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Valuatiom, 1- i Corponat* Value-Eased Maraagemremtu eorporate amd uoveg"maE?ee Tl r,..r \.rd inra.tpd $.0rl,r in th, \\:l I Cumpo-rlp IndF\ l0 V.dr, .r':,'. \.,ur Irnvp.lmen. rvou d h"r c gros r to S2.2q4 t..ullin8 nr 8.t- .,rrru.,lr.rteoI return Hid y.r 'n pui rhP sl 000 rn Berl-hrn Hathah'ay,you would nor\, havc $2,960, rvhich an 11.5% is annualrcturn.And if you hadbeen really smart (or lucky) and invest ed rr Dell. \ou sL'uld llow have gi17r'. \rf i.l' r,nr,lJ (. i,rlo i hhoppinB 2L.u. annualreiurnl Berkshir Hathaway and Dcll compete in very diffcrent jndustries ,nJ urrli,,Fdiffrrrn -l..rleF,ie.. )et borlr Ldv"b.,,r(,' rl-, m.,.ke,b\ dn,.p, r "hdrint rrirB pl- lu.,.ph\ lhe) hr\..rcrt,J \.,lLL for shareholders by foftsing on the Iree cashflows of their undcrlyinB busjnesses. Whn this focus is applied systematically .Irorg\nJt r.umpJ.r\ rt r...rlled v.rl , basedmanailement, $'hich is thc .cntral th{rlne this chapier. of Berkshire Hatha$'ay's p mary stratety h;lsbeen to gro| through acquisitions. hhffn Buffett, Berkshire's CEO, lvrote in n recent letter to shareholdersthat hc seeksi 'bu'rre-.e- ll-,rl Sencr.rl( ( rnd o\\1 corsistenilv earn above-averagereturns on Voriomanildl,epo lh'.r..'pir.rl. Wh.n ' vrlu"lrrg J potentr,rl ,1(.tui.iri,'n. BuffLlr n,v- he (omprrF. rl. purchasc price {,ith its "intrinsic value, whj. h ',f Jerl|rer.r. lhe dr-counred\aluy ,.f rh, cr-h th,,rcdI be lalen out oi a bu,in.'ss during its remaining Iife-" Thus. Buffett's Brou'th strategy is Sovemed by the principles of value-basedmanagement. Instcad of gror'\'ing primarily through acquisitions, Dell has chosento grow "or8anic.lly" by expanding its existing businesses and developing ncw products and markets. Fnr mr^l ,,'nrprni... rdprd 8row,h n .al,* r,\|rrri- r.rpr.ierowlh ir opernlirg (dpil.rl. whrch r,J,r'F. Iee.r,h fl('(. BL,l Dell i5 rcle1rtless minimizing the amount of oper in JtirE (.rt.ilr'e,tuirLd tu,upporl Tr. "ale.. rints l.r-L ).rr.. Dpll h". hdd oul t.r.!.JL thc i p .r.l|trlirt i,frf.,nn.rn. in rhed rivFr, ol \ alu(basd management:(1) Iis saleshave grown /2) f.r.lrr lh.rr ll',\ . ve'.rge, rr- prolil has cxcccdcd the inctustry ai.erage, nargin and (3) its capitalrequnemenis have remained Lowrthan the industry average. Kccp Berkshife Hatha\^'ay's and DeU's f,,.,,. ,'t) , .r.h flor,- ir m ind .i\ ) uu .e.,dtl,r" ch.rpter. : olBe*shne Horhowoyli. oid DelCompde6 518 Chopier15 Monosemeni, Coporote ond Govornonce Corporore Voluollon, Vdlu+Bosed As we have emphasized throughout the book, maximizint shareholder value should be managemenfs primary objective. However, to maximize value, manIn agrsneeda tool for estimatingthe effects altemativestrategies. this chapiet of e le50Llfce we dvelop and illustrate such a tool-the corporatevaluation model, which i! Thr.xlbookh Websire discountedat the weithted contoins Excel lhor the presentvalue o{ expectedfuture free cashflows, on file the valuation model is the culmina. averagecost of capital.ln a snse/ corPorate rhechopErtcol.ulolions. tion of aI the material coverd thus far, kause it puls together financial state Thefile for lhh choprd i3 ments, cash flows, financial projectionr time value of mone, risk and the costof F 12Ch 15 ToolKt.xh, capital. Companispractice valu-basedmanagementby systematicallyusing you ondw ncouroge the corporate valuation model to tuide their decisions. Finally, the deSreeio to op6nthefileond fol. management often depnds which a companyemploysprinciplesoI value-based on its corporat govenance, which is the set of laws, rules. and procedures that influence its operations and the decisions made by its managers. Valuation l5.l Overview Corporate of As stated earliet managers should evaluate the effects of alternative strategieson their firms' values. This really means {orccasting financial statemmts under alter finding the presentvalue of each strategy'scash flow stream, native strategies, and then choosjng the strategy that provides the maximum value. The financial and procedures discussd in statements should be pmjectedusing the teclmiques Chapter 14,and the discount rate should be the risk adjusted cost of capital as discussed ;n Chapter 10- But what model should managers use to discount the casl flows? One possibilits/ is the dividend growth model ftom Chapter 8. Howevet that model is olten unsuitable for managerial purposes. For example, supposea start-up company is formed to develop and market a new product. Its managers will focus on product development, marketing, and mising capital. They wil probably be thinking about an eventual IPO, or prhaps the sale of the company to a larger firm- <isco, Microsoft, Intel, IBM, or another of the indusEy leaders that buy hundreds of successful new companies each year. For th manaters ol such a starFup, the decision to initiate dividend payments in the foreseeable future will be totaliy off the radar screen.Thus, the dividend growth model i6 not useful for valuing most start-upcompanies. Also, many stablished firms pay no dividends- lnvestors may expect them to pay dividends sometime in the future, but when, and how much? As long as inter' nal opportunties and acquisitions are so attractive, the initiation of dividends will be postponed, and this makes the dividend growih model of little use. Even Microsoft, one of the world's most succes'sfulcompanies, only started paying a dividend in 2003. Final, the dividend trowth model is generaly of limited use for internal manaSementpurposes, even for a dividend-payint company. [f the 6rm consisted of just one bi8 asset, and that asset produced all of the cash flows used to pay dividends, ihen altemative stmtegiescould be judged through the use of the dividelld growth modl. However, mosi firms have severaldifferent divisioN with mally assets, the corporation'svalue depends on the cash f]ows from so many different assets, and on the actions of many managers. These managers need a way to measure the effects o{ their decisions on corporate value, but the individual divisions don'l discounteddividmd model isn't very usetul because dividends. l)av TheCorporote uotion Vo Mode 519 g.*'tl}.' Thevolue of a flrm is deiermined ihe size,ilmirrg, by ond risk of ls expeciedt!r!,e free cqshflows IFCF). Chopter 14 showed how lo proiect finonclo sior+ menh, ond Chopier3 showedhow lo colc!lab free cosh flows. Chopter l0 expio ied how ro estimate ihe welghied overose cosi of copllol. This chopler puh lhe plecestogeiherand showshow to co cu dle ihe voloeof o lnm t o so showshow ro use ihe vo uoiion model os o g!ide for choosingomong differ eni corpofoiesiroregies dfcl operalingioctics. FCFI F C F, * " ''' " : t r , w a c c j , 1l + WACC)' (r wAcc)r (1 + WACC)' ForLunalel]., corporatc valuatior model does rrot depend on dividcndi., the andii canbe apdied b divisnns nn.l subunitsas rvell as to the enftc firm. Arother important aspcd ol v.lue-based marugementis the con.cpt of coT,o, ratego\.ernance. lhc cor}roraicvaluaft,n model shows how cor!(rak decisbns ;r(ect s/o.ft/ro/dcrs. Howcvcr,l:orporate decisions rnadebi, minagcrs,not stock are holders, maxnnizingshflrcholdcr and lve.lih is not the sameashdividualnrflna8ers .rarimjzingthetu o{/n "satisfa.tior."'Thus,a key aspct valuc bascd of managenreni isuraking surc that managds focnson thegoal of stockloldeNc.rlth maxnnizntion. Ihe set of lal\'s, rulcs, and procedures ihal rnfluerlce company'sopcrationsand a notivate its .rrllcls fnllsrnder lhe general headi^Bol cotpornte gor\\nnni. Thls chaptcr .liscusses coryoratevaluation modcl, valuc-based lhe manage ment, anclco+lorakrSovcrnance, be$urirl8 $,lth thc corPordtcvaluaLion model. 5EIF"TF5T !n1it,l! lLl; (.rF6fie ',ttut{nn irc*e, iaroli.*}ie ii !xr.r, r;r.ul.i'ro(ei ${n"i.iefld g..wth nrodeli -11:r:;, *1r b':so:]n,r:r,uqqgol? -r'Jlsi is .e.l.rdJ. {*!.rr.ii'r jr? i :i , l r ,i ' i'l,it"--:i,r: i !/i r,. ., Corpora!e assets of trfo tvpes:operating an.l nonoperating.Operatingassets, are ir furn, L.1ke t\,'o foflns: assets-in-pli.e .nd growth options. Assetsin placc ir.[rd slrch tani]lble assctsas lan.l, builLljrgs, nuchines, and in1'enbry, plus iftirgible assets srch as pnicnts, c stomcr lisls, reputation,and generalkno$hoN Cro\rth optb s arc opporhnities io expand that arise from thc fiml's cur(nt opratnrt knorvldgc,cxpc orce, and other resources. lhe assets h-placc provide expecte(l an streamof cashflows, and so do the growth options.'fo iilustmte, Wal lvlart o$'ns sbrcs, invcnh)ry, anLl oiher tangible assets, has a lvcllit knorvnnamean(lagoodrcput.tiol;andittlasalotoibusilesskno\,\'ho,.Thcsc assets producecurrcnt saicsand flows, and thev also provide opp.rlunitics for nerv jnvestments thnt \dill produce addiliorul cash flo\,vs h thc fuiurc. A dt i i d i o i s s o m e r i m en .d e b e we e i "e r e cu r ve i o id m o n o g eE ,w i fi ere.dvstei .a6 s Jo r m.mbm of rhebp mrncsemen|edm We lo D. iDle rrro'lnfnclion n rh5 book o peoptewi$ rc desqiored "n0ncqer " 520 Chdpter l5 Monogemeft, ond Corporote Govemonce Cofporate Vo uarlon,Volue-Bosed ind Sinilarhr Mrrck owns manufncturingplants,patents,an.l other real asscis, il lus a knorrlcdgc b.1se fn.ilitatesihe dcvok)pmentof ne'v ctrLrgs thusne\ that nnd cashflon'strcams. Most .onipdnics also own some nonopor.rtint assets,rtrich conlc in two portfolio o\-erand rlrove the cashnccdrd forms.The fiht is a marketablc sccurities For b operatethc business. cxample,Ford Motor Conrpanv'sautomotivc oPera20(15, tion had nbout S10.3 billion in short term invcshnentsas of D(.ceDrber and this rvasin a(ldition to 513.4L,illbn h cash.Sccond,Ford also hacl$1.8billnnroi invcstmentsin othcr busnresscs, $,hjch$,erc rcportedon thc nssetside of thc bdlancc sheeins "Iquitv ln Ncl Assetsof Afliliaic(l Companics."In toial ford hid compaft,dwjth its Xjll3.8Lril $j]0.3 $l.lJ = $12.1bilhnl of nonoperatingnsscts, ol of the lion of autonrclile asscts, 10.6% the tolal. For most cornpanies, pclcrnt oi age is much lu'er. For exaDlplc,as of the end of 2005\\hl M.rt's percentaBo !!as th.rn 1%,i{hi.h is nlore 5,pical. nonopcratingdssets Wc scc,thcri, that f('r n1ost opcratingassets far more important arr conrPanies Mofeovcr,companicscan infhen.c thc valuesof tlrcll than nonopcf.rr(ng asscts. operating.lssets,but ihc vnllres of nonoprntinsassetstrre lnlgcli/ out of tlrcir hcncethis chaptcr,focuscs on direct corrirol.lhereforc, !irluebased manngcnlent, Eslirnating Valuc {}pcraiiorrs lire of Tables15 I nnLl15-2contain thc actual 2007aird Projected2008to 2011fjnnncirl siatcmnisf(n MagnaVisionInI..,$'hich produccsoptical svstrms for use jn nrcd ical phob8rdphv (SccChnpter l-l for morc dctails on how k) project finaDcril staiemcnts.) Crowth has beenrapi.l in the pnst,bui the market is becomings.rrLrgro$,th f.rteis expccted dcclinc from 211 in 2008to a]to Iated,so th! snles able raic of 501in 20ll anclbcycnd. I'rofit irnrgins arlr expectcdk) improve .s tho productior\ Pfocessbcconcs nrcrc cfficie t nnd \^,ill n0 i{ifi the irrtroductnrnof n m.rjor lorgcr bc hcuring nlarkrting cosisassocjntcd product. All itens on ihe lin. dal statcncnls are pmjccied k) groN at a 5, .ite after 2011.Not that the (ompany docs ndt p.r)' a divi.lcnd, Lrlrtii is cxpe.te.l t(, startpaying oui aboui 757 ot iis earnnlgsbcginnjng in 2010.(Chaptcl 18 explnifs ho{,DrLrchLopay out in clividends.) nr morc dctilil hor{'companios decicle Rccall thnt free cnsh flor\, (FCF)is the c,rsh fron olic lions thai is actrullv avail.ble f(n (tjslribrition to inlestors, inclu!ting stockho]tlers, I'ondholders,aid preferre.lsk)ckholders. Thc value of op'rrnti()nsis the presentr'.rluc oi the lrcc cash noivs tlle firm is c\Pected to g$erat oLri into thc (Lrture.Therci(tre, Magnavisi('n'svalLre car bc cnlculated the presentvalue 1riils expcctcdflrilrre as free cash flows from operations, .]iscotlnlcdni its il.eiBhtcdnveragecosi of c;rFrtal, WACC, plus the valuc of its rronoperating issets.Hcrc is the ectuati('rh' the \,lue,'1, 1!r.,lr,.rr.. r,ir r- lh, trrn- \,. r'u.,- 6oi p,., r'r',t[ hl " Value of opcrations= Vq. = I'V oI expcctcel Iuture frec cashllo*' = ' 1r* w,^,i--l' (r , w^c+ FCF, S (r + WACC)'' 3 rcFr FCf., - tr wecdjr {r5) T h eC o r p o r o r e o u o l o n M o d e V MognaVision S i o i e m e ni s 2007 $700.0 599.0 28.0 2008 $850.0 734.O 31.0 $/65.0 $ 85.0 2009" 2010 201I a^.k 1 6 ..6 ^r.1 6 ^1 6 l ^r ^^r D e p r ec loliof Toto operoungcosis Eoriingsbeforelnleresiond iaxes {EB T) Eoriingsbelore toxes Toxes{40%) Ner incomebefore prefered dlvidends Prefened divldends Nei i.come ovolloblefor commoi dlvideids Ad dit iono r eloined o rn l n g s t e $627.O $ 73. 0 t3 0 r 5.0 $ 60.0 $ 70.0 24.O 28.0 $ 36 . 0 $ 42.0 6. 0 7.O $ 350 = $ 30.0 100 $ 35.0 t00 $ 1 , 0 0 0 . 0 $ t , 1 0 0 . 0 $r ,r55.o 9t t.0 935.0 942.O 34.0 36.0 38.0 9.4s.0 $ 9/1.0 $ $1,02o.0 $ 5s.0 $ 129.0 $ 1 3 5 . 0 17.O t9.0 $ 39.0 $ rr2.o $ It6.0 l5 6 44.8 $ 234 $ 67.2 $ 69.6 8.0 8.3 $ r!? t6.0 100 44.2 t5.0 100 $ 0.442 $ $ $ qL! $ 45.3 $ r 6.0 100 $ 0 r'53 mo'lGfis pros,om | fiorye.r 'Nei s proiecbd b declie n 2009 Ths n dle ro fie cosf.,..n+tme "'Nelinlercn n n|erenpod ondebt es inlereneome! oi morkelobesecufli6 Bolhilemscoud be 5hownreporolev on the incomesble meds,blrtor fi. erlmpie {e combie $em ond JhowNr fre,e!r.Moonov.ion poysnorc inreret$oi I edm; herce 15 rel nlers, i5 abho.led Magnavision's To costof c.pjtal is 10.84,o2. find its valueof gonrgconcern,we usc an aPproachsimilnr to the norrconstant dividend growih rnodelfor siocksin Chaptcr 8, procccdnlgas follolvs: L Assume that the firln r{'ill experience nonconstant gro\,{th for N vears,after \aftichit lrill $or\,.rt somc constantratc. 2. Cal.ulatc thc cxpcctcd frcc cash flow lbr cach of thc N n{nconstant gros,th L RecogDizcthat altcr Ycar N gros,th will bc corsiant, so wc can use thc constantgro\dth fonnula to find ihc fiml's valuc at YearN. This is ihc sum of thc IrVs for ycar N + 1 and all subscqucnt vcnrs,diecounicdback b Ycar N. 1. f.ind tllc I'V of thc frcc cashflows for cachof thc N nonconstant grou,ih years. Also, find thc I'V of thc firm's value ai )'car N. 5. Nolv sum flll ihc PVs,thoscof ihe annral freecashflor{s during the norrconstant period plus the PV of the Year N vnlue, io ftrd the firrn's value of Tablc l5-3 calculaicsfrcc cashflov\'tur cich )'caausing l,roccdulcsdiscussc.l in Chnptd 3. Lille 1, $,ith.1ata lbr 2007 fron thc balnnceshcetsh Tablc i5 2, 522 Chopter 15 Colporoie uolion, Vo Volue-Bosed Monogement, CoTororeGovemonce ond (Millions Dollors) Inc.: Sheels of Mognovision Bolonce Proiecied 2007 2010 201I Co5h Morksloble secuilies" $ r7.o 63.0 85.0 170.0 $335.0 279.O Totocurrcni osseis plonlond equipmenl Nel Liobiliricr and Equity $ 20.0 70.0 100.0 200.0 $390.0 310.0 $911.0 9209! $ r7.0 Tolol entliobililies cuff $ 22.O 80.0 I I0.O 220.O $432.0 341.0 $773.O $ 22.O 160.0 55.0 $237.O 160.0 80.0 200.o 96.0 $296.0 $773.O $ 23.0 84.0 I t;.0 23t.O $454.0 358.0 $812.0 $ 23.0 I68.0 .59.0 $249.0 t68.0 84.0 200.o l |. 0 $ 3 r1 . 0 $ 8 r2 . 0 $ 2.1.0 88.0 t21.0 243.O $a76.0 376.0 $852.0 $ 24.0 176.4 6t.0 $ 2 6 r. 0 176.0 88.0 200.0 127.O $327.0 $852.0 t23. 0 43.0 $ 183 . 0 t24. O 62.O 200.0 ,t5.0 $245.0 Toiol liobililies equiiy ond 4.0 $6r $ 20.0 140.0 50.0 $ 2 r0 . 