1

Ch 3 and Ch 15Ch 3 and Ch 15Corporate ValuationCorporate Valuation

Overview of Financial StatementsOverview of Financial Statements Corporate ValuationCorporate Valuation

Free Cash Flow (FCF)Free Cash Flow (FCF) Market Value Added (MVA) and Economic Market Value Added (MVA) and Economic

Value Added (EVA)Value Added (EVA) Corporate GovernanceCorporate Governance

Entrenched Management Entrenched Management Agency ProblemAgency Problem Compensation and Stock OptionCompensation and Stock Option

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Worksheet and Spreadsheet for MagnaVision Co.

MagnaVisionMagnaVision

3Why are we concerned about “valuing Why are we concerned about “valuing

the firm?”the firm?” Microsoft’s ProblemMicrosoft’s Problem

Microsoft have many affiliates and subsidiaries. Microsoft have many affiliates and subsidiaries. How can a CEO judge whether subsidiaries are How can a CEO judge whether subsidiaries are doing good jobs or not?doing good jobs or not?

How can she compensate her subordinates or How can she compensate her subordinates or managers according to performance?managers according to performance?

JP Morgan’s ProblemJP Morgan’s Problem As a portfolio manager, how can he distinguish As a portfolio manager, how can he distinguish

good stocks from bad stocks?good stocks from bad stocks? Which stock would provide more wealth to Which stock would provide more wealth to

shareholders?shareholders? In order to value the firm, we must In order to value the firm, we must

carefully review the firm’s financial carefully review the firm’s financial statements.statements.

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GAAP RequirementsGAAP Requirements

Three Financial StatementsThree Financial Statements Balance SheetsBalance Sheets Income StatementsIncome Statements Cash Flow StatementCash Flow Statement

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Issues with GAAP StatementsIssues with GAAP Statements

However, we learned that GAAP has However, we learned that GAAP has many problems in measuring the many problems in measuring the truetrue value of the firm. value of the firm. For example, balance sheet records For example, balance sheet records

historical cost, not market value.historical cost, not market value. Income statement contains non-cash Income statement contains non-cash

items such as depreciation.items such as depreciation. Mismatch between the time when the Mismatch between the time when the

income (cost) is realized and the time income (cost) is realized and the time when the revenue (cost) is collectedwhen the revenue (cost) is collected

Free Cash FlowFree Cash Flow

So, we introduced Free Cash Flow So, we introduced Free Cash Flow (FCF), Market Value Added (MVA), (FCF), Market Value Added (MVA), and Economic Value Added (EVA) to and Economic Value Added (EVA) to accurately measure the true value of accurately measure the true value of the firm.the firm.

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7

The Goal of Financial ManagersThe Goal of Financial Managers

The financial manager is to The financial manager is to increase the market value of the increase the market value of the firm, or the stock value. firm, or the stock value.

““Shareholder Wealth Shareholder Wealth Maximization”Maximization”

New Concept:New Concept:FREE CASH FLOWFREE CASH FLOW

The cash from operations that is The cash from operations that is actually available for distribution to actually available for distribution to investors (including stockholders, investors (including stockholders, bondholders, and preferred bondholders, and preferred stockholders), after the company has stockholders), after the company has made all the investments in fixed made all the investments in fixed assets and working capital necessary assets and working capital necessary to sustain ongoing operations.to sustain ongoing operations.

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Total Corporate ValueTotal Corporate Value

Total corporate value is sum Total corporate value is sum of:of: Value of operations (or Value of operations (or

operating assets)operating assets) Value of nonoperating assetsValue of nonoperating assets

10List two types of assets that a List two types of assets that a

company owns.company owns.

