Chapter 15
Corporate Valuation, Value-Based Management, and
Corporate Governance
ANSWERS TO END-OF-CHAPTER QUESTIONS
15-1
a. Assets-in-place, also known as operating assets, include the land, buildings,
machines, and inventory that the firm uses in its operations to produce its products
and services. Growth options are not tangible. They include items such as R&D and
customer relationships. Financial, or nonoperating, assets include investments in
marketable securities and non-controlling interests in the stock of other companies.
b. Operating current assets are the current assets used to support operations, such as
cash, accounts receivable, and inventory. It does not include short-term investments.
Operating current liabilities are the current liabilities that are a natural consequence of
the firm’s operations, such as accounts payable and accruals. It does not include
notes payable or any other short-term debt that charges interest. Net operating
working capital is operating current assets minus operating current liabilities.
Operating capital is sum of net operating working capital and operating long-term
assets, such as net plant and equipment. Operating capital also is equal to the net
amount of capital raised from investors. This is the amount of interest-bearing debt
plus preferred stock plus common equity minus short-term investments. NOPAT is
the amount of net income a company would generate if it had no debt and held no
financial assets. NOPAT is a better measure of the performance of a company’s
operations because debt lowers income. In order to get a true reflection of a
company’s operating performance, one would want to take out debt to get a clearer
picture of the situation. Free cash flow is the cash flow actually available for
distribution to investors after the company has made all the investments in fixed
assets and working capital necessary to sustain ongoing operations. It is the most
important measure of cash flows because it shows the exact amount available to all
investors.
Answers and Solutions: 15 - 1
c. The value of operations is the present value of all the future free cash flows that are
expected from current assets-in-place and the expected growth of assets-in-place
when discounted at the weighted average cost of capital:
∞
FCFt
Vop(at time 0) = ∑
.
t
t =1 (1 + WACC)
The terminal, or horizon value, is the value of operations at the end of the explicit
forecast period. It is equal to the present value of all free cash flows beyond the
forecast period, discounted back to the end of the forecast period at the weighted
average cost of capital:
FCFN +1
FCFN (1 + g)
=
Vop(at time N) =
.
WACC − g
WACC − g
The corporate valuation model defines the total value of a company as the value of
operations plus the value of nonoperating assets plus the value of growth options.
d. Value-based management is the systematic application of the corporate value model
to a company’s decisions. The four value drivers are the growth rate in sales (g),
operating profitability (OP=NOPAT/Sales), capital requirements (CR=Capital/Sales),
and the weighted average cost of capital (WACC). Return on Invested Capital
(ROIC) is NOPAT divided by the amount of capital that is available at the beginning
of the year.
e. Managerial entrenchment occurs when a company has such a weak board of directors
and has such strong anti-takeover provisions in its corporate charter that senior
managers feel there is very little chance that they will be removed. Non-pecuniary
benefits are perks that are not actual cash payments, such as lavish offices,
memberships at country clubs, corporate jets, and excessively large staffs.
f. Targeted share repurchases, also known as greenmail, occur when a company buys
back stock from a potential acquiror at a higher than fair-market price. In return, the
potential acquiror agrees not to attempt to take over the company. Shareholder rights
provisions, also known as poison pills, allow existing shareholders in a company to
purchase additional shares of stock at a lower than market value if a potential acquiror
purchases a controlling stake in the company. A restricted voting rights provision
automatically deprives a shareholder of voting rights if the shareholder owns more
than a specified amount of stock.
Answers and Solutions: 15 - 2
g. A stock option allows its owner to purchase a share of stock at a fixed price, called
the strike price, no matter what the actual price of the stock is. Stock options always
have an expiration date, after which they cannot be exercised. A restricted stock
grant allows an employee to buy shares of stock at a large discount from the current
stock price, but the employee is restricted from selling the stock for a specified
number of years. An Employee Stock Ownership Plan, often called an ESOP, is a
type of retirement plan in which employees own stock in the company.
15-2
The first step is to find the value of operations by discounting all expected future free
cash flows at the weighted average cost of capital. The second step is to find the total
corporate value by summing the value of operations, the value of nonoperating assets,
and the value of growth options. The third step is to find the value of equity by
subtracting the value of debt and preferred stock from the total value of the corporation.
The last step is to divide the value of equity by the number of shares of common stock.
