Solution manual financial management 10e by keown chapter 13

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 I Top Creators of Shareholder Wealth A Market Value Added (MVA) measures wealth created by the firm B Value creation results from two activities: II MVA = Firm value – invested capital Firm value = market value of firm’s outstanding debt and equity securities Invested capital = total funds invested in the firm Identifying performance measures linked to value creation that are under management’s control Designing incentives to encourage employees to base decisions on these performance metrics Business Valuation A Accounting model Focuses on firm’s earnings Assumes increases (decreases) in earnings will lead directly to increases (decreases) in stock price based on the price-earnings relationship Decreases in current earnings may result in increases in future cash flows, which may increase firm value and stock price 75 B Free cash flow model Focuses on firm’s projected cash flows for all future years a Future years cash flows consist of the cash flows during a planning period of a finite number of years and a terminal value of all years beyond the planning period b Firm value is calculated as Free Cash Flow Free Cash Flow1 Free Cash Flow Free Cash Flow Terminal Value Firm = + + + + Value 4 (1 + k ) (1 + k ) (1 + k ) (1 + k ) (1 + k ) wacc wacc wacc wacc wacc Terminal value is calculated as Terminal Value = Components of free cash flow values a b c d III IV Free Cash Flow k wacc Estimated revenues Estimated net operating profits Investment in net working capital Capital expenditures Firm value equals market value of its debt and equity Value Drivers A Managers can increase firm value by managing value drivers B Using value drivers to increase firm value may increase equity value Economic Value Added (EVA®) A EVA is the change in firm value during a specific time interval, usually year B EVA is calculated as EVA t C  Net Operating   =  Profit After  −  Tax (NOPAT) t      Average  Weighted Cost of ×  Capital (k wacc )  [ ]  Invested   Capital t -1   EVA can also be calculated as on Invested − Weighted Average  × Invested EVA t =  Return Capital (ROIC)t Cost of Capital (k wacc )  Capital (IC)t −1  76 V Paying for Performance A Agency problems arise when firm ownership and management are separate B Linking EVA measures to employee compensation encourages employees to act on behalf of owners C Compensation Policy Three components of compensation are base pay, bonus, and longterm compensation The mix of base pay and performance-based pay is important in attracting quality employees and achieving target performance measures Percentage of total compensation that is ‘at-risk’ typically increases with employee rank Incentive pay should be linked to achieving target performance measures a Incentive pay can be calculated as    Actual Performance  Incentive =  Base   Fraction    of Pay   Pay  Pay   at Risk   Target Performance    b Bounded incentive pay rewards employees only when a minimum threshold of performance is achieved and caps the bonus payout at a maximum level of performance c Unbounded incentive pay has no upper or lower bonus limits Incentive pay can be paid in cash, stock, or a combination of cash and stock a Stock rewards employees for current and future performance b Stock compensation may be the majority of CEO and Board of 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 priceearnings ratio For example, if the 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 77 The 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 13-3 A B C D Sales growth—annual growth of revenues Steps a firm’s management can 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 • Invest in R&D to create new products • Acquire a competitor’s firm Operating profit margin—net operating income as a percent of a firm’s 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 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 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 78 • Improve maintenance of existing plant and equipment to improve operating time, which reduces the need for additional plant and equipment 79 13-4 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: EVA t   Weighted Average    Net Operating   Invested     =  Profit After  −  Cost of ×  Capital (k  Capital t −   Tax (NOPAT) t  )    wacc    An alternative definition of EVA is: Return Invested − Weighted Average  ×  Invested  EVA t =  Capital (ROIC)t Cost of Capital(k wacc )  Capital (IC)t −1   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: A Base pay is the fixed salary component of compensation B Bonus payment This is generally a quarterly, semi-annual, or