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10 - 1 CHAPTER 10 Corporate Valuation and Value. Based Management n Corporate Valuation 10 - 1 CHAPTER 10 Corporate Valuation and Value. Based Management n Corporate Valuation n Value-Based Management n Corporate Governance Copyright © 2002 South-Western

10 - 2 Corporate Valuation: List the two types of assets that a company 10 - 2 Corporate Valuation: List the two types of assets that a company owns. n Assets-in-place n Financial, or nonoperating, assets Copyright © 2002 South-Western

10 - 3 Assets-in-Place n Assets-in-place are tangible, such as buildings, machines, inventory. n 10 - 3 Assets-in-Place n Assets-in-place are tangible, such as buildings, machines, inventory. n Usually they are expected to grow. n They generate free cash flows. n The PV of their expected future free cash flows, discounted at the WACC, is the value of operations. Copyright © 2002 South-Western

10 - 4 Value of Operations Copyright © 2002 South-Western 10 - 4 Value of Operations Copyright © 2002 South-Western

10 - 5 Nonoperating Assets n Marketable securities n Ownership of non-controlling interest in 10 - 5 Nonoperating Assets n Marketable securities n Ownership of non-controlling interest in another company n Value of nonoperating assets usually is very close to figure that is reported on balance sheets. Copyright © 2002 South-Western

10 - 6 Total Corporate Value n Total corporate value is sum of: l. 10 - 6 Total Corporate Value n Total corporate value is sum of: l. Value of operations l. Value of nonoperating assets Copyright © 2002 South-Western

10 - 7 Claims on Corporate Value n Debtholders have first claim. n Preferred 10 - 7 Claims on Corporate Value n Debtholders have first claim. n Preferred stockholders have the next claim. n Any remaining value belongs to stockholders. Copyright © 2002 South-Western

10 - 8 Applying the Corporate Valuation Model n Forecast the financial statements, as 10 - 8 Applying the Corporate Valuation Model n Forecast the financial statements, as shown in Chapter 8. n Calculate the projected free cash flows. n 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. Copyright © 2002 South-Western

10 - 9 Data for Valuation n FCF 0 = $20 million n WACC 10 - 9 Data for Valuation n FCF 0 = $20 million n WACC = 10% n g = 5% n Marketable securities = $100 million n Debt = $200 million n Preferred stock = $50 million n Book value of equity = $210 million Copyright © 2002 South-Western

10 - 10 Value of Operations: Constant Growth Suppose FCF grows at constant rate 10 - 10 Value of Operations: Constant Growth Suppose FCF grows at constant rate g. Copyright © 2002 South-Western

10 - 11 Constant Growth Formula n Notice that the term in parentheses is 10 - 11 Constant Growth Formula n 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. Copyright © 2002 South-Western

10 - 12 Constant Growth Formula (Cont. ) n The summation can be replaced 10 - 12 Constant Growth Formula (Cont. ) n The summation can be replaced by a single formula: Copyright © 2002 South-Western

10 - 13 Find Value of Operations Copyright © 2002 South-Western 10 - 13 Find Value of Operations Copyright © 2002 South-Western

10 - 14 Value of Equity n Sources of Corporate Value l. Value of 10 - 14 Value of Equity n Sources of Corporate Value l. Value of operations = $420 l. Value of non-operating assets = $100 n Claims on Corporate Value l. Value of Debt = $200 l. Value of Preferred Stock = $50 l. Value of Equity = ? Copyright © 2002 South-Western

10 - 15 Value of Equity Total corporate value = VOp + Mkt. Sec. 10 - 15 Value of Equity Total corporate value = VOp + Mkt. Sec. = $420 + $100 = $520 million Value of equity = Total - Debt - Pref. = $520 - $200 - $50 = $270 million Copyright © 2002 South-Western

