value.ThecompanysCEOandfounder,MiaKulpa,hasaskedyoutoestimatethevalueoftwoprivatelyheld MiniCase:Chapter13(CorporateValuation,ValueBasedManagementandCorporateGovernance
YouhavebeenhiredasaconsultanttoKulpaFishingSupplies(KFS),acompanythatisseekingtoincreaseits
companiesthatKFSisconsideringacquiring.Butfirst,theseniormanagementofKFSwouldlikeforyouto
explainhowtovaluecompaniesthatdontpayanydividends.Youhavestructuredyourpresentationaround
thefollowingitems.
a.
Listthetwowaysofassetsthatcompaniesown.
ThetwowaysofassetsthatcompaniesownareAssetsinplaceandnonoperatingassets.
b.
Whatareassetsinplace?Howcantheirvaluebeestimated?
Assetsinplacearetangible,suchasbuildings,machines,andinventory(alsoreferredtoas
fixedassetsorproperty,plant&equipment).Usuallyassetsinplaceareexpectedtogrow
inworth. Assetsinplacegeneratefreecashflows. Thepresentvalueoftheirexpected
futurefreecashflows,discountedattheweightedaveragecostofcapital,isthevalueof
operations.
c.
Whatarenonoperatingassets?Howcantheirvaluebeestimated?
Growth options are not tangible. They include research and development, such as at
pharmaceutical companies and computer software companies, and building customer
relationships.Growthoptionsarevaluedusingoptionpricingtechniques.
d.
Whatisthetotalvalueofacorporation?Whohasclaimsonthisvalue?
Totalcorporatevalueissumofvalueofoperations,valueofnonoperatingassets,and
valueofgrowthoptions.Debtholdershavefirstclaim. Preferredstockholdershavethe
nextclaim.Anyremainingvaluebelongstostockholders.
e.
Thefirstacquisition target is aprivately heldcompanyinamature industryownedbytwo
brothers,eachwith5millionsharesofstock.Thecompanycurrentlyhasfreecashflowof$20
million. ItsWACCis11%,andtheFCFisexpectedtogrowataconstantrateof5%. The
companyownsmarketablesecuritiesof$100million.Itisfinancedwith$200millionofdebt,
$50millionofpreferredstock,and$210millionofbookequity.
FCF0 (1 + g )
( WACC g )
20 (1 + 0.05)
VOp =
= 420
( 0.10 0.05)
VOp =
(1).
Whatisitsvalueoperations?
(2).
Whatisittotalcorporatevalue?
TotalCorporateValue=ValueofOperations+MarketableSecurities
TotalCorporateValue=$420million+$100million
TotalCorporateValue=$520million
(3).
Whatisitsintrinsicvalueofequity?
ValueOfEquity=TotalCorporateValueDebtPreferredStock
ValueOfEquity=$520million$200million$50million
ValueOfEquity=$270million
(4).
Whatisitsintrinsicstockpricepershare?
StockPricePerShare=ValueOfEquitySharesofStock
StockPricePerShare=$270million5millionSharesofStock
StockPricePerShare=$54perShare
(5).
What is its intrinsic MVA (MVA=Total corporate valeTotal book value of capital
suppliedbyinvestors)?
MVA=$520million($210million+$200million+$50million)
MVA=$60million
f.
Thesecondacquisitiontargetisaprivatelyheldcompanyinagrowingindustry.Thetargethas
recentlyborrowed$40milliontofinanceitsexpansion;ithasnototherdebtorpreferredstock.
Itpaysnodividendsandcurrentlyhasnomarketablesecurities.KFSexpectsthecompanyto
producefreecashflowsof$5millionin1year,$10millionin2years,and$20millionin3
years.After3years,freecashflowwillgrowatarateof6%.ThetargetsWACCis10%andit
currentlyhas$10millionsharesofstockoutstanding.
(1).Whatisthecompanyshorizonvalue(i.e.,itsvalueofoperationsatyear3)? Whatisits
currentvalueofoperations(i.e.,atTime0)?
01234N
||||||
51020
$4.545
8.264
15.026
398.197
Vop 3 = 530 = 20 (1 + 0.06)
0.10 0.06
$416.942=ValueOfOperations
(2).Whatisitsintrinsicvalueofequityonapricepersharebasis?
Valueofequity=ValueofoperationsDebt
Valueofequity=$416.94million$40million
Valueofequity=$376.94million
PriceperShare=ValueofEquityNumberofShares
PriceperShare=$376.94million10millionshares
PriceperShare=$37.69
g.
KFSisalsointerestedinapplyingvaluebasedmanagementtoitsowndivision.Explainwhat
valuebasedmanagementis.
VBM is the systematic application of the corporate valuation model to all corporate
decisionsandstrategicinitiatives.TheobjectiveofVBMistoincreasemarketvalueadded
(MVA).
g.
Whatarethefourvaluedrivers?Howdoeseachofthemaffectvalue?
MVA is determined by four drivers: sales growth, operating profitability
(OP=NOPAT/sales),capitalrequirements(CR=operatingcapital/sales,andtheweighted
averagecostofcapital. MVAwillimproveifWACCisreduced,operatingprofitability
(OP)increases,orthecapitalrequirement(CR)decreases. Seethenextquestionforan
explanationoftheimpactofgrowth.
i. WhyisthespreadbetweenEROICand Whatisexpectedreturnoninvestedcapital(EROIC)?
