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

2. Topics Corporate Valuation Value-Based Management Corporate Governance1

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

4. CORPORATE VALUE

5. 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

6. 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.

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

8. 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.

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

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

11. 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

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

13. Value of Operations

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

15. 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

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

17. 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 = ?

18. 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 = $ = Value of Preferred Stock
VE = $270 = Value of Equity = VCORP-VD-VPF

19. Topics Corporate Valuation Value-Based Management Corporate Governance1

20. 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

21. Breakdown of Corporate Value

22. 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

23. 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

24. 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.

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

26. Value of operations is PV of FCF discounted by WACC
Vop at 3
-4.545
8.264
15.026 1 2 3 4
rc=10%
= Vop
g = 6%
FCF=
$21.2 .
.06
$530. 10  

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

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

29. 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

30. MVA for a Constant Growth Firm

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

32. 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

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

34. 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:

35. 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.

36. 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%).

37. 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

38. Expected ROIC and MVA Division A Division B Capital0 $780 $270 Growth5% 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

39. 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

40. 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

41. Topics Corporate Valuation Value-Based Management Corporate Governance1

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

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

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

45. 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

46. 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

47. 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

48. 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

49. 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 . .)

50. 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.

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

52. 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

53. 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.

54. 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

55. 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