CASE STUDY

Corbridge Industries, Inc.

In 2016, Corbridge Industries, Inc. (Corbridge) was ramifications. We are changing the basic decision
starting a process that could lead to major changes in rules by which we evaluate our plans and our
its planning and measurement systems. Chantal accomplishments. We have become convinced
Coombs, vice president of planning, explained: that for Corbridge, at least, the traditional
accounting measures such as net earnings or
The basic thrust of what we are starting to do is
return on net assets, are neither good criteria on
very simple, although it has potentially major
 which to base decisions, nor reliable indicators of divided into 70 product departments, each with
performance. profit-center responsibility.
The primary objective of our company is to In 2016, the compensation of a typical manager was
create value for our shareholders. We believe that expected to be approximately 60% salary and 40%
stock values, like the values of all economic performance incentives. The performance incentives
resources, depend on investors’ expectations of were based 75% on operating income less a capital
future cash flows, discounted for time and risk. change (i.e. residual income), and 25% on the accom-
Consequently, we think that in evaluating possi- plishment of specific KPI (key performance indicator)
ble actions, it is more important to focus on the targets.
possible impacts of our decisions on future cash Corbridge was a growth-oriented company with rel-
flows and risk, rather than estimating the impact atively young management. Most general managers
on the accounting indicators. In addition, we think had an engineering education and either technical or
that it makes sense to judge our performance marketing experience, or both. The average age of the
based on what we accomplish for our sharehold- division managers was approximately 41. Tom
ers—meaning the amount of value we generate McDowell, the chair of the board, was only 51. Top
for them. management was interested in maintaining at least
moderate levels of overall internal growth and in
acquiring companies with operations that comple-
The company
mented Corbridge’s portfolio.
Corbridge was a midsize but diversified company with
$2.2 billion in annual sales of specialized, business-to-
business supplies to some large manufacturers mainly
Planning processes
in the midwestern United States. The company had Planning at Corbridge was intended to be a bottom-
experienced robust growth in both revenues and earn- up process. The strategic planning process started in
ings over the years (see Exhibit 1). March with headquarters sending general planning
Corbridge was organized into four business guidelines to the business units. These guidelines
groups: Semiconductor, Electrical Products, Indus- included an economic forecast and some preliminary
trial Products, and Custom Products. The Semicon- estimates of the resources the company would make
ductor Group (SG) (2015 sales of $561 million, four available to each business unit. The department
divisions) designed, manufactured, and marketed a managers (and lower-level managers where appro-
broad line of semiconductor components, including priate) were expected to propose their own goals and
electronic sensors (e.g. photodiodes), memor y strategies. They were asked to prepare three-year
devices, microprocessors, and transmission devices plans with the emphasis on market analysis and
(e.g. fiber optics, speech synthesis chips). The Electri- identification of strategic alternatives. Quantitative
cal Products Group (EPG) ($507 million, five divi- data (including financial) were required in only
sions) produced assorted components or various summary form.
subcomponents for generators and motors, circuit These plans were then reviewed at successively
breakers and electrical connectors. The Industrial higher organizational levels. The Corporate Manage-
Products Group (IPG) ($774 million, six divisions) ment Committee (CMC) reviewed the plans and evalu-
sold a wide range of components including custom ated the total portfolio of businesses early in September.
engineered ball, roller, and slider bearings, precision The CMC rarely made material changes to the strategic
engine parts, mechanical seals, industrial laminates, plans at this time: changes were usually made only if
and some other nonwoven materials. The Custom the resource position changed or if an acquisition or
Products Group (CPG) ($310 million, four divisions) divestment was imminent.
designed, manufactured, and distributed products After CMC approval of the strategic plan, the depart-
that used in-house technologies for small-order, ment managers prepared detailed operating plans
sometimes one-off specialized components for the (budgets) for the next year. The operating plans
military and space technology sectors among others. included targets for sales growth, profit margins, and
A financial comparison of these groups is presented in operating earnings and were intended to be consistent
Exhibit 2. The groups’ 19 divisions were, in turn, with the strategic plans. The operating plans were also
