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

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 273TABLE 1Valuation Results WhenTotal Earnings Equal Hurdle Rate and There IsNo Growth10-Year ForecastIn PerpetuityModel Period Terminal Value (Total)DCF 75.28 24.72 100.00EVA(a) 100.00 0.00 100.00EVA(b) 100.00 0.00 100.00DCF and EVA models. The DCF model must be computed inperpetuity (forecast period plus terminal value) to capture thecapital value in the company. The EVA models, however, recognizethe value of the capital “immediately” as it incorporates thecapital amount directly in the value computation. Therefore, theEVA model will produce higher estimates of value than DCF whenearnings are not valued in perpetuity.3.4. Total Earnings Equal Hurdle Rate and the Company IsGrowingTable 2 displays the company value results for the three modelsin which the annual total earnings relative to capital equals thehurdle rate and the company’s capital and earnings are growingby 3% per annum. Exhibits 2A, 2B, and 2C show the calculationsleading to these results.The results in Table 2 are nearly identical to the value resultsshown in Table 1 in which no business growth was modeled.Basically, the two EVA models behave exactly the same–theearnings each year are exactly offset by the cost of capital. Incorporatinggrowth into the model only changes the earnings andcost of capital amounts for each year, not the difference betweenthe two values. However, this basic demonstration still emphasizesthe relationship of earnings to hurdle rate as the determinantof value, positive or negative, in conjunction with starting capital.