1. 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

2. Worksheet and Spreadsheet for MagnaVision Co.

3. 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.

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

5. 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

6. 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.

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

8. 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.

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

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

11. 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

12. 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.

13. 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

14. 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.

15. 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.

16. 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.

17. 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%

18. 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

19. 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

20. 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

21. 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

22. 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: ( ) – ( ) = $212
2002: $250

23. 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.

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

25. 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

26. 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.

27. Calculating Free Cash Flow
Operating Cash Flow (OCF)
OCF = NOPAT + Depreciation
2001: = 71.8
2002: = 92.0

28. 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

29. 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 ….

30. 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.

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

32. 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.

33. Value of Operations

34. 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.

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

36. 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.

37. 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
– 0.05
Sum: $929.99

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

39. Total Corporate Value
The MagnaVision’s total corporate value in 2001 is sum of
Value of operations, $ 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
= $ $63
= $ million

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

41. Value of Equity Sources of Corporate Value Claims on Corporate Value
Total value of the firm = $ 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.)

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

43. 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

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

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

47. 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

48. 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.

50. 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!

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

52. 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.

53. 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.

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

55. 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).

56. 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.