reviewed at successively increasing organizational lev- averaged about 8% returns in this time period. And
els, usually with only minor modifications being made. although we increased our dividends as earnings
increased, this never provided shareholders with a
return greater than 4%.
The shareholder value model In 2013, the merger and acquisition people in our
In the early 2010s, corporate staff began experiment- corporate planning department were involved in a
ing with a model called V-Plan as an aid in evaluating lot of value analyses. We were using pretty sophis-
strategic plans. V-Plan was developed by a manage- ticated models which helped us analyze the deter-
ment consulting firm, with the help of some leading minants of value – cash flow potentials and risk –
academics in the fields of finance, accounting, and under various business and economic assump-
business planning. tions, so that we could put a value on business seg-
At the heart of V-Plan was a discounted cash flow ments we were considering buying or selling. In our
(DCF) model, which, with the input of estimates of planning meetings, my group saw the need for the
future cash flows and factors for discounting time and same types of analyses. One choice our manage-
risk, could be used to place a value on any business ment was often faced with was whether to acquire
entity at any point in time. For strategic planning pur- an existing business or to build one by allocating
poses, V-Plan could be used to value an entity given the resources to one of our existing business units.
assumptions behind any of a number of different strate- Thus, it was natural that we began to use cash
gic alternatives. A particular strategy was considered flow-based value models in our planning analyses.
to generate a positive value for shareholders only if it
increased the business entity’s cash flows in a manner Corbridge first applied the shareholder value models
sufficient to more than offset new investments that to the plans submitted during the 2014 planning pro-
might be required. Cash flows (and value) might be cess. The operating managers were not involved in the
generated by, for example, increasing the volume of actual use of the models; corporate staff just took the
sales, increasing the contribution generated by each numbers in the plans and plugged them into the mod-
incremental sale, or reducing the amount of invest- els. The purpose of this exercise was not to use the out-
ment tied up in working capital as compared to the lev- put in decision-making, but just to get some familiarity
els in the base period. In concept, V-Plan was identical with the problems that might arise when the models
to capital-investment-analysis models based on the net were used to compare internal business units.
present value (NPV) method. But with V-Plan, all cash In the first year, the corporate planning staff used
outlays that were required to implement a strategy the model’s cash flow-based estimates of changes in
were considered, not just capital investments, which intrinsic shareholder value at the corporate level and
typically composed only a small fraction of the total. compared them with Corbridge’s actual changes in
market value over the period 2009–13 and the year
2014. The model’s estimates were quite accurate. They
History of use of the shareholder showed that the corporation’s net cash returns during
value model the 2009–13 period were actually not sufficient to
increase shareholder value, but that the plans for 2014,
Prasad Vepa, director of corporate planning, described
if they were achieved, would do so. And, indeed, at the
how Corbridge came to incorporate V-Plan in its plan-
end of 2014, when the plans had been achieved, the
ning processes:
total Corbridge market value had risen to over
By all the traditional accounting measures, our per- $750 million, up from the $550 million level where it
formance over the last two decades was excellent. had been for virtually the entire prior decade.
Take any measure you want – sales growth, earn- At this time, top-level Corbridge managers indicated
ings growth, return on equity, return on assets, and that they were very comfortable with these findings.
earnings per employee – they all indicate we had Tom McDowell (chairman) stated that the value con-
done very well. Our shareholders, however, hadn’t cept supported intuitive feelings he had had.
really derived any benefit from this success. In Later in the year, V-Plan was given a real credibility
2013, our market value was essentially where it was boost. At year-end 2014, Corbridge stock was selling at
in 2004, even though stocks in the S&P 500 had about $32 per share, and at midyear 2015 it was around
$40. In June 2015, Rick Aubrey, an analyst in the Cor- Now, suppose a manager identifies a strategy
porate Planning Department, used V-Plan to analyze which requires an investment of $5 million in mar-
Corbridge’s financial performance and concluded that keting expenses in each of the next three years
despite continuing improvement in the accounting (2016–18) but which promises five percent real
numbers, company performance did not justify the growth in 2017 and 2018. The projected income
higher stock price. Rick estimated that by year-end the statements for this alternative (Strategy 2) are
stock price would be around $31 per share if the com- shown in Schedule 2.
pany maintained its current strategy and performance The implication should be clear. With a projected
came in as projected. This estimate was shown to the decline in earnings in 2016, this strategy will prob-
high-level corporate managers, but they did not choose ably suffer an early death. The division manager will
to alter company strategies at that time. be reluctant to propose it because top manage-
At year-end, with everything going according to ment is not likely to look at it enthusiastically and,
plan, Corbridge stock was selling at $30. Rick observed: furthermore, if the strategy were implemented it
would adversely affect his bonus.
You can’t depend on the model showing that kind
From the shareholder’s standpoint, however, this
of accuracy consistently. We have to make a num-
is a good plan. The cash flow and shareholder value
ber of assumptions and approximations; nobody
numbers are shown in Schedule 3. As per our stand-
really knows how the stock market will respond at
ard conservative procedure, I’ve assumed the oper-
any given time; and the market does not have
ating cash flows will remain constant at the 2018
access to the confidential information I used in my
level in perpetuity. But even so, the value numbers
analysis. But the theory behind the model is cor-
make it obvious that our shareholders would want
rect; the intrinsic value of our company should
us to invest in this plan. An analysis would show
depend on the size, pattern, and uncertainty sur-
that the internal rate of return is over 30 percent.
rounding the cash flows we expect to be able to
The accounting biases can also operate in the
generate in the future.
opposite direction—that is, a decision that prom-
The success of this forecast was very important.
ises excellent profits can be bad for the sharehold-
It gave the model credibility. Everybody is used to
ers. Here is such an example [shown as Strategy 3
thinking in terms of sales and earnings growth, and
in Exhibit 4].
we have always used those numbers to plan with,
I’ve taken the same base case (Schedule 1) and
even though they are not very good numbers on
this time assumed that a manager has identified an
which to base our decisions or to judge our success.
investment of $25 million in capital equipment and
working capital that would increase the operating
V-Plan and strategic planning margin from 20 to 22 percent. This provides an
improved profit picture (Schedule 2), but this is actu-
Rick went on to describe how the model could be used
ally a bad investment that yields less than the
to support Corbridge’s planning efforts:
18 percent cost of capital that I’ve assumed. The net
Let me show you some examples of why I think we effect is to reduce the value of the earning assets in
should use V-Plan in our planning processes. Here this business unit by almost $5 million (Schedule 3).
is a situation where operating managers might be These are very simple examples, of course, but I
discouraged from investing in, or even proposing, can assure you that these patterns occur in some
good strategies because of their adverse impact of the plans submitted by our operating units. Let
on accounting earnings [Exhibit 3]. Schedule 1 me show you one example. During the 2015 plan-
shows pro-forma income statements for a three- ning process, one of our divisions proposed a
year period in which I’ve assumed no real growth strategy which showed sharp increases in both
but 10 percent inflation, which I know is unrealistic sales and earnings [Exhibit 5]. From these num-
in the current day and age, but bear with me—this bers, it is easy to conclude that this is a pretty
is just to make my point and for ease of computa- decent plan. In truth, however, it is not.
tion and dramatic effect. I’ve called this Strategy 1; Using V-Plan, I calculated that the pre-strategy
it can be considered a base case or a maintenance value of this division (net of liabilities) is approxi-
strategy. mately $500,000. But if this strategy is implemented,
 I figure that the value of this division would actually The future of the shareholder
be a negative $1.2 million [Exhibit 6]. This is true value model
because the strategy requires a considerable up-
front investment for items which do not show up in Corbridge planned to work with and to refine the share-
the income statement for some time. I conclude that holder value model and eventually to spread its use
implementing this strategy would cause a decrease throughout the organization. Tom McDowell (chair-
of $1.7 million in the intrinsic value of this division man) promised to use V-Plan and related models “more
and the value of Corbridge stock. And if anything, intensively and extensively.”
my calculation may be optimistic because for this A number of important issues remained to be solved,
