2. 1 FI 8360 Spring 2003 Corporate Financial Strategy Roger A. Morin, PhD Distinguished Professor Finance, College of Business, Georgia State University Chairman & CEO Utility Research International

3. 2 FI 8360 Lecture #1 Roadmap F Course overview & organization F Valuation and the “Value Movement” F Lecture #2 preview

4. 3 Value Creation Principle that overall business strategies and their implementation should be guided by the pursuit and selection of alternatives which maximize shareholder value

7. 6 Economic Value n E(C t ) Present Value =  ------------- t=0 (1 + k) t Future value corresponds to future and uncertain business cash flows, C t. So we discount expected cash flows Cash flow and Risk Because business cash flows occur over many future periods, we locate them in time, then discount and add them all. Timing Because business cash flows are risky, investors demand a higher return: the discount rate, k, contains a risk premium. Risk

8. Asset Valuation  PV= CF 1+k... + 1+k 1n 1 2 2 1 k n. 012n k CF 1 CF n CF 2 Value... ++ +

9. 8 How Investors Value Securities n Bond Value = Cash Flow t t=1 (1 + k) t n Stock Value = Dividends t ~ D 1 t=1 (1 + k) t k - g

10. 9 How Companies Value Capital Projects n NPV = Cash Flow t - Investment 0 t=1 (1 + k) t

11. 10 Corporate Value infinity Value = Cash Flow t t=0 (1 + Cost of Capital) t

12. 11 Free cash flow is the basis of value! Investors watch this pattern…… ….which is “cash in and cash out” Free cash flow = NOPAT adjusted for depreciation and other accounting elements Less net investment in working capital, fixed assets, capitalized R&D, etc. Trend Time

13. 12 Shareholder value analysis focuses on the factors that investor use to value companies: F Cash Flows F Long-Term Expected Performance F Risk

14. 13

16. 15 Alternative Valuation Framework NOPAT V = ------------- K Where: NOPAT = Net Operating Profits After Tax K = Cost of Capital V = As Is Value

17. 16 Valuation Framework NOPAT R - K V = ------------- + ------------ * I * T K K WHERE: NOPAT = NET OPERATING PROFITS AFTER TAX K = COST OF CAPITAL R = RETURN ON CAPITAL I = ANNUAL INCREMENTAL INVESTMENT T = NO. OF YEARS THAT I CAN BE INVESTED AT R > K V = As Is Value + Value Growth Opportunities

18. 17 3 Factors in Value Creation Ê ROI > WACC Ë Amount of Investment Ì Interval of Competitive Advantage Note: –Forward-looking –Expected cash flows

19. 18 Fundamental Principle of Valuation CORPORATE RETURN MARKET VALUE = --------------------------------------------------- INVESTORS’ REQUIRED RETURN MARKET VALUE RETURN ON TOTAL CAPITAL -------------------------------- = ------------------------------------------- CAPITAL EMPLOYED COST OF CAPITAL

20. 19 Value Created for Shareholders (R - K) M/B - 1 = ------------- (K - G) F Spread return on equity over cost of equity F Volume of new investment measured as earnings retained in the business F Duration of positive spread Note: Growth adds value only if R > K

21. 20 Value Creation

22. 21 0 2 4 6 SALES GROWTH MARKET-TO-BOOK RATIO 3.00%4.50%7.50%10.50%13.50%15.00% SPREAD < -5% SPREAD -5% to -2% SPREAD -2% to +2% SPREAD +2% to +5% SPREAD > 5% VALUE vs SPREADS & GROWTH MARKET-TO-BOOK RATIOS

23. 22 Shareholder Value Network Creating Shareholder Value Shareholder Return Dividends Capital Gains Corporate Objective

24. 23 Shareholder Value Network Creating Shareholder Value Shareholder Return Dividends Capital Gains Cash Flow From Operations Discount RateDebt Corporate Objective Valuation Components

25. 24 Shareholder Value Network Creating Shareholder Value Shareholder Return Dividends Capital Gains Cash Flow From Operations Discount RateDebt Value Growth Duration Sales Growth Operation Profit Margin Income Tax Rate Working Capital Investment Fixed Capital Investment Cost of Capital Corporate Objective Valuation Components Value Drivers

26. 25 Shareholder Value Network Creating Shareholder Value Shareholder Return Dividends Capital Gains Cash Flow From Operations Discount RateDebt Value Growth Duration Sales Growth Operation Profit Margin Income Tax Rate Working Capital Investment Fixed Capital Investment Cost of Capital Operating InvestmentFinancing Corporate Objective Valuation Components Value Drivers Management Decisions

27. 26 Shareholder Value and Value Drivers F Investment decisions u Working capital investment u Fixed capital investment F Financing decisions u Cost of capital u Debt-equity mix u Dividend policy F Operating decisions u Sales growth u Operating profit margin u Income tax rate F Value growth duration

28. 27 Value Creation - Another View Value Created = (Return On Investment - Cost of Capital) x Capital employed Dependent Upon: F Cost of Capital Spread F Duration of Spread F Amount of Capital Employed