0 t40.0 70.o 200.0 80.0 $280.0 $700.0 .Alld$.b arpr mo aroblo3*!riros ore operariis a$srs rcqlirod to $pporr !d s! lha md{6lobl c0riiies oG fiiotrc]o o$ok not rcqu rcd shows the rquired net operating workinS capiial, ot operating current assets minus operatingcurrent liabilities,for 2m7: Requirednet Cash i / \ / Accounts \ 'tttt F operating Accounts,eceivable | l- lpavable I \ Accru.rls / | Invenlorie5 / worungepital \ = ($17.00 $8s.00+ $170.00) ($17.00 $43.00) + + = $2'12.00 Line 2 shows requircd net plant and equipment,and Line 3, which is the sum of Lines I and 2, shows the required net operating assets,also called total net operatingcapiial, or just operatingcapital.For 2007,operating capiial is 5212+ $279= $491milion. Ihe Corporqle Model Voluorion 523 Expecied FreeCoshFlow Colcu otingMognoVision's of Dollors) 2007 Col.ulorion of Free Cosh Flo\'v I Reqoired operollngworking copltol rel 2 . Requir ed pon i o rd e q u l p m e n i nel 3. Required toto nel opersling coPiiq' 4. Required new invesimenl nei in ope.oling copllol = chongein ioiol net operoringcopito from previous yeor 5. NOPAT[Nei operoi]ngpro]it ofier ioxes = EBT x (l Tox ,oie)lb Required inveslment 6. Less: in operdtingcopiio 2010 2011 $2I2 . 0 0 $ 250.00 279.AO 3 1 0 . 0 0 $49r . 0 0 $ 560.00 $ 225.00 34t.00 6 r6 . 0 0 $ $289.00 $303.00 358.00 376.40 $64l.00 $679.00 9_q4q $ 51.00 69.00 $ s6.00 $ 33.00 56.00 ($ 23.00) $ 3 r. 0 0 $ 3 2 . 0 0 $ /7.40 $ 8t.00 32.00 3t.00 $ 46.40 $ 49.00 dl" F r m , n " ' o p p ' o r 1 s. o p o p e ,o a n q co po l o t e opeorrqo,.or ol neo, l eroaer rc ol rNOP A | d e 'lon " , r . 2 0 0 4 b d o u .e 'o lo m d 4 .r n q ..p .n d r .. p ,o ted.d thor)ri scN ohonl obl . l 5l ' bl 'd Line.l shorvsth reqldred annual additi(n k) opcratint capital,found as the in changc operatingcapital from the previousyoar.For 2008,th requireclinvestnent in operatingcapiial is 9560 $191= $69million. Line 5 shows NOPAT,or net operatnrgprofit aftcr tnxcs.Note that EBIT is operaitugearnings lrcFrctaxes,while NOPAT is opcrating cimings i/h/ taxes. Therefore, NOI'AT = EBIT(I T). With 2008EBIT of $u5:rsshown in l'.lble 15 I anda iar rate of 40%,NOPAI as projectedfor 2007is $51millbn: NOPAT: EBIT(I - T) - tj8s(1.0 0.4) = $51nillion. Although MagnavisicD'sopratirg capital is proiectedio proctlrce milliorr S51 after tax profits in 2008,the conrpanynrust invcst $69million h new operating of capitalin 2008to support its growth plan. Thorcforc,the fr cashnow for 2008, shoim on Line 7, is a neilative$18rrillion: Freecashflow (FCF) = $51 $69 = $18million. This negativeftee cash flolv in thc early yenrs is typical ft)r yount4,high-gro$'th companies. Even though net opcratingprofit nfLer taxes(NOPAT)is positivcin all ii of kr l'ars,ftee cashflow is lcgaiivc bccausc the meccl invesL opcraiing asscts. The negative free cash flou, moansthc compnny will have to obtairi nei{ funds from in\-estom, and ihebalanceshcctsin Tablc'15-2 show that notespa)'able,lorgtelm bonds, and prefered stock all incrcascfrom 2007to 2008.Sbckholdcrs {'ill alsohelp fund Magnavisirris grot{ih-thcy will rcceiveno dividends uniil 2010, Ijowever as grorvih soall of the nei incomefroDr2008and 2009will be reirrvesled. 524 Chopt r l5 Corpordte Vo uotion, Vo ue BosedMonogement,ond Corporole Governonce slows,free cashI1o ' wi]l bccomcpositive,and Ma8nnMsiol plans hr tlsesomeol its FCFto palr dividends boSnnringir 2010.: A variant of the constnntgR)\ ,th dividend model is shown bclow as EqLration 15-2.Tlis equatiol can bc uscd h) find the value of Magnavisiol's opcrrii(Ds ai timc N, r^'I1en freecashIl(,wsstabilizeand begin lo Brow at a consiantrnle.Tljs its is ihe value of all FCFS bevond tirnc t.\, discouniedback to time N, wlrich is 20ll for Magnavision. (1 + WACC)' N FCFN(I + s) FCFM WACC 8 WACC g (r5-21 cost of capiial, $49mil]n'n of free cashfloh' in 2011,and a 591 Basedon a 10.84% gowth rate, the value of Magnavisior's opcrationsas of December31,2011,is milliorl: forecasred bc $880.99 to FCF,,i r (t + g) ,, v,,p(1,.3,/r) WACC _;-.. (ls.2o) + $49(r 0.0s) 0.10{J,l 0.05 $51.45 = $880.4q 0.108.1 0.05 mil|i()n figurc is called the co panv's terminal, or horizon, value, fts 5880.99 It is also sometimcscalld because is the valuc at thc enctof the forecast it a continuing value. it is thc amount that Magnavision could expcct to rccei\'ii it sold its operatingassets Dccmber on 31,2011. Figure 151 shows tho frcc cash flow for each year during thc nouconstant grorvthpedod,alonit,iththehorizonvalueofoperafionsnr2011.Tofinctthcvalu of operations oi "k)clat" Dcccmber as 31,2002 .e find the PV of cachrnnual cash flo\,vin Figure 15 1, discourtin8 at the 1{).84% ofcapilal. ThC' cost surn of ihc l'jVsis pricc MitnnVistun approximatel)r and it rcpnrsents estimate irhe an oI 5615milli(Jn, could expectto receive it solcllts opcraungassets if today,Decernbcr 31,2007. per the EstimatingPrice Share The iotal valuc of any compnnyis the value of its opcraiionspllrs the vallrc of ih nonoperating asscts.l s the Dc'ceDrber 31,2007, balance shcciin ll)blc l5-2 shows, Magnavisior had $63 milli(D of narkeiable securitie5 that .latc. Urlikc oper on (,e ating assets, do )lot havc k) calculate present\.aluc for Drarkctablc a securities bcause shori-tern financialassts reportedon the balanccshcetafeat, or clos as to, their m.rket valuc.Thcrefffe, Matnavision's total valuc on Dcce Lre.31,2007, = + is 5615.27 $61.00 $678.27 million. nilli(m, lvhat rs If the cornpany'sk)tal vahrcon December 2007,is $678.27 31, ihe \.alueof its colrnnoncqlri ty? Firsi,the sum of notespayableancl long-tcrm (lcbt is$123 | $124= $247milli(nl,.rnd thcsesecurities luve the filstclaim on.ssctsdnd income.Accountspayablcand accru.ils were netted out earlicr whcn cilculit g lMos^ovii oi pl.r! ro n.reose l. debrord prclotrodno.l eochyeo, io o! r. m.lnrd , o corbd oD iolttudu! We d scus.ap bliildu,e in dcb i Chope, l6 rThebb vo !e oko nc uler lhe vo ue ois,owrr oprion3 o*ocioled qil$ oscrrin po.e, burMooiovisionho! nore nor TheCorporoie uollonMod6 Vo 525 lhe of Process Finding Volue Operorions for Growih Cornpony 12n1707 1A31toA 12731/49 1431t1a 12/31t11 9-57a 12131t12 46.00 $ 16.24 -14,72 34,O7 _q-qJ--6 $615,27 vefar'1r= 49.00 51.,tti 51.45 880.90= 01044 - 0.05 929,99 fteecash flow, so they have been accounted for. However, the prcferred stock has the a claim of $62rnillion, and it also ranks abovc thc common.Therefore, value is million. leftfor common stockholders 5678.27 $247- $62 = $369.27 Figure 15-2is a bar chart that provides a breakdown of Magnavision'svalue. SeeFMl2 Ch 15Tool Theleft bar sho(.s the companv'stotal value as lhe suln of its nonoperatint assets plus iis goiig concernvalue. NexL the middle bar shows the claim of eachclass ofinvestorson that total value. Debtholdershave thc hi8hestpdority claim, and MagnavisionoR'es$123million on notespayableand $124million on lont-term boDds,for a total of 5247 million. The prferred stockholdcrs have the next claim, 31, Mognovision's os of December 2007 Volle Dolars (ltlllions) 700 Claims 526 Chopter 15 Corporote Voluoiiof, ue.Based Vo Mondgemeni, Corporore ond Governonce ihe Findino Volue MccncVision Stock of s (Mil iois of Do lors, Exce"pr PerShcre Doto) for L Volle of operoiions(prcsent volueof free coshfows) 2. P Lrs ue ol nonoperoling vo osseis Toro morketvolueof the firm 3. 4. tess:Voloeof debr Volueof prefered stock 5. Volueof comnro'r equity (i 6 . D i v i d eb y n u mb eo f shores n ml l l i ons) r $6t5.27 63.00 $678.27 247.OO 62.OO !36e-.27 100.00 $ 369 562 rnillion. The remaining valuc bclongsto thc common equity, and it amounts to $678.27 5247.00 $62.00= $369.27 millhn.l In Chapter 3, \^,eclefincdthe (MVA) as the differcnccbctwcen the market vallre of sto(k Markct VallreAddec:t and thc cquity capital supplicd by shareholdr'lrs. Hrre, we assumethaLLheesit nratcd market value of eqlriLyis approrimatcly lqual io the actual narket value of {]quiiy; in other h'ords,thc inLrinsic value of Mngnavisionis equalto ils rrarket valuc. Thc bar on the right side of Figxre l5-2 divicles the market vnlue oi the equity into t!r'o componelts, the book value of('quity, which.epresentsth eqrity capitnl supplied by stockholders, aud the MVA. Tablc l5-,1sunmarizes the calculaiionsused h) find Magnavision's stocl valuc. Thcrc are 1il{l million shtlresoutstanding,and thcir total vallre is $369.27 = nillnn. Thcrcfore,the vnloe of a singleshareis llj36cl.27l100 $3.69. The Dividend Model Growth Applied l\4agnavision t0 MagMvision has not vel bcgrn b pav dividcnds. I lowever as rve sa\^'in Tablc l5-1, a cash dividend of $0.442per sharc is forccastd 2010.The dividend is for cxPcctccttogro-byabolrt2.5%nl2011,andthcnataconstant5%ratethcrcaftcr Magnivision's cost of e.tuiiy is 1,1%. this sitlr.rtion,we can apply thc nonconln stantciiviclend gro 'thmodcl asdcvelopcdcarlicr in ChapterS.Figure 15-3shows ihat thc value of Magnavjsi(rls bbck, bascd otr this model is 93.70pcr share, which is ihe sameas the value found using ihc corporatevaluation rnodcl erccpi for a rounding difference. K,txli o he textbook's C o r r r p , i l iIn g( o r p0 r .ll{ . lu d lio t. he Va andDividend Gr0wth Models Bc'causc ihc coryorate vAluatiur and dividcnd gro$'th models giv Lhesanre ans$,cr, docs it matter rvhjch rnodelyou choosc? gcncral,it does.For exaDrple, In if you rtrc a fhancial anailtstestinatilg ihe valuc'of a mature companyi{Ios a wh e ne ,m o r n s r h e n ti5 cm o ervoueofeql i t, i rw ou! be bek b l bkad fi e md'l erv.l !e! ofdebrand p,eteirsdno.l rdherfi.n fien 600[vouei Hoaever, i horco5er, nc!d no fi5 one, ihe booL volles ol lixed in.ome secu,rier are cose ro thei, ma*d yo les when fis n tue. one coi rimolv re bookvalue5 TheCorporote uotion Vo Model 527 tlsing DCF the Dividend Model Find ro Mosnovisiont Srock Volue 121311O7 12n1/48 1/31t09 12131110 12t31t11 D2o1 = A.453 12t31112 o2oft- 0442 s0 0000 0.0000 0.2903 !1!9!Z - $3.70= P,?4i,0? . Pzuo !?99 = or4 5 743 o'os di'idends are expcctcdk) grolr,sieadily in the foture, it rvolrld probablv bc m{)rc efficint use thc clividcndgrowth model.Here you wolrid only need to cstinutr to the$olvth rate ir diviclcnds,not the entire set of p(r forma financialstatements. Ilowever if a conlpany is payhg a dividend but is still in the hjgh'Browth stateof its life cyclc, you wo ld nccd to project tho tuture financial statcmcnts before you could rnake a reasonable estimatcof future (tividends.Then, becarrsc vou$'ould luve nlrcady csfinatcd ftlturc financialstntements, would be a k)ssit up as to whether thc corporaielaluaiioll modcl or the dividend grorvih rnodcl wor d be easierto applv. lntel, \vhich pays a dilidc'nd of aboul 40 centsper sharo \rsusearmrgs of about SLI1 per sharc,is an crample'of a conpan]' to {+ich },ou couldapplv eithef nrcdel. No\^' sopposeyou iverc trying b esfimatcthe vallre of a conpanl' that has nevcrpaid a cliviL{cnd, or.r new firm that is nbout kr go public, or a division ihat GEor someother largecompanyis plannnrg k) scll. In aLlof thesesituations,i'ou ould have no choicerYoLr would have to esiimaic flrture financiaistatements ancl usathc corporatcvrluation model. AcLually, cvcn ii:r companyis payin8 stcadydivntcnds,much can be learned honrthc corporatc vahration model;hence rnanyrnalyststod.ryuseit for all typesoI laluatiorls. proccss projecting fulxre ftrancial statcments revealquite Th! of the can abit aboutthc corrpnny'soperations ftlancnr8nc'ds. Aiso,suchan analysiscan and providenrsightsirk) nctionsihat might be taken to nrcro.rsc company's\'ilue. thc Ttis is \.aluc-basoLt Dranatement,Illrich l| disculs in thc next scction.5 SEiF"TEST sonreexompiesof ossets-in'pld(e, Give g.owth oplions, osrets. ond nonoperoiing W , ilp ou l l h e .a u o l i o nfo r i h e v o l u eo f o ocrotronr Whoi is t|t terminol,or hori"on, vdlue?Why i5 it qlro <olledthe continuin!, voluc? Enploi,r how to estmotethe priceper sfiorcusingfie (orporotevdluotionmodcl. A co'npory expects FCF o of $I0 nrillionot Ycqr I ond o FCF $20 m;llionol Yeo,2. FCF e/pecl' of i\ ed to grow qto 5% rote ofter Yedr2. lf the WACCi5 l0,",, whoti5 the ho,iron vdlue of operotionr;i.e., voloe of ope.ationi;i-e.,V.or".,or? {$420 milliou 5354.55 million) 44.., r ? Whot is the cL,rrent A .ohpony hqs o <urent vol'reof ope.orion5 $800 m;liion.Thecomponyhos Sl00 millionin short' of ierm invennents.ll the componyhos 5400 millionin debi ond hos I 0 millionshore5out5tond whot ins, is lhe pri c ep e r s h o re ? 5 5 0 .0 0 ) 1 +o,o moredeb ed expdnoron of.orpo,ore yo!.rlon, sae P Ddves, Eh,fodr, ond R. Shreves,Co/p.i.r. M's.ndl,vero^lMason,or'l:rhomson/sodllweiern,200,il 528 Corporole Voluot on, VolueBosedMo.ogemenl, ond Corporote Governonce I5.3 l/aiue"Basccl Management hlc- has hlo dilisions, Menor)' and lnstrumcnts,i4'ith total silcs Bell Electronics of 51.5billion a'ld opcratingcapi(alof $1.07billion. Basedon its current stockand bittion, jivingit rn bond priccs,ihc.onpany's kxal market value is about .$1.215 = MVA of 5115millbn, folrndas 51.215 $1.070 S0.145 billbn = Sl45 million. it Because has a positivc MVA, Bell has crcaied \.a]ue for iis invcsbrs. Even$, plansin iis effortsio incrcas thc managementisconsiLlcrhgsever.rl new strategic All of tscll'snssots usedin operaiions. Iinn's value. dre The Menrcr)' division prodlrcesmemory chips for such handhcld clcctronic ctevicesas celtular phoncs and PDAS (personal digital assisiants),whilc tho Instrumentsdivision produccsdcvicesfor measuringand conrdlinli sc{,agcnnd .ater treahncntfacilitics.'fablcl5-5 shows the latesi financialresults for ihc two divisions and for thc co pany ns r whole. As Tablc 15-5 shows, llcll Me'mory is the larger of the hvo.livisi(rrs, $ritlr higher salesand nrorcopcratingcapiial.Bell Memo{r is alsomore prcfitablc, with ya:sxs 7.2q. for Bel] Instrumenis.This ycar as in a NOPAT/Salesratio ('l 7.91)1 other recenl l,ears,thc focusof ihc initial strategicplarrl1hg sessions was or tlre Memorl, division. Bell Momor), has grown rapidl)' becauseof ihe phenomcnal nnd this division rocketedpast Instrurncntssrv Browth in consurncrclcclronics, eral l'ears aBo.AlthouBh Mrmory's Bro\^'thhad taperedoft senior lnanagcnroni generally agreed lhflt ihis dilisron world receivethe lion's share of corpor.{e attention and resources boc.lusc it is Ltrger more profitable, and, frankll', Drore exciting. Aiter all, Bcll M.'m('ry is associntol with the filamorous markct ior telecommunications personalelecfronicdcvices,whereasBll Instrumenisis and associated rvith servage and sludgc. The financial assumpti(nrs h'ith the prlimnrafy and projcctionsassociated strategicplans for th t\^r divisions arL shown in Tables15 6 and 15 7. Basedon the initial strateglcpltrrs, cachdivision is projcctcd to have 5% annual gror,{thlor the next5 yearsan(l thereafter. strategic The plans also assumethat the coststrocturcs of thc t$'o divisions will renanr unchanged from the currcnt ycar, 2007. Only pariial financirl projecti N are shorvr in Tables15-6 and l5-7, but $/hcn Bcll's managenent decic{es a firal strategicplan, it will dcvclop cotnplci! on furancial statementsfor the conrpany as a whole and use thcm b dctcmii! financingrc.luirements, clescribed Clrapter14. as in Finoncio Resuhs BeI Elecironics {Millions Dolors,Except Percenlogesl for Inc. of for Division2: S oles Eqrrinssbefore interest ond ioxes IEBIT) Nel operolingprofll ofter ioxes INOPATI operoiins, profiiobiliry{NOPAT/Soles) $t.006.0 874.A t3t.0 78.6 7.9% $5000 200.0 60.0 36.0 7.2% 0 $ r,500 1,070.0 t9t.0 |4 . 