Financial Management Chapter 13 IM 10th Ed

8/2/2019 Financial Management Chapter 13 IM 10th Ed

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CHAPTER 13Managing for Shareholder Value

CHAPTER ORIENTATION

This chapter identifies methods to measure firm value and techniques that can be employedto assure management and the firm‘s board of directors make decisions that increase the

value of the firm. Increases in firm value lead to increases in stock value, which aligns withthe firm‘s goal of maximizing shareholder wealth. Measures such as free-cash flowvaluation, market value added, and economic value added can be used to evaluate the firm‘s

performance. Management of the firm can be provided compensation incentives that guidetheir decisions toward increasing the value of the firm.

CHAPTER OUTLINE

I. Top Creators of Shareholder Wealth

A. Market Value Added (MVA) measures wealth created by the firm

1. MVA = Firm value – invested capital

2. Firm value = market value of firm‘s outstanding debt and equity

securities

3. Invested capital = total funds invested in the firm

B. Value creation results from two activities:

1. Identifying performance measures linked to value creation that areunder management‘s control

2. Designing incentives to encourage employees to base decisions onthese performance metrics.

II. Business Valuation

A. Accounting model

1. Focuses on firm‘s earnings

2. Assumes increases (decreases) in earnings will lead directly to increases(decreases) in stock price based on the price-earnings relationship



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3. Decreases in current earnings may result in increases in future cashflows, which may increase firm value and stock price.

B. Free cash flow model

1. Focuses on firm‘s projected cash flows for all future years

a. Future years cash flows consist of the cash flows during aplanning period of a finite number of years and a terminalvalue of all years beyond the planning period

b. Firm value is calculated as

4)

wacck (1

4ValueTerminal

4

)wacc

k (1

4FlowCashFree

3

)wacc

k (1

3FlowCashFree

2

)wacc

k (1

2FlowCashFree

1

)wacc

k (1

1FlowCashFree

ValueFirm

Terminal value is calculated as

wacc

54

k

FlowCashFree ValueTerminal

2. Components of free cash flow values

a. Estimated revenues

b. Estimated net operating profits

c. Investment in net working capital

d. Capital expenditures3. Firm value equals market value of its debt and equity

III. Value Drivers

A. Managers can increase firm value by managing value drivers.

B. Using value drivers to increase firm value may increase equity value.

IV. Economic Value Added (EVA®)

A. EVA is the change in firm value during a specific time interval, usually 1 year

B. EVA is calculated as

1-t

CapitalInvested

)

wacc(k Capital

of Cost

AverageWeighted

(NOPAT)Tax

AfterProfit

OperatingNet

EVA t

t

C. EVA can also be calculated as

1twacctt (IC)Capital

Invested

)(k Capitalof Cost

AverageWeighted

(ROIC)CapitalInvestedonReturn

EVA



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V. Paying for Performance

A. Agency problems arise when firm ownership and management are separate.

B. Linking EVA measures to employee compensation encourages employees toact on behalf of owners

C. Compensation Policy

1. Three components of compensation are base pay, bonus, and long-term compensation

2. The mix of base pay and performance-based pay is important inattracting quality employees and achieving target performancemeasures.

3. Percentage of total compensation that is ‗at-risk‘ typically increases

with employee rank.

4. Incentive pay should be linked to achieving target performancemeasures.

a. Incentive pay can be calculated as

ePerformancTarget

ePerformancActual

Risk atPayof

Fraction

PayBase

PayIncentive

b. Bounded incentive pay rewards employees only when aminimum threshold of performance is achieved and caps thebonus payout at a maximum level of performance.

c. Unbounded incentive pay has no upper or lower bonus limits.

5. Incentive pay can be paid in cash, stock, or a combination of cash andstock.

a. Stock rewards employees for current and future performance.

b. Stock compensation may be the majority of CEO and Board of Directors‘ pay.

ANSWERS TOEND-OF-CHAPTER QUESTIONS

13-1. The accounting model of equity evaluation focuses on reported earnings inconjunction with the market‘s valuation of those earnings as reflected in the price-earnings ratio. For example, if the price-earnings ratio is 20 then a dollar increase inearnings per share should create $20 in additional equity value per share. Similarly,a one-dollar loss in earnings per share may lead to a drop of $20 in share value.