Operating assetsOperating assetsNonoperating assetsNonoperating assets

11List two types of assets that a List two types of assets that a

company owns.company owns. Operating assetsOperating assets

Assets-in-place Assets-in-place Tangible Assets: Buildings, Inventory, Usually Tangible Assets: Buildings, Inventory, Usually

shown in balance sheetshown in balance sheet Intangible Assets: Copyrights, Patents (usually Intangible Assets: Copyrights, Patents (usually

shown on balance sheets), Reputation, Name shown on balance sheets), Reputation, Name value, Significant potentials from research and value, Significant potentials from research and development (usually not shown in balance development (usually not shown in balance sheet)sheet)

Growth optionsGrowth options Opportunity to expand that arise from the Opportunity to expand that arise from the

firm’s current operating knowledgefirm’s current operating knowledge

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Assets-in-PlaceAssets-in-Place

Usually they are expected to grow.Usually they are expected to grow. They generate free cash flows.They generate free cash flows. The PV of their expected future free The PV of their expected future free

cash flows, discounted at the WACC, cash flows, discounted at the WACC, is the is the value of operationsvalue of operations..

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What is the Free Cash Flow (FCF)?What is the Free Cash Flow (FCF)?

• The cash from operations that is actually The cash from operations that is actually available for distribution to investors available for distribution to investors (including stockholders, bondholders, (including stockholders, bondholders, and preferred stockholders), after the and preferred stockholders), after the company has made all the investments company has made all the investments in fixed assets and working capital in fixed assets and working capital necessary to sustain ongoing operations.necessary to sustain ongoing operations.

• Free Cash Flow Free Cash Flow = = NOPAT – Net Investment in Operating NOPAT – Net Investment in Operating

CapitalCapital

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Why Free Cash Flow? Why Free Cash Flow? To value the firm or operating units To value the firm or operating units

within the firmwithin the firm To evaluate the manager’s performance, To evaluate the manager’s performance,

so we can compensate her based on so we can compensate her based on performance.performance.

Dividend discount model is often of Dividend discount model is often of limited use of internal management limited use of internal management purpose.purpose.

For example, GE have many affiliates and For example, GE have many affiliates and subsidiaries but only few of them pay dividends subsidiaries but only few of them pay dividends as separate entities.as separate entities.

Or some firms simply do not pay dividends.Or some firms simply do not pay dividends.

15List two types of assets that a company List two types of assets that a company

owns.owns.

Financial, or nonoperating assetsFinancial, or nonoperating assets Marketable securities over and above Marketable securities over and above

the cash needed to operate the businessthe cash needed to operate the business ““Equity in Net Assets of Affiliated Equity in Net Assets of Affiliated

Companies”, or ownership of non-Companies”, or ownership of non-controlling interest in another companycontrolling interest in another company

Value of nonoperating assets usually is Value of nonoperating assets usually is very close to figure that is reported on very close to figure that is reported on balance sheets.balance sheets.

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Applying the Corporate Valuation Applying the Corporate Valuation ModelModel

Forecast the financial statements.Forecast the financial statements. Calculate the projected free cash flows.Calculate the projected free cash flows. Model can be applied to a company Model can be applied to a company

that does not pay dividends, a that does not pay dividends, a privately held company, or a division of privately held company, or a division of a company, since FCF can be a company, since FCF can be calculated for each of these situations.calculated for each of these situations.

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Example: MagnaVisionExample: MagnaVision

You are given the current and You are given the current and projected financial statements of projected financial statements of MagnaVision. Growth is expected to MagnaVision. Growth is expected to be 5% for each year after the be 5% for each year after the projections. If the WACC is 10.84%, projections. If the WACC is 10.84%, what is the value of operations?what is the value of operations?

So, in our notation,So, in our notation, g = 5% g = 5% after projectionsafter projections WACC = 10.84%WACC = 10.84%

18Data: Income Statement (millions)Data: Income Statement (millions)

Actual Projected

  2001 2002

Net Sales $700.0 $850.0

Costs (except depreciation) $599.0 $734.0

Depreciation 28.0 31.0

Total operating costs $627.0 $765.0

Earning before int. & tax $73.0 $85.0

Less: Net interest 13.0 15.0

Earning before taxes $60.0 $70.0

Taxes (40%) 24.0 28.0

Net income before pref. div. $36.0 $42.0

19Income Statement (continued)Income Statement (continued)2001 2002

Preferred div. 6.0 7.0

Net income avail. for com. div. $30.0 $35.0

Common dividends $0.0 $0.0

Addition to retained earnings $30.0 $35.0

     

