A CVA calculation includes only cash items, ie. Earnings before depreciation, interest and tax – EBDIT, working capital movements and non strategic investments. The sum of these three items is the operating cash flow ( OCF). The OCF is compared with a cash flow requirement, the Operating Cash flow Demand ( OCFD ). The OCFD represents the cash flow needed to meet investor’s financial requirements on the company’s strategic investments, the capital cost.
CVA may be a somewhat esoteric metric developed by the research firm Boston Consulting Group, which measures a company’s ability to get income above and beyond its cost of capital. The required return is an annuity based on the purchase price of the assets being used in the business, inflated with the value of money today, the weighted average cost of capital (WACC), and the assets’ economic life.
In general, a high CVA signifies the capacity of a company to produce net income from one financial cycle to the next. There is an absolute sum of residual. The CVA is determined by subtracting the cost of capital employed expressed as a minimum cash flow required from the cash flow generated in a year. This can also be represented as an index, where the necessary return divides the CVA. The CVA is positive and value is generated when the particular income is above the minimum income required to hide the value of capital employed.
Instead of measuring the investor’s opportunity cost of capital in percentage terms, the cash value added model uses the investor’s opportunity cost of capital in cash terms. The difference between the OCF and OCFD is CVA. The CVA for a period is a good estimate of the cash flow generated above of below the investor’s requirement for that period.
The main advantage of CVA is that it can be calculated at divisional level.
The Boston Consulting Group designed the following two CVA calculation methods:
Direct: CVA = gross cash flow – economic depreciation – capital charge
Indirect: CVA = (CFROI – cost of capital) x gross investment
CFROI is cash flow return on investment, or ((gross cash flow – economic depreciation) / gross investment)
Gross cash flow is adjusted profit + interest expense + depreciation
The capital charge is the cost of capital x gross investment
Gross investment is net current assets + historical initial cost
In reality, CVA gives investors an idea of the capacity of the company to produce cash from one fiscal cycle to another. The minimum cash flow needed is the amount of the needed return on capital hired, a rate of capital recovery, and the flat rate of taxation. CVA focuses primarily on the cash flow of a business while the EVA focuses on the overall valuation of a company. Capital returns are measured using the weighted average capital cost (WACC) which includes both debt and equity.