thatweturntothebookvalueofcapitalasaproxyforthe
capitalinvestedinassetsinplace.Thebookvalue,however,
isanumberthatreflectsnotjusttheaccountingchoicesmade
inthecurrentperiod,butalsoaccountingdecisionsmadeover
timeonhowtodepreciateassets,valueinventory,and deal
withacquisitions.Attheminimum,thethreeadjustmentswe
made to capital invested in the discounted cash flow
valuation—convertingoperatingleasesintodebt,capitalizing
R&D expenses, and eliminating the effect of one-time or
cosmeticcharges—havetobemadewhencomputingEVAas
well.Theolderthefirm,themoreextensivetheadjustments
that haveto be madeto book valueof capitalto getto a
reasonableestimateofthemarketvalueofcapitalinvestedin
assetsinplace.Sincethisrequiresthatweknowandtakeinto
accounteveryaccountingdecisionovertime,therearecases
wherethebookvalueofcapitalistooflawedtobefixable.
Here, it is best to estimate the capital invested from the
ground up, starting with the assets owned by the firm,
estimating the value of these assets, and cumulating this
market value.
Toevaluatethereturnonthisinvestedcapital,weneedan
estimateoftheaftertaxoperatingincomeearnedbyafirmon
these investments. Again, the accounting measure of
operating income has to be adjusted for operating leases,
R&Dexpenses,andone-timechargestocomputethereturn
on capital.
The third and final component needed to estimate the
economicvalueaddedisthecostofcapital.Inkeepingwith
ourargumentsinthediscountedcashflowvaluationsection,
thecostofcapitalshouldbeestimatedbasedonthemarket
valuesofdebtandequityinthefirm,ratherthanbookvalues.