Value Enhancement

In a discounted cashflow valuation, the value of a firm is the function of four key inputs - the cashflows from existing investments, the expected growth rate in these cashflows for the high growth period, the length of time before the company becomes a obtained by multiplying the pre-tax cost of borrowing (5.5%) by the present value of the operating leases (6.7 m))

34 Silber did this in a 1989 study, where he found that the discount tended to be larger for companies with smaller revenues and negative earnings.

35 See Investment Valuation (John Wiley and Sons) for more details.

stable growth company and the cost of capital. Put simply, to enhance the value of a firm, we have to change one or more of these inputs:

a. Increase cashflows from existing assets: There are a number of ways in which we can increase cashflows from assets. First, we can use assets more efficiently, cutting costs and improving productivity. If we succeed, we should see higher operating margins and profits. Second, we can, within the bounds of the law, reduce the taxes we pay on operating income through good tax planning. Third, we can reduce maintenance capital expenditures and investments in working capital - inventory and accounts receivable - thus increasing the cash left over after these outflows.

b. Increase the growth rate during the high growth period: Within the structure that we used in the last section, there are only two ways of increasing growth. We can reinvest more in internal investments and acquisitions or we can try to earn higher returns on the capital that we invest in new investments. To the extent that we can do both, we can increase the expected growth rate. One point to keep in mind, though, is that increasing the reinvestment rate will almost always increase the growth rate but it will not increase value, if the return on capital on new investments lags the cost of capital.

c. Increase the length of the high growth period: It is not growth per se that creates value but excess returns. Since excess returns and the capacity to continue earning them comes from the competitive advantages possessed by a firm, a firm has to either create new competitive advantages - brand name, economies of scale and legal restrictions on competition all come to mind - or augment existing ones.

d. Reduce the cost of capital: In chapter 8, we considered how changing the mix of debt and equity may reduce the cost of capital, and in chapter 9, we considered how matching your debt to your assets can reduce your default risk and reduce your overall cost of financing. Holding all else constant, reducing the cost of capital will increase firm value.

Which one of these four approaches you choose will depend upon where the firm you are analyzing or advising is in its growth cycle. For large mature firms, with little or no growth potential, it is cashflows from existing assets and the cost of capital that offer the most promise for value enhancement. For smaller, risky, high growth firms, it is likely to be changing the growth rate and the growth period that generate the biggest increases in value.

Illustration 12.13: Value Enhancement at Disney

In illustration 12.11, we valued Disney at $11.14 a share. In the process, though, we assumed that there would be no significant improvement in the return on capital that Disney earns on its existing assets, which at 4.42% is well below the cost of capital of 8.59%. To examine how much the value per share could be enhanced at Disney if it were run differently, we made the following changes:

- We assumed that the current after-tax operating income would increase to $3,417 million, which would be 8.59% of the book value of capital. This, in effect, would ensure that existing investments do not destroy value.

- We also assumed that the return on capital on new investments would increase to 15% from the 12% used in the status quo valuation. This is closer to the return that Disney used to make prior to its acquisition of Capital Cities. We kept the reinvestment rate unchanged at 53.18%. The resulting growth rate in operating income (for the first 5 years) is 7.98% a year.

- We assumed that the firm would increase its debt ratio immediately to 30%, which is its current optimal debt ratio (from chapter 8). As a result the cost of capital will drop to 8.40%.

Keeping the assumptions about stable growth unchanged, we estimate significantly higher cashflows for the firm for the high growth period in table 12.6.

Table 12.6: Expected Free Cashflows to the Firm- Disney


Expected Growth

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