Chapter 15

Corporate Valuation, Value-Based Management, and

Corporate Governance
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 considering acquiring. But first, the senior management of
KFS would like for you to explain how to value companies that dont pay any dividends.
You have structured your presentation around the following questions.

a. List the three types of assets that companies own.

Answer: Assets-in-place, growth options, and nonoperating, or financial, assets.

b. What are assets-in-place? How can their value be estimated?

Answer: 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.

c. What are growth options? How can their value be estimated?

Answer: Growth options are not tangible. They include R&D, such as at drug companies and
genetic engineering companies, and building customer relationships, such as at
amazon.com. Growth options are valued using option pricing techniques in Chapter
17.

d. What are nonoperating assets? How can their value be estimated?

Answer: Nonoperating assets are marketable securities and ownership of non-controlling

interest in another company. The value of nonoperating assets usually is very close to
figure that is reported on balance sheets.

Mini Case: 15 - 1
e. What is the total value of a corporation? Who has claims on this value?

Answer: Total corporate value is sum of value of operations, value of nonoperating assets, and
value of growth options. (No examples in this chapter have a growth option-- this is
deferred until chapter 17). Debt holders have first claim. Preferred stockholders have
the next claim. Any remaining value belongs to stockholders.

f. 1. The first acquisition target is a privately held company in a mature industry.

The company currently has free cash flow of $20 million. Its WACC is 10% and
it is expected to grow at a constant rate of 5%. The company has marketable
securities of $100 million. It is financed with $200 million of debt, $50 million of
preferred stock, and $210 million of book equity. What is its value of
operations?

Answer:
FCF0 (1 g )
VOp
WACC g
20 (1 0.05)
VOp 420
0.10 0.05

f. 2. What is its total corporate value? What is its value of equity?

Answer: Total Corporate Value = VOP + MKT. SEC.

= $420 + $100
= $520 million

Value Of Equity = Total - Debt - Pref.

= $520 - $200 - $50
= $270 million

f. 3. What is its MVA (MVA = total corporate value total book value)?

Answer: 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

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g. 1. The second acquisition target is a privately held company in a growing industry.
The target has recently borrowed $40 million 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 free cash flows of -
$5 million in one year, $10 million in two years, and $20 million in three years.
After three years, free cash flow will grow at a rate of 6%. Its WACC is 10%
and it currently has 10 million shares of stock. What is its horizon value (i.e., its
value of operations at year three)? What is its current value of operations (i.e.,
at time zero)?

Answer: 0rc = 10% 1 2 3g = 6% 4 N

| | | | | |
-5 10 20

$ -4.545
8.264
15.026 Vop 3 = 530 = 20 (1 0.06)
398.197 0.10 0.06
$416.942 = Value Of Operations

g. 2. What is its value of equity on a price per share basis?

Answer:

Value of equity = value of operations - debt

= $416.94 - $40 = $376.94 million.

price per share = $376.94/10 = $37.69.

h. KFS is also interested in applying value-based management to its own divisions.

Explain what value-based management is.

Answer: 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).

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i. What are the four value drivers? How does each of them affect value?

Answer: MVA is determined by four drivers: sales growth, operating profitability

(OP=NOPAT/sales), capital requirements (CR=operating capital / sales, and the
weighted average cost of capital. MVA will improve if WACC is reduced, operating
profitability (OP) increases, or the capital requirement (CR) decreases. See the next
question for an explanation of the impact of growth.

j. What is return on invested capital (ROIC)? Why is the spread between ROIC and
WACC so important?

Answer: ROIC is the return on the capital that is in place at the beginning of the period:
NOPAT t 1
ROIC
t 1 Capital t
If the spread between the expected return, ROICt+1, and the required return, WACC, is
positive, then MVA is positive and growth makes MVA larger. The opposite is true if
the spread is negative.

k. 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 (OP=6%)
but high capital requirements (CR=78%). Division B has low profitability
(OP=4%) but low capital requirements (CR=27%). What is the MVA of each
division, based on the current growth of 5%? What is the MVA of each division
if growth is 6%?

Answer:
Sales t (1 g) CR
MVA t OP WACC
WACC g (1 g )

Division A Division B
OP 6% 6% 4% 4%
CR 78% 78% 27% 27%
Growth 5% 6% 5% 6%
MVA (300.0) (360.0) 300.0 385.0

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l. What is the ROIC of each division for 5% growth and for 6% growth? How is
this related to MVA?

Answer:
Division A Division B
Capital0 $780 $780 $270 $270
Growth 5% 6% 5% 6%
Sales1 $1,050 $1,060 $1,050 $1,060
Nopat1 $63 $63.6 $42 $42.4
Roic1 8.1% 8.2% 15.6% 15.7%
Mva (300.0) (360.0) 300.0 385.0

The expected ROIC of division A is less than the WACC, so the division should
postpone growth efforts until it improves ROIC by reducing capital requirements
(e.g., reducing inventory) and/or improving profitability.
The expected ROIC of division b is greater than the WACC, so the division should
continue with its growth plans.

m. The managers at KFS have heard that corporate governance can affect
shareholder value. List for them the three mechanisms of corporate governance.

Answer: The three mechanisms are provisions in the charter that affect takeovers, composition
of the board of directors, and compensation plans.

n. Why is entrenched management potentially harmful to shareholders?

Answer: Entrenchment occurs when there is little chance that poorly performing managers will
be replaced. There are two causes: anti-takeover provisions in the charter and a weak
board of directors.
Management consumes perks: lavish offices, corporate jets, excessively large staffs,
memberships at country clubs
Management accepts projects (or acquisitions) to make firm larger, even if MVA goes
down. This is because salary and prestige are highly correlated with size.

o. List three provisions in the corporate charter that affect takeovers.

Answer: These include targeted share repurchases (i.e., greenmail), shareholder rights
provisions (i.e., poison pills), and restricted voting rights plans.

Mini Case: 15 - 5
p. Explain the difference between insiders and outsiders on the board of directors.
What are interlocking boards?

Answer: Weak boards have many insiders (i.e., those who also have another position in the
company) compared with outsiders. Interlocking boards are weaker (CEO of
company A sits on board of company B, CEO of B sits on board of A).

q. What is a stock option in a compensation plan?

Answer: Gives owner of option the right to buy a share of the companys stock at a specified
price (called the exercise price) even if the actual stock price is higher. Usually cant
exercise the option for several years (called the vesting period). Cant exercise the
option after a certain number of years (called the expiration, or maturity, date).

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