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Ch. 13 -13ed Corporate Valuation - Master

Ch. 13 -13ed Corporate Valuation - Master

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CHAPTER 13

Corporate Valuation, Value-Based Management and Corporate Governance
1

Topics in Chapter
  

Corporate Valuation Value-Based Management Corporate Governance

2

Intrinsic Value: Putting the Pieces Together

Net operating profit after taxes

− Free cash flow (FCF) =

Required investments in operating capital

FCF∞ Value = + + ··· + 1 2 (1 + WACC)∞ (1 + WACC) (1 + WACC)
Weighted average cost of capital (WACC) Market interest rates Market risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Firm’s business risk
3

FCF1

FCF2

Corporate Valuation: A company owns two types of assets.
 

Assets-in-place Financial, or nonoperating, assets

4

Assets-in-Place

  

Assets-in-place are tangible, such as buildings, machines, inventory. Usually they are expected to grow. They generate free cash flows. The PV of their expected future free cash flows, discounted at the WACC, is the value of operations.
5

Value of Operations ∞ Vop = t=1 Σ FCFt (1 + WACC)t 6 .

7 .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.

Total Corporate Value  Total corporate value is sum of:   Value of operations Value of nonoperating assets 8 .

9 . Any remaining value belongs to stockholders.Claims on Corporate Value    Debtholders have first claim. Preferred stockholders have the next claim.

as shown in Chapter 12. or a division of a company. 10 .Applying the Corporate Valuation Model    Forecast the financial statements. Calculate the projected free cash flows. since FCF can be calculated for each of these situations. Model can be applied to a company that does not pay dividends. a privately held company.

Data for Valuation         FCF0 = $24 million WACC = 11% g = 5% Marketable securities = $100 million Debt = $200 million Preferred stock = $50 million Book value of equity = $210 million Number of shares =n = 10 million 11 .

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

term approaches zero. As t gets very large.Constant Growth Formula  Notice that the term in parentheses is less than one and gets smaller as t gets larger. Vop = t=1 Σ FCF ∞ 0 1+ g 1 + WACC t 13 .

g) FCF0(1+g) = (WACC .g) 14 .Constant Growth Formula (Cont.)  The summation can be replaced by a single formula: Vop = FCF1 (WACC .

05) = 420 (0.05) 15 .Find Value of Operations Vop = Vop = FCF0 (1 + g) (WACC .11 – 0.g) 24(1+0.

$420.Total Value of Company (VTotal) Voperations + ST Inv.00 16 .00 100.00 VTotal $520.

00 100.00 50.00 17 .00 200. − Debt $420. VTotal − Preferred Stk.00 $520.Intrinsic Value of Equity (VEquity) Voperations + ST Inv.00 VEquity $270.

00 200.00 100. − Debt VEquity ÷n $420.00 10 P $27.00 $270. P Voperations + ST Inv. VTotal − Preferred Stk.00 18 .Intrinsic Stock Price per Share.00 50.00 $520.

Intrinsic Market Value Added (MVA)   Intrinsic MVA = Total corporate value of firm minus total book value of capital supplied by investors Total book value of capital = book value of equity + book value of debt + book value of preferred stock MVA = $520 .($210 + $200 + $50) = $60 million 19 .

Breakdown of Corporate Value 600 500 400 300 200 100 0 Sources Claims Market of Value on Value vs. Book Intrinsic MVA Book equity Intrinsic Value of Equity Preferred stock Debt Marketable securities Value of operations 20 .

Expansion Plan: Nonconstant Growth   Finance expansion by borrowing $40 million and halting dividends. Year 3 FCF = $20 million FCF grows at constant rate of 6% after year 3. Projected free cash flows (FCF):     Year 1 FCF = -$5 million. (More…) 21 . Year 2 FCF = $10 million.

22 . WACC.  The weighted average cost of capital. The company has 10 million shares of stock. is 10%.

Growth in free cash flows is not constant during the forecast. 23 . so the forecast horizon is three years.Horizon Value   Free cash flows are forecast for three years in this example. so we can’t use the constant growth formula to find the value of operations at time 0.

)  Growth is constant after the horizon (3 years).Horizon Value (Cont. discounted back to the horizon. 24 . so we can modify the constant growth formula to find the value of all free cash flows beyond the horizon.

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

10−0.06 $530 = Vop at 3 Vop $530/(1+WACC)3 26 .264 15.942 = $20(1.197 416. 0 WACC =10% 1 2 10.00 −4.Value of operations is PV of FCF discounted by WACC.06) 0.00 3 g = 6% 20.00 FCF3(1+g) (WACC−g) −5.026 398.545 8.

69 27 . P Voperations + ST Inv.942 0 $416.942 0 40. − Debt VEquity ÷n $416.Intrinsic Stock Price per Share.942 10 P $37. VTotal − Preferred Stk.000 $376.

Value-Based Management (VBM)   VBM is the systematic application of the corporate valuation model to all corporate decisions and strategic initiatives. The objective of VBM is to increase Market Value Added (MVA) 28 .

MVA and the Four Value Drivers  MVA is determined by four drivers:     Sales growth Operating profitability (OP=NOPAT/Sales) Capital requirements (CR=Operating capital / Sales) Weighted average cost of capital 29 .

g OP – WACC CR (1+g) 30 .MVA for a Constant Growth Firm MVAt = Salest(1 + g) WACC .

g 31 . Salest(1 + g) WACC . its operating profit margin is 100%) and that never has to make additional investments in operating capital.e..Insights from the Constant Growth Model  The first bracket is the MVA of a firm that gets to keep all of its sales revenues (i.