6 7.6% Vo ue.Bosed Monogemeni 529 (Milions Dollon,Excepr Percenioses) lor of Iniiio Proieciions the BellMemoryDivision for ' 2008 Pdnel A: Inpuls Costs/Soles po Depr ec lolion/ Nel n i Cosh/So es Accounis recevobe/So es 2009 2010 20I I 2012 Accounts poyqbe/Sq e5 8l% 10 I I 30 59 5 6 40 5% 8t 10 tt 88 30 59 55 4A 5% 8t r0 30 59 40 5% 8l t0 I I 30 59 5 6 40 5% 8t r0 t1 88 30 59 55 4A 5% 8t t0 30 59 40 Pdnel 8: Portiol lncom Stolement 0 $r,000 Cosh (excepldeprecloilonl Ioio operoiingcots EBIT Ponel cr Pdrridl Bolon(e Sheers Operdring Assets $1, 0 5 0 . 0 t , 1 0 2 . 5 $ r, r5 2 . 6 $ $ 8l0.0 $ 8s0.s $ 893.0 $ 9 s 7 . 7 65.0 68.3 59.0 62.A $ 869.0 $ 9 r2 . 5 $ 9 5 8 . 1 $ 137.6 $ 144.4 $ 151.6 r $ 1 , 25 . 5 $ 1 , 2 7 6 . 3 $ 984.6 $1,033.8 71.7 75.3 $t,056.3 $t,109 I $ )s9.2 $ 1672 Operoiing.utrenl ossets Nel ploniond equl p me n l r o . 5 $ I 1.0 $ r .6 $ r2.2 $ 1 2 . 8 92.6 97.2 102.1 840 882 364.7 382.9 3t5.0 330.I 347.3 .9 $.4ezz 409.s $ 430.0 $_11L9 3 424 $ $ 590.0 $ 6 1 9 . s $ 650.5 $ 6 8 3 . 0 $ 7 1 7 . 1 $ 253.0 $ t 0.0 80.0 300.0 $ OpercrinsLiobiliries 50.0 $ 52.5 $ 5 5 . 1 $ sz.9 $ 60.8 $ 63.8 72.9 76.6 63.0 66.2 69.5 60.0 1 3 3 $ r.40.4 7 $ 110.0 $ |5.5 $ 121.3 $ 1 2 7 . 3 $ $ Opercling cutreniI obilllies "P.. ecbd fsres moy nor lololexodf dle b roufd fs Chdpier15 Governdnce Co.porore Vdlu+Bosed Monosemenl, Co.porote ond Voludtion, Division of Excepi Percentoges) for lnitiolProieclions he BellInskumenls for {Miilions Dollors, 2009 Ponel A: Inpuls growihroie Soles Cosls/Soles plont Depreciotion/Nl cosh/soles Accounis receivob e/Soles Nei plonl/Soles poyobe/soles Accounts 2010 201I 85% t0 l 5 t5 30 5 6 40 5% 85 t0 t t t rl s5555 t5 30 555s5 66666 4A 5% 85 t0 5% 8s t0 5% 85 r0 5% 85 r0 rs 30 t5 30 t5 30 t5 30 4A 40 40 40 Ponel B: Pqrliol In(ome Stotement (excepi Costs deprsciolion) Toldl costs operoling EBIT Ponl C! Porlidl Bdlonce Shfs Operoling As5et3 $500.0 $425.0 15.0 $440.0 $ 0q.0 $ 50.0 25.O 75.O $525.0 $55r.3 .$578.8 $602.8 $/46.3 $468.6 $492.O 16.5 17.4 18.2 15.8 $462.O $485.1 $s09.! $s34.8 $ 63.0 s_!21 $_l2s $638.l $542.4 t9.l $561.6 $ 76.6 $ 5.s 26.3 78.8 []j0! $rs7.5 27.6 82.7 $ 5.8 28.9 Operoting c!rfenlqsseis Nel plonlond eqoipmenl Operqring Lidbiliries $r Eq 91?]o $r65.r' $ 27.6 33.1 $ 60.6 $ 28.9 34.7 $ 63./ $ 6.1 30.4 91.2 D27_.6 $ r8 2 . 3 $ 30.4 36.5 $ 66.9 $ 6.4 3i.9 95.7 qt_94.q $19r .4 $ 31.9 38.3 74.2 $ $ 25.0 30.0 Operoting curentliobilities qProi{tedf suresmoyno olo exoclyduetoroundis $ 26.3 31.5 57.8 $ Volue-Bosed Moiogemenr 531 To evaluate the plans, Bell's managementapplied the corporate valuahon modelto eachdivisjon, thus valuing them usint the freecash0o . valuationtechand Table15-8showsthe rcsults.The nique. Eachdivision has a WACC of 10.5%, threekey items are NOPAT, the required investment in operatinS capital, and the resulting free cash flows for each year In addition, the table shows each division's horizon value of operations at 2012 which is the end of the 5 years of explicit forecasts,calculated with Equation 15-2. The value of operations at 2007 is the present value of the free cash flows and the horizon value, dismunted at the weighted average cost of capital. As expected, Bell Memory has the greater value of operations, $709.6million ve6us $505.5million for Bell Instruments. However, the managerc were sulprisd to see that Be]] Memory's Market Value Added l\tNA) is negatir.)e: $709.6value of operations - $870.0operaring capital = -$150.4 million.6In contrast, Bell Instuments' MVA is positiver $505.5value o{ operations - $200operatingcapital : $305.5 million. A second shategic plaming meeting was called to addrcss this uno,?ected re6uli.In it, Bell Memory's manageB proposed a S20million marketing campaign to boosttlrcir salesgroMh rate from 5% to 6%. They argued that becauseBell Memory j-sso Fofitable, its value would be much higher if they could push up sales.Before acceptingthis proposal, thouglr the proposed changeswere run ihrough the valuahon model. The managers changed ihe Bell Memory division's growth Iaie from to 6%) seei\e hle FM12 Ch 15 TooI Kit.xl9 at the textbook s Web site for details. Totheir surpris, the division s l?lue of operations fell to $691.5milio& and its MVA 'Ea alsodeclined, from $160-4milion to -$178.5 milion. Although BI Memory was profitable, increasing its salsgrowth actually reducd its value! To better understand these results, we can express the firm's value in terms of four fundamental wealth ddvers: s = oF = CR = WACC = Grcwth in sales operating profitabiliry (oP) = NoPAT,/sales (CR) = Operatingcapital/Sales Capital requirements Wightedaverate cosi of capital e-re50ufc S.e FMl2 Ch | 5 lool How do these drivers alfect the value of a firm? First, the sales growth mte generally, not always,hasa positive effecton value,provided the companyis but profitable enough. However, the effect can be negative if growth requires a great dealof capital,and the cost of that capital is high. Second, operatingprofitability, profit per dollar of sales,always has a posiiive which measuresthe after-tax effect-the higher the better. Third, the capital lequirements raho, which meas ures how much operating capital is needed to generate a dollar of sales,also has a con6istent effect the lower the CR the bettet since a low CR means that the company can tenerate new sales with smaller amounts of new capital- Finall, i. his chopbr *E.timoiad MVA os $e esrimobd wl@ oI oquit/ hinur b@l wlrc ol equiry. rgIll 'to,lid 'h. I'd Chopll 3 ihoi wo con olso deline MVA os MVA = Iobl mo{r vdlls - Toral.ap rdl. + . ' o J o o l o - ' +o rb-oc r r \ . - r . r n f / . r - p + !o n r-. lLo r o c rche."eget S e,cu"ol op"roror, l .a e - ' 1 ' ".- - r to n o b n o to -!aorore.MV A col b" obl oo'o i1 ,6 r o r so p i 6do4oi 19coprol ^ ss6 nvosrotssppod opoEtins.opiro. l -"o o MVA = Voluoofoperarom ho l o . C l d p b ' l l - o r' *o ' @' oo l . o p i o TtEloG - o .o l p p i- d o p Eo .s.o p o l r a q - o oob l orop. o'ns copl l \ad,o,po' 7 o. -\ e r m o e M r ' a fo ' o d . r o 1 o lor o p,o!t MVA : Value ol operoiion! - Ior. ..Plr. Chopi,er5 1 o Corporote Voludr Volue on, Bosed Monogement,nd CoporoteGovemonce FCFVoluctionof EochDivision(Mil ions of Do lors, Exceptfor Percenioses) 2009 Ponel A: FCFVoluqtion of rhe Bell Memory Division Cdl.ulorion of FCF copllol Nel operoilng working Netploni Nei operoiing copiiol nvestmenl operoling in copilol NOPAT in Growrh FCF volue oI Operotions 2010 20rI 2012 $ 280.0 590.0 $ 8/0.0 $ 78.6 $294.0 $308.2 $ 324.1 $ 340.3 $ 357.4 683.0 717.1 753.4 619.5 650.5 $!!l $!l-?2 s!992.1 $1,0921 $LIAl 48.0 $ 9l.0 $ 43.0 $ 5.0% $ 43.5 $ 45.7 $ $ 82.5 $ 86./ $ $ 3 9 . 0 $ . 4 r. 0 $ 5.0% 50..4 $ s2.9 95.5 $ 100.3 45.2 $ 474 5 A% 5.0% $ 905.7 $ 709.6 MVA(Volue of Divisiono operotions Copiiol) Pcnel B: FCF Voluolion of lhe Bell lnslruments Division Colculdtionof FCF Nel operoiing worklng copltol Nei operoiing copiiol copiiol nvesherlin operoiing NOPAT ($160.4) $ 50.0 150.0 $ 52.5 $ 55.1 157.5 165.4 $ 57.9 $ 60.8 $ 6 3 . 8 191.4 173.6 182.3 1r. 0 $ r r .6 $ 41.7 $ 4 3 . 8 $ 30.6 $ 32.2 $ 0 $-?-q9 $ 36.0 ELA! $??ql ! ?!tl $]43.1 $ r 0.0 $ 1 0 . 5 $ $ 37.8 $ 3 9 . 7 $ .8 $ 27 $ 2 9 . 2 $ 5.O% 12.2 45.9 33.8 volue of Operotions $ 645.l Dlvisionol MVA(Vo of ue ope'oiions Copito J $305.5 Nobs r T h e W A C C i 3 l O . 5' ;lo r e o ch d iv.i.n IGfo zo fva l@ IHUd 2 012i s.acucbdusi sE ql ori onl 52,l hecomtnl g,ow l hformuofo, .",,.\ " HV?. r- [ Fc F?o:r r 1 l +s ) ] / l w A c c s) Thevolue ofopflaran5. rh. preFni.oF af heho,zon/olue $e lrcecorh dfd fl.wsdkcolnbd.r$e WAcc, cal.!obd in r. F gra l5 l Proe red f gr a- m . , n. r boleoJ ) dueb, olndiig S e e f h l l 2 C h l S l o o k K i t . x l s . l l h e l e x l b o o k t We b r i l t o r l s l o i s . VolueBosed Monogemeit 533 thefourth iactor,thc WACC,also hasn consistent effeci-lhe lo'ver il is, the higher Another inrporiant mci c in thc corporrte valuation model is th expected retum on invested capital (EROIC),clclincr'l thc oxpcctccl as NOPATIor the conl ing year divnted by the anount of opcrating c|pitil .ii thc beginningof the year Ktxls dt the rer'book! (r'hich is the end of the precedingycar). Thus, IITOIC rcpresenisthe expectec:t reiurnon the capiialthal hasalreadybcc invostcd.]i) illlrstrrte,the EROICofthe BellMemory division for 2012,thc last yoar in thc forocnst pcrnxt, is \OlAlro Caprr.'l \()f\T | ( ,,pr.'l il {lrl'l lrrcl ^- \l .1,r.1 To sceexactlv ho\.the four vallre clrivcrsrnd EIIOIC dctcrminc !.rluc for a constant growth firn, n'e can start with Equalnn l5'2, FCF\ I I w c (( _ t and rera'rite ii in terms of thc laluc dIilc'rs: S a l e s !(l + [ WACC {ls-21 \Le! , r ine\ i: Ca p i ta l ' + q I rll"n wACc- !! ( \r+ l l /i )l r r 5 .3 ) Eclualion 3 shoNs that the value oi otrratiorsc.n bo dividcd inkJ hr'o compo 15 (1) ncnts: ihe dollars of operatingcapital that invcsiorshavL provided and (2) the additionalIalue that managenent has added or subtracted,rthi.h is cquivrLcnt to \,IVA. Noic that thc fifst bracketof Eclortion L53 sho\^,s prese t viluc of grow thc ing sales, discountcciat the WACC. fhis $'oold bc ihe MVA of n firm that hns no c.rpital.BLrt firnrs do hnve costsand cosis and ihat nevcr nccdsb hvest ac].{ition,rl capital requirenlcnts, and thcir cffcct is shoi{n in ihe seconcl bracket.Here we see ihat,holding g constant,MVA s,ill improl,e if opcrilting proiiL.rbiliiy(Of) incrensor es, capitalrequirenlents(CR)dccrcasc, WACC c{ecre.rses. Note thai an increascin gr(tr{th \dill not ncccss.irily increase value.OP could bepositive,but if CR is quitc high, nlcaning thlt n lot oi new capital is neededto in slrpporia tiven increasc salcs,thcn thc sccondbracketc.rr be negaiive.In this situation, causesthc tcmr in thc first brnckct !o incfease, bui it is being trowth nuliiplied by a negativ'ierm i thc scc(n!1brackct,ancl dre net resuli {.il] be a decrease MVA. in We can also rewrite Equation 15-2nr tcrns of EltOlC: C.,pr..rlN(IROICN - WACC) _ a WA(.C Vr ". C.rFil,l\ (r5-4) thc lquation 15-4alsobreaksvalue into two corrponcnLs, !,ahc of cnpitaland the tcrnl. This term for MVA shors ihat vnhrcdcpcndson lvfvA,shoNn iI ihc scconcl rctu|n o nrlestcd .apilal, [Ri)lC, nnd WACC.lf thespread bet{'ccn thc expectcd js EROIC gleatcl than I{ CC, ihcn ihe retlrn\ or cnpit.l is grcatcl ihan thc rcturn in urlesiors e\peci, and managcnentis n.lding valuc. ln lhis, an incrcase the l5 Chdpter Corporote Voluotion,VolueBosedMo.ogemenl, ond Corporote Governonce equalto WACC, thcn ihc iirn grorvthratc camesvaluetogoup.If IROIC is exact]y "breakilg even." lt has positive accoulting profits and is, in an cconomicsense, vahe causnlS cashflowrbut thesecashflows arejust sufficicntto satisfyinvestors, lessilar to exacilycqual the amouni ofcapital ihat hasbccn provided.lf EROICis WACC, thc icrm in bracketsis negaiivc, managementis destroying value, and ihe groriih is harmtul. Here the fasterthc growth rateis, the ]o\,ver Iirm's valuc. We should alsonotethat the insjghishonl Equtions 15 3 and 15'4apply k, all ihemseh'es can only be applied to relatively stablefirnrs limrs, but thc equations For in out whosegros,th haslevelec:l at a constantratc. example, 2001HomeDepot ard gre$.at around20%per vear,so at lhai iime wc could not aPply Equations15-3 15 4 directly (although \,vecould ah^.aysapply Equation 15 1). Ilome Depott for ra which rvasexcellerli its tudustrt blri evenihough NOPAT/Salcs tio $/as5.6%, IIome Depo! r'as il was profitablc,it had negativefreecashflo{,s. This is because st nr its high-grolvthphase,r.Hch requiredenormoushvestmentsin operatrng 2001,Home Depot'ssalesgrorvth has slowed due to markei satura capital.Snrce Basedon its 2005 tion, and iis frcc cashflows havebecone very largeand positive.T which is much la$ Home Depot'sEROICwas about 21.5%, financialstaiemcnts, contdbutesto iis $45biltion MVA. er than its WACC.This large spreac:l Tablel5-9 shot\'sthc vahe drivers for Bell's two divisions,measuredat 2012, the end of lhe forecastpcriod. We report theseIor the end of thc forecastPeriod By period due io input changes. th because ratioscan changcdurhg the forecast enc:l the forecasipe.iod, howcver,all inplrts and ratios shoul.l bc stable. of Table15 9 shorvsthat both divisionshave the samegro 'th .ate and the same WACC. Bell Memory is morc profitable, but it also has much highcr capital rvell bclott'its rcquirements. The result is thai Be]]Mcmory's EROICis only 9.57o, 10.5%WACC. Thus, growth doesn't hclp Dell Memorlr indeed, ji lowers tlc decidednot to reqriesttunds Basedon this analj'sis, Bell Memory's managers for a marketingcampaigr.Instead,theydcvclopedaplantoreduce capiialre+rircmcnts.The new plan calledfor spendnlgS50million on an integratedsupply chain infonnation system that .or c1albw thcm to cut their In'ento es/Salesratio from 307. to 2{l% and also reduce the Nei plant/S.rlesratio from 59% to 50%. Tabk l5-10 showsoperatnrg results basedorrihis ner{ plan.Thevalue of operalions Forecosted Volue Drivers 2012 for BellElecironics' Divirion l: BellMemory Growih: g 610rr) Prof,tabiliiy: lNOPATr0rr/So C o p i i o re q u l rc me n(C opl l ql r0rr/S ol esror, t: WACC reiurnon nvesied copilol, EROC: Expecled lNoPATrorr(l r- s)/Copiio ro,, Division2: Belllnstrumenls 5.O% 7.9 87.4 105 9.5 5.A% 7.2 40.0 r 0.5 r 8.9 7Io, exompe, in 200,1HomeDepotgefe,aren dmoi $3 4 blion nFCl FCFlumbled i 2005 due r. severol EROC in 2005 maioroirr! !rom rl,dr,equ,edsotrti.o invenmenlsn opercrng copiro H.wave,, Depor's Volue Bosed Monogemeni 535 r orpo-isonot fF P'.lirr ro-y o-d .ro Pons Bell of Do lors, Exceplfor Percenrogesj Bell lnslruments Soles growihroie,g 30 59 Resulls EROC (20r2F nvesied (operoiins) capiial{201 2)! vo ue ot operorrons (2007)b Currenr Curent MVA (200l)b 9.5% 5L 2A 50 t3.0% $ 867.9 I,157.4 287.4 5% t5 30 18.9% $255.3 505.5 305.5 30 18 6% $274.3 574.1 374.1 r $ 1 ,r 0.4 709.6 (r60.41 "Werepod fof rheenl o'$e fore.o:r pe'lod be.ouseraloi.on.honse drins $e pe,iodf trput.h.nse du, ns fie foracoi pe,.d By [a end.f 6e lorc..i per..], fowaver d inpds oid .rlos sho! d 6a i.hle bwercporrfie volle ofoperarions ond fie MVA !s ofihe.utrenl dob,2007, be.ousewewoffb seethe efiedfiol'he prcposed on5 hoveon p rE.rftd vo ue oI the d Yni.n5 ircreases lrom $i709.6 milion io $il.1574 biltion, orby Si447.8 million. Because is this $eLl over ihe $j50 million rec]uired implementthe p1an, nunagemenldecided to top positiveat $287.4 jllion, anctihe toapprove plan.Note alsothal MVA becornes ihe m dLlisional EROICrisesto 13.0%, r'e]l o\.erthe 10.5% WACC. Bell Instruments'managersalso used the valuation model lo assess changes in plansfor their di\.ision.Given their high EROIC,the Instrumentsdivision pro Fsed (1) an agi+essivemarketinil campaiitr and (2) an increasein inventoies thatr.ould allol\' faster delivery and fe 'er stock outs. Together, thesecharlges r,ouldboostthe growth rate from 5% to 6%.Th direct costto implement the plan r,as$20 million, but therc h'as also an indirect cost in that significantly