1. Residual income= Net Income- Cost of Equity (Equity rate*total equity outstanding)=E-(r*Equity)=(ROE-r)*BV(t-1)
2. Economic Value Added (EVA)= NOPAT -$WACC, where NOPAT= EBIT(1-t)
$WACC= WACC* Invested Capital
Invested capital= Change in NWC+ Net fixed Assets = BV of Long term debt + BV of Equity
Some adjustments that need to be made:
- R&D costs should be capitalized instead of expensed
- Strategic investments that will earn returns in the future should not be charged.
- Amortization needs to be added back to the earnings; goodwill should be capitalized and depreciation should be added back to the invested capital.
- only cash taxes should be considered. Deferred taxes are eliminated.
- Operating leases are treated as capital leases
3. Market Value Added (MVA)= MV of long term debt and MV of long term equity – BV of long term debt and equity (same as invested capital acc. to #2; a.k.a total capital)
4. Single state residual income model:
V0=B0+[(ROE-r)/(r-g)] *B0 (From the equation P0/B0=(ROE-g)/(k-g)
5. Bt=B(t-1)+Et-Dt. The residual income model assumes this clear surplus relationship.
6. In general, V0=B0+ Present Value of (Future residual income). For multi stage RI model, first forecast RI over the short term growth period, and then make some simplifying assumptions over the long term period. The RI over the long term period is assumed to have constant growth and ROE and is known as continual RI.
The value of continual RI in year (T-1) is RI(t)/(1+r-w) where w= persistance factor and ranges betn. 0 and 1.
Alternate method of finding continual RI= P(t)-B(t) and then discount this back to the present.