15-3
A company can be profitable and yet have an ROIC that is less than the WACC if the
company has large capital requirements. If ROIC is less than the WACC, then the
company is not earning enough on its capital to satisfy its investors. Growth adds even
more capital that is not satisfying investors, hence, growth decreases value.
15-4
Entrenched managers consume to many perquisites, such as lavish offices, excessive
staffs, country club memberships, and corporate jets. They also invest in projects or
acquisitions that make the firm larger, even if they don’t make the firm more valuable.
15-5
Stock options in compensation plans usually are issued with a strike price equal to the
current stock price. As long as the stock price increases, the option will become valuable,
even if the stock price doesn’t increase as much as investors expect.
Answers and Solutions: 15 - 3
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
15-1
NOPAT
= EBIT(1 - T)
= 100(1 - 0.4) = $60.
Net operating WC07
= ($27 + $80 + $106) - ($52 + $28)
= $213 - $80 = $133.
Operating capital07 = $133 + $265 = $398.
Net operating WC08
= ($28 + $84 + $112) - ($56 + $28)
= $224 - $84 = $140.
Operating capital08 = $140 + $281 = $421.
FCF = NOPAT - Net investment in operating capital
= $100(0.6) - ($421 - $398)
= $37.0.
15-2
Value of operations = Vop = PV of expected future free cash flow
Vop =
15-3
15-4
15-5
$400,000(1.05)
FCF (1 + g)
= $6,000,000.
=
WACC − g
0.12 − 0.05
The growth rate in FCF from 2009 to 2010 is g=($750.00-$707.55)/$707.50 = 0.06.
$707.55 (1.06)
= $15,000.
VOp at 2009 =
0.11 − 0.06
⎡ $200,000,000 ⎤
Vop = $200,000,000 + ⎢
⎥ [0.09 − 0.10]
⎣ 0.10 − 0.05 ⎦
=$200,000,000 + (-$40,000,000)= $160,000,000.
MVA = $160,000,000 - $200,000,000 = -40,000,000.
Capital2011 = Sales2011 (0.43)= $129,000,000.
⎡ $300,000,000 (1 + 0.05) ⎤ ⎡
⎛ 0.43 ⎞⎤
0
.
06
(
0
.
098
)
−
Vop at 2011 = $129,000,000 + ⎢
⎜
⎟⎥
⎢
⎥
0.098 − 0.05
⎝ 1 + 0.05 ⎠⎦
⎣
⎦⎣
= $129,000,000 + [$6,562,500,000][0.0198666667]
= $129,000,000 + $130,375,000 = $259,375,000.
Answers and Solutions: 15 - 4
15-6
a. Vop2 =
$108 ,000
= $2,700,000.
0.12 − 0.08
b.
0 WACC = 12%1
2 g = 8%
3
N
|
|
|
|
$80,000
$100,000
$108,000
• • •
|
$
71,428.57
79,719.39
2,152,423.47
$2,303,571.43
15-7
a. Vop3 =
b.
$40 (1.07)
= $713.33.
0.13 − 0.07
0
1
WACC = 13%
|
|
-20
($ 17.70)
23.49
522.10
$527.89
2
| g = 7%
30
3
4
|
|
N
• • •
|
40
Vop 3
= 713.33
753.33
c. Total valuet=0 = $527.89 + $10.0 = $537.89.
Value of common equity = $537.89 - $100 = $437.89.
$437.89
Price per share =
= $43.79.
10.0
15-8
Total corporate value = Value of operations + marketable securities
= $756 + $77 = $833 million.
Value of equity = Total corporate value – debt – Preferred stock
= $833 – ($151 + $ 190) - $76 = $416 million.
15-9
Total corporate value = Value of operations + marketable securities
= $651 + $47 = $698 million.
Value of equity = Total corporate value – debt – Preferred stock
= $698 – ($65 + $131) - $33 = $469 million.
Price per share = $469 / 10 = $46.90.
Answers and Solutions: 15 - 5
15-10 a. NOPAT2008 = $108.6(1-0.4) = $65.16
NOWC2008 = ($5.6 + $56.2 + $112.4) – ($11.2 + $28.1) = $134.9 million.
Capital2008 = $134.9 + $397.5 = $532.4 million.
