Corporate Strategy & Financial Policies FIN4921 prepared by Dr. Sarina P.

FIN4921 prepared by Dr. Sarina P.

FIN4921 prepared by Dr. Sarina P.

Course materials: can be downloaded in https://sarinapree. wordpress FIN4921 prepared by Dr. Sarina P.

FIN4921 prepared by Dr. Sarina P. TENTATIVE CLASS SCHEDULE Period Topic Remarks 1 Overview of Corporate Strategy, Financial Policy and Value-Based Management (VBM) Lecture 1 2 Strategic Management Concept & Process Lecture 2 3 Linking Corporate and Financial Strategies Lecture 3 4 Presentation: Case 1( Formulating Corporate and Business Strategies) - 5 Strategic Capital Structure & Financial Decision Lecture 4 6 Strategic Capital Structure & Working Capital Management Lecture 5 7 Strategic Dividend Policy Lecture 6 8 Presentation: Case 2   MIDTERM EXAMINATION Period Topic Remarks 9 Strategic Capital Budgeting & Real Options Lecture 7 10 Presentation: Case 3   11 Strategic Financial Planning Lecture 8 12 Presentation: Case 4 - 13 Merger and Acquisitions Lecture 9 14 Presentation: Case 5 15 Review FINAL EXAMINATION FIN4921 prepared by Dr. Sarina P.

Details and objectives of the case(s) Case 1 (Walt Disney): Formulating Corporate and Business Strategies • Formulate corporate and business strategies based on SWOT analysis. • Create Balance Score Card (BSC) and strategy map. Case 2: Hampton Machine Tool Company Case 3: Health Development Corporation Case 4: Hospital Corporation of America Case 5: American Home Products Corporation FIN4921 prepared by Dr. Sarina P.

How to Analyze a Business Case Study FIN4921 prepared by Dr. Sarina P.

What are Case Studies? Case studies are used in many professional education programs, primarily in business school, to present real-world situations to students and to assess their ability to parse out the important aspects of a given dilemma. In general, a case study should include, in order: background on the business environment, description of the given business, identification of a key problem or issue, steps taken to address the issue, your assessment of that response, and suggestions for better business strategy. FIN4921 prepared by Dr. Sarina P.

Case Study Most MBA programs, and some undergraduate programs, use the case study method of instruction. Students are given a case study to analyze. These case studies are written by professors at top business schools as educational tools. The case study method was introduced and perfected by Harvard Business School, and many, if not most, of the case studies in use in business schools around the world come from HBS. Case studies provide students with experience in problem solving across many organizations and industries. Effective case analysis is a key element to being successful in business school. With case studies, there is no "right" answer. The professor is interested in how the student approaches and comes up with solutions to problems. Different students may come up with different answers, all equally correct. FIN4921 prepared by Dr. Sarina P.

The steps to analyze a case study Read the case lightly at first to get a general feel, then read it again and again before beginning your analysis. The purpose of reading the case multiple times is to become familiar with the case, not to find a magic answer hidden like an Easter egg in the text. There isn't one. Might do a basic SWOT analysis: strengths, weaknesses, opportunities and threats. Do this both for the internal environment of the organization and the external environment. If this is a company analysis -- as compared to an industry, for example -- what is the current corporate strategy? Identify the relevant problem or problems. Come up with alternative courses of action, and evaluate each. Recommend a course of action. Specify how the solution is to be implemented. Be prepared to deliver a defense of your analysis in class. FIN4921 prepared by Dr. Sarina P.

Tips & Warnings Cases are normally meant to be self-contained. Do not read outside the case to see what the "real" solution was, bearing in mind it's not really the point of the exercise to guess what happened in real life. Your professor may ask you to "update" the case using outside materials, however. He or she will explain what is meant in that case. FIN4921 prepared by Dr. Sarina P.

Example : Case study LVMH https://prezi.com/jtv5al9ywneh/lvmh-case-study/ https://vimeo.com/141168409 https://www.slideshare.net/khattab303/lvmh-presentation-11182014 FIN4921 prepared by Dr. Sarina P.