Number of shares 100 100

Dividends per share $0.000 $0.000

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Data: Balance Sheets (millions)Data: Balance Sheets (millions)

Actual Projected

  2001 2002

Cash $17.0 $20.0

Marketable Securities 63.0 70.0

Accounts receivable 85.0 100.0

Inventories 170.0 200.0

Total current assets $335.0 $390.0

Net plant and equipment 279.0 310.0

Total Assets $614.0 $700.0

21Data: Balance Sheet (continued)Data: Balance Sheet (continued)

  20012001 20022002

Liabilities and Equity

Accounts Payable $16.0 $20.0

Notes payable 123.0 140.0

Accruals 44.0 50.0

Total current liabilities $183.0 $210.0

Long-term bonds 124.0 140.0

Preferred stock 62.0 70.0

Common Stock (par plus paid in capital) $200.0 $200.0

Retained earnings 45.0 80.0

Common equity $245.0 $280.0

Total liabilities and equity $614.0 $700.0

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Calculating Free Cash FlowCalculating Free Cash Flow

Net Operating Working Capital (NOWC)Net Operating Working Capital (NOWC) Another name for NOWC is operating current Another name for NOWC is operating current

asset and operating current liabilitiesasset and operating current liabilities The working capital acquired with investor-The working capital acquired with investor-

supplied fundssupplied funds Current assets that do not pay interest Current assets that do not pay interest

minus current liabilities that do not charge minus current liabilities that do not charge interestinterest

(Cash + AR + Inventory) – (AP + Accruals)(Cash + AR + Inventory) – (AP + Accruals) 2001: (17 + 85 + 170) – (16 + 44) = $2122001: (17 + 85 + 170) – (16 + 44) = $212 2002: $2502002: $250

23Calculating Free Cash FlowCalculating Free Cash Flow

Why Short-term securities are excluded from Why Short-term securities are excluded from operating current assets?operating current assets? It generally result from investment decisions It generally result from investment decisions

by the treasurer and they are not used in the by the treasurer and they are not used in the core operation.core operation.

It is not a natural consequence of operations or It is not a natural consequence of operations or it is a discretionary choice by management.it is a discretionary choice by management.

Why we deduct accounts payable and Why we deduct accounts payable and accruals?accruals? They do not represent dollars generated from They do not represent dollars generated from

investors to acquire current assets.investors to acquire current assets. However, notes payable are treated as However, notes payable are treated as

investor-supplied capital and thus are not investor-supplied capital and thus are not deducted.deducted.

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Calculating Free Cash FlowCalculating Free Cash Flow

Total Operating CapitalTotal Operating Capital Net operating working capital + Net operating working capital +

operating long-term assets (e.g., plant operating long-term assets (e.g., plant and equipment)and equipment) 2001: $212 + 279 = $4912001: $212 + 279 = $491 2002: $250 + 310 = $5602002: $250 + 310 = $560

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Calculating Free Cash FlowCalculating Free Cash Flow

Net Operating Profit after Taxes Net Operating Profit after Taxes (NOPAT)(NOPAT) Definition: The amount of profit a Definition: The amount of profit a

company would generate if it had company would generate if it had no debt and held no financial no debt and held no financial assets.assets.

NOPAT = EBIT(1 – Tax rate)NOPAT = EBIT(1 – Tax rate) 2001: 73 (1 – 40%) = 43.82001: 73 (1 – 40%) = 43.8 2002: 85 (1 – 40%) = 51.02002: 85 (1 – 40%) = 51.0

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Calculating Free Cash FlowCalculating Free Cash Flow

Why NOPAT?Why NOPAT? If the two companies have different If the two companies have different

amounts of debt, hence different amounts amounts of debt, hence different amounts of interest charges, they could have of interest charges, they could have identical operating performances, but identical operating performances, but different net incomes – the one with more different net incomes – the one with more debt would have a lower net income.debt would have a lower net income.

For the same NOPAT, net income measure For the same NOPAT, net income measure unfairly punish operating units with debt.unfairly punish operating units with debt.

