Chapter 10

Corporate Valuation, Value-Based Management, and

Corporate Governance
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
10-1 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 firms operations as a going concern and
then add the value of the non-operating assets to find the firms 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 firms assets are needed
in operations. These assets total to 70% of sales, or 0.7($200) = $140
in 2001, 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 2001.
Again, this number is expected to grow with sales.

10-2 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: 10 - 1
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 firms operations. The firms total value is the value of its
operations plus the value of its non-operating assets.
Note that the corporate valuation model can be applied to the
various divisions or other units of a large firm as well as to the firm
as a whole. This separation is useful when determining managerial
compensation, and also when trying to determine the value of a division
that the firm is thinking about selling.
Note also that the FCF model requires less restrictive assumptions
than the Discounted Dividends model because it calculates all cash flow
that could be paid out, not just the amount of dividends that
management chooses to pay out. Of course, the accuracy of the FCF
model does depend on the accuracy of the cash flow forecast and the
WACC discount rate (which in our example is the cost of equity, because
the company uses no interest-bearing debt), and those forecasts are
fraught with uncertainty, just as they are for the Discounted Dividends
model. The Scenario analyses shown in the model output show how
changes in the inputs can lead to huge changes in the firms valuation.
10-3 Value-based management means a system of management under which all
significant decisions are evaluated in terms of their effects on the
value of the firm using the corporate valuation model. For example, if
the firm were considering changing its inventory procedures, it would
estimate the effects of the change on its inventory requirement,
production costs, and so on, and then run the model to see how
inventory changes would affect value. So, value-based management
simply makes decisions based on whether or not they increase the firms
expected value.
There is no economically efficient alternative to value-based
management, although management in some firms consider the effects on
the firms value subjectively rather than through the use of a
quantitative model. In situations where the inputs required to use the
model simply cannot be quantified, and the use of the model would just
make a speculative guess look more precise than it really was, the
subjective approach is probably appropriate. However, as computer
power increases, and as corporate data bases become increasingly
complete, it is becoming less and less necessary to make decisions in a
purely judgmental manner, so the corporate model is being used to an
ever-increasing extent in business.
10-4 EVA is Economic Value Added, defined back in Chapter 6 as follows:
EVA = Operating income - Cost of all capital used to finance
operations
= EBIT(1-T) WACC(Debt and Equity necessary to finance
operating assets).