more in\,entodes $'ould have to be carried.Indeed,the ratio of inventoriesto sales was iofecasted increas to from 15%to 16%. ShouldInstruments'ne$'plan be implenented? Table15 l0 shor{'sthe fore casted results.The capltal reqdrements associated with the jncreased inventory caused EItOtC to fall frol,I1llJ.g%to llJ.a,%, (1) the liJ.a,% the brt retrrn greatl]' erceeds 10.s%W CC, and (2) th(] spreadbch{lrl]n lO.s%r'ould be thc and earncd additional capital. This causcd thc forccastcd\'.rluc of opcrntionsto on hcrcnscfron 5505.; to $57{1.1 milljon, or bv $64.6million. An 1t1.6% rcturn on million ol capital is morc val ablc than an 1tj.9"/" rchrm on $255.3 nillion $274.3 of cnpital.s Yor, or onc of Bcll's stockhol.lcrs, \^/ouldsurely ratlier have an asset tlat pro!'idcs a 5070rcturn on an hvcshncnt of $1,(l(l{) than onlr that provides a llU%rchrn on an irlvcstmcnt of $1.Thcrcforc,thc nc , plan should be accepted, evcnthough it blvcrs thc Instruncnts dilision's EIlOlC. rA p. r a r . I y i r f a . d i i a d ! r fe p o ii6 ilr y li.r Be l h a so ..m p e B or.n pd,6dsed oi r.res.f,eturndnd n.r L Jo ' t 5 o o94' ,-ot .o 9i loq " , o o popod rpo qoo! o I. onpa, o.d bo o ,q \ \, r a 1 oL o t-, w ' o "o .l:stu$ha at{e.rof.o'ipeis.t.i p.ns i m.E.lard l.rer I rfa.fopre, 536 Chopier 15 Corporote Vo uoron, Volue-Bosed Mofogement, dnd Copo.ote Govemonce A l thorgh Morokon s o rel ol i vey i smol fi ' m, w i th ony 225 consul onl sversus omosr 5,000 { o' McKinse, ii ge'rerolesoboul $4/5,000 in revenle per consulioni,whlch iies ii wrlh McK isey os ihe mosrexpen5ive consuhng compony Nore, though, thot ils roles seem ro be i!siified. D!ring lhe rore Fino y, a fecenl Fattuneott.le describedhow 1990s, Moroko' r'cl l ent s componi es creol ed cdd on m uc hc o. por a l o n so re p o y i n g c o rs u l o i l s i o hel p lioio $68 bi ion of weolth versuswhot they wourd ihem implemenithe model. Morokon Associoies, o fo.e c eoi edhod hey -ot.hed l e' rde.t1 pe-r eodingodvocote ofvo ue.bosed monosemenr, p'ides Itselfon hoving o singl+minded vlew lhor o compo' ny shouldhoveone, ond only one, gool ro increose 5ou,.e5:ThomoiA Srewan,'Mcrckon Runner, Fodune, shoreholder weolth r ofien iokes Morokon severo S eprembe,28, 1998, pp 153 158,-l aseph M.C ol l e y,'w h. yeors ro f!lly impemeni o vo ue-bosed monogemenr Acq! .inq Minds won|a Kiow," cFo, februory t 999, p I r oid TomCopean!, Tim K. Ler, ond lo.k t{n n, Volr.ti.n: MedsDrng syslemoi o compony.One reoson for lhe lengihy a d \^a"as opo.-.1N e,,dL oL,^o stev..-at im pem enioio n e ri o d i s i h a l Mo ro k o nb re o ksthe p v T he c or por ole o l u o ri o n o d e , n w h i c h fre e cosh m flowsore discounred ihe welghiedoverogecoslo{ oi ihe copitol ro derermine vo/ueof the compony,liesot the heorr of volle-bdsed moiogemeit Therefore, v b- r or eodop' irq o r" .b o s " d- o ro g " me r- ^ o rog" r' wou d be wlse io osk iflhe corpo.oievd uoiionmode producesresulhlhol ore consislenl wllh octuol mor kel valles. The onswer, occording ro o sludy by Cooelond . oie r. o rd Mr rr o ' te c o r u r9 rn McKinsey & Compony, is o resounding yes. They oppied t he mo d e lro 3 5 c o m p o n i e s n d fo uncr o o 0.94 conelolon ben eei lhe modelt estimaled volr " s or d r he o c -u o rm o r\-r v o J e 5 . Ad d Io n o . e/i derce of rhe models usefulness wos provided by Mccofferty! recenisurvey,in whlch CFOs roied rhe corporole voluolion model os rhe mosl imporront technique for esrimoringrhe voitie of o porenliol componyinlo segmenhlo deiermine where voLue is curently belig creotedor destoyed These segmenrs misht be divisions, producllines,colrome6, or even choi i es of di sti bl i i on." D eepdri i i g,' os theyco lhls process, ordlols ond iime .ofs!ming, ond li is requires greordeol of dolo ond onolysis. so, ond o A perhops even more imporiorl, flrll impenieniollon requiresboih o chongeli corporolec! lure ond ihe creoiionofon "orgorizoiioi's colecilveobiliiy io olr lhint ils rivols." l. orher words, lhe skill'ser use ro vo ue bosed monogemeni mut permeoielhe eiil.e S(melimescomp.uies iocuson their profit.bility and grdt'th, i{ithout gn,nrg ndcquntcconsideratiurk) ihcir capitalrec]u ircnrcnts.This is a Lrigmistak rLlthc i{ealth crcnti l drivers, not jLrsti+orvth, nrrst bc takn inti) acco ni. Forturutcly for Bcll's investors, rcvisodplan rvasaccoptcd. the Howe\,er,is this cxampleilh! iratcs, it is easv for a conrp.t]r]'to misiakonly focrls orrl)'on P ofitabilitv .rfd ilro\fih. ]'hcy are imporinnt, but so are lhe othcr \'al e driYcrs-c.1pital require. n1ents anctthe \^,eighiecl av,rrngc costoi capiLrl.\hluc-basedm.lnngenentc\plicitlv incluclcsihe effects all the value drivefs brcauscit usesthe corporatcvnluot ation odd,:rnd thev arc ill cnbodied in thc nrodel.! 5Ei-F-Tf5T ore whc* the four voluc driver:? How i! l t p o ri b l e rh !r i o .5 !ro w rh w o u d d..reose he vd !. of o prol i i ob fi rnr? l e Youorc siv.n the fo low ,rs {orecosied infonrotio. {or d coDstont growth codtony: so tr .' Sl0 nill on; Op{,rot'ns profirabiliry Growli l9l = 6:;; d.d dle *elghred IOpi ., 5%j aqdlol r.qu;eneni5 {(RJ.., 401i,; = dverosc.ost Df codtol IWACCj l0%. lvhol is lhe levclof.opidl? W|{l i' the .udeni levcloi 'rDreni NoPAI? Whoi ir thc E!lOl.-? Whoi is lhc volu. of operdtios,?154fl;llion;50.5 t11.25%t;/.25 's;llinn; tr!illiorl "F o , m o ,eo i.o ,p o r o r e la L u d r o id,d vo uebosed monoseD edi 5eeTmK oe,,Mo(Goedl on,ondD ovdWc*c! M..'nry VoluotiDn and Monogng th. votft al^ies, 4t ) .d lHDbolei, r.lj ioh I W cy & 5on5,20051 tI. .p..-o..p.^,.tr,"\ta?L.l de. o "- , r'"3o"dvoo9f^,. lo l D v,h o d {1o D- .....r 8 ..!,., v v o90, od.^.oa" ," a .r B, )000 od/ t. "...\.ao., Monkin5,rhc vnlLra riper.ive lNew Y.,l llie tea P,es, l994lroid G Beiier sraw.i ft. Aocn lor Vd/L,e lNev Yorr.farper c. ns, r99rl Monoger Behovior Shoeholder ol ond Weoih I5.4Managerial Behavior Shareholder and Wealth Shareholders want companiesto hire managers who arc ableand willing to take whatever legal and ethical actions they can to maximize stock p ces.'oThis obviously requires managers with techdcal competence,but it also requires managers lthe who are ('illing to put fofth the extfa effort neceqsaryto identify and implement Co PERS Co ifomo lalue-addint activities. However, managers are people, and people have botll personal and corpomte goals.Logically,therefore.managerscan be expectedto hrp://w.colpe6.or9, actin their own self intefests, and if their selI-inieresis noi aliqned with those ondIIAA CREF are lTeoche6 of -Io($o.der.. lhFn.orpora.e valuesi. not be m.r\rmi-/ed. lh;re"re'i\ wayin which a manager'sbehaviormighi harm a firm's intrinsic vahe. 1. Managem might not expend the time and effori required to maximize firm value. Rather than focusing on corporaietasks,they might spend too much time on externalactivities,such as serving on boardsof other companies, or on nonproductive activities, such as golfint, lunching, traveling, surfing the Net, and so fofth. 2. Manage$ might use corporateresources activitiesthat benefitthemselves on rather than shareholdeis. example,they might spendcompanymoney on For sucll perquisites as lavish offices, membe$hips at country c1ubs,museum quality art fo( corporateaparimenis,large personalstaffs,and corporaiejets. Because theseperks arc not actually cashpaymentsto the managers, they are callednonpecuniary benefits. 3. Managersmitht avoid making difficult but value-enhancintdecisionsthat harm friends ilr the company. For example,a managermithi not closea plant or terminate a project if the managerhas personalrelaiionshipswith those who are adversely affected by sucll decisions, even if temdnation is the economicallysound action. 4. Manaters mighi take on too much dsk or they might not take on enoughrisk. For example,a company might have the opportunity to unde ake a dsky projeci with a positive NPV If the project fums out badly, then the manager's reputation will be harmed and the manager might even be fired. Thus, a manager might chooseto avoid dsky projectseven iI they are desirablefrom a shareholder's point of view On the otherhand. a managermight takeon projctswith too much risk. Consider a prcject that is not iiving up to expectations.A managermi8ht be tempted to invest even more money in the project raiher than admit that the projectis a failure.Or a managermight be willing to take on a secondprojectwith a negativeNPV iJ ii has even a slight chance ol a very positive outcome,sjncehitting a home run with this secondproject might cover rp the first project's poor perlormance.In other words, tlle mana8ermight throw good rnoneyalter bad. 5. If a company is generatingpositive fiee cashflow, a managermight "stock. pile" it in the form of marketable securitiesinstead of retuming FCF to lNo' " t o L "g o o d e p-p-ro"ob,.,o .o o .io r ' - \"o . o ,1 sl od o.o o ^".odLot o. doh s l o .0 0 o - d o .L p ". \e o . b! ol ,b.o si 1."j o'.^"'"n. ^"'-'1,o.-"d , "1 " o l" o ro oo .ar.nol reeoed " dob o . r r e c o m o o l c , " l 'o l" o . o " d - . o .l"o o o L q + o e o o r d a ' r o o ' "1 01 ol o"m",r o -.. b .,.r _o ose-s1 od l - Fo a g q ....e e .iir q doo' " " " o l"s. slo.f "oo's ' q'(r' o o. _ /i qo ro o o.o-rrl o p u _ p p ' sp o - d so . o l o ^ d - "' ,- l o'dod s ' 'T5 or' on o l o g - o " ' g " d o ro n i" o .o l e o rool s'eo ? !,so 'r: 'soon! Rerlremeni tund), Eq0iry htrp://lwv.rioq<retory, for exceleni dncu$om governonc. ol corporote 538 Chopter 15 Corporole Vo uorlon, Volue-Bosed Monogement,ond Corporore Govemonce in|estors. This potenlinllv hamrs mvcsbls becauscjt prercnls them fron) .rllocatingthtsc funds to other comp:rnicswith go('d grolvth opporhrnities. Ilvcn worsr', positive FCf ('ften tempts r managerinn) payhg nr) much ior thc acqrdsitionof a[othcr ompany. In f.rct,most mcrgrs a|cl nccluis]tions cnd up as brcak-eveudrals, at best, i()r thc acquiring compnny bccause thc prcniuDs pn for the i.rrgctsare often Icry large.why i'ou[] .r rnanageL be rcluctant to rcturn cash to investors?Irirst, extra .ash on hand rcducesthc c('mpany'srisk, \,vhichippcals to lnrny managcrs.Sccond,.1l.rrgc distrltrrtion of crsh h) investors is an adnrissi{n that Lhc compan}, clocsn't hilc cnough good nrvestmenloppofturriticb. Sio\{ growlh is noflnal for a mahu' ing companr trut it isn't !('.y cxciiir)gfor d ftanaScr toidmit this. Third, ihdc i! a Lotof gl.nro r associdted $,ith nr.rkinga I'ugr .1c.tuisiton, and this c.rn provide n lnrgc boost io,r manager'sego. ForLrih,conrpcnsnii(nr usually is highd for crccutives .ll largcr companics.Cash distribuiions io ilvcsb rnake.r conrpanvsmaller,not larger 6. Minagers ight not relc.rse the nrfornation tlut is dcsned bv nveskns .ril Somctimes lhey mighi ivithhoLd inlormation to prevent compeiiiors fronl giininS.rn ddvflntagc.At oLhertinc's Lhe)'mi8ht try Loavricl rdeisnrg b.rd nelvs.For exnmplc,thry lnighi "nrassrge"thc dnir or 'lnanage the eannrg$" so thai tht nes,sdocsn't bok so bad. lf inlesiors nre unsurcnbout ihe qunlit\l oi inforn;rtion provmcd bl, m.nagcrs, they ten.i k) discount th(. companl s rcduces the comcxpecicrlfrue cash fk)ws .rt a highcr cost of capitrl, r,,'hich inifinsicvaluc. Pany's lf senior Dr.rnagers bclirle there is litile chancr ih.rt the_v $'ill be retnold, ivo s<rv ihat thcy <rre r,rtft,./rfd. Suchd .ompany faces.r high risk of being poorlv (rrtrcnchedmanngers ablc to trctin th('ir olvn interestsratherthirn run/ becausc are in the intercstsof shareholdcl1s. SETF.TE5T Nom es l x i l p e s o l n o i o s e ri o l b e h o v i oc horcoi redu& o {i ,m! i ni ri n!i .vql ue. i , i:;.5ieIt;-,r;;1*{llt"r+:rE;inr e A key rectuirolncnt succossflrl for implcnlontationof v.rlLre basednr.rnagemnt is ('xrcutivesa d othermanaSr'rs to inflLrence sothat Lhcyclonotbeh.vcin the r,alrs doscibed nr tho sectionabo!,c,but inslcad beha\,ein .r .| av thal nrarhizes I ,an pr,rrl, 1r.i .,,,ti.,,' ,nrl,,Fn, ',rn1- ,nlnr*h \.rl,,F ( o4r,'.rt, govcrr'.,n,, (i,rporate govcrnance bc clcfinedis thc sci of larvs,rulcs,anclprocedures can ih.\t inflLrence fonrpiny's opernti()lls a anc:l dccisionsmndc by its mnnagcrs. tlr thc At risk of oversjnrplificaiion,mo.stcorporntc governanceprovisions .oD1cin h{0 forDrs, sticksand caffots.Tho p nary slick is the t/r,11rl of'",nolnl, eithcr as a deci' snm bv the bo:r of dirct('rs or as the rcsult ofa irostilet:rkcover If a firm's nu . r(1 agcrsare nuxinrizing the vahe of the rcsourccs entmstcd to them, they nccd nol Ic.rr the loss of thcir jobs. Or1ihc other hand, if man.Sers arc not maximi/ing v.luc, the)' should be removcd by iheir orvrl bo.rrcls dirccbrs, by dissidcnt oi sl(,ckholders, by other companiesseekint to profit bv installing n beiier Dranor agementte.rm.TIle n1alncarrot is.orry.1rnrltur. Manarers ha!,c gfeaterLncenti\'rs kJ maximize intrinsic stock vflluc if tLir conpcis.rtion is linkcr{ kr their firDl's pcrformancernthcr than being shictly irl Lheform of salarv. Corporole Govemonce 539 Almo6t all corporate governance provisions affect either the threat of removal or compensation.Some provisions are internal to a firm and are under its control.'r Tlles intenal pmvisions and leatur6 can be divided into five areas:(1) monitoring anddiscipline by the boad of dircctoE; (2) charter provisions and bylaws that affect the likelihood of hostile takmveN; (3) compensation plans; (4) capital structure choices, alrd (5) accounting control systems.ln addition to the corporate Bovernance provisions lhal are under a firm'5.onLrol,thereare alsoenvironmental lactor- out sideof a firm's control, such as the re8ulatory environment, block ownership pat tems,competition in the product markets, the media, ard litigation. Our discussion besinswith the intmal Drovisio$. and of Monitoring Discipline theBoard Directors by Shareholde$ are a coryomtion's owners and they elect the board of directors to actas agents on thir behalf. In the Unitd States,it is the board's duty to monitor seniormanagers and discipline them, either by removal or by a reduction in com pensation,iJ the manaSers do not act in ihe interests of shareholders.r'? This is not necessadlythe case outside the United States. For example, many companies in Europeare rquird to have employee representatives on the board. Also, many Euopean and Asian companies have bank representatives on the board. But even in the United States, many boards fail to act in the shareholdery best interests. How can this be? Consider the election process.The ballot for a bo6rd poeition usually lists only onecandidate. Although outside candidates can run a "write-in" campaitn, only tho6ecandidates named by ihe board's nominating committee are on the ballot,rl At many companies, dre CEO is also the chairman of the board and has consider ablemfluence on this nomfunting committee. This means that in practice it often is the CEO who in effect nominates candidates for the board. Hith compensation and prestige go with a position on the board of a major company, so board seats are prized possessions.Boad members typically want to rctain their positions, and they are gratetul to whoever helped 8et them on the boad. Thus, th nominatingprocess often rcsults in a board thai favonbly is djsposedto the CEO.ra Many board membeE are "inside$," drat is, people who hold managerial positions within the company, such as the CFO. Becauseinsiders rcport to the CEo, it may be dit{icult for thm io oppose the CEO at a board meeting. rwo hore oddp,edihii fromeworlfron $6one providodby9uorr t. Gilon, in " DavsopmonrJ comorcle Gs- o.F 4 o\c'l"b i.u.. olCorpo.o rioicd .Lro 2006. pp. 38 J02. ci o- p.o ,o po'oc so.c"a'.. . dkl ol ofr s n.ue. o*o W.l-i91"y rc..r-rd f I poFerb h" rco!