WACCsoimportant?
ROIC is the return on the capital that is in place at the beginning of the period:
NOPATt +1
ROIC
=
t +1
Capital t
If the spread between the expected return, ROIC t+1, and the required return, WACC, is
positive,thenMVAispositiveandgrowthmakesMVAlarger. Theoppositeistrueifthe
spreadisnegative.
j. KFShastwodivisions. Bothhavecurrentsalesof$1000,currentexpectedgrowthof5%,anda
WACCof10%.DivisionAhashighprofitability(OP=6%)buthighcapitalrequirements(CR=78
%).DivisionBhaslowprofitability(OP=4%)butlowcapitalrequirements(CR=27%.).Given
thecurrentgrowthrateof5%,determinetheintrinsicMVAofeachdivision.Whatistheintrinsic
MVAofeachdivisionifgrowthisinstead6%?
Sales t (1 + g)
CR
MVA t =
OP WACC
(1 + g)
WACC g
DivisionADivisionB
OP
6%
6%
4%
4%
CR
78%
78%
27%
27%
Growth
5%
6%
5%
6%
MVA
(300.0)
(360.0)
300.0
385.0
k. WhatistheEROICofeachdivisionfor5%growthandfor6%growth? Howisthisrelatedto
intrinsicMVA?
Capital0
Growth
Sales1
Nopat1
Roic1
Mva
DivisionA
$780
$780
5%
6%
$1,050
$1,060
$63
$63.6
8.1%
8.2%
(300.0)
(360.0)
DivisionB
$270
$270
5%
6%
$1,050
$1,060
$42
$42.4
15.6%
15.7%
300.0
385.0
Theexpected ROIC ofdivisionAislessthantheWACC,sothedivision shouldpostpone
growth efforts until it improves ROIC by reducing capital requirements (e.g., reducing
inventory)and/orimprovingprofitability.TheexpectedROICofdivisionbisgreaterthanthe
WACC,sothedivisionshouldcontinuewithitsgrowthplans.
l. List6potentialmanagerialbehaviorsthatcanharmafirmsvalue.
Managersmight:
1.Expendtoolittletimeandeffort.
2.Consumetoomanynonpecuniarybenefits.
3.Avoiddifficultdecisions(e.g.,closeplant)outofloyaltytofriendsincompany.
4. Reject risky positive NPV projects to avoid looking bad if project fails; take on risky
negativeNPVprojectstotryandhitahomerun.
5.Avoidreturningcapitaltoinvestorsbymakingexcessinvestmentsinmarketablesecurities
orbypayingtoomuchforacquisitions.
6.Massageinformationreleasesormanageearningstoavoidrevealingbadnews.
m. ThemanagersatKFShaveheardthatcorporategovernancecanaffectshareholdervalue.Whatis
corporategovernance? List5corporategovernanceprovisionsthatareinternaltoafirmandare
underthecontrol.
Thefivemechanismsareprovisionsinthecharterthataffecttakeovers,toneatthetop,a
corporatecodeofconductandethics,compositionoftheboardofdirectors,andcompensation
plans.
n. Whatcharacteristicsoftheboardofdirectorsusuallyleadtoeffectivecorporategovernance?
(1)TheCEOisnotalsothechairmanoftheboardanddoesnothaveundueinfluenceoverthe
nominatingcommittee;(2)theboardhasamajorityoftrueoutsiderswhobringsometypeof
businessexpertisetotheboard(andheboardisnotaninterlockedboard);(3)theboardisnot
toolarge;and(4)boardmembersarecompensatedappropriately(nottoohigh,andsome
compensationislinkedtocompanysperformance).
o. List3provisionsinthecorporatecharterthataffecttakeovers.
Theseincludetargetedsharerepurchases(i.e.,greenmail),shareholderrightsprovisions(i.e.,
poisonpills),andrestrictedvotingrightsplans.
p. Brieflydescribetheuseofstockoptionsinacompensationplan.Whataresomepotentialproblems
withstockoptionsasaformofcompensation?
Givesownerofoptiontherighttobuyashareofthecompanysstockataspecifiedprice
(called thestrikeprice)even iftheactualstockprice ishigher.Usuallycantexercise the
optionforseveralyears(calledthevestingperiod).Cantexercisetheoptionafteracertain
numberofyears(calledtheexpiration,ormaturity,date).
Managercanunderperformmarketorpeergroup,yetstillreaprewardsfromoptionsaslong
asthestockpriceincreasestoabovetheexercisecost.Optionssometimesencouragemanagers
tofalsifyfinancialstatementsortakeexcessiverisks.
q. Whatisblockownership?Howdoesitaffectcorporategovernance?
Blockownershipoccurswhenanoutsideinvestorownslargeamount(i.e.,block)ofcompanys
shares.Largeinstitutionalinvestors,suchasCalPERSorTIAACREF,oftenownlargeblocks.
Blockholders often monitor managers and take active role, leading to better corporate
governance.
r. Brieflyexplainhowregulatoryagenciesandlegalsystemsaffectcorporategovernance.
Companies in countries with strong protection for investors tend to have better access to financial
markets, a lower cost of equity, increased in market liquidity, and less noise in stock prices.