Corporate Valuation and Value-Based Management CHAPTER 11 Corporate Valuation and Value-Based Management

Topics Corporate Valuation Value-Based Management Corporate Governance 1

Corporate Valuation: A company owns two types of assets. Assets-in-place Financial, or nonoperating, assets

CORPORATE VALUE

CORPORATE VALUE Growth Opportunities Assets-in-place Opportunities to expand arising from firm’s current knowledge, experience and resources Assets-in-place Tangible: land, buildings Intangible: patents, reputation

Assets-in-Place Assets-in-place are tangible, such as buildings, machines, inventory Usually expected to grow Generate free cash flows The PV of their expected future free cash flows, discounted at the WACC, is the value of operations.

CORPORATE VALUE Marketable securities Ownership of non-controlling interest in another company Value  Balance Sheet figures

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.

VCORP = VOP + VNOA Total Corporate Value Total corporate value is sum of: VOP = Value of operations VNOA = Value of nonoperating assets

Claims on Corporate Value 1st claim: Debt-holders 2nd claim: Preferred stockholders Residual claim: Common Stockholders

Applying the Corporate Valuation Model Forecast the financial statements Shown in Chapter 9 Calculate projected free cash flows Model can be applied to a company that: Does not pay dividends Is privately held Is a division … since FCF can be calculated for each

Value of Operations: Constant FCF Growth at Rate of g Vop = Σ ∞ t = 1 FCFt (1 + WACC)t = FCF0(1+g)t

Value of Operations

Constant Growth Formula Vop = FCF1 (WACC - g) = FCF0(1+g)

Expansion Plan: Target #1 Input Values: FCF0 = $20 million WACC = 10% g = 5% Marketable securities = $100 million Debt = $200 million Preferred stock = $50 million Book value of equity = $210 million

Find Value of Operations Vop = FCF0 (1 + g) (WACC - g) 20(1+0.05) (0.10 – 0.05) = 420

Value of Equity Sources of Corporate Value Claims on 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 = ?

Value of Equity Sources of Corporate Value Claims on Corporate Value VOP = $420 = Value of operations VNOA = $100 = Value of non-operating assets VCORP = $520 = VOP + VNOA Claims on Corporate Value VD = $200 = Value of Debt VPF = $ 50 = Value of Preferred Stock VE = $270 = Value of Equity = VCORP-VD-VPF

Topics Corporate Valuation Value-Based Management Corporate Governance 1

Market Value Added (MVA) MVA = Total corporate value of firm minus total book value of firm Total corporate value of firm $ 520 Total book value of firm = Book value of equity $ 210 + book value of debt 200 + book value of preferred stock 50 MVA = $520 - ($210 + $200 + $50) = $60 million

Breakdown of Corporate Value

Expansion Plan: Target #2 Non-constant Growth Privately held company $40 million in new debt No other debt No preferred stock Pays no dividend No marketable securities

Expansion Plan: Target #2 Projected free cash flows (FCF): Year 1 FCF = -$5 million. Year 2 FCF = $10 million. Year 3 FCF = $20 million FCF after year 3 = 6% constant growth WACC = 10% 10 million shares of stock outstanding

Horizon Value Forecast horizon = three years Growth in FCF is not constant Can’t use the constant growth formula Growth is constant after the horizon Modify the constant growth formula to find the value of all free cash flows beyond the horizon, discounted back to the horizon.

Horizon Value Formula Vop at time t = HV = FCFt(1+g) (WACC - g) Horizon value is also called terminal value, or continuing value.

