Transcript Columbia Gas System

FI 8360 Spring 2003
Corporate Financial Strategy
Roger A. Morin, PhD
Distinguished Professor Finance,
College of Business, Georgia State University
Chairman & CEO Utility Research International
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FI 8360
Lecture #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 Value- Based Management Framework
Strategic
Financial
Value
Corporate
Governance
Figure 1. The Value- Based
Management Framework
Present Value
Future
Cash Flows
Present
Value
Cost of
Capital
Figure 2. Present Value
Economic Value
Cash flow and Risk
Future value corresponds
to future and uncertain
business cash flows, Ct.
So we discount expected
cash flows
n
Present Value = 
t=0
E(Ct)
------------(1 + k)t
Timing
Risk
Because business cash
flows occur over many
future periods, we locate
them in time, then
discount and add them all.
Because business cash
flows are risky, investors
demand a higher return:
the discount rate, k,
contains a risk premium.
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Asset Valuation
0
1
2
k
...
Value
PV =
n
CF1
CF1
(1+ k)
1
+
CF2
CF2
(1+ k)
2
+ ... +
CFn
CFn
(1+ k)
n
.
How Investors Value Securities
n
Bond Value =

t=1
Cash Flowt
(1 + k)t
n
Stock Value =

t=1
Dividendst ~ D1
(1 + k)t
k-g
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How Companies Value Capital
Projects
n
NPV =

t=1
Cash Flowt - Investment0
(1 + k)t
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Corporate Value
infinity
Value =

