week 7

Slide 1

Introduction

Welcome to Financial Management. In this lesson we will discuss corporate valuation, valued-based management and corporate governance.

Next slide

Slide 2

Topics

The following topics will be covered in this lesson:

Overview of corporate valuation;

The corporate valuation model;

Value-based management;

Managerial behavior and shareholder wealth;

Corporate governance; and

Employee stock ownership plans.

Next slide

Slide 3

Overview of corporate valuation

A number of firms practice value-based management by using the corporate valuation model to guide their decision-making process. Corporate governance is the set of laws, rules, and procedures that influence the degree to which the firm implements the principles of value-based management.

Recall, the primary objective of management is to maximize the intrinsic value of the firm. To do this we must forecast financial statements under different scenarios, determine the present value of the cash flows of each scenario, and select the strategy that yields the maximum value.

What model should we use to discount the cash flows? We could use the dividend growth model but the model is not suitable for valuing most start–up companies since they don’t pay dividends.

Additionally, many mature companies don’t pay dividends either. Whether mature or start-up a firm will most likely not paid dividends so long as there are investment opportunities that are attractive enough so the firm postpones paying a dividend and uses its internally generated funds for expansion.

The dividend growth model is also not useful because typically firms have more than one division and individual divisions don’t pay dividends. Since the corporate valuation model does not depend on dividends we can use it to value the entire firm, divisions, and subunits of the firm. This valuation method focuses on how corporate decisions impact the stockholders but, corporate decisions are made by managers, not stockholders. For this reason there could be a conflict between maximizing manager satisfaction and maximizing shareholder wealth. Therefore, a key element of value-based management is ensuring that managers focus on maximizing shareholder wealth which is part of corporate governance.

Next slide

Slide 4

The corporate valuation model

Firms own two types of assets:

Operating assets; and

Non-operating assets.

Operating assets are composed of assets-in-place such land, buildings, machinery, inventories, patents, reputation, and consumer lists. Growth options enabled the firm to expand because of its current operating know-how and experience. Both assets-in-place and growth options provide an expected stream of cash flows.

In contrast, non–operating assets are in the form of marketable securities in addition to the cash the firm needs to operate the business and investments in other businesses. Since firms can influence the value of their operating assets but not their non-operating assets, operating assets are more important and are the basis for value-based based management.

Next slide

Slide 5

The corporate valuation model - continued

To use the corporate valuation model to determine the firm’s value we must first determine the value of the firm’s operations, or the value of the firm as an ongoing concern which is the present value of the expected future free cash flows discounted at the weighted average cost of capital. Recall, free cash flows from operations is the amount of cash available for distribution to all investors, including stockholders, bondholders, and preferred stockholders. Then the value of the firm as an ongoing concern or its value of operations is given by the formula:

V sub OP equals summation T equals one through infinity FCF sub T divided by the quantity one plus WACC raised to the tth power.

Next slide

Slide 6

The corporate valuation model - continued

As a practical matter, the procedure used to determine the total value of the firm are as follows:

Forecast the balance sheet and income statements over the forecasting period;

Calculate the non-constant free cash flows;

Calculate the terminal, or horizon value of the firm;

Add the non-constant free cash flows to the terminal, or horizon value of the firm to obtain the value of the firm as an ongoing concern or the value of its operations;

Calculate the value of the firm’s non-operating assets which consist of marketable securities or non-controlling investments in other firms;

To obtain the total value of the firm add the value of the firm as an ongoing operation to the value of the firm’s non-operating assets. We do not have to calculate the present value of the non-operating assets because they are short-term in nature and the values reported on the balance sheet are very close to their market value.

Next slide

Slide 7

The corporate valuation model - continued

Given the value of the firm, how do we calculate the value of its common equity?

First remember notes payable and long-term debt have first claim on assets and income.

Next, recall that preferred stockholders must be paid before common stockholders.

Therefore, if we subtract notes payable plus long-term debt plus preferred stock from the value of the firm we obtain the amount left for common stockholders.

The market value added or MVA is defined as the difference between the market value of equity and the book value of equity capital supplied by shareholders. If we focus on intrinsic MVA we calculate it as the difference between the intrinsic market value of stock and the book value of equity.

To determine the intrinsic value of the firm’s equity we start with the value of the firm’s operations:

Add to it the value of non-operating assets;

This yields the total intrinsic value of the firm;

Subtract debt and preferred stock;

This yields the intrinsic value of the firm’s equity; and

Dividing this figure by the number of shares outstanding yields the intrinsic stock price per share.

Next slide

Slide 8

Value-based management

Value-based management uses the corporate valuation model to evaluate potential decisions by the firm. To understand value-based management we need to look at four fundamental wealth drivers of the firm, namely, G or growth in sales, OP or operating profitability which is net profit after taxes or NOPAT divided by sales, CR or capital requirement which is operating capital divided by sales, and WACC or the weighted average cost of capital. These drivers can affect the value of the firm.

The growth in sales more often than not has a positive effect on firm value unless the firm’s growth requires a large amount of capital and if the cost of capital high in which case the effect is negative.

