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CHAPTER 10

Corporate Valuation and Value-Based Management

Corporate Valuation

Value-Based Management

Corporate Governance

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Corporate Valuation

!ist t"e t#o t$pes o% assets t"at acompan$ o#ns&

Assets-in-place' includinggro#t" options

(inancial' or nonoperating'assets

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Assets-in-Place

Assets-in-place are tangi)le' suc" as)uildings' mac"ines' inventor$&

*suall$ t"e$ are e+pected to gro#&

T"e$ generate %ree cas" %lo#s&

T"e PV o% t"eir e+pected %uture %reecas" %lo#s' discounted at t"e ,ACC'is t"e value o% operations&

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Value o% perations

= +

=

1t

t

tOp

)WACC1(

FCFV

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.onoperating Assets

Mar/eta)le securities

#ners"ip o% non-controllinginterest in anot"er compan$

Value o% nonoperating assets usuall$is ver$ close to %igure t"at isreported on )alance s"eets&

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Total Corporate Value

Total corporate value is sum o%

Value o% operations

Value o% nonoperating assets

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Claims on Corporate Value

e)t"olders "ave %irst claim&

Pre%erred stoc/"olders "ave t"e ne+tclaim&

An$ remaining value )elongs tostoc/"olders&

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Appl$ing t"e Corporate Valuation

Model(orecast t"e %inancial statements as

practised )$ companies in t"e industr$&

Calculate t"e proected %ree cas" %lo#s&

Model can )e applied to a compan$t"at does not pa$ dividends' a privatel$

"eld compan$' or a division o% acompan$' since (C( can )e calculated%or eac" o% t"ese situations&

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ata %or Valuation

(C(02 340 million

,ACC 2 105

g 2 65Mar/eta)le securities 2 3100 million

e)t 2 3400 million

Pre%erred stoc/ 2 360 million

Boo/ value o% e7uit$ 2 3410 million

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Value o% perations

Constant Gro#t"8uppose (C( gro#s at constant rate g&

( )

( )

=

=

+

+=

+=

1tt

t0

1tt

tOp

WACC1

)g1(FCF

WACC1FCFV

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Constant Gro#t" (ormula

.otice t"at t"e term in parent"esesis less t"an one and gets smaller as t

gets larger& As t gets ver$ large' termapproac"es 9ero&

= + += 1t

t

0OpWACC1g1FCFV

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Constant Gro#t" (ormula :Cont&;

T"e summation can )e replaced )$ asingle %ormula

( )

( )gWACC

)g1(FCF

gWACCFCFV

0

1Op

+=

=

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(ind Value o% perations

( )

( ) 42005.010.0

)05.01(20

V

gWACC

)g1(FCF

V

Op

0

Op

=

+

=

+

=

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Value o% E7uit$

8ources o% Corporate Value

Value o% operations 2 3

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Value o% E7uit$

Total corporate value 2 Vp> M/t& 8ec&

2 3 3100

2 3640 million

Value o% e7uit$ 2 TCV - e)t - Pre%&

2 3640 - 3400 - 360

2 34?0 million

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Mar/et Value Added :MVA;

MVA 2 Total corporate value o% %irmminus total )oo/ value o% %irm

Total )oo/ value o% %irm 2 )oo/ valueo% e7uit$ > )oo/ value o% de)t > )oo/value o% pre%erred stoc/

MVA 2 3640 - :3410 > 3400 > 360;

2 3@0 million

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Brea/do#n o% Corporate Value

0

100

400

00

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E+pansion Plan .onconstant Gro#t"

(inance e+pansion )$ )orro#ing 3

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T"e #eig"ted average cost o% capital'rc' is 105&

T"e compan$ "as 10 million s"areso% stoc/&

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Hori9on Value

(ree cas" %lo#s are %orecast %ort"ree $ears in t"is e+ample' so t"e

%orecast "ori9onis t"ree $ears&Gro#t" in %ree cas" %lo#s is not

constant during t"e %orecast'so #e

canDt use t"e constant gro#t"%ormula to %ind t"e value o%operations at time 0&

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Hori9on Value :Cont&;

Gro#t" is constant a%ter t"e "ori9on: $ears;' so #e can modi%$ t"e

constant gro#t" %ormula to %ind t"evalue o% all %ree cas" %lo#s )e$ondt"e "ori9on' discounted )ac/ to t"e"ori9on&

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Hori9on Value (ormula

Hori9on value is also called terminalvalue' or continuingvalue&

( )gWACC

)g1(FCFVHV tttimeatOp

+

==

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Vopat

(ind t"e value o% operations )$ discounting

t"e %ree cas" %lo#s at t"e cost o% capital&0

-

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(ind t"e price per s"are o% common

stoc/&Value o% e7uit$ 2 Value o% operations

- Value o% de)t

2 3

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Value-Based Management :VBM;

VBM is t"e s$stematic applicationo% t"e corporate valuation model

to all corporate decisions andstrategic initiatives&

T"e o)ective o% VBM is to

increase Mar/et Value Added:MVA;

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MVA and t"e (our Value rivers

MVA is determined )$ %our drivers

8ales gro#t"

perating pro%ita)ilit$:P2.PAT8ales;

Capital re7uirements:CR2perating capital 8ales;

,eig"ted average cost o% capital

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MVA %or a Constant Gro#t" (irm