Net income reflects interest expense, Net income reflects interest expense, while NOPAT does not.while NOPAT does not.

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Calculating Free Cash FlowCalculating Free Cash Flow

Operating Cash Flow (OCF)Operating Cash Flow (OCF) OCF = NOPAT + DepreciationOCF = NOPAT + Depreciation

2001: 43.8 + 28 = 71.82001: 43.8 + 28 = 71.8 2002: 51.0 + 31 = 92.02002: 51.0 + 31 = 92.0

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Calculating Free Cash FlowCalculating Free Cash Flow Free Cash Flow (FCF)Free Cash Flow (FCF)

The cash from operations that is actually The cash from operations that is actually available for distribution to investors after available for distribution to investors after the company has made all the investments the company has made all the investments in fixed assets and working capital in fixed assets and working capital necessary to sustain ongoing operations. necessary to sustain ongoing operations.

FCF = NOPAT – net investment in operating FCF = NOPAT – net investment in operating assetsassets where net investment in operating asset where net investment in operating asset

= change in total operating capital= change in total operating capital= 560 – 491 = 560 – 491 = $69= $69

FCFFCF20022002 = 51 – 69 = -$18 = 51 – 69 = -$18

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Calculating Free Cash FlowCalculating Free Cash Flow We repeat this process for year 2003, 2004, We repeat this process for year 2003, 2004,

and 2005.and 2005. FCFFCF20032003 = -$23 = -$23 FCFFCF20042004 = $46.4 = $46.4 FCFFCF2005 2005 = $49= $49

FCF are expected to grow at 5% after 2005.FCF are expected to grow at 5% after 2005. FCFFCF20062006 = ($49)(1.05) = $51.45 = ($49)(1.05) = $51.45 FCFFCF20042004 = $54.02 = $54.02 …….. ……..

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Negative FCFNegative FCF

A negative current FCF is not A negative current FCF is not necessarily bad, provided it is due to necessarily bad, provided it is due to high growth. (e.g., investing on more high growth. (e.g., investing on more operating assets to meet an increase operating assets to meet an increase in sales demand)in sales demand)

However, negative FCFs However, negative FCFs over long over long periodsperiods means that mangers have means that mangers have failed in increasing shareholders’ failed in increasing shareholders’ value.value.

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The Uses of FCFThe Uses of FCF

Pay interest to debt holdersPay interest to debt holders Retire some debtsRetire some debts Pay dividendsPay dividends Repurchase stockRepurchase stock Buy marketable securitiesBuy marketable securities Acquire other companiesAcquire other companies

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Maximizing Free Cash FlowMaximizing Free Cash Flow

The goal of financial managers are to The goal of financial managers are to maximize the shareholder’s value.maximize the shareholder’s value.

Maximizing free cash flow available Maximizing free cash flow available to investors is in accordance with to investors is in accordance with shareholder’s wealth maximization.shareholder’s wealth maximization.

The value of a company depends on The value of a company depends on its expected future FCFs.its expected future FCFs.

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Value of OperationsValue of Operations

1tt

tOp )WACC1(

FCFV

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Horizon ValueHorizon Value

Free cash flows are forecast for four years in Free cash flows are forecast for four years in this example, so the forecast this example, so the forecast horizonhorizon is four is four years.years.

Growth in free cash flows is not constant Growth in free cash flows is not constant during the forecast, so we can’t use the during the forecast, so we can’t use the constant growth formula to find the value of constant growth formula to find the value of operations at time 0. operations at time 0.

Growth is constant after the horizon (4 years), Growth is constant after the horizon (4 years), so we can modify the constant growth formula so we can modify the constant growth formula to find the value of all free cash flows beyond to find the value of all free cash flows beyond the horizon, discounted back to the horizon.the horizon, discounted back to the horizon.

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Horizon Value FormulaHorizon Value Formula

Horizon value is also called Horizon value is also called terminal valueterminal value, or , or continuingcontinuing valuevalue..

gWACC

)g1(FCFVHV t

ttimeatOp

36We repeat this for year 2003, 2004, We repeat this for year 2003, 2004, and 2005 and find FCFs as follows:and 2005 and find FCFs as follows:

2001

-18.0

2002

-23.0

2003

46.4

2004WACC=10.84%

49.0

2005…..