FCF2008 = NOPAT – Investment in Capital = $65.16 – ($532.4 - $502.2)
= $65.16 - $30.2 = $34.96 million.
b. HV2008 = [$34.96(1.06)]/(0.11-0.06) = $741.152 million.
c. VOp at 12/31/2007 = [$34.96 + $741.152]/(1+0.11) = $699.20 million.
d. Total corporate value = $699.20 + $49.9 = $749.10 million.
e. Value of equity = $749.10 – ($69.9 + $140.8) - $35.0 = $503.4 million.
Price per share = $503.4 / 10 = $50.34.
Answers and Solutions: 15 - 6
SOLUTION TO SPREADSHEET PROBLEM
15-11 The detailed solution for the problem is available in the file Solution for FM12 Ch 15
P11 Build a Model.xls on the textbook’s Web site.
Answers and Solutions: 15 - 7
MINI CASE
You have been hired as a consultant to Kulpa Fishing Supplies (KFS), a company that is
seeking to increase its value. KFS has asked you to estimate the value of two privately
held companies that KFS is considering acquiring. But first, the senior management of
KFS would like for you to explain how to value companies that don’t pay any dividends.
You have structured your presentation around the following questions.
a.
List the two types of assets that companies own.
Answer: Assets-in-place and nonoperating, or financial, assets.
b.
What are assets-in-place? How can their value be estimated?
Answer: 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.
c.
What are nonoperating assets? How can their value be estimated?
Answer: Nonoperating assets are marketable securities and ownership of non-controlling
interest in another company. The value of nonoperating assets usually is very close to
figure that is reported on balance sheets.
d.
What is the total value of a corporation? Who has claims on this value?
Answer: Total corporate value is sum of value of operations, value of nonoperating assets, and
value of growth options. (No examples in this chapter have a growth option-- this is
deferred until chapter 18). Debt holders have first claim. Preferred stockholders have
the next claim. Any remaining value belongs to stockholders.
Mini Case: 15 - 8
e.
1. The first acquisition target is a privately held company in a mature industry.
The company currently has free cash flow of $20 million. Its WACC is 10% and
it is expected to grow at a constant rate of 5%. The company has marketable
securities of $100 million. It is financed with $200 million of debt, $50 million of
preferred stock, and $210 million of book equity. What is its value of
operations?
Answer:
FCF0 (1 + g )
(WACC − g )
20 (1 + 0.05)
VOp =
= 420
(0.10 − 0.05)
VOp =
e.
2. What is its total corporate value? What is its value of equity?
Answer:
Total Corporate Value = VOP + MKT. SEC.
= $420 + $100
= $520 million
Value Of Equity = Total - Debt - Pref.
= $520 - $200 - $50
= $270 million
e.
3. What is its MVA (MVA = total corporate value – total book value)?
Answer: MVA = total corporate value of firm minus total book 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)
= $60 million
Mini Case: 15 - 9
f.
1. The second acquisition target is a privately held company in a growing industry.
The target has recently borrowed $40 million to finance its expansion; it has no
other debt or preferred stock. It pays no dividends and currently has no
marketable securities. KFS expects the company to produce free cash flows of $5 million in one year, $10 million in two years, and $20 million in three years.
After three years, free cash flow will grow at a rate of 6%. Its WACC is 10%
and it currently has 10 million shares of stock. What is its horizon value (i.e., its
value of operations at year three)? What is its current value of operations (i.e.,
at time zero)?
Answer:
0 rc = 10%
1
2
3 g = 6%
4
|
|
|
|
|
-5
10
20
$ -4.545
8.264
15.026
398.197
$416.942 = Value Of Operations
f.
N
• • •
|
Vop 3 = 530 = 20 (1 + 0.06)
0.10 − 0.06
2. What is its value of equity on a price per share basis?
Answer:
Value of equity = value of operations - debt
= $416.94 - $40 = $376.94 million.
Price per share = $376.94/10 = $37.69.
g.
KFS is also interested in applying value-based management to its own divisions.
Explain what value-based management is.
Answer: 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).
Mini Case: 15 - 10
h.
What are the four value drivers? How does each of them affect value?
Answer: MVA is determined by four drivers: sales growth, operating profitability
(OP=NOPAT/sales), capital requirements (CR=operating capital / sales, and the
weighted average cost of capital. MVA will improve if WACC is reduced, operating
profitability (OP) increases, or the capital requirement (CR) decreases. See the next
question for an explanation of the impact of growth.
i.
