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### Chapter 10.doc

1. 1. Chapter 10 Corporate Valuation, Value-Based Management, and Corporate Governance ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 10-1 Operating assets include cash required for liquidity purposes, inventories, receivables, and fixed assets necessary to operate a business, while non-operating assets include financial assets like marketable securities (above the level needed for liquidity) and investments in other businesses. We make this distinction because we want to find the value of the firm’s operations as a going concern and then add the value of the non-operating assets to find the firm’s total value. This breakdown is useful in management, where line managers have control over operating assets but not over financial assets (which are under the control of top management and under the supervision of the treasurer). Managers are judged and compensated on the basis of the returns they produce on the operating assets under their control, and for this purpose it is essential to segregate assets over which managers do and do not have control. The breakdown is also useful when valuing firms for purposes of mergers, spin-offs, IPOs, and the like, because it is helpful to find the value of operations and the separate value of any non-operating asset the firm might hold. In the BOC model, we assume that all of the firm’s assets are needed in operations. These assets total to 70% of sales, or 0.7(\$200) = \$140 in 2001, and they are forecasted to grow over time at the same rate as sales. Net working capital is current assets minus the sum of A/P and accruals, which is (35% - 15%)(\$200) = 0.2(\$200) = \$40 in 2001. Again, this number is expected to grow with sales. 10-2 Free cash flow (FCF) is generally taken to mean the cash flow generated by operations less the new investment in operating assets required to keep the business going so that it can generate cash flows in the future. In other words, FCF is the amount of cash flow that can be paid out as dividends or interest, used to repurchase stock or retire debt, invested in assets to support growth, or invested in other businesses. FCF can be calculated as follows: FCF = NOPAT – Required investment in operating assets, where NOPAT = EBIT(1 – T), Investment = ∆ Net Operating W.C. + ∆ Net F.A. = [∆ Op. C.A. - ∆ (A/P and Accruals)] + ∆ Net F. A. FCF can be calculated for past years from the financial statements, but for valuation purposes the FCF of interest is the estimated future stream of FCF. For our firm in 2002, FCF is \$14.4 - \$14 - \$14 + \$6 = -\$7.6 as detailed in the model printout shown at the end of the answer. Answers and Solutions: 10 - 1
2. 2. The corporate valuation model is used to find the expected future FCF, and then the PV of the FCF is calculated to determine the value of the firm’s operations. The firm’s total value is the value of its operations plus the value of its non-operating assets. Note that the corporate valuation model can be applied to the various divisions or other units of a large firm as well as to the firm as a whole. This separation is useful when determining managerial compensation, and also when trying to determine the value of a division that the firm is thinking about selling. Note also that the FCF model requires less restrictive assumptions than the Discounted Dividends model because it calculates all cash flow that could be paid out, not just the amount of dividends that management chooses to pay out. Of course, the accuracy of the FCF model does depend on the accuracy of the cash flow forecast and the WACC discount rate (which in our example is the cost of equity, because the company uses no interest-bearing debt), and those forecasts are fraught with uncertainty, just as they are for the Discounted Dividends model. The Scenario analyses shown in the model output show how changes in the inputs can lead to huge changes in the firm’s valuation. 10-3 Value-based management means a system of management under which all significant decisions are evaluated in terms of their effects on the value of the firm using the corporate valuation model. For example, if the firm were considering changing its inventory procedures, it would estimate the effects of the change on its inventory requirement, production costs, and so on, and then run the model to see how inventory changes would affect value. So, value-based management simply makes decisions based on whether or not they increase the firm’s expected value. There is no economically efficient alternative to value-based management, although management in some firms consider the effects on the firm’s value subjectively rather than through the use of a quantitative model. In situations where the inputs required to use the model simply cannot be quantified, and the use of the model would just make a speculative guess look more precise than it really was, the subjective approach is probably appropriate. However, as computer power increases, and as corporate data bases become increasingly complete, it is becoming less and less necessary to make decisions in a purely judgmental manner, so the corporate model is being used to an ever-increasing extent in business. 