Measures such as free-cash flow valuation, market value added, and economic value added can be used to evaluate the firm’s performance.. Fundamental components of a firm’s compensation p
Trang 1
CHAPTER 13
Managing for Shareholder Value
CHAPTER ORIENTATION
This chapter identifies methods to measure firm value and techniques that can be employed
to assure management and the firm’s board of directors make decisions that increase the value of the firm Increases in firm value lead to increases in stock value, which aligns with the firm’s goal of maximizing shareholder wealth Measures such as free-cash flow valuation, market value added, and economic value added can be used to evaluate the firm’s performance Management of the firm can be provided compensation incentives that guide their decisions toward increasing the value of the firm
CHAPTER OUTLINE
securities
under management’s control
these performance metrics
(decreases) in stock price based on the price-earnings relationship
flows, which may increase firm value and stock price
Trang 2B Free cash flow model
planning period of a finite number of years and a terminal value of all years beyond the planning period
4 ) wacc k (1
4 Value Terminal 4
) wacc k (1
4 Flow Cash Free 3 ) wacc k (1
3 Flow Cash Free 2 ) wacc k (1
2 Flow Cash Free 1 ) wacc k
(1
1 Flow Cash
Free
ValueFirm
+
+ +
+ +
+ +
+ +
=
Terminal value is calculated as
wacc
5 4
k
Flow Cash Free Value
×
−
=
1 -t CapitalInvested
) wacc (k CapitalCost of
Average Weighted
(NOPAT)
Operating Net
EVA
t t
1 t wacc
t
t Return Capitalon (ROIC)Invested Cost Weightedof CapitalAverage(k ) CapitalInvested(IC)
EVA
−
×
=
Trang 3V Paying for Performance
act on behalf of owners
long-term compensation
attracting quality employees and achieving target performance measures
with employee rank
measures
=
e Performanc Target
e Performanc Actual
Risk
at of Pay
Fraction
Pay
Base Pay Incentive
minimum threshold of performance is achieved and caps the bonus payout at a maximum level of performance
stock
Directors’ pay
ANSWERS TO END-OF-CHAPTER QUESTIONS
13-1 The accounting model of equity evaluation focuses on reported earnings in
conjunction with the market’s valuation of those earnings as reflected in the price-earnings ratio For example, if the price-price-earnings ratio is 20 then a dollar increase in earnings per share should create $20 in additional equity value per share Similarly,
a one-dollar loss in earnings per share may lead to a drop of $20 in share value
Trang 4The accounting model has its limitations, however For example, this method relies
on historical earnings and ignores other factors that may influence the share value in the market
13-2 The free cash flow valuation model provides a method for analyzing firm value as
the present value of the firm's projected free cash flows
take to manage its sales growth:
• Implement a new promotional campaign to promote existing or new
products
• Form a distributional alliance to enter a new market
revenue Steps that can be taken to manage the operating profit margin:
• Initiate cost control programs to reduce operating and administrative
expenses
• Invest in a promotional campaign aimed at improving the brand
image of the firm’s products or services in an effort to support premium-pricing policies
C Net working capital to sales ratio—the percent of new investments in current
assets (excluding the part financed by non-interest bearing liabilities) relative
to firm sales Steps to manage the net working capital to sales ratio:
• Initiate inventory control policies designed to reduce the time that
inventory is held before sale
• Implement a program of credit analysis and control designed to either
decrease the time customers take to pay for their purchases or to incorporate penalties for late payment
• Negotiate more lenient credit terms from the firm’s suppliers
D Property, plant, and equipment to sales ratio—the percent of firm sales that is
invested in property, plant, and equipment Steps to manage the property, plant, and equipment to sales ratio:
• Consider outsourcing of production to strategic partners who might be
more efficient in their operations so as to reduce the firm’s need for plant and equipment
• Implement stringent controls over the acquisition of new plant and
equipment to assure that all purchases are economically viable
Trang 5• Improve maintenance of existing plant and equipment to improve
operating time, which reduces the need for additional plant and equipment
Trang 613-4 Economic Value Added (EVA) measures the change in firm value over a specific
period of time Managers of a firm use EVA to evaluate the performance of the firm over specific intervals of time, usually one year EVA for a particular year (e.g., year
t) is defined as follows:
−
×
−
=
1 t CapitalInvested
) wacc (k CapitalCost of
Average Weighted
(NOPAT)
Operating Net
EVA
t t
An alternative definition of EVA is:
×
=
− 1 t wacc
t
t CapitalReturn (ROIC)Invested Cost WeightedofCapitalAverage(k ) CapitalInvested(IC) EVA
EVA is related to MVA in the following way: MVA is the present value of all future EVAs over the life of the firm Thus, managing the firm in ways that increase EVA will generally lead to a higher MVA
13-5 Fundamental components of a firm’s compensation program:
payment that is dependent upon firm performance compared to targets set at the beginning of the period EVA provides one such performance measure that can be used in this regard
also made periodically to employees This type of compensation is the most direct method available to the firm to align the interests of the firm’s employees with those of its shareholders
Note that both bonus and long-term compensation are at-risk in that they are both dependent upon performance of the individual and the firm We often use the term
incentive or performance-based compensation to describe this at-risk component of
managerial compensation
13-6 The four basic issues that every firm’s compensation program must address are:
the portion should be incentive based
be paid in long-term (equity) compensation
Issue #1: How much to pay?
