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Financial Management Chapter 13 IM 10th Ed

Financial Management Chapter 13 IM 10th Ed

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Published by: Dr Singh on Mar 16, 2012
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Prof. Rushen Chahal
Managing for Shareholder Value
This chapter identifies methods to measure firm value and techniques that can be employed
to assure management and the firm‘s board of directors make decisions that increase the
value of the firm. Increases in firm value lead to increases in stock value, which aligns with
the firm‘s goal of maximizing shareholder wealth. Measures such as free
-cash flowvaluation, market value added, and economic value added can be used to evaluate the
performance. Management of the firm can be provided compensation incentives that guidetheir decisions toward increasing the value of the firm.
I. Top Creators of Shareholder WealthA. Market Value Added (MVA) measures wealth created by the firm1. MVA = Firm value
invested capital2.
Firm value = market value of firm‘s outstanding debt and equity
securities3. Invested capital = total funds invested in the firmB. Value creation results from two activities:1. Identifying performance measures linked to value creation that are
under management‘s control
 2. Designing incentives to encourage employees to base decisions onthese performance metrics.II. Business ValuationA. Accounting model1.
Focuses on firm‘s earnings
 2. Assumes increases (decreases) in earnings will lead directly to increases(decreases) in stock price based on the price-earnings relationship
Prof. Rushen Chahal
3323. Decreases in current earnings may result in increases in future cashflows, which may increase firm value and stock price.B. Free cash flow model1.
Focuses on firm‘s projected cash flows for all future years
 a. Future years cash flows consist of the cash flows during aplanning period of a finite number of years and a terminalvalue of all years beyond the planning periodb. Firm value is calculated as
4)wacc(14ValueTerminal 4)wacc(14FlowCashFree 3)wacc(13FlowCashFree 2)wacc(12FlowCashFree 1)wacc(11FlowCashFree ValueFirm
 Terminal value is calculated as
FlowCashFree ValueTerminal
 2. Components of free cash flow valuesa. Estimated revenuesb. Estimated net operating profitsc. Investment in net working capitald. Capital expenditures3. Firm value equals market value of its debt and equityIII. Value DriversA. Managers can increase firm value by managing value drivers.B. Using value drivers to increase firm value may increase equity value.IV. Economic Value Added (EVA®)A. EVA is the change in firm value during a specific time interval, usually 1 yearB. EVA is calculated as
    
1-tCapitalInvested )wacc(k Capitalof CostAverageWeighted (NOPAT)TaxAfterProfitOperatingNetEVA
 C. EVA can also be calculated as
(IC)CapitalInvested )(k Capitalof Cost AverageWeighted (ROIC)CapitalInvestedonReturnEVA
    
Prof. Rushen Chahal
333V. Paying for PerformanceA. Agency problems arise when firm ownership and management are separate.B. Linking EVA measures to employee compensation encourages employees toact on behalf of ownersC. Compensation Policy1. Three components of compensation are base pay, bonus, and long-term compensation2. The mix of base pay and performance-based pay is important inattracting quality employees and achieving target performancemeasures.3.
Percentage of total compensation that is ‗at
risk‘ typically increases
with employee rank.4. Incentive pay should be linked to achieving target performancemeasures.a. Incentive pay can be calculated as
            
ePerformancTargetePerformancActual Risk atPayof Fraction PayBase PayIncentive
 b. Bounded incentive pay rewards employees only when aminimum threshold of performance is achieved and caps thebonus payout at a maximum level of performance.c. Unbounded incentive pay has no upper or lower bonus limits.5. Incentive pay can be paid in cash, stock, or a combination of cash andstock.a. Stock rewards employees for current and future performance.b. Stock compensation may be the majority of CEO and Board of 
Directors‘ pay.
13-1. The accounting model of equity evaluation focuses on reported earnings in
conjunction with the market‘s valuation of those earnings as reflected in the price
-earnings ratio. For example, if the price-earnings ratio is 20 then a dollar increase inearnings per share should create $20 in additional equity value per share. Similarly,a one-dollar loss in earnings per share may lead to a drop of $20 in share value.

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