Discussion Issues and Derivations
- A Framework for Value Creation
The value of a firm is the present value of its expected cash flows, discounted back at the cost of capital. There are ultimately only three outlets for all types of value creation:
a. Increase current cash flows: This can be accomplished by increasing cash flows from current operations (by making them more efficient) or by cutting back on reinvestment needs.
b. Increase expected growth: This can be accomplished by increasing reinvestment needs (which puts you in conflict with (a)), or improving the returns on investments taken.
c. Reducing the cost of capital: Since both the cost of equity and debt are market-set, firms can change their cost of capital by changing their mix of debt and equity. If they can reduce their cost of capital by altering this mix, they could potentially increase value.
The real challenge in value creation is that few actions have only positive value effects. Take, for instance, the decision to increase reinvestment. This increases growth, but reduces current cash flows. It may become even more complicated if the reinvestment is in a different business, with its own risk profile. This will affect the firm's cost of capital. The net effect is what drives value.
- Economic Value Added as a Value Enhancement Tool
Economic value added is a value enhancement concept that has caught the attention of both firms interested in increasing their value and portfolio managers, looking for good investments. EVA is a measure of dollar surplus value created by a firm or project and is measured by doing the following:
Economic Value Added (EVA) = (Return on Capital - Cost of Capital) (Capital Invested)
where the return on capital is measured using "adjusted" operating income, where the adjustments eliminate items that are unrelated to existing investments, and the capital investment is based upon the book value of capital, but is designed to measure the capital invested in existing assets. Firms which have positive EVA are firms which are creating surplus value, and firms with negative EVA are destroying value.
In the context of value creation, there are three ways that EVA suggest that you can increase value
a. increase return on capital
b. reduce cost of capital
c. keep the spread the same and increase capital invested
To read more about EVA, click here.