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FINANCE 384: Corporate Valuation, Investment Decisions and Risk Management
STUDENT LECTURE NOTE 3 Sp14CR (Rev Su’14)
I. Corporate Value and Value-Based Management A. Maximization of Shareholder Wealth requires forecasting financial statements under alternative investment strategies, finding the NPV of the alternatives and choosing the investment strategy that yields the maximum value. B. The Dividend Growth Model is not appropriate for valuing firms in several circumstances.
- Valuing ________ ________ that cannot afford to pay dividends
- Established firms not yet paying dividends
- Dividend-paying firms with multiple divisions C. Value-Based Management must ensure that managers have the proper incentives to ________ stockholder welfare.
II. Estimating Firm (Share) Value with Free Cash Flow A. Free Cash Flow is a measure that can be used in a (FCF) Firm Valuation Model in place of the Discounted Dividend Model for firms that do not pay dividends. B. Operating Assets are the assets necessary to operate the business and may be in the form of either assets-in-place or growth options. C. Non-operating assets are typically in the form of marketable securities and investments in other businesses. D. For most companies operating assets are ____ ____ important than non-operating assets.
E. Value of Operations is found in this model as the discounted present value of the expected future FCFs. E..1 The model can account for FCFs that are growing at a constant rate or at a nonconstant rate (if a constant rate can be assumed at some future point). E..2 Since FCF is the return on both debt and equity, the appropriate discount rate is the firm’s (WACC) weighted average cost of capital (k (^) C ). E..3 The constant growth model is given in equation (3.1) below. Note the exact parallel with the constant growth dividend model for finding stock price, where D 1 = D0*(1+g).
V (^) Op(0) (Constant) =. (3.1)
⇒ P 0 =.
E..4 The value of common equity is then equal to: Total Assets - (Total Liabs + Pref Equity), Hello? More specifically its calculation is shown in equation (3.2) below.
V (^) Equity = TAs – (TLs + PE); (3.2) = (V (^) OpAssets + VNonOpAssets ) – (S-T + L-T Debt + PE).
Ex. 3. Assume that the following information applies to Zebco, Inc. Determine: a) The firm’s value of operations, b) Value of common equity and c) Price per share.
FCF for the year just ended (FCF 0 ) $450, Long-term FCF growth rate (g (^) n ) 8%
where: n = last year of non-constant FCFs.
Note: In this formulation the final term, i.e., , is called variously the Terminal , Horizon or Continuing value. Once the last non-constant FCF is forecast, it is often useful to calculate this Terminal value first, and then work _________ to find the more near-term V (^) Op s.
Ex. 3.2A Assume it is year-end 2012. As part of his internship at First Guaranty Bank , Rasmus Astrand (F382, Sp’10) has been assigned to project the five-year FCFs and firm value for Abbott Labs as of December 31,
- Sales growth is expected to peak in 2013, be above-average, but decline in years 2014 and 2015, and then settle down to a long-run constant growth rate of gn-4% for years 2016 and beyond (which also equals the Sales Growth Rate for 2016, and beyond). Thus, the pattern of growth in FCF is expected to be variable also, but become stable.
Also, because of this expected sales growth pattern the firm’s weighted average cost of capital is expected to increase over the next four years. Assume that the WACC for 2016 is expected to apply in the projected future. Estimates of the FCF growth rates and WACCs are given below. These actual FCFs will be calculated in the “ Abbott_Valuation ” worksheet contained in F384_LN03_SS_Sp14CR_Rev Su. 2012 2013 2014 2015 2016 Sales Growth 2.63%^ 11.90%^ 10.90%^ 10.20%^ 4.00% % Growth in FCF na^ 76.92020%^ -18.74740%^ 13.58750%^ 33.29360% WACC 6.50%^ 7.00%^ 7.50%^ 8.00%^ 8.00%
a) Assume FCF for 2012 equals $3,003,006 (in thousands). Calculate Abbott's expected FCFs for years 2013 through 2017. Round amounts to the nearest dollar in the answer.
A.3.2A a) Note, where the number 12 is used as the subscript, it represents 2012, and so on.
FCF 13 = FCF 12 * (1+g (^) 13) = $3,003,006 * (1+0.7692020) = $__5312923_______.
FCF 14 = FCF 12 * (1+g13) * (1+g14) = $3,003,006 * (1+0.7692020) * ( +(-0.1874740)) = $____4316889___.