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The accounting model has its limitations, however. For example, this method relieson historical earnings and ignores other factors that may influence the share value inthe market.

13-2. The free cash flow valuation model provides a method for analyzing firm value asthe present value of the firm's projected free cash flows.

13-3. A. Sales growth —annual growth of revenues. Steps a firm‘s management can

take to manage its sales growth:

Implement a new promotional campaign to promote existing or new products.

Form a distributional alliance to enter a new market.

Invest in R&D to create new products.

Acquire a competitor‘s firm.

B. Operating profit margin —net operating income as a percent of a firm‘s

revenue. Steps that can be taken to manage the operating profit margin:

Initiate cost control programs to reduce operating and administrativeexpenses.

Invest in a promotional campaign aimed at improving the brandimage of the firm’s products or services in an effort to support

premium-pricing policies.

C. Net working capital to sales ratio — the percent of new investments in currentassets (excluding the part financed by non-interest bearing liabilities) relative

to firm sales. Steps to manage the net working capital to sales ratio: Initiate inventory control policies designed to reduce the time that

inventory is held before sale.

Implement a program of credit analysis and control designed to either decrease the time customers take to pay for their purchases or toincorporate penalties for late payment.

Negotiate more lenient credit terms from the firm’s suppliers.

D. Property, plant, and equipment to sales ratio — the percent of firm sales that isinvested in property, plant, and equipment. Steps to manage the property,

plant, and equipment to sales ratio: Consider outsourcing of production to strategic partners who might be

more efficient in their operations so as to reduce the firm’s need for

plant and equipment.

Implement stringent controls over the acquisition of new plant andequipment to assure that all purchases are economically viable.



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Improve maintenance of existing plant and equipment to improveoperating time, which reduces the need for additional plant andequipment.



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13-4. Economic Value Added (EVA) measures the change in firm value over a specificperiod of time. Managers of a firm use EVA to evaluate the performance of the firmover specific intervals of time, usually one year. EVA for a particular year (e.g., yeart

) is defined as follows:

1tCapital

Invested

)wacc

(k Capitalof CostAverageWeighted

(NOPAT)Tax

AfterProfitOperatingNet

EVA t

t

An alternative definition of EVA is:

1twacct

t (IC)CapitalInvested

)(k Capitalof Cost

AverageWeighted(ROIC)CapitalInvestedReturn

EVA

EVA is related to MVA in the following way: MVA is the present value of all futureEVAs over the life of the firm. Thus, managing the firm in ways that increase EVAwill generally lead to a higher MVA.

13-5. Fundamental components of a firm‘s compensation program:

A. Base pay is the fixed salary component of compensation.

B. Bonus payment. This is generally a quarterly, semi-annual, or annual cashpayment that is dependent upon firm performance compared to targets set atthe beginning of the period. EVA provides one such performance measurethat can be used in this regard.

C. Long-term compensation. This consists of stock options and grants that arealso made periodically to employees. This type of compensation is the mostdirect method available to the firm to align the interests of the firm‘s

employees with those of its shareholders.

Note that both bonus and long-term compensation are at-risk in that they are bothdependent upon performance of the individual and the firm. We often use the termincentive or performance-based compensation to describe this at-risk component of managerial compensation.

13-6. The four basic issues that every firm‘s compensation program must address are:

A. How much to pay for a particular job

B. The portion of the total compensation package should be in base salary andthe portion should be incentive based

C. How to link incentive pay to performanceD. The portion of the incentive pay to be paid as a cash bonus and the portion to

be paid in long-term (equity) compensation

Issue #1: How much to pay?

How much to pay for a particular job is dictated by market forces. This means that a firmmust be constantly comparing its pay scales with the labor market because the firm willonly be able to hire good employees where it offers a competitive level of total



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compensation. The size of the total compensation package may determine whereemployees go to work, but the mix of base pay and performance based pay willdetermine how hard they will work.

Issue #2: Base pay versus at-risk or incentive compensationUsually a firm's highest-ranking employees generally have a larger fraction of theirtotal compensation ―at-risk‖ and the fraction declines with the employee's rank in the

firm. Most firms base the at-risk fraction of an em ployee‘s compensation on either salary level or responsibilities. This often mirrors the responsibilities of the firm‘s

top managers and their ability to control firm performance.

Issue #3: Linking incentive compensation to performance

The third issue in designing a compensation program relates to choosing a functionalrelationship between performance and pay for the incentive portion of thecompensation package. The basic formula for specifying this relationship is:

ePerformancTarget

ePerformancActual

Risk -at

Payof

Fraction

Pay

Base

Pay

Incentive

There are two types of incentive compensation plans based on the above formula.The first type is called unbounded incentive compensation plan. This means in theabove equation there are no limits specified as to the maximum or minimum levelsof incentive pay that can be earned.

The other type is called bounded incentive compensation plan. This system providesfor a minimum or threshold level of performance (in relation to the target level)

before the incentive plan kicks in, and a maximum level of performance (again inrelation to the target) above which no incentive pay is rewarded. Consequently,incentive compensation is only paid for performance levels that fall within theminimum and maximum levels.

Issue #4: Paying with a cash bonus versus equity

A firm can pay its compensation plan in cash, stock or some mixture of the two. If the firm chooses stock then the employees are rewarded for current performance andare also provided with a long-term incentive to improve performance. Equity-basedcompensation is an important and valuable tool in a firm‘s compensation package.

Solutions to Problem Set A

13-1A.

Given:

Earnings for 2001 per share $ 1.90Closing stock price for 2001 $25.50



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Estimated earnings per share for 2002 $ 1.06

Price-earnings ratio: Closing stock price/earnings per share 13.42

Estimated stock price for 2002: Price-earnings ratio estimated earnings

per share for 2002 $14.23

13-2A.

Given:Sales growth for years 1-3 10.0%

Operating profit margin 16.0%

Net working capital to sales ratio 13.0%

Property, plant, and equipment to sales ratio 18.0%

Beginning sales $ 27,272.73

Cash tax rate 30.0%

Total liabilities $ 4,000.00

Cost of capital 12.0%

Number of shares 2,000.00

FREE CASH FLOWS:

Years

1 2 3 4

Sales $30,000.00 $33,000.00 $36,300.00 $36,300.00

Operating income (Earnings Before Interest and Taxes) 4,800.00 5,280.00 5,808.00 5,808.00

Less cash tax payments (1,440.00) (1,584.00) (1,742.40) (1,742.40)

Net operating profits after taxes (NOPAT) $ 3,360.00 $ 3,696.00 $ 4,065.60 $ 4,065.60

Less investments:

Investment in Net Working Capital (354.55) (390.00) (429.00) -

Capital expenditures (CAPEX) (490.91) (540.00) (594.00) -

Total investments $ (845.46) $ (930.00) $ (1,023.00) $ -

Free cash flow $ 2,514.54 $ 2,766.00 $ 3,042.60 $ 4,065.60

PV of FCF 2,245.13 2,205.04 2,165.66 $24,115.11

Present value of free cash flows:

Planning horizon cash flows $ 6,615.83

Terminal value in year 4: 33,880.00

PV of terminal value $ 24,115.11

a) Firm value $ 30,730.94

Invested capital (year 0) $ 9,818.18

b) Market Value Added $ 20,912.76

Debt $ 4,000.00

Shareholder value ($30,730.94 – 4,000) $ 26,730.94

No. of shares



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c) Value per share $ 13.37



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13-3A.

Sales growth for years 1-3 10.0%


Net working capital to sales ratio 13.0%Current assets to sales ratio 18.0%

Property, plant, and equipment to sales ratio 18.0%

Beginning sales $27,272.73

Cash tax rate 30.0%




Years

0 1 2 3 4

Change in current assets $ 354.55 $ 390.00 $ 429.00 $ -

Current assets $ 4,909.09 $ 5,263.64 $ 5,653.64 $ 6,082.64 $ 6,082.64Capital expenditures $ 490.91 $ 540.00 $ 594.00 $ -

Property, plant and equipment 4,909.09 $ 5,400.00 $ 5,940.00 $ 6,534.00 $ 6,534.00

Total Capital = Total Assets - Non-interestliabilities

$ 9,818.18 $10,663.64 $11,593.64 $12,616.64 $12,616.64

a) Calculation of EVA:Years

0 1 2 3 4 and beyond

Sales $30,000.00 $33,000.00 $36,300.00 $ 36,300.00

Operating income 4,800.00 5,280.00 5,808.00 $ 5,808.00


Net operating profits after taxes (NOPAT) $3,360.00 $ 3,696.00 $ 4,065.60 $ 4,065.60

Less capital charge (Invested Capital xKwacc)

$(1,178.18) $(1,279.64) $ (1,391.24) $ (1,514.00)

Economic Value Added $2,181.82 $2,416.36 $ 2,674.36 $ 2,551.60

Invested Capital $ 9,818.18 $ 10,663.64 $11,593.64 $12,616.64 $12,616.64

b) Return on Invested Capital

(NOPATt ICt-1) 34.22% 34.66% 35.07% 32.22%

c) Market Value Added = PV(EVAs) $20,640.89

Plus Invested Capital (year 0) 9,818.18

Firm Value $31,459.07

a. The EVAs are positive each year, indicating Bergman is creating value for its

shareholders.

b. The ROIC is greater than the cost of capital, so the firm is creating value for itsshareholders. When the ROIC is greater than the cost of capital, we should seepositive EVAs.

c. The present value of the EVAs exceeds the market value added in Problem 13-2A.



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13-4A.Given:

Base pay $ 100,000.00Incentive % 20.00%

Target EVA Performance $ 20,000,000.00

a. Unbounded incentive plan

Scenario A Scenario B Scenario C

Actual EVA Performance $ 15,000,000 $ 20,000,000 $ 30,000,000

Plant Manager Compensation

Base pay $ 100,000.00 $ 100,000.00 $ 100,000.00

Incentive pay 15,000.00 20,000.00 30,000.00

Total compensation $ 115,000.00 $ 120,000.00 $ 130,000.00

b. Bounded incentive plan (80/120)


Actual EVA Performance $15,000,000 $20,000,000 $30,000,000

Plant Manager Compensation

Base pay $ 100,000.00 $ 100,000.00 $ 100,000.00

Incentive pay - 20,000.00 24,000.00


This plan encourages employees to meet targets only within range of performancewhere payout varies with performance (between floor and cap). Employees have no

incentive to improve performance if below floor or above cap.

SOLUTION TO

INTEGRATIVE PROBLEM

A. From the financial statements of RealNetworks over the 1996-98 period we can tellthat it did not earn profit. Indeed, it suffered increasing losses in every year, and in1998, the firm lost over $20 million.

B. The invested capital for RealNetworks at the end of 1998 should be the sum of thecurrent figure of total assets less noninterest-bearing liabilities in its balance sheet

and part of the marketing and R&D expenditure it paid but will generate value infuture years.

Charging the full marketing and R&D expenditures against revenues in the year inwhich the expenditures are made will distort total assets as an indication of the firm‘sinvested capital. The investment in marketing and R&D does not create value onlyfor the year it is made. Actually, it will bring benefits for the company in severalfuture years. Therefore, putting the whole amount in the income statement for one



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year cannot properly reveal the company‘s performance for that year because the

revenue the company created only related to a part of the total investment inmarketing and R&D.



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C. The EVA for year t is defined as following:

1twacct

t

Capital

Invested

)(k Capital

of CostAverageWeighted

(NOPAT)Tax

AfterProfitOperatingNet

EVA

Using the GAAP financial reports of 1998, assuming that the invested capital equalstotal assets – accounts payable – accrued expenses – other current liabilities – deferred revenue, and weighted average cost of capital is 20%, we get the followingresult:

EVA1998 = (-20840) – (20% x 78,865) = -36,613

However, as we discussed in part B, NOPAT is understated since we put the entiremarketing and R&D expenditure for 1998 in the GAAP accounting earnings sheetfor that year. Invested capital is also understated for the same reason. If we amortize

the marketing and R&D expenditures over several years, during which it willgenerate value, our EVA result will be positive.

Solutions to Problem Set B

13-1B.

Given:

Earnings for 2001 per share $ 0.87Closing stock price for 2001 $ 16.06Estimated earnings per share for 2002 $ 1.09

Price-earnings ratio: Closing stock price/ earnings per share 18.46

Estimated stock price for 2002: Price-earnings ratio estimatedearnings per share for 2000 $ 20.12



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13-2B.

Given:



Net working capital to sales ratio 13.0%

Property, plant and equipment to sales ratio 18.0%


Cash tax rate 28%



No. of shares 4,000.00

FREE CASH FLOWS: Years

1 2 3 4

Sales $ 34,500.00 $ 37,950.00 $ 41,745.00 $ 41,745.00

Operating income (Earnings Before Int. & Taxes) 5,865.00 6,451.50 7,096.65 7,096.65


Net operating profits after taxes (NOPAT) $ 4,222.80 $ 4,645.08 $ 5,109.59 $ 5,109.59

Less investments:

Investment in Net Working Capital (407.73) (448.50) (493.35) -

Capital expenditures (CAPEX) (564.55) (621.00) (683.10) -

Total investments $ (972.28) $ (1,069.50) $ (1,176.45) $ -

Free cash flow $ 3,250.52 $ 3,575.58 $ 3,933.14 $ 5,109.59

PV of FCF 2,826.54 2,703.65 2,586.10 $ 22,397.59

Present value of free cash flows:

Planning horizon $ 8,116.29

Terminal value

In year 10: 34,063.93

PV of terminal value $ 22,397.59

a) Firm value $ 30,513.88

Invested capital in year (0) 11,290.91

b) Market Value Added $ 19,222.97c) Calculation of equity value

Firm Value $ 30,513.88

Less: Debt $ 6,000.00

Equals: Shareholder value $ 24,513.88


Value per share $ 6.13



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13-3B.Given:



Net working capital to sales ratio 13.0%Current assets to sales ratio 18.0%

Property, plant and equipment to sales ratio 18.00%


Cash tax rate 28.00%




Years

0 1 2 3 4

Change in current assets $ 407.73 $ 448.50 $ 493.35 $ -

Current assets $ 5,645.45 $ 6,053.18 $ 6,501.68 $ 6,995.03 $ 6,995.03

Capital expenditures $ 564.55 $ 621.00 $ 683.10 $ -

Property, plant and equipment 5,645.45 $ 6,210.00 $ 6,831.00 $ 7,514.10 $ 7,514.10

Total Capital = Total Assets - Non-interest $ 11,290.90 $12,263.18 $13,332.68 $14,509.13 $14,509.13

liabilities (Invested Capital)

a) Calculation of EVA:

Years

0 1 2 3 4 & beyond

Sales $34,500.00 $37,950.00 $41,745.00 $ 41,745.00

Operating income 5,865.00 6,451.50 7,096.65 7,096.65

Less cash tax payments (1,642.20) (1,806.42) (1,987.06) (1,987.06)Net operating profits after taxes (NOPAT) $ 4,222.80 $ 4,645.08 $ 5,109.59 $ 5,109.59

Less capital charge (Invested Capital x Kwacc) $(1,693.64) $(1,839.48) $ (1,999.90) $(2,176.37)

Economic Value Added $ 2,529.16 $ 2,805.60 $ 3,109.69 $ 2,933.22

b) Return on Invested Capital

(NOPATt ICt-1) 37.40% 37.88% 38.32% 35.22%

c) MVA and the present value of future

EVAs

Market Value Added = PV(EVAs) $ 19,996.52

Plus Invested Capital (year 0) 11,290.90

Firm Value $31,287.42

a. The EVAs are positive each year, indicating the Bergman is creating value for its

shareholders.b. The ROIC is greater than the cost of capital, so the firm is creating value for itsshareholders. When the ROIC is greater than the cost of capital, the EVAs are positive.c. The present value of the EVAs exceeds the market value added in Problem 13-2B.



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13-4B.Given:

Base pay $ 150,000

Incentive % 30.00%

Target EVA Performance $30,000,000

a. Unbounded incentive plan



Division Manager Compensation

Base pay $ 150,000.00 $ 150,000.00 $ 150,000.00

Incentive pay 30,000.00 45,000.00 60,000.00


b. Bounded incentive plan (80/120)



Division Manager CompensationBase pay $ 150,000.00 $ 150,000.00 $ 150,000.00

Incentive pay - 30,000.00 54,000.00


This plan encourages employees to meet targets within range of performance wherepayout varies with performance (between floor and cap). Employees have no incentive toimprove performance if below floor or above cap.

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Financial Management Chapter 13 IM 10th Ed