04/28/23 Robert C. Radcliffe 1

Analysis of Continuing Value

These notes are based on the assumption thatThe accounting depreciation expense

=The amount of cash needed to restore assets to start on year productivity

(to generate the same NOPAT in period n+1 as generated in year n)

Accounting depreciation expense = Economic depreciation

04/28/23 Robert C. Radcliffe 2

Definition of Continuing Value

Continuing Value is the value of Future Free Cash Flows from Operating Invested Capital (FCF) at a point in time after

which the expected growth of FCF is constant.

CVn = Continuing Value at end of period nFCFn+1 = Free Cash Flow at end of period n+1GFCF = Constant yearly growth rate of FCF (after date n+1)

WACC = Weighted Average Cost of Capital

CVn = FCFn+1 / (WACC – GFCF)

04/28/23 Robert C. Radcliffe 3

Value to Capital Suppliers at Date n

Value to Capital Suppliers at end of Period n=Free Cash Flow received at end of period n+Continuing Value at end of period n

We will see that the NOPAT Retention Rate

affects both FCFn andCVn

It is the sum of the two, orValue to Capital Suppliers at

end of period n

that matters

04/28/23 Robert C. Radcliffe 4

Determinants of Value to Capital Suppliersat the end of Period n

• WACC• NOPAT retention rate (% of NOPAT retained in the firm)

= b NOPAT (this is assumed to be constant forever)• Return on Operating Invested Capital = ROIC

(this is assumed to be constant forever, it is a proxy for IRR)

When ROIC = WACC, increases in b NOPAT have no affect onValue to Capital Suppliers at end of period n

When ROIC < WACC, increases in b NOPAT have no affect onValue to Capital Suppliers at end of period n

When ROIC > WACC, increases in b NOPAT have no affect onValue to Capital Suppliers at end of period n

04/28/23 Robert C. Radcliffe 5

WHY?!!!!!!

• ROIC is a proxy for the Internal Rate of Return on operating capital invested in the firm (OIC).

• When the IRR > than WACC, positive Net Present Value projects are acquired by the firm.

• The greater the NOPAT retention rate (b NOPAT ), the greater the amount of NPV generated.

• Thus, increased retention of operating profits leads to an increase in the total Value of Capital suppliers when ROIC > WACC!

04/28/23 Robert C. Radcliffe 6

Components of Continuing Value:1. Value of Existing Assets

Value of Existing Assets• If the firm does not increase its productivity by acquiring new Net

Operating Working Capital and expanding Net Plant & Equipment, its current productivity will generate a stream of future NOPAT equal to the current year’s NOPAT.

• Since this stream is, conceptually, a perpetuity, it can be valued according to the value of a perpetuity (where the discount rate is the WACC).

Value of Existing Assets* = NOPAT / WACC

*Remember, we are assuming the accounting depreciation expenseIs equal to true economic depreciation. Do you understand why this must be the case in the equation above? If not, ask the instructor.

04/28/23 Robert C. Radcliffe 7

Components of Continuing Value:2. Cost of new OIC Acquired

Cost of new Operating Invested Capital Acquired to support future growth of NOPAT and FCF’s

• If a portion of current NOPAT is to be retained in the firm, this dollar retention adds to the value of current OIC in an amount equal to the dollar amount retained.

04/28/23 Robert C. Radcliffe 8

Components of Continuing Value:3. Cost of new OIC Acquired