FCF 15 = FCF 12 * (1+g13) * (1+g14) * (1+g (^) 15) = $3,003,006 * (1+0.7692020) * ( +(-0.1874740))
- (1+0.135875) = $____4903446_____. ( vs. $4,903,445 fr. LN03 SS)
FCF 16 = FCF 12 * (1+g13) * (1+g14) * (1+g (^) 15) * (1+g16) = 3,003,006 * (1+0.7692020) * ( +(-0.1874740))
- (1+0.135875) * (1+0.3329360) = $_6535980________. (vs. $6,535,977 fr. LN03 SS)
FCF 17 = FCF 16 * (1+(Sales)g (^) 17) = $6,535,980 * (1+.04) = $_6797419________. (vs. $6,797,416 fr. LN03 SS) b) In what year will Abbott's first normal-growth FCF occur?
$____116_______.
Projected MPS = $116,380,869 ÷ 1,575,378 = $ _73.87____.
f) What might Rasmus conclude about his estimate compared to the market price of $65.50 (as of that date)?
A.3.2A f) Obviously Rasmus’ estimate of $73.87 is somewhat higher ($8.37) than the current share price of $65.50 (or, about 12.8% = (Diff ÷Actual)).
F.Y.I. To make the 2012 Value of Operations even this low, I have decreased the Yahoo forecast for Industry and Firm growth rates and also increased the WACC. Obviously, there are a lot of estimates involved here, and I believe there are no mistakes in my calculations. But, this last point does not guarantee that my analysis matches that of other analysts, eg. Bloomberg.
Homework Extension: Extra Critical Thinking
g) Determine the value of Abbott’s operations at year-end 2014 (V (^) Op(14)) given the previous information, including the estimated FCFs and WACCs.
A.3.2A g) If you were the CFO performing this valuation you would need to identify the FCFs received and then find the present value at the appropriate discount rates. If the firm were purchased at year-end 2014, the 2014 FCF is not relevant, as it is an historical cash
flow (rather than an expected cash flow) and its present value has already been calculated (capitalized) in finding the value of operations for 2014 and it has no impact on the 2014 valuation.
Thus, the expected value of operations for year-end 2014 reflects the combined present values of FCF (^) 15, FCF 16 and V (^) Op(16).
V (^) Op(14) = +
= $____155857108_______.
Ex. 3.2B (Extended) The (Actual) 2012 Income Statement and Balance Sheet for Abbott Labs are shown below. You will also find the projected ratios/figures for the relevant accounts/etc. needed to project the future cash flows. a) (^) Forecast the parts of the Income Statement and Balance Sheet required to calculate and forecast Free Cash Flow for 2013-2017. Assume that Other Current Assets and Other L-T Assets are unchanged over the forecast period. Use the ROUND function to round all forecast amounts to the nearest dollar. b) Calculate Free Cash Flow for each projected year. Also calculate the percentage growth rates of FCF each year. Round the calculated FCF growth rate to six decimal places. c) Calculate Operating Profitability, Capital Require- ments, Return on Invested Capital and the Spread between ROIC and WACC. Use the additional
Earnings before taxes $6,262, Taxes $299, EAT (Net income before pref. div.) $5,962, Preferred div. - EAC (Net income avail. for com. div.) $5,962, Common dividends $3,182, Addition to retained earnings $2,780,
Number of shares (in millions) 1,575, Dividends per share $2.
Projected Inputs Actual Projected Projected Projected Projected 2012 2013 2014 2015 2016 Sales Growth Rate 2.63% 11.90% 10.90% 10.20% 4.00% COS / Sales 37.92% 43.08% 43.08% 43.08% 43.08% Other Costs (exc Depr)/Sales (^) 38.39% 35.49% 35.49% 35.49% 35.49% Depreciation / Net PPE 16.91% 14.94% 14.94% 14.94% 14.94% Cash / Sales 27.09% 13.43% 13.43% 13.43% 13.43% Acct. Rec. / Sales 19.09% 19.10% 19.10% 19.10% 19.10% Inventories / Sales 9.51% 11.15% 11.15% 11.15% 11.15% Net PPE / Sales 20.22% 26.60% 26.60% 26.60% 26.60% Acct. Pay. / Sales 4.51% 4.82% 4.82% 4.82% 4.82% Accruals / Sales 20.60% 18.64% 18.64% 18.64% 18.64% Tax rate 4.79% 23.66% 23.66% 23.66% 23.66% WACC 6.50% 7.00% 7.50% 8.00% 8.00%
A3.2B.a) Use the “Projected Input” ratios to forecast Sales, Costs, Depreciation, and then calculate EBIT. Note: FAs must be forecast before Depr. Partial Income Statement for the Year Ending December 31 ($ thousands) Actual Projected Projected Projected Projected 2012 2013 2014 2015 2016 Net Sales $39,873,910 $44,618,905 $49,482,366 $54,529,567 $56,710, Cost of Sales $15,119,718 $19,221,824 $21,317,003 $23,491,338 $24,430, Other Costs (exc Depr) $15,306,004 $15,835,249 $17,561,292 $19,352,543 $20,126, Depreciation $ 1,363,673 $ 1,773,173 $ 1,966,449 $ 2,167,027 $ 2,253, Total Oper Costs $31,789,395 $36,830,246 $40,844,744 $45,010,907 $46,811, EBIT $8,084,515 $ 7,788,659 $ 8,637,622 $ 9,518,660 $ 9,899,
Next, use the relevant ratios to forecast Cash, Accounts Receivable, Inventory, Net Physical Plant and Equipment (PPE), Accounts Payable and Accruals. Recall that Other Current Assets and Other L-T Assets are assumed to be unchanged.
