1. Corporate Valuation, Value-Based Management, and Corporate Governance
CHAPTER 15
Corporate Valuation,
Value-Based Management, and Corporate Governance

2. Topics in Chapter Corporate Valuation Value-Based Management
Corporate Governance 1

3. Corporate Valuation: A company owns two types of assets.
Assets-in-place
Financial, or nonoperating, assets

4. Assets-in-Place
Assets-in-place are tangible, such as buildings, machines, inventory.
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.

5. Value of Operations
Vop = ∑ ∞
t = 1
FCFt
(1 + WACC)t

6. Nonoperating Assets Marketable securities
Ownership of non-controlling interest in another company
Value of nonoperating assets usually is very close to figure that is reported on balance sheets.

7. Total Corporate Value Total corporate value is sum of:
Value of operations
Value of nonoperating assets

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

9. Applying the Corporate Valuation Model
Forecast the financial statements, as shown in Chapter 14.
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.

10. Data for Valuation FCF0 = $20 million WACC = 10% g = 5%
Marketable securities = $100 million
Debt = $200 million
Preferred stock = $50 million
Book value of equity = $210 million

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

12. 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

13. Constant Growth Formula (Cont.)
The summation can be replaced by a single formula:
Vop =
FCF1
(WACC - g) =
FCF0(1+g)

14. Find Value of Operations
Vop =
FCF0 (1 + g)
(WACC - g)
20(1+0.05)
(0.10 – 0.05)
= 420

15. Value of Equity Sources of Corporate Value Claims on Corporate Value
Value of operations = $420
Value of non-operating assets = $100
Claims on Corporate Value
Value of Debt = $200
Value of Preferred Stock = $50
Value of Equity = ?

16. Value of Equity Total corporate value = Vop + Mkt. Sec. = $420 + $100
= $520 million
Value of equity = Total - Debt - Pref.
= $520 - $200 - $50
= $270 million

17. Market Value Added (MVA)
MVA = Total corporate value of firm minus 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

18. Expansion Plan: Nonconstant Growth
Finance expansion by borrowing $40 million and halting dividends.
Projected free cash flows (FCF):
Year 1 FCF = -$5 million.
Year 2 FCF = $10 million.
Year 3 FCF = $20 million
FCF grows at constant rate of 6% after year 3.
(More…)

19. The weighted average cost of capital, WACC, is 10%.
The company has 10 million shares of stock.

20. Horizon Value
Free cash flows are forecast for three years in this example, so the forecast horizon is three 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.

21. Horizon Value (Cont.)
Growth is constant after the horizon (3 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.

22. Horizon Value Formula Vop at time t = HV = FCFt(1+g) (WACC - g)
Horizon value is also called terminal value, or continuing value.

23. Value of operations is PV of FCF discounted by WACC.
Vop at 3
-4.545
8.264
15.026 1 2 3 4
rc=10%
= Vop
g = 6%
FCF=
$21.2 .
.06
$530. 10  

24. Find the price per share of common stock.
Value of equity = Value of operations
- Value of debt
= $ $40
= $ million.
Price per share = $ /10
= $37.69.

25. Value-Based Management (VBM)
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)

26. MVA and the Four Value Drivers
MVA is determined by four drivers:
Sales growth
Operating profitability (OP=NOPAT/Sales)
Capital requirements (CR=Operating capital / Sales)
Weighted average cost of capital

27. MVA for a Constant Growth Firm
MVAt =
Salest(1 + g)
WACC - g ┐ │ ┘ ┌ └ ┌ │ └
OP – WACC CR (
(1+g) ) ┐ ┘

28. Improvements in MVA due to the Value Drivers
MVA will improve if:
WACC is reduced
operating profitability (OP) increases
the capital requirement (CR) decreases

29. Six Potential Problems with Managerial Behavior
Expend too little time and effort.
Consume too many nonpecuniary benefits.
Avoid difficult decisions (e.g., close plant) out of loyalty to friends in company.
(More . .)

30. Six Problems with Managerial Behavior (Continued)
Reject risky positive NPV projects to avoid looking bad if project fails; take on risky negative NPV projects to try and hit a home run.
Avoid returning capital to investors by making excess investments in marketable securities or by paying too much for acquisitions.
Massage information releases or manage earnings to avoid revealing bad news.

31. 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)

32. Corporate Governance Provisions Under a Firm’s Control
Board of directors
Charter provisions affecting takeovers
Compensation plans
Capital structure choices
Internal accounting control systems

33. Anti-Takeover Provisions
Targeted share repurchases (i.e., greenmail)
Shareholder rights provisions (i.e., poison pills)
Restricted voting rights plans

34. 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).

35. Stock Options (Cont.)
Can’t exercise the option after a certain number of years (called the expiration, or maturity, date).

36. 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.