1 FI 8360 Spring 2003 Corporate Financial Strategy Roger A. Morin, PhD Distinguished Professor Finance, College of Business, Georgia State University

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FI 8360 Spring 2003

Corporate Financial Strategy Roger A. Morin, PhDDistinguished Professor Finance,

College of Business, Georgia State University

Chairman & CEO Utility Research International

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FI 8360Lecture #1 Roadmap

Course overview & organization Valuation and the “Value Movement” Lecture #2 preview

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Value Creation

Principle that overall business strategies and their implementation should be guided by the pursuit and selection of alternatives which maximize shareholder value

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The Va lue- Ba sed M a na gem ent Fra m ework

Va lue

Figure 1. The Va lue- Ba sedM a na gem ent Fra m ew ork

Stra teg ic

Fina ncia l

Corpora teG overna nce

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Present Va lue

PresentVa lue

FutureCa sh Flows

Cost ofCa p ita l

Figure 2. Present Va lue

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Economic Value

n E(Ct)

Present Value = ------------- t=0 (1 + k)t

Future value corresponds to future and uncertain business cash flows, Ct. So we discount expected cash flows

Cash flow and Risk

Because business cash flows occur over many future periods, we locate them in time, then discount and add them all.

Timing

Because business cash flows are risky, investors demand a higher return: the discount rate, k, contains a risk premium.

Risk

EMBA Finance II

Asset Valuation

PV =

CF

1+ k ... +

CF

1+k1 n

12

21

CF

kn .

0 1 2 nk

CF1 CFnCF2Value

...

+ ++

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How Investors Value Securities

n

Bond Value = Cash Flowt

t=1 (1 + k)t

n

Stock Value = Dividendst ~ D1

t=1 (1 + k)t k - g

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How Companies Value Capital Projects

n

NPV = Cash Flowt - Investment0

t=1 (1 + k)t

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Corporate Value

infinity

Value = Cash Flowt

t=0 (1 + Cost of Capital)t

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Free cash flow is the basis of value!

Investors watch this pattern……

….which is “cash in and cash out”

Free cash flow = NOPAT adjusted for depreciation and other accounting elementsLess net investment in working capital, fixed assets, capitalized R&D, etc.

Trend

Time

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Shareholder value analysis focuses on the factors that investor use to

value companies:

Cash Flows Long-Term Expected Performance Risk

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Com pa ny Va lue

Ca shFlow

Cost ofCa p ita l

Com pa nyVa lue

Figure 3. Determ ina nts of Va lue

Return

Risk

G rowth

Ca pita l

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Alternative Valuation Framework

NOPAT

V = -------------

K

Where: NOPAT = Net Operating Profits After Tax

K = Cost of Capital

V = As Is Value

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Valuation Framework

NOPAT R - K

V = ------------- + ------------ * I * T

K K

WHERE: NOPAT = NET OPERATING PROFITS AFTER TAX

K = COST OF CAPITAL

R = RETURN ON CAPITAL

I = ANNUAL INCREMENTAL INVESTMENT

T = NO. OF YEARS THAT I CAN BE INVESTED

AT R > K

V = As Is Value + Value Growth Opportunities

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3 Factors in Value Creation

ROI > WACCAmount of InvestmentInterval of Competitive Advantage

Note:

– Forward-looking– Expected cash flows

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Fundamental Principle of Valuation

CORPORATE RETURN

MARKET VALUE = ---------------------------------------------------

INVESTORS’ REQUIRED RETURN

MARKET VALUE RETURN ON TOTAL CAPITAL

-------------------------------- = -------------------------------------------

CAPITAL EMPLOYED COST OF CAPITAL

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Value Created for Shareholders

(R - K) M/B - 1 = ------------- (K - G)

Spread return on equity over cost of equity Volume of new investment measured as earnings

retained in the business Duration of positive spread Note: Growth adds value only if R > K

