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ADAPTED FOR THE SECOND CANADIAN EDITION BY: THEORY & PRACTICE JIMMY WANG LAURENTIAN UNIVERSITY FINANCIAL MANAGEMENT
CHAPTER 23 CORPORATE VALUATION, VALUE- BASED MANAGEMENT, AND CORPORATE GOVERNANCE
CHAPTER 23 OUTLINE Overview of Corporate Valuation The Corporate Valuation Model Value-Based Management Managerial Behaviour and Shareholder Wealth Corporate Governance Copyright © 2014 by Nelson Education Ltd. 23-3
Copyright © 2014 by Nelson Education Ltd. 23-4
Overview of Corporate Valuation Managers often forecast financial statements under alternative strategies, finding the present value of each strategy’s cash flow stream, and then choose the one with the maximum present value. The dividend growth model is often unsuitable for managerial purposes considering start-up companies, firms not paying dividends, or firms with divisions. The corporate valuation model fits in. Copyright © 2014 by Nelson Education Ltd. 23-5
Overview of Corporate Valuation (cont’d) The corporate valuation model shows how corporate decisions affect shareholders. However, corporate decisions are made by managers, not shareholders. A key aspect of value-based management is making sure that managers focus on the goal of shareholder wealth maximization. Corporate governance is one of the main tools used in value-based management. Copyright © 2014 by Nelson Education Ltd. 23-6
The Corporate Valuation Model Types of corporate assets Estimating the value of operations Estimating the price per share Comparing the corporate valuation and dividend growth models Copyright © 2014 by Nelson Education Ltd. 23-7
Types of Corporate Assets Operating assets – Assets-in-place include tangible assets such as buildings, machines, inventory plus intangible assets such as patents, customer lists, reputation, and general know-how – Growth options are opportunities to expand arising from the firm’s current operating knowledge, experience, and other resources. Nonoperating assets Value-based management focuses on operating assets. Copyright © 2014 by Nelson Education Ltd. 23-8
Nonoperating Assets Come in two forms – A marketable securities portfolio over and above the cash needed to operate the business – Noncontrolling investments in other businesses Operating assets are far more important than nonoperating assets. Moreover, companies can influence the values of their operating assets. Copyright © 2014 by Nelson Education Ltd. 23-9
Value of Operations V op = ∑ ∞ t = 1 FCF t (1 + WACC) t PV of expected future free cash flows (FCF) from operations, that is, operating assets. Copyright © 2014 by Nelson Education Ltd
Relevant Formulas FCF = NOPAT – Change in net operating capital NOPAT = EBIT(1 – T) Change in net operating capital = Change in net operating working capital + Change in net plant and equipment Required net operating working capital = Operating current assets – Operating current liabilities = (Cash + A/R + Inv.) – (A/P + Accruals) Copyright © 2014 by Nelson Education Ltd
Relevant Formulas (cont’d) Change in net operating working capital = Net operating working capital current – Net operating working capital last year Change in net plant and equipment = Net plant and equipment current – Net plant and equipment last year Copyright © 2014 by Nelson Education Ltd
Total Corporate Value Total corporate value is sum of: – value of operations – value of nonoperating assets Firms can only influence the values of their operating assets, not the nonoperating assets. Copyright © 2014 by Nelson Education Ltd
Claims on Corporate Value Debtholders have first claim. Preferred stockholders have the next claim. Any remaining value belongs to stockholders. Copyright © 2014 by Nelson Education Ltd
Applying the Corporate Valuation Model Forecast the financial statements. Calculate the projected free cash flows. Model can be applied to a company that does not pay dividends, a privately held company, or a division of a company, since FCF can be calculated for each of these situations. Copyright © 2014 by Nelson Education Ltd
Data for Valuation FCF 0 = $20 million WACC = 10% Growth rate g = 5% Marketable securities = $100 million Debt = $200 million Preferred stock = $50 million Book value of equity = $210 million Copyright © 2014 by Nelson Education Ltd
Value of Operations: Constant FCF Growth at Rate of g V op = ∑ ∞ t = 1 FCF t (1 + WACC) t = ∑ ∞ t = 1 FCF 0 (1+g) t (1 + WACC) t Copyright © 2014 by Nelson Education Ltd
Constant Growth Formula Notice that the term in parentheses is less than one and gets smaller as t gets larger. As t gets very large, term approaches zero. V op = ∑ ∞ t = 1 FCF WACC ( 1+ g ) t Copyright © 2014 by Nelson Education Ltd
Constant Growth Formula (cont’d) The summation can be replaced by a single formula: V op = FCF 1 (WACC – g) = FCF 0 (1+g) (WACC – g) Copyright © 2014 by Nelson Education Ltd
Find Value of Operations V op = FCF 0 (1 + g) (WACC – g) V op = 20(1+0.05) (0.10 – 0.05) = $420m Copyright © 2014 by Nelson Education Ltd
Value of Equity Sources of corporate value – Value of operations = $420 – Value of nonoperating assets = $100 Claims on corporate value – Value of debt = $200 – Value of preferred stock = $50 – Value of equity = ? Copyright © 2014 by Nelson Education Ltd
