested that is used to compute excess returnsin future periods should be the capital invested atthe beginning of the period: