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CHAPTER 13
1
Corporate Valuation,
Value-Based Management andCorporate Governance
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Topics in Chapter
Corporate ValuationValue-Based Management
2
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FCF FCF FCF
Free cash flow(FCF)
Net operatingprofit after taxes
Required investmentsin operating capital
=
Intrinsic Value: Putting the Pieces Together
3
Value = + +
+(1 + WACC)1 (1 + WACC)(1 + WACC)2
Market interest rates
Firms business riskMarket risk aversion
Firms debt/equity mix
Cost of debt
Cost of equity
Weighted averagecost of capital
(WACC)
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Corporate Valuation: A companyowns two types of assets.
Assets-in-place Financial, or nonoperating, assets
4
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Dave Tufte
Its not quite clear here: the big issue isthat the value of assets-in-place could
Book value
Market value
Ability to generate cash flow
5
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Dave Tufte
We prefer a free cash flow basis forvaluing assets in place
Market values arent always clear if yourenot trying to sell the assets
Free cash flow can be measured off ofaccounting statements
6
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Assets-in-Place
Assets-in-place are tangible, such asbuildings, machines, inventory.
7
.
They generate free cash flows.
The PV of their expected future free
cash flows, discounted at the WACC, isthe value of operations.
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Value of Operations
8
Vop =t = 1
t
(1 + WACC)t
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Nonoperating Assets
Marketable securities Ownership of non-controlling interest in
9
Value of nonoperating assets usually isvery close to figure that is reported on
balance sheets.
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Total Corporate Value
Total corporate value is sum of:Value of operations
10
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Claims on Corporate Value
Debtholders have first claim. Preferred stockholders have the next
11
.
Any remaining value belongs tostockholders.
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Applying the CorporateValuation Model
Forecast the financial statements, asshown in Chapter 12.
Calculate the ro ected free cash flows.
12
Model can be applied to a company thatdoes not pay dividends, a privately heldcompany, or a division of a company,since FCF can be calculated for each ofthese situations.
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Data for Valuation
FCF0 = $24 million WACC = 11%
=
13
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: ConstantFCF Growth at Rate of g
FCFt
14
op t = 1 (1 + WACC)t
=
t = 1
FCF0(1+g)t
(1 + WACC)t
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Constant Growth Formula
Notice that the term in parentheses isless than one and gets smaller as t gets
15
larger. As t gets very large, termapproaches zero.
Vop =t = 1
FCF01 + WACC
1+ g t
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Constant Growth Formula(Cont.)
The summation can be replaced by asingle formula:
16
Vop =FCF1
(WACC - g)
=FCF0(1+g)
(WACC - g)
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Find Value of Operations
Vop =FCF0 (1 + g)
(WACC - g)
17
Vop
=24(1+0.05)
(0.11 0.05)= 420
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Total Value of Company (VTotal)
Voperations $420.00+ ST Inv. 100.00
18
otal
.
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Intrinsic Value of Equity (VEquity)
Voperations $420.00+ ST Inv. 100.00
19
ota .
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
20
ota .
Preferred Stk. 50.00
Debt 200.00
VEquity $270.00 n 10
P $27.00
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Dave Tufte
All firms envision themselves as addingsome value (through their brilliance )
such as dumb doctors The market valuation of this is intrinsic
MVA
Broadly, its similar to goodwill
We cant value it directly, but we can back outits value
21
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Intrinsic Market Value Added(MVA)
Intrinsic MVA = Total corporate value of firmminus total book value of capital supplied byinvestors
22
=equity + book value of debt + book value ofpreferred stock
MVA = $520 - ($210 + $200 + $50)
= $60 million
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Breakdown of Corporate Value
400
500
600 Intrinsic MVA
Book equity
23
0
100
200
300
Sources
of Value
Claims
on Value
Market
vs. Book
EquityPreferred stock
Debt
Marketablesecurities
Value of operations
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Dave Tufte
Its not clear that what follows is anexample for a
,
The same firm in a different situation
So, its comparable, but be careful
I think this was just carelessness on thepart of the Powerpoint shows authors
24
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Expansion Plan: NonconstantGrowth
Finance expansion by borrowing $40million and halting dividends.
Pro ected free cash flows FCF :
25
Year 1 FCF = -$5 million.Year 2 FCF = $10 million.
Year 3 FCF = $20 million
FCF grows at constant rate of 6% afteryear 3.
(More)
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The weighted average cost of capital,WACC, is 10%.
