FINANCIAL MANAGEMENT
THEORY & PRACTICE
ADAPTED FOR THE SECOND CANADIAN
EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
CHAPTER 23
CORPORATE VALUATION, VALUEBASED MANAGEMENT, AND
CORPORATE GOVERNANCE
CHAPTER 23 OUTLINE
•
•
•
•
Overview of Corporate Valuation
The Corporate Valuation Model
Value-Based Management
Managerial Behaviour and Shareholder
Wealth
• Corporate Governance
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Overview of Corporate Valuation
• Managers often forecast financial statements
under alternative strategies, finding the present
value of each strategy’s cash flow stream, and
then choose the one with the maximum present
value.
• The dividend growth model is often unsuitable
for managerial purposes considering start-up
companies, firms not paying dividends, or firms
with divisions.
• The corporate valuation model fits in.
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Overview of Corporate Valuation (cont’d)
• The corporate valuation model shows how
corporate decisions affect shareholders.
• However, corporate decisions are made by
managers, not shareholders.
• A key aspect of value-based management is
making sure that managers focus on the goal
of shareholder wealth maximization.
• Corporate governance is one of the main tools
used in value-based management.
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The Corporate Valuation Model
•
•
•
•
Types of corporate assets
Estimating the value of operations
Estimating the price per share
Comparing the corporate valuation and
dividend growth models
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Types of Corporate Assets
• Operating assets
– Assets-in-place include tangible assets such as
buildings, machines, inventory plus intangible assets
such as patents, customer lists, reputation, and
general know-how
– Growth options are opportunities to expand arising
from the firm’s current operating knowledge,
experience, and other resources.
• Nonoperating assets
• Value-based management focuses on operating
assets.
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Nonoperating Assets
• Come in two forms
– A marketable securities portfolio over and above the
cash needed to operate the business
– Noncontrolling investments in other businesses
• Operating assets are far more important than
nonoperating assets.
• Moreover, companies can influence the values of
their operating assets.
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Value of Operations
∞
Vop =
∑
t=1
FCFt
(1 + WACC)t
PV of expected future free cash flows (FCF)
from operations, that is, operating assets.
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Relevant Formulas
• FCF = NOPAT – Change in net operating capital
• NOPAT = EBIT(1 – T)
• Change in net operating capital = Change in net
operating working capital + Change in net plant and
equipment
• Required net operating working capital = Operating
current assets – Operating current liabilities = (Cash
+ A/R + Inv.) – (A/P + Accruals)
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Relevant Formulas (cont’d)
• Change in net operating working capital = Net
operating working capital current – Net operating
working capital last year
• Change in net plant and equipment =
Net plant and equipment current – Net plant and
equipment last year
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Total Corporate Value
• Total corporate value is sum of:
– value of operations
– value of nonoperating assets
• Firms can only influence the values of their
operating assets, not the nonoperating assets.
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Claims on Corporate Value
• Debtholders have first claim.
• Preferred stockholders have the next claim.
• Any remaining value belongs to stockholders.
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Applying the
Corporate Valuation Model
• Forecast the financial statements.
• Calculate the projected free cash flows.
• Model can be applied to a company that does
not pay dividends, a privately held company,
or a division of a company, since FCF can be
calculated for each of these situations.
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Data for Valuation
•
•
•
•
•
•
•
FCF0 = $20 million
WACC = 10%
Growth rate g = 5%
Marketable securities = $100 million
Debt = $200 million
Preferred stock = $50 million
Book value of equity = $210 million
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Value of Operations: Constant FCF
Growth at Rate of g
∞
Vop =
∑
t=1
∞
=
∑
t=1
FCFt
(1 + WACC)t
FCF0(1+g)t
(1 + WACC)t
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Constant Growth Formula
• Notice that the term in parentheses is less
than one and gets smaller as t gets larger. As t
gets very large, term approaches zero.
∞
Vop =
∑FCF (
1+ g
0
t=1
1 + WACC
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t
)
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Constant Growth Formula (cont’d)
• The summation can be replaced by a single
formula:
Vop =
FCF1
(WACC – g)
FCF0(1+g)
=
(WACC – g)
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Find Value of Operations
Vop =
FCF0 (1 + g)
(WACC – g)
20(1+0.05)
= $420m
Vop =
(0.10 – 0.05)
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Value of Equity
• Sources of corporate value
– Value of operations = $420
– Value of nonoperating assets = $100
• Claims on corporate value
– Value of debt = $200
– Value of preferred stock = $50
– Value of equity = ?
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Value of Equity (cont’d)
• Total corporate value = Vop + Mkt. Sec.
= $420 + $100
= $520 million
• Value of equity = Total – Debt – Pref.
= $520 – $200 – $50
= $270 million
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Market Value Added (MVA)
• MVA = Total corporate value of firm – 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
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Breakdown of Corporate Value
600
500
400
MVA
Book equity
300
Equity (Market)
Preferred stock
200
Debt
Marketable securities
100
Value of operations
0
Sources of
Value
Claims on
Value
Market vs.
Book
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Expansion Plan:
Nonconstant Growth
• Finance expansion by borrowing and halting
dividends
• Projected free cash flows (FCF):
– Year 1 FCF = -$18.00 million
– Year 2 FCF = -$23.00 million
– Year 3 FCF = $46.40 million
– Year 4 FCF = $49.00 million
– FCF grows at constant rate of 5% after year 4
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Expansion Plan:
Nonconstant Growth (cont’d)
• The weighted average cost of capital, WACC, is
10.84%.
• The company has 100 million shares of stock.
• Value of nonoperating = $63 million
• Value of debt = $247 million
• Value of preferred stock = $62 million
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Horizon Value
• Free cash flows are forecast for 4years
in this example, so the forecast horizon
is 4 years.
