AnaIyst programme 7 August 2006 - 12 September 20061. FinanciaI statements 2. BaIance sheet 3. Income statement 4. Cash fIow statements 5. M&A accounting 6. Enterprise and equity vaIue 7. Accounting & anaIysis exercises 8. Accounting & anaIysis soIutions 9. FinanciaI maths 10. VaIuation 11. ComparabIe companies anaIysis (comps) 12. Precedent deaIs anaIysis (pre deaIs) 13. VaIuation exercises 14. VaIuation soIutions 15. FinanciaI modeIIing 16. PracticaI investment banking 17. Debt 18. FinanciaI markets 19. Taxation 20. Law Published financial statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] FinanciaI statements 1 Published accounts 1 Components of financial statements 3 Ìnternational comparison 4 Historical development 4 Ìnternational accounting standards 5 Balance sheet 6 Assets 6 Liabilities 7 Shareholders' funds 7 Ìncome statement 8 Revenue 8 Expenses 8 Exceptional & extraordinary items 9 Earnings per share 9 Second income statement 10 Cash flow statement 11 Cash flow 11 Categories 11 Methods 12 Cash flow links to income statement and balance sheet 13 Free cash flow 13 Published financial statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 FinanciaI statements PubIished accounts Companies in most countries publish a balance sheet; and an income statement (or profit and loss account). Most also publish a cash flow statement. Primary statements Balance sheet Income statement Cash flow statement £m £m £m 'snapshot' for period for period accruals basis accruals basis cash basis Balance sheet The balance sheet is a 'snapshot' of a company's financial position. Ìt delineates the enterprise's: resource structure (major classes and amounts of assets); and financial structure (major classes and amounts of liabilities and equity). Ìt reflects the accruals concept. Corporate vaIue The balance sheet does not show the value of a business as: many assets which are included (eg land and buildings) are not included at market value; some features which contribute to corporate value (eg internally generated intangibles) are not recognised as assets; and expectations about future performance (reflected in share prices) are not reflected. The balance sheet provides some useful information for those who wish to make their own assessment of a company's value. Published financial statements 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Going concern The financial statements are prepared on the assumption that the enterprise will continue in operation for the foreseeable future. Ìt is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations. Key metrics Net debt is compiled from the balance sheet. Net debt is used in calculating enterprise value and gearing ratios. Income statement The income statement is a report of financial performance for a period. Ìt focuses attention on key characteristics of components of performance by: classifying costs by function (eg operating v financial); and identifying separately items that are unusual in size or incidence (eg exceptional items) or that have special characteristics (eg interest and taxation). Ìt reflects the accruals (or matching) concept. AccruaIs concept The effects of transactions and other events are: recognised when they occur, not as cash is received or paid; and reported in the financial statements of the periods to which they relate. Revenues are recognised when they are earned. Expenses are recognised when they are incurred. AnaIysis Key metrics calculated from the income statement include: EBÌTDA (earnings before interest, tax, depreciation and amortisation); and net income or 'earnings' (as used in EPS and PER). Cash flow statement The cash flow statement reports cash inflows and outflows for a period. Ìt focuses attention on key characteristics of components of cash generation and absorption by: stripping out the effects of the accruals concept; classifying cash flows by category (eg operating, investing and financing); and reconciling cash flows to operating profit or net income and (in some countries) net debt. Published financial statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 AnaIysis Key metrics calculated from the cash flow statement include: operating cash flow; and free cash flow. Components of financiaI statements Components Asset Past event present control future benefit Liability Past event present obligation future outflow Expense Benefit used up Revenue Benefit earned Assets An asset is a resource: controlled by an enterprise as a result of past events; and from which future economic benefits are expected to flow to the enterprise. LiabiIities A liability is a present obligation: arising from past events; and in respect of which economic benefits are expected to flow from the enterprise. Recognition criteria Assets and liabilities are only recognised if: there is sufficient evidence of existence (including evidence that a future inflow or outflow of benefit will occur); and the monetary amount can be measured with sufficient reliability. Published financial statements 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] InternationaI comparison Generally accepted accounting practice (GAAP) can differ from country to country. This affects the format and content of financial statements; and measurement of items included in financial statements. HistoricaI deveIopment US GAAP equity market focus, so accounting profit taxable profit accounting standards (FASs) issued by FASB (private sector) lots of rules, detailed coverage, prescriptive treatments, emphasis on consistency UK GAAP, Hong Kong GAAP equity market focus, so accounting profit taxable profit accounting standards (FRSs) issued by ASB (private sector) few(er) rules, (some) alternative treatments, subjectivity in applying concepts, emphasis on substance IAS equity market focus, so accounting profit taxable profit accounting standards (ÌASs) issued by ÌASC [2001 ÌFRSs issued by ÌASB] (to date) political, incomplete coverage, alternative treatments European GAAP, Japanese GAAP tax driven Commercial Code (eg HGB, PCG) written by government some alternative treatments, emphasis on prudent calculation of net profit (to protect lenders and minimise tax) Europe Accounting differences are major and deep seated. They are mainly caused by differences in legal systems corporate ownership and finance; and tax systems. The Commission of European Communities issues Directives on company law to reduce differences in accounting in member states of the EU. The 4 th Directive (formats and rules of accounting) was largely based on German law. The 7 th Directive (consolidated accounts) was substantially based on UK practice. Published financial statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 InternationaI accounting standards The Ìnternational Accounting Standards Committee (ÌASC) was formed in 1973. Ìt aimed to improve and harmonise accounting worldwide by issuing Ìnternational Accounting Standards (ÌASs). The ÌASC was restructured in 2001 to a newly constituted Ìnternational Accounting Standards Board (ÌASB) which has issued Ìnternational Financial Reporting Standards (ÌFRSs) from 2002. The trustees of the ÌASB, who approve the budget, monitor effectiveness and have responsibility for constitutional changes, in addition to raising funds, are representative of the ÌASB's member nations as follows: 6 North Americans; 6 Europeans; 4 from Asia Pacific; and 3 from other areas. IASB (InternationaI Accounting Standards Board) members 1. Sir David Tweedie, ÌASB chairman (formerly UK ASB); 2. Tom Jones, ÌASB vice chairman (retired Citibank CEO); 3. Jim Leisenring (US FASB); 4. Anthony Cope (US FASB); 5. Mary Barth (Stanford University Business School); 6. Geoffrey Whittington (Cambridge University, UK ASB); 7. Patricia O'Malley (Canadian ASB); 8. Gilbert Gélard (KPMG France); 9. Hans-Georg Bruns (Daimler Chrysler); 10. Robert Garnett (Anglo American); 11. Warren McGregor (Australian Accounting Research Foundation); 12. Tatsumi Yamada (PwC Japan); 13. John Smith (Deloitte & Touche, US); 14. Jan Engström (formerly Volvo CFO) A simple majority of member votes will be enough to pass an accounting standard. Ìn March 2004 ÌASB completed the development and enhancement of its core set of ÌASs and ÌFRSs (2005 stable platform). Europe Ìn 2002 the EU adopted a regulation requiring all listed companies to prepare their consolidated financial statements in accordance with 'adopted international accounting standards' with effect from 1 January 2005. Published financial statements 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] BaIance sheet Assets Tangible assets Tangible assets are assets that have physical substance. TangibIe fixed assets (UK) Property, pIant and equipment (US) Tangible fixed assets are assets that have physical substance and are held for use on a continuing basis. PPE are tangible assets that are held for use during more than one period. Depreciation Depreciation is the systematic allocation of the depreciable amount (cost or carrying amount less residual value) of a tangible asset to the periods expected to benefit from its use. Intangible assets Ìntangible assets are assets that do not have physical substance. Amortisation Amortisation is the systematic allocation of the depreciable amount of an intangible asset to the periods expected to benefit from its use. Working capital Current assets include stocks (inventories) and debtors (accounts receivable). Current liabilities include creditors (accounts payable). Working capital can mean: current assets less current liabilities; or specific elements of current assets (such as inventories and accounts receivable) less specific elements of current liabilities (such as accounts payable). Stocks (UK) Inventories (US) Stocks comprise: goods purchased for resale; consumable stores; raw materials and components purchased for inclusion in products for resale; products and services in intermediate stages of completion; and finished goods. Ìnventories are assets: held for sale in the ordinary course of business; in the process of production for such sale; or in the form of materials or supplies to be consumed in production or delivering a service. Published financial statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 Debtors (UK) ReceivabIes (US) Assets created by providing money, goods or services directly to a debtor (eg a customer). LiabiIities Creditors Creditors (or payables) are liabilities where the timing and amounts are reasonably certain. Debt Debt is indebtedness for borrowed money (eg loan stock, bonds, commercial paper) plus certain other obligations (eg in respect of leases). Provisions Provisions are liabilities of uncertain outcome, timing or amount. SharehoIders' funds Shareholders' funds (UK) or stockholders' equity (US) represent(s) the residual interest in an enterprise's assets after liabilities have been deducted. This arises mainly from: amounts paid in by shareholders; and earnings which have been retained, rather than paid out as dividends, over time. Paid in capital Main components: UK US Called up share capital (ords and prefs) Preferred stock Common stock Share premium Additional paid in capital Other reserves (eg merger reserve) Published financial statements 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Retained earnings Balance sheet presentation: UK US Profit and loss account Retained earnings Other components UK US Revaluation reserve Accumulated other comprehensive income Other reserves (eg capital redemption reserve) Income statement Revenue Revenue usually arises from: sale of goods; and/or rendering of services. Expenses Expenses are usually categorised by nature (the total cost method) or by function (the cost of sales method). By nature By function ExampIes ExampIes Depreciation Purchase of materials Wages and salaries Ìnterest Taxation Cost of sales Distribution costs Administrative expenses Ìnterest Taxation Published financial statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 ExceptionaI & extraordinary items Different countries have different views on what is exceptional, what is extraordinary and how these items should be presented. Extraordinary items ExampIes Expropriation of assets Natural disasters IAS/IFRS Under ÌAS/ÌFRS, no items are presented as extraordinary. Exceptional items ExampIes Restructuring costs Profits and losses on disposal of PPE Earnings per share Earnings per share (EPS) = shares of Number Earnings Basic EPS UK US Earnings Net profit or loss for the period attributable to ordinary shareholders Earnings Ìncome attributable to common stock Number of shares Weighted average number of ordinary shares outstanding during the period Number of shares Weighted average number of common shares outstanding Published financial statements 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Consequently, earnings used in reported EPS are after: Depreciation and amortisation; exceptional items interest and tax; minority interests; and preference dividends. Earnings therefore reflect the financing structure of the enterprise (as they are after deducting interest). IIMR headline earnings Ìn order to facilitate comparability across different accounting regimes and between different companies, the Ìnstitute of Ìnvestment Managers and Researchers have suggested that a headline EPS figure is additionally calculated using the earnings calculated to Ìnclude all trading results (discontinued, exceptional, interest etc) Exclude: profits or losses on sale or termination provisions for exceptional items disclosed on face of P&L profits or losses on sale of fixed assets impairment write-downs exceptional profits or losses on reorganisation or redemption of long term debt any impact of goodwill pension cost impact of discontinuance extraordinary items (if any) Diluted EPS Certain securities (eg convertible bonds, convertible preference shares [preferred stock] and share [stock] options) permit their holders to: become ordinary shareholders [common stockholders;] or increase the number of shares already held. When potential reduction ['dilution'] of EPS figures is inherent in a company's capital structure, diluted EPS is presented in addition to basic EPS. Second income statement Ìn some countries, some gains and loss are recognised directly in shareholders' funds/equity. These items are: excluded from the calculation of earnings presented in a separate statement ('second income statement'). Published financial statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 UK US Statement of totaI recognised gains and Iosses Statement of comprehensive income Profit for the financial year (as reported in the P&L account) Unrealised gains and losses (eg on revaluation of properties and on foreign currency translation) Net income (as reported in the income statement Unrealised gains and losses (eg on available- for-sale securities and on foreign currency translation) Cash fIow statement Cash fIow Some countries report flows of cash. Some countries report flows of cash and cash equivalents. Cash Cash comprises cash on hand and demand deposits. Cash equivalents Cash