Ch 3 and Ch 15 Corporate Valuation Overview of Financial Statements Corporate Valuation Free Cash Flow (FCF) Market Value Added (MVA) and Economic Value Added (EVA) Corporate Governance Entrenched Management Agency Problem Compensation and Stock Option 1

Worksheet and Spreadsheet for MagnaVision Co.

Why are we concerned about “valuing the firm?” Microsoft’s Problem Microsoft have many affiliates and subsidiaries. How can a CEO judge whether subsidiaries are doing good jobs or not? How can she compensate her subordinates or managers according to performance? JP Morgan’s Problem As a portfolio manager, how can he distinguish good stocks from bad stocks? Which stock would provide more wealth to shareholders? In order to value the firm, we must carefully review the firm’s financial statements.

GAAP Requirements Three Financial Statements Balance Sheets Income Statements Cash Flow Statement

Issues with GAAP Statements However, we learned that GAAP has many problems in measuring the true value of the firm. For example, balance sheet records historical cost, not market value. Income statement contains non-cash items such as depreciation. Mismatch between the time when the income (cost) is realized and the time when the revenue (cost) is collected

Free Cash Flow So, we introduced Free Cash Flow (FCF), Market Value Added (MVA), and Economic Value Added (EVA) to accurately measure the true value of the firm.

The Goal of Financial Managers The financial manager is to increase the market value of the firm, or the stock value. “Shareholder Wealth Maximization”

New Concept: FREE CASH FLOW The cash from operations that is actually available for distribution to investors (including stockholders, bondholders, and preferred stockholders), after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations.

Total corporate value is sum of: Value of operations (or operating assets) Value of nonoperating assets

List two types of assets that a company owns. Operating assets Nonoperating assets

List two types of assets that a company owns. Operating assets Assets-in-place Tangible Assets: Buildings, Inventory, Usually shown in balance sheet Intangible Assets: Copyrights, Patents (usually shown on balance sheets), Reputation, Name value, Significant potentials from research and development (usually not shown in balance sheet) Growth options Opportunity to expand that arise from the firm’s current operating knowledge

Assets-in-Place Usually they are expected to grow. They generate free cash flows. The PV of their expected future free cash flows, discounted at the WACC, is the value of operations.

What is the Free Cash Flow (FCF)? The cash from operations that is actually available for distribution to investors (including stockholders, bondholders, and preferred stockholders), after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations. Free Cash Flow = NOPAT – Net Investment in Operating Capital

Why Free Cash Flow? To value the firm or operating units within the firm To evaluate the manager’s performance, so we can compensate her based on performance. Dividend discount model is often of limited use of internal management purpose. For example, GE have many affiliates and subsidiaries but only few of them pay dividends as separate entities. Or some firms simply do not pay dividends.

List two types of assets that a company owns. Financial, or nonoperating assets Marketable securities over and above the cash needed to operate the business “Equity in Net Assets of Affiliated Companies”, or ownership of non-controlling interest in another company Value of nonoperating assets usually is very close to figure that is reported on balance sheets.

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.

Example: MagnaVision You are given the current and projected financial statements of MagnaVision. Growth is expected to be 5% for each year after the projections. If the WACC is 10.84%, what is the value of operations? So, in our notation, g = 5% after projections WACC = 10.84%

Data: Income Statement (millions) Actual Projected   2001 2002 Net Sales $700.0 $850.0 Costs (except depreciation) $599.0 $734.0 Depreciation 28.0 31.0 Total operating costs $627.0 $765.0 Earning before int. & tax $73.0 $85.0 Less: Net interest 13.0 15.0 Earning before taxes $60.0 $70.0 Taxes (40%) 24.0 Net income before pref. div. $36.0 $42.0

Income Statement (continued) 2001 2002 Preferred div. 6.0 7.0 Net income avail. for com. div. $30.0 $35.0 Common dividends $0.0 Addition to retained earnings   Number of shares 100 Dividends per share $0.000

Data: Balance Sheets (millions) Actual Projected   2001 2002 Cash $17.0 $20.0 Marketable Securities 63.0 70.0 Accounts receivable 85.0 100.0 Inventories 170.0 200.0 Total current assets $335.0 $390.0 Net plant and equipment 279.0 310.0 Total Assets $614.0 $700.0

Data: Balance Sheet (continued)   2001 2002 Liabilities and Equity Accounts Payable $16.0 $20.0 Notes payable 123.0 140.0 Accruals 44.0 50.0 Total current liabilities $183.0 $210.0 Long-term bonds 124.0 Preferred stock 62.0 70.0 Common Stock (par plus paid in capital) $200.0 Retained earnings 45.0 80.0 Common equity $245.0 $280.0 Total liabilities and equity $614.0 $700.0

Calculating Free Cash Flow Net Operating Working Capital (NOWC) Another name for NOWC is operating current asset and operating current liabilities The working capital acquired with investor-supplied funds Current assets that do not pay interest minus current liabilities that do not charge interest (Cash + AR + Inventory) – (AP + Accruals) 2001: (17 + 85 + 170) – (16 + 44) = $212 2002: $250

Calculating Free Cash Flow Why Short-term securities are excluded from operating current assets? It generally result from investment decisions by the treasurer and they are not used in the core operation. It is not a natural consequence of operations or it is a discretionary choice by management. Why we deduct accounts payable and accruals? They do not represent dollars generated from investors to acquire current assets. However, notes payable are treated as investor-supplied capital and thus are not deducted. Operating current assets are the CA needed to support operations. Op CA include: cash, inventory, receivables. Op CA exclude: short-term investments, because these are not a part of operations. Operating current liabilities are the CL resulting as a normal part of operations. Op CL include: accounts payable and accruals. Op CA exclude: notes payable, because this is a source of financing, not a part of operations.

Calculating Free Cash Flow Total Operating Capital Net operating working capital + operating long-term assets (e.g., plant and equipment) 2001: $212 + 279 = $491 2002: $250 + 310 = $560

Calculating Free Cash Flow Net Operating Profit after Taxes (NOPAT) Definition: The amount of profit a company would generate if it had no debt and held no financial assets. NOPAT = EBIT(1 – Tax rate) 2001: 73 (1 – 40%) = 43.8 2002: 85 (1 – 40%) = 51.0

Calculating Free Cash Flow Why NOPAT? If the two companies have different amounts of debt, hence different amounts of interest charges, they could have identical operating performances, but different net incomes – the one with more debt would have a lower net income. For the same NOPAT, net income measure unfairly punish operating units with debt. Net income reflects interest expense, while NOPAT does not.

Calculating Free Cash Flow Operating Cash Flow (OCF) OCF = NOPAT + Depreciation 2001: 43.8 + 28 = 71.8 2002: 51.0 + 31 = 92.0

Calculating Free Cash Flow Free Cash Flow (FCF) The cash from operations that is 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. FCF = NOPAT – net investment in operating assets where net investment in operating asset = change in total operating capital = 560 – 491 = $69 FCF2002 = 51 – 69 = -$18

Calculating Free Cash Flow We repeat this process for year 2003, 2004, and 2005. FCF2003 = -$23 FCF2004 = $46.4 FCF2005 = $49 FCF are expected to grow at 5% after 2005. FCF2006 = ($49)(1.05) = $51.45 FCF2004 = $54.02 ….

Negative FCF A negative current FCF is not necessarily bad, provided it is due to high growth. (e.g., investing on more operating assets to meet an increase in sales demand) However, negative FCFs over long periods means that mangers have failed in increasing shareholders’ value.

The Uses of FCF Pay interest to debt holders Retire some debts Pay dividends Repurchase stock Buy marketable securities Acquire other companies

Maximizing Free Cash Flow The goal of financial managers are to maximize the shareholder’s value. Maximizing free cash flow available to investors is in accordance with shareholder’s wealth maximization. The value of a company depends on its expected future FCFs.

Value of Operations

Horizon Value Free cash flows are forecast for four years in this example, so the forecast horizon is four 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. Growth is constant after the horizon (4 years), so we can modify the constant growth formula to find the value of all free cash flows beyond the horizon, discounted back to the horizon.

Horizon value is also called terminal value, or continuing value. Horizon Value Formula Horizon value is also called terminal value, or continuing value.

We repeat this for year 2003, 2004, and 2005 and find FCFs as follows: WACC=10.84% 2001 2002 2003 2004 2005….. -18.0 -23.0 46.4 49.0 Free cash flow generally grow over time. Using the growth rate of 5%, we can estimate future free cash flows occurring beyond year 2005.

