CHAPTER 11

Corporate Value and

Value-Based Management

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 Topics in Chapter
• Corporate Valuation
• Value-Based Management
• Corporate Governance

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 Intrinsic Value: Putting the Pieces Together

Net operating Required

−
profit after investments
taxes in operating capital
Free cash
flow =
(FCF)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC) 1
(1 + WACC)2 (1 + WACC)∞

Weighted
average
cost of capital
(WACC)

Market interest Firm’s debt/equity

rates Cost of debt mix

Market risk Cost of Firm’s business

aversion equity risk 3
 Corporate Valuation: A company owns two
• Assets-in-place
types of assets.
• Financial, or non-operating, assets

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• Assets-in-placeAssets-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.

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 Value of Operations

∞
Vop = Σ
t=1
FCFt
(1 + WACC)t

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 Non-operating
• Marketable securities Assets
• Ownership of non-controlling interest in another
company
• Value of non-operating assets usually is very close
to figure that is reported on balance sheets.

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 Totalvalue
• Total corporate Corporate
is sum of: Value
– Value of operations
– Value of nonoperating assets

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• DebtClaims onfirst
holders have Corporate
claim. Value
• Preferred stockholders have the next claim.
• Any remaining value belongs to stockholders.

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•Applying the
Forecast the Corporate
financial Valuation
statements, Model
as shown in
Chapter 9.
• 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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 Calculate the Free Cashflow

• Based on the projected IS and BS for Garnet to estimate the FCF for the
company?
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• Data for Valuation
FCF0 = $24 million
• WACC = 11%
• g = 5%
• Marketable securities = $100 million
• Debt = $200 million
• Preferred stock = $50 million
• Book value of equity = $210 million
• Number of shares =n = 10 million

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Value of Operations: Constant FCF Growth at
Rate of g
∞
Vop = Σ
t=1
FCFt
(1 + WACC)t

∞ FCF0(1+g)t
= Σ
t=1 (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.

∞ t
Vop = Σ FCF
t=1
0
1+ g
1 + WACC
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 Constant Growth Formula (Cont.)
• The summation can be replaced by a single
formula:
FCF1
Vop =
(WACC - g)

FCF0(1+g)
= (WACC - g)
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 Find Value of Operations
FCF0 (1 + g)
Vop =
(WACC - g)

24(1+0.05)
Vop = = 420
(0.11 – 0.05)

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Total Value of Company (VTotal)
Voperations $420.00
+ ST Inv. 100.00
VTotal $520.00

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Intrinsic Value of Equity (VEquity)

Voperations $420.00
+ ST Inv. 100.00
VTotal $520.00
− Preferred Stk. 50.00
− Debt 200.00
VEquity $270.00

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Intrinsic Stock Price per Share, P
Voperations $420.00
+ ST Inv. 100.00
VTotal $520.00
− Preferred Stk. 50.00
− Debt 200.00
VEquity $270.00
÷n 10
P $27.00 1
 Intrinsic
• Intrinsic MVAMarket Value value
= Total corporate Added (MVA)
of firm minus
total book value of capital supplied by investors
• Total book value of capital = 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

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• Expansion Plan:
Finance expansion Nonconstant
by borrowing $40 millionGrowth
and halting
dividends.
• Projected free cash flows (FCF):
– Year 1 FCF = -$5 million.
– Year 2 FCF = $10 million.
– Year 3 FCF = $20 million
• FCF grows at constant rate of 6% after year 3.
The weighted average cost of capital, WACC, is 10%.
• The company has 10 million shares of stock.

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• Free cash flowsHorizon
are forecast Value
for three years in this
example, so the forecast horizon is three 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.

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• Growth Horizon
is constant Value
after the(Cont.)
horizon (3 years),
so 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 Formula

FCFt(1+g)
HV = Vop at time t =
(WACC - g)

• Horizon value is also called terminal value,

or continuing value.
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 Value of operations is PV of FCF discounted
by WACC.