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VALUE CREATION

VALUE

SPREAD

RETURN ONEQUITY

COST OFEQUITY

GROWTH

Value Creation

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0

2

4

6

SALES GROWTH

MA

RK

ET

-TO

-BO

OK

RA

TIO

3.00% 4.50% 7.50% 10.50% 13.50% 15.00%

SPREAD < -5%

SPREAD -5% to -2%

SPREAD -2% to +2%

SPREAD +2% to +5%

SPREAD > 5%

VALUE vs SPREADS & GROWTHMARKET-TO-BOOK RATIOS

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Shareholder Value Network

Creating ShareholderValue

Shareholder Return• Dividends• Capital Gains

CorporateObjective

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Cash Flow FromOperations

Discount Rate Debt

CorporateObjective

ValuationComponents

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Discount Rate Debt

• Value Growth Duration

• Sales Growth• Operation Profit Margin• Income Tax Rate

• Working Capital Investment• Fixed Capital Investment

• Cost of Capital

CorporateObjective

ValuationComponents

ValueDrivers

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Discount Rate Debt

• Value Growth Duration

• Sales Growth• Operation Profit Margin• Income Tax Rate

• Working Capital Investment• Fixed Capital Investment

• Cost of Capital

Operating Investment Financing

CorporateObjective

ValuationComponents

ValueDrivers

ManagementDecisions

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Shareholder Value and Value Drivers

Investment decisions Working capital investment Fixed capital investment

Financing decisions Cost of capital Debt-equity mix Dividend policy

Operating decisions Sales growth Operating profit margin Income tax rate

Value growth duration

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Value Creation - Another View

Value Created = (Return On Investment

- Cost of Capital)

x Capital employed

Dependent Upon: Cost of Capital Spread Duration of Spread Amount of Capital Employed

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Economic Value Added

(r - c*) x capital

NOPAT - c* x capital

Operating profits - a capital charge

EVA ties directly to NPV

NPV = market value - capital

NPV = the present value of projected EVA

Market value = capital + P.V. of projected EVA

c* = WACC r = NOPAT / Capital

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Va lue


Stra teg ic

Fina ncia l


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Stra teg ic D eterm ina nts of Va lue Crea tion

Com petitive PositionFinancia l

Determ ina nts

M a rket Econom ics

Figure 6. Stra teg ic D etermina nts of Va lue Crea tion

Differentia tion ,Cost Position

Structura lFa cto rs & Trends

Va lue

Sprea d

G rowth

Investm entSca le

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H igh

W eak A verage Stro ng

M ed ium

Low

Increa sing Va lue Crea tion Potentia l

Incre

asin

g V

alu

e C

rea

tion

Po

ten

tial

MA

RK

ET A

TTR

AC

TIV

ENES

S

CO M PETITIVE PO SITIO N

Actua l

Desired

Improving Stra tegic Position Crea tes Va lue

Figure 7. M a rket A ttra ctiveness/ Comp etitive Position M a trix

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H ig h

Wea k

Excellen t va lue crea tion po tentia l(h ig h susta ina b le p ro fits a nd growth)G row - a nd - b uild stra tegy

D a ng er o f va lue d issipa tion(low or n eg a tive RO I sp rea ds)Position a nd / or stra teg y cha ng e need ed

Va lue destruction like ly(neg a tive RO I sprea d s)Divest unless p osition ca n b e im p roved

G ood va lue crea tion p oten tia l(keep RO I sp rea d p ositive)Selective g row th

Fa ir to p oor va lue crea tion p oten tia l(d epen din g on susta in a ble ca sh flows)Emp ha size ca sh flow a nd w a tch RO I sp rea d

A vera g e Strong

M edium

Low

Increa sing Va lue Crea tion Potentia l

Incre

asin

g V

alu

e C

rea

tion

Po

tentia

l

IND

USTR

Y R

OI

SPR

EAD

CO M PAN Y RO I SPREAD(RO I - Cost of Ca pita l)

PO SITIO N S A N D IM PLICATIO N S FO R CO RPO RATE STRATEG Y

Im porving Stra tegic Position Crea tes Va lue

Figure 8. Stra tegy a nd Va lue Crea tion

F

A

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Fa ctors Sha ping Industry A ttra ctiveness

Com petitiveRiva lry

Custom erPower

SupplierPower

REG U LATO RY

SO CIAL G LO BAL

ECO N O M IC

IN DUSTRY FO RCES

EN VIRO N M EN TAL FO RCES

TECH N O LO G ICA L

Threa t ofSubstitutes

Threa t ofEntry

Fig ure 9. Porter's Ind ustry Ana lysis Fra m ew ork

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Va lue Cha in Business Systemor

Support A ctivities

Prima ry A ctivities

M a rg in

O U TPU TSIN PU TS

Figure 10. The Ba sic Va lue Cha in

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Flexib ility to Exercise G rowth O ptions

IntenseCompetitive

Riva lry

Sha redO ptions

Threa t o f pre- em ptio n ; the m a rketpo w er o f do m ina nt firm s increa sestheir ab ility to o bta in fu ll va lue o fthe o ptio ns exercised .