business segment it would be easy to justify using a however. One issue was the planning horizon. In mak-
risk-adjusted discount rate greater than the 18 per- ing the value calculations, all cash flows, no matter
cent that I used in making these calculations. The how far into the future, had to be considered, but the
18 percent is the overall corporate weighted-aver- Corbridge operating plans only included three years of
age cost of capital, and this particular business unit data. To work around this limitation, the planning staff
is probably one of the riskiest businesses in our had been making the assumption that the operating
portfolio. cash flows in the last year of the plan would remain
I think we should seriously consider selling this constant in perpetuity, in the absence of information to
business, assuming someone would be willing to the contrary. While the most immediate cash flows had
pay something close to the $500,000 that it is worth the largest value impact because of discounting, this
right now. We certainly should not be investing the assumption was subject to obvious criticisms, particu-
money proposed in this plan. The increased sales larly for those divisions with products with relatively
and earnings picture is misleading; this plan will short product life cycles. Thus, to improve the accuracy
actually be very costly to our shareholders. of V-Plan’s calculations, one possibility that had to be
Let me make one qualification, however. I am not considered was an extension of the planning horizon,
suggesting that impact on shareholder value should from three years to five, or perhaps even longer.
be the only criterion we should look at when we make A second issue was whether the plans should reflect a
our strategic resource allocation decision. What I am single point estimate of future results or whether they
suggesting is that impact on shareholder value should reflect a range of possible outcomes and an
should be an important financially-oriented criterion assessment of the likelihood of each. V-Plan’s value cal-
and that it is far superior to looking at projections culations were intended to reflect the expected value of
expressed in traditional accounting terms. the future cash flows, and the model could easily accom-
modate probabilistic cash flow estimates. However, sev-
eral senior managers thought that single-point estimates
Change in statement of objectives were necessary for control purposes, so that managers
At the end of 2015, the wording of Corbridge’s pri- could be held responsible for achieving a specific plan.
mary statement of objectives was changed to read as Risk presented another problem. Corbridge’s early
follows: uses of the model used the same discount factor – the
corporate average cost of capital – in all analyses. If
The primary objective of Corbridge Industries is to
Corbridge had been highly vertically integrated and in
increase shareholder value. This will be accom-
a single market, this might have been acceptable, but
plished by focusing on markets where the Com-
the corporate planning staff felt that the various busi-
pany has or can capture a major share, by
ness units faced quite different levels of risk. Quantify-
developing a higher-than-average flow of success-
ing the amounts of risk faced in order to reflect them in
ful new products, and by continuing to emphasize
the discount rates used in the value calculations was
productivity of Company personnel and assets.
not straightforward, however, and more thought would
Formerly, the primary objective had been “to grow have to be given to this issue before use of the model
and to improve profitability.” This change in the word- was made more widespread.
ing of the statement of company objectives was not A fourth issue was the speed of implementation, mean-
brought about by the V-Plan directly, but it was moti- ing how fast to involve managers at each organization
vated by the same logic that the model used. level in the use of the model. Because they were convinced
of its worth, top management was inclined to use the Finally, if impact on shareholder value became an
impact-on-shareholder-value criterion for evaluating important criterion in strategic decision-making,
plans immediately. This might, however, cause frustra- another issue would arise; that is, whether or not to
tion and conflict if the lower-level managers did not link a value-related performance criterion – impact on
understand the bases on which the decisions were being shareholder value – to the management reward system.
made. All managers were familiar with the NPV concept To reinforce the shareholder value concept, some por-
because they were required to use it in preparing their tion of management compensation could be made con-
capital investment proposals, but it was not clear whether tingent on value increases – either of the corporation as
they could easily transfer their knowledge of this basic a whole or of specific business units. The question was:
concept to the preparation of entire operating plans. should this be done, and if so, how soon?