0 WACC =10% 1 2 3 g = 6%

−5.00 10.00 20.00

FCF3(1+g)
−4.545 (WACC−g)
8.264 $20(1.06)
15.026 0.10−0.06
398.197 $530 = V op at 3

416.942 = Vop $530/(1+WACC)3

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Intrinsic Stock Price per Share, P
Voperations $416.942
+ ST Inv. 0
VTotal $416.942
− Preferred Stk. 0
− Debt 40.000
VEquity $376.942
÷n 10
P $37.69 1
• Value-Based Management
VBM is the systematic application of (VBM)
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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Corporate Valuation Example

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 MVAis determined
• MVA and the Four
by fourValue
drivers:Drivers
– Sales growth
– Operating profitability (OP=NOPAT/Sales)
– Capital requirements (CR=Operating capital /
Sales)
– Weighted average cost of capital

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MVA for a Constant Growth Firm

MVAt =

Salest(1 + g) CR
OP – WACC
WACC - g (1+g)

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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.

Salest(1 + g)
WACC - g
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 Insights (Cont.)
• 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
• MVA will improve if:
Drivers
– 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
• If the Impact
second term inof Growth
brackets (Cont.)
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:

OPt+1
NOPATt+1 CRt
EROICt = =
Capitalt Capitalt
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 MVA in Terms of Expected EROIC and Value
Drivers
Capitalt (EROICt – WACC)
MVAt = WACC - g
Capitalt (OPt+1/CRt – WACC)
MVAt = 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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MVA in Terms of Expected EROIC

Capitalt (OPt+1/CRt – WACC)

MVAt = 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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• A The
companyImpact of Growth
has two divisions. oncurrent
Both have MVA
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%?
Division A Division B
OP 6% 6% 4% 4%
CR 78% 78% 27% 27%
Growth 5% 6% 5% 6%
MVA (300.0) (360.0) 300.0 385.0

Note: MVA is calculated using the formula on slide 11-

28.

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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 $63.6 $42 $42.4
EROIC0 8.1% 8.2% 15.6% 15.7%
MVA (300.0) (360.0) 300.0 385.0

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 Analysis
• The expected ofofGrowth
ROIC Division A Strategies
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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 Six Potential Problems with Managerial
• Expend too little time and effort.
Behavior
• Consume too many nonpecuniary benefits.
• Avoid difficult decisions (e.g., close plant) out of
loyalty to friends in company.

(More . .) 44
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 Six Problems with Managerial Behavior
• Reject risky positive NPV projects to avoid looking
bad if project fails; (Continued)
take on risky negative NPV
projects to try and hit a home run.
• Avoid returning capital to investors by making excess
investments in marketable securities or by paying too
much for acquisitions.
• Massage information releases or manage earnings to
avoid revealing bad news.

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• The set Corporate Governance
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
• Board of directors
• Under a Firm’s Control
Charter provisions affecting takeovers
• Compensation plans
• Capital structure choices
• Internal accounting control systems

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 Effective
• Election Boards
mechanisms makeofit Directors
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

(More . .) 48
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• CEOEffective Boards
is not chairman of Directors
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.

(More . .) 49
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•Effective Boards of
Is not an interlocking Directors
board (CEO of company A
(Continued)
sits on board of company B, CEO of B sits on
board of A).
• Board members are not unduly busy (i.e., set on
too many other boards or have too many other
business activities)

(More . .) 50
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•
Effective Boards of Directors
Compensation for board directors is appropriate
(Continued)
– 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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• TargetedAnti-Takeover
share repurchasesProvisions
(i.e., greenmail)
• Shareholder rights provisions (i.e., poison pills)
• Restricted voting rights plans

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• Stock Options
Gives owner in Compensation
of option Plansof
the right to buy a share
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
• Can’t exercise theOptions
option after(Cont.)
a certain number
of years (called the expiration, or maturity, date).

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 Problems
• Manager with Stock
can underperform marketOptions
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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 Block
• Outside investor ownsOwnership
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

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 Regulatory
• Companies Systems
in countries andprotection
with strong Laws 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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