Value of Equity (cont’d) Total corporate value = V op + Mkt. Sec. = $420 + $100 = $520 million Value of equity = Total – Debt – Pref. = $520 – $200 – $50 = $270 million Copyright © 2014 by Nelson Education Ltd
Market Value Added (MVA) MVA = Total corporate value of firm – Total book value of firm Total book value of firm = Book value of equity + Book value of debt + Book value of preferred stock MVA= $520 – ($210 + $200 + $50) = $60 million Copyright © 2014 by Nelson Education Ltd
Breakdown of Corporate Value Copyright © 2014 by Nelson Education Ltd
Expansion Plan: Nonconstant Growth Finance expansion by borrowing and halting dividends Projected free cash flows (FCF): – Year 1 FCF = -$18.00 million – Year 2 FCF = -$23.00 million – Year 3 FCF = $46.40 million – Year 4 FCF = $49.00 million – FCF grows at constant rate of 5% after year 4 Copyright © 2014 by Nelson Education Ltd
Expansion Plan: Nonconstant Growth (cont’d) The weighted average cost of capital, WACC, is 10.84%. The company has 100 million shares of stock. Value of nonoperating = $63 million Value of debt = $247 million Value of preferred stock = $62 million Copyright © 2014 by Nelson Education Ltd
Horizon Value Free cash flows are forecast for 4years in this example, so the forecast horizon is 4 years. Growth in free cash flows is not constant during the forecast, so we can’t use the constant growth formula to find the value of operations at time 0 (i.e., 2013). Copyright © 2014 by Nelson Education Ltd
Horizon Value (cont’d) Growth is constant after the horizon (4 years), which is year We can modify the constant growth formula to find the value of all free cash flows beyond the horizon, discounted back to the horizon. Copyright © 2014 by Nelson Education Ltd
Horizon Value (HV) Formula Horizon value is also called terminal value, or continuing value. V op at time t = FCF t (1+ g) (WACC – g) HV = Copyright © 2014 by Nelson Education Ltd
Copyright © 2014 by Nelson Education Ltd
Copyright © 2014 by Nelson Education Ltd
Finding the Value of Magnavision’s Stock Copyright © 2014 by Nelson Education Ltd
Comparing the Corporate Valuation and Dividend Growth Models For a mature company whose dividends are expected to grow steadily in the future, the dividend growth model seems to be more efficient. For a dividend-paying but still fast-growing company, either model can be applied. For a company that never paid a dividend, a new company, or a division of a large company, the corporate valuation model must be used. Actually, much can be learned from the corporate valuation model in all these situations. Copyright © 2014 by Nelson Education Ltd
Value-Based Management Value-based management (VBM) is the systematic application of the corporate valuation model to all corporate decisions and strategic initiatives. The objective of VBM is to increase market value added (MVA). Copyright © 2014 by Nelson Education Ltd
MVA and the Four Value Drivers MVA is determined by four drivers: – Sales growth (g) – Operating profitability (OP=NOPAT/Sales) – Capital requirements (CR=Operating capital / Sales) – Weighted average cost of capital (WACC) Copyright © 2014 by Nelson Education Ltd
MVA for a Constant Growth Firm MVA t = ┌ │ └ OP – WACC CR ( (1+g) ) ┐ │ ┘ Sales t (1 + g) WACC – g ┐ │ ┘ ┌ │ └ Copyright © 2014 by Nelson Education Ltd
Insights from the Constant Growth Model The first bracket is the MVA of a firm that gets to keep all of its sales revenues (i.e., its operating profit margin is 100%) and that never has to make additional investments in operating capital. Sales t (1 + g) WACC - g ┐ │ ┘ ┌ │ └ Copyright © 2014 by Nelson Education Ltd
Insights (cont’d) The second bracket is the operating profit (as a %) the firm gets to keep, less the return that investors require for having tied up their capital in the firm. ┌ │ └ OP – WACC CR ( (1+g) ) ┐ │ ┘ Copyright © 2014 by Nelson Education Ltd
Improvements in MVA Due to the Value Drivers MVA will improve if: – WACC is reduced – operating profitability (OP) increases – the capital requirement (CR) decreases Copyright © 2014 by Nelson Education Ltd
The Impact of Growth The second term in brackets can be either positive or negative, depending on the relative size of profitability, capital requirements, and required return by investors. ┌ │ └ OP – WACC CR ( (1+g) ) ┐ │ ┘ Copyright © 2014 by Nelson Education Ltd
The Impact of Growth (cont’d) If the second term in brackets is negative, then growth decreases MVA. In other words, profits are not enough to offset the return on capital required by investors. If the second term in brackets is positive, then growth increases MVA. Copyright © 2014 by Nelson Education Ltd
Expected Return on Invested Capital (EROIC) The expected return on invested capital is the NOPAT expected next period divided by the amount of capital that is currently invested: EROIC t = NOPAT t + 1 Capital t Copyright © 2014 by Nelson Education Ltd
MVA in Terms of Expected ROIC If the spread between the expected return, EROICt, and the required return, WACC, is positive, then MVA is positive and growth makes MVA larger. The opposite is true if the spread is negative. MVA t = Capital t (EROIC t – WACC) WACC – g Copyright © 2014 by Nelson Education Ltd