Exhibit 1 Corbridge financial results 2004–2015 ($ million)

2015 2014 2013 2012 2011 2010 2009 2008 2007 2006

Net sales 2,152 1,841 1,577 1,334 1,139 1,025 883 762 647 533

Net earnings 110 96 84 71 61 50 44 38 33 28

Capital expenditures 98 86 57 59 59 35 40 45 36 19

Market value (ave.) 755 769 544 526 551 619 581 563 625 662

Ratios (%)

Increase in sales 16.9 16.7 18.2 17.1 11.1 16.1 15.8 17.8 213 16.5

Increase in net earn. 14.6 14.2 18.3 16.4 21.9 13.6 15.8 15.2 17.8 21.7

Net earn. as % of sales 5.1 5.2 5.3 5.3 5.3 4.9 5.0 4.9 5.1 5.3

Dividends as % of net earn. 29.7 27.4 25.7 26.2 24.1 20.7 19.2 21.8 22.5 24.9

Ret. on ave. shareholder 15% 14.6% 14.6% 13.5% 12.9% 12.0% 12.2% 11.9% 11.6% 11.1%
equity

Exhibit 2 Financial comparison of major business groups

2015 2014 % Change

Semiconductor
Net sales $561 $428 31.1
Net earnings 6 5 20.0

Electrical Products
Net sales $507 $469 8.1
Net earnings 28 27 3.7

Industrial Products
Net sales $774 $701 10.4
Net earnings 63 56 12.5

Custom Products
Net sales $310 $243 27.6
Net earnings 13 8 62.5

Corbridge Total
Net sales $2,152 $1,841 16.9
Net earnings 110 96 14.6
Exhibit 3 Example showing discouragement of a good investment ($ million)

Schedule 1: Projected Income Statements, Division A, Strategy 1 (Base Case)

Forecast

Actual 2015 2016 2017 2018

Sales $200 $220 $242 $266

Variable operating expenses 160 176 194 213

Depreciation 10 11 11 12

Discretionary expenses 20 22 24 27

Total expenses 190 209 229 252

Profit before tax 10 11 13 15

Income tax (40%) 4 4 5 6

Profit after tax $6 $7 $8 $9

Schedule 2: Projected Income Statements, Division A, Strategy 2 (Real Growth)

Forecast

Actual 2015 2016 2017 2018

Sales $200 $220 $253 $291

Variable operating expenses 160 176 202 233

Depreciation 10 11 11 12

Discretionary expenses 20 27 29 32

Total expenses 190 214 243 276

Profit before tax 10 6 10 15

Income tax (40%) 4 2 4 6

Profit after tax $6 $4 $6 $9

Schedule 3: Value Calculations

Annual Cash Flows 2016 2017 2018 2019 and beyond

Strategy 1 $18 $19 $21 $21

Strategy 2 15 17 21 24

Value of Division A on December 31, 2015 at 18% (ignoring liabilities)

Schedule 1: Projected Income Statements, Division A, Strategy 1 (Base Case)

Forecast

Actual 2015 2016 2017 2018

Sales $200 $220 $242 $266

Variable operating expenses 160 176 194 213

Depreciation 10 11 11 12

Discretionary expenses 20 22 24 27

Total expenses 190 209 229 252

Profit before tax 10 11 13 15

Income tax (40%) 4 4 5 6

Profit after tax $6 $7 $8 $9

Schedule 2: Projected Income Statements, Division A, Strategy 3 (Improve Operating Margins)

Forecast

Actual 2015 2016 2017 2018

Sales $200 $220 $242 $266

Variable operating expenses 160 172 189 208

Depreciation 10 12 13 14

Discretionary expenses 20 22 24 27

Total expenses 190 206 226 248

Profit before tax 10 14 16 18

Income tax (40%) 4 6 6 7

Profit after tax $6 $9 $10 $11

Schedule 3: Value Calculations

Annual Cash Flows Investment 2016 2017 2018 2019 and beyond

Strategy 1 $18 $19 $21 $21

Strategy 3 $(25) 21 23 25 25

Value of Division A on December 31, 2015 at 18% (ignoring liabilities)

2016 2017 2018

Sales $74 $89 $106

Expenses 70 84 99

Profit before taxes 4 5 7

Income taxes 2 2 3

Profit after taxes $2 $3 $4

Exhibit 6 Division A, Strategy X: Shareholder value calculations ($ million)

Present value of earning assets at end of implementation of strategy $16.8

Less: Present value of investment required (7.9)

Less: Market value of debt (net of monetary assets) (10.1)

Present value of division if strategy is implemented (1.2)

Less: Pre-strategy value of division .5

Shareholder value contribution of strategy $(1.7)