Tendency to de la y o ptio n exerciseuntil the w ea ker p layers exercisethem .

N o threa t o f to ta l p re- em ptio n ; butrisk o f lo ss o f va lue o f the o ptio nbecause o f co m petitio n .

Tendency to exercise the o ptio n ea rlyin o rder to a vo id ero d ing the va lueo f the o ptio n .

D o m ina nt firm s ca n benefit fu lly fro mthe va lue o f the o ptio n .

N o risk o f pre - em ptio n ; o ptio ns a reheld until m a turity.

Little a b ility to benefit fro m the fu llva lue o f a n investm ent o ppo rtunity.

Q u ick exercise o f o ptio ns in orderto surpa ss a co m petito r o r fo rdefensive rea so ns.

Proprieta ryO ptions

M inima lCompetitive

Riva lry

Figure 11. Stra tegy a nd O p tion Va lue

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Stra tegic Determ ina nts of Va lue

Figure 12. Stra tegy M odule of VBM Fra m ew ork

FO RCES

IN DUSTRY

FO RCES

EN VIRO N M EN TAL O PTIO N VALU E

Sup port A ctivities

Prima ry Activities

M a rgin O U TPU TSIN PU TS

Increa sing Va lue Crea tionPotentia l

Incre

asin

g V

alu

e C

rea

tion

Po

ten

tial

MA

RK

ET A

TTR

AC

TIV

EN

ESS

CO M PETITIVE PO SITIO N

A ctua l

Desired

IntenseCompetitive Riva lry

Sha redO ptions

Proprieta ryO ptions

M inima lComp etitive Riva lry

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Strategic Drivers

Optimal Cost Structure Competitive Advantage Asset Utilization Protect Strategic Resources Reduce Risk Value Based Management

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Value Drivers and Strategy

VALUE

Cash Flows Discount Rate

Value Growth Duration

• Sales Growth• Profit Margin• Tax Rate

• Working Capital • Fixed Capital

Cost of Capital

Operating Investment Financing

CorporateObjective

ValuationComponents

ValueDrivers

ManagementStrategies

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Strategic Value Drivers

ReturnRisk

Value

Financial Value Drivers

Sales growth Working Capital Tax rate

Profit Margin Fixed Assets Cost of Capital

OperationalValue Drivers

Unit sales volume Selling termsPrices Vendor termsProduct mix Purchasing policiesLabour rate Payment proceduresOverhead Sourcing strategiesProductivity Capital budgetingWork schedules Innovation tacticsDowntime Location decisions

From Macro to Micro Drivers

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ReturnRisk

Value





Production costs per kWhNon-production costs per kWhLoad factorFuel mix in MWhGrowth in total MWh salesAverage prices


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ReturnRisk

Value





Operating cost per customerOperating cost per units distributedElectricity/gas distributed per employeeDistribution operating profit per customer


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Va lue


Stra teg ic

Fina ncia l


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Fina ncia l D eterm ina nts

Figure 13. Fina ncia l D eterm ina nts of Va lue

Re

turn

Re

turn

% Debt/ Equity Risk

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Financial Drivers

Optimal Capital Structure Capital Allocation Based on Value Financial Engineering Minimize Tax Rate Dividend Policy

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Va lue


Stra teg ic

Fina ncia l


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Corporate Drivers

Governance Performance Evaluation Incentive Compensation

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VBM

Are accounting metrics consistent with value creation?

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Accounting Measures Misleading

Accrual accounting undependable Growth of earnings not necessarily related to stock

value Earnings do not reflect changes in risk and inflation Earnings do not show the cost of added plant that

may have been invested to finance growth Focusing on short-term earnings growth jeopardizes

ability to create long-term value

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Drawbacks of EPS

Accounting latitude Risk excluded Investment requirements excluded Dividend policy excluded Time value of money excluded Empirical evidence: EPS vs value unrelated

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The Agency Problem

Managers act in their own self-interest (corporate jets, country clubs, perks, etc.)

