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CHAPTER 10

Managing for Shareholder


Value

9-1

Outline Managing
Shareholder Value

Market Value Added (MVA)


Business Valuation

The Accounting Model


Free Cash Flow Valuation Model

Value Drivers
Economic Value Added (EVA)
Paying for Performance
9-2

Market Value Added (MVA)

Goal of the firm:

Maximize shareholder wealth/value

Market Value Added (MVA)

Firm Value Invested Capital

9-3

MVA
MVA = Firm Value Invested Capital

Firm Value = market values of


outstanding debts and equities

Invested Capital = sum of all fund


invested in the firm = Total Assets
9-4

MVA

If MVA is positive, the firm has


added value.
If it is negative, the firm has
destroyed value.

9-5

Business Valuation

How firms are valued the financial


market the value of firms
common stock
Two models:

The Accounting Method

Free Cash Flow Valuation Model


9-6

Business Valuation
Model Approach

Accounting Model

Discounted CF
Model

Equity Value

[price earnings
ratio-PER] X
[earning per shareEPS]

PV of Future CF

Value drivers

Determinants of
accounting earnings
and the priceearnings ratio

Determinants of
firms future cash
flow and the cost of
capital

9-7

The accounting model

Focus on reported earnings and


the price-earnings ratio to
determine equity value
Using accounting numbers
historical

9-8

Free Cash Flow Valuation


Model

Focus on expected future cash flow


and cost of capital in estimating
value
Have to forecast all future cash
flow for infinite period (which is not
possible), therefore:

A planning period, and


A Terminal value
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Free Cash Flow Valuation


Model
Firm Value =
[FCF1/(1+kwacc)1] + [FCF2/(1+kwacc)2] +

[FCF3/(1+kwacc)3] + [FCF4/(1+kwacc)4] +
[TV4/(1+kwacc)4]
TV4 = [FCF5 / kwacc ] assumption: FCF5 and the
rest are all equal, then discounted as a
perpetuity)

9-10

Free Cash Flow Valuation


Model
FCF =
Operating Income (earnings before interest and
taxes)

xxx

Less: Tax

(xxx)

= Net Operating Profit After Taxes (NOPAT)

=xxx

Plus: Depreciation Expenses

+xxx

Less investments:
- In net working capital

(xxx)

- In new capital (CAPEX)

(xxx)

Free Cash Flow (FCF)

XXX

9-11

Example

Free Cash Flow Valuation

9-12

9-13

9-14

Value Drivers

Variables that affect firm value and


can be controlled or influenced by
the firms management.

9-15

Value Drivers
Value Drivers

Value-enhancing strategies

Sales growth

New promotion campaign; acquire


competitor firm; create new market

Operating profit margin

Reduce operating and administrative


expenses

Net working capital to sales


ratio

Tight inventory control policy; engage


credit analysis to decrease customer
payment time; negotiate shorter new
credit term with customers

Cost of capital

Review sources of financing to lower the


cost of financing; approach large
institutional investors to develop direct
financing with them to bypass significant
cost from public capital market
9-16

Economic Value Added


(EVA)

Market Value Added (MVA) the


difference in the market value of the
firm and the invested capital at a
particular point in time.

Economic Value Added (EVA): the


difference in the firms net operating
profit after taxes (NOPAT) and the
capital charge for the specific period
9-17

Economic Value Added


(EVA)(method 1)
EVA =
[ Net Operating Profit After Taxes
(NOPAT)t ]

minus
[kwacc x invested capitalt-1]
Capital charge = the firms invested capital in the
beginning period multiplied by the firms WACC

9-18

Economic Value Added


(EVA)(method 2)
EVA =
[ Return on invested capital (ROIC)t kwacc ]

multiply by
Invested capital (IC)t-1

9-19

EVA calculation example

9-20

9-21

Paying for Performance

Base pay

Bonus payment

Fixed salary component


Depend upon firm performance based
on certain target

Long-term compensation

Aligning interest of employees and


shareholders in the long term
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Issues on Paying for


Performance

How much to pay


Base pay vs at-risk / incentive
compensation
Linking pay to performance
Paying with Cash Bonus or Equity

9-23

How much to pay

Labor market forces


Competitive level of payment
The total pay will determine where
you go for work, however the
combination between base pay and
performance-based pay will affect
how hard you will work.

9-24

Base pay vs At-risk /


Incentive compensation

The right mix between base pay


and Incentives compensation
Fixed compensation vs variable
compensation

9-25

Linking Pay to
Performance
Incentive Pay =
[base pay] x [fraction of pay at-risk]
x [actual performance/target
performance]

9-26

Cash Bonus or Equity

Pay performance in form of Cash,


Equity, or mixture of them
Paying with Equity:

Rewarded for current performance


and also provide a long-term
incentives to improve performance
Increase ownership feeling to the
company, better performance
9-27

The End

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