equivalents are short term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. Categories UK US 1. Operating activities 2. Dividends from associates and joint ventures 3. Returns on investments & servicing of finance 4. Taxation 5. Capital expenditure & financial investment 6. Acquisitions & disposals 7. Equity dividends paid 8. Management of liquid resources 9. Financing 1. Operating 2. Ìnvesting 3. Financing Published financial statements 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Operating Operating activities are the principal revenue producing activities of the enterprise and other activities that are not investing or financing activities. Investing Ìnvesting activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. Financing Financing activities are activities that result in changes in the size and composition of the equity capital and borrowings of the enterprise. Methods Cash flows from operating activities are reported using the direct method or the indirect method. Direct method Major classes of gross cash receipts and gross cash payments are disclosed. ExampIes Receipts from customers Payments to suppliers Payments in respect of employees (wages and social security costs paid) Indirect method Profit or loss is adjusted for: the effect of transactions of a non-cash nature; any deferrals or accruals of past or future operating cash receipts or payments; and items of income or expense associated with investing or financing cash flows. ExampIes of adjustments Depreciation and amortisation Changes in (operating) working capital Published financial statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 Cash fIow Iinks to income statement and baIance sheet Income statement UK US Operating profit (P&L account) is reconciled to net cash flow from operating activities (CFS). Reconciling items comprise items which: have impacted operating profit; and do not involve a cash inflow or outflow. Net income (income statement) is reconciled to net cash flow from operating activities (CFS). Reconciling items comprise items which: have impacted net income; and do not involve an operating cash inflow or outflow. Balance sheet Ìn some countries, the movement in cash in the period (CFS) is reconciled to the movement in net debt (balance sheet). Net debt Net debt comprises debt less (the aggregate of) cash and liquid resources/cash equivalents. Free cash fIow 'Free' means available. Free cash flow means different things for different purposes. Enterprise level Free cash flow is seen as a surplus available to make payments to capital providers (debt and equity). For this purpose, free cash flow is: before interest; and after (adjusted) tax and capital expenditure. Ìn practice this involves adjusting actual tax paid to eliminate any interest tax shield. Equity level Free cash flow is seen as a surplus available for shareholders. Here 'free' means free to acquire other businesses, repay debt, repurchase shares or pay equity dividends. Ìt is calculated after cash payments to service existing debt (interest). For this purpose, free cash flow is: after interest; and after (actual) tax and capital expenditure. Practically this means operating cash flow less interest and tax and capital expenditure. Published financial statements 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] BaIance sheet 1 Components of financial statements 1 Components 1 Definitions 1 Recognition criteria 1 Assets 2 Current v non-current 2 Ìntangible assets 2 Depreciation 3 Ìmpairment 3 Revaluations 4 Capitalisation of interest 5 Liabilities 6 Current v non-current 6 Debt 6 Convertible bonds 8 Leases 11 Provisions and contingent liabilities 13 Pensions and other post-employment benefits 17 Net debt 23 Debt 23 Cash equivalents 23 Ìllustration 23 Shareholders' funds (stockholders' equity) 25 Components 25 Different classes of share 26 Share issues 26 Bonus / capitalisation / scrip issues 28 Rights issues 28 Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 BaIance sheet Components of financiaI statements Components Asset Past event present control future benefit Liability Past event present obligation future outflow Expense Benefit used up Revenue Benefit earned Definitions Assets An asset is a resource: controlled by an enterprise as a result of past events; and from which future economic benefits are expected to flow to the enterprise. Liabilities A liability is a present obligation: arising from past events; and in respect of which economic benefits are expected to flow from the enterprise. Recognition criteria Assets and liabilities are only recognised if: there is sufficient evidence of existence (including evidence that a future inflow or outflow of benefit will occur); and the monetary amount can be measured with sufficient reliability (eg a cost has been incurred). Balance sheet issues 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Reliable measurement Cost or fair vaIue? What constitutes reliable measurement can differ between: countries; and asset (or liability) categories. Assets Current v non-current Ìn many countries, assets are distinguished between current and non-current (or fixed). Ìn some countries the distinction is based on time (realisation expected within or in more than one year). Ìn others, the distinction is based on whether or not the asset will be sold or consumed as part of the operating cycle. IntangibIe assets Ìntangible assets are assets that do not have physical substance. Recognition An intangible asset should be recognised if, and only if: it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and the cost of the asset can be measured reliably. Separate acquisition Ìf an intangible asset (eg brand, publishing title) is acquired separately, the cost of the intangible asset can usually be measured reliably. Acquisition as part of a business combination An intangible asset acquired as part of the acquisition of a business should be capitalised separately from goodwill, at fair value (eg by applying multiples reflecting current market transactions to turnover, earnings etc or discounting estimated future net cash flows), if its value can be measured reliably on initial recognition. Internally generated intangible assets Ìn most countries, internally generated intangible assets are not recognised as assets on the basis that expenditure on internally generated brands, publishing titles, customer lists etc cannot be distinguished from the cost of developing the business as a whole. Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 Goodwill Purchased goodwill is the excess of the cost of an acquisition over the acquirer's interest in the fair values of the identifiable assets and liabilities acquired. Goodwill is recognised as an asset and reviewed at least annually for impairment. Ìt is not amortised. Ìnternally generated goodwill is not recognised as an asset. Depreciation The depreciable amount of an item of PPE is allocated on a systematic basis over its useful life. The depreciation method used reflects the pattern in which the asset's economic benefits are consumed. Useful lives are reviewed periodically and, if expectations are significantly different from previous estimates, depreciation for the current and future periods is adjusted. Impairment An asset is impaired when its carrying amount exceeds its recoverable amount. Assets subject to depreciation and amortisation A review for impairment is carried out if events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Indicators Current period operating loss Significant decline in market value Obsolescence or physical damage Significant adverse changes in business, market, statutory environment, regulatory environment or indicator of value used to measure fair value on acquisition. Commitment to significant reorganisation Significant change in market rates of return likely to affect recoverable amount. Assets not subject to depreciation and amortisation Ìrrespective of whether there is any indication of impairment, the following are reviewed for impairment annually: Ìntangibles with an indefinite useful life; and Goodwill acquired in a business combination. Balance sheet issues 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Measurement Ìf an asset is impaired, its carrying amount is written down to its recoverable amount. The impairment loss is recognised as an expense. RecoverabIe amount Recoverable amount is the higher of an asset's: net selling price; and value in use. Value in use Value in use is the present value of estimated future cash flows expected to arise from: continuing use of the asset; and from its disposal at the end of its useful life. RevaIuations Initial measurement Ìn most countries, PPE (or tangible fixed assets) are initially measured at purchase price or production cost. Revaluation Ìn most countries (incl US), revaluation is prohibited. Where a policy of revaluation is adopted, revaluations is made with sufficient regularity that the carrying amount does not differ materially from current value at the balance sheet date. When an item is revalued, the entire class of PPE to which that asset belongs is revalued. Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 CapitaIisation of interest Ìn some countries, companies add borrowing costs to the cost of assets produced or constructed. Finance costs which are directly attributable to the construction or production of an asset may be capitalised as part of the cost of that asset. Presentation Method 1 Method 2 Income statement Income statement Cm Cm Revenue 48,000 Revenue 48,000 Capitalised interest 65 48,065 Ìnterest expense (500) Ìnterest expense (435) Balance sheet issues 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] LiabiIities Current v non-current Ìn most countries, liabilities are distinguished between current and non-current (or long-term). Ìn some countries the distinction is based on time (due to be settled within or in more than one year). Ìn others, the distinction is based on whether or not the liability is expected to be settled as part of the operating cycle. Debt InitiaI measurement Debt instruments issued are recognised initially at cost (fair value of consideration received less transaction costs). Subsequent measurement Debt instruments are measured at amortised cost. Amortised cost The initial carrying amount (eg net proceeds) is increased by finance charges in respect of the period and reduced by payments made in the period. Finance charges Finance costs are allocated to periods over the term of the debt at a constant rate on the carrying amount (the effective interest rate, level yield to maturity or internal rate of return). Where a debt instrument is issued and redeemed at the same amount, the effective interest rate is the same as the coupon. Where a debt instrument is issued at a discount, or redeemable at a premium, the effective interest rate is higher than the coupon. IIIustration 1 A company issues a C100m bond at par. The bond pays a coupon of 6% per annum. The bond is redeemable five years later at par. Ìgnore issue costs. year BS P&L cash BS @ start charge @ 6% paid end 1 100.00 6.00 (6.00) 100.00 2 100.00 6.00 (6.00) 100.00 3 100.00 6.00 (6.00) 100.00 4 100.00 6.00 (6.00) 100.00 5 100.00 6.00 (6.00) 100.00 TotaI 30.00 (30.00) Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 Issue costs IIIustration 2 A company issues a C100m bond at par. The bond pays a coupon of 6% per annum. The bond is redeemable five years later at par. Ìssue costs are C2m. year BS P&L cash BS @ start charge ?? paid @ end 1 98.00 (6.00) 2 (6.00) 3 (6.00) 4 (6.00) 5 (6.00) 100.00 Solution The effective interest rate is 6.48%. This is applied to the opening balance to calculate finance charges for the period. year BS P&L cash BS @ start charge @ 6.48% paid @ end 1 98.00 6.35 (6.00) 98.35 2 98.35 6.37 (6.00) 98.72 3 98.72 6.40 (6.00) 99.12 4 99.12 6.42 (6.00) 99.54 5 99.54 6.46 (6.00) 100.00 TotaI 32.00 30.00 Discounted debt IIIustration 3 A company issues a C100m bond for net proceeds of C83.15m. The bond pays a coupon of 2% per annum. The bond is redeemable five years later at par. year BS P&L cash BS @ start charge ?? paid @ end 1 83.15 (2.00) 2 (2.00) 3 (2.00) 4 (2.00) 5 (2.00) 100.00 Balance sheet issues 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Solution The effective interest rate is 6%. This is applied to the opening balance to calculate finance charges for the period. year BS P&L cash BS @ start charge @ 6% paid @ end 1 83.15 4.99 (2.00) 86.14 2 86.14 5.17 (2.00) 89.31 3 89.31 5.36 (2.00) 92.67 4 92.67 5.56 (2.00) 96.23 5 96.23 5.77 (2.00) 100.00 TotaI 26.85 10.00 ConvertibIe bonds From the perspective of the issuer, a convertible bond comprises two components: A financial liability (a contractual arrangement to deliver cash or other financial assets); and An equity instrument (a call option granting the holder the right, for a specified period, to convert into common shares of the issuer). Classification of the liability and equity components of a convertible instrument is not revised as a result of a change in the likelihood that a conversion option will be exercised. Measurement When the initial carrying amount of a compound instrument is allocated to its equity and liability elements, the equity component is assigned the residual carrying amount after deducting from the instrument as a whole the amount separately determined for the liability component. Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 Illustration (IAS) A company issues C100,000 3% convertible debt at par. Ìnterest is paid annually in arrears. Five years later, the debt is redeemable at a premium of 10% or convertible into equity shares of the issuer. [The effective interest rate on similar non-convertible debt is 7%.] InitiaI recognition The debt component of the proceeds, calculated by discounting the future cash flows at the market rate of 7%, is C90,729. The balance of the proceeds (C9,271) is deemed to be the fair value of the consideration received for writing a call option on the issuer's shares. Balance sheet C000 Cash + 100 Debt (liability) 90.73 Derivative (equity) 9.27 Subsequent measurement The debt component is measured at amortised cost. The initial carrying amount is increased by finance charges (at the effective interest rate) in respect of the period and reduced by payments made in the period. balance interest cash paid balance @ 7% 90,729 6,351 (3,000) 94,080 94,080 6,586 (3,000) 97,666 97,666 6,836 (3,000) 101,502 101,502 7,105 (3,000) 105,607 105,607 7,393 (3,000) 110,000 C34,271 At the end of the first year Balance sheet Income statement Cash flow statement C000 C000 C000 Debt 94.08 Ìnterest expense (6.35) Ìnterest paid (3.00) Equity 9.27 Balance sheet issues 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] US GAAP FAS 133 requires convertible debt to be classified as a liability. The embedded equity option is not separated. InitiaI recognition Balance sheet C000 Cash + 100 Debt 100 Equity Subsequent measurement The debt is measured at amortised cost. The initial carrying amount is increased by finance charges (at the effective interest rate) in respect of the period and reduced by payments made in the period. The effective interest rate, treating the whole proceeds as debt, is 4.82%. balance interest cash paid balance @ 4.82% 100,000 4,816 (3,000) 101,816 101,816 4,904 (3,000) 103,720 103,720 4,996 (3,000) 105,716 105,716 5,092 (3,000) 107,808 107,808 5,192 (3,000) 110,000 C25,000 At the end of the first year Balance sheet Income statement Cash flow statement C000 C000 C000 Debt 101.82 Ìnterest expense (4.82) Ìnterest paid (3.00) Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 Leases A lease is a contract between a lessor and a lessee for the hire of a specific asset. The lessor retains ownership of the asset but conveys the right to the use of an asset to the lessee for an agreed period in return for the payment of specified rentals. Recognition Finance (capitaI) Ieases A finance lease should be recorded in the balance sheet of a lessee as an asset and as an obligation to pay future rentals. Operating Ieases An operating lease is not recognised in the balance sheet. Lease rental payments are recognised as an expense in the income statement. Measurement Finance (capitaI) Ieases At the inception of the lease, the sum to be recorded both as an asset and as a liability is the lower of: the present value of the minimum lease payments (derived by discounting at the interest rate implicit in the lease or, if this cannot be determined reliably, the lessee's incremental borrowing rate); and the fair value of the leased asset. Rentals payments are apportioned between the finance charge and a reduction of the outstanding obligation for future amounts payable. The total finance charge under a finance lease is allocated to accounting periods during the lease term so as to produce a constant periodic rate of charge on the remaining balance of the obligation for each accounting period (or a reasonable approximation thereto). Operating Ieases The rental under an operating lease should be charged on a straight-line basis over the lease term. Illustration A company enters into a 7 year lease to acquire the use of an asset. Annual instalments are C120m (payable in arrears). The interest rate implicit in the lease is 8½% (approximately). The present value of the minimum lease payments is C614m. At the end of the first year of the lease, the financial statements would show: Balance sheet issues 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Finance Iease Balance sheet P&L account Cash flow statement Cm Cm Cm Property, plant & equipment 526 Operating expenses (depreciation) (88) Ìnterest paid (52) Debt ÷ finance leases (546) Ìnterest expense (52) Financing repayment (68) Working year BS P&L finance cash BS @ start charge @ 8½% paid @ end 1 614 52 (120) 546 2 546 46 (120) 472 3 472 40 (120) 392 4 392 33 (120) 305 5 305 26 (120) 211 6 211 18 (120) 109 7 109 11 (120) 0 TotaI 226 (840) Operating Iease Balance sheet P&L account Cash flow statement Cm Cm Cm Operating expenses (120) Operating cash flow (120) Classification Finance (capitaI) Ieases A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred. Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 US (FAS 13) Ìf one or more of the following criteria is present at the inception of a lease, it is classified as a capital lease by the lessee: 1. Ownership is transferred to the lessee by the end of the lease term; or 2. The lease contains a bargain purchase option; or 3. The lease term, at inception, represents 75% or more of the estimated economic life of the leased asset, including earlier years of use; or 4. At inception, the present value of the minimum lease payments represents 90% or more of the fair value of the leased asset Operating Ieases An operating lease is a lease other than a finance lease. Provisions and contingent IiabiIities A provision is a liability of uncertain timing or amount. Recognition A provision is recognised when: an enterprise has a present obligation (legal or constructive) as result of a past event; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and a reliable estimate can be made of the amount of the obligation. ObIigating event A past event that leads to a present obligation is an obligating event. For an event to be an obligating event, the enterprise must have no realistic alternative to settling the obligation created by the event. This is the case only where: the settlement of the obligation can be enforced by law; or the event creates valid expectations in other parties that the enterprise will discharge the obligation (a constructive obligation). Only those obligations arising from past events existing independently of an enterprise's future actions (incl the future conduct of its business) are recognised as provisions. A board decision does not give rise to a constructive obligation at the balance sheet date unless the decision has been communicated before the balance sheet date to those affected by it in a sufficiently specific manner to raise a valid expectation in them that the enterprise will discharge its responsibilities. Balance sheet issues 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] ProbabIe outfIow An outflow is regarded as probable if it is more likely than not to occur (ie the probability that the outflow will occur is greater that the probability that it will not). ReIiabIe estimate Ìf an enterprise can determine a range of possible outcomes, it can make an estimate of the obligation that is sufficiently reliable to use in recognising a provision. Measurement The amount recognised as a provision is the best estimate (eg an expected value) of the expenditure required to settle the present obligation at the balance sheet date. Disclosure Unless the probability of any outflow in settlement is remote, an enterprise discloses a contingent liability at the balance sheet date. Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 Summary Present obligation as a result of an obligating event? no Possible obligation? no yes yes Probable outflow? no Remote? yes yes no Reliable estimate? no yes Provide Disclose contingent liability Do nothing Balance sheet issues 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Illustration Lufthansa Lufthansa operates a customer loyalty programme, 'Miles & More'. Provision is made for bonus miles granted but unredeemed at the balance sheet date. Opening balance sheet Cm Provision 442 Closing balance sheet P&L account Cash flow statement Cm Cm Cm EBÌT Provision 524 Cost of sales (82) Change in provision 82 EBÌT Operating cash flow Notes to accounts Cm Opening balance 442 Utilisation (170) Additions 280 Release (28) ______ Closing balance 524 ______ Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 Pensions and other post-empIoyment benefits Some companies promise employees benefits which are payable after the completion of employment. Examples include: Retirement benefits (pensions); and Medical care and life insurance. Defined contribution plans Under defined contribution plans: The employer's obligation is limited to the amount that it agrees to contribute to the fund. The benefits received by the employee are determined by the amount of contributions paid to the fund (together with investment returns arising from the contributions). Actuarial risk (that the benefits will be less than expected) and investment risk (that assets invested will be insufficient to meet expected benefits) fall on the employee. Defined benefit plans Under defined benefit plans: The employer's obligation is to provide the agreed benefits to current and former employees. Actuarial risk (that benefits will cost more than expected) and investment risk fall on the employer. Accounting BaIance sheet Many GAAPs (eg US GAAP, ÌAS) do not require the full pension surplus or deficit to be recognised as an asset or liability in the balance sheet. Surplus or deficit The pension surplus or deficit must be: disclosed in the notes; and reconciled to the amount(s) recognised in the balance sheet. Balance sheet issues 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Income statement Some GAAPs (eg US GAAP) aggregate operating, financing and other elements in the calculation of pension cost for the period. This total pension cost ('net periodic pension cost') is charged to the income statement at the operating level. IFRS Under ÌFRS the different elements of the total pension cost may be: aggregated and charged at the operating level; or separated and charged as appropriate (eg as operating and financing items). The total expense recognised for each element of the pension cost, and the line item in which it is included, must be disclosed. Current service cost The current service cost is a key element of the total pension cost for the period. Ìt is the increase in the obligation resulting from employee service in the period. Ìt is a deferred wage cost and can be regarded as a genuine operating expense. Illustration 1 Rhodia has a defined benefit pension scheme. Ìts consolidated financial statements show: Balance sheet (extracts) P&L account Cm Cm Net funds/(debt) (2,050) EBÌTDA 365 D&A (524) Pension liability 431 EBÌT (159) Net financial expense (348) Shareholders equity 252 EBT (507) Minority interests 23 275 Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 Pension IiabiIity Projected benefit obligation Opening balance 2,056 Service cost 33 Ìnterest cost 118 Benefits paid (103) Actuarial losses (gains) 170 Foreign currency translation differences (124) _________ Closing balance 2,150 _________ Plan assets @ fair value Opening balance 1,122 Actual return on plan assets 123 Contributions paid 8 Benefits paid (103) Foreign currency translation differences (84) _________ Closing balance 1,066 _________ Projected benefit obligation in excess of plan assets 1,084 Unrecognised net gains (losses) (653) _________ Pension liability recognised 431 _________ Net periodic pension cost Benefits earned during the year (current service cost) 33 Ìnterest cost 118 Expected return on plan assets (83) Net amortisation and other deferrals 33 _________ 101 _________ The net periodic pension cost has been deducted in arriving at EBÌTDA. Balance sheet issues 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Credit metrics Unadjusted net debt/EBITDA Net debt/EBÌTDA = m 365 C m 050 , 2 C = 5.6 Adjusted net debt/EBITDA Net debt/EBÌTDA = m 433 C m 134 , 3 C = 7.2 Adjusted net debt = 2,050m + 1,084m = C3,134m Adjusted EBÌTDA = 365m + 101m ÷ 33m = C433m Summary To adjust metrics and ratios for pensions, find the notes disclosing: pension deficit (projected benefit obligation in excess of plan assets) or surplus (plan assets in excess of projected benefit obligation); and net periodic pension cost and current service cost. Illustration 2 Tesco operates defined benefit pension schemes. The consolidated financial statements show: Balance sheet (extracts) Income statement (extracts) £m £m Net debt (4,509) EBÌTDA 3,118 D&A (838) Pension liability (1,211) EBÌT 2,280 Finance income 114 Shareholders' equity 9,380 Finance costs (241) Minority interests 64 EBT 2,153 9,444 Statement of recognised income & expense (extracts) £m Actuarial losses (442) Exchange differences (1) Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 Notes Charged to income statement Charged to operating profit Current service cost 328 _________ Total charge to operating profit 328 _________ Credited/(charged) to finance income Expected return on pension schemes' assets 209 Ìnterest on pension schemes' liabilities (184) _________ Net pension finance income 25 _________ Amount recognised in the statement of recognised income and expense Actual return less expected return on pension schemes' assets 309 Experience gains and losses arising on the schemes' liabilities (24) Changes in assumptions underlying the present value of liabilities (727) _________ Total actuarial loss recognised in the SORÌE (442) _________ Defined benefit pension pIan assets Opening fair value of plan assets 2,718 Expected return 209 Actuarial gains 309 Contributions by employer 270 Actual member contributions 6 Foreign currency translation differences - Benefits paid (64) _________ Closing fair value of plan assets 3,448 _________ Balance sheet issues 22 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Defined benefit obIigation Opening defined benefit obligation (3,453) Service cost (328) Ìnterest cost (184) Losses on change of assumptions (727) Experience losses (24) Foreign currency translation differences (1) Benefits paid 64 Actual member contributions (6) __________ Closing balance (4,659) __________ Movement in deficit Deficit in schemes at beginning of the year (735) Current service cost (328) Other finance (charge)/income 25 Contributions 270 Foreign currency translation differences (1) Actuarial (loss)/gain (442) _________ Deficit in schemes at end of the year (1,211) _________ Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 23 Net debt Net debt comprises debt less (the aggregate of) cash and cash equivalents. Debt Debt comprises: borrowings (instruments issued as a means of raising finance which are classified as liabilities); and obligations under finance leases. Cash equivaIents Cash equivalents (or liquid resources) are short term highly liquid investments held as a liquidity reserve, which are readily convertible into cash and subject to insignificant changes in value. Money market deposits and certificates of deposit are likely to meet this requirement. IIIustration A company's balance sheet shows: note Cm Short term securities 1 31 Cash 1,292 Liabilities 5 16,003 Provisions 1,685 The notes to the accounts show: Note 1 Short term securities comprise investments in equities. Balance sheet issues 24 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Note 5 Liabilities comprise: Cm Bonds 1,812 Due to banks 797 Loan notes 649 Finance leases 2,329 Financial debts 5,587 Trade payables 9,119 Tax liabilities 648 Payroll 649 16,003 Net debt Cm Bonds 1,812 Due to banks 797 Loan notes 649 Finance leases 2,329 Debt 5,587 Cash and cash equivaIents (1,292) Net debt 4,295 Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 25 SharehoIders' funds (stockhoIders' equity) Shareholders' funds (or stockholders' equity) represents the residual interest in an enterprise's assets after liabilities have been deducted. This arises mainly from: amounts paid in by shareholders; and earnings which have been retained, rather than paid out as dividends, over time. Components Paid in capital Main components: UK US Called up share capital (ords and prefs) Preferred stock Common stock Share premium Additional paid in capital Other reserves (eg merger reserve) Retained earnings Balance sheet presentation: UK US Profit and loss account Retained earnings Other components UK US Revaluation reserve Accumulated other comprehensive income Other reserves (eg capital redemption reserve) Creditor protection Ìn some countries, (non-distributable) legal reserves are built up by transferring a % of net profit each year (eg 10%) to legal reserves until these equal a % of capital stock (eg 20%). Balance sheet issues 26 