EVA is determined annually, and it differs from year to year. For our
firm in 2002, EVA = $0.80, so the company is earning more than its cost
of capital.
MVA is Market Value Added, defined as the market value of the stock
minus the book value of the equity:
Answers and Solutions: 10 - 2
MVA = (Shares outstanding * P
0
) - (Common stock + Retained
earnings).
In 2002, based on the FCF model, MVA is $21.74, so the company has
been successful over its lifetime.
MVA changes from year to year, but it really reflects managements
effectiveness over the firms entire history.
If management is doing a good job, then both EVA and MVA will be
positive. Both can be estimated within the corporate valuation model.
EVA for the just-passed year is often used to help determine the
compensation for managers at all levels, while the MVA is used to help
determine the compensation of the firms top managers, especially CEOs
who have held that position for many years.
10-5 We often think of corporate managers as being focused on just one thing
shareholder wealth maximization. However, in truth managers are
people, and many of them no more concentrate single-mindedly on wealth
maximization than all students do on grade maximization. And, if a
manager does not inherently focus on wealth maximization, then he or
she will not necessarily make decisions based on the corporate
valuation model. So, the field of corporate governance has been
developed to help us understand how managers are likely to behave, and
actions that stockholders can take to insure that managerswho are
really employees of the stockholdersbehave in a manner that is
consistent with wealth maximization.
a. Entrenched managers are ones who have a firm control over the firms
board of directors and who cannot easily be replaced if they are
ineffective or simply not interested in maximizing shareholder
wealth. Entrenchment can obviously exist if the CEO and the other
executives have a majority of the stock, but it can also exist
through other means. Years ago, before the increase in
institutional ownership of stock, managers controlled the proxy
mechanism, and the thousands of small stockholders voted with their
feet instead of voting incompetent managers out of office. So, in
the past, management entrenchment and the inefficiencies it brings
on was a huge problem that retarded economic efficiency. The
increasing importance of institutional investors, who have so much
stock that it is difficult for them to just sell out, has changed
the situation, and management entrenchment has been significantly
weakened, which is good. Other factors as discussed below have also
impacted managerial entrenchment.
Based on the analysis in the model, there is no obvious reason
why stockholders would want to replace our firms managers.
However, before reaching a firm conclusion on this, we would want to
compare the firms performance to other firms in its industry.
Also, potential raiders (a buyout firm or another corporation) would
construct a model like ours, but more complete, and analyze the
situation to determine if they could improve the companys
performance and thus derive a higher estimated value. See Chapter
25 for a discussion of mergers and buyouts. If they could, then
they might try to take the firm over and earn a profit.
b. Hostile takeovers have also reduced entrenchment. The concentration
of ownership in institutional hands, and the development of the junk
bond market for financing takeovers, has made hostile takeovers
Answers and Solutions: 10 - 3
easier, and that has led to the replacement of many ineffective
management teams.
Note that if a firm is operating at maximum efficiency, then it
would be unlikely that any other firm or management group could take
the company over, improve operations, and earn a profit. Thus,
there is incentive for management to operate efficiently as shown by
the corporate valuation model.
c. Incentive compensation plans, such as those that pay managers (and
even lower-level employees) in part with stock and options, and
where the size of the awards are based on EVA, MVA, and other
market-related metrics, are a key part of corporate governance, and
they are designed to align managers interests with stockholders
interests.
If compensation is based on EVA and/or MVA, then management will
have an incentive to operate on a value-based management system,
plan to improve these metrics, and then try to implement the plans
so that the predicted results occur.
d. Greenmail is like blackmail, and it refers to a situation where a
firms management buys the stock of a person or company that is
threatening a takeover at price higher than the fair market price of
the firms stock. Managements sometimes pay greenmail to ward off
hostile takeovers and retain their entrenched positions. This is
doubly bad for stockholders, because it (1) dissipates corporate
assets and (2) leaves an ineffective management team in place.
e. Poison pills refer to any action that a management might take to
ward off a takeover. Originally, companies did things like build
into debt contracts terms that would greatly increase the interest
rate the firm was required to pay in the event of a takeover, hence
they really were poison pills. Now, though, clever lawyers have
devised a multitude of schemes to slow down if not thwart takeovers.
The most common one today is a provision that gives a firms
stockholders the right to buy, at a low price, shares of any firm
that takes it over without managements approval. A hostile
takeover firm can get around this provision, and most other poison
pills, given enough time, but the pills do give a firms managers
time to mount defenses and head off takeovers at prices well below
the firms true intrinsic value, often by bringing in another firm
that is willing to pay more for the company (a white knight).
Poison pills are not necessarily good or bad. They are good
(from the target firms shareholders perspective) if they prevent
takeovers at too low a price, but they are bad if they simply
entrench an incompetent management. We have much more to say about
takeovers in Chapter 25, which deals with mergers.
f. A strong board of directors is one that is not controlled by the
chairman of the board, that has competent independent (outside)
directors, and that is willing to replace an ineffective management
team. Some characteristics of a strong board are (1) outside
directors as opposed to employees of the firm, (2) directors who do
not have ties to the firm, such as one of its lawyers or other
suppliers who get fees from the firm, (3) people who are financially
independent and do not need their director fees, and (4) people who
have a demonstrated ability in some capacity that relates to the
firms business. Weak boards consist of insiders (whom the chairman
can fire), cronies of the chairman, and people whose incomes and/or
status are dependent on remaining on the board. Also, a board is
Answers and Solutions: 10 - 4
weakened if the CEOs of different boards are interlocked, as that
leads to a you scratch my back and Ill scratch yours attitude.
It is useful for a firm to have on its board executives of
companies that themselves practice value-based management, because
such directors would be less tolerant of managers who do not
consider the effects of their actions on stockholders in a rational
manner.

