CHAPTER 11
Corporate Valuation and
Value-Based Management
1
Topics
Corporate Valuation
 Value-Based Management
 Corporate Governance

2
Corporate Valuation: A company
owns two types of assets.


Assets-in-place
Financial, or nonoperating, assets
3
CORPORATE VALUE
Corporate Assets
Operating Assets
Assets in Place
Tangible
Growth Opps
Non-Operating Assets
Securities
Investments
Intangible
4
CORPORATE VALUE
Corporate Assets
Operating Assets
Assets in Place
Tangible

Growth Opps

Securities
Investments
Intangible
Assets-in-place

Non-Operating Assets
Tangible: land, buildings
Intangible: patents, reputation

Growth Opportunities

Opportunities to expand arising
from firm’s current knowledge,
experience and resources
5
Assets-in-Place




Assets-in-place are tangible, such as
buildings, machines, inventory
Usually expected to grow
Generate free cash flows
The PV of their expected future free
cash flows, discounted at the WACC, is
the value of operations.
6
CORPORATE VALUE
Corporate Assets
Operating Assets
Assets in Place
Tangible
Intangible
Non-Operating Assets
Growth Opps
Securities
Investments

Marketable securities
Ownership of non-controlling
interest in another company

Value  Balance Sheet figures

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.
8
Total Corporate Value
VCORP = VOP + VNOA

Total corporate value is sum of:

VOP = Value of operations

VNOA = Value of nonoperating assets
9
Claims on Corporate Value



1st claim:
2nd claim:
Residual claim:
Debt-holders
Preferred stockholders
Common Stockholders
10
Applying the Corporate
Valuation Model

Forecast the financial statements



Shown in Chapter 9
Calculate projected free cash flows
Model can be applied to a company that:
Does not pay dividends
 Is privately held
 Is a division
… since FCF can be calculated for each

11
Value of Operations:
Constant FCF Growth at Rate of g
∞
Vop =
Σ
t=1
∞
=
Σ
t=1
FCFt
(1 + WACC)t
FCF0(1+g)t
(1 + WACC)t
12
Value of Operations

VOP
FCFt

t
t 1 ( 1  WACC )
13
Constant Growth Formula
Vop =
=
FCF1
(WACC - g)
FCF0(1+g)
(WACC - g)
14
Expansion Plan: Target #1
Input Values:

FCF0
= $20 million

WACC
= 10%

g
= 5%

Marketable securities
= $100 million

Debt
= $200 million

Preferred stock
= $50 million

Book value of equity = $210 million
15
Find Value of Operations
Vop =
FCF0 (1 + g)
(WACC - g)
20(1+0.05)
= 420
Vop =
(0.10 – 0.05)
16
Value of Equity

Sources of Corporate Value



Value of operations
= $420
Value of non-operating assets = $100
Claims on Corporate Value



Value of Debt
Value of Preferred Stock
Value of Equity
= $200
= $50
=?
17
Value of Equity

Sources of Corporate Value




VOP
= $420
= Value of operations
VNOA
VCORP
= $100
= $520
= Value of non-operating assets
= VOP + VNOA
Claims on Corporate Value

VD
VPF
= $200
= $ 50

VE
= $270

= Value of Debt
= Value of Preferred Stock
= Value of Equity = VCORP-VD-VPF
18
Topics
Corporate Valuation
 Value-Based Management
 Corporate Governance

19
Market Value Added (MVA)

MVA = Total corporate value of firm minus
total book value of firm


Total corporate value of firm
$
Total book value of firm
 = Book value of equity
$
 + book value of debt
 + book value of preferred stock
MVA
520
210
200
50
= $520 - ($210 + $200 + $50)
= $60 million
20
Breakdown of Corporate Value
MVA
600
500
Book equity
400
Equity (Market)
300
Preferred stock
200
Debt
100
0
Sources Claims Market
of Value on Value vs. Book
Marketable
securities
Value of operations
21
Expansion Plan: Target #2
Non-constant Growth






