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

274 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESTABLE 2Valuation Results WhenTotal Earnings Equal Hurdle Rate andEarnings (and Capital) Are Growing @ 3% Per Annum10-Year Forecast Terminal In PerpetuityModel Period Value (Total)DCF 66.78 33.22 100.00EVA(a) 100.00 0.00 100.00EVA(b) 100.00 0.00 100.00The components of the results for the DCF model do changebetween the no-growth and growth scenarios. The value amountfor the 10-year forecast decreases and is exactly offset by anincrease in the terminal value. The “total” in perpetuity amount,however, is not affected by growth because annual earnings arestill equivalent to the hurdle rate. Growth, however, shifts moreof the company’s value to later projected years at the expenseof earlier projected years. This “value shift” occurs because theDCF model accounts for capital growth via a reinvestment of aportion of annual earnings, thereby reducing free cash flows.3.5. Funding Capital Growth: Comparing the DCF and EVAModelsThe DCF and EVA models have different treatments of thecosts associated with growing the capital base of the company.We can think of the DCF model as a reinvestment for growthprocess and the EVA model as a capital borrowing process.Exhibit 2A, Column (8), shows the annual capital reinvestmentamount necessary for the DCF model to account for the3% growth in capital. The capital reinvestment amount is takenfrom current year earnings to fund the following year startingcapital–Column (2) equals Column (8) shifted one year. TheDCF model fully funds capital growth, thereby reducing “freecash flows” for valuation.