The Impact of Growth on MVA A company has two divisions. Both have current sales of $1,000, current expected growth of 5%, and a WACC of 10% Division A has high profitability (OP=6%) but high capital requirements (CR=78%) Division B has low profitability (OP=4%) but low capital requirements (CR=27%) Copyright © 2014 by Nelson Education Ltd
What is the Impact on MVA if Growth Goes from 5% To 6%? Division ADivision B OP6% 4% CR78% 27% Growth5%6%5%6% MVA(300.0)(360.0) Copyright © 2014 by Nelson Education Ltd
Expected ROIC and MVA Division ADivision B Capital 0 $780 $270 Growth5%6%5%6% Sales 1 $1,050$1,060$1,050$1,060 NOPAT 1 $63$63.6$42$42.4 EROIC 0 8.1%8.2%15.6%15.7% MVA(300.0)(360.0) Copyright © 2014 by Nelson Education Ltd
Analysis of Growth Strategies The expected ROIC of Division A is less than the WACC, so the division should postpone growth efforts until it improves EROIC by reducing capital requirements (e.g., reducing inventory) and/or improving profitability. The expected ROIC of Division B is greater than the WACC, so the division should continue with its growth plans. Copyright © 2014 by Nelson Education Ltd
Managerial Behaviour and Shareholder Wealth SIX POTENTIAL PROBLEMS 1.Expend too little time and effort. 2.Consume too many nonpecuniary benefits. 3.Avoid difficult decisions (e.g., close plant) out of loyalty to friends in company. Copyright © 2014 by Nelson Education Ltd
Six Potential Problems (cont’d) 4.Reject risky positive NPV projects to avoid looking bad if project fails; take on risky negative NPV projects to try to hit a home run. 5.Avoid returning capital to investors by making excess investments in marketable securities or by paying too much for acquisitions. 6.Massage information releases or manage earnings to avoid revealing bad news. Copyright © 2014 by Nelson Education Ltd
Corporate Governance The set of laws, rules, and procedures that influence a company’s operations and the decisions made by its managers. – Sticks (threat of removal) – Carrots (compensation) Copyright © 2014 by Nelson Education Ltd
Corporate Governance Provisions Under a Firm’s Control Board of directors Charter provisions affecting takeovers Compensation plans Capital structure choices Internal accounting control systems Copyright © 2014 by Nelson Education Ltd
Effective Boards of Directors Election mechanisms make it easier for minority shareholders to gain seats: – Not a “classified” board (i.e., all board members elected each year, not just those with multi-year staggered terms) – Board elections allow cumulative voting Copyright © 2014 by Nelson Education Ltd
Effective Boards of Directors (cont’d) CEO is not chairman of the board and does not have undue influence over the nominating committee. Board has a majority of outside directors (i.e., those who do not have another position in the company) with business expertise. Copyright © 2014 by Nelson Education Ltd
Effective Boards of Directors (cont’d) Is not an interlocking board (CEO of company A sits on board of company B, CEO of B sits on board of A). Board members are not unduly busy (i.e., sit on too many other boards or have too many other business activities). Copyright © 2014 by Nelson Education Ltd
Effective Boards of Directors (cont’d) Compensation for board directors is appropriate. – Not so high that it encourages cronyism with CEO – Not all compensation is fixed salary (i.e., some compensation is linked to firm performance or stock performance) Copyright © 2014 by Nelson Education Ltd
Anti-Takeover Provisions Targeted share repurchases (i.e., greenmail) Shareholder rights provisions (i.e., poison pills) Restricted voting rights plans Copyright © 2014 by Nelson Education Ltd
Stock Options in Compensation Plans Gives owner of option the right to buy a share of the company’s stock at a specified price (called the strike price or exercise price) even if the actual stock price is higher Usually can’t exercise the option for several years (called the vesting period) Copyright © 2014 by Nelson Education Ltd
Stock Options (cont’d) Can’t exercise the option after a certain number of years (called the expiration, or maturity, date) Copyright © 2014 by Nelson Education Ltd
Problems With Stock Options Manager can underperform market or peer group, yet still reap rewards from options as long as the stock price increases to above the exercise cost. Options sometimes encourage managers to falsify financial statements or take excessive risks. Copyright © 2014 by Nelson Education Ltd
External Factors Affecting Corporate Governance Corporate governance is also affected by environmental factors that are outside of a firm’s control, including: – regulatory/legal environment – block ownership patterns – competition in the product markets – media – litigation Copyright © 2014 by Nelson Education Ltd
Regulatory Systems and Laws Companies in countries with strong protection for investors tend to have: – better access to financial markets – a lower cost of equity – increased market liquidity – less noise in stock prices Copyright © 2014 by Nelson Education Ltd
Block Ownership Outside investor owns large amount (i.e., block) of company’s shares – Canadian Coalition for Good Governance (CCGG) representing 48 institutional investors Blockholders often monitor managers and take an active role, leading to better corporate governance. Copyright © 2014 by Nelson Education Ltd
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