t=0
Cash Flowt
(1 + Cost of Capital)t
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Free cash flow is the basis of value!
Investors watch this pattern……
Trend
Time
….which is “cash in and cash out”
Free cash flow = NOPAT adjusted for depreciation and other accounting elements
Less net investment in working capital, fixed assets, capitalized R&D, etc.
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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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13
Company Value
Return
Growth
Cash
Flow
Company
Value
Capital
Risk
Cost of
Capital
Figure 3. Determinants of Value
Alternative Valuation Framework
V =
NOPAT
------------K
Where: NOPAT = Net Operating Profits After Tax
K = Cost of Capital
V = As Is Value
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Valuation Framework
V =
NOPAT
------------K
+
R - K
------------ * I * T
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
> WACC
Amount of Investment
Interval 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
CREATION
RETURN ON
EQUITY
SPREAD
COST OF
EQUITY
VALUE
GROWTH
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VALUE vs SPREADS & GROWTH
MARKET-TO-BOOK RATIO
MARKET-TO-BOOK RATIOS
6
SPREAD < -5%
SPREAD -5% to -2%
4
SPREAD -2% to +2%
SPREAD +2% to +5%
SPREAD > 5%
2
0
3.00%
4.50%
7.50%
10.50%
13.50%
15.00%
SALES GROWTH
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Shareholder Value Network
Corporate
Objective
Creating Shareholder
Value
Shareholder Return
• Dividends
• Capital Gains
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Shareholder Value Network
Corporate
Objective
Valuation
Components
Creating Shareholder
Value
Cash Flow From
Operations
Shareholder Return
• Dividends
• Capital Gains
Discount Rate
Debt
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Shareholder Value Network
Creating Shareholder
Value
Corporate
Objective
Valuation
Components
Value
Drivers
Shareholder Return
• Dividends
• Capital Gains
Cash Flow From
Operations
• Value
Growth
Duration
Discount Rate
• Sales Growth
• Operation Profit
Margin
• Income Tax Rate
Debt
• Working Capital
Investment
• Fixed Capital
Investment
• Cost of
Capital
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Shareholder Value Network
Creating Shareholder
Value
Corporate
Objective
Valuation
Components
Value
Drivers
Shareholder Return
• Dividends
• Capital Gains
Cash Flow From
Operations
• Value
Growth
Duration
Management
Decisions
Discount Rate
• Sales Growth
• Operation Profit
Margin
• Income Tax Rate
Operating
Debt
• Working Capital
Investment
• Fixed Capital
Investment
• Cost of
Capital
Investment
Financing
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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*)
NOPAT
Operating profits
x
-
capital
c* x capital
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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The Value- Based Management Framework
Strategic
Financial
Value
Corporate
Governance
Figure 1. The Value- Based
Management Framework
Strategic Determinants of Value Creation
Competitive Position
Financial
Determinants
Differentiation,
Cost Position
Spread
Value
Market Economics
Structural
Factors & Trends
Growth
Investment
Scale
Figure 6. Strategic Determinants of Value Creation
Improving Strategic Position Creates Value
High
Medium
Desired
Actual
Low
Weak
Average
Increasing Value Creation Potential
MARKET ATTRACTIVENESS
Increasing Value Creation Potential
Strong
COMPETITIVE POSITION
Figure 7. Market Attractiveness/ Competitive Position Matrix
Imporving Strategic Position Creates Value
A
High
Medium
Low
F
Weak
Increasing Value Creation Potential
INDUSTRY ROI SPREAD
Increasing Value Creation Potential
Average
Strong
COMPAN Y ROI SPREAD
(ROI - Cost of Ca pita l)
POSITIONS AND IMPLICATION S FOR CORPORATE STRATEGY
Excellent value creation potential
(high sustainable profits and growth)
Grow- and- build strategy
Danger of value dissipation
(low or negative ROI spreads)
Position and/ or strategy change needed
Good value creation potential
(keep ROI spread positive)
Selective growth
Value destruction likely
(negative ROI spreads)
Divest unless position can be improved
Fair to poor value creation potential
(depending on sustainable cash flows)
Emphasize cash flow and watch ROI spread
Figure 8. Stra tegy a nd Va lue Crea tion
Factors Shaping Industry Attractiveness
ENVIRONMENTAL FORCES
REGULATORY
ECONOMIC
INDUSTRY FORCES
Threat of
Substitutes
Supplier
Power
Competitive
Riva lry
Customer
Power
Threat of
Entry
GLOBAL
SOCIAL
TECHN OLOGICAL
Figure 9. Porter's Industry Ana lysis Fra mework
Value Chain or Business System
Support Activities
em
en
OUTPUTS
t
ce
vi
Se
r
ar
Sa ke
le ti n
s g/
M
Lo O u
gi tp
st ut
ic
s
tio
ra
pe
ut ics
p
t
I n gi s
Lo
ns
Margin
O
INPUTS
Re Hu
so m
ur a n
ce
s
al
e r i n.
en
G Adm
ur
oc
Pr
D Tec
ev h
e l no
op l o
m gy
en
t
Primary Activities
Figure 10. The Basic Value Chain
Flexibility to Exercise Growth Options
Threat of pre-emption; the market
power of dominant firms increases
their ability to obtain full value of
the options exercised.
Minimal
Competitive
Rivalry
Dominant firms can benefit fully from
the value of the option.
No risk of pre-emption; options are
