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

THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES 275In the EVA models, the cost for growing the capital is a partof the cost of capital calculation. For the EVA(a) model, Exhibit2B, Columns (10a) and (10b), show the components of the costof capital related to the initial capital and additional capital forgrowth, respectively. The reduction in growth-related earningsequals the product of the hurdle rate and the cumulative additionalcapital amount beyond the initial capital. This incrementcan be thought of as the interest payment on “borrowed” capitalused to fund business growth.Although the negative cash flows necessary to support capitalgrowth are different for the DCF and EVA models, the presentvalues of the cash flows are identical when considered in perpetuity.The DCF model reinvestment to grow the capital is a largeroffset to earnings in early forecasted years than the EVA modelrequired return on additional capital amounts. By the ninth forecastedyear, however, the EVA model capital growth cost (Exhibit2B, Column 10b) overtakes the reinvestment amount in the DCFmodel (Exhibit 2A, Column 8).3.6. Total Earnings Are Not Equal to the Hurdle Rate and theCompany is Not GrowingTable 3 displays the company value results for the three modelsin the scenario in which the annual total earnings relative tocapital do not equal the hurdle rate and the company is not growing.Exhibits 3A, 3B, 3C, 4A, 4B, and 4C show the calculationsleading to these results.Table 3 reaffirms the in perpetuity equivalence of the DCFand EVA models. Like the previous examples, the 10-year andterminal values are different between the DCF and EVA valuationsbut the in perpetuity valuations are equal. The equivalencyof the DCF and EVA models in perpetuity will be shown on analgebraic basis in Appendix B.When the earnings are not equal to the hurdle rate there isa marginal value (positive or negative) in addition to the initial