29. 28 Economic Value Added (r - c*)xcapital NOPAT-c* x capital Operating profits-a capital charge EVA ties directly to NPV NPV = market value - capital NPV = the present value of projected EVA Market value = capital + P.V. of projected EVA c* = WACC r = NOPAT / Capital

38. 37 Strategic Drivers F Optimal Cost Structure F Competitive Advantage F Asset Utilization F Protect Strategic Resources F Reduce Risk F Value Based Management

39. 38 Value Drivers and Strategy VALUE Cash Flows Discount Rate Value Growth Duration Sales Growth Profit Margin Tax Rate Working Capital Fixed Capital Cost of Capital Operating InvestmentFinancing Corporate Objective Valuation Components Value Drivers Management Strategies

40. 39 Strategic Value Drivers Return Risk Value Financial Value Drivers Sales growthWorking CapitalTax rate Profit MarginFixed AssetsCost of Capital Operational Value Drivers Unit sales volume Selling terms Prices Vendor terms Product mix Purchasing policies Labour rate Payment procedures Overhead Sourcing strategies Productivity Capital budgeting Work schedules Innovation tactics Downtime Location decisions From Macro to Micro Drivers

41. 40 Strategic Value Drivers Return Risk Value Financial Value Drivers Sales growthWorking CapitalTax rate Profit MarginFixed AssetsCost of Capital Operational Value Drivers Production costs per kWh Non-production costs per kWh Load factor Fuel mix in MWh Growth in total MWh sales Average prices From Macro to Micro Drivers

42. 41 Strategic Value Drivers Return Risk Value Financial Value Drivers Sales growthWorking CapitalTax rate Profit MarginFixed AssetsCost of Capital Operational Value Drivers Operating cost per customer Operating cost per units distributed Electricity/gas distributed per employee Distribution operating profit per customer From Macro to Micro Drivers

45. 44 Financial Drivers F Optimal Capital Structure F Capital Allocation Based on Value F Financial Engineering F Minimize Tax Rate F Dividend Policy

47. 46 Corporate Drivers F Governance F Performance Evaluation F Incentive Compensation

48. 47 VBM F Are accounting metrics consistent with value creation?

49. 48 Accounting Measures Misleading F Accrual accounting undependable F Growth of earnings not necessarily related to stock value F Earnings do not reflect changes in risk and inflation F Earnings do not show the cost of added plant that may have been invested to finance growth F Focusing on short-term earnings growth jeopardizes ability to create long-term value

50. 49 Drawbacks of EPS F Accounting latitude F Risk excluded F Investment requirements excluded F Dividend policy excluded F Time value of money excluded F Empirical evidence: EPS vs value unrelated

51. 50 The Agency Problem F Managers act in their own self-interest (corporate jets, country clubs, perks, etc.) F Shareholders do not have the influence or finances to govern issues such as election of board members F Board members tend to be largely responsive to mgt..; top mgrs... are often board members F Mgt time horizon may be short-term, due to compensation mode F Mgt tends to have lower risk tolerance than sh’ers due to compensation mode

52. 51 How to reduce the agency problem F Large ownership positions F Compensation tied to shareholder return F Threat of takeovers F Competitive labor markets for corporate executives

54. 53 VBM Process F Experiment F Strategic Restructuring F Value-based Planning F Value-based Compensation

55. 54 Restructuring F Value “as is” F Internal improvements –Strategic & Operating F External improvements –Acquisitions, divestitures, jvs F Financial engineering F HQ costs

56. 55 Restructuring Pentagon Current Market Value Optimal Restructured Value Potential Value with Internal Improvements Company Value As Is 1 2 3 4 5 Potential Value with External Improvements Strategic and Operating Opportunities Current Perceptions Gap Disposal / Acquisition Opportunities Maximum Raider Opportunity Total Company Opportunities

57. 56 Value-Based Planning F Value-creation potential of each SBU F Value drivers controlled by SBU mgrs. F Value objectives F Capital allocation based on value- creation potential of each SBU

58. 57 Value Planning ($43) $1,883

59. 58 Foundations of a VBM System F Committed CEO F Properly organized company F Credible plans F Supportive functional action plans F Realistic resource allocations F Culturally compatible strategies F Effective strategy monitoring system F Compensation linked to strategy

60. 59 VALUE HALL OF FAME H GENERAL ELECTRIC H COCA-COLA H WAL-MART H MERCK H PHILIP MORRIS H PROCTER & GAMBLE H EXXON H AT&T H PEPSICO H JOHNSON & JOHNSON H BRISTOR-MYERS H ABBOTT LABS H MICROSOFT H WALT DISNEY H INTEL H MOTOROLA H PFIZER H HOME DEPOT H AMERICAN HOME PRODUCT H 3M H GTE H McDONALD’S H BELLSOUTH H GILLETTE

61. 60 Hall of Fame Companies Common Traits F Focus F Global F Innovation F Leadership F Continuous improvement F Empowerment

62. 61 Innovation F Greater new product intro F Engineering, benchmarking F Reward risk-taking

63. 62 FI 8360 Lecture #2 Preview F Value and Capital Markets F Why Value Value F The Value Manager F Valuation Frameworks: DCF u NPV, FTE, FCF, APV, etc.

64. 63 THE END