held until maturity.
Tendency to delay option exercise
until the weaker players exercise
them.
Proprietary
Options
Shared
Options
Little ability to benefit from the full
value of an investment opportunity.
No threat of total pre-emption; but
risk of loss of value of the option
because of competition.
Quick exercise of options in order
to surpass a competitor or for
defensive reasons.
Intense
Competitive
Rivalry
Tendency to exercise the option early
in order to avoid eroding the value
of the option.
Figure 11. Stra tegy a nd Option Va lue
Strategic Determinants of Value
ENVIRONMENTAL
OPTION VALUE
Increasing Value Creation
Potential
FORCES
Desired
Actual
Minimal
Competitive Rivalry
Increasing Value Creation
Potential
MARKET ATTRACTIVENESS
INDUSTRY
Shared
Options
Intense
Competitive Rivalry
COMPETITIVE POSITION
FORCES
Support Activities
INPUTS
Margin
OUTPUTS
Primary Activities
Figure 12. Strategy Module of VBM Framework
Proprietary
Options
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
Corporate
Objective
VALUE
Valuation
Components
Value
Drivers
Value
Growth
Duration
Management
Strategies
Cash Flows
Discount Rate
• Sales Growth
• Profit Margin
• Tax Rate
• Working Capital
• Fixed Capital
Operating
Investment
Cost of
Capital
Financing
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From Macro to Micro Drivers
Value
Strategic
Value Drivers
Return
Risk
Financial
Value Drivers
Operational
Value Drivers
Sales growth
Working Capital
Tax rate
Profit Margin
Fixed Assets
Cost of Capital
Unit sales volume
Prices
Product mix
Labour rate
Overhead
Productivity
Work schedules
Downtime
Selling terms
Vendor terms
Purchasing policies
Payment procedures
Sourcing strategies
Capital budgeting
Innovation tactics
Location decisions
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From Macro to Micro Drivers
Value
Strategic
Value Drivers
Risk
Financial
Value Drivers
Operational
Value Drivers
Return
Sales growth
Working Capital
Tax rate
Profit Margin
Fixed Assets
Cost of Capital
Production costs per kWh
Non-production costs per kWh
Load factor
Fuel mix in MWh
Growth in total MWh sales
Average prices
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From Macro to Micro Drivers
Value
Strategic
Value Drivers
Risk
Financial
Value Drivers
Operational
Value Drivers
Return
Sales growth
Working Capital
Tax rate
Profit Margin
Fixed Assets
Cost of Capital
Operating cost per customer
Operating cost per units distributed
Electricity/gas distributed per employee
Distribution operating profit per customer
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The Value- Based Management Framework
Strategic
Financial
Value
Corporate
Governance
Figure 1. The Value- Based
Management Framework
Return
Return
Financial Determinants
% Debt/ Equity
Risk
Figure 13. Financial Determinants of Value
Financial Drivers
 Optimal
Capital Structure
 Capital Allocation Based on Value
 Financial Engineering
 Minimize Tax Rate
 Dividend Policy
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The Value- Based Management Framework
Strategic
Financial
Value
Corporate
Governance
Figure 1. The Value- Based
Management Framework
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 value48
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 Framework: Putting It All Together
Strategic
EN VI RO NM EN TAL
O PTIO N VALUE
Increa sing Va lue Creation
Potentia l
FO RCES
Desi red
Actual
M inima l
Competitive Rivalry
Increa sing Value Crea tion
Potentia l
MARKET ATTRACTIVEN ESS
I NDUSTRY
Sha red
O ptions
Proprietary
O ptions
I ntense
Competitive Riva lry
CO M PETI TI VE PO SI TIO N
FO RCES
Support Activities
INPUTS
M a rgin
OUTPU TS
Prima ry Activiti es
Value
Return
Financial
Return
Return
Growth
Company
Value
Capital
Risk
% Debt/ Equity
Cash
Flow
Cost of
Capital
Risk
Corporate Governance
Performance
Compensation
Investor Relations
Figure 14. VBM Framework: Putting It All Together
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
 HQ
engineering
costs
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Restructuring Pentagon
Current Market
Value
1
Company
Value As Is
Current
Perceptions
Gap
Maximum
Raider
Opportunity
2
5
Strategic and
Operating
Opportunities
3
Potential Value
with Internal
Improvements
Optimal
Restructured
Value
Total Company
Opportunities
Disposal /
Acquisition
Opportunities
4
Potential Value
with External
Improvements
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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 valuecreation potential of each SBU
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$500
Shareholder
Value
$2,000
Merger
Savings
$445
Investments
$1,500
Margin
Initiatives
$1,000
Growth
Strategies
Baseline
Value
Millions of Dollars
Value Planning
$1,883
($43)
$438
$543
$500
$0
Expected Value Creation
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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

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








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 Companies
Common 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 8360
Lecture #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
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