FI 8360 Spring 2003 Corporate Financial Strategy

1. FI 8360 Spring 2003Corporate Financial Strategy Roger A. Morin, PhD Distinguished Professor Finance, College of Business, Georgia State University Chairman & CEO Utility Research International

2. FI 8360Lecture #1 Roadmap • Course overview & organization • Valuation and the “Value Movement” • Lecture #2 preview

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

6. Economic Value Cash flow and Risk Future value corresponds to future and uncertain business cash flows, Ct. So we discount expected cash flows n E(Ct) Present Value = ------------- t=0 (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.

7. 0 1 2 n Value CF1 CF2 CFn Asset Valuation k ... CF CF CF 1 2 n + + + PV = . . . . ( ) ( ) ( ) 1 2 n 1 + k 1 + k 1 + k

8. 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

9. How Companies Value Capital Projects n NPV =Cash Flowt - Investment0 t=1 (1 + k)t

10. Corporate Value infinity Value = Cash Flowt t=0 (1 + Cost of Capital)t

11. 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.

12. Shareholder value analysis focuses on the factors that investor use to value companies: • Cash Flows • Long-Term Expected Performance • Risk

15. Alternative Valuation Framework NOPAT V = ------------- K Where: NOPAT = Net Operating Profits After Tax K = Cost of Capital V = As Is Value

16. 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

17. 3 Factors in Value Creation • ROI > WACC • Amount of Investment • Interval of Competitive Advantage Note: • Forward-looking • Expected cash flows

18. Fundamental Principle of Valuation CORPORATE RETURN MARKET VALUE = --------------------------------------------------- INVESTORS’ REQUIRED RETURN MARKET VALUE RETURN ON TOTAL CAPITAL -------------------------------- = ------------------------------------------- CAPITAL EMPLOYED COST OF CAPITAL

19. 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

20. Value Creation

21. VALUE vs SPREADS & GROWTH MARKET-TO-BOOK RATIOS 6 SPREAD < -5% SPREAD -5% to -2% 4 SPREAD -2% to +2% MARKET-TO-BOOK RATIO SPREAD +2% to +5% SPREAD > 5% 2 0 3.00% 4.50% 7.50% 10.50% 13.50% 15.00% SALES GROWTH

22. Shareholder Value Network • Shareholder Return • Dividends • Capital Gains Creating Shareholder Value Corporate Objective

23. Shareholder Value Network • Shareholder Return • Dividends • Capital Gains Creating Shareholder Value Corporate Objective Valuation Components Cash Flow From Operations Discount Rate Debt

24. Shareholder Value Network • Shareholder Return • Dividends • Capital Gains Creating Shareholder Value Corporate Objective Valuation Components Cash Flow From Operations Discount Rate Debt Value Drivers • Value Growth Duration • Sales Growth • Operation Profit Margin • Income Tax Rate • Working Capital Investment • Fixed Capital Investment • Cost of Capital

25. Shareholder Value Network • Shareholder Return • Dividends • Capital Gains Creating Shareholder Value Corporate Objective Valuation Components Cash Flow From Operations Discount Rate Debt Value Drivers • Value Growth Duration • Sales Growth • Operation Profit Margin • Income Tax Rate • Working Capital Investment • Fixed Capital Investment • Cost of Capital Management Decisions Operating Investment Financing

26. 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

27. 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

28. 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

37. Strategic Drivers • Optimal Cost Structure • Competitive Advantage • Asset Utilization • Protect Strategic Resources • Reduce Risk • Value Based Management

38. Value Drivers and Strategy Corporate Objective VALUE Valuation Components Cash Flows Discount Rate Value Drivers Value Growth Duration • Sales Growth • Profit Margin • Tax Rate Cost of Capital • Working Capital • Fixed Capital Management Strategies Operating Investment Financing

39. From Macro to Micro Drivers Strategic Value Drivers Value Return Risk Financial Value Drivers Sales growth Working Capital Tax rate Profit Margin Fixed Assets Cost of Capital Operational Value Drivers Unit sales volume Selling terms Prices Vendor terms Product mix Purchasing policies Labour rate Payment procedures Overhead Sourcing strategies Productivity Capital budgeting Work schedules Innovation tactics Downtime Location decisions

40. From Macro to Micro Drivers Strategic Value Drivers Value Return Risk Financial Value Drivers Sales growth Working Capital Tax rate Profit Margin Fixed Assets Cost of Capital Operational Value Drivers Production costs per kWh Non-production costs per kWh Load factor Fuel mix in MWh Growth in total MWh sales Average prices

41. From Macro to Micro Drivers Strategic Value Drivers Value Return Risk Financial Value Drivers Sales growth Working Capital Tax rate Profit Margin Fixed Assets Cost of Capital Operational Value Drivers Operating cost per customer Operating cost per units distributed Electricity/gas distributed per employee Distribution operating profit per customer

44. Financial Drivers • Optimal Capital Structure • Capital Allocation Based on Value • Financial Engineering • Minimize Tax Rate • Dividend Policy

46. Corporate Drivers • Governance • Performance Evaluation • Incentive Compensation

47. VBM • Are accounting metrics consistent with value creation?

48. 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

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

50. 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