10-4 EVA is Economic Value Added, defined back in Chapter 6 as follows: EVA = Operating income - Cost of all capital used to finance operations = EBIT(1-T) – WACC(Debt and Equity necessary to finance operating assets). EVA is determined annually, and it differs from year to year. For our firm in 2002, EVA = \$0.80, so the company is earning more than its cost of capital. MVA is Market Value Added, defined as the market value of the stock minus the book value of the equity: Answers and Solutions: 10 - 2
3. 3. MVA = (Shares outstanding * P0) - (Common stock + Retained earnings). In 2002, based on the FCF model, MVA is \$21.74, so the company has been successful over its lifetime. MVA changes from year to year, but it really reflects management’s effectiveness over the firm’s entire history. If management is doing a good job, then both EVA and MVA will be positive. Both can be estimated within the corporate valuation model. EVA for the just-passed year is often used to help determine the compensation for managers at all levels, while the MVA is used to help determine the compensation of the firm’s top managers, especially CEOs who have held that position for many years. 10-5 We often think of corporate managers as being focused on just one thing —shareholder wealth maximization. However, in truth managers are people, and many of them no more concentrate single-mindedly on wealth maximization than all students do on grade maximization. And, if a manager does not inherently focus on wealth maximization, then he or she will not necessarily make decisions based on the corporate valuation model. So, the field of corporate governance has been developed to help us understand how managers are likely to behave, and actions that stockholders can take to insure that managers—who are really employees of the stockholders—behave in a manner that is consistent with wealth maximization. a. Entrenched managers are ones who have a firm control over the firm’s board of directors and who cannot easily be replaced if they are ineffective or simply not interested in maximizing shareholder wealth. Entrenchment can obviously exist if the CEO and the other executives have a majority of the stock, but it can also exist through other means. Years ago, before the increase in institutional ownership of stock, managers controlled the proxy mechanism, and the thousands of small stockholders “voted with their feet” instead of voting incompetent managers out of office. So, in the past, management entrenchment and the inefficiencies it brings on was a huge problem that retarded economic efficiency. The increasing importance of institutional investors, who have so much stock that it is difficult for them to just sell out, has changed the situation, and management entrenchment has been significantly weakened, which is good. Other factors as discussed below have also impacted managerial entrenchment. Based on the analysis in the model, there is no obvious reason why stockholders would want to replace our firm’s managers. However, before reaching a firm conclusion on this, we would want to compare the firm’s performance to other firms in its industry. Also, potential raiders (a buyout firm or another corporation) would construct a model like ours, but more complete, and analyze the situation to determine if they could improve the company’s performance and thus derive a higher estimated value. See Chapter 25 for a discussion of mergers and buyouts. If they could, then they might try to take the firm over and earn a profit. b. Hostile takeovers have also reduced entrenchment. The concentration of ownership in institutional hands, and the development of the junk bond market for financing takeovers, has made hostile takeovers Answers and Solutions: 10 - 3
4. 4. easier, and that has led to the replacement of many ineffective management teams. Note that if a firm is operating at maximum efficiency, then it would be unlikely that any other firm or management group could take the company over, improve operations, and earn a profit. Thus, there is incentive for management to operate efficiently as shown by the corporate valuation model. c. Incentive compensation plans, such as those that pay managers (and even lower-level employees) in part with stock and options, and where the size of the awards are based on EVA, MVA, and other market-related metrics, are a key part of corporate governance, and they are designed to align managers’ interests with stockholders’ interests. If compensation is based on EVA and/or