g. The vesting period refers to how soon options really belong to an
employee. For example, an employee might be given options to buy
5,000 shares of stock, but only if he or she remains with the
company for 3 years after the option was granted. Obviously,
options cannot be exercised (and sold) until they have been vested.
The vesting period helps to keep valuable employees from leaving the
firm, and it also helps to make employees focus on actions that
provide long-term as opposed to short-term benefits to the firm.
h. An ESOP is an Employee Stock Ownership Plan. ESOPs provide
significant tax advantages to companies, and they were authorized by
Congress to encourage employee ownership of the companies they work
for. ESOPs are fairly complicated, but in terms of corporate
governance, if an ESOP owns a large block of a companys stock, this
often helps entrench management, because the employee-owners often
rightly think that if the firm is taken over, there will be layoffs,
so they vote with management and against the takeover firm.
10-6 In principle the two methods should give the same answers, provided
they make the same underlying assumptions. However, in practice it is
difficult to calibrate the two models so that they give the exact same
answers. Over the short term the dividend level is basically a
management choice, and the dividend growth model doesnt have any built
in mechanism to make sure that the assumed dividend payments are
consistent with the amount of cash that the firm generates and its
current capital structure. For an assumed dividend to be consistent in
this fashion it must be a residual dividend. That is, small enough
so that the firm is able to make all of its required investments
without having to issue new stock or increase the proportion of debt in
its capital structure, and large enough so that the firm doesnt
accumulate cash or pay down its debt. If the assumed dividend payment
satisfies this condition, then the Discounted Dividends Model should
give the same value for the firm as the Free Cash Flow Model. The
examples below, in the BOC spreadsheet model, show the results of
calculating the value of a firm using both models, along with the P/E
multiple approach.

Answers and Solutions: 10 - 5
ANSWERS TO END-OF-CHAPTER QUESTIONS
10-1 a. Assets-in-place, also known as operating assets, include the land,
buildings, machines, and inventory that the firm uses in its
operations to produce its products and services. Growth options are
not tangible. They include items such as R&D and customer
relationships. Financial, or nonoperating, assets include
investments in marketable securities and non-controlling interests
in the stock of other companies.
b. Operating current assets are the current assets used to support
operations, such as cash, accounts receivable, and inventory. It
does not include short-term investments. Operating current
liabilities are the current liabilities that are a natural
consequence of the firms operations, such as accounts payable and
accruals. It does not include notes payable or any other short-term
debt that charges interest. Net operating working capital is
operating current assets minus operating current liabilities.
Operating capital is sum of net operating working capital and
operating long-term assets, such as net plant and equipment.
Operating capital also is equal to the net amount of capital raised
from investors. This is the amount of interest-bearing debt plus
preferred stock plus common equity minus short-term investments.
NOPAT is the amount of net income a company would generate if it had
no debt and held no financial assets. NOPAT is a better measure of
the performance of a companys operations because debt lowers
income. In order to get a true reflection of a companys operating
performance, one would want to take out debt to get a clearer
picture of the situation. Free cash flow is the cash flow actually
available for distribution to investors after the company has made
all the investments in fixed assets and working capital necessary to
sustain ongoing operations. It is the most important measure of
cash flows because it shows the exact amount available to all
investors.
Answers and Solutions: 10 - 6
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:
( )
.
WACC 1
FCF
V
1 t
t
t
0) time op(at

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:
.
g WACC
) g 1 ( FCF
g WACC
FCF
V
N 1 N
N) time op(at

+
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.
Answers and Solutions: 10 - 7
g. A stock option allows its owner to purchase a share of stock at a
fixed price, called the exercise 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.
10-2 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.
10-3 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.
10-4 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.
10-5 Stock options in compensation plans usually are issued with an exercise
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.
Answers and Solutions: 10 - 8
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
10-1 NOPAT = EBIT(1 - T)
= 100(1 - 0.4) = $60.
Net operating WC
03
= ($27 + $80 + $106) - ($52 + $28)
= $213 - $80 = $133.
Operating capital
03
= $133 + $265 = $398.
Net operating WC
04
= ($28 + $84 + $112) - ($56 + $28)
= $224 - $84 = $140.
Operating capital
04
= $140 + $281 = $421.
FCF = NOPAT - Net investment in operating capital
= $100(0.6) - ($421 - $398)
= $37.0.
10-2 Value of operations = V
op
= PV of expected future free cash flow
V
op
=
g WACC
) g 1 ( FCF

+
=
05 . 0 12 . 0
) 05 . 1 ( 000 , 400 $

= $6,000,000.
10-3 a.
2
op
V =
08 . 0 12 . 0
000 , 108 $

= $2,700,000.
b. 0 1 2 3 N
| | | | |
$80,000 $100,000 $108,000
$ 71,428.57
79,719.39
2,152,423.47
2
op
V = 2,700,000 =
$2,303,571.43
Answers and Solutions: 10 - 9
04 . 0
000 , 108
WACC = 12%
g = 8%
10-4 a.
3
op
V =
07 . 0 13 . 0
) 07 . 1 ( 40 $