=

)g1(

CRWACCOP

gWACC

)g1(Sales

MVA

t

t

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nsig"ts %rom t"e Constant Gro#t"

ModelT"e %irst )rac/et is t"e MVA o% a %irm

t"at gets to /eep all o% its sales

revenues :i&e&' its operating pro%itmargin is 1005; and t"at never "asto ma/e additional investments inoperating capital&

gWACC

)g1(Salest

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nsig"ts :Cont&;

T"e second )rac/et is t"e operatingpro%it :as a 5; t"e %irm gets to /eep'

less t"e return t"at investors re7uire%or "aving tied up t"eir capital in t"e%irm&

)g1(

CRWACCOP

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mprovements in MVA due to t"e

Value riversMVA #ill improve i%

,ACC is reduced

operating pro%ita)ilit$ :P;increases

t"e capital re7uirement :CR;decreases

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T"e mpact o% Gro#t"

T"e second term in )rac/ets can )eeit"er positive or negative'

depending on t"e relative si9e o%pro%ita)ilit$' capital re7uirements'and re7uired return )$ investors&

)g1(

CRWACCOP

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T"e mpact o% Gro#t" :Cont&;

% t"e second term in )rac/ets isnegative' t"en gro#t" decreases

MVA& n ot"er #ords' pro%its are notenoug" to o%%set t"e return on capitalre7uired )$ investors&

% t"e second term in )rac/ets ispositive' t"en gro#t" increases MVA&

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E+pected Return on nvested

Capital :ERC;T"e e+pected return on invested

capital is t"e .PAT e+pected ne+t

period divided )$ t"e amount o%capital t"at is currentl$ invested

t

1t

t Capital

NOPAT

EROIC +

=

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MVA in Terms o% E+pected RC

[ ]gWACC

WACCEROICCapitalMVA ttt

=

% t"e spread )et#een t"e e+pectedreturn' ERCt' and t"e re7uired

return' ,ACC' is positive' t"en MVAis positive and gro#t" ma/es MVAlarger& T"e opposite is true i% t"espread is negative&

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T"e mpact o% Gro#t" on MVA

A compan$ "as t#o divisions& Bot" "avecurrent sales o% 31'000' current e+pectedgro#t" o% 65' and a ,ACC o% 105&

ivision A "as "ig" pro%ita)ilit$ :P2@5;)ut "ig" capital re7uirements :CR2?5;&

ivision B "as lo# pro%ita)ilit$ :P2

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,"at is t"e impact on MVA i% gro#t"goes %rom 65 to @5=

ivision A ivision B

P @5@5

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E+pected RC and MVA

ivision A ivision B

Capital0 3?03?034?0 34?0

Gro#t" 65@5 65@58ales1 31'06031'0@0 31'06031'0@0

.PAT1 3@3@&@3

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Anal$sis o% Gro#t" 8trategies

T"e e+pected RC o% ivision A is lesst"an t"e ,ACC' so t"e division s"ouldpostpone gro#t" e%%orts until itimproves ERC )$ reducing capitalre7uirements :e&g&' reducing inventor$;andor improving pro%ita)ilit$&

T"e e+pected RC o% ivision B isgreater t"an t"e ,ACC' so t"e divisions"ould continue #it" its gro#t" plans&

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T#o Primar$ Mec"anisms o%

Corporate Governance8tic/ :Punis"ments;

Provisions in t"e c"arter t"ata%%ect ta/eovers&

Composition o% t"e )oard o%directors&

Carrot Compensation plans:Re#ards;

10 40

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Entrenc"ed Management

ccurs #"en t"ere is little c"ancet"at poorl$ per%orming managers #ill

)e replaced&T#o causes

Anti-ta/eover provisions in t"e

c"arter

,ea/ )oard o% directors

10 41

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Ho# are entrenc"ed managers

"arm%ul to s"are"olders=Management consumes per/s

!avis" o%%ices and corporate ets

E+cessivel$ large sta%%s

Mem)ers"ips at countr$ clu)s

Management accepts proects :orac7uisitions; to ma/e %irm larger' eveni% MVA goes do#n&

10 42

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Anti-Ta/eover Provisions

Targeted s"are repurc"ases :i&e&'greenmail;

8"are"older rig"ts provisions :i&e&'poison pills;

Restricted voting rig"ts plans

10 43

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Board o% irectors

,ea/ )oards "ave man$ insiders:i&e&' t"ose #"o also "ave anot"er

position in t"e compan$; compared#it" outsiders&

nterloc/ing )oards are #ea/er :CE

o% compan$ A sits on )oard o%compan$ B' CE o% B sits on )oardo% A;&

10 44

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8toc/ ptions in Compensation

PlansGives o#ner o% option t"e rig"t to

)u$ a s"are o% t"e compan$Ds stoc/

at a speci%ied price :called t"ee+ercise price; even i% t"e actualstoc/ price is "ig"er&

*suall$ canDt e+ercise t"e option %orseveral $ears :called t"e vestingperiod;&

10 45

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8toc/ ptions :Cont&;

CanDt e+ercise t"e option a%ter a certainnum)er o% $ears :called t"e e+piration' ormaturit$' date;&

Helps to motivate sta%% :emplo$ees; to#or/ "arder and smarter' t"us ma/ingcompan$ more valua)le and )ene%icial to

s"are"oldersners"ipDs interest :)eing s"are"olders;