Market Value Added (MVA) is known as the difference between the market valuations of a company and the sum of the adjusted book value of debt and equity invested in a company. When broken up MVA can simply be defined as ‘the difference between the total market value of the company and the economic capital’ (Firer, 1995: 57, Reilly and Brown, 2003:591). The economic capital of the company is the amount that has been invested in the company which is simply the fixed assets plus the networking capital. MVA is the best external measure of a company’s performance. MVA is determined by EVA. ‘A company’s EVA is the fuel that fires up its MVA’ (Stewart 1991: 153). The major link that can be identified between MVA, which is known as the cumulative measure, and EVA, which is known as an incremental measure, is that MVA is equal to the present value of all future EVA to be produced by the company. In order to see whether a value has been added, or destroyed, to the company over a period of time the difference in MVA from one date to a the next should be calculated. With MVA representing the stock markets assessment of a company it can be derived that the higher the MVA the better as this would represent greater wealth for the shareholders.
The finance decision model Net Present Value (NPV) can be defined as the difference between the present value of an investment’s future net cash flows less the initial investment. The result of NPV expresses how much value an investment will result in which is done by measuring over a period of time all cash flows, and back towards the present time. Should the result of the NPV method be positive, should there not be a better investment anywhere else, it can be concluded that an investment should be made. However, although the NPV measurement is widely used for making investment decisions, a disadvantage can be found as NPV does not account for uncertainty after the project decision is made. The relationship between MVA and NPV can be defined as, ‘MVA is a cumulative measure of corporate performance and it represents the stock market’s assessment from a particular time onwards of the NPV of all a company’s past and projected capital projects.’(Stewart 1991:153)
Summary of conditions if WACC is to be used as cut-off rate
For the WACC that has been calculated to be used as the marginal cut-off rate for investment, certain conditions must be met. The first thing is that it assumes that new projects have the same level of business risk as the company’s existing activities. In other words, the cost of a company’s capital reflects the variability of future expected dividend and interest flows. WACC also shows the overall risk of these flows. The new investment will have risk and return rates which should match up with the company’s existing dividend and interest statistics for it to be considered feasible. Also each project is marginal to the scale of existing operations. When a new investment is being considered, the costs are mainly associated with returns that a firm needs to earn to its main capital base structure. Another thing is that the firm will retain its existing capital structure as specifically requested. In this method, it will help make sure that the level of financial risk is still the same as it was before the new investment. WACC provides you with the correct cut-off rate for investment if the new investment is financed in the same kind of way as already invested projects.
If debt is used in the right way, it can help to lower the WACC, so it must be made sure that the WACC calculation has taken account of all factors that could affect it. A company's WACC is a very important figure, both to the stock market for stock valuation purposes and to the company's management for capital budgeting purposes. In an analysis of a potential investment by the company, investment projects that have an expected return that is greater than the company's WACC will generate additional free cash flow and will create positive net present value for stock owners. These corporate investments should result in an increase in stock prices. These are the projects that should be invested in. Investments that earn less than the firm's WACC will result in a decrease in stockholder value and should be avoided by the company. So, in other words the WACC must be looked at to see if the current capital structure of the company is in good shape and will benefit any investors.