FIN4921 prepared by Dr. Sarina P. Overview of Corporate Strategy, Financial Policy and Value-Based Management (VBM) Lecture 1 FIN4921 prepared by Dr. Sarina P.

Content Goal of the management The value-based management framework Strategy Finance Corporate Governance Market Value Added (MVA) FIN4921 prepared by Dr. Sarina P.

What is the Goal of Management? “To maximize shareholder’s wealth (max: corporate value or shareholder value)” Concept of Value-Based Management (VBM) FIN4921 prepared by Dr. Sarina P.

Measures of shareholder value Improving the worth of the business from the shareholders’ perspective Value-based management Using shareholder value analysis to manage a business A framework for making key business decisions that add economic value to the business Consists of four aspects Valuation, strategy, finance and corporate governance FIN4921 prepared by Dr. Sarina P.

Measures of shareholder value (cont.) Valuation Discounted cash flows (DCF) are usually used to measure value Future cash flows of the business are discounted taking into account the risk associated with those cash flows Value drivers are the activities or actions that create value for a business Include spread, growth, sustainability and cost of capital (cont.) FIN4921 prepared by Dr. Sarina P.

Measures of shareholder value (cont.) Economic value added (EVA) Measure of the value created over a single accounting period The spread between the return generated by the business activities and the cost of capital EVA = EBIT(1-tax) – (WACC x capital) FIN4921 prepared by Dr. Sarina P.

Economic Value Added(EVA) The popular tool to measure the performance of CEOs EVA = EBIT(1-tax) – (WACC x capital) FIN4921 prepared by Dr. Sarina P.

Economic Value Added(EVA) To improve EVA Improve profitability without employing additional capital Borrow additional funds when profits earned are more than the cost of borrowing Pay off debt by selling assets Limitations of EVA Potential for manipulation and short-term orientation FIN4921 prepared by Dr. Sarina P.

Are we concerned only how to maximize the shareholder’s wealth? “In practice (not in theory)” FIN4921 prepared by Dr. Sarina P.

What determines the value of a stock? The value of any stock is the present value of expected future cash flows received from the investment aka. Intrinsic value Fair Value 1 2 3 4 n CF1 CF2 CF3 CF4 --- CFn The discount rate (Required rate of return) 22 FIN4921 prepared by Dr. Sarina P.

Estimating the Inputs FCFE = NI + DEPRECIATION – CAPEX – CHANGE IN WORKING CAPITAL – PRINCIPAL DEBT REPAYMENTS + NEW DEBT and P/S ISSUES – PREFERRED DIV Three critical inputs on most valuation models: 1. The Required Rate of Return Expected Growth Rates Cash Flow 23 FIN4921 prepared by Dr. Sarina P.

Stream of Expected Cash Flows Types of cash flows & Timing Depend on the investment, CFs can be in the form of: Dividends Free Cash Flow to Equity (FCFE) 24 FIN4921 prepared by Dr. Sarina P.

The Discount Rate or Required Rate of Return Determined by the summation of: The real risk-free rate of return (to compensate for the time for which funds are invested) The expected rate of inflation A risk premium (to compensate for the uncertainty of expected cash flows) Sources of uncertainty, and therefore risk premiums, vary by the type of investment 25 FIN4921 prepared by Dr. Sarina P.

FCFFi PV Corporate Value Financial Modeling Discounted by WACC TV = PV12 = FCFF13 / (wacc – L-T inflation rate) Corporate Value Financial Modeling FCFFi 0 1 2 3 4 5 6 7 8 9 10 11 12 … ∞ PV Discounted by WACC ERP Revenue growth = Long-term inflation rate Transitional Phase Transitional Phase >> Revenue growth drops, Capex rate drop ((capex rate during ERP + depre rate during ERP)/2) , R&D = 0 (exclude R&D before calculating NOPM) Revenue growth (transitional phase) = (Revenue growth during ERP + Long-term inflation rate) / 2 FIN4921 prepared by Dr. Sarina P.