Privately held company
$40 million in new debt
No other debt
No preferred stock
Pays no dividend
No marketable securities
22
Expansion Plan: Target #2

Projected free cash flows (FCF):






Year 1 FCF = -$5 million.
Year 2 FCF = $10 million.
Year 3 FCF = $20 million
FCF after year 3 = 6% constant growth
WACC = 10%
10 million shares of stock outstanding
23
Horizon Value


Forecast horizon = three years
Growth in FCF is not constant


Can’t use the constant growth formula
Growth is constant after the horizon

Modify the constant growth formula to find
the value of all free cash flows beyond the
horizon, discounted back to the horizon.
24
Horizon Value Formula
HV = Vop at time t

FCFt(1+g)
=
(WACC - g)
Horizon value is also called terminal
value, or continuing value.
25
Value of operations is PV of
FCF discounted by WACC
0 r =10%
c
1
2
3
4
g = 6%
FCF=
-5.00
10.00
20.00
21.2
-4.545
8.264
15.026
Vop at 3
398.197
416.942
=
Vop
$21.2

 $530.
0 .10  0.06
26
Common Stock Price per Share

Value of equity
= Value of operations
- Value of debt
= $416.94 - $40
= $376.94 million

Price per share
= $376.94 /10
= $37.69
27
Value-Based Management
(VBM)

The systematic application of the
corporate valuation model to all
corporate decisions and strategic
initiatives.
Objective =increase MVA
28
MVA and the Four Value Drivers


g
OP
= Sales growth
= Operating profitability
(OP=NOPAT/Sales)

CR
= Capital requirements
(CR=Operating capital / Sales)

WACC = Weighted average cost of
capital
29
MVA for a Constant Growth Firm
 Salest (1  g )  
 CR 

MVA t  
OP  WACC 

 WACC  g  
 (1  g ) 
30
MVA for a Constant Growth Firm
 Salest (1  g )  
 CR 

MVA t  
OP  WACC 

 WACC  g  
 (1  g ) 
= MVA if:


Operating profit
margin is 100%
Never any
additional
investments in
operating capital
31
MVA for a Constant Growth Firm
 Salest (1  g )  
 CR 

MVA t  
OP  WACC 

 WACC  g  
 (1  g ) 
= MVA if:



Operating profit
margin is 100%
Never any
additional
investments in
operating capital


% Operating profit the
firm gets to keep, less
the return that
investors require
Can be positive or
negative
If negative, then
growth decreases MVA
32
MVA for a Constant Growth Firm
 Salest (1  g )  
 CR 

MVA t  
OP  WACC 

 WACC  g  
 (1  g ) 
MVA will improve if:
• Operating profitability (OP) increases
• WACC is reduced
• The capital requirement (CR) decreases
33
Expected Return on Invested
Capital (EROIC)

The expected return on invested capital
=the NOPAT expected next period
divided by the amount of capital
currently invested:
NOPATt 1
EROICt 
Capitalt
34
MVA in Terms of Expected ROIC
Capitalt EROICt WACC
MVAt 
WACC g
•If (EROICt - WACC) is positive, then:
• MVA is positive
• Growth makes MVA larger
•The opposite is true if the spread is
negative.
35
The Impact of Growth on MVA
KFS’ Divisions

KFS has two divisions:





Both have current sales of $1,000
Current expected growth of 5%
WACC of 10%
Division A has high profitability (OP=6%) but
high capital requirements (CR=78%).
Division B has low profitability (OP=4%) but
low capital requirements (CR=27%).
36
What is the impact on MVA if
growth goes from 5% to 6%?
Division A
OP
CR
Growth
MVA
6%
78%
5%
Division B
6%
78%
6%
4%
27%
5%
4%
27%
6%
(300.0) (360.0)
300.0
385.0
 Salest (1  g )  
 CR 

