1. Corporate Valuation and Financial Planning
Chapter 12
Corporate Valuation and Financial Planning

3. 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.

4. 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.

5. 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

6. 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.

7. 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 non-operating assets.
Moreover, companies can influence the values of their operating assets.

8. Value of Operations
Vop = ∑ ∞
t = 1
FCFt
(1 + WACC)t
PV of expected future free cash flows (FCF) from operations, that is, operating assets.

9. 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)

10. 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

11. 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.

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

13. 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.

14. Data for Valuation FCF0 = $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.

15. Value of Operations: Constant FCF Growth at Rate of g
Vop = ∑ ∞
t = 1
FCFt
(1 + WACC)t =
FCF0(1+g)t

16. 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.
Vop = ∑ ∞
t = 1
FCF0
1 + WACC (
1+ g ) t

17. Constant Growth Formula (cont’d)
The summation can be replaced by a single formula:
Vop =
FCF1
(WACC – g) =
FCF0(1+g)

18. Find Value of Operations
Vop =
FCF0 (1 + g)
(WACC – g)
20(1+0.05)
(0.10 – 0.05)
= $420m

19. Value of Equity Sources of corporate value Claims on 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.

20. Value of Equity (cont’d)
Total corporate value = Vop + Mkt. Sec.
= $420 + $100
= $520 million
Value of equity = Total – Debt – Pref.
= $520 – $200 – $50
= $270 million
Copyright © 2014 by Nelson Education Ltd.

21. 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

22. Breakdown of Corporate Value
Copyright © 2014 by Nelson Education Ltd.

24. Overview of Financial Planning
Three important components:
Strategic plans: Define its corporate purpose, scope, and objectives, and develop strategies for achieving its goals
Operating plans: Provide detailed implementation guidance to help meet the corporate objectives
Financial plans: Forecast the amount of external financing that will be required

25. Profit Planning: Pro Forma Statements
Pro forma financial statements are projected, or forecast, financial statements - income statements and balance sheets.
The inputs required to develop pro forma statements using the most common approaches include:
financial statements from the preceding year
the sales forecast for the coming year
key assumptions about a number of factors
The development of pro forma financial statements will be demonstrated using the financial statements for Vectra Manufacturing.

26. FINANCIAL PLANNING—FORECASTING
Sales Forecast
most important part of financial planning
generally based on the trend in sales in recent periods
inaccurate sales forecasts can have serious repercussions—if the firm is too optimistic, such assets as inventory will be built up too much; if the firm is too conservative, it might miss valuable opportunities because existing production capabilities might not be sufficient to meet new demand

27. Trend in Sales for Vectra Manufacturing
100
200
300
400
500
600
1999
2000
2001
2002
2003
2004
Sales
($ millions)
Average growth = 12%

28. Profit Planning: Pro Forma Financial Statements
Step 1: Preparing the Pro Forma Income Statement
Estimate the percentage growth (increase or decrease) in sales, cost of goods sold, and other variable revenues and expenses
Change the current values by the estimates
An easy way to approach this task is to apply a single growth rate to all revenue and expense categories that change when production changes
To be more accurate, each category should be examined individually to determine what the effect of any forecasted change is

29. Profit Planning: Pro Forma Financial Statements
Step 1: Preparing the Pro Forma Income Statement
Assumptions
Vectra Manufacturing operated at full capacity in 2004.
Sales are expected to grow by 12 percent.
The variable cost ratio remains at 80 percent (same as 2004)
2005 dividend payout will be maintained at 60 percent of net income.

30. Profit Planning: Pro Forma Financial Statements
Step 1: Preparing the Pro Forma Income Statement

31. Profit Planning: Pro Forma Financial Statements
Step 2: Preparing the Pro Forma Balance Sheet
Assumptions
Vectra Manufacturing operated at full capacity in 2004.
Sales are expected to grow by 12 percent.
The variable cost ratio remains at 80 percent (same as 2004)
2005 dividend payout will be maintained at 60 percent of net income.

32. Profit Planning: Pro Forma Financial Statements
Step 2: Preparing the Pro Forma Balance Sheet
2004
Current assets $155.00
Fixed assets
Total assets $275.00
Payables & accruals
Notes Payable
Current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities & equity $275.00
x (1 + g) Initial Forecast
x $176.60 x
$308.00
x $
13.00
46.60
100.00
146.60
44.00
+9.70  RE
97.70
141.70
$288.30

33. Profit Planning: Pro Forma Financial Statements
Spontaneously generated funds
Spontaneously generated funds
Spontaneously generated funds are those that increase with the same rate as sales, i.e. higher sales increase taxable income but also higher wages
However, notes payable, long-term bonds and common stock are not spontaneously generated sales, they do not increase with the same rate as sales.

34. Profit Planning: Pro Forma Financial Statements
Step 3: Raising the additional funds needed
If Vectra Manufacturing does not raise additional capital by borrowing from the bank or issuing new stocks or bonds, then, based on the pro forma balance sheet, the following exists:
Total assets $308.00
Total liabilities and equity $288.30
Additional funds needed $19.7

35. Profit Planning: Pro Forma Financial Statements
Step 3: Raising the additional funds needed
Vectra Manufacturing plans to raise the additional funds needed (AFN) as follows:
Proportion
Notes payable 15.0%
New long-term debt 20.0
New common stock
100.0
Amount
$2,95
3,94
$12,81
19,70
Cost
7.0%
10.0
dividend

36. Profit Planning: Pro Forma Financial Statements
Step 4: Financing Feedbacks
If Vectra Manufacturing issues new debt and common stock, the total amount of interest and dividends paid will increase.
Because interest and dividends must be paid with cash, any increase in these costs will decrease the funds the firm has to invest—that is, the amount of income added to retained earnings will be less than originally forecasted.
When we consider the effects of the increased interest and dividend payments, we find that the AFN is actually greater than originally expected.
Financing feedbacks—that is, the effects on the financial statements of actions taken to finance forecasted increases in assets—must be considered to determine the exact amount of AFN.

37. Evaluation of Pro Forma Statements
Weaknesses of Simplified Approaches
The major weaknesses of the approaches to pro forma statement development outlined above lie in two assumptions:
that the firm’s past financial performance will be replicated in the future
that certain accounts can be forced to take on desired values
For these reasons, it is imperative to first develop a forecast of the overall economy and make adjustments to accommodate other facts or events.

38. Financial Breakeven Analysis
Financial breakeven point is defined as the level of operating income (NOI or EBIT) that covers all fixed financing charges.
At the financial breakeven point, EPS = 0.
For the most part, fixed financial charges include interest paid on debt and preferred stock dividends.
For firms that do not have preferred stock, the financial breakeven point, EBITFinBE, is simply interest on debt.
Most firms do not have preferred stock.

39. Financial Breakeven Analysis—Example
Worldwide Widgets, Inc. is financed with the following sources of long-term funds:
8% interest $ 50,000
Preferred stock
Common stock (5,000
shares outstanding) ,000
Total capital $100,000

40. Financial Breakeven Analysis—Graph
-2.00
-1.50
-1.00
-0.50
0.50
1.00
1.50
2.00
-8,000
-4,000
4,000
8,000
12,000
16,000
EPS ($)
EBIT ($)
Financial breakeven point

41. Financial Breakeven Analysis—Computation
The financial breakeven point is computed as follows:
If Worldwide Widgets’ marginal tax rate is 40 percent, its financial breakeven point is:

42. Financial Breakeven Analysis—Uses
Financial breakeven analysis gives an indication as to how the firm’s mix of debt and preferred stock (fixed financing) affects EPS (net income).