Although this method mixes cash and book items, it can lead to correct equity valuations if applied carefully. There are many ways to formulate this model, the most common being: EP = Net Operating Profit - Capital Charge
where: Capital Charge = Cost of Capital * Adjusted Book Value in Previous Period
The EP is calculated each period and discounted at the Cost of Capital to get a present value (PVEP). Adjusted Book Value is increased by the total incremental net investment for each period, so in general, a growing firm increases Capital charge over time. Then: Corporate Value = PVEP + Beginning Adjusted Book Value
which should be the same as the Corporate Value computed using the Shareholder Value Method. The Equity Value can be computed by the usual method of subtracting the market value of debt and other obligations and adding back the market value of investments.
If the Adjusted Book Value is a proxy for the owner investment in the business, the Capital Charge is the hurdle that must be reached to provide a break-even return on that investment. The Adjustments (on both the asset and liability side of the equation) that are made to Book Value make it a more reasonable proxy for owner investment in the firm, whether in the form of cash or as foregone dividends. The Economic Profit Model focuses management's attention on obtaining returns greater than the "floor" imposed by the Capital Charge.
The problems with the Economic Profit approach are:
Beginning Adjusted Book Value is used as a proxy for the investment in the firm, but this number requires you to decide on the adjustments necessary to obtain the actual economic value of the firm. If the Adjusted Book Value is higher than the actual economic value, Economic Profit in the forecast period appears to be lower than it actually is—possibly causing a firm that is actually creating value to appear to be destroying value. For firms whose economic value can be measured in market terms, requiring historical, albeit adjusted, book values as part of the model is an unnecessary complication.
Economic Profit is a short-term measure which may cause management to focus on the "wrong" targets, leading to dysfunctional behavior. Many value-creating projects don't return the cost of capital in their first or second year, although the long-term cash flows easily make up for the investment required in the early years of the project. A manager measured on EP may not propose such a project because of the negative Economic Profit impact in the short-term.
The Economic Profit Model usually assumes that a firm can generate excess returns indefinitely, which runs counter to the idea that a firm creates value due to a competitive advantage that can only be maintained for a limited number of years.