Value of Operation g = 5% WACC=10.84% 2002 2003 2004 2005 2006 -18.0 -23.0 46.4 49.0 51.45 $51.45 Vop at 2005   $880.99 0.1084 – 0.05 Sum: $929.99

Calculator Solution Value of Operation =$615.27 million Enter in CFj : -18 -23 46.4 929.99 10.84 CF0 CF1 CF2 Value of Operation =$615.27 million CF3 CF4 I/YR NPV = 615.27

Total Corporate Value The MagnaVision’s total corporate value in 2001 is sum of Value of operations, $615.27 million Value of nonoperating assets marketable securities, $63 million We take the face value from balance sheet because the short-term financial assets as reported on the balance sheet are at, or close to, their market value. Thus, Total Corporate Value in 2001 = $615.27 + $63 = $678.27 million

Claims on Corporate Value Debtholders have first claim. Preferred stockholders have the next claim. Any remaining value belongs to stockholders.

Value of Equity Sources of Corporate Value Claims on Corporate Value Total value of the firm = $678.27 million Claims on Corporate Value Value of Debt = $247 million Sum of notes payable ($123) and log-term debt ($124) Accounts payable and accruals were netted out earlier when calculating NOWC. Value of Preferred Stock = $62 million Value of Equity = ? Assume market value of debt = book value of debt.)

Value of Equity in 2001 Total corporate value = $678.27 million Value of equity = Total - Debt - Pref. = $678.27 - $247 - $62 = $369.27 million Value of Common Stock per Share = $369.27 million / 100 million share = $3.69

Market Value Added (MVA) The difference between the market value of the firm’s stock and the amount of equity capital that was supplied by shareholders. MVA = Total corporate value of firm minus total book value of firm Total book value of firm = BV of equity + BV of debt + BV of preferred stock MVA = $678 - ($245 + $247 + $62) = $124 million

Market Value Added (MVA) Or MVA = share outstanding*stock price – Total common equity = 100 million shares * $3.69 - $245 million = $369 – $245 = $124 million

Economic Value Added Developed by Stern Stewart & Co. EVA www.sternstewart.com EVA = NOPAT – After-tax dollar cost of capital used to support operations = EBIT(1 – T) – Operating Capital (WACC)

Economic Value Added Net income does not reflect the amount of equity capital employed. An estimate of a business’s true economic profit for the year The residual income that remains after the cost of all capital, including equity capital EVA reflects an opportunity cost faced by shareholders because shareholders could have invested funds elsewhere. The extent to which the firm has added to shareholder value Useful basis for measuring managerial effectiveness

EVA: MaginaVision EVA = EBIT(1 – T) – Operating Capital (WACC) = 73 (1 - 40%) – 491 (10.84%) = -$9.42 million A negative EVA suggests that the company destroyed shareholder’s value for the given year.

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Agency problem In typical corporations, ownership can be spread over a huge number of stockholders Principal-Agent problem Agency relationship exists when someone (the principal) hires another (the agent) to represent his or her interest. Shareholders hire mangers (e.g, CEO, CFO, and other mangers) The separation of ownership and management creates agency problem. Agency problem: the possibility of conflict of interest between the owners and management of a firm. In to order to control the agency problem, managerial compensation is closely tied to share value of the firm. The agency problem: Mangers won’t work for the firm’s owners unless it’s in their best interest!

Organizational Structures of Corporation Chairman CEO CFO VP Board of Directors SHs

Two Key Groups in Corporation Managers (CEO, CFO) Investors (Stockholders Or Owners) FIRM The agency problem: Mangers won’t work for the firm’s owners unless it’s in their best interest! These two groups may have different goals. The separation of ownership and management creates conflicts. One way to mitigate conflicts is to offer stock options to mangers.

How are entrenched managers harmful to shareholders? Management act in the best interest of themselves, not in the best interest of shareholders. Management consume perks such as lavish offices and corporate jets, excessively large staffs, and memberships at country clubs. More critically, management engages in non-value increasing activities. Management accepts projects (or acquisitions) to make firm larger, even if its value after the event may go down.

CEO Stock Options Why are the corporations willing to provide stock options to CEOs? What does stock options have to do with agency problems?

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 exercise price) even if the actual stock price is higher. Usually can’t exercise the option for several years (called the vesting period or the expiration).

Class syllabi: Course description says that ……… Class syllabi: Course description says that ………..by exploring the role of financial managers in creating value and maximizing shareholder wealth within the constraints of legal and ethical behavior.