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Different cIasses of share Preference shares (preferred stock) These shares have preferential rights over ordinary shares. These may include: a specified, fixed rate of dividend (eg 9½% preference shares would pay a dividend of 9½% of the nominal value each year); and/or priority to repayment of capital on a winding up. Preference shares may be: cumulative convertible redeemable Ordinary shares (common stock) These shares usually have no guarantee as to the amount of dividend or repayment on a winding-up. Ìn some countries, ordinary shares can be: subdivided into classes (eg A shares, B shares), which rank for dividends from different dates or receive dividends on different bases; and/or redeemable. Share issues Share capital (stock) Ìn most countries, shares are issued with a par or nominal (or face) value. Ìn some countries a minimum par value is laid down in statute. This amount is recorded in the share capital or (common or preferred) stock account. Share premium (additional paid-in capital) When shares are issued above par value, the excess is recorded in the share premium (additional paid-in capital) account. This is a non-distributable reserve (it cannot be paid out as a dividend) and its uses are restricted by legislation. Ìn most countries, it can be used to issue (fully paid) bonus shares. Ìn many jurisdictions, shares cannot be issued at a discount to par value. Share issue costs Costs that are incurred directly in connection with the issue of a capital (or financial) instrument are: Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 27 deducted from the fair value of the instrument issued to give the net proceeds of the issue. [Ìn this case, issue costs (or transaction costs) reduce the amount to be recorded as premium in either the share premium account or the merger reserve.]; or written off to the P&L account. IIIustration During the period, a company issues shares with a par value of C732m for gross proceeds of C10,613m. Share issue costs were C240m. Treatment 1 Balance sheet Income statement Cm Cm Common stock + 732 Additional paid-in capital + 9,881 Share issue costs (240) Retained earnings - 240 + 10,373 Treatment 2 Balance sheet Income statement Cm Cm Common stock + 732 Additional paid-in capital + 9,641 Retained earnings + 10,373 IAS 32 Financial instruments: disclosure and presentation An enterprise typically incurs various costs in issuing or acquiring its own equity instruments. These costs might include registration and other regulatory fees, amounts paid to legal, accounting and other professional advisors and stamp duties. The transaction costs of an equity instrument are accounted for as a deduction from equity (net of any related income tax benefit) to the extent they are incremental costs directly attributable to the equity transaction that otherwise would have been avoided. The costs of an equity transaction that is abandoned are treated as an expense. Transfers A company makes no accounting entries when its issued shares are transferred between shareholders (eg when traded on a stock exchange), although it will update its register of members. Balance sheet issues 28 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Bonus / capitaIisation / scrip issues Ìn a bonus issue, a company issues new shares to existing shareholders for no additional consideration. This may be done to: reduce the market value per share, thus making the shares more liquid; or create an additional class of share (eg redeemable shares). As there is no corresponding change in resources, the issue is recorded at nominal value by capitalising reserves (eg by reducing the balance on the share premium account). Illustration At the beginning of the period, a company had 2,200 million 5p ordinary shares in issue and the balance on the share premium account was C1,528m. During the period, 2 additional ordinary shares were issued for every share already in issue (UK: 2 for 1 bonus issue; US: 3 for 1). BaIance sheet extracts Before bonus After bonus Cm Cm Net assets y y _________ _________ Share capital ( C220m) 110 330 Share premium account ( C220m) 1,528 1,308 Profit and loss account x x _________ _________ y y _________ _________ The market value per share immediately after the bonus issue should be one third of the market value per share immediately before the bonus issue. Theoretically, total market capitalisation should remain unchanged. Rights issues Ìn a rights issue, a company issues new shares to existing shareholders for additional consideration. To encourage existing shareholders to take up the shares, the exercise price is often less than the fair value of the shares. Ìn this case, the rights issue includes a bonus element. A shareholder who doesn't wish to exercise the right to subscribe for additional shares can usually sell the right. Balance sheet issues © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 29 Illustration A company has a 31 st December year end. On 1 st January there were 300,000 $1 ordinary shares in issue. On 31 st August, there was a rights issue of 1 new ordinary share for every 3 shares held at $11 per share. Ìssue costs are negligible. Ìmmediately prior to becoming ex- rights, the share price was $15. Earnings for the year ended 31 st December are $295,000. Accounting impact Share issue Cash (100,000 x $11) $1.1m Share capital (100,000 x $1) $0.1m Share premium (100,000 x $10) $1.0m Earnings per share EPS = 619 , 347 000 , 295 $ = 84.9c No of shares: 1 Jan ÷ 31 Aug 300,000 x 8/12 x 15/14 214,286 1 Sep ÷ 31 Dec 400,000 x 4/12 133,333 347,619 CommerciaI effect The rights issue contains a bonus element (as the exercise price is less than the fair value). This can be isolated by calculating a theoretical ex-rights fair value per share from: the exercise price per share; and the fair value per share before exercise of rights. Balance sheet issues 30 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Bonus element of rights issue 3 x $15 $45 1 x $11 $11 4 $56 Theoretical ex rights price = 4 56 $ = $14 Adjustment = 14 $ 15 $ Treasury stock method Proceeds of $1,100,000 would buy 73,333 shares @ $15 (full market price) Subscribers to rights issue get 100,000 for $1,100,000 'Free' shares 26,667 To get free shares need to hold 373,333 shares [300,000 + 73,333] After rights issue 400,000 shares in issue No of shares: 1 Jan ÷ 31 Aug 300,000 x 8/12 x 400,000 / 373,333 214,286 1 Sep ÷ 31 Dec 400,000 x 4/12 133,333 347,619 Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Income statement & EPS 1 Ìncome statement 1 Format 1 Second income statement 2 Revenue recognition 2 Exceptional & extraordinary items 8 Earnings per share 10 Accounting standards 10 Earnings ÷ basic 11 Number of shares - basic 11 Diluted EPS 14 Restatement 17 Financial assets and liabilities 18 Financial assets 18 Financial liabilities 19 Measurement 20 Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 Income statement & EPS Income statement The income statement (or P&L account) is a report of financial performance for a period. Ìt focuses attention on key characteristics of components of performance by: classifying revenues and expenses by function (eg operating v financial) or nature (eg personnel costs v depreciation); and identifying separately items that are unusual in size or incidence (eg exceptional or extraordinary items) or that have special characteristics (eg interest and taxation). Ìt reflects the accruals (or matching) concept. Format Costs classified by nature Costs classified by function Income statement Income statement Cm Cm Revenue 48,309 Revenue 48,309 Change in inventories (7) Capitalised wages 821 Cost of sales (30,640) Capitalised interest 65 49,188 Selling expenses (2,973) Goods & services purchased (13,477) Administrative expenses (6,385) Personnel costs (12,114) Operating profit 8,311 Depreciation & amortisation (15,221) Financial expenses (5,348) Financial expenses (5,283) Profit before tax 3,028 Profit before tax 3,028 Operating expenses comprise: Cost of goods sold (13,484) Personnel costs (11,293) Depreciation & amortisation (15,221) (39,998) Operating expenses are classified as: Cost of sales (30,640) Selling expenses (2,973) Administrative expenses (6,385) (39,998) Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 2 EBITDA C3,028m + 5,348m + 15,221m ÷ 65m = C23,532m C8,311m + 15,221m = C23,532m Second income statement Ìn some countries, a 'second income statement' reports other gains and losses recognised in the period but not reflected in the (first) income statement or profit and loss account. IAS 1 A complete set of financial statements includes: an income statement a statement showing either: all changes in equity; or changes in equity other than those arising from capital transactions with owners and distributions to owners. FAS 130 Entities are required to report comprehensive income. Comprehensive income is the change in equity of an entity, excluding transactions with shareholders (eg issue of shares, payment of dividends, purchase of treasury shares). Ìt has 2 major components: net income (as reported in the income statement); and other comprehensive income (eg unrealised gains and losses on available-for-sale securities and on foreign currency translation). Reclassification is needed (eg when gains and losses are realised). There is no standard way of presenting other comprehensive income. Ìt may be: presented as a separate statement; presented as a note to the financial statements; or integrated with the income statement. Revenue recognition There are two approaches to revenue recognition. Revenue may be recognised: at a critical point; or over a period. Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 Ìn some cases, customers pay for goods or services before the goods or services are delivered. Ìn other cases, customers pay for goods or services after the goods or services have been delivered. Critical point Customers pay before Receipt of cash from customer i Cash increases ii The liability 'unearned revenue' increases because the business has an obligation to deliver goods or services Delivery of goods or services i The liability 'unearned revenue' decreases because the business has fulfilled the obligation to deliver goods or services ii Retained earnings increase because the revenue is now earned Unearned revenue is part of working capital. Flights At the beginning of the period, an airline had received C346m from customers in respect of future flights. During the period the airline: (1) Received C9,045m from customers in respect of flights booked; and (2) Delivered flights for which customers had paid C8,912m. All customers pay in advance. BaIance sheet extract (Cm) start (1) (2) end Cash x +9,045 x x x Unearned revenue 346 +9,045 -8,912 479 Retained earnings x +8,912 x x x Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 4 Customers pay after Delivery of goods or services i The asset 'accounts receivable' increases because the business has the right to receive cash from customers ii Retained earnings increase because the revenue is earned Receipt of cash from customer i Cash increases ii The asset 'accounts receivable' decreases because the business has no further right to receive cash from customers Goods At the beginning of the period, a supplier of office stationery had accounts receivable of C847m. During the periodthe supplier : (1) Delivered stationery with selling prices of C9,250m to customers; and (2) Received C9,154m from customers in respect of stationery sales. All sales are on credit. BaIance sheet extract (Cm) start (1) (2) end Accounts receivable 847 +9,250 -9,154 943 Cash x +9,154 x x x Retained earnings x +9,250 x x x Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 Over a period Customers pay before Receipt of cash from customer i Cash increases ii The liability 'unearned revenue' increases because the business has an obligation to deliver goods or services Delivery of goods or services i The liability 'unearned revenue' decreases because the business has fulfilled the obligation to deliver goods or services ii Retained earnings increase because the revenue is now earned Gym membership A customer: joins a gym in early April; and pays membership fees of C840 for the right to use the gym's facilities for 12 months. The gym has a 31 December year end. BaIance sheet extract start cash revenue end Cash x +840 x x x Unearned revenue x +840 -630 210 Retained earnings x +630 x x x Revenue for the year ended 31 December = C840 x 9 / 12 = C630 Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 6 Customers pay after Delivery of goods or services i The asset 'accounts receivable' increases because the business has the right to receive cash from customers ii Retained earnings increase because the revenue is earned Receipt of cash from customer i Cash increases ii The asset 'accounts receivable' decreases because the business has no further right to receive cash from customers Building works A builder agrees to build a loft extension for a customer for C50,000. The customer will pay in full when the work is complete. The builder has a 30 September year end. At 30 September the loft extension is proceeding to the customer's satisfaction and is 80% complete. BaIance sheet extract (C000) start revenue cash end Accounts receivable x +40 40 Cash x x x x Retained earnings x +40 x x x Revenue for the year ended 31 September = C50,000 x 80% = C40,000 Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 IAS 19 SaIe of goods Revenue from the sale of goods is recognised when all the following conditions have been satisfied: the enterprise has transferred to the buyer the significant risks and rewards of ownership of the goods; the enterprise retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over goods sold; the amount of revenue can be measured reliably; it is probable that the economic benefits associated with the transaction will flow to the enterprise; the costs incurred or to be incurred in respect of the transaction can be measured reliably. Rendering of services When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction is recognised by reference to the stage of completion of the transaction at the balance sheet date (percentage of completion method). The outcome of a transaction can be estimated reliably when all the following conditions are satisfied: the amount of revenue can be measured reliably; it is probable that the economic benefits associated with the transaction will flow to the enterprise; the stage of completion of the transaction at the balance sheet date can be measured reliably; and the costs incurred for the transaction and the costs to complete the transaction can be measured reliably. When the outcome of the transaction cannot be reliably estimated, revenue should be recognised only to the extent of the expenses recognised that are recoverable (ie no profit is recorded ÷ the completed contract method). Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 8 Lufthansa Revenue is recognised upon the performance of services. Where customers have purchased and paid for flights not yet taken, a liability ('unearned transportation revenue') is recorded. Opening balance sheet Cm Liability ÷ unearned revenue 570 Closing balance sheet P&L account Cash flow statement Cm Cm Cm Revenue EBÌT Liability ÷ unearned revenue 670 Change in unearned revenue 100 ExceptionaI & extraordinary items Different countries have different views on what is exceptional, what is extraordinary and how these items should be presented. Classification Ordinary activities Ordinary activities are any activities which are undertaken as part of an enterprise's business and such related activities in which the enterprise engages in furtherance of, incidental to, or arising from these activities. Extraordinary items Extraordinary items are income or expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and therefore are not expected to recur frequently or regularly. Examples Expropriation of assets Natural disasters Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 ExceptionaI items Exceptional items are items which arise from events or transactions that fall within the ordinary activities of the enterprise and which need to be disclosed by virtue of their size or incidence. Examples Restructuring costs Profits and losses on disposal of PPE Presentation Extraordinary items Extraordinary items are presented on the face of the P&L account. ExceptionaI items Exceptional items are presented either on the face of the P&L account or in the notes to the accounts. Country specifics IAS Ìtems are not presented as extraordinary. US Extraordinary items include expropriations of property, direct results of major casualties, gains and losses on extinguishment of debt, gains on troubled debt restructuring, and losses resulting from prohibition under newly enacted legislation. Unusual or infrequent items that do not qualify as extraordinary items can be reported separately, but must not be reported in a manner that implies that they are extraordinary (eg by presentation net of tax or exclusion from earnings per share). Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 10 Earnings per share Earnings per share (EPS) is a key indicator of financial performance. Ìt is used to calculate the price / earnings ratio (PER), a key indicator of corporate value. Accounting standards To improve comparison of the performance of different entities, accounting standards (eg ÌAS33 and FAS128 [US]): prescribe methods for determining the number of shares to be included in the calculation; and specify how EPS should be presented. Summary Earnings The net profit or loss for the period after deducting dividends and other appropriations in respect of non-equity shares. Number of shares The weighted average number of ordinary shares outstanding (ie issued shares less treasury shares) during the period. Earnings bases Basic (always disclose) Diluted (disclose if material dilution) Types of issue Corresponding change in resources Ìssue to the market Conversion of debt instrument Ìssue as part of consideration for business combination No corresponding change in resources Bonus issue Bonus element in any other issue or buy-back Share split or share consolidation Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 Earnings - basic Earnings = net income. For this purpose, net income is the profit earned for equity owners (ordinary shareholders) during the period. Ìt is after: Depreciation and amortisation Ìnterest Tax Preference dividends (if any) Number of shares - basic Number of shares = weighted average number of ordinary shares outstanding during period. Change in resources Ìn most cases, shares are included in the weighted average number of shares from the date consideration is receivable (which is generally their date of issue), for example: Ordinary shares issued in exchange for cash are included when cash is receivable; and Ordinary shares issued as a result of the conversion of a debt instrument to ordinary shares are included as of the date when interest ceases accruing. IIIustration 1 A company had 20,000 shares in issue on 1 January. On 1 March it repurchased 3,000 of its own shares. On 31 May it issued 8,000 new shares for cash to the market. Time section No of shares Weighting Weighted average 1 Jan ÷ 28 Feb 20,000 2/12 3,333 1 Mar ÷ 31 May 17,000 3/12 4,250 1 Jun ÷ 31 Dec 25,000 7/12 14,583 22,166 Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 12 No change in resources The weighted average number of ordinary shares outstanding during the period and for all periods presented should be adjusted for events that have changed the number of ordinary shares without a corresponding change in resources. These include: Bonus issues; Bonus elements of other issues or buy-backs (eg the bonus element in a rights issue to existing shareholders); Share splits; and Share consolidations. Bonus issues The number of ordinary shares outstanding before the event is adjusted for the proportionate change in the number of ordinary shares outstanding as if the event had occurred at the beginning of the earliest period reported. Illustration 2 A company with a 31 December year-end had earnings of C18,000 in the prior year and has earnings of C22,500 in the current year. Until 30 September in the current year, it had 60,000 ordinary shares outstanding. On 1 October, 2 ordinary shares were issued for each ordinary share outstanding at 30 September. Reported in prior year EPS = 000 , 60 000 , 18 C = 30.0c Reported in current year Current year EPS = 000 , 180 500 , 22 C = 12.5c Prior year EPS = 30c x 1/3 = 10.0c Time section No of shares Weighting Adj Weighted average 1 Jan ÷ 30 Sep 60,000 9/12 3/1 135,000 1 Oct ÷ 31 Dec 180,000 3/12 45,000 180,000 Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 Rights issues The number of shares used in calculating basic EPS for all periods before the rights issue is the number of ordinary shares outstanding before the issue, multiplied by: share per value fair rights ex l Theoretica rights of exercise the before y immediatel share per value Fair Illustration 3 A company with a 31 December year-end had earnings of C30,000 in the prior year and has earnings of C38,000 in the current year. On 1 January in the current year it had 500,000 ordinary shares outstanding. Ìn February it announced a 1 for 5 rights issue at C5.00 per share. The last date to exercise rights was 1 March. The fair value of 1 share immediately before exercise on 1 March was C11.00. Reported in prior year EPS = 000 , 500 000 , 30 C = 6.0c Reported in current year Current year EPS = 667 , 591 000 , 38 C = 6.4c Prior year EPS = 6 c x 10/11 = 5.5c Time section No of shares Weighting Adj Weighted average 1 Jan ÷ 28 Feb 500,000 2/12 11/10 91,667 1 Mar ÷ 31 Dec 600,000 10/12 500,000 591,667 Theoretical ex rights value 6 5 C ) 11 C x 5 ( = C10.00 Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 14 DiIuted EPS Potential ordinary shares Potential ordinary shares are financial instruments or other contracts or rights that may entitle the holder to ordinary shares. ExampIes Convertible debt instruments and preference shares; and Share warrants and options. Dilutive potential ordinary shares Potential ordinary shares should be treated as dilutive when their conversion to ordinary shares would decrease net profit (or increase net loss) per share from continuing operations. Earnings - diluted Earnings = net profit attributable to ordinary shareholders adjusted for effects of all dilutive potential ordinary shares. Adjustments The post-tax effect of: any dividends on dilutive potential ordinary shares that have been deducted in arriving at net profit attributable to ordinary shareholders; interest recognised in the period for the dilutive potential ordinary shares; and any other changes in income or expense that would result from the conversion of the dilutive potential ordinary shares. Number of shares - diluted Number of shares = weighted average number of ordinary shares outstanding during period plus weighted average number of ordinary shares that would be issued on conversion of all dilutive potential ordinary shares into ordinary shares. Potential ordinary shares are deemed to have been converted into ordinary shares at the beginning of the period or, if not in existence at the beginning of the period, the date of issue of the financial instrument or the granting of the rights by which they are generated. Where more than one basis of conversion exists, the calculation assumes the most advantageous conversion rate or exercise price from the standpoint of the holder of the potential ordinary shares. Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 Convertible debt IIIustration Net profit C1,000 Ordinary shares outstanding 10,000 Convertible 10% C1 bonds 1,000 Ìnterest expense for the year relating to the convertible bond C100 Tax relating to interest expense C40 The convertible bonds have been outstanding throughout the period. Each block of 10 bonds is convertible into 15 ordinary shares. Basic EPS 000 , 10 000 , 1 C = 10.0c FuIIy diIuted EPS 500 , 11 060 , 1 C = 9.2c Adjusted net profit C1,000 + C100 - C40 C1,060 Number of ordinary shares for diluted EPS Ordinary shares outstanding 10,000 Number of ordinary shares resulting from bond conversion 1,500 11,500 IAS/IFRS As ÌAS requires split accounting for convertible debt, interest expense is unlikely to correspond to the cash coupon on the bond. For diluted EPS, the adjustment to net profit relates to interest expense recognised in the income statement rather than the cash coupon. Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 16 Share warrants & options For the purpose of calculating diluted EPS, an entity assumes the exercise of dilutive options and other dilutive potential ordinary shares. The assumed proceeds from these issues should be regarded as having been received from the issue of shares at fair value. The difference between the number of shares issued and the number of shares that would have been issued at fair value should be treated as an issue of ordinary shares for no consideration. Fair value is calculated on the basis of the average price of the shares during the reporting period. DiIutive arrangements Options and other share purchase arrangements are dilutive when they would result in the issue of ordinary shares for less than fair value. The amount of the dilution is fair value less the issue price. Each such arrangement is treated as consisting of: 1. A contract to issue a certain number of ordinary shares at fair value during the period. The shares so to be issued are fairly priced and are assumed to be neither dilutive nor anti- dilutive. They are ignored in the computation of diluted EPS; and 2. A contract to issue the remaining ordinary shares for no consideration. Such ordinary shares generate no proceeds and have no effect on the net profit attributable to shares outstanding. Therefore, such shares are dilutive and they are added to the number of ordinary shares outstanding in the calculation of diluted EPS. Dilution adjustments ÌFRS requires an expense to be recognised in respect of share based payment transactions (including share options). Net income is reduced by the after tax effect of this charge. No adjustment is made in calculating diluted earnings. Ìn calculating diluted EPS the exercise price is adjusted to include the fair value of any goods or services to be supplied in the future under the share based payment arrangement. IIIustration A company had earnings of C1,200,000 for the year ended 31 December. The weighted average number of shares for the year was 5,000,000. The average fair value of 1 ordinary share during the year was C4.00. Options to subscribe for 1,000,000 shares at an exercise price of C3.00 per share were outstanding throughout the year. These options vest in one year's time. The fair value of services to be supplied in future years under the option arrangement is C0.10 per option. Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 Basic EPS 000 , 000 , 5 000 , 200 , 1 C = 24.0c Diluted EPS 000 , 225 000 , 000 , 5 000 , 200 , 1 C = 23.0c Issue of shares for no consideration Number of shares under option 1,000,000 Number of shares that would have been issued at fair value = (1,000,000 x C3.10) C4 775,000 Ìssue of shares for no consideration 225,000 Adjusted exercise price = C3.00 + C0.10 = C3.10 Restatement Ìf the number of ordinary or potential ordinary shares outstanding is changed by events, other than the conversion of potential ordinary shares, without a corresponding change in resources, all previous periods' calculations of basic and diluted EPS should be adjusted. Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 18 FinanciaI assets and IiabiIities FinanciaI assets Financial assets include: Accounts receivable Ìnvestments in debt or equity securities Derivatives Accounting Financial assets are classified into four categories. These categories determine: The amounts at which financial assets are carried in the balance sheet The treatment of gains and losses (if any) FinanciaI assets Ioans and receivabIes heId-to-maturity @ fair vaIue through profit or Ioss avaiIabIe-for-saIe Balance sheet carrying amount Amortised cost Amortised cost Fair value Fair value Gains and losses N/a N/a Ìn income statement Ìn equity Examples Accounts receivable Ìnvestment in debt securities Derivatives Ìnvestment in equity securities Impact Classification as available-for-sale (AFS) introduces balance sheet volatility. Classification as at fair value through profit or loss (AFVTPL) introduces balance sheet and income statement volatility. Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 FinanciaI IiabiIities Financial liabilities include: Accounts payable Debt instruments of an issuer Derivatives Accounting Financial liabilities are classified into two categories. These categories determine: The amounts at which financial liabilities are carried in the balance sheet The treatment of gains and losses (if any) FinanciaI IiabiIities @ fair vaIue through profit or Ioss other Balance sheet carrying amount Fair value Amortised cost Gains and losses Ìn income statement N/a Examples Derivatives Accounts payable Debt instruments of an issuer Impact Classification as at fair value through profit or loss (AFVTPL) introduces balance sheet and income statement volatility. Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 20 Measurement Amortised cost Amortised cost is: the amount at which an asset or liability is measured at initial recognition; minus principal repayments; plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount (premium or discount on issue). Fair value Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arm's length transaction. The best indication of fair value is the quoted price in an active market. Ìf the market for a financial instrument is not active, fair value is established by using a valuation technique (a model). Illustration A company has the following assets: Amortised cost Fair vaIue @ start Fair vaIue @ end 1. Trade receivables 200 200 203 2. Purchased option 5 35 45 3. Ìnvestment in corporate bond 300 285 289 4. Ìnvestment in equities 200 257 265 Requirement Show the impact of these assets on the income statement and closing balance sheet. Ìgnore coupon receipts on the corporate bond, dividend receipts on the equities and taxation. Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 Impact Closing balance sheet Income statement Assets Trade receivables Purchased option Ìnvestment in corporate bond Ìnvestment in equities Equity Retained earnings Other recognised gains Other recognised income and expense Ìncome statement, EPS, EV & ROÌC © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 22 SoIution Closing balance sheet Income statement Assets Trade receivables 200 Purchased option 45 Gain on purchased option 10 Ìnvestment in corporate bond 300 Ìnvestment in equities 265 Equity Retained earnings + 10 Net income + 10 Other recognised gains + 8 Other recognised income and expense Gain on equities 8 Cash flow statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Cash fIow statements 1 Ìndirect method 1 Adjusting EBÌT 1 Adjusting net income 2 Depreciation and amortisation 3 Working capital adjustments 3 Cash flow for valuation 7 Levered free cash flow 7 Unlevered free cash flow 7 Cash flow statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 Cash fIow statements Indirect method The indirect method arrives at operating cash flow by adjusting profit for non-cash items which have impacted its calculation. Adjusting EBIT EBÌT 1,014 Depreciation 405 Amortisation - EBÌTDA 1,419 Changes in non-cash working capital Ìncrease in accounts receivable (328) Ìncrease in inventories (605) Ìncrease in accounts payable 798 (135) (135) Operating cash flow before interest and tax 1,284 Ìnterest paid (184) Tax paid (221) Operating cash flow after interest and tax 879 Capital expenditure (995) Decrease (increase) in net debt (116) Cash flow statements 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] EBIT v net income Sales 17,204 Cost of sales (15,150) Other operating expenses (1,040) Earnings before interest and tax (EBÌT) 1,014 Ìnterest (184) Tax (249) Net income 581 Adjusting net income Net income 581 Depreciation 405 Amortisation - Changes in non-cash working capital Ìncrease in accounts receivable (328) Ìncrease in inventories (605) Ìncrease in accounts payable 798 (135) (135) Change in tax and interest liabilities 28 Operating cash flow after interest and tax 879 Capital expenditure (995) Decrease (increase) in net debt (116) Change in tax and interest liabilities As net income is after interest and tax, adjustments must be made to reflect any differences between income statement expenses and cash payments. Cash flow statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 Depreciation and amortisation Depreciation is added back to cancel its effect. Ìt has reduced EBÌT and is not a cash flow. Amortisation is added back for the same reason. EBÌT 1,014 Depreciation 405 Amortisation - EBÌTDA 1,419 Working capitaI adjustments Principles Accounts receivabIe Profit must be adjusted for the difference between: Sales (in the income statement and impacting EBÌT); and Receipts from customers (a cash inflow). Sales 17,204 Ìncrease in accounts receivable (328) Receipts from customers 16,876 Adjustment An increase in accounts receivable is subtracted from EBÌT or EBÌTDA to arrive at operating cash flow. This is because sales increase EBÌT (and EBÌTDA) and receipts from customers are less than sales if accounts receivable have increased. EBÌTDA x Changes in non-cash working capital Ìncrease in accounts receivable (328) Ìncrease in inventories Ìncrease in accounts payable Operating cash flow x Cash flow statements 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Inventories and accounts payabIe Profit must be adjusted for the difference between: Cost of goods sold (in the income statement and impacting EBÌT); and Payments to suppliers (a cash outflow). An increase in inventories means that the cost of goods purchased is greater than the cost of goods sold. An increase in accounts payable means that payments to suppliers are less than the cost of goods purchased. Cost of goods sold 15,150 Ìncrease in inventories 605 Cost of goods purchased 15,755 Ìncrease in accounts payable (798) Payments to suppliers 14,957 Payments to suppliers can be calculated by adding an increase in inventories to and subtracting an increase in accounts payable from cost of goods sold. Adjustment Because cost of goods sold is an expense which reduces EBÌT: An increase in inventories is subtracted from EBÌT or EBÌTDA to arrive at operating cash flow; and An increase in accounts payable is added to EBÌT or EBÌTDA to arrive at operating cash flow. EBÌTDA x Changes in non-cash working capital Ìncrease in accounts receivable Ìncrease in inventories (605) Ìncrease in accounts payable 798 Operating cash flow x Cash flow statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 Practice Ìn published financial statements the balance sheet changes in working capital may not correspond to the adjustments for these items shown in the cash flow statement. IIIustration BaIance sheet Cash fIow statement end start Accounts receivable 652 271 Ìncrease in accounts receivable (328) The balance sheet change in accounts receivable [652 ÷ 271 = 381] will include: The difference between sales and cash receipts from customers The impact of acquisitions and disposals of subsidiaries Foreign exchange differences Other items For example Sales in excess of cash receipts from customers 328 Accounts receivable in subsidiaries acquired 61 Exchange differences (8) Ìncrease in accounts receivable 381 This analysis is typically not provided in the financial statements. Unless a company has not acquired or disposed of subsidiaries and has no foreign exchange differences or similar items, the balance sheet movements in the components of working capital will not correspond to the working capital adjustments in the cash flow statement. Cash flow statements 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Action points Historics When inputting historical data into a cash flow statement proforma, use the working capital adjustments in the published historical cash flow statement (328 in the illustration above) rather than the balance sheet movements. Forecasts One pager Ìntegrated balance sheets are not included. Sales growth is a key value driver. Working capital can be assumed to grow in line with sales. Fully integrated Working capital adjustments link to opening and closing balance sheets. Adjustments are needed for significant acquisitions and disposals of subsidiaries (and exchange differences, if relevant). Cash flow statements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 Cash fIow for vaIuation Levered free cash fIow Use Levered free cash flow (or free cash flow to equity) is forecast and discounted at the cost of equity to arrive at an equity value. Calculation Levered free cash flow is post tax and reflects the company's capital structure. Ìt is after interest, tax and capital expenditure. Ìt represents the cash available to make payments to equity (dividends or share repurchases) and capital repayments of debt. ExampIe Operating cash flow before interest and tax 1,295 Ìnterest paid (180) Tax paid (228) Capital expenditure (590) Levered free cash flow 297 UnIevered free cash fIow Use Unlevered free cash flow (or free cash flow to the enterprise) is forecast and discounted at the weighted average cost of capital to arrive at an enterprise value. Calculation Unlevered free cash flow is post tax and is independent of the company's capital structure. Ìt is before interest but after tax and capital expenditure. Ìt represents the cash available to make any payments to equity (dividends or share repurchases) and debt (interest and capital repayments). Interest tax shieId Ìnterest is tax deductible in most countries ÷ it 'shields' tax. Ìf a company had no net debt and therefore no interest, its tax bill would be higher. To calculate unlevered free cash flow, tax is adjusted to remove this interest tax shield. Cash flow statements 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Given Ìnterest paid (180) Tax paid (228) Tax rate 30% Interest tax shield Ìnterest tax shield = 30% x 180 = 54 Adjusted tax Tax adjusted for interest tax shield = 228 + 54 = 282 ExampIe Operating cash flow before interest and tax 1,295 Adjusted tax (282) Capital expenditure (590) Unlevered free cash flow 423 Reconciling levered and unlevered cash flow Unlevered free cash flow 423 Post tax cost of interest (126) Levered free cash flow 297 Post tax cost of interest As interest is tax deductible, the cost to the company is the post tax cost. Ìnterest after tax = 180 x 70% = 126 M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] M&A accounting 1 Parent 1 Group 1 Consolidated financial statements 1 Ìnvestments 1 Subsidiaries (ÌAS 27) 2 Recognition 2 Measurement 2 Business combinations (ÌFRS 3) 3 Applying the purchase method 3 Goodwill 5 Ìllustration ÷ fair values and goodwill 6 Joint ventures (ÌAS 31) 7 Recognition 7 Measurement 7 Ìllustration 8 Associates (ÌAS 28) 9 Recognition 9 Measurement 9 Ìllustrations 10 Summary 15 M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 M&A accounting Ìn most countries, a parent presents consolidated financial statements for its group. Ìn some countries, a parent also presents its own, legal entity, financial statements. Parent A parent is an enterprise that has one or more subsidiaries. Group A group is a parent and all its subsidiaries. ConsoIidated financiaI statements Consolidated financial statements present financial information about the group as that of a single enterprise (without regard for the legal boundaries of the separate legal entities). Investments Ìn consolidated financial statements, the treatment of long term investments in the equity of other entities depends on the degree of influence which the group exerts over the other entity. degree of infIuence little significant jointly controlled dominant / controlling financiaI asset cost (subject to impairment) or fair value (ÌAS) associate equity account joint venture proportionately consolidate or equity account subsidiary consolidate (purchase / acquisition accounting) M&A accounting 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Subsidiaries (IAS 27) Recognition A subsidiary is an entity that is controlled by another entity. Control Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity unless, in exceptional circumstances, it can clearly be demonstrated that such ownership does not constitute control. Control also exists when the parent owns half or less of the voting power of an entity when there is: power over more than half of the voting rights by virtue of an agreement with other investors; power to govern the financial and operating policies of the entity under a statute or agreement; power to appoint or remove the majority of the members of the board of directors and control of the entity is by that board; or power to cast the majority of votes at meetings of the board of directors and control of the entity is by that board. Measurement A parent which presents consolidated financial statements consolidates all subsidiaries (except those required to be excluded from consolidation). Consolidation Consolidation is the process of adjusting and combining, on a line by line basis, financial information from the individual financial statements of a parent and its subsidiaries to prepare consolidated financial statements. A parent which presents consolidated financial statements consolidates all subsidiaries (except those required to be excluded from consolidation). M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 Business combinations (IFRS 3) All business combinations are accounted for by applying the purchase method. AppIying the purchase method Applying the purchase method involves: 1. identifying an acquirer; 2. measuring the cost of the business combination; and 3. allocating, at the acquisition date, the cost of the business combination to the assets acquired and liabilities and contingent liabilities assumed. Acquisition date The acquisition date is that on which the acquirer effectively obtains control of the acquiree. 1. Identifying the acquirer An acquirer is identified for all business combinations. The acquirer is the combining entity that obtains control of the other combining entities or businesses. Although sometimes it may be difficult to identify an acquirer, there are usually indications that one exists. For example: Ìf the fair value of one of the combining entities is significantly greater than that of the other combining entity, the entity with the greater fair value is likely to be the acquirer. Ìf the business combination is effected through an exchange of voting ordinary equity instruments for cash or other assets, the entity giving up cash or other assets is likely to be the acquirer. Ìf the business combination results in the management of one of the combining enterprises being able to dominate the selection of the management team of the resulting combined entity, the entity whose management is able so to dominate is likely to be the acquirer. When a new entity is formed to issue equity instruments to effect a business combination, one of the combining entities that existed before the combination is identified as the acquirer on the basis of the evidence available. 2. Cost of a business combination The acquirer measures the cost of a business combination as the aggregate of: The fair values, at the date of exchange, of assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer, in exchange for control of the acquiree; plus Any costs directly attributable to the business combination. M&A accounting 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Acquisition date/date of exchange The acquisition date is the date on which the acquirer effectively obtains control of the acquiree. When this is achieved through a single exchange transaction, the date of exchange coincides with the acquisition date. LiabiIities incurred or assumed Future losses or other costs expected to be incurred as a result of a combination are not liabilities incurred or assumed by the acquirer in exchange for control of the acquiree, and are not, therefore, included as part of the cost of the combination. Costs directIy attributabIe to the combination The cost of a business combination includes any costs directly attributable to the combination, such as professional fees paid to accountants, legal advisers, valuers and other consultants to effect the combination. General administrative costs, including the costs of maintaining an acquisitions department, and other costs that cannot be directly attributed to the particular combination being accounted for are not included in the cost of the combination; they are recognised as an expense when incurred. Issue costs Debt issues The costs of arranging and issuing financial liabilities are an integral part of the liability issue transaction (even when the liabilities are issued to effect a business combination) rather than costs directly attributable to the combination. Entities do not include such costs in the cost of a business combination. Equity issues Similarly, the costs of issuing equity instruments are an integral part of the equity issue transaction (even when the equity instruments are issued to effect a business combination) rather than costs directly attributable to the combination. Entities do not include such costs in the cost of a business combination. 