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 don’t pay any
dividends. You have structured your presentation around the following
questions.

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

Assets-in-place and nonoperating, or financial, assets.

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

Assets-in-place are tangible, such as buildings, machines, and 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 non-operating assets? How can their value be estimated?

Non-operating assets are marketable securities and ownership of non-controlling

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

d. What is the total value of a corporation? Who has claims on this

value?

Total corporate value is sum of value of operations, value of non-operating

assets, and value of growth options. Debt holders have first claim. Preferred
stockholders have the next claim. Any remaining value belongs to stockholders.

e. 1. The first acquisition target is a privately held company in a

mature industry owned by two brothers, each with 50 shares of stock.
The company currently has free cash flow of $24 million. Its WACC is
11% and it is expected to grow at a constant rate of 5%. The company
owns 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?

24 (1+0.05)

( 011.−005)

Vop =420

e. 2. What is its total corporate value?

Total corporate value = Vop + Mkt. sec.

= $420 + $100
= $520 million

e. 3. What is its intrinsic value of equity?

Intrinsic value of equity = Total value- Debt - Pref.

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

e. 4. What is its intrinsic stock price per share?

Intrinsic stock price per share = Value of equity / Number of shares

= $270 / 10 - $200 - $50
= $27.00
e. 5. What is its MVA (MVA = total corporate value – total book value)?

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

f. 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)?

$ -4.545
8.264
15.026
398.197
$416.942 = Value of operations

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

Value of equity = value of operations - debt

= $416.94 - $40 = $376.94 million.

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

g. KFS is also interested in applying value-based management to its

own divisions. Explain what value-based management is.

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.

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

i. What is expected return on invested capital (EROIC)? Why is the

spread between EROIC and WACC so important?

EROIC is the return on the capital that is in place at the beginning of the period:

EROICt = NOPATt+1
Capitalt

If the spread between the expected return, ROICt, 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.

j. 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%?

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

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 and/or improving profitability.

The expected ROIC of division b is greater than the WACC, so the division should continue with its
growth plans.

l. List six potential managerial behaviors that can harm a firm’s value.

Managers might:
1. Expend too little time and effort.
2. Consume too many nonpecuniary benefits.
3. Avoid difficult decisions out of loyalty to friends in company.
4. 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.
5. Avoid returning capital to investors by making excess investments in marketable securities or by
paying too much for acquisitions.
6. Massage information releases or manage earnings to avoid revealing bad news.

m. The managers at KFS have heard that corporate governance can

affect shareholder value. What is corporate governance? List five
corporate governance provisions that are internal to a firm and are
under its control.

Corporate governance is the set of laws, rules, and procedures that influence a company’s operations
and the decisions made by its managers.
The provisions under a firm’s control are:

(1) Monitoring and discipline by the board of directors.

(2) Charter provisions and bylaws that affect the likelihood of hostile takeovers.

(3) Compensation plans.

(4) Capital structure choices.

(5) Accounting control systems.

n. What characteristics of the board of directors usually lead to
effective corporate governance?

(1) The CEO is not also the chairman of the board and does not have undue
influence over the nominating committee.

(2) The board has a majority of true outsiders who bring some type of business
expertise to the board (and he board is not an interlocked board)

(3) The board is not too large.

(4) Board members are compensated appropriately.

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

(1) Shareholder rights provisions.

(2) Restricted voting rights plans.

(3) Targeted share repurchases.

p. Briefly describe the use of stock options in a compensation plan.

What are some potential problems with stock options as a form of
compensation?

The owner of stock options has the right to buy a share of the company’s stock at a specified price
even if the actual stock price is higher. Usually these options can’t be exercised for several years.

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.

q. What is block ownership? How does it affect corporate governance?

Block ownership occurs when an outside investor owns a large amount of

company’s shares. Large institutional investors, such as CalPERS or TIAA-CREF,
often own large blocks. Block holders often monitor managers and take active
role, leading to better corporate governance.

r. Briefly explain how regulatory agencies and legal systems affect

corporate governance.

Companies in countries with strong protection for investors tend to have better
access to financial markets, a lower cost of equity, increased in market liquidity,
and less noise in stock prices.