Free cash flow generally grow over time. Using the growth rate of 5%, we can estimate future free cash flows occurring beyond year 2005.

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Value of OperationValue of Operation

0

-18.0

2002

-23.0

2003

46.4

2004WACC=10.84%

49.0

2005 2006

g = 5%

51.45

Vop at 2005$51.45

$880.99 0.1084 – 0.05

Sum: $929.99

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Calculator SolutionCalculator Solution

Enter in CFj :

0

-18

-23

46.4

929.99

10.84

CF0

CF1

NPV

CF2

CF3

I/YR = 615.27

CF4

Value of Operation

=$615.27 million

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Total Corporate ValueTotal Corporate Value The MagnaVision’s total corporate The MagnaVision’s total corporate

value in 2001 is sum of value in 2001 is sum of Value of operations, $615.27 millionValue of operations, $615.27 million Value of nonoperating assetsValue of nonoperating assets

marketable securities, $63 millionmarketable securities, $63 million We take the face value from balance sheet We take the face value from balance sheet

because the short-term financial assets as because the short-term financial assets as reported on the balance sheet are at, or close reported on the balance sheet are at, or close to, their market value.to, their market value.

Thus, Total Corporate Value in 2001Thus, Total Corporate Value in 2001= $615.27 + $63 = $615.27 + $63

= $678.27 million= $678.27 million

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Claims on Corporate ValueClaims on Corporate Value

Debtholders have first claim.Debtholders have first claim. Preferred stockholders have the next Preferred stockholders have the next

claim.claim. Any remaining value belongs to Any remaining value belongs to

stockholders.stockholders.

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Value of EquityValue of Equity

Sources of Corporate ValueSources of Corporate Value Total value of the firm = $678.27 millionTotal value of the firm = $678.27 million

Claims on Corporate ValueClaims on Corporate Value Value of Debt = $247 millionValue of Debt = $247 million

Sum of notes payable ($123) and log-term Sum of notes payable ($123) and log-term debt ($124)debt ($124)

Accounts payable and accruals were netted Accounts payable and accruals were netted out earlier when calculating NOWC.out earlier when calculating NOWC.

Value of Preferred Stock = $62 millionValue of Preferred Stock = $62 million Value of Equity = ?Value of Equity = ?

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Value of Equity in 2001Value of Equity in 2001

Total corporate value = $678.27 millionTotal corporate value = $678.27 million

Value of equity = Total - Debt - Pref. Value of equity = Total - Debt - Pref. = $678.27 - $247 - $62= $678.27 - $247 - $62

= $369.27 million= $369.27 million

Value of Common Stock per Share Value of Common Stock per Share = $369.27 million / 100 million share= $369.27 million / 100 million share= $3.69= $3.69

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Market Value Added (MVA)Market Value Added (MVA) The difference between the market value The difference between the market value

of the firm’s stock and the amount of of the firm’s stock and the amount of equity capital that was supplied by equity capital that was supplied by shareholders.shareholders.

MVA = Total corporate value of firm minus MVA = Total corporate value of firm minus total book value of firmtotal book value of firm

Total book value of firm Total book value of firm = = BV of equity + BV of debt + BV of preferred stockBV of equity + BV of debt + BV of preferred stock

MVA = $678 - ($245 + $247 + $62)MVA = $678 - ($245 + $247 + $62)

= $124 million= $124 million

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Market Value Added (MVA)Market Value Added (MVA)

Or MVA Or MVA = = share outstanding*stock price – Total common share outstanding*stock price – Total common equityequity

= 100 million shares * $3.69 - $245 = 100 million shares * $3.69 - $245 millionmillion

= $369 – $245= $369 – $245

= $124 million= $124 million

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Economic Value AddedEconomic Value Added

Developed by Stern Stewart & Co.Developed by Stern Stewart & Co. www.sternstewart.com

EVA EVA

= NOPAT – After-tax dollar cost of = NOPAT – After-tax dollar cost of capital used to support operationscapital used to support operations

= EBIT(1 – T) – Operating Capital = EBIT(1 – T) – Operating Capital (WACC)(WACC)

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Economic Value AddedEconomic Value Added

Net income does not reflect the amount of Net income does not reflect the amount of equity capital employed.equity capital employed.