^ro 'o"d hbBnad h dn.lodn.led;kqrs on'lof ihe F{etr n rh 3 !..r.i rlThe,e o bw excpr orc ois ihis rue. Foreiomplo, !om6 sroi.! hovlow! o lowiig ih6 boord b iake nro comid. ddon r e ' T p ' - i o f o 5 " ' 'ol- h o d p ' . .Jd o r n p o ) .o i o - d r o h b.B oi .F..ohmLl ry o j-t 66 *o v b o lo . sl' o ' a to ldeR b.!o rc-roa coaddakro l -" boc'd l 2 o 0 o l o m o ."- " I' i" -imer s 1 lI, il whe$er ,hk movemonri. rucc6*tu1 c u wi bll oi y prcceduG ako ofied rhe obiliryol olh dei o soin polirion! on rk b@d tor 6xomplo, b@ds ..n be 'rvorins .kbd bv s'rhs' c'mulor o' non.umubNe d'no Unde' .umuld* 6h..o.h sho'.holds' B o numbe' . l6b. q @ l b h f d h s + E G | Br h e n u n b o io l6 @ d i6 h u p lo r d iroad.$mpl ,;hol ddol IOO i'*rollhtwlllgP' l,omv*'l loHRo'ebh.n[.d lh.n, o.horcholdd (on dft,hh h"o' h"' Er.r hwr h6 or shs gg fiL One hundrd rcter cdld b..or (.l 6.h 6l l0 cdndid.rr.s. d oll L000 rctes dU b con I( ft @ndidoi. ll mrundor L osd, ou, illoslrc[ rlocldoud conmr @ncenrrob his or "oiins ldtu me fion lm v*.on be @n ld ony oe condido'. Wlt ntrumulohw dns, nonogemenr onhols 5la olrh.rh.'.r Ey con fllmry kron fip bd'd 'l d$dcnr i(lhoue6 .oircr pu' o on rfie b@d Wiih amdoh* vorins, ho@6. il rO *ob op k, 'ep'hpnbriwp@vidd 6or ho6 l0% pl6 on ,ho. of tE 3'al !. hled, disidents 6n eld o rcpce'dre, r+.,reols rfid b,,lds s ,to whefie, fie enh,e bd,d B b b. .Lcbd onnuollv d ,l dtr(rra o,e b haw sba qdod hrmr, wiilr, sy, oErhird oI .eb hr be tilld eocn 6nd dn&b6 l,o ft 3.ror b' nr. wirh ios. ' bl o fi" hoord or.d bmr feF qts om up 6.h ysr molins n hodd 'er d6rid.ib ro qo,n 'pr.r6nrorion 5,lO Chopier l5 Volue3osed Monosement, Corporote ond Govmonco Corporcte Voluotion, Even outsid board memberc often have strons connections with the CEO through personal friendships,consulling, or olher leeeneratinSdctivities. In fact, outsiders sometimes have very little expert business knowledSe but have "celebdty" status ftom nonbusiness achvities. Some companies also have interlockingboar& oI dire.tors, whereCompanyA s CEo sits onCompany B'sboard and B's CEO sits on A s board. In these situaiions, even the ouiside directors arc noi tluly independentand impartial. l,arye boards (those with more than about ten to twelve members) often ar less effective than smaller boards. As anyone who llas been on a committe can attest individual padicipation tmds to fall as committee size increases. Thut there is a greater likelilood ihat memberc of a large board will be Iess achve than thoseon smallerboards. The compensation of board members has an impact on the board's effective ness. When board memberc have extraordinarily lugh compensatio& the CEO also tends to have e)(tlemely hith compeNation. This suggests that such boards The form of board compensation also affects tend to be too lenient with the CEO.15 Ratherthan compensating board membe$ with only salary, boad performance. now include restdctedstockgmnts or stockoptions rn an effort many companies to befter aliSn board member6 with stockholders. Studies show that corporate govemance usually improves if (1) the CEO is not also the chairman of the board; (2) the boad has a mai)rity of true outsiders who bdng some type o{ business expertise io the board; (3) the board is not too large, and (4) board members are compensated appropriately. The good news foi the sharcholder is that the boards at many companies have made signiJicant improvements in these dLctions during the last decade. Fewer CEOS are also boaid chaimen, and as ltower has shiJted ftom CEOS to boards as a whole therc has been a tendency to replace insiders with shon& independent outsiders. Today, the typical boad has about one-third insiders and two-ihirds outside$, and most outsiders are truly independent. Moreover, board members arc compensated p marily with stock or options rather than a straight salary. These changes clearly have decreased the patience of boards with poorly performinS CEOS.Within the past several years the CEO9 of Preter & Gamble, Coca'Cola, GI\4 IBM, Maftel, Campbell Soup, and Xerox, to name just a few, have been removed by their boards.This would have beenunheardof 30 veals aeo. Provisions Bylaws Affect and Thal Charter thelikelihood l{ostile of Takeovers Hostile takeovers usually occur when managers have not been willing or able to maximize ihe profit potential of the rcsources under their control. In such a situatio& another company can acquire the poorly performing firm, replace its managers, increase free cash flow, and improve MVA. The following paragapfu descdbsome provisions'thatcan be included in a corporatechafter to makeit harder for poorly performing manateis to rcmain in control.r6 rrs* | t Brcl, O Polmm. ond J. wbld. 'Cf o GmFn$rion. D'tr' Compnbrid. ond li,m Pelonoe. E'de'.e orC o'yi- ?' ./oJrd'or Cae.Bb t non e l.r 2006. pp !01 /t2J rdsome$obs hov. owr fioroo fu hd rhoi ofiere !o m.noaemenr. Th3 ir on. rcosonthor moivcomoonies d " f .dpo dao h nolos" i' ov Dao^o- :. . compo"e, i'. 1 + lao +a,.b! ol iro p;rc'o. ro torl . l py N o. \.ro Do o a o e b e co .3 . \o i - o n o q e .r .'\o o ororp -l o'"5od6/._tl 'ol nrong -o. choder"colLddnd rclld waive the.omponyt ristu b "o,. oir-rokeoverpror..r oi, evenif lfre:raroo owed 1. Corooroie Govefnonce A sllareholder-friendly chafter should ban targeted share repurchases, also kno$'nas greenmail. For example,supposea company'sstock is selling for $20 pershare. Now ahostilebiddet or raider,$.ho plansto replace management ifihe takeoveris successful, buys 57ooI the company's stock at the !i20 price.rT The raider then makes an oI{er to purchase the remanrder oI the stock Ior $30 per share.The company mitht offer io buy back ihe bidder's stock at a price of say, 635per share. This is called a tarteted sharc rcpurchase since the stock wili be pur chasedonly {rom the bidder and not Ircm any other shareholders. Becausethe bidder paid oniy $20 per sharc Ior the stock, he or she would be making a quick prcfit of $15 per share,which could easily total sevemlhundred million dollars. As a part of the deal ihe raider would sign a document promisint not to attempt to take over ihe company Ior a specified number of years, hence the buyback also js called greenmail. Grcenmail hurts shareholders in two ways. First, they are left wiih $20 stock when thy could have received $30 per share.Second,th company purchased stock frcm the bidder at $35 per share, which represents a direct loss by ihe remaining shareholders of $15 for each rcpurchased share. ManateE who buy back stock in targetedrepurchases typically argue that iheir firms are woth morc ihan the raiders offered, and that in time the "rue value" will be revealed in ihe folm oI a much higher stock price. This siiuation might be true if a company were in the prccess of resiructuring iiself, or if new products with high potential werc in the pipeline. But iJ the old managemeni had beenin power for a long time, and if it had a history of makint empty prcmises, &en one should question whether the true purpose oI the buyback was io protect stockholders manaeement. or Another characteristic of a stockholder-friendlv charter is that it does not containa shareholderdghts provision, beiter descdbedas a poison pill. Thesepro visions give the shareholders of iaet firms the ght to buy a specified numbr of sharesin the company at a very low price if an outside group or firm acquires aspcified percentage of ihe Ifirn's stock. Therefore, if a potential acquirer tries to takover a company, its other shareholders wiil be enhtled to purchase additional shares stock at a bargain price, thus seriously diluting the holdings of the raider. of Forthis reaso&theseclauses arecalledpoisonpills, because they arein the charif ter,the acquirer will end up swallowing a poison pill if ihe acquisifion is successtuI.Obviously,the existence a poison pi]I makesa takeovermore difficult, and of thishelps to entrench managment. A third management entrnchment tool is a reshictedvoting rights provision, which automatically depdves a shareholder of votint dthts if the shareholder ownsmore than a specifiedamount ofstock. Theboard can grant vohng nghts to sucha shareholder, but this is udikely iJ ihe shareholder plans to tal over the company. toAlign Using Compensation Managerial Shareholder Iflterests nnd The typical CEO today receives a fixed salart a cash bonus based on the tum's lerformance, and stock-based compensation. eiiher in the for-rnof stock grants or Tsommne.on,unde,fie low, ocqu rd !p 1o5% ol o frm! $ocl wiihod .nnounclnsthe ocqus on oncethe 5% byfilins o rcpo with rheSEC,ond the reporrmusl milhdsboen hir, $e a.quiref mut 'otriouice' fie acqut 'ion iuch 6 o po$ive nvetmenror o rokeoverThese lnior.iy e a.quner'3pos lion bul olso his o, he, nlsnlions, k posib It o(o *p"d" *; .s :ooi oJ one k fied, monosemenr a erbn b $e immlnent '."rb;d "",;y' - chopler l5 ColPoore Voloolion,VoloeiGed Monogenenl, ond Coryorcle Govemonce option grants. Cash bonusesoften arc based upon short-run operating factors, such as this year's growth in earnings per share, or medium-term operating performance, such as eamings growth over the last 3 years. Stock-based .ompensationis olien in the folm of options.Chapter S explains option valuation in deiail,but we discussherc how a standardBtockoption com. penBation plan works. Suppose IBM decides to grant an option to an employeei allowing him or her to purchase a specified number of IBM sharesat a fixed p cc, called the exer.ise price, regardlss the actual price of the stock.The exercise of price is usually set equal to the current stock price at the time the option is granted.Thus, if IBM'S curent p ce were $100,then ihe option would have an exercisepri|3 of $lm. Options usualy cannot be exercisil until after some specified period (the vesting period), which is usualy 1 to 5 years. Morover, they have an expiration date, usually 10 years afier issue. For our IBM example, assume that ihe vestingperiod is 3 yeals ard the expirationdateis 10 years.Thus, theemployeecanexercise option 3 yearsafterissueorwaitaslonSas 10years. the Of course, the employee would not exerciseur ss IBM'S stock is above the $100 exercise pdce, and if the price never rose above $100, the option would expire unexercised. However,if the stock pdce were above$100on the expimtion daie, the option would surely be exercised. Suppos the stock price had grown to $134 after 5 years, at which point the employe decided to exercisethe option. He or she would buy stock from IBM for $100,so IBM would get only $100 for stock wolih $134.The employee would (prcbably)sell the stockthe samedayhe or slrcexercised option/ hencewould the receivein cashthe $34differcnce betweenthe $134stockprice and the $100exercise price. People often time the exerciseof options to tlre purchase of a new home or some other large expendituie. In iheory stock options should aliSn a mana8er's interests with those of share holders, influencing tlrc manager to behave in a way that maximizes the companyt value. But in practice there are two reasonswhy this does not always occur First, suppose in the example above a CEO is granted options on 1 million shares.In this case,the executive would receive$34 for eachoption, or a total of $34 million. Keep in mind that this is iI addition to an annual salary and cash bonuses. The lodc behind employee options is that they motivate people to work harder and smarter thus making the company more valuable and benefiting shareholders.But take a clo6erlook at lhis example-If the rbk-fre rate is 5.5%,the market risk premium is 6%, and IBM'Sbetais 1.19.then the expected retum, basedon the CAPM,is + 5.5o/a 1..L9(6%) 12.(AEa. IBM'S dividend yield is only 0.8%, so dre expected (12.54a/a A.gVa 1'1.847.). = annualprce appreciation must be around 11.8470 Now note that if IBM'S stock price grew frcm $100to $134over 5 years, that would translate to an annual Srowth rate of only 57o,not the 11.84%shareholders expected. Thus, the execntive would receive $34 million for helping run a company that per. formed below shareholders' expeciations. As this example illusirates, standard stock options do not necessariiylink executives' wealth widr that of shareholders. Even worce, the evmts of the early 2000sshowd that some executives were willint to illegally Ialsily financial statements in order to drive up stock pices iust p or to exercjsingtheir stockoptions.ln somenotable cases, subsequent the stock price drcp and lossofinvesior confidence have forcedfirms into ba*npicy. Tlis behavior is certainly not in shareholders' best interestsll3 6 5 . r o ,o d 6 m .r u d a 3 sl- o "fo ooroabo*o.oro610i o o l 4h.od.rao \branf,r "oo bdaGo? '1q! oro o.ien'rc.d 56A aq o"ol oro S C od o Co po o! Co,erc(6 ;-d Arc! nra ko do s Jorror oldo"dEmJo" . m6 pp " 40d \ B, s Kedia ll.p po ol D.lo -o1 "{o$d Co-pp o olo_ ' Mirpo'r 19,'./ounorol ino- iorf.o"otj.. .on a 2006.pp l\-37.o"dD.D"', P Ho$u o. o d a to 1 "h Da o Dd'r 5id6 b li@rir C@pneton?' ./odo, o, Co'poo rircfta lune 200d, pp. ,io7-.d88 ' Corporore Govemance 543 As a rcsult, conrp, arc cxpcrim.rrlinil with differcnt typcs of .ompcnsatnrn plans,r{ilh rlifferent vcsting}rcri( s ilrd differentmc.lsurcs pcr oi f{)nn.rncc. cxanrple,it is irorc cliffic lt io lcgallv Danlpulate EVA (ll\ onri. For \r.rluc A.l.lcd) thnn iL is to m.rlipl,lntc cannrgs pcf sh.rre.'just as "all ships fise ir n fising iide," so t(x) do mst stocks rise in ,r blrll markct such .1sih(' onc durnrgthe 1990s In a sh(rlg Durkei, even the st()ck\ol.