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CHAPTER 13

1

Corporate Valuation,

Value-Based Management andCorporate Governance

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Topics in Chapter

Corporate ValuationValue-Based Management

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FCF FCF FCF

Free cash flow(FCF)

Net operatingprofit after taxes

Required investmentsin operating capital

=

Intrinsic Value: Putting the Pieces Together

3

Value = + +

+(1 + WACC)1 (1 + WACC)(1 + WACC)2

Market interest rates

Firms business riskMarket risk aversion

Firms debt/equity mix

Cost of debt

Cost of equity

Weighted averagecost of capital

(WACC)

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Corporate Valuation: A companyowns two types of assets.

Assets-in-place Financial, or nonoperating, assets

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Dave Tufte

Its not quite clear here: the big issue isthat the value of assets-in-place could

Book value

Market value

Ability to generate cash flow

5

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Dave Tufte

We prefer a free cash flow basis forvaluing assets in place

Market values arent always clear if yourenot trying to sell the assets

Free cash flow can be measured off ofaccounting statements

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Assets-in-Place

Assets-in-place are tangible, such asbuildings, machines, inventory.

7

.

They generate free cash flows.

The PV of their expected future free

cash flows, discounted at the WACC, isthe value of operations.

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Value of Operations

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Vop =t = 1

t

(1 + WACC)t

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Nonoperating Assets

Marketable securities Ownership of non-controlling interest in

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Value of nonoperating assets usually isvery close to figure that is reported on

balance sheets.

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Total Corporate Value

Total corporate value is sum of:Value of operations

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Claims on Corporate Value

Debtholders have first claim. Preferred stockholders have the next

11

.

Any remaining value belongs tostockholders.

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Applying the CorporateValuation Model

Forecast the financial statements, asshown in Chapter 12.

Calculate the ro ected free cash flows.

12

Model can be applied to a company thatdoes not pay dividends, a privately heldcompany, or a division of a company,since FCF can be calculated for each ofthese situations.

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Data for Valuation

FCF0 = $24 million WACC = 11%

=

13

Marketable securities = $100 million

Debt = $200 million

Preferred stock = $50 million Book value of equity = $210 million

Number of shares =n = 10 million

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Value of Operations: ConstantFCF Growth at Rate of g

FCFt

14

op t = 1 (1 + WACC)t

=

t = 1

FCF0(1+g)t

(1 + WACC)t

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Constant Growth Formula

Notice that the term in parentheses isless than one and gets smaller as t gets

15

larger. As t gets very large, termapproaches zero.

Vop =t = 1

FCF01 + WACC

1+ g t

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Constant Growth Formula(Cont.)

The summation can be replaced by asingle formula:

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Vop =FCF1

(WACC - g)

=FCF0(1+g)

(WACC - g)

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Find Value of Operations

Vop =FCF0 (1 + g)

(WACC - g)

17

Vop

=24(1+0.05)

(0.11 0.05)= 420

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Total Value of Company (VTotal)

Voperations $420.00+ ST Inv. 100.00

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otal

.

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Intrinsic Value of Equity (VEquity)


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ota .

Preferred Stk. 50.00

Debt 200.00

VEquity $270.00

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Intrinsic Stock Price per Share, P


20

ota .

Preferred Stk. 50.00

Debt 200.00

VEquity $270.00 n 10

P $27.00

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Dave Tufte

All firms envision themselves as addingsome value (through their brilliance )

such as dumb doctors The market valuation of this is intrinsic

MVA

Broadly, its similar to goodwill

We cant value it directly, but we can back outits value

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Intrinsic Market Value Added(MVA)

Intrinsic MVA = Total corporate value of firmminus total book value of capital supplied byinvestors

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=equity + book value of debt + book value ofpreferred stock

MVA = $520 - ($210 + $200 + $50)

= $60 million

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Breakdown of Corporate Value

400

500

600 Intrinsic MVA

Book equity

23

0

100

200

300

Sources

of Value

Claims

on Value

Market

vs. Book

EquityPreferred stock

Debt

Marketablesecurities

Value of operations

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Dave Tufte

Its not clear that what follows is anexample for a

,

The same firm in a different situation

So, its comparable, but be careful

I think this was just carelessness on thepart of the Powerpoint shows authors

24

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Expansion Plan: NonconstantGrowth

Finance expansion by borrowing $40million and halting dividends.

Pro ected free cash flows FCF :

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Year 1 FCF = -$5 million.Year 2 FCF = $10 million.

Year 3 FCF = $20 million

FCF grows at constant rate of 6% afteryear 3.

