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

278 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLES3.8. Comparison of DCF and EVA ModelsThe parameterization of the DCF and EVA models presentedin the paper cause the models to produce equal value if consideredin perpetuity. The parameters selected to populate themodels should be equivalent as they are independent of whichmodel is used. For example, the appropriate hurdle rate does notdepend on the model selected. Appendix B discusses the formulaassumptions necessary to ensure the equivalence property.The equivalence of these valuation methodologies is expectedbecause each model is measuring the same value contributors,just using different formula structures.In the DCF model, the starting capital is used only to determinefree cash flow at time 0. The principle of a DCF valuationis that an investment, a company for our discussion, is worth thevalue of its future earnings. If the capital leads to future earnings(by investment and supporting profitable business), then valuewill emerge. If future earnings are less than the hurdle rate, thenthe capital invested in this entity is less than its face value. 18The EVA model (both forms, EVA(a) and EVA(b)) includesthe full starting capital for its determination of value, but at acost represented by the cost of capital calculation. Column 10ain the EVA model calculations (Exhibits 1B, 2B, 3B, 4B, 5B,and 6B) shows the cost of the initial capital. The present valueof this negative cash flow in perpetuity exactly offsets the valuecontributed by immediate recognition of the capital in the EVAformula. If the capital does not provide earnings equal to orgreater than the hurdle rate in the form of excess profits, thenthe capital does not substantiate its value and is worth less than100 cents on the dollar.18 The value of capital is worth 100 cents on the dollar if you can release the capital attime zero. Otherwise, the capital is worth the present value of the distributable earningsgenerated by the capital. If distributable earnings represent a return lower than the hurdlerate, then capital is worth less than 100 cents on the dollar.