{mpanies slx)sc p.!' hDnanceranks m the botnrn l0',i of their peer gnrp can risc and ihus lriggcr h,rfdsoDre This siiuation is lending !o clDpcnsniior tl.ns thnt exectltiyebornrscs. .rr b.scll orr rrlalir'( .s opp,)s.cito rlrsol,n,slockpride prrn,rman.c. For x,rnrple, conrpersaiiof plalrshnve nr.lcxcdoptiors, lt,hoscexcrcisc priccsdc|crrl (rr $omc lhcpcrforrnance ih(. m.rrkd or of a subsetoI conrpeiibrs. Ihralli', ihe empific.ll oI r$ults from acaderricstudi(s sholv ihal the cofr!lnti(D bctweerlexecutiv(.c(rnind corpor.rtep('rlo.manceis nixed. S(nnr stucliessuggesi thnt th( Ffrrsn(ion ii po of culpensatnrn plin us.'d aifeciscompamv pfrf(nrnance,$41ileoth(ys sug gfst littlc ii anl' eifect.:' iJut \vc .an say with ccrtnirlv that lnanagriaL conrfcrlsn ijon plans r{ill contnire k) ru.pive lots of attenti(,rr n1))| researchers, poFrl.rr thc truss,and boardsof !lirc.lofs. (apilai {Jon[!sl Syshms Struc{*rc furhrnrdI an{l C.rPital structure dc'cisnnrs can aUect managffi.rl bchavior. As the (lcbi lfvcl rupt.y bnngs \^'iih it th(r filecis on behavior fjrst, \\,hen tines ire good, ntrn.rg |r5nuv t \ - as t c n s h i l ()i | o n Pe rq u i s j t s a n d dfscrilred earlier in this chnptc'r The good nc\vs is thai an nrcreasnrg oi l .'n lr |r . . l. ! r F , r , . . ,., r. h \,r.l , i rl -| F Id ,! ' BLrtthe bad ncws is rhnr a nanager m.ry bcc(nr1cgun shy and rcjc.t p(\irivc NI'V proiects if thcy arc risky. From a,lLlcr's ponlt of view it \lould bc uf f(Jrlurute if a risky l ,j('cLcaused the conpany l(, Bo into balkruptc!, tr t nolc thrt other companics in thc stockhol.:ler's portfi,lio nriry be takinS on rlsky pnrj r.ts lhat torn ort su.rcssioll),. Since most sbckh('ldfrs are r\rell .ln'crsilicd, thov nnr .rifoftl for a managcr t() Lrke on risky bui positi!c NPV projects. But.r ni:rn.rg cfr fepl,taft)n and re.lth.rr generall-v fic.l to i singl.orlpan),, so the projr,.t riy be unacccptabl! ri:kv lrom ihe manigcr's t()int oi |ie\r. -l hus, Iligh dct't.nrl .iuse mnnagc$ to for8o positive NPV projccts unlcss they are cxtrcnlclv \nle. Tlis is cnlled thc under;'r!estment problenr, anLl iL is nnother type ofagcn$ cosl. \olice that dcbt can rcd!cr one aspect of agcncy (osts (urastetul spcidnrit), Llrl il nr,ryincreasean(,thcr (Lrrt]t,finvstment), so thc rict oflccl on value isn't clenr Inteffal conbol sysLenrs llrve beconc an incrcasingly important issftr sni(c lhL' prs\lgc of the Sarl,anes-O\lcv Act of 2{102. ScI:tiolr4(14of the act rcclunc! conrp.r li.q lo cstablish eifeciivc nrternal conLrol systenrs. the Sc.uritics 1i\chnngc Conlltlissidl, \\nrich is chnrg.d with thc impleDrent.ltn)n oi Safbancs-()\le\r dcfin.s lr\ cttrcti!c inienrnl curtfol svstcn as one thnt P(^'ides "rcasonablc.rtsLrnr\.c rsg.rrdnrgihc reliabilit! ot lmancirl reporiing and the preparatbn of financi.rl nitLincnis lbr cxicrnnl pLrrposc's accordan.c with gfr)erally acceptccla..omting in pril]ciplcs." 1n other $'ords, lrvestors shou].] bc.blc lo lrLrsta conpany's rcPrlod i i rn c ial\ t aic m eni s . 'fo,o d s.u* of.l EVA,5eeA Ef,b(, fV,4: l,e Re.lKayrD Credtrg t4l..lrr lNew Yo (rlohi W ay & S.f\, 9931ond Pome P Pererci oil D.v ,l R Pcrcrcn,C.mponlPelormo,.c.rdMeosores.IVoloeAdded o Th!Re*drchfoundd.n of fie ij rlb ol cl,drqeJ I nan. o ana yr: 9961 fo,eiompa seeieni ler Corpedc,.nd Dovd Yermd.[,edi E'e."r*' C.nFD^saranon'1'hdrct.]de' v.1,. sr.or K !we. Acodemi.Pub rhe( ree9) Chopter 15 Cofpodte Vo uotion, Va ue BosedMonogement, dnd Corporole Governonce p rh Aci I n 2002 Congre s s o s s e d e So rb o n e s o x e y , known in ihe indlsrry now os SOX, os o measlre ro lr iy o g im pr ov e ons p o re n c n U n o n c i o l c c o u n i i n o n d to pfeve.i ko!d. SOX conslsisof eleven chopters,or fiiles,which enoblishwide{oiging new reguiorions Ior oldiiorc, CEOSond CFOs, boqrds of dlreclo,s, invesrmeninolyns,ond lnveslmeni o borks. These 'eg s or e de s l g n e d e n s !rerh o rl o ) c o mp on to ' , lqiioisf or m lhol per oud i ho re s u ffi c i e n ry e p e i d e n tofi he fd - o- po, es lo re / o J d r { b l o L e / F .F c fi ve r rhor rhe finoic'o eoch componyperoono//y certi{ies sioiements completeoid occ!roie, (c) rhe boord ore ol directo6' oldit comhifleeB re oiivelyindependenr of m onos em e n (d l fl fo n c l o o .o y s i s o re re o i ivel y t, ndependeniof ihe compones lhey onolyze, ond ( e) c om ponlesp u b l l c l yo n d p ro m p tl yre l e o s eoL n l on im por loillnf ormo rl oo b o !l l h e i rl i n o n c i oc o n d ll below. Th r.dividrol ti es ore brieflysommorized | T r t le. s t obrs r" n - o rb r C o mp o ry ..o u i ro A Oversght Boord,whosechorse is ro oveEeeoldllors for ond esiobish quo ity contro and elhlcolsiondords Tile ll requiresihoi oudilorsbe idependenl of rh t he c om pones h o r th e yo u d i t B o s i c o l y i sm e ons l ro rhey con'l p.ovde consu llrg services lhe compo n es rhey oldlr. The purposels ro removefinanciol cook ihe incenrives oldlrols io help monogemeni for Ti e l l reqliresihoi lhe boord of direciors'oldir musr composed "independeni" of mem. commiflee be rh beE . S ec r ion 2 re q u i re s o rfh e C EO o n d CFO 30 ihe fn m ! n r ev iew o n .u q i o n d q u o n e rl y o n c i c lstote ce.rit fiol theyore mertsond reporisoid personolly did o.c!roie. Penoliies ce'riv ng repods for complele execlllvesknow ore folse ronse up to o $5 mi ioi fiie, 20 yeotsln prison,or bolh. UnderSecllon304, itlhe fi.oncio toremenls turnourro be fo seond husr be retoied, the. cerroin boiuses ond eqliry-bdsed compensoiionrhor execuuveseorn musl be rem bu6ed io ihe compony. prcmpldi scl o Tte l V s S ecl on401{o)rcqunes sure ond more exlensiverepo ng on off bolonce 404 reql i resrhor mc^ sheeti ra.sodons S eci i on dgemenlevo uore its interio finoicio conirok ond repori whelher they ore "effecrve" The exrerno i oudl l i ngfl rm mL:st so i rdi corew herher i ogrees al wiih monogemenr!evohoi on of k iniernolconiroh rhoi o compo.y disclose lhe io Seciion409 requires pubic p,omptly o.d in ploin Fng/ishony moreno Ti ro chonges i tsIi noi ci ol condi i i on. e l V ol sopl oces on resrricliois rhe loonsihoi o componycon mokelo Tlle V odd.esses relorionsh betweenflidiihe p rhe bonkstheywork for, ond ciolonolysrs, inveslment rhe componieslhey cover li requireslhot ondlysls ond brokea who moke siock recommendqio.sdis theym ghl hovewlrh ihe cose ony conflctsof inleresi ihey recommend. siocks TiilesV ond Vl ore iechnicolin nolure,deolng wiih rheSECi bldger ond powersond requlfng ihai severo studies underrokeiby ihe SEC be penol ri es desi royngor {or Ti l l eV l esl obi shes l foki l yi ng oudt records. r ol so provi des' w hi sfl + who repo* frouo. blower proteciior" for employees Title lX increoses penolilesfor o voriery of ihe whiteco lor crimes ossocloiedwiih secu'iilesfrold, ord wlrc froud. Seclon 902 o so moKes suchos moiL ir o crime lo dher, destroy,or hlde documenisrhol lr might be used ii on invesrigorion. oko mokesir o crimeto coisplrc 10do so. r l e ' req fo rh-' O + 9' l . ' ompory ' ,e, iedero lfcome iox reiLrrn. Tille Xl provdes penoliles for obstructlnson invetigol on ond grorrs rhe SECollhorlry lo femove officers or directorsfrom o compony if they hove nri.ntal rs t tn,-"rlon Facto Oirlside .rFilnil Co lroi 0t r\s noled onrlicr,coryor.ic )lolernancc is nlso nlfcctdbl, cn,'ironnenial f.rf(rs that are olriside of a Iirnr's ronirol, incllLdi,rsthc rcgulatory / lcgal enviro,rnrcnt, bbck o\^,rorshippatierns, (ompetitjorl in thc Fro.luct mnfkfts, the medii, rnd litigatior. ld\t\ Thc r('gLrlator\'/l.g.rl the I{egLllili0rt\,lI]d en\i.on ent lrr(lu(lcs n:t.'rr.ics tllat regulnic fin.lnciil markcts,sLr.has the SllC. Ivcn though thc finesafd f( n.rl Li()n tieslevied on firr$ for fini,nci.rl misrcprcscnL,r by the SE( ,rrurelaiil ely snr.rll, rcpulntion havesiBrrifi.ant.osts, lcadi g to erlrclncl)r the danngon' n firDl's can Co.poroie Governonce 545 large reductions in the firm's value.2r Thus, the regulatory system has an enormousimpact on corporate governance and firm value. The rc$latory/legal environment also includ$ the Iaws and legal system under which a company operates,Tllesevary greatly from country to country. Studies show that firms located in countries with strong legal proiection for investors have stron8er corporate governance, and thai this is rcflected in better access financial markets, a lower cost of equity, increases in market liquidiry, to and less noise in stock prices.z Bl0ckownership Patterns Pdor to the 1960s, most U.S. stock was owned by a largenumber of individual investors,each'ofwhom owned a diveEified portfolio of stocks,Because theseindividuals owned a small amount of any given com' stock/ they could do little to influence its operations. Also, with srch a lany's smallinvestment, it was not cost effective Ior them to monitor companies closely. Indeed,if a stockholder was dissatisfied, he or she would typically iust "vote with hisor her feet " that it sell his or her stock. This situa tion began to change as instihrtional investors such as pension and mu tual funds gained conhol of a larger and larger share of investment capital. and as they then acquired a larger and larger percentage all outstanding stock. Civen the large block holdings, ii now of makes sense institutional investorsto monitor manasement, for and thev have the ple,ledtherrown clout influence bo.rrd. some(dse-.the) havc;ctu.rlly to lhe In reprcsentativesto the board. For example, when TIAA-CREE a huge pdvate pen sion fund, became Irustrated with the performance and leaderghip oI For's/Bishop, a cafeteda chain, the tund led a fight that ousted the entirc boad andthen elected a new board, which only of outsiders. ':onsisted In ge eral, activist investoE with large blocks in compani6 have bn good for all shareholdeB. They have searchedfor firms wiih poor prcfitability and then replaced management with new teamsthat are well-ve$ed in value-based managementtecllniques, and thereby have improved profitability. Not surp singly, stockprices usually se when the news comes out that a well-known activist invstorhas taken a major position in an underperforming company. Note that activist investors can improve performance even if they don't go so far as to take over a film. More oftery they either elect their own representatives to the board or simply point out the firm's problems to other board members. In suchcases, boads often chante their attitudes and becomeless tolerant when they realizethat themanagement teamis not followirg ihe dictates ofvalue-based nanagement. Morover/the firm's top managersrecognizewhat will happen if they don't whip the companyinto shape,and they go about doingjust that. C0mpetitionin the Pnduct Markets Th degree of competition in a firm's productmarket has an impact on its corporate govemance- For example, companies in industries with lots ofcompetition don t have the luxury of toleratingpoorly perfomint CEO6.As might be expected, CEO turnover is more likely in competitive idustries ihan in thosewith 1es6 competition.'z3 When most fums in an industry p,,onorhon <o'@{, D.5(onl6a,o.d b"'old r odn Tho(odbri'hrolCoolino M 'fo' ^ &.15_U{.(h 8, 20061 A{'loble or SSRN. htE//tunv&ltu r=652121. ,rd Mhd6, 36 R b Po,ro,t Lopzdesilon.r,A SlleiG', ond R.v6hiy, -t sol oere'ninonrrol Eierul tin6e," lou6l ot Fimne, t997, pp.l I 3 l -l I 50i Hoam Do@I, Chod$ M. C t.. ond D@idNs, "Copibl rlo erG@6@. HN Do sRunry towr A{.d MoAd Perfomanrez'le'nal ol C6.tnob tmre, hQ 2006 'R) pp 5.0J93: ondL lin onds'esd C. Myts. A6und6s wb'ld Ne Tl'o5o^d N* raB' .lourolo, hnorcial 2446, pp. 257-292 EcaDani.s, rSEe Ds t6ndandC. Por[,"ThsEft*f of Compsrrion cEo Iun6v6t," on ond ].unol afAccauntina Ecananid, ' 0oopp 3 5J6 o-d T re eo d C, odod M o. oqer 6 - no, . .o . o P 6 d . . M o , o C o d r o r E r p i . o l ^,1. hdq .\o-.\6 Us N"! oooe. I d. t . v ' iolr or oI Bu. i"r 200 0 p p 2 0 5 - 2 4 J Chopter l5 Corpo,ote Vo uouon, Vo ue BasedMonogemeir, d.d Corpo,ore Goverionce Corporotegovefnoice inc[des the fo lowing foctors e$ prevolenr ihon in Germonyond lopan. In both ( l) t he lik elhoo d rh o io p o o ry p e rfo rm fi rmcon cermory ond Jopon,bonksoftenown oree bock of .g b- - o. " , o - . l /l * !-rte -" b o o d o d " tor, : siock,somerhing thor is not perminedby ow ln the qnd corcoraiio.soho own lorge bocks dominoiedby insiders olbiders, (3) lhe exleflo or UniledSroles, whlch mosrof the stockis held by o few lorge "bock of nock l. orlrercorporollois li lopon, combinotiois holdea mo n ys .o l l s h o re h o l d e ,sn d { a)i .e of compoiies, colled keirersus, hove cro*owner o, ' er eos compones, ond ihese size ond form of execlr ve compeisoron. A re.eir shipofsrockomongrhemember in slldy comporedcorporoiegovernonce Germoi,y, inte o.king bocks d srorllhe definllionof on ouiside Si for F.ompF ' 1-1 ,r- p-fo ^or " ond lhe U n i te d o i e s . J opan, F lr s t ,nor e fro m l h e o c c o mp o i y i n gl o b l e thor of o compoiy ii o kelrersu deleriorores, d reclo^ new ihe r hr eoiof o ro k e o v e r e rv e so s o s ri .k i . r' , oreo{ienoppointed s lrom rhestoffs ofother membersot LJ n S t or es l l n o i i n l o p d n o ' Ge rmo n y . s ihe keirelsu. Thl Suchoppoinlees mighi be cossifledofl ied b ihr eoi,whc h r e d u c e s n o g e me ne n i re n c hmenr,clollyos inslders, mo r buitheyrepreseni inreresis other ron s houd benef ils h o re h o e ts i n rh eL J i l te d l o i e s d S re thoseof the troubledcompony's CEO or iv er o ihe or h e . tv o c o u n r.i e sS c o n d , r mon . Ge li seneral,lorse b ockholde.s ore befle.oble ro ond lc pones eb o o rd so re l o rg e ri h o n i h o s ei n rhe monitormonogemenr 6an ore smoI nveno6, so one Unlr edS loies o n d J o p o n e s e o o rd sc o n s i np rl mo mighiexpectihe bockho der foctorlo fovor Germon , b r ily of ins lde rsv e rs u 5Ge rm o n o n d Ame rcon ond Joponeseshoreholdem. However,these blocr wh; c hh o v es i n i o r n s l d e /o u ts i dm i xes I holder hove other reor onshipswilh ihe compony boor ds , e s hord be not e d ,i h o u s h ,i h o t l h e b o o rd so f most rhol mlghrbe detrlme.rolro oursde shoreho dere.For LargeGermon corporoiionsinc !de representotives exompe, lf one componybuysfrom onother, rrqnsfer of obor ,wher e o s .S. b o o rd sre p re s e n r s rs hare. prlcins might be used to shlft weoth to o fovorecr U iu holden. T hus , r w o u d o p p e o r l h o t U S. b o ords, componr or o componymightbe forcedto buy {,om w rh o hisher percentoge ouisiders,world hove o sister of componyin 5pifeo{ the ovoilobilii} of lowe. ,te \ m o5t o o l q r" d d ,t\ ' 1 o .. o r ,l - o,e. cosl reso!rces lrom ouhide the group. -l l Exec!uv compensorion packogesdifferdromor fnmsore o so moreLi[ely icollyofioss the ihreecouniries, rh U.S.execurives Germonond Joponese w to 6e controed by orge bocks of nock lhon rhose n receiving tor lhe highest by compensorionHowever, rheUnitedSrores. Athough pension ond mltuo f!nds, compei so' i on ors ore remorkoby mi l or r terms pl s ds wellos oiherinnuiond inveslors, increosirgly of how seis rive rorolcornpeisoiionis io corporoie ore mpo oir i the Un led Sroies, !s blockownershlp sii arc f.lifly simil.r, then i,ou nright cxpe.l il to bc ersier b fin.i . qualificrl rcplace n n i ri tro D rn n rn h c r fi rn 1f{ r' ,r foorl \' }n rfornri ng (l l i Ll Thi si sc\.rcl l v\!h.l theei clen.c sho\\.s: ,\s industry hrmogeneitv, so does thc likelihor)cl of ClO T h f U fd i ,r a n { l l i l i q ,l i i o rt ( l rryoratf S o\rernanco, cspecj al l y c.rrpersati on, l s a hoi h,pLc Ln ih( nrc(lLa.The nledia .;rn hnre a p('sitiv rnrpn.i bv disco!'crLng or repoftirlg crr por.iL' problcnrs, sLrchns thc Enron scnrldal. Another ex.nrplc ls the if e \k l s i v e re c (n t (2 0 0 6 )co!f| nge bci nB gi ren Lo opti on Lracl (dnti ng, r hi ch the e \c r.i s 0 p ri c e s r)f c \e c u i i !o stock otl i ,)ns are s(i rfi .r thc ofl i ons ol i i ci .rl l ! hare bcn gf.rntecl. Bf.nLrs the e\cr.