J. K. Dietrich - FBE 532 – Spring 2006 Value-Based Management and Course Summary Week 14 – April 20, 2006

J. K. Dietrich - FBE 532 – Spring 2006 Maximize Shareholders’ Wealth u Management seeks financial policies and strategies that increase value of shares u Policies and strategies that produce returns larger than investors’ opportunity costs increase value (economic value added) u Sustained ability of management to add economic value increases the value of the firm’s assets relative to investment costs (market value added)

J. K. Dietrich - FBE 532 – Spring 2006 Market and Economic Value Added

J. K. Dietrich - FBE 532 – Spring 2006 Positive NPVs, MVA and EVA u Positive net present value projects earn higher than the discount rate u The discount rate captures the opportunity cost of capital being tied up u The dollar amounts of free cash flow earned above the opportunity rate is EVA u The present value at the discount rate of EVA is MVA

J. K. Dietrich - FBE 532 – Spring 2006 Advisors and Service Providers u Investment bankers assist management in adding value –Advice –Implementation u Venture capitalists create value –For their investors through excess returns –For the clients through realization of investment plans (LBOs and venture capital)

J. K. Dietrich - FBE 532 – Spring 2006 Performance Assessment u For public companies, share price performance is the first step in assessing management’s performance u To dig into details, must use accounting data –Dupont analysis –Analysis of operations and segments u Objective is to identify realized or potential sources of value

J. K. Dietrich - FBE 532 – Spring 2006 Market Value of the Firm u Value of the entire firm = entity value u Copland et al and PVFIRM calculate market value of the entity = market value of D + E u Entity value is present value of all free cash flows, available for division among all investors, whether in form of debt or equity u Cash flows to entire firm discounted at weighted average cost of capital

J. K. Dietrich - FBE 532 – Spring 2006 Advantages of Entity Approach u Focuses on operations and not financing, avoiding problem of changing capital structure through time u Focuses on free cash flow and pinpoints impact of alternative strategies u Free cash flow is net operating profit less an allowance for taxes (NOPLAT) minus necessary investments in working capital and fixed assets u Can focus on explicit forecast period and continuing values after explicit forecast period

J. K. Dietrich - FBE 532 – Spring 2006 Free Cash Flow u Free cash flow is standard approach u Net Operating Profit less Adjustment for Taxes (NOPLAT) - Net Investments u Free cash flow does not include interest expenses (or other financing costs) u Net investments are from working capital and capital expenditures u Need sales, operating costs, cash, accounts receivable, accounts payable, and inventory assumptions

J. K. Dietrich - FBE 532 – Spring 2006 Financial Analysis u Required for assumptions concerning future performance u Require historical and comparable firm data but future may not be like the past u You can use my handout Financial Statement Analysis and Assumptions for Valuation u Always apply plausibility check to both ratios, assumptions, and projections u Ratio analysis of projections useful in assessing plausibility of assumptions

J. K. Dietrich - FBE 532 – Spring 2006 Dupont Analysis of Performance u Dupont Analysis focuses on return on equity (RWJ, p. 39): u Closest to goal of management u Ratios can be calculated in different ways –Year-ending number balance sheet number or averages of two years –Before tax or after tax

J. K. Dietrich - FBE 532 – Spring 2006 Abbreviations used in Ratios u Abbreviations for accounting values used: ROE = return on equity EAC = earnings available to common BVE = book value of equity EBT = earnings before tax EBIT = earnings before tax and interest SLS = sales ASSTS = total operating assets

J. K. Dietrich - FBE 532 – Spring 2006 Basic Ratio Approach u ROE can be decomposed into elements: u Focus first on gross return on assets (p. 38) u ROA = “Earning Power” determined by gross profit margin and asset turnover

J. K. Dietrich - FBE 532 – Spring 2006 Gross Profit Margin (p. 38) u Sales u Components of Costs –Materials –Labor –SG&A –Other u Common size income statement valuable u Need assumptions for future on these

J. K. Dietrich - FBE 532 – Spring 2006 Asset Turnover (p. 35) u Working Capital –Inventories –Accounts Receivable u Look at liquidity and activity ratios –Turnover, days u Current liabilities: trade and bank debt u Fixed Assets – Net vs. Gross –Turnover, average age u Need assumptions to project these

J. K. Dietrich - FBE 532 – Spring 2006 Valuation is Critical to Finance u Three critical factors in valuation –Cash flows –Discount rates –Calculation of net present value u Where does value come from? –Ability to earn excess returns (EVA) –Sustained ability to invest at excess returns (results in MVA)

J. K. Dietrich - FBE 532 – Spring 2006 Markets and Firms u Firms operate in markets –Goods and services (products and investments) –Financial markets u Efficient market theory is benchmark for analysis in finance –No excess returns possible –Forces close examination on sources of value –Inefficiencies or inability to arbitrage are sources of value

J. K. Dietrich - FBE 532 – Spring 2006 Financial Theory and Practice u Well-defined objective function (maximize shareholders’ wealth) u Theories of how corporate policies and strategies influence value –Investments –Capital structure –Dividends u All require analysis of cash flows, discount rate, and present value

J. K. Dietrich - FBE 532 – Spring 2006 Course Summary – Apr. 27, 2006 u Prepare Vyaderm Pharmaceutical case (no write-up required) but bring analysis u Begin review for final examination by looking over past cases analyses and reviewing issues raised