10 - 16 Market Value Added (MVA) n MVA = Total corporate value of 10 - 16 Market Value Added (MVA) n MVA = Total corporate value of firm minus total book value of firm n Total book value of firm = book value of equity + book value of debt + book value of preferred stock n MVA = $520 - ($210 + $200 + $50) = $60 million Copyright © 2002 South-Western

10 - 17 Breakdown of Corporate Value Copyright © 2002 South-Western 10 - 17 Breakdown of Corporate Value Copyright © 2002 South-Western

10 - 18 Expansion Plan: Nonconstant Growth n Finance expansion by borrowing $40 million 10 - 18 Expansion Plan: Nonconstant Growth n Finance expansion by borrowing $40 million and halting dividends. n Projected free cash flows (FCF): l. Year 1 FCF = -$5 million. l. Year 2 FCF = $10 million. l. Year 3 FCF = $20 million l. FCF grows at constant rate of 6% after year 3. (More…) Copyright © 2002 South-Western

10 - 19 n The weighted average cost of capital, kc, is 10%. n 10 - 19 n The weighted average cost of capital, kc, is 10%. n The company has 10 million shares of stock. Copyright © 2002 South-Western

10 - 20 Horizon Value n Free cash flows are forecast for three years 10 - 20 Horizon Value n Free cash flows are forecast for three years in this example, so the forecast horizon is three years. n 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. Copyright © 2002 South-Western

10 - 21 Horizon Value (Cont. ) n Growth is constant after the horizon 10 - 21 Horizon Value (Cont. ) n 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. Copyright © 2002 South-Western

10 - 22 Horizon Value Formula n Horizon value is also called terminal value, 10 - 22 Horizon Value Formula n Horizon value is also called terminal value, or continuing value. Copyright © 2002 South-Western

10 - 23 Find the value of operations by discounting the free cash flows 10 - 23 Find the value of operations by discounting the free cash flows at the cost of capital. 0 k =10% c 1 2 3 4 g = 6% FCF= -5. 00 10. 00 21. 2 -4. 545 8. 264 15. 026 Vop at 3 398. 197 416. 942 = Vop Copyright © 2002 South-Western $21. 2 $530. 0. 10 0. 06

10 - 24 Find the price per share of common stock. Value of equity 10 - 24 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. Copyright © 2002 South-Western

10 - 25 Value-Based Management (VBM) n VBM is the systematic application of the 10 - 25 Value-Based Management (VBM) n VBM is the systematic application of the corporate valuation model to all corporate decisions and strategic initiatives. n The objective of VBM is to increase Market Value Added (MVA) Copyright © 2002 South-Western

10 - 26 MVA and the Four Value Drivers n MVA is determined by 10 - 26 MVA and the Four Value Drivers n MVA is determined by four drivers: l. Sales growth l. Operating profitability (OP=NOPAT/Sales) l. Capital requirements (CR=Operating capital / Sales) l. Weighted average cost of capital Copyright © 2002 South-Western

10 - 27 MVA for a Constant Growth Firm Copyright © 2002 South-Western 10 - 27 MVA for a Constant Growth Firm Copyright © 2002 South-Western

10 - 28 Insights from the Constant Growth Model n The first bracket is 10 - 28 Insights from the Constant Growth Model n 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. Copyright © 2002 South-Western

10 - 29 Insights (Cont. ) n The second bracket is the operating profit 10 - 29 Insights (Cont. ) n 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. Copyright © 2002 South-Western

10 - 30 Improvements in MVA due to the Value Drivers n MVA will 10 - 30 Improvements in MVA due to the Value Drivers n MVA will improve if: l. WACC is reduced loperating profitability (OP) increases lthe capital requirement (CR) decreases Copyright © 2002 South-Western

10 - 31 The Impact of Growth n The second term in brackets can 10 - 31 The Impact of Growth n 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. Copyright © 2002 South-Western

10 - 32 The Impact of Growth (Cont. ) n If the second term 10 - 32 The Impact of Growth (Cont. ) n 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. n If the second term in brackets is positive, then growth increases MVA. Copyright © 2002 South-Western

