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

272 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESwith respect to (i) expected growth in earnings by future periodand (ii) expected changes in capital required by future period.3.3. Total Earnings Equal Hurdle Rate and the Company Is NotGrowingTable 1 displays the company value results for the three modelsin which the annual total earnings relative to capital equalthe hurdle rate, and neither the company’s capital nor its businessis growing. 17 Exhibits 1A, 1B, and 1C show the calculationsleading to these results.The In Perpetuity results are 100.00, equal to the starting capitalof the company.For the DCF model, the value calculation simplifies toOE 1 ¡ 0= (100 £ 15%) ¥ 15% = 100:h ¡ 0For the EVA(a) model, Exhibit 1A shows that for each forecastedyear the total earnings are exactly offset by the cost ofcapital. This result, of course, follows because both earnings andcost of capital are 15% of each year’s starting capital of 100. Thesame progression is demonstrated by the EVA(b) model exceptearnings are only 100 £ 11% (earnings on insurance operationsonly) offset by cost of capital of 100 £ (15% ¡ 4%).As noted in Section 2.2, a company has value in excess ofits capital invested or hurdle rate only when future returns arein excess of the hurdle rate requirement. In the DCF model, thepresent value of the perpetual cash flow is equal to the startingcapital because annual earnings of 15% of capital, discountedat 15% annually, yield the starting capital. In the EVA models,excess returns are always 0 and, therefore, the only contributionto value is the capital.Looking at the modeled time periods (10-year forecast periodand terminal value) reveals a fundamental difference in the17 Excess earnings are 0, so value for the EVA methods is equal to the starting capital.