An estimate of a business’s true economic An estimate of a business’s true economic profit for the yearprofit for the year

The residual income that remains after the The residual income that remains after the cost of all capital, including equity capitalcost of all capital, including equity capital

EVA reflects an opportunity cost faced by EVA reflects an opportunity cost faced by shareholders because shareholders could shareholders because shareholders could have invested funds elsewhere.have invested funds elsewhere.

The extent to which the firm has added to The extent to which the firm has added to shareholder valueshareholder value

Useful basis for measuring managerial Useful basis for measuring managerial effectivenesseffectiveness

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EVA: MaginaVisionEVA: MaginaVision

EVA EVA

= EBIT(1 – T) – Operating Capital = EBIT(1 – T) – Operating Capital (WACC)(WACC)

= 73 (1 - 40%) – 491 (10.84%)= 73 (1 - 40%) – 491 (10.84%)

= -$9.42 million= -$9.42 million A negative EVA suggests that the A negative EVA suggests that the

company destroyed shareholder’s company destroyed shareholder’s value for the given year.value for the given year.

49www.sternstewart.comwww.sternstewart.com

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Agency problemAgency problem In typical corporations, ownership can be In typical corporations, ownership can be

spread over a huge number of stockholdersspread over a huge number of stockholders Principal-Agent problemPrincipal-Agent problem

Agency relationship exists when someone (the Agency relationship exists when someone (the principal) hires another (the agent) to represent principal) hires another (the agent) to represent his or her interest.his or her interest.

Shareholders hire mangers (e.g, CEO, CFO, and Shareholders hire mangers (e.g, CEO, CFO, and other mangers)other mangers)

The separation of ownership and The separation of ownership and management creates agency problem.management creates agency problem. Agency problem: the possibility of conflict of Agency problem: the possibility of conflict of

interest between the owners and management of interest between the owners and management of a firm. In to order to control the agency problem, a firm. In to order to control the agency problem, managerial compensation is closely tied to share managerial compensation is closely tied to share value of the firm. value of the firm.

Organizational Structures of Organizational Structures of CorporationCorporation

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Two Key Groups in CorporationTwo Key Groups in Corporation

FIRMInvestors

(StockholdersOr

Owners)

Managers(CEO, CFO)

The agency problem: Mangers won’t work for the firm’s owners unless it’s in their best interest! These two groups may have different goals. The separation of ownership and management creates conflicts. One way to mitigate conflicts is to offer stock options to mangers.

53How are entrenched managers How are entrenched managers

harmful to shareholders?harmful to shareholders?

Management act in the best interest of Management act in the best interest of themselves, not in the best interest of themselves, not in the best interest of shareholders.shareholders. Management consume perks such as lavish Management consume perks such as lavish

offices and corporate jets, excessively large offices and corporate jets, excessively large staffs, and memberships at country clubs.staffs, and memberships at country clubs.

More critically, management engages in More critically, management engages in non-value increasing activities.non-value increasing activities. Management accepts projects (or acquisitions) to Management accepts projects (or acquisitions) to

make firm larger, even if its value after the event make firm larger, even if its value after the event may go down.may go down.

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CEO Stock OptionsCEO Stock Options

Why are the corporations willing to Why are the corporations willing to provide stock options to CEOs?provide stock options to CEOs?

What does stock options have to do What does stock options have to do with agency problems?with agency problems?

55Stock Options in Compensation Stock Options in Compensation

PlansPlans

Gives owner of option the right to Gives owner of option the right to buy a share of the company’s stock buy a share of the company’s stock at a specified price (called the at a specified price (called the exercise price) even if the actual exercise price) even if the actual stock price is higher.stock price is higher.

Usually can’t exercise the option Usually can’t exercise the option for several years (called the for several years (called the vesting period or the expiration).vesting period or the expiration).

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