Excess Return Period: ERP Tell us how far into the future we should forecast the company’s cash flow The period that the company will have the competitive advantage The period that the firm is able to earn returns on new investments that are greater than its cost of capital (WACC)or IRR > WACC (aka. Spread > 0) FIN4921 prepared by Dr. Sarina P.

Strategic Financial Value Corporate Governance The value-based management framework FIN4921 prepared by Dr. Sarina P.

VBM-Framework Valuation- Defines corporate value and explains the key drivers of the value. Strategy- Establishes a clear link between corporate value and strategic business strategies. Finances-Describes values enhancing financial policies available to the company. Corporate Governance-Explains the actions and policies of senior management such as performance measurement, compensation systems and investor communications that foster value creations. FIN4921 prepared by Dr. Sarina P.

Strategic Financial Corporate Governance Corporate Strategy Business Strategy Functional Strategy Strategic Selecting Investments Raising the capital Working Capital Management Dividend Policy Risk Management Financial Actions and policy of senior management Performance measurement Compensation systems Investor communications Corporate Governance FIN4921 prepared by Dr. Sarina P.

Corporate Valuation: A company owns two types of assets. Assets-in-place Assets-in-place are tangible, such as buildings, machines, inventory. Usually they are expected to grow. They generate free cash flows. The PV of their expected future free cash flows, discounted at the WACC, is the value of operations. Financial, or nonoperating, assets Marketable securities Ownership of non-controlling interest in another company Value of nonoperating assets usually is very close to figure that is reported on balance sheets. FIN4921 prepared by Dr. Sarina P.

∑ Value of Operations ∞ VOp = FCFt (1 + WACC)t t = 1 FIN4921 prepared by Dr. Sarina P.

Total Corporate Value and Claims on Corporate Value Total corporate value is sum of: Value of operations Value of nonoperating assets Claims on corporate value are Debtholders have first claim. Preferred stockholders have the next claim. Any remaining value belongs to stockholders. FIN4921 prepared by Dr. Sarina P.

Applying the Corporate Valuation Model Forecast the financial statements. Calculate the projected free cash flows. Model can be applied to a company that does not pay dividends, a privately held company, or a division of a company, since FCF can be calculated for each of these situations. FIN4921 prepared by Dr. Sarina P.

Data for Valuation FCF0 = $20 million WACC = 10% g = 5% Marketable securities = $100 million Debt = $200 million Preferred stock = $50 million Book value of equity = $210 million FIN4921 prepared by Dr. Sarina P.

Value of Operations: Constant FCF Growth at Rate of g VOp = ∑ ∞ t = 1 FCFt (1 + WACC)t = FCF0(1+g)t Notice that the term in parentheses is less than one and gets smaller as t gets larger. As t gets very large, term approaches zero. The summation can be replaced by a single formula: VOp = ∑ ∞ t = 1 FCF0 1 + WACC ( 1+ g ) t FIN4921 prepared by Dr. Sarina P.

Find Value of Operations VOp = FCF0 (1 + g) (WACC - g) 20(1+0.05) (0.10 – 0.05) = 420 FIN4921 prepared by Dr. Sarina P.

Value of Equity Sources of Corporate Value Value of operations = $420 Value of non-operating assets = $100 Claims on Corporate Value Value of Debt = $200 Value of Preferred Stock = $50 Value of Equity = ? FIN4921 prepared by Dr. Sarina P.

Value of Equity Total corporate value = VOp + Mkt. Sec. = $420 + $100 = $520 million Value of equity = Total Corp. Value- Debt - Pref. = $520 - $200 - $50 = $270 million FIN4921 prepared by Dr. Sarina P.

Value Based Management: Market Value Added (MVA) MVA = Total corporate value of firm minus total book value of firm Total book value of firm = book value of equity + book value of debt + book value of preferred stock MVA = $520 - ($210 + $200 + $50) = $60 million FIN4921 prepared by Dr. Sarina P.