How much to pay for a particular job is dictated by market forces This means that a firm must be constantly comparing its pay scales with the labor market because the firm will only be able to hire good employees where it offers a competitive level of total compensation The size of the total compensation package may determine where employees go to work, but the mix of base pay and performance based pay will determine how hard they will work
Trang 7Issue #2: Base pay versus at-risk or incentive compensation
Usually a firm's highest-ranking employees generally have a larger fraction of their total compensation “at-risk” and the fraction declines with the employee's rank in the firm Most firms base the at-risk fraction of an employee’s compensation on either salary level or responsibilities This often mirrors the responsibilities of the firm’s top managers and their ability to control firm performance
Issue #3: Linking incentive compensation to performance
The third issue in designing a compensation program relates to choosing a functional relationship between performance and pay for the incentive portion of the compensation package The basic formula for specifying this relationship is:
=
e Performanc Target
e Performanc Actual
Risk
-at
Pay of
Fraction Pay
Base Pay Incentive
There are two types of incentive compensation plans based on the above formula The first type is called unbounded incentive compensation plan This means in the above equation there are no limits specified as to the maximum or minimum levels
of incentive pay that can be earned
The other type is called bounded incentive compensation plan This system provides for a minimum or threshold level of performance (in relation to the target level) before the incentive plan kicks in, and a maximum level of performance (again in relation to the target) above which no incentive pay is rewarded Consequently, incentive compensation is only paid for performance levels that fall within the minimum and maximum levels
Issue #4: Paying with a cash bonus versus equity
A firm can pay its compensation plan in cash, stock or some mixture of the two If the firm chooses stock then the employees are rewarded for current performance and are also provided with a long-term incentive to improve performance Equity-based compensation is an important and valuable tool in a firm’s compensation package
Solutions to Problem Set A
13-1A
Given:
Trang 8Given:
Property, plant, and equipment to sales ratio 18.0%
FREE CASH FLOWS:
Years
Operating income (Earnings Before Interest and Taxes) 4,800.00 5,280.00 5,808.00 5,808.00
Net operating profits after taxes (NOPAT) $ 3,360.00 $ 3,696.00 $ 4,065.60 $ 4,065.60 Less investments:
Investment in Net Working Capital (354.55) (390.00) (429.00) - Capital expenditures (CAPEX) (490.91) (540.00) (594.00) - Total investments $ (845.46) $ (930.00) $ (1,023.00) $ -
Present value of free cash flows:
Terminal value in year 4: 33,880.00
Shareholder value ($30,730.94 – 4,000) $ 26,730.94
Trang 9Net working capital to sales ratio 13.0%
Property, plant, and equipment to sales ratio 18.0%
Years
Change in current assets $ 354.55 $ 390.00 $ 429.00 $ - Current assets $ 4,909.09 $ 5,263.64 $ 5,653.64 $ 6,082.64 $ 6,082.64 Capital expenditures $ 490.91 $ 540.00 $ 594.00 $ - Property, plant and equipment 4,909.09 $ 5,400.00 $ 5,940.00 $ 6,534.00 $ 6,534.00 Total Capital = Total Assets - Non-interest
liabilities $ 9,818.18 $10,663.64 $11,593.64 $12,616.64 $12,616.64
a) Calculation of EVA:
Years
Net operating profits after taxes (NOPAT) $3,360.00 $ 3,696.00 $ 4,065.60 $ 4,065.60 Less capital charge (Invested Capital x
Invested Capital $ 9,818.18 $ 10,663.64 $11,593.64 $12,616.64 $12,616.64
b) Return on Invested Capital
c) Market Value Added = PV(EVAs) $20,640.89
Plus Invested Capital (year 0) 9,818.18
a The EVAs are positive each year, indicating Bergman is creating value for its
shareholders
b The ROIC is greater than the cost of capital, so the firm is creating value for its
shareholders When the ROIC is greater than the cost of capital, we should see
positive EVAs
c The present value of the EVAs exceeds the market value added in Problem 13-2A
Trang 10Given:
Base pay $ 100,000.00
Target EVA Performance $ 20,000,000.00
a Unbounded incentive plan
Scenario A Scenario B Scenario C Actual EVA Performance $ 15,000,000 $ 20,000,000 $ 30,000,000
Plant Manager Compensation
Base pay $ 100,000.00 $ 100,000.00 $ 100,000.00