= $713.33.
b. 0 1 2 3 4 N
| | | | | |
-20 30 40
($ 17.70)
23.49
3
op
V = 713.33
522.10 753.33
$527.89
c. Total value
t=0
= $527.89 + $10.0 = $537.89.
Value of common equity = $537.89 - $100 = $437.89.
Price per share =
0 . 10
89 . 437 $
= $43.79.
10-5 The growth rate in FCF from 2005 to 2006 is g=($750.00-$707.55)/$707.50
= 0.06.
V
Op at 2005
=
0.06 0.11
(1.06) $707.55

= $15,000.
10-6 0.10] [0.09
0.05 0.098
00 $200,000,0
00 $200,000,0 V
op

1
]
1

+
=$200,000,000 + (-$40,000,000)= $160,000,000.
MVA = $160,000,000 - $200,000,000 = -40,000,000.
10-7 Capital
2007
= Sales
2007
(0.43)= $129,000,000.
[ ] [ ]
. 000 , 375 , 259 $ 000 , 375 , 130 $ 000 , 000 , 129 $
020 . 0 000 , 500 , 562 , 6 $ 000 , 000 , 129 $
05 . 0 1
43 . 0
) 098 . 0 ( 06 . 0
05 . 0 098 . 0
) 05 . 0 1 ( 000 , 000 , 300 $
000 , 000 , 129 $ V
2007 at Op
+
+
1
]
1

,
_

1
]
1

+
+
10-8 Total corporate value = Value of operations + marketable securities
= $756 + $77 = $833 million.
Value of equity = Total corporate value debt Preferred stock
= $833 ($151 + $190) - $76 = $416 million.
10-9 Total corporate value = Value of operations + marketable securities
= $651 + $47 = $698 million.
Value of equity = Total corporate value debt Preferred stock
= $698 ($65 + $131) - $33 = $469 million.
Price per share = $469 / 10 = $46.90.
10-10 a. NOPAT
2004
= $108.6(1-0.4) = $65.16
NOWC
2004
= ($5.6 + $56.2 + $112.4) ($11.2 + $28.1) = $134.9 million.
Capital
2004
= $134.9 + $397.5 = $532.4 million.
FCF
2004
= NOPAT Investment in Capital = $65.16 ($532.4 - $502.2)
= $65.16 - $30.2 = $34.96 million.
b. HV
2004
= [$34.96(1.06)]/(0.11-0.06) = $741.152 million.
c. V
Op at 12/31/2003
= [$34.96 + $741.152]/(1+0.11) = $699.20 million.
Answers and Solutions: 10 - 10
WACC = 13%
g = 7%
d. Total corporate value = $699.20 + $49.9 = $749.10 million.
e. Value of equity = $749.10 ($69.9 + $140.8) - $35.0 = $503.4
million.
Price per share = $503.4 / 10 = $50.34.
Answers and Solutions: 10 - 11
SOLUTION TO SPREADSHEET PROBLEM
10-11 The detailed solution for the problem is available both on the
instructors resource CD-ROM (in the file Solution for Ch 10-11 Build
a Model.xls) and on the instructors side of the web site,
http://brigham.swcollege.com.
Answers and Solutions: 10 - 12
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. LIST THE THREE TYPES OF ASSETS THAT COMPANIES OWN.
ANSWER: ASSETS-IN-PLACE, GROWTH OPTIONS, AND NONOPERATING, OR FINANCIAL,
ASSETS.
B. WHAT ARE ASSETS-IN-PLACE? HOW CAN THEIR VALUE BE ESTIMATED?
ANSWER: ASSETS-IN-PLACE ARE TANGIBLE, SUCH AS BUILDINGS, MACHINES,
INVENTORY. USUALLY THEY ARE EXPECTED TO GROW. THEY GENERATE FREE
CASH FLOWS. THE PV OF THEIR EXPECTED FUTURE FREE CASH FLOWS,
DISCOUNTED AT THE WACC, IS THE VALUE OF OPERATIONS.
C. WHAT ARE GROWTH OPTIONS? HOW CAN THEIR VALUE BE ESTIMATED?
ANSWER: GROWTH OPTIONS ARE NOT TANGIBLE. THEY INCLUDE R&D, SUCH AS AT DRUG
COMPANIES AND GENETIC ENGINEERING COMPANIES, AND BUILDING CUSTOMER
RELATIONSHIPS, SUCH AS AT AMAZON.COM. GROWTH OPTIONS ARE VALUED
USING OPTION PRICING TECHNIQUES IN CHAPTER 17.
D. WHAT ARE NONOPERATING ASSETS? HOW CAN THEIR VALUE BE ESTIMATED?
ANSWER: NON OPERATING ASSETS ARE MARKETABLE SECURITIES AND OWNERSHIP OF NON-
CONTROLLING INTEREST IN ANOTHER COMPANY. THE VALUE OF NONOPERATING
ASSETS USUALLY IS VERY CLOSE TO FIGURE THAT IS REPORTED ON BALANCE
SHEETS.
E. 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
15). DEBTHOLDERS HAVE FIRST CLAIM. PREFERRED STOCKHOLDERS HAVE THE
NEXT CLAIM. ANY REMAINING VALUE BELONGS TO STOCKHOLDERS.
Mini Case: 10 - 13
F. 1. THE FIRST ACQUISITION TARGET IS A PRIVATELY HELD COMPANY IN A MATURE
INDUSTRY. THE COMPANY CURRENTLY HAS FREE CASH FLOW OF $20 MILLION.
ITS WACC IS 10% AND IT IS EXPECTED TO GROW AT A CONSTANT RATE OF
5%. THE COMPANY HAS MARKETABLE SECURITIES OF $100 MILLION. IT IS
FINANCED WITH $200 MILLION OF DEBT, $50 MILLION OF PREFERRED STOCK,
AND $210 MILLION OF BOOK EQUITY. WHAT IS ITS VALUE OF OPERATIONS?
ANSWER:
F. 2. WHAT IS ITS TOTAL CORPORATE VALUE? WHAT IS ITS VALUE OF EQUITY?
ANSWER: TOTAL CORPORATE VALUE = VOP + MKT. SEC.
= $420 + $100
= $520 MILLION
VALUE OF EQUITY = TOTAL - DEBT - PREF.
= $520 - $200 - $50
= $270 MILLION
F. 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
Mini Case: 10 - 14
( )
( )
420
05 . 0 10 . 0
) 05 . 0 1 ( 20
V
g WACC
) g 1 ( FCF
V
Op
0
Op