Breakdown of Corporate Value

Expansion Plan: Nonconstant Growth Finance expansion by borrowing $40 million and halting dividends. Projected free cash flows (FCF): Year 1 FCF = -$5 million. Year 2 FCF = $10 million. Year 3 FCF = $20 million FCF grows at constant rate of 6% after year 3. The weighted average cost of capital, WACC, is 10%. The company has 10 million shares of stock. (More…) FIN4921 prepared by Dr. Sarina P.

Horizon Value VOp at time t = HV = FCFt(1+g) (WACC - g) Free cash flows are forecast for three years in this example, so the forecast horizon is three years. Growth in free cash flows is not constant during the forecast, so we can’t use the constant growth formula to find the value of operations at time 0. Growth is constant after the horizon (3 years), so we can modify the constant growth formula to find the value of all free cash flows beyond the horizon, discounted back to the horizon. Horizon value is also called terminal value, or continuing value. VOp at time t = FCFt(1+g) (WACC - g) HV = FIN4921 prepared by Dr. Sarina P.

Find the value of operations by discounting the free cash flows at the cost of capital. Vop at 3 -4.545 8.264 15.026 398.197 1 2 3 4 rc=10% 416.942 = Vop g = 6% FCF= -5.00 10.00 20.00 21.2 $21.2 . .06 $530. 10   FIN4921 prepared by Dr. Sarina P.

Find the price per share of common stock. Value of equity = Value of operations - Value of debt = $416.94 - $40 = $376.94 million. Price per share = $376.94 /10 = $37.69. FIN4921 prepared by Dr. Sarina P.

Value-Based Management (VBM) VBM is the systematic application of the corporate valuation model to all corporate decisions and strategic initiatives. The objective of VBM is to increase Market Value Added (MVA) FIN4921 prepared by Dr. Sarina P.

MVA and the Four Value Drivers MVA is determined by four drivers: Sales growth Operating profitability (OP=NOPAT/Sales) Capital requirements (CR=Operating capital / Sales) Weighted average cost of capital FIN4921 prepared by Dr. Sarina P.

MVA for a Constant Growth Firm MVAt = Salest(1 + g) WACC - g ┐ │ ┘ ┌ └ OP – WACC CR ( (1+g) ) The first bracket is the MVA of a firm that gets to keep all of its sales revenues (i.e., its operating profit margin is 100%) and that never has to make additional investments in operating capital. The second bracket is the operating profit (as a %) the firm gets to keep, less the return that investors require for having tied up their capital in the firm. FIN4921 prepared by Dr. Sarina P.

Improvements in MVA due to the Value Drivers MVA will improve if: WACC is reduced operating profitability (OP) increases the capital requirement (CR) decreases FIN4921 prepared by Dr. Sarina P.

( ) ┌ │ └ ┐ ┘ The Impact of Growth CR OP – WACC (1+g) The second term in brackets can be either positive or negative, depending on the relative size of profitability, capital requirements, and required return by investors. If the second term in brackets is negative, then growth decreases MVA. In other words, profits are not enough to offset the return on capital required by investors. If the second term in brackets is positive, then growth increases MVA. ┌ │ └ OP – WACC CR ( (1+g) ) ┐ ┘ FIN4921 prepared by Dr. Sarina P.

Expected Return on Invested Capital (EROIC) The expected return on invested capital is the NOPAT expected next period divided by the amount of capital that is currently invested: EROICt = NOPATt + 1 Capitalt FIN4921 prepared by Dr. Sarina P.

MVA in Terms of Expected ROIC Capitalt (EROICt – WACC) MVAt = WACC - g If the spread between the expected return, EROICt, and the required return, WACC, is positive, then MVA is positive and growth makes MVA larger. The opposite is true if the spread is negative. FIN4921 prepared by Dr. Sarina P.

The Impact of Growth on MVA A company has two divisions. Both have current sales of $1,000, current expected growth of 5%, and a WACC of 10%. Division A has high profitability (OP=6%) but high capital requirements (CR=78%). Division B has low profitability (OP=4%) but low capital requirements (CR=27%). FIN4921 prepared by Dr. Sarina P.