What is return on invested capital (ROIC)? Why is the spread between ROIC and
WACC so important?
Answer: ROIC is the return on the capital that is in place at the beginning of the period:
NOPATt +1
ROIC t +1 =
Capital t
If the spread between the expected return, ROICt+1, 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.
j.
Answer:
KFS has two divisions. Both have current sales of $1,000, current expected
growth of 5%, and a 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%). What is the MVA of each
division, based on the current growth of 5%? What is the MVA of each division
if growth is 6%?
⎡ Sales t (1 + g) ⎤ ⎡
⎛ CR ⎞⎤
MVA t = ⎢
⎟⎟⎥
⎢OP − WACC ⎜⎜
⎥
⎣ WACC − g ⎦ ⎣
⎝ (1 + g ) ⎠⎦
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
Mini Case: 15 - 11
k.
What is the ROIC of each division for 5% growth and for 6% growth? How is
this related to MVA?
Answer:
Capital0
Growth
Sales1
Nopat1
Roic1
Mva
Division A
$780
$780
5%
6%
$1,050
$1,060
$63
$63.6
8.1%
8.2%
(300.0)
(360.0)
Division B
$270
$270
5%
6%
$1,050
$1,060
$42
$42.4
15.6%
15.7%
300.0
385.0
The expected ROIC of division A is less than the WACC, so the division should
postpone growth efforts until it improves ROIC by reducing capital requirements
(e.g., reducing inventory) and/or improving profitability.
The expected ROIC of division b is greater than the WACC, so the division should
continue with its growth plans.
l.
List six potential managerial behaviors that can harm a firm’s value.
Answer: Managers might:
1. Expend too little time and effort.
2. Consume too many nonpecuniary benefits.
3. Avoid difficult decisions (e.g., close plant) out of loyalty to friends in company.
4. Reject risky positive NPV projects to avoid looking bad if project fails; take on
risky negative NPV projects to try and hit a home run.
5. Avoid returning capital to investors by making excess investments in marketable
securities or by paying too much for acquisitions.
6. Massage information releases or manage earnings to avoid revealing bad news.
m.
The managers at KFS have heard that corporate governance can affect
shareholder value.
What is corporate governance? List five corporate
governance provisions that are internal to a firm and are under its control.
Answer: Corporate governance is the set of laws, rules, and procedures that influence a
company’s operations and the decisions made by its managers.
The provisions under a firm’s control are: (1) monitoring and discipline by the board
of directors; (2) charter provisions and bylaws that affect the likelihood of hostile
takeovers; (3) compensation plans; (4) capital structure choices; and (5) accounting
control systems.
Mini Case: 15 - 12
n.
What characteristics of the board of directors usually lead to effective corporate
governance?
Answer: (1) The CEO is not also the chairman of the board and does not have undue influence
over the nominating committee; (2) the board has a majority of true outsiders who
bring some type of business expertise to the board (and he board is not an interlocked
board); (3) the board is not too large; and (4) board members are compensated
appropriately (not too high, and some compensation is linked to company’s
performance).
.
o.
List three provisions in the corporate charter that affect takeovers.
Answer: These include targeted share repurchases (i.e., greenmail), shareholder rights
provisions (i.e., poison pills), and restricted voting rights plans.
p.
Briefly describe the use of stock options in a compensation plan. What are some
potential problems with stock options as a form of compensation?
Answer: Gives owner of option the right to buy a share of the company’s stock at a specified
price (called the strike price) even if the actual stock price is higher. Usually can’t
exercise the option for several years (called the vesting period). Can’t exercise the
option after a certain number of years (called the expiration, or maturity, date).
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.
q.
What is block ownership? How does it affect corporate governance?
Answer: Block ownership occurs when an outside investor owns large amount (i.e., block) of
company’s shares. Large institutional investors, such as CalPERS or TIAA-CREF,
often own large blocks. Blockholders often monitor managers and take active role,
leading to better corporate governance.
r.
Briefly explain how regulatory agencies and legal systems affect corporate
governance.
Answer: Companies in countries with strong protection for investors tend to have better access
to financial markets, a lower cost of equity, increased in market liquidity, and less
noise in stock prices.
Mini Case: 15 - 13