466 CHAPTER 12 Corporate Valuation, Value-Based Management, and Corporate Governance
The terminal, or horizon, value, is the value of operations at the end of the ex-
plicit forecast period. It is also called the continuingvalue, and 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: The corporate valuation model can be used to calculate the total value of a com-
pany by finding the value of operations plus the value of nonoperating assets.
The value of equity is the total value of the company minus the value of the debt
and preferred stock. The price per share is the total value of the equity divided by
the number of shares.
Value-based management involves the systematic use of the corporate valuation
model to evaluate a company’s potential decisions.
The four value drivers are (1) the growth rate in sales (g), (2) operating profitabil-
ity (OP), which is measured by the ratio of NOPAT to sales, (3) capital require-
ments (CR) as measured by the ratio of operating capital to sales, and (4) the
weighted average cost of capital (WACC).
Expected return on invested capital (EROIC) is equal to expected NOPAT di-
vided by the amount of capital that is available at the beginning of the year.
A company creates value when the spread between expected ROIC and WACC is
positive, i.e., when EROIC WACC 0.
Corporate governance involves the manner in which shareholders’ objectives are
implemented, and it is reflected in a company’s policies and actions.
The two primary mechanisms used in corporate governance are: (1) the threat of
removal of a poorly performing CEO and (2) the type of plan used to compensate
executives and managers.
Poorly performing managers can be removed either by a takeover or by the com-
pany’s own board of directors. Provisions in the corporate charter affect the diffi-
culty of a successful takeover, and the composition of the board of directors affects
the likelihood of a manager being removed by the board.
Managerial entrenchment is most likely when a company has a weak board of di-
rectors coupled with strong anti-takeover provisions in its corporate charter. In this
situation, the likelihood that badly performing senior managers will be fired is low.
Nonpecuniary benefits are noncash perks such as lavish offices, memberships at
country clubs, corporate jets, foreign junkets, and the like. Some of these expendi-
tures may be cost effective, but others are wasteful and simply reduce profits. Such
fat is almost always cut after a hostile takeover.
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 re-
turn, the potential acquiror agrees not to attempt to take over the company.
Shareholder rights provisions, also known as poison pills, allow existing share-
holders to purchase additional shares of stock at a lower than market value if a po-
tential acquiror purchases a controlling stake in the company.
A restricted voting rights provision automatically deprives a shareholder of vot-
ing rights if the shareholder owns more than a specified amount of stock.
Interlocking boards of directors occur when the CEO of Company A sits on the
board of Company B, and B’s CEO sits on A’s board.
A stock option provides for the purchase of a share of stock at a fixed price, called
the exercise price, no matter what the actual price of the stock is. Stock options
have an expiration date, after which they cannot be exercised.Continuing valueVop(at time N)FCFN 1
WACCgFCFN (1g)
WACCg.