MVA, then management will have an incentive to operate on a value-based management system, plan to improve these metrics, and then try to implement the plans so that the predicted results occur. d. Greenmail is like blackmail, and it refers to a situation where a firm’s management buys the stock of a person or company that is threatening a takeover at price higher than the fair market price of the firm’s stock. Managements sometimes “pay greenmail” to ward off hostile takeovers and retain their entrenched positions. This is doubly bad for stockholders, because it (1) dissipates corporate assets and (2) leaves an ineffective management team in place. e. Poison pills refer to any action that a management might take to ward off a takeover. Originally, companies did things like build into debt contracts terms that would greatly increase the interest rate the firm was required to pay in the event of a takeover, hence they really were poison pills. Now, though, clever lawyers have devised a multitude of schemes to slow down if not thwart takeovers. The most common one today is a provision that gives a firm’s stockholders the right to buy, at a low price, shares of any firm that takes it over without management’s approval. A hostile takeover firm can get around this provision, and most other poison pills, given enough time, but the pills do give a firm’s managers time to mount defenses and head off takeovers at prices well below the firm’s true intrinsic value, often by bringing in another firm that is willing to pay more for the company (a “white knight”). Poison pills are not necessarily good or bad. They are good (from the target firm’s shareholders perspective) if they prevent takeovers at too low a price, but they are bad if they simply entrench an incompetent management. We have much more to say about takeovers in Chapter 25, which deals with mergers. f. A strong board of directors is one that is not controlled by the chairman of the board, that has competent independent (outside) directors, and that is willing to replace an ineffective management team. Some characteristics of a strong board are (1) outside directors as opposed to employees of the firm, (2) directors who do not have ties to the firm, such as one of its lawyers or other suppliers who get fees from the firm, (3) people who are financially independent and do not need their director fees, and (4) people who have a demonstrated ability in some capacity that relates to the firm’s business. Weak boards consist of insiders (whom the chairman can fire), cronies of the chairman, and people whose incomes and/or status are dependent on remaining on the board. Also, a board is Answers and Solutions: 10 - 4
5. 5. weakened if the CEOs of different boards are interlocked, as that leads to a “you scratch my back and I’ll scratch yours” attitude. It is useful for a firm to have on its board executives of companies that themselves practice value-based management, because such directors would be less tolerant of managers who do not consider the effects of their actions on stockholders in a rational manner. g. The vesting period refers to how soon options really belong to an employee. For example, an employee might be given options to buy 5,000 shares of stock, but only if he or she remains with the company for 3 years after the option was granted. Obviously, options cannot be exercised (and sold) until they have been vested. The vesting period helps to keep valuable employees from leaving the firm, and it also helps to make employees focus on actions that provide long-term as opposed to short-term benefits to the firm. h. An ESOP is an Employee Stock Ownership Plan. ESOPs provide significant tax advantages to companies, and they were authorized by Congress to encourage employee ownership of the companies they work for. ESOPs are fairly complicated, but in terms of corporate governance, if an ESOP owns a large block of a company’s stock, this often helps entrench management, because the employee-owners often rightly think that if the firm is taken over, there will be layoffs, so they vote with management and against the takeover firm. 10-6 In principle the two methods should give the same answers, provided they make the same underlying assumptions. However, in practice it is difficult to calibrate the two models so that they give the exact same answers. Over the short term the dividend level is basically a management choice, and the dividend growth model doesn’t have any built in mechanism to make sure that the assumed dividend payments are consistent with the amount of cash that the firm generates and its current capital structure. For an assumed dividend to be consistent in this fashion it must be a “residual dividend.” That is, small enough so that the firm is able to make all of its required investments without having to issue new stock or increase the proportion of debt in its capital structure, and large enough so that the firm doesn’t accumulate cash or pay down its debt. If the assumed dividend payment satisfies this condition, then the Discounted Dividends Model should give the same value for the firm as the Free Cash Flow Model. The examples below, in the BOC spreadsheet model, show the results of calculating the value of a firm using both models, along with the P/E multiple approach. Answers and Solutions: 10 - 5