(More)

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The weighted average cost of capital,WACC, is 10%.

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stock.

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Horizon Value

Free cash flows are forecast for threeyears in this example, so the forecast

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Growth in free cash flows is notconstant during the forecast, so we

cant use the constant growth formulato find the value of operations at time0.

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Horizon Value (Cont.)

Growth is constant after the horizon (3years), so we can modify the constant

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free cash flows beyond the horizon,discounted back to the horizon.

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Horizon Value Formula

FCFt(1+g)

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Horizon value is also called terminalvalue, or continuing value.

op a me

(WACC - g)

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Value of operations is PV ofFCF discounted by WACC.

0 1 2 3WACC =10% g = 6%

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FCF3(1+g)

(1+WACC)4.545

8.264

15.026

398.197

416.942 = Vop

.

$20(1.06)

0.100.06

$530 =Vop at 3

$530/(1+WACC)3

. .

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Intrinsic Stock Price per Share, P

Voperations $416.942+ ST Inv. 0

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ota .

Preferred Stk. 0

Debt 40.000

VEquity $376.942 n 10

P $37.69

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Value-Based Management(VBM)

VBM is the systematic application of thecorporate valuation model to all

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initiatives. The objective of VBM is to increase

Market Value Added (MVA)

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Dave Tufte

Careful Capital requirements on the next slide are

a ratio not a total

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MVA and the Four ValueDrivers

MVA is determined by four drivers: Sales growth

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Capital requirements (CR=Operatingcapital / Sales)

Weighted average cost of capital

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Dave Tufte

How MVA is driven Positively related to sales growth

Negatively related to WACC

Negatively related to capital requirements

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Dave Tufte

A big formula follows, that does getexplained over the following several

It is derived in the text in Section 13.3

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MVA for a Constant GrowthFirm

MVAt =

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OP WACCCR

(1+g)Salest(1 + g)

WACC - g

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Dave Tufte

You can think of the first term (on thenext slide) as gross cash inflows

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Insights from the Constant

Growth Model

The first bracket is the MVA of a firm thatgets to keep all of its sales revenues (i.e.,

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that never has to make additionalinvestments in operating capital.

Salest(1 + g)

WACC - g

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Dave Tufte

You can think of the second term (onthe next slide) as how much the firm

A margin of gross cash inflows, minus

How much of that has to be paid back toinvestors

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Insights (Cont.)

The second bracket is the operatingprofit (as a %) the firm gets to keep,less the return that investors require for

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having tied up their capital in the firm.

OP WACC CR(1+g)

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Dave Tufte

The last term on the previous slide isvery similar to the first term in the MVA

Substitute out CR with its definition

Use the approximation for dividing by 1+g

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d

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Improvements in MVA due to

the Value Drivers

MVA will improve if: WACC is reduced

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the capital requirement (CR) decreases

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The Impact of Growth

The second term in brackets can be eitherpositive or negative, depending on therelative size of profitability, capital

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requirements, and required return byinvestors.

OP WACC CR(1+g)

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The Impact of Growth (Cont.)

If the second term in brackets isnegative, then growth decreases MVA.

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to offset the return on capital requiredby investors.

If the second term in brackets ispositive, then growth increases MVA.

E t d R t I t d

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Expected Return on Invested

Capital (EROIC)

The expected return on invested capitalis the NOPAT expected next period

46

divided by the amount of capital that iscurrently invested:

EROICt = NOPATt+1

Capitalt

OPt+1

CRtCapitalt

=

MVA i T f E t d

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MVA in Terms of Expected

EROIC and Value Drivers

MVAt = Capitalt (EROICt WACC)WACC - g

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If the spread between the expected return, EROICt,and the required return, WACC, is positive, then MVAis positive and growth makes MVA larger. Theopposite is true if the spread is negative.

MVAt = Capitalt (OPt+1/CRt WACC)WACC - g

MVA i T f E t d

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MVA in Terms of Expected

EROIC

MVAt =Capitalt (OPt+1/CRt WACC)

WACC - g

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If the spread between the expected return, EROICt,and the required return, WACC, is positive, then MVAis positive and growth makes MVA larger. Theopposite is true if the spread is negative.

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Dave Tufte

What follows is just an example, but itpoints out that there is a tradeoff

capital requirements that can produce apitfall for management (withoutadequate financial advice) about how to

proceed

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The Impact of Growth on MVA

A company has two divisions. Both havecurrent sales of $1,000, current expectedgrowth of 5%, and a WACC of 10%.

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Division A has high profitability (OP=6%) buthigh capital requirements (CR=78%).