MVA t  
OP  WACC 

 WACC  g  
 (1  g ) 
37
Expected ROIC and MVA
Division A
Division B
Capital0
$780
$780
$270
$270
Growth
5%
6%
5%
6%
Sales1
$1,050
NOPAT1
$63
EROIC0
8.1%
MVA
$1,060 $1,050 $1,060
$63.6
$42
$42.4
8.2% 15.6%
15.7%
(300.0) (360.0)
300.0
385.0
38
Analysis of Growth Strategies
Division A
Division B
Capital0
$780
$780
$270
$270
Growth
5%
6%
5%
6%
$1,050
$1,060
$1,050
$1,060
NOPAT1
$63
$63.6
$42
$42.4
EROIC0
8.1%
8.2%
15.6%
15.7%
(300.0)
(360.0)
300.0
385.0
Sales1
MVA
EROIC(A) < WACC (10%)
• Should postpone growth efforts until it improves EROIC
• Reduce capital requirements (e.g., reducing inventory)
• And/or improve profitability
39
Analysis of Growth Strategies
Division A
Division B
Capital0
$780
$780
$270
$270
Growth
5%
6%
5%
6%
$1,050
$1,060
$1,050
$1,060
NOPAT1
$63
$63.6
$42
$42.4
EROIC0
8.1%
8.2%
15.6%
15.7%
(300.0)
(360.0)
300.0
385.0
Sales1
MVA
EROIC(B) > WACC (10%)
Division should continue with its growth plans
40
Topics
Corporate Valuation
 Value-Based Management
 Corporate Governance

41
CORPORATE GOVERNANCE
“The set of rules and
procedures that ensure that
managers do indeed employ
the principles of value-based
management”
42
Two Primary Mechanisms of
Corporate Governance

“Stick”
Provisions in the charter that affect
takeovers
 Composition of the board of directors


“Carrot”

Compensation plans
43
Corporate Governance Provisions
Under a Firm’s Control





Board of directors
Charter provisions affecting takeovers
Compensation plans
Capital structure choices
Internal accounting control systems
44
Effective Boards of Directors

Election mechanisms make it easier for
minority shareholders to gain seats:




Not a “classified” board (i.e., all board
members elected each year, not just those
with multi-year staggered terms)
Board elections allow cumulative voting
CEO ≠ Chairman of the Board
Majority of outside directors
45
Effective Boards of Directors
(Continued)



Not an interlocking board
Board members not unduly busy
Compensation for board directors is
appropriate


Not so high that it encourages cronyism
with CEO
Not all compensation is fixed salary
46
Entrenched Management


Occurs when there is little chance
that poorly performing managers
will be replaced
Two causes:
Anti-takeover provisions in the charter
 Weak board of directors

47
Two Effects of Entrenched
Management


Management consumes perks:

Lavish offices and corporate jets

Excessively large staffs

Country club memberships
Management accepts projects (or
makes acquisitions) to make firm larger,
even if MVA goes down
48
Harmful Managerial Behavior



Expend too little time and effort
Consume too many non-pecuniary
benefits
Avoid difficult decisions (e.g., close
plant) out of loyalty to friends in
company
(More . .)
49
Harmful Managerial Behavior

Reject risky positive NPV projects to avoid
looking bad if project fails


Avoid returning capital to investors



Take on risky negative NPV projects to try for a
home run.
Make excess investments in marketable securities
Pay too much for acquisitions
Massage information releases or manage
earnings to avoid revealing bad news.
50
Anti-Takeover Provisions

“Greenmail”


“Poison Pills”


Targeted share repurchases
Shareholder rights provisions
Restricted voting rights plans
51
Stock Options as Compensation



Gives option holder the right to
buy a share of the company’s
stock at a specified price
Vesting period
Expiration or maturity date
52
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.
53
Block Ownership

Outside investor owns large amount
(i.e., block) of company’s shares


Institutional investors, such as CalPERS or
TIAA-CREF
Blockholders often monitor managers
and take active role, leading to better
corporate governance
54
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

55