Value of operations is PV of FCF discounted by WACC 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  

Common Stock Price per Share Value of equity = Value of operations - Value of debt = $416.94 - $40 = $376.94 million Price per share = $376.94 /10 = $37.69

Value-Based Management (VBM) The systematic application of the corporate valuation model to all corporate decisions and strategic initiatives. Objective =increase MVA

MVA and the Four Value Drivers g = Sales growth OP = Operating profitability (OP=NOPAT/Sales) CR = Capital requirements (CR=Operating capital / Sales) WACC = Weighted average cost of capital

MVA for a Constant Growth Firm

MVA for a Constant Growth Firm = MVA if: Operating profit margin is 100% Never any additional investments in operating capital

MVA for a Constant Growth Firm = MVA if: Operating profit margin is 100% Never any additional investments in operating capital % Operating profit the firm gets to keep, less the return that investors require Can be positive or negative If negative, then growth decreases MVA

MVA for a Constant Growth Firm MVA will improve if: Operating profitability (OP) increases WACC is reduced The capital requirement (CR) decreases

Expected Return on Invested Capital (EROIC) The expected return on invested capital =the NOPAT expected next period divided by the amount of capital currently invested:

MVA in Terms of Expected ROIC If (EROICt - WACC) is positive, then: MVA is positive Growth makes MVA larger The opposite is true if the spread is negative.

The Impact of Growth on MVA KFS’ Divisions KFS has two divisions: Both have current sales of $1,000 Current expected growth of 5% 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%).

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

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

Analysis of Growth Strategies 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 EROIC(A) < WACC (10%) Should postpone growth efforts until it improves EROIC Reduce capital requirements (e.g., reducing inventory) And/or improve profitability

Analysis of Growth Strategies 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 EROIC(B) > WACC (10%) Division should continue with its growth plans

Topics Corporate Valuation Value-Based Management Corporate Governance 1

CORPORATE GOVERNANCE “The set of rules and procedures that ensure that managers do indeed employ the principles of value-based management”

Two Primary Mechanisms of Corporate Governance “Stick” Provisions in the charter that affect takeovers Composition of the board of directors “Carrot” Compensation plans

Corporate Governance Provisions Under a Firm’s Control Board of directors Charter provisions affecting takeovers Compensation plans Capital structure choices Internal accounting control systems

Effective Boards of Directors Election mechanisms make it easier for minority shareholders to gain seats: Not a “classified” board (i.e., all board members elected each year, not just those with multi-year staggered terms) Board elections allow cumulative voting CEO ≠ Chairman of the Board Majority of outside directors

Effective Boards of Directors (Continued) Not an interlocking board Board members not unduly busy Compensation for board directors is appropriate Not so high that it encourages cronyism with CEO Not all compensation is fixed salary

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

Two Effects of Entrenched Management Management consumes perks: Lavish offices and corporate jets Excessively large staffs Country club memberships Management accepts projects (or makes acquisitions) to make firm larger, even if MVA goes down

Harmful Managerial Behavior Expend too little time and effort Consume too many non-pecuniary benefits Avoid difficult decisions (e.g., close plant) out of loyalty to friends in company (More . .)

Harmful Managerial Behavior Reject risky positive NPV projects to avoid looking bad if project fails Take on risky negative NPV projects to try for a home run. Avoid returning capital to investors Make excess investments in marketable securities Pay too much for acquisitions Massage information releases or manage earnings to avoid revealing bad news.

Anti-Takeover Provisions “Greenmail” Targeted share repurchases “Poison Pills” Shareholder rights provisions Restricted voting rights plans

Stock Options as Compensation Gives option holder the right to buy a share of the company’s stock at a specified price Vesting period Expiration or maturity date

Problems with Stock Options Manager can underperform market or peer group, yet still reap rewards from options as long as the stock price increases to above the exercise cost. Options sometimes encourage managers to falsify financial statements or take excessive risks.

Block Ownership Outside investor owns large amount (i.e., block) of company’s shares Institutional investors, such as CalPERS or TIAA-CREF Blockholders often monitor managers and take active role, leading to better corporate governance

Regulatory Systems and Laws Companies in countries with strong protection for investors tend to have: Better access to financial markets A lower cost of equity Increased market liquidity Less noise in stock prices