Division B has low profitability (OP=4%) but

low capital requirements (CR=27%).

What is the impact on MVA if

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What is the impact on MVA if

growth goes from 5% to 6%?

Division A Division B

OP 6% 6% 4% 4%

CR 78% 78% 27% 27%

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Growth 5% 6% 5% 6%MVA (300.0) (360.0) 300.0 385.0

Note: MVA is calculated using the formulaon slide 13-28.

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Expected ROIC and MVA

Division A Division B

Capital0 $780 $780 $270 $270

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Sales1 $1,050 $1,060 $1,050 $1,060

NOPAT1 $63 $63.6 $42 $42.4

EROIC0 8.1% 8.2% 15.6% 15.7%

MVA (300.0) (360.0) 300.0 385.0

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Analysis of Growth Strategies

The expected ROIC of Division A is less thanthe WACC, so the division should postponegrowth efforts until it improves EROIC by

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reducing capital requirements (e.g., reducinginventory) and/or improving profitability.

The expected ROIC of Division B is greater

than the WACC, so the division shouldcontinue with its growth plans.

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Dave Tufte

Recall that on my pink sheet of thingswe dont know in finance, is that it isnt

liability so much of the time.A lot of this has to do with mismanaging

value

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Six Potential Problems with

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Six Potential Problems with

Managerial Behavior

Expend too little time and effort. Consume too many nonpecuniary

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.

Avoid difficult decisions (e.g., closeplant) out of loyalty to friends in

company.

(More . .)

Six Problems with Managerial

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Six Problems with Managerial

Behavior (Continued)

Reject risky positive NPV projects to avoidlooking bad if project fails; take on riskynegative NPV projects to try and hit a home

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run.

Avoid returning capital to investors by makingexcess investments in marketable securitiesor by paying too much for acquisitions.

Massage information releases or manageearnings to avoid revealing bad news.

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Dave Tufte

The key to mitigating these is notavoiding them

avoided Instead, you need to have mechanisms

to avoid letting management getentrenched

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Corporate Governance

The set of laws, rules, and proceduresthat influence a companys operations

58

managers. Sticks (threat of removal)

Carrots (compensation)

Corporate Governance Provisions

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Corporate Governance Provisions

Under a Firms Control

Board of directors Charter provisions affecting takeovers

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Capital structure choices

Internal accounting control systems

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Effective Boards of Directors

Election mechanisms make it easier forminority shareholders to gain seats:

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. .,

members elected each year, not just thosewith multi-year staggered terms)

Board elections allow cumulative voting

(More . .)

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CEO is not chairman of the board anddoes not have undue influence over the

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Board has a majority of outsidedirectors (i.e., those who do not haveanother position in the company) withbusiness expertise.

(More . .)


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Effective Boards of Directors(Continued)

Is not an interlocking board (CEO ofcompany A sits on board of company B,

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Board members are not unduly busy(i.e., set on too many other boards orhave too many other business activities)

(More . .)


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Effective Boards of Directors(Continued)

Compensation for board directors isappropriate

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with CEO Not all compensation is fixed salary (i.e.,

some compensation is linked to firm

performance or stock performance)

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Dave Tufte

The next slide is things to be avoided

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Anti-Takeover Provisions

Targeted share repurchases (i.e.,greenmail)

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. .,

poison pills) Restricted voting rights plans

Stock Options in

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p

Compensation Plans

Gives owner of option the right to buy ashare of the companys stock at a

66

exercise price) even if the actual stockprice is higher.

Usually cant exercise the option forseveral years (called the vestingperiod).

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Stock Options (Cont.)

Cant exercise the option after a certainnumber of years (called the expiration,

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Dave Tufte

This text doesnt say anything aboutbackdating on the next slide

,

but it is current

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Problems with Stock Options

Manager can underperform market orpeer group, yet still reap rewards from

69

increases to above the exercise cost. Options sometimes encourage

managers to falsify financial statementsor take excessive risks.

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Dave Tufte

I think the next slide is a load of cr*p. Increasingly blockholders foster

conservatism in mana ers

We need more obnoxious blockholders like Kirk Kerkorian

We need less CALPers and TIAA-CREF

This is a knock on those organizations I think they can do better

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Block Ownership

Outside investor owns large amount(i.e., block) of companys shares

71

,

TIAA-CREF Blockholders often monitor managers

and take active role, leading to better

corporate governance

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Regulatory Systems and Laws

Companies in countries with strongprotection for investors tend to have:

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A lower cost of equity Increased market liquidity

Less noise in stock prices

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