G. 1. THE SECOND ACQUISITION TARGET IS A PRIVATELY HELD COMPANY IN A

GROWING INDUSTRY. THE TARGET HAS RECENTLY BORROWED $40 MILLION TO
FINANCE ITS EXPANSION; IT HAS NO OTHER DEBT OR PREFERRED STOCK. IT
PAYS NO DIVIDENDS AND CURRENTLY HAS NO MARKETABLE SECURITIES. KFS
EXPECTS THE COMPANY TO PRODUCE FREE CASH FLOWS OF -$5 MILLION IN
ONE YEAR, $10 MILLION IN TWO YEARS, AND $20 MILLION IN THREE YEARS.
AFTER THREE YEARS, FREE CASH FLOW WILL GROW AT A RATE OF 6%. ITS
WACC IS 10% AND IT CURRENTLY HAS 10 MILLION SHARES OF STOCK. WHAT
IS ITS HORIZON VALUE (I.E., ITS VALUE OF OPERATIONS AT YEAR THREE)?
WHAT IS ITS CURRENT VALUE OF OPERATIONS (I.E., AT TIME ZERO)?
ANSWER: 0 1 2 3 4 N
| | | | | |
-5 10 20
$ -4.545
8.264
15.026
398.197
$416.942 = VALUE OF OPERATIONS
G. 2. WHAT IS ITS VALUE OF EQUITY ON A PRICE PER SHARE BASIS?
ANSWER:
VALUE OF EQUITY = VALUE OF OPERATIONS - DEBT
= $416.94 - $40 = $376.94 MILLION.
PRICE PER SHARE = $376.94/10 = $37.69.
H. KFS IS ALSO INTERESTED IN APPLYING VALUE-BASED MANAGEMENT TO ITS OWN
DIVISIONS. EXPLAIN WHAT VALUE-BASED MANAGEMENT IS.
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).
I. WHAT ARE THE FOUR VALUE DRIVERS? HOW DOES EACH OF THEM AFFECT
VALUE?
ANSWER: MVA IS DETERMINED BY FOUR DRIVERS: SALES GROWTH, OPERATING
PROFITABILITY (OP=NOPAT/SALES), CAPITAL REQUIREMENTS (CR=OPERATING
CAPITAL / SALES, AND THE WEIGHTED AVERAGE COST OF CAPITAL. MVA WILL
IMPROVE IF WACC IS REDUCED, OPERATING PROFITABILITY (OP) INCREASES,
OR THE CAPITAL REQUIREMENT (CR) DECREASES. SEE THE NEXT QUESTION
FOR AN EXPLANATION OF THE IMPACT OF GROWTH.
Mini Case: 10 - 15
3
op
V = 530 =
06 . 0 10 . 0
) 06 . 0 1 ( 20

