Corporate Value and ValueBased Management

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Corporate Value and Value-Based Management

• Chapter 11

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Mini Case

• You have been hired as a consultant to Kulpa
  Fishing Supplies (KFS), a company that is seeking
  to increase its value. KFS has asked you to
  estimate the value of two privately held
  companies that KFS is thinking about acquiring.
  But first, KFS would like for you to explain how
  to value companies that dont pay dividends.

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Overview of Corporate Valuation

• What model?
• Dividend Growth?
• Start-up company?
• Not paying dividend?
• Internal management?
• Assumes firm is one asset
• Corporate Valuation Model
• More general
• Corporate decisions affect stockholders
• Who makes decisions?
• S/h wealth max. not the same as mgt satisfaction
• Need rules/procedures
• Corporate governance

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Corporate Valuation Model

• Assets that company owns
• Assets-in-place nonoperating
• Assets-in-place
• Tangible, such as ________________
• Expected to grow and generate free cashflows
• PV of their expected FCFs, discounted at WACC, is
  value of operations
• Value of Operations

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Corporate Valuation Model

• Nonoperating assets (financial)
• Marketable securities
• Non-controlling interest in another company
• Value is usually close to value on B/S
• Total Corporate Value
• Value of Operations value of nonoperating
  assets
• Claims against
• Debtholders
• Preferred
• Then, common

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Corporate Valuation Model

• Applied to
• Company w/o dividends, private company, division
• Example
• KFS first acquisition target is a privately held
  company in a mature industry. The company
  currently has FCF of 20 m and it is expected to
  grow at a constant rate of 5. Its WACC is 10.
  It has mkt secur of 100 m. It is financed with
  200 m debt, 50 m preferred, 210 m of book
  equity.

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Corporate Valuation Model
So,
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Corporate Valuation Model
Then,
Look familiar????? Better or not? Example
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Corporate Valuation Model

• Total corporate value Vop Mkt Sec
• Value of equity Total corp value Debt - Pref

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Market Value Added

• MVA Total corporate value total book value
• Total book value Book value of equity book
  value of debt book value of preferred
• MVA

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Nonconstant Growth

• The second acquisition target is a privately held
  company in a growing industry. The target has
  recently borrowed 40m to finance its expansion
  it has no other debt or preferred stock. It pays
  no dividends and currently has no marketable
  securities. KFS expects the company to produce
  FCF of -5 m in 1 year, 10m in 2 years, and 20m
  in 3 years. After that, FCF will grow at a
  constant rate of 6. Its WACC is 10 and it
  currently has 10 m shares of stock.
• Concept of horizon value
• FCFs are forecast for three years in this
  example, so the forecast horizon is three years
• Growth is constant after the horizon (3 years),
  so we can modify the constant growth formula to
  find the value of all FCFs beyond the horizon,
  discounted back to the horizon
• Horizon value is also called terminal value or
  continuing value

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Horizon Value
Example
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Corporate Valuation Model

• Find value of operations.
• Find price per share.

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Value-Based Management

• Systematic application of the corporate valuation
  model to all corporate decisions and strategic
  initiatives
• Goal Increase MVA
• Drivers of MVA
• Sales growth
• Operating profitability
• OP NOPAT/Sales
• Capital requirements
• CR Operating Capital/Sales
• WACC

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MVA for Constant Growth Firm
First term MVA of firm that keeps all of its
sales revenue (100operating profit margin) and
never has to make any additionalinvestments in
operating capital. Second term Operating profit
the firm keeps LESS the return thatinvestors
require for using their capital.
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More on MVA

• Improve by
• Increasing or decreasing WACC?
• Increasing or decreasing OP?
• Increasing or decreasing CR?
• Impact of growth
• Second term can be or -. Depends on relative
  size of profitability, capital requirements and
  required return of investors.
• If negative, then growth ______ MVA.
• If positive, then growth ______ MVA.

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Expected Return on Invested Capital (EROIC)
Then,
If spread between EROIC and WACC is positive,
then MVA is _______ and growth makes MVA
________. The opposite istrue if spread is
negative.
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Impact of Growth on MVA

• KFS 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
  (OP6) but high capital requirements (CR78).
  Division B has low profitability (OP4) but low
  capital requirements (CR27).

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Impact of Growth on MVA

• Find MVA if growth is 5 then 6 for each
  division.

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Analysis of Growth Strategies

• EROIC for A is less than WACC, so A should
  postpone growth until it improves EROIC by
  reducing capital requirements (e.g., reducing
  inventory) and/or improving profitability.
• EROIC for B is greater than WACC, so B should
  continue with growth plans.

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Who is Creating Wealth?
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Corporate Governance

• Rules and procedures that ensure that managers do
  employ the principals of VBM.
• Stick
• Threat of removal
• Board or takeover
• Carrot
• Compensation

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Corporate Governance

• Entrenched management
• Occurs when little chance poorly performing
  managers will be replaced
• Causes
• Manager owns controlling stake
• Anti-takeover provisions in charter
• Weak board
• Problems
• Consumption of perks
• Lavish offices, corporate jets, large staffs,
  country club memberships, etc.
• Accepts projects that make firm larger even if
  MVA goes down
• Makes bad acquisitions

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Corporate Governance

• Anti-takeover provisions
• Targeted share repurchases
• Greenmail
• Hostile bidder, who is planning to fire CEO, buys
  5of stock at 20. Raider then makes offer to
  purchase the rest at 30. The company might
  offer to buy back bidders stock at 35. Raider
  signs a document promising not to attempt
  takeover again for a number of years.
• Charter should ban
• Shareholder rights provisions
• Poison pills
• Give s/hs of target firms the right to buy a
  specified number of shares in the company at a
  very low price if takeover is attempted. This
  dilutes holdings of raider.
• Entrench!

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Corporate Governance

• Restricted voting rights plans
• Deprives a s/h of voting rights if s/h owns more
  than a specified amount of stock.
• Board of directors
• Weak
• Many insiders or quasi-insiders
• Enron consulting fees
• Interlocking boards
• CEO of A on Bs board, CEO of B on As board

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Corporate Governance

• Using compensation to align s/h and manager
  interests
• Stock options
• Gives owner the right to purchase a share of
  company stock at a specified price (exercise
  price).
• Usually cant exercise for a number of years
  (vesting)
• Does have expiration period usually 10 years
• Restricted stock
• Grants shares to managers. Subject to vesting.