annual cash 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 C Long-term compensation This consists of stock options and grants that are 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: A How much to pay for a particular job B The portion of the total compensation package should be in base salary and the portion should be incentive based C How to link incentive pay to performance D The portion of the incentive pay to be paid as a cash bonus and the portion to 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 80 Issue #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:  Fraction    Actual Performance  Incentive  Base     of Pay    =  Pay  Pay   at - Risk   Target Performance    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: Earnings for 2001 per share Closing stock price for 2001 Estimated earnings per share for 2002 $ 1.90 $25.50 $ 1.06 Price-earnings ratio: Closing stock price/earnings per share Estimated stock price for 2002: Price-earnings ratio × estimated earnings per share for 2002 81 13.42 $14.23 13-2A Given: Sales growth for years 1-3 10.0% Operating profit margin 16.0% Net working capital to sales ratio 13.0% Property, plant, and equipment to sales ratio 18.0% Beginning sales $ 27,272.73 Cash tax rate 30.0% Total liabilities $ Cost of capital 4,000.00 12.0% Number of shares 2,000.00 FREE CASH FLOWS: Years Sales Operating income (Earnings Before Interest and Taxes) Less cash tax payments $30,000.00 4,800.00 $33,000.00 5,280.00 $36,300.00 5,808.00 $36,300.00 5,808.00 (1,440.00) Net operating profits after taxes (NOPAT) $ 3,360.00 (1,584.00) $ 3,696.00 (1,742.40) $ 4,065.60 (1,742.40) $ 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 Free cash flow PV of FCF Present value of free cash flows: Planning horizon cash flows Terminal value in year 4: 33,880.00 PV of terminal value a) Firm value Invested capital (year 0) b) Market Value Added Debt Shareholder value ($30,730.94 – 4,000) No of shares c) Value per share $ (845.46) $ (930.00) $ (1,023.00) $ $ 2,514.54 $ 2,766.00 $ 3,042.60 $ 4,065.60 2,245.13 2,205.04 2,165.66 $24,115.11 $ 6,615.83 $ 24,115.11 $ 30,730.94 $ 9,818.18 $ 20,912.76 $ 4,000.00 $ 26,730.94 2,000.00 $ 13.37 82 - 13-3A Sales growth for years 1-3 Operating profit margin Net working capital to sales ratio Current assets to sales ratio Property, plant, and equipment to sales ratio Beginning sales Cash tax rate Total liabilities Cost of capital Number of shares 10.0% 16.0% 13.0% 18.0% 18.0% $27,272.73 30.0% $ 4,000.00 12.0% 2,000.00 Years Change in current assets Current assets Capital expenditures Property, plant and equipment Total Capital = Total Assets - Non-interest liabilities $ 4,909.09 4,909.09 $ 9,818.18 $ 354.55 $ 5,263.64 $ 490.91 $ 5,400.00 $10,663.64 $ 390.00 $ 5,653.64 $ 540.00 $ 5,940.00 $11,593.64 $ 429.00 $ 6,082.64 $ 594.00 $ 6,534.00 $12,616.64 $30,000.00 4,800.00 (1,440.00) $3,360.00 $(1,178.18) $33,000.00 5,280.00 (1,584.00) $ 3,696.00 $(1,279.64) and beyond $36,300.00 $ 36,300.00 5,808.00 $ 5,808.00 (1,742.40) (1,742.40) $ 4,065.60 $ 4,065.60 $ (1,391.24) $ (1,514.00) $2,181.82 $ 10,663.64 $2,416.36 $11,593.64 $ 2,674.36 $12,616.64 $ $ 6,082.64 $ $ 6,534.00 $12,616.64 a) Calculation of EVA: Years Sales Operating income Less cash tax payments Net operating profits after taxes (NOPAT) Less capital charge (Invested Capital x Kwacc) Economic Value Added Invested Capital b) Return on Invested Capital (NOPATt ÷ ICt-1) c) Market Value Added = PV(EVAs) Plus Invested Capital (year 0) Firm Value $ 9,818.18 34.22% 34.66% $ 2,551.60 $12,616.64 35.07% $20,640.89 9,818.18 $31,459.07 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 83 32.22% 13-4A Given: Base pay Incentive % Target EVA Performance $ 100,000.00 20.00% $ 20,000,000.00 a Unbounded incentive plan Actual EVA Performance Scenario A $ 15,000,000 Plant Manager Compensation Base pay Incentive pay Total compensation $ 100,000.00 15,000.00 $ 115,000.00 b Bounded incentive plan (80/120) Scenario A Actual EVA Performance $15,000,000 Plant Manager Compensation Base pay Incentive pay Total compensation $ $ 100,000.00 100,000.00 Scenario B $ 20,000,000 Scenario C $ 30,000,000 $ 100,000.00 20,000.00 $ 120,000.00 $ 100,000.00 30,000.00 $ 130,000.00 Scenario B $20,000,000 $ 100,000.00 20,000.00 $ 120,000.00 Scenario C $30,000,000 $ $ 100,000.00 24,000.00 124,000.00 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 A From the financial statements of RealNetworks over the 1996-98 period we can tell that it did not earn profit Indeed, it suffered increasing losses in every year, and in 1998, the firm lost over $20 million B The invested capital for RealNetworks at the end of 1998 should be the sum of the 