6. 6. ANSWERS TO END-OF-CHAPTER QUESTIONS 10-1 a. Assets-in-place, also known as operating assets, include the land, buildings, machines, and inventory that the firm uses in its operations to produce its products and services. Growth options are not tangible. They include items such as R&D and customer relationships. Financial, or nonoperating, assets include investments in marketable securities and non-controlling interests in the stock of other companies. b. Operating current assets are the current assets used to support operations, such as cash, accounts receivable, and inventory. It does not include short-term investments. Operating current liabilities are the current liabilities that are a natural consequence of the firm’s operations, such as accounts payable and accruals. It does not include notes payable or any other short-term debt that charges interest. Net operating working capital is operating current assets minus operating current liabilities. Operating capital is sum of net operating working capital and operating long-term assets, such as net plant and equipment. Operating capital also is equal to the net amount of capital raised from investors. This is the amount of interest-bearing debt plus preferred stock plus common equity minus short-term investments. NOPAT is the amount of net income a company would generate if it had no debt and held no financial assets. NOPAT is a better measure of the performance of a company’s operations because debt lowers income. In order to get a true reflection of a company’s operating performance, one would want to take out debt to get a clearer picture of the situation. Free cash flow is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations. It is the most important measure of cash flows because it shows the exact amount available to all investors. Answers and Solutions: 10 - 6
7. 7. c. The value of operations is the present value of all the future free cash flows that are expected from current assets-in-place and the expected growth of assets-in-place when discounted at the weighted average cost of capital: ∞ FCFt Vop(at time 0) = ∑ . t = 1 ( 1 + WACC) t The terminal, or horizon value, is the value of operations at the end of the explicit forecast period. It is equal to the present value of all free cash flows beyond the forecast period, discounted back to the end of the forecast period at the weighted average cost of capital: FCFN + 1 FCFN (1 + g) Vop(at time N) = = . WACC − g WACC − g The corporate valuation model defines the total value of a company as the value of operations plus the value of nonoperating assets plus the value of growth options. d. Value-based management is the systematic application of the corporate value model to a company’s decisions. The four value drivers are the growth rate in sales (g), operating profitability (OP=NOPAT/Sales), capital requirements (CR=Capital/Sales), and the weighted average cost of capital (WACC). Return on Invested Capital (ROIC) is NOPAT divided by the amount of capital that is available at the beginning of the year. e. Managerial entrenchment occurs when a company has such a weak board of directors and has such strong anti-takeover provisions in its corporate charter that senior managers feel there is very little chance that they will be removed. Non-pecuniary benefits are perks that are not actual cash payments, such as lavish offices, memberships at country clubs, corporate jets, and excessively large staffs. f. Targeted share repurchases, also known as greenmail, occur when a company buys back stock from a potential acquiror at a higher than fair-market price. In return, the potential acquiror agrees not to attempt to take over the company. Shareholder rights provisions, also known as poison pills, allow existing shareholders in a company to purchase additional shares of stock at a lower than market value if a potential acquiror purchases a controlling stake in the company. A restricted voting rights provision automatically deprives a shareholder of voting rights if the shareholder owns more than a specified amount of stock. Answers and Solutions: 10 - 7