$e pri.cs ir set nt ihe lor\'r'st ltock pfi.e durlng the qorrter xr $,hich the options are !,rnnted, thc ('ptions irr. in the m(nrcy and morc v.rluablc \4,hcnthir'1)fficial" lifc begrns. I lowcver lhf mcdia carr .rlso hurt corp( n .riL' golerrrnnce bv;rg too Dru.h attenlnn on a Cl( ). Such "\uticr \tar' r .se e R ll, d ., "cEo t, iDe r o n. odrJes!..e$i onrA co$sedi oN t.aD.r n s, )997, Pp 165 )97 A fdys5 l ./{,/.l fi ,dn./ot I C o , p o r o t eG o v e r i o n . e Which country's syslem of corporoie govef nonce is besi from the siondpoiniof q shorehoder whosegoo is stockprice moxlmizotion? Thereis no defintive onswer.U S. stockshdve hod ihe best per lormon.e in rccent yeos. Moreover, Germon ond componiesore s owy moving toword ihe .lopanese U.S. sysiemwiih respectlo slze of compensqtio,,, ond compensoiioi plqns in oi ihree counlriesore being inked ever more closelyto performodce. Ai q the s om er im e,r h o l s h , U .S .c o m p o i l e s re m o y rs ioword ihe othersin ihe seise of having orger own e6hi p bl ocks, ond stncei hosebocks ore pri morry hed by pensi on ond mrtro fui ds rorher rhanbonks ond reoied corporoilons,lhey betrei represefl the lnierests shoreholders. of So, Sreven KaDon,"ToDFrecdive i.enrveslncem!. N. !"odd po'ooran'l shatehaldet v.lre, )er^ife, aoroeder ond DovtdYermoct erl. lB.ron: Kuver A.odem. Pub ;he6, i9991, pp 3 t 2 niernotionol Charocieristics Cofpofote Governonce of UniledSiols tsi gh 26 27% 73% Are orse bocks of siockiyplcq ly owned by A c onlr oling o m i l y ? I Anothercorporoiion? Execurive compensotion Amouir of conrpensouon Sensilivily pe.lormonce io 2l 9l% 67% nrgn CEOS oficn conrmand excessilc conrpoNation packagcs;rnd spend roo mu.h timc on activities outside thc conrpnnv resulung in too much patr for too ljttlc hr addilion to penalticsand fires iroDl regr ahrrv bodn'ssuchnsthe StC, civil liiig.tion also occufs r hcn cornpanies s spcctc.lof frauct. are The recentrcscarch indicates that such suiis lcad to improvementsin corporaiegovernance.zi 5EI-I-TE5T litr6i irr] hro pr;mart r'.!ft5 oi.orp.r*b $alenan.e (ifiin ;, ll,e i.,trili *ni the 3iiakl! lrJlnl fn.loi5 iftF.o'-e a h$ri,] at 'lir..ros' VJarri !re ihrse il.oriijicni in i\rr:. .<!filrrcte .hr:rie,r tid li)to trli-.!rs? Se5.ri[eii6.r o ipi.s' ;"r ;,lntr,'.! .t. \trai j'"]tl.ic riiil u,",,Fir6l 5i"" oFtn]rFl,irr ',.:'rni r,5a Ll lv1llms.liartrdC A iie, "5!pc61orCtOs," Worliig Pdp,"rSrorfor,lUnverl,,2OO5 +o, er.mpe, sc. D. B Flrbei'Ras.riig I n.frer Froud Doci c.vern.d.,a Mofier?"l...ynrnq l eq 2005, pp 539-561, and Slephei P Fetris Ton.sloid I, RobcrlM towes, oid AnlM.lf io 'Deiyorve t.va15 or o Me.honi5m: EmpnicoEvden.e.r B..r!l Chans.s sutrolndiio F ias, lanal.l tiran.i.tarl O!.ntit.r airyr,r, t , i,.;mhs. 548 15 Chopter Copofoie Vo udiion, ueBosed Vo Monogement, Corporore ond Gove,nonce !5.6limployce {lwnerchip {ESt}i's} Plans Stolk (,f who re.irivr stockunder option plansscll Siudicssholv thai r)0'1. the mployees their optnrns,so the plans motivatc cmployors lhe sbck as soon ns the),xercisc lirnit their stock oplrof orlv lbr n limit(rciperiod.rr \4orco!er, nanv coDrpanies plans to ke)' nan.rilers an(l crccrtives. To helF pftx l.:l long term Frocluctiritr .ors fof moreon ESOPS. ganrs,.rndalso b help inprovc rctirerncni incomcs for all (n'rployecs, Congrcss Toda,v about nuihofizcd thc usc'of Employee Sto.k Ownership Plans (ESOPS). t),000 pr^atetv helclcompaniesanct 1,000publicly held finns hale liSOPs,ind major assetis sharcsol the morearc bejnEicrc.ited evcry d.r)'.fypicnllr ihc ESOP's cren it, anLlof the 10,1100 IISOI'S, otal about rommon stockof ihe conlp:rnyLhat led 2,500of ihenr actunllv o{,n n Dlajoritvof ihcir coDlpan\'ssiock.zB To illust.aic how an ESOPivorks, crn:ider C.rllagher& Abboit lnc. (C&A),. Knoxvillo, Tenncssce, construcii(rl conrpanv G&A's si plificd bal,lnccsheetis C&A s Balance Shctpri(rr b ESOI'(Millions of Dollars) I-i .bi l i ti esand E qui ty Canr ()thcr 5t0 l 91l (1 l-qLrit), milli( Tot.1 shafcs) $ t00 100 $200 s200 No$' C&A creites.rn ESOI),rvhich is n new lcgal eniity. The compary issucs s{10,000 shalsof nr\^/stock.t $100pef sh.ue,or $50miln)rr h total, \^,hichit sclls b the ESi)l'. C&A's cmplovccsare thr ISOP'Ssk,ckhol.tcrb, ancte;rchemplovce rcceives ownership intefestbasedon the size of his or her salari,and ycarE an ol scl.vice.Thc ESOP borows thc Sso lrliliion to buy the neu,ly issued sk)ck.Jt financjal nrstituti(lis are rvilling to lend thc ESO]rthc mol]ey bccnusc C&A \igns gxarnntcctor the lo.rn.H.e is thc companv'sne\! balanceshedi .1 G&A's Balance Shcctafter rhc ESO| (Milliolrs of Dolllr\) l i l bi l i ti s i nd !qui ty $60 t90 $101) l 5l l s250 ()llrcr Total L{ l ui t! (1.5 l l j (n sh.res) nri Totil s2i0 'Thc conrp.ry l.s rtrar.niced lhe ESO]"sl(rtr, and il has pronriql to nakr pnvDrcnts thc ESOI)srffi.icrl k) retirc lhe l,,ad,b!l lhi\ n) docsrot shoF !p on thc balan.. shcc!. Jo "o d oo3rp ra"N o ovo,\ 3oo r o io ' . q. r Io .1O. ,/D l '1. v M. ,.l o o. ". -. "%,, " ,11 ,16roidDotre Eisenbeg^"or ESOP of rhe Evidcre, /.yrnol o/ Fiidn.tol Fdir..i.,, Sprirc 1997, pp 'No fobe h n e , M .y tO.1 9 9 9 , p 9 5 :'Omderpr.i is s.mewhar 1ed tc.hi.olr rlic no.l w.!ld bc pLocedi o:u5Fefie....!nrond,liei le iimpl o ocokrl ro emp.yees os ,e debr s Employee Ownership (ESOPS) 549 Slock Plon! The company now has an additional $50 million of cash and $50 million more of book equity, but it has a de facto liability due to its guarantee of the ESOPS debt.It could use the cash to finance an expansion, but many companies use the cash repurchase io their own common stock/so we assume that G&Awill do likewise. The company'snew balancesheets, and that ofthe ESODare shown belowl c&l(s Balaflce Sheetafter the ESOPand ShareRepurchase (Millions oI Dollars) Liabilitis and Equily Cash Other Total $10 190 $200 Debt Equty (1 milion shars) Total $r00 'ty) (50) $200 ESOP'S Initial Balance Sheet(Milllons of Dollals) Liabiliii$ and lquity Cash Other Total $10 Debt Eqdlr. (1 hillion sharcs) Total _99 $200 $100 1(X) $2m Note that while the company's balancesheet look exactly as it did inidally, there is rallya huge diJference-the footnote thai disclosesthat the company has guaranteedthe ESOP'Sdebt, hence that it has an off-balancesheet liability of 950 million. Morcover, because the ESOP has no equity, the guarantee is vry real indeed. Finally,note that operatifig assetshave not been increased at all, but the total debt outstandint supported by those assetshas increasedby $50 million.30 If this were the whole story, ther would be no reason to have an ESOP Howevr, C&A has promised to make payments to the ESOP in suflicient amountsto enable the ESOPto pay interest and principal charges on the debt so asto amortize the debt over 15 years, Thus, after 15 years the debt will be paid oft and the ESOPS equity holders, who ar the employees, will have equity with a bookvalue of $50 million and a market value that could be much higher if C&A s stockincreass,as it should over time. Then, as employees retire, the ESOPwill distribuie pro rata amount of the G&Astock to eachemployee, a who canthen use it asa part of his or her retirement plan. An ESOPis clearlybeneficialfor employees, why wordd a companywant but to establisll one? There are five pdmary reasonsl i. Congress passedthe enabling legislaiionin hopes of enhancingemployees' productivity and ihus making the economy more efficient. In theory if an employee has equity in the enterpdse, he or she will work harder and sma er Note too that if employees are more produclive and creative, this will benefit 4h csmed E he conponyosd $ $J0 milljonpoid lo br ilB ESOP ..purchor cmnoi sro.l ond ltus ro rD hdsse ir5de locro couid hov. used $50 millron rclircdobr, which $e 1o in cos ik rue debr Eitowoud eron..(\o se d ori.o Ld t o' . - 3ed f e no e/ r o ' ppo o e?p o ! i o . Chopter 15 Corporole Voluollon, VolueBosed Monosemeni, Coporoie Governonce cnd outside shaleholders, because prcductivity enhancements that benelit ESOP shareholders also benefii outside sharcholdeb. 2. The ESOP represents additional compensation to employees, becausein our example there is a $50million (or more) transfer of wealth from existing shareholdeF to employees over the l$year period. Presumabl, if the ESOPwen not created, then some other form of compensation would have been' required, and that alternativecompensationmight not have the secondary benedt of enhancing productivity. Note too that the ESOP'Spayments to employees (as opposed to the payment by the company) come primarily at retirement and ConSress wanted to boost retiremntincomes, 3. Depending on when all employee's rights to the ESOP are vested, the ESOI may help the firm retain employes. 4. Therc are also strong tax incentivs to encourate a company to form an ESOP or First, Congress decreed that in case6 wher the ESOPowns 50Eo mole of the company's cornmon stock, the financial insiituiiolls that lend money to ESOPS can exclude fiom taxable income 50% of the interest they receive on the loar This improves the financial institutions' after-lax retums, making them willing to lend to ESOPSat below-ma(ket rates. Therefore, a company that establishesan ESOPcan borrow through the ESOPat a lower mte than wodd otherwise be available-in our example, the $50 million of debt would be ata There is also a second tax advantag.If the company were to borow dircctlt it could deduci intercstbut not principal paymentsftom its taxableincom. ir However, companies typically make the required payments to theil ESOPS the form oI cash dividends. Dividends are not normally deductible from tax' able income, , l cashdi.,idendsWid on E9OP stockarc deduclibleif the dioida ds participants areusedto rcWytheloar. Thus, companies ot whose orepaidlo pla11 ESOPSown 50% oI iheir stock can in effect borrow on ESOP loans ai subsi dized rates and then deduct both the interest and principal payments made on the loans. American Airlines and Publix Supermarkets are two of the many finns that have used ESOPSto obtain dris benefit, along with motivating givrnS them dn equity interesiin the enterprise. is A less dsirable use of ESOPS to help companis avoid being acquired by another company. The company's CEO, or someone appointed by the CEO, typically acts as trusteefor iis ESOB and the trusteeis supposedto vote the sharesaccordint to the will of the plan participants.Moreover,the ESOP'S participants, who are the company's employees, usually oppose takeovers becausethey hequently involve labor cutbacks. Therefore, if an FSOPowns a has a powsignificantpercentage ihe company'ssharcs,thn management of This G not tood Ior outsidestockholders. erful iool for warding offtakeovers. Are ESOPSgood {or a company's shareholders? In theory ESOPSmotivate employees by providing them with an ownership interest. That should increase productivity and thereby enhance stock values. Moreover, tax incentives mitiSate the co6ts associated with some ESOPS.However, an ESOP can be used to help entrench management and that could hurt stockholderc. How do the PIos and cons balance out? The empirical evidence is not entirely dear, but certain findings are wordr noting. FirsL if an ESOPis established to heip defend a8ainst a takeover, then the 6lm's stock price typically falls when plans for the ESOPare announced. The market does not like the prcspect of mtenchint manatement and havint to give up the premium normally associatedwith a takeover. However, if the ESO? is established for tax purposs and/or to motivate employees, the stock price generallygoes up at the time of the announcement. ln these cases,the comPany tl?ically has a subsequent imprcvement in sales per employee and other lonttermpe{ormance measures, which stimulatsthe stock p ce. Indeed, a recent study showed that companies with ESOPSenjoyed a 26% average annual stock ThereJore, ntum vercus a return of only 19%for peer companies without ESOPs.3r it appearsthat ESOPS, used appropriately, can be a powertul tool to help create if shareholder value. SEI,F'TEST ore ESOP5? dre iomeof theirodvqnbs5 dhodvonrEses? whot Whdt ond Summary . . . . Coryorate assets consist oI operaiing assets and financial, or nonoperating, Operating assets take two form6: assets-in-placeand growth options. and inventory that the Assets-in-place include the land, buildings, machines, firm usesin its operaiionsto prcduce productsafid services. Growth optioN reler to opporiunities the firm has to increasesaies.They include opporlunities adsing from R&D expenditures, custome! relationshipr and the like. Financial, or nonopentin& assk are dGtinguished from operating assets and include items such as investments in marketable securities and nonconrrolUngi^lerestsin lhe )lock of other compdnies. The value oI nonoperating assetsis usually close to ihe Iiture reported on the balance sheetThe value of operations is the present value of all the futule free cash flows xpected from operations when discounted at the weithted average cost of capital: . . . FC4 + wAcc), The terminal, or horizon, value is the value of operations at the end of the expliot forecast period. It is also called the continuing value, and it is equat to the preseni value of all ftee cash flows beyond the forecast peiod. discounied back to fie end of the forecast period at the weighted average cost of capital: Continuint value : V"l",r*Nt: FcFN*r *Oaa == + FCFN(1 g) WA-CC _, The corporatevaluation model can be used to calculatethe total value of a companyby finding the value of opemtionsplus the value of nonoperating assets. The value of equity is the total value of the company minus the value of the debt and preferred stock. The price per share is the total value of the equity divided by the number of shares. I 56.Don Eseibers, "No ESOP Foble," ri'6, Mdy 10, 1999,p. 95 e 552 l5 Chopbr VolueBosed Corpo,ore Voluorion, Monogehenl, ond CoporoteGovemonce . Value-basd management involves the systematic use of the corporat valuafion model io evaluatea company'spotenfial decisions. The four value drivers are (1) the Browth rate in sales(g), (2) operaiingprofitability (OP),which is neas ed by the ratio of NOPAT to sales,(3) capitaL (CR) as measuredby the ratio of operatingcapital to sales, requirements and (4) the weighted average cost of capital (WACC). Expcctedretum on invested capital (EROIC) is equal to expectedNOPAT divided b)' tlre amouni of capitalthat is availableat the bednninS oftheyear Acompany createsvalue when the spradbetwcenEROICand WACC is pos itive, ihat is, r ,henEROIC WACC > 0. Corpoiate govemanceinvoh,esthe mannerin which shareholders' objectives are jmplemented,and it is reflectedin a company'spoliciesand actions. The tr./opdmary mechanisms used in .oryomtc governance ar:(1) the ttueat of removal of a poorly prformingCEO and (2) the type ofplan used to compensateexecutives and managers, Poorly perfonning managerscan be removed either by a takeoveror by the companys own board of directo$. Provisionsin the corporatecharteraffect the difiiculty of a successful takeover,and the composition of the boardof directorsaffectsthe likelihood of a managerbeing removedby the board. Managenal entrcn.hnent is most likely il'hen a company has a weak board of directo6 coupled with strong anti-takeoverprovisions in its corporale charter.In this situafion, the likelihood that badly performing senior maragerswill be fired is low Nonpecuniary benefits are noncashperks such as lavish offices,memberships at country club6,corporatejets/ foreign junkets,and the like. Someof theseexpendiiuresmay be cost effective, but oihers are wasteful and simplv reduceprofits.Suchfat is almost always cut after a hostile takeover. Taeted sharerepurchases, also known as greenmail, occur when a company buys back stock from a