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 84 C The EVA for year t is defined as following:  Net Operating   Weighted Average   ×  Invested  EVA t =  Profit After  −  Cost of Tax (NOPAT) t   Capital (k wacc )  Capital t −1      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: EVA1998 = (-20840) – (20% x 78,865) = -36,613 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: Earnings for 2001 per share Closing stock price for 2001 Estimated earnings per share for 2002 Price-earnings ratio: Estimated stock price for 2002: $ 0.87 $ 16.06 $ 1.09 Closing stock price/ earnings per share Price-earnings ratio × estimated earnings per share for 2000 85 18.46 $ 20.12 13-2B Given: 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 Cash tax rate 28% Total liabilities $ 6,000.00 Cost of capital 15.0% No of shares 4,000.00 FREE CASH FLOWS: Years Sales Operating income (Earnings Before Int & Taxes) Less cash tax payments $ 34,500.00 $ 37,950.00 5,865.00 6,451.50 $ 41,745.00 7,096.65 $ 41,745.00 7,096.65 (1,642.20) (1,806.42) (1,987.06) $ 4,222.80 $ 4,645.08 $ 5,109.59 $ 5,109.59 Investment in Net Working Capital (407.73) (448.50) (493.35) - Capital expenditures (CAPEX) (564.55) (621.00) (683.10) - Net operating profits after taxes (NOPAT) (1,987.06) Less investments: Total investments Free cash flow PV of FCF $ (972.28) $ (1,069.50) $ (1,176.45) $ $ 3,250.52 2,826.54 Present value of free cash flows: Planning horizon Terminal value In year 10: PV of terminal value a) Firm value Invested capital in year (0) b) Market Value Added c) Calculation of equity value Firm Value Less: Debt Equals: Shareholder value Number of shares Value per share $ 3,575.58 $ 3,933.14 $ 5,109.59 2,703.65 2,586.10 $ 22,397.59 $ 8,116.29 34,063.93 $ 22,397.59 $ 30,513.88 11,290.91 $ 19,222.97 $ 30,513.88 $ 6,000.00 $ 24,513.88 4,000.00 $ 6.13 86 - 13-3B Given: Sales growth for years 1-3 Operating profit margin Net working capital to sales ratio Current assets to sales ratio Property, plant and equipment to sales ratio Beginning sales Cash tax rate Total liabilities Cost of capital Number of shares 10.0% 17.0% 13.0% 18.0% 18.00% $ 31,363.64 28.00% $ 6,000.00 15.00% 4,000.00 Years Change in current assets Current assets Capital expenditures Property, plant and equipment Total Capital = Total Assets - Non-interest liabilities (Invested Capital) a) Calculation of EVA: $ 407.73 $ 5,645.45 $ 6,053.18 $ 564.55 5,645.45 $ 6,210.00 $ 11,290.90 $12,263.18 Years Sales Operating income Less cash tax payments Net operating profits after taxes (NOPAT) Less capital charge (Invested Capital x Kwacc) Economic Value Added b) Return on Invested Capital (NOPATt ÷ ICt-1) c) MVA and the present value of future EVAs Market Value Added = PV(EVAs) Plus Invested Capital (year 0) Firm Value $ 448.50 $ 493.35 $ 6,501.68 $ 6,995.03 $ 621.00 $ 683.10 $ 6,831.00 $ 7,514.10 $13,332.68 $14,509.13 $ $ 6,995.03 $ $ 7,514.10 $14,509.13 $34,500.00 5,865.00 (1,642.20) $ 4,222.80 $(1,693.64) $ 2,529.16 $37,950.00 6,451.50 (1,806.42) $ 4,645.08 $(1,839.48) $ 2,805.60 $41,745.00 7,096.65 (1,987.06) $ 5,109.59 $ (1,999.90) $ 3,109.69 & beyond $ 41,745.00 7,096.65 (1,987.06) $ 5,109.59 $(2,176.37) $ 2,933.22 37.40% 37.88% 38.32% 35.22% $ 19,996.52 11,290.90 $31,287.42 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 87 13-4B Given: Base pay Incentive % Target EVA Performance $ 150,000 30.00% $30,000,000 a Unbounded incentive plan Scenario A Actual EVA Performance $20,000,000 Division Manager Compensation Base pay $ 150,000.00 Incentive pay 30,000.00 Total compensation $ 180,000.00 b Bounded incentive plan (80/120) Scenario A Actual EVA Performance $20,000,000 Division Manager Compensation Base pay $ 150,000.00 Incentive pay Total compensation $ 150,000.00 Scenario B $30,000,000 Scenario C $40,000,000 $ 150,000.00 45,000.00 $ 195,000.00 $ 150,000.00 60,000.00 $ 210,00.00 Scenario B $30,000,000 Scenario C $40,000,000 $ 150,000.00 30,000.00 $ 180,000.00 $ 150,000.00 54,000.00 $ 204,000.00 This plan encourages employees to meet targets 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 88 ... 2,586.10 $ 22,397.59 $ 8,116.29 34,063.93 $ 22,397.59 $ 30, 513. 88 11,290.91 $ 19,222.97 $ 30, 513. 88 $ 6,000.00 $ 24, 513. 88 4,000.00 $ 6 .13 86 - 13- 3B Given: Sales growth for years 1-3 Operating profit... $ 3,042.60 $ 4,065.60 2,245 .13 2,205.04 2,165.66 $24,115.11 $ 6,615.83 $ 24,115.11 $ 30,730.94 $ 9,818.18 $ 20,912.76 $ 4,000.00 $ 26,730.94 2,000.00 $ 13. 37 82 - 13- 3A Sales growth for years... estimated earnings per share for 2002 81 13. 42 $14.23 13- 2A Given: Sales growth for years 1-3 10.0% Operating profit margin 16.0% Net working capital to sales ratio 13. 0% Property, plant, and equipment