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c. The value of operations is the present value of all the future free cash flows that are
expected from current assets-in-place and the expected growth of assets-in-place
when discounted at the weighted average cost of capital:
Vop(at time 0)
FCFt
t 1 1 WACC
The terminal, or horizon value, is the value of operations at the end of the explicit
forecast period. It is equal to the present value of all free cash flows beyond the
forecast period, discounted back to the end of the forecast period at the weighted
average cost of capital:
Vop(at time N)
FCFN 1
FCFN (1 g )
.
WACC g
WACC g
The corporate valuation model defines the total value of a company as the value of
operations plus the value of nonoperating assets plus the value of growth options.
d. Value-based management is the systematic application of the corporate value model
to a companys decisions. The four value drivers are the growth rate in sales (g),
operating profitability (OP=NOPAT/Sales), capital requirements (CR=Capital/Sales),
and the weighted average cost of capital (WACC). Return on Invested Capital (ROIC)
is NOPAT divided by the amount of capital that is available at the beginning of the
year.
e. Managerial entrenchment occurs when a company has such a weak board of directors
and has such strong anti-takeover provisions in its corporate charter that senior
managers feel there is very little chance that they will be removed. Non-pecuniary
benefits are perks that are not actual cash payments, such as lavish offices,
memberships at country clubs, corporate jets, and excessively large staffs.
f. Targeted share repurchases, also known as greenmail, occur when a company buys
back stock from a potential acquiror at a higher than fair-market price. In return, the
potential acquiror agrees not to attempt to take over the company. Shareholder rights
provisions, also known as poison pills, allow existing shareholders in a company to
purchase additional shares of stock at a lower than market value if a potential acquiror
purchases a controlling stake in the company. A restricted voting rights provision
automatically deprives a shareholder of voting rights if the shareholder owns more
than a specified amount of stock.
g. A stock option allows its owner to purchase a share of stock at a fixed price, called
the strike price, no matter what the actual price of the stock is. Stock options always
have an expiration date, after which they cannot be exercised. A restricted stock grant
allows an employee to buy shares of stock at a large discount from the current stock
price, but the employee is restricted from selling the stock for a specified number of
years. An Employee Stock Ownership Plan, often called an ESOP, is a type of
retirement plan in which employees own stock in the company.
135-2 The first step is to find the value of operations by discounting all expected future free
cash flows at the weighted average cost of capital. The second step is to find the total
corporate value by summing the value of operations, the value of nonoperating assets,
and the value of growth options. The third step is to find the value of equity by
subtracting the value of debt and preferred stock from the total value of the corporation.
The last step is to divide the value of equity by the number of shares of common stock.
135-3 A company can be profitable and yet have an ROIC that is less than the WACC if the
company has large capital requirements. If ROIC is less than the WACC, then the
company is not earning enough on its capital to satisfy its investors. Growth adds even
more capital that is not satisfying investors, hence, growth decreases value.
135-4 Entrenched managers consume to many perquisites, such as lavish offices, excessive
staffs, country club memberships, and corporate jets. They also invest in projects or
acquisitions that make the firm larger, even if they dont make the firm more valuable.
135-5 Stock options in compensation plans usually are issued with a strike price equal to the
current stock price. As long as the stock price increases, the option will become valuable,
even if the stock price doesnt increase as much as investors expect.
135-1 NOPAT
= EBIT(1 - T)
= 100(1 - 0.4) = $60.
FCF (1 g )
$400,000 (1.05)
=
= $6,000,000.
WACC g
0.12 0.05
135-3 The growth rate in FCF from 201009 to 20110 is g=($750.00-$707.55)/$707.50 = 0.06.
$707.55 (1.06)
VOp at 201009 =
= $15,000.
0.11 0.06
$200,000,000
0.10 0.05
[0.09 0.10]
0.098 0.05
1 0.05
$129,000,000 $6,562,500,000 0.0198666667
$129,000,000 $130,375,000 $259,375,000.
Answers and Solutions: 135 - 4
135-6 a. HV2 =
$108,000
= $2,700,000.
0.12 0.08
b.
0WACC = 12% 1
|
2g = 8%
$80,000
$100,000
$108,000
N
|
71,428.57
79,719.39
2,152,423.47
$2,303,571.43
135-7 a. HV3 =
b.
$40 (1.07)
= $713.33.
0.13 0.07
0WACC = 13% 1
-20
30
($ 17.70)
23.49
522.10
$527.89
|g = 7%
40
Vop 3 = 713.33
753.33
$437.89
= $43.79.
10.0
135-11 The detailed solution for the problem is available in the file Solution for FM12 CF3 Ch
135 P11 Build a Model.xls aton the textbooks Web site.
MINI CASE
You have been hired as a consultant to Kulpa Fishing Supplies (KFS), a company that is
seeking to increase its value. KFS has asked you to estimate the value of two privately
held companies that KFS is considering acquiring. But first, the senior management of
KFS would like for you to explain how to value companies that dont pay any dividends.
You have structured your presentation around the following questions.
a.
