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ch11 - Chapter 11 Corporate Value and Value-Based...

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Chapter 11 Corporate Value and Value-Based Management ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 11-1 Operating assets include cash required for liquidity purposes, inventories, receivables, and fixed assets necessary to operate a business, while non-operating assets include financial assets like marketable securities (above the level needed for liquidity) and investments in other businesses. We make this distinction because we want to find the value of the firm’s operations as a going concern and then add the value of the non- operating assets to find the firm’s total value. This breakdown is useful in management, where line managers have control over operating assets but not over financial assets (which are under the control of top management and under the supervision of the treasurer). Managers are judged and compensated on the basis of the returns they produce on the operating assets under their control, and for this purpose it is essential to segregate assets over which managers do and do not have control. The breakdown is also useful when valuing firms for purposes of mergers, spin-offs, IPOs, and the like, because it is helpful to find the value of operations and the separate value of any non-operating asset the firm might hold. In the BOC model, we assume that all of the firm’s assets are needed in operations. These assets total to 70% of sales, or 0.7($200) = $140 in 2006, and they are forecasted to grow over time at the same rate as sales. Net working capital is current assets minus the sum of A/P and accruals, which is (35% - 15%)($200) = 0.2($200) = $40 in 2006. Again, this number is expected to grow with sales. 11-2 Free cash flow (FCF) is generally taken to mean the cash flow generated by operations less the new investment in operating assets required to keep the business going so that it can generate cash flows in the future. In other words, FCF is the amount of cash flow that can be paid out as dividends or interest, used to repurchase stock or retire debt, invested in assets to support growth, or invested in other businesses. FCF can be calculated as follows: FCF = NOPAT – Required investment in operating assets, where NOPAT = EBIT(1 – T), Investment = Net Operating W.C. + Net F.A. = [ Op. C.A. - (A/P and Accruals)] + Net F. A. FCF can be calculated for past years from the financial statements, but for valuation purposes the FCF of interest is the estimated future stream of FCF. For our firm in 2002, FCF is $14.4 - $14 - $14 + $6 = -$7.6 as detailed in the model printout shown at the end of the answer. Answers and Solutions: 11 - 1
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The corporate valuation model is used to find the expected future FCF, and then the PV of the FCF is calculated to determine the value of the firm’s operations. The firm’s total value is the value of its operations plus the value of its non-operating assets.
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