26
stock.
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Horizon Value
Free cash flows are forecast for threeyears in this example, so the forecast
27
Growth in free cash flows is notconstant during the forecast, so we
cant use the constant growth formulato find the value of operations at time0.
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Horizon Value (Cont.)
Growth is constant after the horizon (3years), so we can modify the constant
28
free cash flows beyond the horizon,discounted back to the horizon.
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Horizon Value Formula
FCFt(1+g)
29
Horizon value is also called terminalvalue, or continuing value.
op a me
(WACC - g)
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Value of operations is PV ofFCF discounted by WACC.
0 1 2 3WACC =10% g = 6%
30
FCF3(1+g)
(1+WACC)4.545
8.264
15.026
398.197
416.942 = Vop
.
$20(1.06)
0.100.06
$530 =Vop at 3
$530/(1+WACC)3
. .
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Intrinsic Stock Price per Share, P
Voperations $416.942+ ST Inv. 0
31
ota .
Preferred Stk. 0
Debt 40.000
VEquity $376.942 n 10
P $37.69
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Value-Based Management(VBM)
VBM is the systematic application of thecorporate valuation model to all
32
initiatives. The objective of VBM is to increase
Market Value Added (MVA)
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Dave Tufte
Careful Capital requirements on the next slide are
a ratio not a total
33
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MVA and the Four ValueDrivers
MVA is determined by four drivers: Sales growth
34
Capital requirements (CR=Operatingcapital / Sales)
Weighted average cost of capital
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Dave Tufte
How MVA is driven Positively related to sales growth
Negatively related to WACC
Negatively related to capital requirements
35
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Dave Tufte
A big formula follows, that does getexplained over the following several
It is derived in the text in Section 13.3
36
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MVA for a Constant GrowthFirm
MVAt =
37
OP WACCCR
(1+g)Salest(1 + g)
WACC - g
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Dave Tufte
You can think of the first term (on thenext slide) as gross cash inflows
38
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Insights from the Constant
Growth Model
The first bracket is the MVA of a firm thatgets to keep all of its sales revenues (i.e.,
39
that never has to make additionalinvestments in operating capital.
Salest(1 + g)
WACC - g
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Dave Tufte
You can think of the second term (onthe next slide) as how much the firm
A margin of gross cash inflows, minus
How much of that has to be paid back toinvestors
40
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Insights (Cont.)
The second bracket is the operatingprofit (as a %) the firm gets to keep,less the return that investors require for
41
having tied up their capital in the firm.
OP WACC CR(1+g)
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Dave Tufte
The last term on the previous slide isvery similar to the first term in the MVA
Substitute out CR with its definition
Use the approximation for dividing by 1+g
42
d
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Improvements in MVA due to
the Value Drivers
MVA will improve if: WACC is reduced
43
the capital requirement (CR) decreases
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The Impact of Growth
The second term in brackets can be eitherpositive or negative, depending on therelative size of profitability, capital
44
requirements, and required return byinvestors.
OP WACC CR(1+g)
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The Impact of Growth (Cont.)
If the second term in brackets isnegative, then growth decreases MVA.
45
to offset the return on capital requiredby investors.
If the second term in brackets ispositive, then growth increases MVA.
E t d R t I t d
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Expected Return on Invested
Capital (EROIC)
The expected return on invested capitalis the NOPAT expected next period
46
divided by the amount of capital that iscurrently invested:
EROICt = NOPATt+1
Capitalt
OPt+1
CRtCapitalt
=
MVA i T f E t d
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MVA in Terms of Expected
EROIC and Value Drivers
MVAt = Capitalt (EROICt WACC)WACC - g
47
If the spread between the expected return, EROICt,and the required return, WACC, is positive, then MVAis positive and growth makes MVA larger. Theopposite is true if the spread is negative.
MVAt = Capitalt (OPt+1/CRt WACC)WACC - g
MVA i T f E t d
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MVA in Terms of Expected
EROIC
MVAt =Capitalt (OPt+1/CRt WACC)
WACC - g
48
If the spread between the expected return, EROICt,and the required return, WACC, is positive, then MVAis positive and growth makes MVA larger. Theopposite is true if the spread is negative.
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Dave Tufte
What follows is just an example, but itpoints out that there is a tradeoff
capital requirements that can produce apitfall for management (withoutadequate financial advice) about how to
proceed
49
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The Impact of Growth on MVA
A company has two divisions. Both havecurrent sales of $1,000, current expectedgrowth of 5%, and a WACC of 10%.