What is the impact on MVA if growth goes from 5% to 6%? Division A Division B OP 6% 4% CR 78% 27% Growth 5% MVA (300.0) (360.0) 300.0 385.0 FIN4921 prepared by Dr. Sarina P.

Expected ROIC and MVA Division A Division B Capital0 $780 $270 Growth 5% 6% Sales1 $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 FIN4921 prepared by Dr. Sarina P.

Analysis of Growth Strategies The expected ROIC of Division A is less than the WACC, so the division should postpone growth efforts until it improves EROIC by reducing capital requirements (e.g., reducing inventory) and/or improving profitability. The expected ROIC of Division B is greater than the WACC, so the division should continue with its growth plans. FIN4921 prepared by Dr. Sarina P.

Two Primary Mechanisms of Corporate Governance “Stick” Provisions in the charter that affect takeovers. Composition of the board of directors. “Carrot” Compensation plans. FIN4921 prepared by Dr. Sarina P.

Entrenched Management Occurs when there is little chance that poorly performing managers will be replaced. Two causes: Anti-takeover provisions in the charter Weak board of directors How are entrenched managers harmful to shareholders? Management consumes perks: Lavish offices and corporate jets Excessively large staffs Memberships at country clubs Management accepts projects (or acquisitions) to make firm larger, even if MVA goes down. FIN4921 prepared by Dr. Sarina P.

Anti-Takeover Provisions and Board of Directors Targeted share repurchases (i.e., greenmail) Shareholder rights provisions (i.e., poison pills) Restricted voting rights plans Board of Directors Weak boards have many insiders (i.e., those who also have another position in the company) compared with outsiders. Interlocking boards are weaker (CEO of company A sits on board of company B, CEO of B sits on board of A). FIN4921 prepared by Dr. Sarina P.

Stock Options in Compensation Plans Gives owner of option the right to buy a share of the company’s stock at a specified price (called the exercise price) even if the actual stock price is higher. Usually can’t exercise the option for several years (called the vesting period). Can’t exercise the option after a certain number of years (called the expiration, or maturity, date). FIN4921 prepared by Dr. Sarina P.

Strategy & Real Options The end result of the strategic analysis is a set of strategies (from GE model) and investment opportunities available to the company. But how do we value these strategies and opportunities? And does their value depend on when and how they are implemented? FIN4921 prepared by Dr. Sarina P.

FIN4921 prepared by Dr. Sarina P.

GE Model Strategy and Real Options FIN4921 prepared by Dr. Sarina P.

Portfolio Analysis Company with multiple product lines or business units must ask themselves how these various products and business units should be managed to boost overall corporate performance. Two of the most popular portfolio techniques are 1. BCG Growth-Share Matrix 2. GE Business Screen FIN4921 prepared by Dr. Sarina P.

FIN4921 prepared by Dr. Sarina P.

FIN4921 prepared by Dr. Sarina P.

Real Options Option valuation is used to value financial derivatives, such as call and put options on underlying assets. And it can be applied to use in the capital budgeting process. It refers to management’s ability to adopt and later revise corporate investment decisions in response to unexpected or risky market developments. Since flexibility, which is synonymous with options, can greatly change the value of a corporate investment or strategy, it should be a vital part of strategic analysis. Real options are important for companies whose market value is determined by intangible assets, such as growth opportunities (high R&D such as pharmaceuticals or internet companies) . So, most of the value of these companies is derived from their ability to exercise the option to invest in profitable discoveries and walk away from research failures. Real options, such as the ability to make follow-on investments, to abandon a project, or to wait and learn before investing. FIN4921 prepared by Dr. Sarina P.

Strategy & Real Options It has been found that merely changing the timing of an investment can increase its value by 30% to 300%. And most strategies and projects involve many additional sources of managerial flexibility, each of which can add substantially to the actual value of the investment or company. Passive management invests in a project and lets it ride. Active management keeps an eye on the project, reassessing as new opportunities. Even DCF techniques assume passive management. Real Options pricing represents the final screen through which are viewed in order to obtain an estimate of their true value… option value FIN4921 prepared by Dr. Sarina P.

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