+
r
c
= 10% g = 6%
J. 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:
t
1 t
1 t
Capital
NOPAT
ROIC
+
+

IF THE SPREAD BETWEEN THE EXPECTED RETURN, ROIC
T+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.
K. 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:
DIVISION A DIVISION B
OP 6% 6% 4% 4%
CR 78% 78% 27% 27%
GROWTH 5% 6% 5% 6%
MVA (300.0) (360.0) 300.0 385.0
L. WHAT IS THE ROIC OF EACH DIVISION FOR 5% GROWTH AND FOR 6% GROWTH?
HOW IS THIS RELATED TO MVA?
ANSWER:
DIVISION A DIVISION B
CAPITAL
0
$780 $780 $270 $270
GROWTH 5% 6% 5% 6%
SALES
1
$1,050 $1,060 $1,050 $1,060
NOPAT
1
$63 $63.6 $42 $42.4
ROIC
1
8.1% 8.2% 15.6% 15.7%
MVA (300.0) (360.0) 300.0 385.0
THE EXPECTED ROIC OF DIVISION A IS LESS THAN THE WACC, SO THE
DIVISION SHOULD POSTPONE GROWTH EFFORTS UNTIL IT IMPROVES ROIC BY
REDUCING CAPITAL REQUIREMENTS (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.
Mini Case: 10 - 16
1
1
]
1

,
_

1
]
1

) g 1 (
CR
WACC OP
g WACC
) g 1 ( Sales
MVA
t
t
M. THE MANAGERS AT KFS HAVE HEARD THAT CORPORATE GOVERNANCE CAN AFFECT
SHAREHOLDER VALUE. LIST FOR THEM THE THREE MECHANISMS OF CORPORATE
GOVERNANCE.
ANSWER: THE THREE MECHANISMS ARE PROVISIONS IN THE CHARTER THAT AFFECT
TAKEOVERS, COMPOSITION OF THE BOARD OF DIRECTORS, AND COMPENSATION
PLANS.
N. WHY IS ENTRENCHED MANAGEMENT POTENTIALLY HARMFUL TO SHAREHOLDERS?
ANSWER: ENTRENCHMENT OCCURS WHEN THERE IS LITTLE CHANCE THAT POORLY
PERFORMING MANAGERS WILL BE REPLACED. THERE ARE TWO CAUSES: ANTI-
TAKEOVER PROVISIONS IN THE CHARTER AND A WEAK BOARD OF DIRECTORS.
ENTRENCHED MANAGERS.
MANAGEMENT CONSUMES PERKS: LAVISH OFFICES, CORPORATE JETS,
EXCESSIVELY LARGE STAFFS, MEMBERSHIPS AT COUNTRY CLUBS
MANAGEMENT ACCEPTS PROJECTS (OR ACQUISITIONS) TO MAKE FIRM LARGER,
EVEN IF MVA GOES DOWN. THIS IS BECAUSE SALARY AND PRESTIGE ARE
HIGHLY CORRELATED WITH SIZE.
O. LIST THREE PROVISIONS IN THE CORPORATE CHARTER THAT AFFECT
TAKEOVERS.
ANSWER: THESE INCLUDE TARGETED SHARE REPURCHASES (I.E., GREENMAIL),
SHAREHOLDER RIGHTS PROVISIONS (I.E., POISON PILLS), AND RESTRICTED
VOTING RIGHTS PLANS.
P. EXPLAIN THE DIFFERENCE BETWEEN INSIDERS AND OUTSIDERS ON THE BOARD
OF DIRECTORS. WHAT ARE INTERLOCKING BOARDS?
ANSWER: WEAK BOARDS HAVE MANY INSIDERS (I.E., THOSE WHO ALSO HAVE ANOTHER
POSITION IN THE COMPANY) COMPARED WITH OUTSIDERS. INTERLOCKING
BOARDS ARE WEAKER (CEO OF COMPANY A SITS ON BOARD OF COMPANY B, CEO
OF B SITS ON BOARD OF A).
Q. WHAT IS A STOCK OPTION IN A COMPENSATION PLAN?
ANSWER: GIVES OWNER OF OPTION THE RIGHT TO BUY A SHARE OF THE COMPANYS
STOCK AT A SPECIFIED PRICE (CALLED THE EXERCISE 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).
Mini Case: 10 - 17