Corporate Valuation, Value-Based Management, and
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
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
FCF can be calculated as follows:
FCF = NOPAT – Required investment in operating assets,
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
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
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
= EBIT(1-T) – WACC(Debt and Equity necessary to finance
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
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
MVA = (Shares outstanding * P0) - (Common stock + Retained
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
easier, and that has led to the replacement of many ineffective
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’
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
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
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
Answers and Solutions: 10 - 5
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
Answers and Solutions: 10 - 6
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:
Vop(at time 0) = ∑ .
t = 1 ( 1 + WACC)
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
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
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
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
10-4 a. Vop = = $713.33.
0.13 − 0.07
b. 0 1 2g = 7% 3 4 N
WACC = 13% |
| | | | • • • |
-20 30 40
c. Total valuet=0 = $527.89 + $10.0 = $537.89.
Value of common equity = $537.89 - $100 = $437.89.
Price per share = = $43.79.
10-5 The growth rate in FCF from 2005 to 2006 is g=($750.00-$707.55)/$707.50
VOp at 2005 = = $15,000.
0.11 − 0.06
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, ,
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
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
Price per share = $503.4 / 10 = $50.34.
Answers and Solutions: 10 - 11
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,
Answers and Solutions: 10 - 12