Partial Balance Sheet for December 31 ($ thousands) Actual Projected Projected Projected Projected Operating Assets 2012 2013 2014 2015 2016 Cash $10,802,163 $5,992,319 $6,645,482 $7,323,321 $7,616, Accts Recs $7,612,860 $8,522,211 $9,451,132 $10,415,147 $10,831, Inventories $3,792,313 $4,975,008 $5,517,284 $6,080,047 $6,323, Other Cur Assets $4,743,426 $4,743,426 $4,743,426 $4,743,426 $4,743, Net PPE $8,063,047 $11,868,629 $13,162,309 $14,504,865 $15,085, Other L-T Assets $27,849,314 $27,849,314 $27,849,314 $27,849,314 $27,849, Total Fixed Assets $35,912,361 $39,717,943 $41,011,623 $42,354,179 $42,934, Operating Liabs Accts Payable $1,796,990 $2,150,631 $2,385,050 $2,628,325 $2,733, Accruals $8,215,760 $8,316,964 $9,223,513 $10,164,311 $10,570,
A3.2B.b) Calculate Free Cash Flow using the approach developed in F384 Lecture Note #.
Equations given previously:
- Operating Current Assets = (Cash+AR+Inv+Other CAs).
- Operating Current Liabilities = (AP+Accruals).
- Net Operating Working Capital = Oper CA - Oper CL.
- Operating Capital = NOWC + Net FA.
- (^) NOPAT = EBIT * (1-t).
- Free Cash Flow = NOPAT - Net Cap Invest.
Actual Projected Projected Projected Projected Calculation of FCF 2012 2013 2014 2015 2016 Operating Cur Assets $26,950,762 $24,232,964 $26,357,324 $28,561,941 $29,514, Operating Cur Liabs $10,012,750 $10,467,595 $11,608,563 $12,792,636 $13,304, Net Oper Work Cap $16,938,012 $13,765,369 $14,748,761 $15,769,305 $16,210, Total Fixed Assets $35,912,361 $39,717,943 $41,011,623 $42,354,179 $42,934, Net Operating Capital $52,850,373 $53,483,311 $55,760,384 $58,123,484 $59,144, NOPAT $ 7,697,267 $ 5,945,862 $ 6,593,961 $ 7,266,545 $ 7,557, Investmnt in Oper Cap $ 4,694,261 $ 632,939 $ 2,277,072 $ 2,363,100 $ 1,021,
Horizon value $169,935, Value Oper $142,418,010 $148,366,257 $155,857,108 $163,399,425 $169,935, Oper Capital $ 52,850,373 $ 53,483,312 $ 55,760,384 $ 58,123,484 $ 59,144, MVA $ 89,567,637 $ 94,882,945 $100,096,724 $105,275,941 $110,790,
III. Corporate Governance and Shareholder Wealth
A. Corporate Governance is the set of rules and procedures designed to motivate managers to act in the best interests of stockholders and employ the principles of value management. B. Rewards vs. Punishment C. Performance-based Compensation is the principal reward used to positively motivate managers and employees. C..a Salary based-compensation versus bonuses (cash, stock or stock options) which may reflect various combinations of different types of performance.
- Recent or short-term operating performance
- Longer-term performance like earnings growth
- Stock price performance
.a Stock Option Plans : Employees are granted the right to purchase common shares at a specified ( strike/exercise ) price, usually after a deferred ( vesting ) period and may do so for a limited ( expiration ) amount of time.