Total compensation $ 115,000.00 $ 120,000.00 $ 130,000.00
b Bounded incentive plan (80/120)
Scenario A Scenario B Scenario C Actual EVA Performance $15,000,000 $20,000,000 $30,000,000
Plant Manager Compensation
Base pay $ 100,000.00 $ 100,000.00 $ 100,000.00
Incentive pay - 20,000.00 24,000.00
Total compensation $ 100,000.00 $ 120,000.00 $ 124,000.00
This plan encourages employees to meet targets only within range of performance where payout varies with performance (between floor and cap) Employees have no
incentive to improve performance if below floor or above cap
SOLUTION TO INTEGRATIVE PROBLEM
that it did not earn profit Indeed, it suffered increasing losses in every year, and in
1998, the firm lost over $20 million
current figure of total assets less noninterest-bearing liabilities in its balance sheet and part of the marketing and R&D expenditure it paid but will generate value in future years
Charging the full marketing and R&D expenditures against revenues in the year in which the expenditures are made will distort total assets as an indication of the firm’s invested capital The investment in marketing and R&D does not create value only for the year it is made Actually, it will bring benefits for the company in several future years Therefore, putting the whole amount in the income statement for one year cannot properly reveal the company’s performance for that year because the revenue the company created only related to a part of the total investment in marketing and R&D
Trang 11C The EVA for year t is defined as following:
×
−
=
− 1 t wacc
t
Average Weighted
(NOPAT)
Operating Net
EVA
Using the GAAP financial reports of 1998, assuming that the invested capital equals total assets – accounts payable – accrued expenses – other current liabilities –
deferred revenue, and weighted average cost of capital is 20%, we get the following result:
However, as we discussed in part B, NOPAT is understated since we put the entire marketing and R&D expenditure for 1998 in the GAAP accounting earnings sheet for that year Invested capital is also understated for the same reason If we amortize the marketing and R&D expenditures over several years, during which it will generate value, our EVA result will be positive
Solutions to Problem Set B
13-1B
Given:
Trang 12Given:
Sales growth for years 1-3 10.0%
Operating profit margin 17.0%
Net working capital to sales ratio 13.0%
Property, plant and equipment to sales ratio 18.0%
Beginning sales $ 31,363.64
Total liabilities $ 6,000.00
Sales $ 34,500.00 $ 37,950.00 $ 41,745.00 $ 41,745.00 Operating income (Earnings Before Int & Taxes) 5,865.00 6,451.50 7,096.65 7,096.65 Less cash tax payments (1,642.20) (1,806.42) (1,987.06) (1,987.06) Net operating profits after taxes (NOPAT) $ 4,222.80 $ 4,645.08 $ 5,109.59 $ 5,109.59 Less investments:
Investment in Net Working Capital (407.73) (448.50) (493.35) Capital expenditures (CAPEX) (564.55) (621.00) (683.10) Total investments $ (972.28) $ (1,069.50) $ (1,176.45) $ -Free cash flow $ 3,250.52 $ 3,575.58 $ 3,933.14 $ 5,109.59
PV of FCF 2,826.54 2,703.65 2,586.10 $ 22,397.59 Present value of free cash flows:
Terminal value
c) Calculation of equity value
Trang 13Given:
Net working capital to sales ratio 13.0%
Property, plant and equipment to sales ratio 18.00%
Years
Change in current assets $ 407.73 $ 448.50 $ 493.35 $ - Current assets $ 5,645.45 $ 6,053.18 $ 6,501.68 $ 6,995.03 $ 6,995.03 Capital expenditures $ 564.55 $ 621.00 $ 683.10 $ - Property, plant and equipment 5,645.45 $ 6,210.00 $ 6,831.00 $ 7,514.10 $ 7,514.10 Total Capital = Total Assets - Non-interest $ 11,290.90 $12,263.18 $13,332.68 $14,509.13 $14,509.13 liabilities (Invested Capital)
a) Calculation of EVA:
Years
Net operating profits after taxes (NOPAT) $ 4,222.80 $ 4,645.08 $ 5,109.59 $ 5,109.59 Less capital charge (Invested Capital x K wacc ) $(1,693.64) $(1,839.48) $ (1,999.90) $(2,176.37) Economic Value Added $ 2,529.16 $ 2,805.60 $ 3,109.69 $ 2,933.22
b) Return on Invested Capital
c) MVA and the present value of future
EVAs
Market Value Added = PV(EVAs) $ 19,996.52
Plus Invested Capital (year 0) 11,290.90
a The EVAs are positive each year, indicating the Bergman is creating value for its
shareholders
b The ROIC is greater than the cost of capital, so the firm is creating value for its
shareholders When the ROIC is greater than the cost of capital, the EVAs are positive
c The present value of the EVAs exceeds the market value added in Problem 13-2B