50
Division A has high profitability (OP=6%) buthigh capital requirements (CR=78%).
Division B has low profitability (OP=4%) but
low capital requirements (CR=27%).
What is the impact on MVA if
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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%
51
Growth 5% 6% 5% 6%MVA (300.0) (360.0) 300.0 385.0
Note: MVA is calculated using the formulaon slide 13-28.
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Expected ROIC and MVA
Division A Division B
Capital0 $780 $780 $270 $270
52
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 of Growth Strategies
The expected ROIC of Division A is less thanthe WACC, so the division should postponegrowth efforts until it improves EROIC by
53
reducing capital requirements (e.g., reducinginventory) and/or improving profitability.
The expected ROIC of Division B is greater
than the WACC, so the division shouldcontinue with its growth plans.
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Dave Tufte
Recall that on my pink sheet of thingswe dont know in finance, is that it isnt
liability so much of the time.A lot of this has to do with mismanaging
value
54
Six Potential Problems with
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Six Potential Problems with
Managerial Behavior
Expend too little time and effort. Consume too many nonpecuniary
55
.
Avoid difficult decisions (e.g., closeplant) out of loyalty to friends in
company.
(More . .)
Six Problems with Managerial
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Six Problems with Managerial
Behavior (Continued)
Reject risky positive NPV projects to avoidlooking bad if project fails; take on riskynegative NPV projects to try and hit a home
56
run.
Avoid returning capital to investors by makingexcess investments in marketable securitiesor by paying too much for acquisitions.
Massage information releases or manageearnings to avoid revealing bad news.
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Dave Tufte
The key to mitigating these is notavoiding them
avoided Instead, you need to have mechanisms
to avoid letting management getentrenched
57
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Corporate Governance
The set of laws, rules, and proceduresthat influence a companys operations
58
managers. Sticks (threat of removal)
Carrots (compensation)
Corporate Governance Provisions
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Corporate Governance Provisions
Under a Firms Control
Board of directors Charter provisions affecting takeovers
59
Capital structure choices
Internal accounting control systems
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Effective Boards of Directors
Election mechanisms make it easier forminority shareholders to gain seats:
60
. .,
members elected each year, not just thosewith multi-year staggered terms)
Board elections allow cumulative voting
(More . .)
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Effective Boards of Directors
CEO is not chairman of the board anddoes not have undue influence over the
61
Board has a majority of outsidedirectors (i.e., those who do not haveanother position in the company) withbusiness expertise.
(More . .)
Effective Boards of Directors
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Effective Boards of Directors(Continued)
Is not an interlocking board (CEO ofcompany A sits on board of company B,
62
Board members are not unduly busy(i.e., set on too many other boards orhave too many other business activities)
(More . .)
Effective Boards of Directors
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Effective Boards of Directors(Continued)
Compensation for board directors isappropriate
63
with CEO Not all compensation is fixed salary (i.e.,
some compensation is linked to firm
performance or stock performance)
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Dave Tufte
The next slide is things to be avoided
64
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Anti-Takeover Provisions
Targeted share repurchases (i.e.,greenmail)
65
. .,
poison pills) Restricted voting rights plans
Stock Options in
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p
Compensation Plans
Gives owner of option the right to buy ashare of the companys stock at a
66
exercise price) even if the actual stockprice is higher.
Usually cant exercise the option forseveral years (called the vestingperiod).
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Stock Options (Cont.)
Cant exercise the option after a certainnumber of years (called the expiration,
67
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Dave Tufte
This text doesnt say anything aboutbackdating on the next slide
,
but it is current
68
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Problems with Stock Options
Manager can underperform market orpeer group, yet still reap rewards from
69
increases to above the exercise cost. Options sometimes encourage
managers to falsify financial statementsor take excessive risks.
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Dave Tufte
I think the next slide is a load of cr*p. Increasingly blockholders foster
conservatism in mana ers
We need more obnoxious blockholders like Kirk Kerkorian
We need less CALPers and TIAA-CREF
This is a knock on those organizations I think they can do better
70
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Block Ownership
Outside investor owns large amount(i.e., block) of companys shares
71
,
TIAA-CREF Blockholders often monitor managers
and take active role, leading to better
corporate governance
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Regulatory Systems and Laws
Companies in countries with strongprotection for investors tend to have:
72
A lower cost of equity Increased market liquidity
Less noise in stock prices