Operating profitability always has a positive effect on the value the firm. The lower the capital requirements ratio the better because this implies that the firm can generate new sales with smaller amounts of new capital. Finally, the lower the WACC the higher the firm’s value.

Next slide

Slide 9

Value-based management - continued

The expected return on invested capital or EROIC is also an important concept in the corporate valuation model.

Mathematically:

EROIC at time N equals NOPAT sub N plus one divided by capital sub N.

This equation says that EROIC equals the expected NOPAT for the coming year divided by the operating capital at the beginning of the year.

V sub OP, or the operating value of the firm at time N can be written as FCF sub N plus one divided by the quantity WACC minus G.

We can rewrite this equation in terms of the drivers so that:

V sub OP at time N equals capital sub N plus the quantity sales sub N times the quantity one plus G divided by the quantity WACC minus G times the quantity OP minus WACC times the quantity CR divided by the quantity one plus G;

Where WACC is the weighted average cost of capital;

G is the growth in sales;

OP is operating profitability; and

CR is a capital requirement.

This equation tells us that the value of operations decomposes into two components the operating capital provided by investors and MVA.

The first term of this equation is a present value of growing sales discounted at the WACC.

The second term tells us that if we hold g constant, MVA increases if operating profits increase, if WACC declines, and or if capital requirements decline.

For this reason an increase in growth may not necessarily increase the value the firm. OP could be greater than zero but if the firm needs a lot of new capital to support the increase in sales so that CR is high the second term is negative. In this case the first term increases because of increased growth but it is multiplied by a negative term so the net increase is a decrease in MVA.

Next slide

Slide 10

Value-based management - continued

Our equation can be rewritten in terms of EROIC so that:

V sub OP at time N equals capital sub N plus capital sub N times the quantity EROIC sub N minus WACC divided by the quantity WACC minus G;

Which says that the value of operations at time N decomposes into two terms, the value of capital and the MVA. Then, if the combination of profitability and required capital results in an EROIC which is greater than the WACC the return on capital is greater than the return investors expect and management is adding value.

So an increase in growth results in an increase in value. If EROIC equals WACC the firm is breaking even. If EROIC is less than WACC then the faster the firm’s growth rate the lower the firm’s value. While this analysis can be used to value all firms the equations only apply to relatively stable firms that grow at a stable rate.

Next slide

Slide 11

Managerial behavior and shareholder wealth

While the firm’s shareholders want managers to behave in a legal and ethical manner, there are several ways in which management’s behavior can harm the firm’s intrinsic value.

First, they may not work to maximize firm value.

Next, they may spend money in a way that is irresponsible.

Third, because of personal relationships managers may make decisions that are not in the best interests of the firm.

Fourth, managers may not undertake projects with the appropriate amount of risk.

Fifth, they may invest free cash flows in marketable securities instead of returning them to shareholders.

And sixth, they may withhold information from investors.

Next slide

Slide 12

Corporate governance

Corporate governance is the set of rules, laws, and procedures guide the operations of the company and management decisions. One key requirement to successfully implement value-based management is to guide the decision-making process by the firm’s managers so they operate in an ethical and legal manner so that the firm’s intrinsic value is maximized. The firm has several internal provisions it can use to control managers’ behavior. These are:

Monitoring and disciplining by the board of governors;

Charter provisions and bylaws that prevent the likelihood of hostile takeovers;

Compensation plans;

Capital structure; and

Accounting control systems.

Additionally, the regulatory, block ownership patterns, market competition, media, and litigation or environmental factors outside the first control that encourage ethical and legal behavior on the part of managers.

Next slide

Slide 13

Employee stock ownership plans (ESOPs)

An employee stock ownership plan, ESOP, is a retirement plan in which employees own stock in their company. There are several reasons a firm may want to establish an ESOP.

Employees who have ownership in the company will be more productive which benefits outside shareholders. An ESOP is additional compensation for the employee and may help the firm retain employees.

When the ESOP owns more than fifty percent of the firm’s common stock, there are financial benefits in the areas of taxation and the payment of cash dividends.

Finally, establishing an ESOP may avoid a takeover by another company.

Next slide

Slide 14

Check your understanding

Slide 15

Summary

We have now reached the end of this lesson. Let’s review what we’ve covered.

First, we discussed an overview of corporate valuation, which includes value-based management and corporate governance.

Next, we learned that the corporate valuation model ties together the concepts of financial statements, cash flows, financial projections, time value of money, risk, and the cost of capital.

Also, we studied value-based management and learned the firm uses the corporate valuation model to evaluate potential decisions by the firm. To understand value-based management we looked at the four fundamental wealth drivers of the firm and their impact on the firm.

Next, we defined corporate governance as the set of rules, laws, and procedures that guide the operations of the company and management decisions.

Then, we learned that while the firm’s shareholders want managers to behave in a legal and ethical manner, there are several ways in which management’s behavior can harm the firm’s intrinsic value but the firm has internal and external provisions to control managers’ behavior.

Finally, we identified benefits and drawbacks of employee stock option plans.

This concludes this lesson.