8. 8. g. A stock option allows its owner to purchase a share of stock at a fixed price, called the exercise price, no matter what the actual price of the stock is. Stock options always have an expiration date, after which they cannot be exercised. A restricted stock grant allows an employee to buy shares of stock at a large discount from the current stock price, but the employee is restricted from selling the stock for a specified number of years. An Employee Stock Ownership Plan, often called an ESOP, is a type of retirement plan in which employees own stock in the company. 10-2 The first step is to find the value of operations by discounting all expected future free cash flows at the weighted average cost of capital. The second step is to find the total corporate value by summing the value of operations, the value of nonoperating assets, and the value of growth options. The third step is to find the value of equity by subtracting the value of debt and preferred stock from the total value of the corporation. The last step is to divide the value of equity by the number of shares of common stock. 10-3 A company can be profitable and yet have an ROIC that is less than the WACC if the company has large capital requirements. If ROIC is less than the WACC, then the company is not earning enough on its capital to satisfy its investors. Growth adds even more capital that is not satisfying investors, hence, growth decreases value. 10-4 Entrenched managers consume to many perquisites, such as lavish offices, excessive staffs, country club memberships, and corporate jets. They also invest in projects or acquisitions that make the firm larger, even if they don’t make the firm more valuable. 10-5 Stock options in compensation plans usually are issued with an exercise price equal to the current stock price. As long as the stock price increases, the option will become valuable, even if the stock price doesn’t increase as much as investors expect. Answers and Solutions: 10 - 8
9. 9. SOLUTIONS TO END-OF-CHAPTER PROBLEMS 10-1 NOPAT = EBIT(1 - T) = 100(1 - 0.4) = \$60. Net operating WC03 = (\$27 + \$80 + \$106) - (\$52 + \$28) = \$213 - \$80 = \$133. Operating capital03 = \$133 + \$265 = \$398. Net operating WC04 = (\$28 + \$84 + \$112) - (\$56 + \$28) = \$224 - \$84 = \$140. Operating capital04 = \$140 + \$281 = \$421. FCF = NOPAT - Net investment in operating capital = \$100(0.6) - (\$421 - \$398) = \$37.0. 10-2 Value of operations = Vop = PV of expected future free cash flow FCF (1 + g ) \$400, (1.05) 000 Vop = = = \$6,000,000. WACC − g 0.12 − 0.05 \$108 000 , 10-3 a. Vop = = \$2,700,000. 2 0.12 − 0.08 b. WACC = 12% 1 0 2 = 8% g 3 N | | | | • • • | \$80,000 \$100,000 \$108,000 \$ 71,428.57 79,719.39 108 000 , 2,152,423.47 Vop = 2,700,000 = 0.04 2 \$2,303,571.43 Answers and Solutions: 10 - 9
10. 10. \$40 (1.07) 10-4 a. Vop = = \$713.33. 0.13 − 0.07 3 b. 0 1 2g = 7% 3 4 N WACC = 13% | | | | | • • • | -20 30 40 (\$ 17.70) 23.49 Vop3 = 713.33 522.10 753.33 \$527.89 c. Total valuet=0 = \$527.89 + \$10.0 = \$537.89. Value of common equity = \$537.89 - \$100 = \$437.89. \$437.89 Price per share = = \$43.79. 10.0 10-5 The growth rate in FCF from 2005 to 2006 is g=(\$750.00-\$707.55)/\$707.50 = 0.06. \$707.55 (1.06) VOp at 2005 = = \$15,000. 0.11 − 0.06  \$200,000,000  10-6 Vop = \$200,000,000 +  [0.09 − 0.10]  0.10 − 0.05  =\$200,000,000 + (-\$40,000,000)= \$160,000,000. MVA = \$160,000,000 - \$200,000,000 = -40,000,000. 10-7 Capital2007 = Sales2007 (0.43)= \$129,000,000. \$300 000 000 (1 + 0.05)  , ,  0.43  VOp at 2007 = \$129, , 000 000 +   0.06 − (0.098  1 + 0.05  )  0.098 − 0.05     000 000 + [\$6, , , ] [0.020] = \$129, , 562 500 000 = \$129, , 000 000 + \$130, , 375 000 = \$259, , 375 000. 10-8 Total corporate value = Value of operations + marketable securities = \$756 + \$77 = \$833 million. Value of equity = Total corporate value – debt – Preferred stock = \$833 – (\$151 + \$190) - \$76 = \$416 million. 10-9 Total corporate value = Value of operations + marketable securities = \$651 + \$47 = \$698 million. Value of equity = Total corporate value – debt – Preferred stock = \$698 – (\$65 + \$131) - \$33 = \$469 million. Price per share = \$469 / 10 = \$46.90. Answers and Solutions: 10 - 10
11. 11. 10-10 a. NOPAT2004 = \$108.6(1-0.4) = \$65.16 NOWC2004 = (\$5.6 + \$56.2 + \$112.4) – (\$11.2 + \$28.1) = \$134.9 million. Capital2004 = \$134.9 + \$397.5 = \$532.4 million. FCF2004 = NOPAT – Investment in Capital = \$65.16 – (\$532.4 - \$502.2) = \$65.16 - \$30.2 = \$34.96 million. b. HV2004 = [\$34.96(1.06)]/(0.11-0.06) = \$741.152 million. c. VOp at 12/31/2003 = [\$34.96 + \$741.152]/(1+0.11) = \$699.20 million. d. Total corporate value = \$699.20 + \$49.9 = \$749.10 million. e. Value of equity = \$749.10 – (\$69.9 + \$140.8) - \$35.0 = \$503.4 million. Price per share = \$503.4 / 10 = \$50.34. Answers and Solutions: 10 - 11
12. 12. SOLUTION TO SPREADSHEET PROBLEM 10-11 The detailed solution for the problem is available both on the instructor’s resource CD-ROM (in the file “Solution for Ch 10-11 Build a Model.xls”) and on the instructor’s side of the web site, http://brigham.swcollege.com. Answers and Solutions: 10 - 12
13. 13. Mini Case: 10 - 13