10 - 33 Expected Return on Invested Capital (EROIC) n The expected return on 10 - 33 Expected Return on Invested Capital (EROIC) n The expected return on invested capital is the NOPAT expected next period divided by the amount of capital that is currently invested: Copyright © 2002 South-Western

10 - 34 MVA in Terms of Expected ROIC If the spread between the 10 - 34 MVA in Terms of Expected ROIC 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. Copyright © 2002 South-Western

10 - 35 The Impact of Growth on MVA n A company has two 10 - 35 The Impact of Growth on MVA n A company has two divisions. Both have current sales of $1, 000, current expected growth of 5%, and a WACC of 10%. n Division A has high profitability (OP=6%) but high capital requirements (CR=78%). n Division B has low profitability (OP=4%) but low capital requirements (CR=27%). Copyright © 2002 South-Western

10 - 36 What is the impact on MVA if growth goes from 5% 10 - 36 What is the impact on MVA if growth goes from 5% to 6%? Division A Division B OP 6% 6% 4% 4% CR 78% 27% Growth 5% 6% MVA(300. 0) (360. 0) 300. 0 385. 0 Note: MVA is calculated using the formula on slide 12 -27. Copyright © 2002 South-Western

10 - 37 Expected ROIC and MVA Division B Capital 0 $780$270 Growth 5% 10 - 37 Expected ROIC and MVA Division B Capital 0 $780$270 Growth 5% 6% Sales 1 $1, 050 $1, 060 NOPAT 1 $63. 6 EROIC 0 8. 1% 15. 7% Copyright © 2002 South-Western $1, 050 $42. 4 8. 2% 15. 6%

10 - 38 Analysis of Growth Strategies n The expected ROIC of Division A 10 - 38 Analysis of Growth Strategies n 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. n The expected ROIC of Division B is greater than the WACC, so the division should continue with its growth plans. Copyright © 2002 South-Western

10 - 39 Two Primary Mechanisms of Corporate Governance n “Stick” l. Provisions in 10 - 39 Two Primary Mechanisms of Corporate Governance n “Stick” l. Provisions in the charter that affect takeovers. l. Composition of the board of directors. n “Carrot: Compensation plans. Copyright © 2002 South-Western

10 - 40 Entrenched Management n Occurs when there is little chance that poorly 10 - 40 Entrenched Management n Occurs when there is little chance that poorly performing managers will be replaced. n Two causes: l. Anti-takeover provisions in the charter l. Weak board of directors Copyright © 2002 South-Western

10 - 41 How are entrenched managers harmful to shareholders? n Management consumes perks: 10 - 41 How are entrenched managers harmful to shareholders? n Management consumes perks: l. Lavish offices and corporate jets l. Excessively large staffs l. Memberships at country clubs n Management accepts projects (or acquisitions) to make firm larger, even if MVA goes down. Copyright © 2002 South-Western

10 - 42 Anti-Takeover Provisions n Targeted share repurchases (i. e. , greenmail) n 10 - 42 Anti-Takeover Provisions n Targeted share repurchases (i. e. , greenmail) n Shareholder rights provisions (i. e. , poison pills) n Restricted voting rights plans Copyright © 2002 South-Western

10 - 43 Board of Directors n Weak boards have many insiders (i. e. 10 - 43 Board of Directors n Weak boards have many insiders (i. e. , those who also have another position in the company) compared with outsiders. n Interlocking boards are weaker (CEO of company A sits on board of company B, CEO of B sits on board of A). Copyright © 2002 South-Western

10 - 44 Stock Options in Compensation Plans n Gives owner of option the 10 - 44 Stock Options in Compensation Plans n 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. n Usually can’t exercise the option for several years (called the vesting period). Copyright © 2002 South-Western

10 - 45 Stock Options (Cont. ) n Can’t exercise the option after a 10 - 45 Stock Options (Cont. ) n Can’t exercise the option after a certain number of years (called the expiration, or maturity, date). Copyright © 2002 South-Western