potential acquirer at a higher than fair market price. In rehrrn, the potential acquirer agreesnot to aitenrpt to take over the co'nPany. Shareholderrights provisions, also knoivn as poison pills, allo$' exist g shareholders purchaseadditional sharesof stock at a lower than market b valuc if a poiential acquirerpurchases controlling stakein the compan)'. a A restrictedvoting rights provision automaticallydeprives a sharcholder ol voting rights if the shareholder owns rnore than a specifiedamouni of siock. Interlocking boards of dire.tors occur when the CEO of Company A sits on the boaid of Co pany B, alrd B'dCEO siis on A s board. A sto.k option provides for the purchaseof a shareof sbck at a fixed price, calledthe exercise price/ no maiter what the actualpice of ihe stockis. Stock options have an expiration date, after which they cannotbe exercisrd. An Employee Stock Owne6hip Pla& or ESOP,is a plan that faciliiates employees' owncrship of stockin the companyfor which ihey work. Questions {15-l} Define eachof tl'refollowing termsl a - Assets-in-place; growth options; nonoperating assets b. Net operating working capital; operating capital; NOPAT, free cash flow Value of operations; horizon value; corporate valuation model d . Valuebased managemenq value drivers; EROIC Managerial mtrenchmenq nonpecuniary bnefits f. Greenmail; poison pills; rcstricted voting dghts Stock option; ESOP (15-21 Explain how to use the colporate valuation model to find the price per sharc of common equity. {15-3) Explain how it is possiblefor salesgrowth to de$easeihe value of a profitable comPany. (15-4) What arc some actionsan enhenchedmanagement might take that would harm sharhold$? {15-5) How is it possible for an employee stock option to be valuable even if the firm's stock price fails to meet shareholders' expectations? Self'TeSt PfOblem solurion Appeors inAppendix A IST-I) Watkins Inc. has never paid a dividend, and when it might begin paying diviCorpooie uoiion dendsis unknown. Its currentfree cashIlow is $100,000, this FCFis expected Vo and to grow at a constant77drate. The weighted averagecost of capital is WACC = 1170. Watkins currently holds $325,000 nonoperatingmarketablesecudties. of lts long-term debt is $1,000,000, it has never jssuedpreferredstock.Watkins has but 50,000 sharesof stockoutstandjns. CalculateWatkins'value of operations. b- Calculatethe company'ototal value. Calculate the value of its common equity. d- Calculate the per ghare stock pfice. PfOblemS Answers Appeor Appendix in B Eary Problems l-5 (l5.ll Use the Iollowing income statements balancesheets calculate and io GarnetInc.'s F,ee co3h Fow free cashflow for 2008. s54 Chopler 15 ond Governo.ce Coporoie Volloiion,Vo ueBosed Monosemenr, Corporole Carnet h1c. 2008 2007 Cosis(exceptdepreciation) TotalopeFting costs Eainings before inleresi and iaxes (EBIT) Eanings beforetaxes s530.0 400.0 30.0 1j430.0 100.0 23.0 $ 77.0 30.E $ 46.2 $500.0 380.0 25.0 s405.0 95.0 21.0 $ 74.0 29.6 $ 44.,1 Cash Marketable securities $ 28.0 69.0 81.0 _u!! Total cunent asseis Net plani and equipment $293.0 281.0 $574! $ 27.0 66.4 80.0 106.0 5279.4 265.0 qe4! $ 52.0 130.0 28.0 $210.0 164.0 100.0 Liabilities and Equity Accounts payable Totalcurrent liabilities $ 56_0 138.0 28.0 $222.0 173.0 100.0 J2! Totalliabilitiesand equity zq! $170.0 $544.0 $179.0 $574.0 EMC Corporationhaslevei paid a dividend.lts currentfree cashnowis 5400,000 115-2) and is expectedto Brow at a constantmte of 5%. The weighted averagecostof capitalis WACC : l2%. CalculateEMC'Svalue of operations. its.3l Curent and projected free cash flows for Radell Global Operatiols are shown below.Growth is expected be constantafter 2009.The weighted averate cosiof to capitalis 11%. What is the hoizon, or contimdnS,value at 2009? Actual Projected 2007 Free.ash floa (niUions of douars) 2008 2009 2010 s606.82 $667.s0 9.747.55 S7s0.00 has constant {r5-41A companyhascapitalof $200,000,000.It an EROICof 9%,forecasted growth of 570,and a WACC of 10%.What is its vaiue of operations? What is its MVA? (Hint: Use Equation15-4.) You {r5,51 are gjven the followjng forecasted information for the year 2011: Sales : $300,000,000; Opemting profitability (OP) : 68"; Capital reqlirements (CR) = 43%,Growth (g) = 5%; and the weighted average cost of capital (WACC) : 9.8%. thesevaluesrcmain constanL If what is the ho zon value (that is, the 2011 (Hint:Use Equation15-3-) value of operations)? Brcoks Enierprises has Deverpaid a dividend. Frce cash flo\a'is projectedto be 1r5"6) year it and S100,000Ior next 2 yeals,respecfivelt and after ihe scond the $80.000 cost is expected grow ata constantrate to of8%. The company'sweightedaverage of capital is WACC = 12%. (Hinr Find the value of a. Whai i.S tennjnal, or ho zon, value oI operations? the aII frce cashflows beyond Year2 discountedback io Year2.) b. Calculatethe vahe of Brooks'opemtion.. (15-n Dozieicoryomtion is a fasi-growingsupplier of officeproducts.Analystsproject the following ftee cash flows (FCFS)dunng the nexi 3 years, after which FCF is expected trow at a onstant7% raie. Dozier's cost of capital is WACC = 13%. to Fre cashflo{' ($ milions) $20 $30 $40 What is Dozier's terminal or ho zoD,value?(Hint: Fjrd the value of all Jree cashnows beyond Year3 discouniedback to Year3.) b . What is the cunent value of operations for Dozier? Suppose Dozier has $10 million nr marketable securities, $j100 million in debi, and 10 million shares siock.\ 4rat is the price per share? of Challenging 115"8) The balancesheet of Hutter Amalgamaied is shown below' It the 12/31/2A07 or Vclue Equiry value of operations $755milion, what is the 1213112007 is value of eguity? Ch.Pterl5 Co'Porole uotioi, Volue-Bosed Vo Monogemeni, Corporole ond Govenonce December 2007(Milions of Dolars) Balance SheeL 31, Liabililies and Equity Carh Markeiables{urilies $ 20.0 n.a 100.0 _29qS Totalcurnt assets Net plant and equipment $397.0 2n.o Accounts Payable Notespayable Accruals Totalcurrntliabilitig lrng+rm bonds Prtunedstock Comon slo.k (par pls PIC) Relained amings Totalliabilities and equity $ 19,0 151.0 __q.S $221.0 190.0 76I 100.0 ___89! $4%! Totalassets Wg.a ll5-91 The balancesheetof Roop Industriesis shown below. The 12131/2@7vafueof hic6pd shoB operations $651 is million and therearc 10million sharcsof commonequity.Wl|at is the DriceDrsharc? Balance Sheet, December 3'1,2007 (Milions of Dollals) Liabilities and Equity Cash Markelablesffities $ 20.0 47.0 100.0 Nol6 payable TotalcurrEntliabilities. Long-termbonds Comon stock(par plus PIC) Retained eamings Cornmonequity Toial liabiliri$ and equiry _?!!! Totalcurrentassets Net plant and equipment 6367.0 279.O $ 19.0 65.0 51.0 s135.0 131.0 33.0 '160.0 147.O $347.0 $646.0 s646.0 ll5-10) The financial statements of Lioi Steel Fabricaborsarc shown below, with the actual Cdpo.ote Vollorion results for 2007 and the prciections for 2m8. Free cash flow is expected to gmw at a 5% rate after 2008.The weighted avemge cost of capital is 1l%. a. If operatint capital as of 12/31/2007 is $502.2million, what is the ftee cash Ilow for 72/31/2M8? b. Vfhat is the horizon vallrea6 ol L2/31/2008? c. Vy'hatis the value of opetutio\\s as ol12/37 /2007? d. What is the total value of the company as ot 12/37 /2007? e. What is the price per share for 12/31/2N7? IncomeStatements the YearEndins December for 31 (Millions oI Dollars Exceptfor PerShareData) 2007 Net sales (except Costs depreciaiion) Deprcciation Totalopratingcosts Earnings before int:st taxes and Eanings beforetaxes (40%) Taxes Nt incombeforeprefrred dividends Prefeneddividends Net incomeavailablefo. cornmondividends Commondividends Addition bortainedearnings Dvidends per sharc $500.0 360.0 37.5 2008 $530.0 381.6 39.8 $421.4 $108.6 16.0 $ 92.6 37.0 $ 55.6 74 s397.5 s10r5 13.9 $ 88.6 35.4 $ 53.2 6.0 9 47" $ 40.8 $64 10 $ 4.08 p 482 t 29.7 $ 18.5 10 $ 297 Balance Sheetsfor December 3l (Millions oI Dollars) 2|o7 Cash Ma*etable securitieg $ s.3 49.9 106.0 $214.2 375.0 2008 s 5.6 51.9 56.2 't72.4 9226.1 397.5 Totalcurrentassets Nt plant and quipment Total assetg Liabiliti$ andEquity Not$ payable Total cunent liabilities Long-iermbonds common stock(par plur PIC) Retained earnings Total liabilitiesand equity $5q? $ 9.6 69.9 27.5 $107.0 140.8 35.0 160.0 146.4 $306.4 $589.2 lqr.6 $ 11.2 74.1 28.1 $1114 148.2 37.1, 160.0 't64.9 $324.9 t623.6 Chopiar15 VdlueBosed Govehonce Coryorcte Voluqtion, Monogement, Corporoie ond Problem Spreadsheet lt5-lll Starl widf Lhepanial modef in the file FMI2 C' 15 Pn BuiU a Modalils hosl bextbooks Web site. The Henley Corpomtion is a pivately held company specializing in lawn car poducts and services.The mo6t recent financial statementsar e-fes0utce (xcept Costs depreciation) Deprciation Totaloperatingcosts Earnings beforeintercstand taJs Eamingsbforctaxes (40%) Taxes Net incomebeforeprefrrddividends Preferrddividends Nt incomeavail.ble for commondividods Cornnon dividends Addition to rctainedeamings (in Number of shares millions) Dividendsper sharc @ 31 IncomeStatement the YearEndins December for (Millions of Dollars Exceptfor PerSh:are Data) 2007 $800.0 576.0 60.0 $635.0 $164.0 32.O $132.0 52.8 $n2 '14 LZ2 $ 31.1 $ 46.7 10 s 3.11 Balance Sheetlor December (Millions of Dollars) 31 2007 Liabilities md Equity Cash Mdketable s.urities s 8.0 20.0 Notes payable 80.0 160.0 Total clrrent liabilitis $268.0 t n8+em bonds 600.0 Prefenedsrftk s 16.0 40.0 40.0 $ 96.0 Total curent asstE Net plant and quipment 300.0 15.0 Common stock (pd plus PIC) 257.0 2m.0 $457.0 $868.0 $868.0 Total liabiliiies and equity infolmation for the curent and projectedyearsare shown The ratiosand selected below Salesgrowth late Costs/Sales Depre.iaiion/Net PPE Cash/Sales Accountsreceivable/Sales Net PPElSates Accounts payable/Sales 15Vt 721" 10 I 10 20 75 2 5 40 10.5 72 10 I 10 20 75 2 5 40 10.5 1Dvr 72 10 1 l0 20 75 2 5 40 6Va 72 10 11 10 20 75 22 55 40 10.5 6rc 72 10 10 20 75 40 10.5 Weighiedaveragecost of capital (WACC) Forecastthe parts of the income statement and balance sheetsnecessaryto calculate free cash flow b . Calculate free cash flovr' for each proiectd year. Also calculate the growth rates of free cashflow eachyear to ensurethat there is constantgrowih (that is, the same as the constantgrowth rate in sales)by the end of the lorecasi Perrod, Calculat operating profitability (OP : NOPAT/Sales), capital requirements (CR = Operating capital/Sales), and expected return on invested capital (EROIC : Expected NOPAT/Operating capital at beginning of year). Basd on the spread between EROIC and WACC, do you think that the company will have a positive Market Value Added (MVA = Market value of company Book value of company = Value of operations - Opemhng capital)? cl. Calculate the value of operations and MVA. (Hint: First calculat the hoizon value at the end of the forecast pedod, which is equal to the value of opemtionsat ihe end of the forecastpe od. Assumethat growth beyond the hodzon is 5%.) Caiculatethe pdce per shareof common equity as of 12/31/2007. @ Cyberproblem Please LoLhete\rbook's Website to .rcLess Cyberproblems. any 80 resource 560 15 Chdpter Corporole Voluollon, Volue-Bosd Monogmni, ConororeGovemonce ond iiiiFruf You have beenhired as a consultantio Kulpa Fishing Supplies(KFS),a company that is seekingto increase value.The company'sCEO and founder.Mia Krrlpa,. its has askedyou to estimatethe value of two p vatly held companiesihat KFS is of considedng acquiring.But first, the seniormanagement KFSwould like for you to explainhow to value companies that don't pay any dividends.You have stru$ tured your plesentationaround the foilowing cluestions: a. List the two types of assels lhal con"panics ohr. b. What are assets-in-place? How can thejr value be estimated? c. What are nonoperatingassets? How can their value be estimatd? d. What js the total value of a corporation? Who has claims on this value? e. The first acquisitiolrtarget is a privately held companyin a mature industry The company currently has free cash flow of $20 million. Its WACC is 10% and it is expectedto grow at a constantlate of 5%. The company has mar' ketable securitiesof $100 milljon. Ii is financed with $200 million of debi, million of book equity. $50 million of preferred stock, and trj2'10 (l) What is its value of operations? (2) What is its total corporatevalue?What is its value of equity? (3) What is its MVA (MVA = Total corporatevalue Total book value)? I Thesecondacquisitiontargetisa privately held companyin a growing indue !ry. The target has recently borrowed $40 million to finance its expansion;it has no other debt or preferred stock. [t pays no dividends and currently has no marketable securities. KFSexpects the company to produce free cash flolts of -$5 million in 1 year,510 million in 2 yeaF, and $20 million in 3 years. After 3 years, free cash flow will grow at a rate of 67c.Its WACC is 109cand it currently has l0 mrlbon shares stock. of (1) What is its horizon value (that is, its value of operationsatYear 3)? lvhat is its current value of opentions (that is, at time zero)? (2) What is its value of equity on a price per sharebasis? g. KIS is also interested in applyint value-based manatement to its own dirisions.Explain what value-based manaSement is. h. What are the four value drivers?How doesachof thm affctvalue? i. What is expectedreturn on invested capital (EROIC)?Why is the spread betweenEROICand WACC so important? j. KFS has two divisions. Both have current salesof $1,000, current exp-"cted growth of 5%,and a WACC of 1070. DivisionA hashiSh profiiability (OP = 6%) but high capital requiremenis (CR = 78%). Division B has low prcfitabiliiy (OP 4%)but low capitalrequiremenis (CR = 27%).What is th MVA of ach division, basedon the current growth of 5%? What is the MVA of eachdivi sion if growth is 6%? k. What is the EROICof eachdjvision for 5% Srowth and for 6% growth? How is this relatedto MVA? l. List six potentialmanagerialbehaviorsthat can harm a firm's value. can affectshal' m. The managers KFShave heard that corporateSovemance at List five corporategovernance holder value. What is corporategovemance? provisionsthat are internal to a firm and are under its control. n. What chalacteristics the board of djrccton ltsually lead to effectivecorpo' of rate eovernance? Selecled Addnioiol Coler List three orovisions in dre corDorate charter that affect takeovers. P' Briefly de;cribe ihe use oI sto;k options in a compensation plan. What are 6ome potential problems with stock options as a form of compensation? q What is block ownership? How does it affect corporate governance? Briefly explain how regulatory a#ncie6 and legal 6ystems affect corporate Additional Selected Cases The follouing casesfftn Texrchoi,ce,Thomson Brigham-Buzzard Series: Leafthg's online libnry, caver mafi! of theconcepts Case14,"Maris Distributing Company,"discusses discssed ift this chapterand arc aoailable at valuation techniques usedin a court case. http://wulu,text oice2,c ch om. Kein-Brigham Series: Case41, Fuels Corporatlon," Case and "Advanced 93,'Electro Technology Corporation,"dis{uss financing and valuing a new ventur. ... View Full Document

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