• Growth in free cash flows is not constant
during the forecast, so we can’t use the
constant growth formula to find the value of
operations at time 0 (i.e., 2013).
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Horizon Value (cont’d)
• Growth is constant after the horizon
(4 years), which is year 2017. We can modify
the constant growth formula to find the value
of all free cash flows beyond the horizon,
discounted back to the horizon.
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Horizon Value (HV) Formula
HV = Vop at time t
VOP(12 / 31/13) 
FCFt(1+ g)
=
(WACC – g)
FCF(12 / 31/17) (1  g )
WACC  g
$49(1  0.05)

 $880.99
0.1084  0.05
• Horizon value is also called terminal value, or
continuing value.
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Finding the Value of Magnavision’s
Stock
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Comparing the Corporate Valuation
and Dividend Growth Models
• For a mature company whose dividends are expected
to grow steadily in the future, the dividend growth
model seems to be more efficient.
• For a dividend-paying but still fast-growing company,
either model can be applied.
• For a company that never paid a dividend, a new
company, or a division of a large company, the
corporate valuation model must be used.
• Actually, much can be learned from the corporate
valuation model in all these situations.
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Value-Based Management
• Value-based management (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).
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MVA and the Four Value Drivers
• MVA is determined by four drivers:
– Sales growth (g)
– Operating profitability (OP=NOPAT/Sales)
– Capital requirements (CR=Operating capital /
Sales)
– Weighted average cost of capital (WACC)
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MVA for a Constant Growth Firm
MVAt =
┌
│
└
┐┌
┐
CR
Sales (1 + g)
OP – WACC(
│
│
│
)
(1+g)
WACC – g
┘
┘└
t
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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.e., its
operating profit margin is 100%) and that
never has to make additional investments in
operating capital.
┌
│
└
┐
Sales (1 + g)
│
WACC - g
┘
t
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Insights (cont’d)
• 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
│OP – WACC ((1+g))│
└
┘
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Improvements in MVA
Due to the Value Drivers
• MVA will improve if:
– WACC is reduced
– operating profitability (OP) increases
– the capital requirement (CR) decreases
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The Impact of Growth
• The second term in brackets can be either
positive or negative, depending on the relative
size of profitability, capital requirements, and
required return by investors.
┌
┐
CR
│OP – WACC ((1+g))│
└
┘
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The Impact of Growth (cont’d)
• If the second term in brackets is negative, then
growth decreases MVA. In other words, profits
are not enough to offset the return on capital
required by investors.
• If the second term in brackets is positive, then
growth increases MVA.
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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:
EROICt =
NOPATt + 1
Capitalt
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MVA in Terms of Expected ROIC
MVAt =
Capitalt (EROICt – WACC)
WACC – g
If the spread between the expected return,
EROICt, 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.
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The Impact of Growth on MVA
• A company 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%)
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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)
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Division B
4%
4%
27%
27%
5%
6%
300.0 385.0
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Expected ROIC and MVA
Division A
Division B
Capital0
$780
$780
$270
$270
Growth
5%
6%
5%
6%
Sales1
$1,050 $1,060 $1,050 $1,060
NOPAT1
$63
EROIC0
8.1%
MVA
$63.6
$42
$42.4
8.2% 15.6%
15.7%
(300.0) (360.0)
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300.0
385.0
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Analysis of Growth Strategies
• The expected ROIC of Division A is less than
the WACC, so the division should postpone
growth efforts until it improves EROIC 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.
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Managerial Behaviour
and Shareholder Wealth
SIX POTENTIAL PROBLEMS
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.
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Six Potential Problems (cont’d)
4. Reject risky positive NPV projects to avoid
looking bad if project fails; take on risky negative
NPV projects to try to 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.
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Corporate Governance
• The set of laws, rules, and procedures that
influence a company’s operations and the
decisions made by its managers.
– Sticks (threat of removal)
– Carrots (compensation)
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Corporate Governance Provisions
Under a Firm’s Control
•
•
•
•
•
Board of directors
Charter provisions affecting takeovers
Compensation plans
Capital structure choices
Internal accounting control systems
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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
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Effective Boards of Directors (cont’d)
• CEO is not chairman of the board and does
not have undue influence over the nominating
committee.
• Board has a majority of outside directors (i.e.,
those who do not have another position in the
company) with business expertise.
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Effective Boards of Directors (cont’d)
• Is not an interlocking board (CEO of company
A sits on board of company B, CEO of B sits on
board of A).
• Board members are not unduly busy (i.e., sit
on too many other boards or have too many
other business activities).
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Effective Boards of Directors (cont’d)
• Compensation for board directors is
appropriate.
– Not so high that it encourages cronyism with CEO
– Not all compensation is fixed salary
(i.e., some compensation is linked to
firm performance or stock performance)
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Anti-Takeover Provisions
• Targeted share repurchases
(i.e., greenmail)
• Shareholder rights provisions
(i.e., poison pills)
• Restricted voting rights plans
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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)
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Stock Options (cont’d)
• Can’t exercise the option after a certain
number of years (called the expiration, or
maturity, date)
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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.
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External Factors
Affecting Corporate Governance
• Corporate governance is also affected by
environmental factors that are outside of a
firm’s control, including:
– regulatory/legal environment
– block ownership patterns
– competition in the product markets
– media
– litigation
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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
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Block Ownership
• Outside investor owns large amount (i.e.,
block) of company’s shares
– Canadian Coalition for Good Governance (CCGG)
representing 48 institutional investors
• Blockholders often monitor managers and
take an active role, leading to better corporate
governance.
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