)  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. CR (1+g) 32 OP – WACC .Insights (Cont.

Improvements in MVA due to the Value Drivers  MVA will improve if:    WACC is reduced operating profitability (OP) increases the capital requirement (CR) decreases 33 .

depending on the relative size of profitability. OP – WACC CR (1+g) 34 .The Impact of Growth  The second term in brackets can be either positive or negative. capital requirements. and required return by investors.

profits are not enough to offset the return on capital required by investors. 35 . If the second term in brackets is positive.The Impact of Growth (Cont. In other words.)   If the second term in brackets is negative. then growth decreases MVA. then growth increases MVA.

Expected Return on Invested Capital (EROIC)  The expected return on invested capital is the NOPAT expected next period divided by the amount of capital that is currently invested: OP t+1 CRt NOPATt+1 EROICt = = Capitalt Capitalt 36 .

MVA in Terms of Expected EROIC and Value Drivers Capitalt (EROICt – WACC) MVAt = WACC .g If the spread between the expected return. is positive. 37 . and the required return. WACC. then MVA is positive and growth makes MVA larger. EROICt.g Capitalt (OPt+1/CRt – WACC) MVAt = WACC . The opposite is true if the spread is negative.

MVA in Terms of Expected EROIC Capitalt (OPt+1/CRt – WACC) MVAt = WACC . EROICt. is positive. then MVA is positive and growth makes MVA larger. WACC.g If the spread between the expected return. The opposite is true if the spread is negative. 38 . and the required return.

current expected growth of 5%. and a WACC of 10%. 39 . Both have current sales of $1.000. Division A has high profitability (OP=6%) but high capital requirements (CR=78%).The Impact of Growth on MVA    A company has two divisions. 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%? OP CR Growth MVA Division A 6% 6% 78% 78% 5% 6% (300.0) (360.0) Division B 4% 4% 27% 27% 5% 6% 300.0 385.0 Note: MVA is calculated using the formula on slide 13-28. 40 .

6 Division B $270 5% $42 300.4 15.7% 385.6% (300.0) .060 $1.060 8.2% 15.0 $270 6% $42.0 41 $1.050 $1.050 $63 8.1% $780 6% $63.Expected ROIC and MVA Division A Capital0 Growth Sales1 NOPAT1 EROIC0 MVA $780 5% $1.0) (360.

reducing inventory) and/or improving profitability.Analysis of Growth Strategies   The expected ROIC of Division A is less than the WACC. 42 . so the division should postpone growth efforts until it improves EROIC by reducing capital requirements (e. The expected ROIC of Division B is greater than the WACC.g. so the division should continue with its growth plans..

. close plant) out of loyalty to friends in company. Avoid difficult decisions (e. (More .Six Potential Problems with Managerial Behavior    Expend too little time and effort.g.) 43 . . Consume too many nonpecuniary benefits.

Massage information releases or manage earnings to avoid revealing bad news.Six Problems with Managerial Behavior (Continued)    Reject risky positive NPV projects to avoid looking bad if project fails. 44 . take on risky negative NPV projects to try and hit a home run. Avoid returning capital to investors by making excess investments in marketable securities or by paying too much for acquisitions.

rules. and procedures that influence a company’s operations and the decisions made by its managers.   Sticks (threat of removal) Carrots (compensation) 45 .Corporate Governance  The set of laws.

Corporate Governance Provisions Under a Firm’s Control      Board of directors Charter provisions affecting takeovers Compensation plans Capital structure choices Internal accounting control systems 46 .

not just those with multi-year staggered terms) Board elections allow cumulative voting (More . all board members elected each year.) 47 .e..Effective Boards of Directors  Election mechanisms make it easier for minority shareholders to gain seats:   Not a “classified” board (i. .

) 48 .e. (More .. Board has a majority of outside directors (i. .Effective Boards of Directors   CEO is not chairman of the board and does not have undue influence over the nominating committee. those who do not have another position in the company) with business expertise.

CEO of B sits on board of A). set on too many other boards or have too many other business activities) (More . Board members are not unduly busy (i.e..) 49 .Effective Boards of Directors (Continued)   Is not an interlocking board (CEO of company A sits on board of company B. .

some compensation is linked to firm performance or stock performance) 50 .e..Effective Boards of Directors (Continued)  Compensation for board directors is appropriate   Not so high that it encourages cronyism with CEO Not all compensation is fixed salary (i.

greenmail) Shareholder rights provisions (i.. poison pills) Restricted voting rights plans 51 .e..Anti-Takeover Provisions    Targeted share repurchases (i.e.

Stock Options in Compensation Plans   Gives owner of option the right to buy a share of the company’s stock at a specified price (called the strike price or exercise price) even if the actual stock price is higher. Usually can’t exercise the option for several years (called the vesting period). 52 .

Stock Options (Cont. date). or maturity. 53 .)  Can’t exercise the option after a certain number of years (called the expiration.

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 .

leading to better corporate governance 55 .e.Block Ownership  Outside investor owns large amount (i.. block) of company’s shares  Institutional investors. such as CalPERS or TIAA-CREF  Blockholders often monitor managers and take active role.

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 56 .

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