Ex. 3. In the table below you will find information from Dell Computer Corp.’s DEF 14A filing from the SEC’s website ( www.sec.gov) regarding options granted in 2002 to the top five executives (as required by the disclosure rules) as well as the relevant footnotes. Use this information to answer the following questions. On March 22, 2004, Dell stock is trading at $33.09.
a) Would it be logical for Mr. Dell to exercise his options (K=$27.64) as of this date? If exercised, how much would he make per share? 33.09-27. b) Assume that Mr. Dell decides to exercise all of his options (strike priceK=$21.39) on the above date and he then immediately sells the shares of stock. What is the total exercised value of these shares? 33.09 #sh - 21.39 *sh c) Based on the fair market value of the stock on the grant date of the (K=$21.39) options, in comparison to the stock value two years later what holding period yield would have been earned on the stock (ignoring any dividends)? Wouldn’t make a difference d) Assume further that as of 2004 Dell’s beta is 1.68, the risk-free rate is 3.4% and that the market risk premium equals 6%. Determine the CAPM required return for Dell. In comparison to its actual HPY from part c) above, what conclusion would you draw about the stock’s performance?
DELL COMPUTER CORPORATION (from SEC Form DEF 14A) OPTION GRANTS IN LAST FISCAL YEAR Name
Top 5 execs
Number of Shares Underlying Options Granted
Pctg of Total Options Granted to Employees In Fiscal Year
Exercise Price Per Share
Fair Market Value on Grant Date
Grant Date
Expiration Date
Grant Date Present Valuea
Mr. Dell 500,000b^ 0.59% $27.64 $27.64 3/7/02 3/7/12 $4,451, 64,940 c^ 0.08%^ 21.39^ 26.74^ 3/22/02^ 3/22/12^ 869, Mr. Rollins 500,000 b^ 0.59% 27.64 27.64 3/7/02 3/7/12 4,451, 45,586 c^ 0.05%^ 21.39^ 26.74^ 3/22/02^ 3/22/12^ 610, Mr. Bell 200,000 b^ 0.24% 27.64 27.64 3/7/02 3/7/12 1,780, 200,000 b^ 0.24%^ 25.45^ 25.45^ 9/5/02^ 9/5/12^ 1,639, Mr. Marengi 200,000 b^ 0.24% 27.64 27.64 3/7/02 3/7/12 1,780, 200,000 b^ 0.24%^ 25.45^ 25.45^ 9/5/02^ 9/5/12^ 1,639, Mr. Parra 200,000b^ 0.24% 27.64 27.64 3/7/02 3/7/12 1,780, 35,354 c^ 0.04% 21.39 26.74 3/22/02 3/22/12 473, 200,000 b^ 0.24% 25.45 25.45 9/5/02 9/5/12 1,639,
Conclusion: Since the realized return (from part c) ) is less than the CAPM required return, at least over this period, Dell’s stock underperformed ______________ investor expectations.
.b Employee Stock Ownership Plans (ESOPs): Authorized by Congress to help improve employee retirement incomes and corporate productivity. .c Five principal reasons the firm benefits:
- Employees with an ______ stake are expected to work harder and smarter.
- ESOP represents a potential wealth transfer from ________ shareholders to employees.
- (^) ESOP may improve ________ of employees.
- Tax incentives as the firm can borrow at lower rates through the ESOP and cash dividends paid on ESOP stock may be deductible.
- Potentially undesirable benefit is that if the ESOP owns a significant portion of company stock, this may be used to help avoid a takeover.
H. The Possibility of Takeover is the primary factor that acts as a stick in threatening management with ________ consequences. I. Entrenched Management may result from strong anti-takeover provisions in the corporate charter and/or a weak Board of Directors. There are several undesirable consequences that may result.
- Executives may consume unnecessary perquisites (nonpecuniary benefits).
- Management may not properly reduce _____ through layoffs or plant closures.
- Managers may not undertake projects that will generate primarily long-term profits, or prema- turely abandon such projects.
- Acquisitions may be undertaken at excessive prices, when the focus is on increasing firm ____, instead of firm value.
J. Anti-takeover Provisions serve as barriers to hostile takeovers. In such cases, typically, poorly- performing firms are acquired and incumbent management is replaced. The acquired firm’s shareholders _______ as long as the acquiring firm does a better job of managing the assets.
K. Shareholder-friendly Charters should ban the following provisions. e) Greenmail is a share repurchase where a potential bidder’s stock is targeted for purchase at a ______ price than other shareholders could receive. f) Poison Pills are a shareholder rights provision that allow the target firm’s s-holders to buy a certain number of shares at a very ____price if a bidder acquires a specified percentage of the target’s stock. g) Restricted Voting Rights automatically deprive a shareholder of ______ ______ if they acquire more than a specific amount of the target firm’s stock.
L. Effective Monitoring by the Board of Directors C..b Board seats are ________ in terms of compensation and prestige and the board member might feel allegiance to the person who helped them get the seat.
perceived by the market, the firm’s market value will be _________. F 0D E A ____ share price makes the firm a more attractive takeover target.
- Stocks are valuable due to the expectation that the company will be generating positive (and hopefully growing) cash flows in the future. If you are considering buying an asset, past profits are history, it’s the ______ that counts.