Shareholders do not have the influence or finances to govern issues such as election of board members

Board members tend to be largely responsive to mgt..; top mgrs... are often board members

Mgt time horizon may be short-term, due to compensation mode

Mgt tends to have lower risk tolerance than sh’ers due to compensation mode

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How to reduce the agency problem

Large ownership positions Compensation tied to shareholder return Threat of takeovers Competitive labor markets for corporate

executives

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VBM Fra m ework : Putting It A ll Together

Va lue

Ca shFlow

Cost ofCap ita l

CompanyVa lue

Return

Risk

G rowth

Cap ita l

Fina ncia l

Re

turn

Re

turn

% D eb t/ Eq uity Risk

Corpora te G overna nce

Perform a nce

Com pensa tion

Investor Rela tions

Stra tegic

FO RCES

IN DU STRY

FO RCES

EN VIRO N M EN TA L O PTIO N VA LU E

Supp ort Activ ities

Prima ry A ctiv ities

M a rg in O UTPU TSIN P U TS

In crea sing Va lue C reationPotentia l

Increa

sing

Va

lue

Cre

atio

nP

oten

tial

MA

RK

ET A

TTR

AC

TIV

ENES

S

CO M PETITIV E PO SITIO N

A ctu a l

D esi red

IntenseCom p etitive Riva lry

Sha redO p tions

Prop rietaryO ptions

M inim a lCom p etitive Riva lry

Figure 14. VBM Fra mew ork: Putting It A ll Together

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VBM Process

Experiment Strategic Restructuring Value-based Planning Value-based Compensation

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Restructuring

Value “as is” Internal improvements

– Strategic & Operating External improvements

– Acquisitions, divestitures, jvs Financial engineering HQ costs

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Restructuring Pentagon

Current MarketValue

Optimal Restructured

Value

Potential Valuewith Internal Improvements

CompanyValue As Is

1

2

3 4

5

Potential Valuewith External Improvements

Strategic andOperatingOpportunities

CurrentPerceptions

Gap

Disposal / Acquisition

Opportunities

MaximumRaider

Opportunity

Total CompanyOpportunities

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Value-Based Planning

Value-creation potential of each SBU Value drivers controlled by SBU mgrs. Value objectives Capital allocation based on value-

creation potential of each SBU

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Value Planning

$543

$438

$445

$500

$0

$500

$1,000

$1,500

$2,000

Ba

se

line

Va

lue

Gro

wth

Str

ate

gie

s

Ma

rgin

Init

iati

ve

s

Inv

es

t-m

en

ts

Me

rge

rS

av

ing

s

Sh

are

-h

old

er

Va

lue

Expected Value Creation

Mill

ion

s o

f D

olla

rs

($43)

$1,883

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Foundations of a VBM System

Committed CEO Properly organized company Credible plans Supportive functional action

plans Realistic resource allocations Culturally compatible

strategies Effective strategy monitoring

system Compensation linked to

strategy

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VALUE HALL OF FAME

GENERAL ELECTRIC COCA-COLA WAL-MART MERCK PHILIP MORRIS PROCTER & GAMBLE EXXON AT&T PEPSICO JOHNSON & JOHNSON BRISTOR-MYERS ABBOTT LABS

MICROSOFT WALT DISNEY INTEL MOTOROLA PFIZER HOME DEPOT AMERICAN HOME PRODUCT 3M GTE McDONALD’S BELLSOUTH GILLETTE

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Hall of Fame CompaniesCommon Traits

Focus Global Innovation Leadership Continuous improvement Empowerment

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Innovation

Greater new product intro Engineering, benchmarking Reward risk-taking

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FI 8360Lecture #2 Preview

Value and Capital Markets Why Value Value The Value Manager Valuation Frameworks: DCF

NPV, FTE, FCF, APV, etc.

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THE END

Documents

1 FI 8360 Spring 2003 Corporate Financial Strategy Roger A. Morin, PhD Distinguished Professor Finance, College of Business, Georgia State University