Answer: Assets-in-place are tangible, such as buildings, machines, and inventory. Usually
they are expected to grow. They generate free cash flows. The PV of their expected
future free cash flows, discounted at the WACC, is the value of operations.
c.
What is the total value of a corporation? Who has claims on this value?
Answer: Total corporate value is sum of value of operations, value of nonoperating assets, and
value of growth options. (No examples in this chapter have a growth option-- this is
deferred until chapter 158). Debt holders have first claim. Preferred stockholders
have the next claim. Any remaining value belongs to stockholders.
e.
Answer:
FCF0 (1 g )
WACC g
20 (1 0.05)
420
0.10 0.05
Vop
Vop
e.
Answer:
e.
3. What is its MVA (MVA = total corporate value total book value)?
Answer: MVA = total corporate value of firm minus total book value of firm
total book value of firm = book value of equity + book value of debt
+ book value of preferred stock
MVA = $520 - ($210 + $200 + $50)
= $60 million
f.
Answer:
0rc = 10%
3g = 6%
-5
10
20
$ -4.545
8.264
15.026
398.197
$416.942 = Value oOf Operationsoperations
f.
g.
Answer: VBM is the systematic application of the corporate valuation model to all corporate
decisions and strategic initiatives. The objective of VBM is to increase market value
added (MVA).
h.
What are the four value drivers? How does each of them affect value?
What is return on invested capital (ROIC)? Why is the spread between ROIC and
WACC so important?
Answer: ROIC is the return on the capital that is in place at the beginning of the period:
NOPAT t 1
ROIC t 1
Capital t
If the spread between the expected return, ROICt+1, and the required return, WACC, is
positive, then MVA is positive and growth makes MVA larger. The opposite is true if
the spread is negative.
j.
KFS has two divisions. Both have current sales of $1,000, current expected
growth of 5%, and a WACC of 10%. Division A has high profitability (OP=6%)
but high capital requirements (CR=78%). Division B has low profitability
(OP=4%) but low capital requirements (CR=27%). What is the MVA of each
division, based on the current growth of 5%? What is the MVA of each division
if growth is 6%?
Answer:
Sales t (1 g)
WACC g
MVA t
OP
CR
Growth
MVA
Division A
6%
6%
78%
78%
5%
6%
(300.0)
(360.0)
CR
OP WACC
(
1
g
)
Division B
4%
4%
27%
27%
5%
6%
300.0
385.0
k.
What is the ROIC of each division for 5% growth and for 6% growth? How is
this related to MVA?
Answer:
Capital0
Growth
Sales1
Nopat1
Roic1
Mva
Division A
$780
$780
5%
6%
$1,050
$1,060
$63
$63.6
8.1%
8.2%
(300.0)
(360.0)
Division B
$270
$270
5%
6%
$1,050
$1,060
$42
$42.4
15.6%
15.7%
300.0
385.0
The expected ROIC of division A is less than the WACC, so the division should
postpone growth efforts until it improves ROIC by reducing capital requirements
(e.g., reducing inventory) and/or improving profitability.
The expected ROIC of division b is greater than the WACC, so the division should
continue with its growth plans.
l.
List six potential managerial behaviors that can harm a firms value.
The managers at KFS have heard that corporate governance can affect
shareholder value.
What is corporate governance? List five corporate
governance provisions that are internal to a firm and are under its control.
Answer: Corporate governance is the set of laws, rules, and procedures that influence a
companys operations and the decisions made by its managers.
The provisions under a firms control are: (1) monitoring and discipline by the board
of directors; (2) charter provisions and bylaws that affect the likelihood of hostile
takeovers; (3) compensation plans; (4) capital structure choices; and (5) accounting
control systems.
Mini Case: 135 - 12
n.
Answer: (1) The CEO is not also the chairman of the board and does not have undue influence
over the nominating committee; (2) the board has a majority of true outsiders who
bring some type of business expertise to the board (and he board is not an interlocked
board); (3) the board is not too large; and (4) board members are compensated
appropriately (not too high, and some compensation is linked to companys
performance).
.
o.
Answer: These include targeted share repurchases (i.e., greenmail), shareholder rights
provisions (i.e., poison pills), and restricted voting rights plans.
p.
Briefly describe the use of stock options in a compensation plan. What are some
potential problems with stock options as a form of compensation?
Answer: Gives owner of option the right to buy a share of the companys stock at a specified
price (called the strike price) even if the actual stock price is higher. Usually cant
exercise the option for several years (called the vesting period). Cant exercise the
option after a certain number of years (called the expiration, or maturity, date).
Manager can underperform market or peer group, yet still reap rewards from options
as long as the stock price increases to above the exercise cost. Options sometimes
encourage managers to falsify financial statements or take excessive risks.
q.
Answer: Block ownership occurs when an outside investor owns large amount (i.e., block) of
companys shares. Large institutional investors, such as CalPERS or TIAA-CREF,
often own large blocks. Blockholders often monitor managers and take active role,
leading to better corporate governance.
r.
Briefly explain how regulatory agencies and legal systems affect corporate
governance.
Answer: 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.
Mini Case: 135 - 13