3. Allocation of cost of a business combination The acquirer, at the acquisition date, allocates the cost of a business combination by recognising separately the acquiree's identifiable assets, liabilities and contingent liabilities that satisfy the recognition criteria at their fair values at that date. Fair vaIues Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm's length transaction. M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 Acquiree's identifiabIe assets and IiabiIities The acquirer recognises liabilities for terminating or reducing the activities of the acquiree as part of allocating the cost of the combination only when the acquiree has, at the acquisition date, an existing recognised liability for restructuring. The acquirer, when allocating the cost of the combination, shall not recognise liabilities for future losses or other costs expected to be incurred as a result of the business combination. Acquiree's intangibIe assets A non-monetary asset without physical substance must be identifiable to meet the definition of an intangible asset. An asset meets the identifiability criterion only if it: is separable (ie capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged [either individually or together with a related contract, asset or liability); or arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. Minority interests Because the acquirer recognises the acquiree's identifiable assets, liabilities and contingent liabilities which satisfy the recognition criteria at their fair values at the acquisition date, any minority interests in the acquiree is stated at the minority's proportion of the net fair value of those items. Income statement The acquirer's income statement incorporates the acquiree's profits and losses after the acquisition date by including the acquiree's income and expenses based on the cost of the business combination to the acquirer. eg depreciation expense included after the acquisition date in the acquirer's income statement that relates to the acquiree's depreciable assets is based on the fair value of those depreciable assets at the acquisition date (ie their cost to the acquirer). GoodwiII At the acquisition date, the acquirer: recognises goodwill acquired in a business combination as an asset; and initially measures that goodwill at its cost, being the excess of the cost of the business combination over the acquirer's interest in the net fair value of the identifiable assets, liabilities and contingent liabilities recognised. After initial recognition, the acquirer measures goodwill acquired in a business combination at cost less any accumulated impairment losses. Goodwill acquired in a business combination is not amortised. M&A accounting 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Negative goodwiII Ìf the acquirer's interest in the net fair value of the identifiable assets, liabilities and contingent liabilities recognised exceeds the cost of the business combination, the acquirer: reassesses the identification and measurement of the acquiree's identifiable assets, liabilities and contingent liabilities and the measurement of the cost of the combination; and recognises immediately in profit or loss any excess remaining after that reassessment. IIIustration - fair vaIues and goodwiII Company G acquired 100% of Company W. The cost of acquisition was £9,333m. The book value of Company W's net assets at the date of acquisition comprised: £m Ìntangible assets - Property, plant and equipment @ net book amount 1,043 Net working capital 23 Net funds/(debt) 807 1,873 At the date of acquisition: the fair value of identifiable intangible assets generated internally by Company W (excluding its assembled workforce) is £552m; the fair value of property, plant and equipment is £915m; the fair value of net working capital is £40m; the fair value of net funds is £800m. GoodwiII Cost of acquisition 9,333 less: fair value of identifiable assets less liabilities (2,307) Goodwill 7,026 Fair vaIue of identifiabIe assets Iess IiabiIities £m Ìntangible assets 552 Property, plant and equipment 915 Net working capital 40 Net funds/(debt) 800 2,307 M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 Joint ventures (IAS 31) Recognition A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity which is subject to joint control. Joint control Joint control is the contractually agreed sharing of control over an economic activity, and exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control. Measurement Ìn consolidated financial statements, a venturer reports its interest in a jointly controlled entity using: proportionate consolidation; or the equity method. Proportionate consolidation Proportionate consolidation is a method of accounting whereby a venturer's share of each of the assets, liabilities, income and expenses of a jointly controlled entity is combined line by line with similar items in the venturer's financial statements or reported as separate line items in the venturer's financial statements. Equity method The equity method is a method of accounting whereby an interest in a jointly controlled entity is initially recorded at cost and adjusted thereafter for the post-acquisition change in the venturer's share of net assets of the jointly controlled entity. The profit or loss of the venturer includes the venturer's share of the profit or loss of the jointly controlled entity. M&A accounting 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] IIIustration An investing company has contributed £25m for 50% of the equity of a joint venture company. JV company Balance sheet £m PPE 335.0 Debt 285.0 Share capital 0.2 Share premium 49.8 Total finance 335.0 Investing company Own financiaI statements ConsoIidated financiaI statements Equity method Proportionate consoI n Balance sheet (extract) Balance sheet (extract) Balance sheet (extract) £m £m £m Ìnvestment (cost) 25.0 Ìnvestment 25.0 PPE 167.5 Debt 142.5 M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 Associates (IAS 28) Recognition An associate is an entity in which the investor has significant influence and which is neither a subsidiary nor a joint venture of the investor. Significant influence Significant influence is the power to participate in the financial and operating policy decisions of the investee (but is not control or joint control over those policies). The existence of significant influence is usually evidenced in one or more of the following ways: Representation on the board of directors Participation in policy-making processes (including decisions about dividends) Material transactions between the investor and the investee Ìnterchange of managerial personnel Provision of essential technical information 20% stake Ìf an investor holds, directly or indirectly, 20% or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly, less than 20% of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. [A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence.] Measurement An investment in an associate is accounted for under the equity method (except when the investment is acquired and held exclusively with a view to its disposal within 12 months from acquisition and management is actively seeking a buyer). Equity method The equity method is a method of accounting whereby an interest in a jointly controlled entity is initially recorded at cost and adjusted thereafter for the post-acquisition change in the venturer's share of net assets of the jointly controlled entity. The profit or loss of the venturer includes the venturer's share of the profit or loss of the jointly controlled entity. M&A accounting 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] IIIustrations Base case Some time ago, an investing company had contributed £15m for 30% of the equity of an associate company. Associate company Balance sheet (current) £m PPE 435.0 Debt 285.0 Share capital 0.2 Share premium 49.8 Retained earnings 100.0 Total finance 435.0 Investing company Own financiaI statements ConsoIidated financiaI statements Equity method Balance sheet (extract) Balance sheet (extract) £m £m Ìnvestment (cost) 15.0 Ìnvestment 45.0 (30% x (435 ÷ 285)) Retained earnings 30.0 (30% x 100) Associate company P&L (extract) £m Operating profit 90 Ìnterest (40) Profit before tax 50 Tax (17) Profit after tax 33 M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 ConsoIidated financiaI statements Method 1 Method 2 Method 3 Consolidated P&L (extract) Consolidated P&L (extract) Consolidated P&L (extract) £m £m £m Share of operating profit 27 Share of interest (12) Share of PBT 15 Share of tax (5) Share of tax (5) Share of PAT 10 Premium on acquisition An investing company paid £25m for 30% of the equity of an associate company 3 years ago when the net assets (@ fair value) of that company were £50m. Goodwill is amortised over 10 years. [From the beginning of the first annual period beginning on or after 31 March 2004, amortisation is discontinued.] CaIcuIation and treatment The premium on acquisition is £10m. Amortisation for the year is £1m; amortisation to date is £3m. The unamortised premium at the balance sheet date is £7m. Associate company Balance sheet £m PPE 435.0 Debt 285.0 Share capital 0.2 Share premium 49.8 Retained earnings 100.0 Total finance 435.0 M&A accounting 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Investing company Own financiaI statements ConsoIidated financiaI statements Equity method Balance sheet (extract) Balance sheet (extract) £m £m Ìnvestment (cost) 25.0 Ìnvestment 52.0 Retained earnings 27.0 The investment in the consolidated balance sheet comprises unamortised premium £7m plus share of net assets £45m (30% x (435 ÷ 285)). The consolidation adjustment to retained earnings comprises share of post acquisition earnings £30m less premium amortised to date £3m. Associate company P&L (extract) £m Operating profit 90 Ìnterest (40) Profit before tax 50 Tax (17) Profit after tax 33 ConsoIidated financiaI statements Method 1 Method 2 Method 3 Consolidated P&L (extract) Consolidated P&L (extract) Consolidated P&L (extract) £m £m £m Share of operating profit 26 Share of interest (12) Share of PBT 14 Share of tax (5) Share of tax (5) Share of PAT 9 Share of profit is reduced by premium amortisation of £1m. M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 Distribution by associate An investing company contributed £15m for 30% of the equity of an associate company when the net assets (@ fair value) of that company were £50m. The associate pays a dividend in year 3 of £20m. No dividends have previously been paid. Associate company Balance sheet £m PPE 435.0 Debt 305.0 Share capital 0.2 Share premium 49.8 Retained earnings 80.0 Total finance 435.0 Investing company Own financiaI statements ConsoIidated financiaI statements Equity method Balance sheet (extract) Balance sheet (extract) £m £m Ìnvestment (cost) 15.0 Ìnvestment 39.0 Cash 6.0 Retained earnings 6.0 Retained earnings 24.0 Total 30.0 ConsoIidated P&L Method 1 Method 2 Method 3 Consolidated P&L (extract) Consolidated P&L (extract) Consolidated P&L (extract) £m £m £m Share of operating profit 27 Share of interest (12) Share of PBT 15 Share of tax (5) Share of tax (5) Share of PAT 10 M&A accounting 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] The consolidated P&L account includes the investor's share of the associate's results, whether retained or remitted. M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 Summary Long term investment in equity shares (voting rights) Ìndicative ownership < 20% 20% ÷ 50% > 50% Ìnfluence insignificant significant jointIy controIIed controI Ìnvestment type financiaI asset associate joint venture subsidiary Accounting Amortised cost or FV Equity accounting ProportionaI consoIidation ConsoIidation (purchase/acquisition accounting) ConsoIidated income statement Change in fair value "1 line consolidation¨ Our % of A's PAT (Goodwill impairments) No MÌ (US ÷ 1 line Other ÷ 2 lines UK ÷ 5 lines) Line by line our % of JV's Sales to PAT (Goodwill impairments) No MÌ Line by line 100% of S's Sales to PAT (Goodwill impairments) MÌ = MÌ% x S's PAT ConsoIidated baIance sheet Fair value "1 line consolidation¨ Our % of A's net assets Goodwill No MÌ Line by line our % of JV's net assets Goodwill No MÌ Line by line 100% of S's net assets Goodwill MÌ = MÌ% x S's net assets M&A accounting 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] FinanciaI asset Associate Joint venture Subsidiary Accounting Amortised cost or FV Equity accounting ProportionaI consoIidation ConsoIidation (purchase/acquisition accounting) SaIes 0% 0% (although look out for UK's gross equity method which discloses share of sales) Share of sales 100% EBITDA 0% 0% (assuming EBÌT extracted excluding associate) Share of EBÌTDA 100% EBIT 0% 0% (assuming EBÌT extracted excluding associate) Share of EBÌT 100% Net income Change in fair value Share of net income less goodwill impairment Share of net income less goodwill impairment 100% less minority interests less goodwill impairment Cash fIow Dividends received Dividends received from associate Share of cash flows 100% Assets Fair value Ìnvestments in associates @ equity value (1 line) Goodwill (incl. in above) Share of assets (line by line) Goodwill (in intangibles) 100% (line by line) Goodwill (in intangibles) Debt 0% 0% (although may disclose share of debt) Share of debt (line by line) 100% (line by line) Other IiabiIities 0% 0% Share of other liabilities (line by line) 100% (line by line) Minorities 0% 0% 0% Proportion of subsidiary's net assets Impact on SharehoIders' equity Ìncr/decr with adj to FV Ìncr/decr from share of net income less goodwill impairment Ìncr/decr from share of net income less goodwill impairment Ìncr/decr from share of net income less goodwill impairment M&A accounting © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 FinanciaI asset Associate Joint venture Subsidiary Accounting Amortised cost or FV Equity accounting ProportionaI consoIidation ConsoIidation (purchase/acquisition accounting) From equity vaIue to enterprise vaIue (for common multiples) Subtract investments (@ market value if possible) Subtract investments (@ market value if possible) N/a Add minority interests (@ market value if possible) M&A accounting 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Enterprise and equity value © Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Enterprise and equity vaIue 1 Definitions 1 Enterprise value 1 Equity value 1 Multiples 2 Enterprise value 2 Equity value 2 Exercise 1 4 Exercise 2 5 Corporate adjustments 6 Minority interests 6 Associates and equity accounted joint ventures 7 Pension obligations 8 Operating leases 9 Assessing & comparing corporate performance 10 Return on invested capital 10 Economic profit (residual income or EVA) 15 Exercise solutions 16 Exercise 1 16 Exercise 2 18 Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 1 Enterprise and equity vaIue Definitions Enterprise vaIue Enterprise value is the value available to both debt holders and equity holders regardless of capital structure. Ìt is also known as firm value or aggregate value. Equity vaIue Equity value is the residual value available to equity holders once other providers of capital have been repaid. For listed companies this is equivalent to market capitalisation. Equity Equity vaIue Enterprise vaIue Net debt Corporate adjustments Net debt Strictly this should be the market value of the company's debt less any cash and liquid resources. For bank debt, book value will usually approximate market value. This may not be true for long term bonds, which may be trading at a premium or discount according to the interest rate environment and company's credit status. Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 2 Corporate adjustments When calculating valuation multiples the numerator and denominator must be consistent. Adjustments may be needed in respect of: Minority interests Associates and joint ventures Pension obligations Operating leases Other off balance sheet obligations MuItipIes Enterprise vaIue Enterprise value can be expressed as a multiple of any metric which is capital structure neutral. For income and cash flow statement metrics, this means before interest. Metrics Revenues EBÌTDA EBÌTA EBÌT Unlevered free cash flow Sector specific metrics Subscribers (media) Capex adjusted EBÌTDA (telecoms, chemicals) Equity vaIue Equity value can be expressed as a multiple of any metric which is after deducting amounts due to other providers of capital. For income and cash flow statement metrics, this means after interest. Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 3 Metrics Net income Levered free cash flow Sector specific metric Net asset value (property, shipping) Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 4 Exercise 1 You are given the following data about the pharmaceuticals sector in Hungary: EV $m EV/saIes (x) EV/EBITDA (x) EV/EBIT (x) EBITDA margin (%) 2005 2005 2006F 2005 2006F 2005 2006F 2005 2006F Pharmaceuticals 4.7 3.9 17.5 13.9 24.1 17.8 26.8 28.2 Gedeon Richter 1,870 5.9 4.7 19.4 14.9 25.2 18.0 30.4 31.5 Egis 377 2.3 2.2 11.6 10.4 19.5 16.8 19.8 20.8 Part 1 Reconstruct the 2005 P&L accounts for Gedeon Richter and Egis. Prove the EBÌTDA margin from the reconstructed P&L account. Gedeon Richter $m Egis $m Sales Operating costs, excl depreciation EBÌTDA Depreciation EBÌT Why might Gedeon Richter have a higher EV/EBÌTDA ratio than Egis? Gedeon Richter's EV/sales ratio is 2½ times that of Egis but its EV/EBÌTDA ratio is only just over 1½ times that of Egis. What does this indicate? Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 5 Part 2 Reconstruct the 2006 forecast P&L account for Gedeon Richter. 2006 $m Sales Operating costs, excl depreciation EBÌTDA Depreciation EBÌT Why do Gedeon Richter's EV ratios decline from 2005 to 2006? How do Egis' EV ratios behave between 2005 and 2006 and what does this indicate? Exercise 2 You are given the following data about the building materials sector in Hungary: EV $m EV/saIes (x) EV/EBITDA (x) EV/EBIT (x) EBITDA margin (%) 2005 2005 2006F 2005 2006F 2005 2006F 2005 2006F Building materials 1.7 1.4 11.8 9.0 17.0 12.3 14.2 15.2 Graboplast 151 1.3 1.0 11.1 7.9 15.5 11.4 Pannonplast 165 1.7 1.4 15.5 12.1 28.7 16.9 Zalakerámia 147 2.3 2.0 9.7 7.9 12.5 10.0 1. Which company has the highest EBÌTDA margin and how is this indicated by the EV ratios above? 2. Which company is expected to demonstrate the most explosive growth in EBÌT? Which company is expected to demonstrate the highest growth in EBÌTDA? Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 6 Corporate adjustments Minority interests Minority interests represent the portion of the net income and net assets of a subsidiary attributable to equity interests that are not owned (directly or indirectly through subsidiaries) by the parent. Accounting treatment BaIance sheet Under ÌFRS minority interests reflect the carrying amount of net assets attributable to their stakes. Under US GAAP minority interests reflect the book values, in the relevant subsidiaries, of net assets attributable to their stakes. Income statement Minority interests reflect the portion of net income attributable to their stakes in subsidiaries. Minority interests are presented below interest and tax. EV multiples Denominator Consolidated revenue, EBÌTDA and EBÌT include 100% of subsidiaries' revenue, EBÌTDA and EBÌT. Numerator Equity value (ie market capitalisation) includes only the value attributable to equity interests that are owned by the parent. Net debt includes 100% of subsidiaries' net debt. Adjustment For consistency, the estimated value of minority interests is added to equity value and net debt to arrive at EV. Market value is used where available, otherwise a best estimate is used (eg DCF or book value multiple). EV = equity value + net debt + minority interests Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 7 Associates and equity accounted joint ventures Accounting treatment BaIance sheet Under the equity method, investments are included initially at cost and the carrying amount is increased or decreased to recognise the investor's share of the investee's net income after the date of acquisition. Income statement The investor's share of the investee's net income is included in the consolidated income statement. This amount is presented below EBÌT. EV multiples Denominator Consolidated revenue, EBÌTDA and EBÌT exclude revenue, EBÌTDA and EBÌT of equity accounted investments. Numerator Equity value (ie market capitalisation) the value attributable to equity interests that are owned by the parent. This implicitly includes their share of equity accounted investments. Net debt excludes net debt of equity accounted investments. Adjustment For consistency, the estimated value of equity accounted investments is subtracted from equity value to arrive at EV. Market value is used where available, otherwise a best estimate is used (eg DCF or book value multiple). EV = equity value + net debt + minority interests - equity accounted investments Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 8 Pension obIigations Accounting treatment BaIance sheet Many GAAPs (eg US GAAP, ÌFRS) do not require the full pension surplus or deficit to be recognised as an asset or liability in the balance sheet. The pension surplus or deficit must be disclosed in the notes. Income statement Some GAAPs (eg US GAAP) aggregate operating, financing and other elements in the calculation of pension cost for the period. This total pension cost ('net periodic pension cost') is charged to the income statement at the operating level. Under ÌFRS the different elements of the total pension cost may be: aggregated and charged at the operating level; or separated and charged as appropriate (eg as operating and financing items). The total expense recognised for each element of the pension cost, and the line item in which it is included, must be disclosed. Current service cost The current service cost is one of these elements. Ìt represents the increase in the obligation resulting from employee service in the period. EV multiples Numerator A pension deficit is added as it represents capital provided to generate EBÌTDA or EBÌT. As money owed to pensioners (or pension funds) it is a debt-like obligation. Denominator The current service cost is a deferred wage cost and can be regarded as a genuine operating expense. Other elements of the total pension cost are not operating items. Adjustment EBÌT and EBÌTDA are adjusted to remove any elements of pension cost apart from current service cost. EV = equity value + net debt + MÌ ÷ equity accounted investments + pension deficit Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 9 Operating Ieases Accounting treatment BaIance sheet Obligations under operating leases are off balance sheet. They are not included in net debt as disclosed in financial statements. Income statement Operating lease rentals are charged as operating expenses and reduce EBÌTDA and EBÌT. EV multiples Numerator The present value of obligations under operating leases is added in calculating enterprise value. Operating leases are effectively treated as finance leases for this purpose. A multiple (representing an annuity factor) may be applied to the annual lease rental to capitalise operating leases. Denominator EBITDA For consistency with the numerator, EBÌTDA is adjusted to exclude operating lease rentals. Ìf the leases were finance leases the resultant expenses would be depreciation and interest; EBÌTDA is before both of these. EBÌTDA + rental =EBÌTDAR EBIT For consistency with the numerator, EBÌT is adjusted to exclude the interest element of operating lease rentals. EBÌT is after depreciation but before interest. The interest element may be estimated by: applying an interest rate to the present value of the obligation; or apportioning the rental between depreciation and interest (eg and ). EV = equity value + net debt + minority interests ÷ equity accounted investments + pension deficit + PV of operating Iease rentaIs Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 10 Assessing & comparing corporate performance Return on invested capitaI ROÌC = capital invested NOPLAT Net operating profit less adjusted taxes (NOPLAT) The P&L tax charge is adjusted to remove the impact of the financing structure. Financing structure The tax charge is recalculated to remove the interest tax shield which arises if a company has net debt. The adjusted tax charge represents the tax that would arise if the company had no net debt, so that NOPLAT is capital structure neutral. Adjusted taxes A company's profit and loss account shows the following: Profit and loss account Operating profit Ìnterest Profit before tax Tax Profit after tax £m 1,032 (99) 933 (258) 675 The rate of corporation tax is 30%. Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 11 Tax Accounts NOPLAT Adjustments to profit Profit before tax Depreciation and amortisation Capital allowances Other adjustments Taxable profit Tax @ 30% £m 933 ? (?) (?) (73) 860 258 Profit and loss account Operating profit Ìnterest Profit before tax Tax Profit after tax £m 1,032 (99) 933 (258) 675 NOPLAT Operating profit Tax on operating profit NOPLAT Post tax cost of interest Earnings £m 1,032 (288) 744 (69) 675 Working - tax on operating profit Method 1 Method 2 Tax per P&L 258 Profit before tax, if no interest 1,032 Ìnterest tax shield (30% x £99m) 30 Profit before tax, if no interest 1,032 Tax on operating profit 288 Adjustments to profit (73) Taxable profit, if no interest 959 Tax @ 30% 288 Enterprise and equity value © Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] 13 Invested capital Ìnvested capital can be calculated as either: operating working capital + fixed assets + other net assets, excluding cash and liquid resources; or net debt + shareholders funds + minority interests. Tesco 2006 Excluding JVs and associates: Invested capitaI (£m) 2006 2005 Equity attributable to parent equity holders 9,380 8,603 Minority interests 64 51 Net debt 4,509 3,899 Ìnvestments in joint ventures and associates (476) (416) Other investments (4) (7) Held for disposal (82) Post-employment benefit obligations 1,211 735 Deferred tax liabilities, provisions and other liabilities 344 512 Total 14,946 13,377 Average 14,161 Net operating assets (£m) Ìntangible assets 1,525 1,408 Property, plant and equipment (incl investment property) 16,627 15,086 Ìnventories 1,464 1,309 Trade and other receivables (excl finance leases) 875 769 Trade and other payables (5,083) (4,974) Current tax liabilities (462) (221) Total 14,946 13,377 Average 14,161 Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 14 Net operating profit Iess adjusted taxes (£m) 2006 Operating profit 2,280 Current tax charge (note 6) (664) Ìnterest tax shield [(232 + 67) x 30%] (notes 5 & 6) (90) Adjusted tax (754) NOPLAT 1,526 Return on invested capitaI Based on opening invested capital m 377 , 13 £ m 526 , 1 £ = 11.4% Based on average invested capital m 161 , 14 £ m 526 , 1 £ = 10.8% Enterprise vaIue Market capitalisation (given) 26,035 Minority interests 64 Net debt 4,509 Ìnvestments in joint ventures and associates (476) Other investments (4) Held for disposal (82) Enterprise value 30,046 Enterprise and equity value © Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] 15 Economic profit (residuaI income or EVA ) Economic profit = NOPLAT- (invested capital x cost of capital) = (ROÌC - cost of capital) x invested capital Enterprise value £30,046m ROÌC 11.4% NOPLAT P&L £1,526m Ìnvested capital BS £13,377m minus Economic profit £405m Cost of capital 7.5% 'Capital charge' £1,121m EV - ÌC £16,669m PV of future economic profit To increase economic profit and shareholder value a company can: tie up less capital to produce the same profits; invest more capital at a return above the cost of capital; divest capital from economic profit destroying businesses; or reduce its cost of capital. ROIC/WACC If ROIC/WACC > 1 ROÌC > WACC Economic profit is positive = 1 ROÌC = WACC Economic profit is zero < 1 ROÌC < WACC Economic profit is negative Tesco ROÌC/WACC = % 5 . 7 % 2 . 10 = 1.36 Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 16 Exercise soIutions Exercise 1 Part 1 - Solution 2005 P&L accounts for Gedeon Richter and Egis: EV £1,870m £377m Gedeon Richter $m Egis $m Sales = EV 5.9/2.3 Operating costs, excl depreciation EBÌTDA = EV 19.4/11.6 Depreciation EBÌT = EV 25.2/19.5 316.9 (220.5) 96.4 (22.2) 74.2 163.9 (131.4) 32.5 (13.2) 19.3 Gedeon Richter may have a higher EV/EBÌTDA ratio than Egis as the market expects Gedeon Richter's future EBÌTDA to grow more quickly than Egis'. Gedeon Richter's EV/sales ratio is 2½ times that of Egis but its EV/EBÌTDA ratio is only just over 1½ times that of Egis. This indicates that the market values Gedeon Richter's sales more highly than Egis's since Gedeon Richter is able to turn a higher proportion of those sales into profit. This is reflected by Gedeon Richter's higher EBÌTDA margin. Enterprise and equity value © Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] 17 Part 2 - Solution 2006 forecast P&L account for Gedeon Richter: EV £1,870m £1,870m 2006F $m 2005 $m Sales = EV 4.7/5.9 Operating costs, excl depreciation EBÌTDA = EV 14.9/19.4 Depreciation EBÌT = EV 18.0/25.2 397.9 (272.4) 125.5 (21.6) 103.9 316.9 (220.5) 96.4 (22.2) 74.2 Gedeon Richter's EV ratios decline considerably from 2004 to 2006 due to anticipated growth in sales (26%) and profit (30% in EBÌTDA, 40% in EBÌT). Egis' EV ratios decline only slightly due to the very modest expectations of growth. Enterprise and equity value © The Corporate Training Group Limited - +44 (0)20 7490 4770;
[email protected] 18 Exercise 2 Solution EV $m EV/saIes (x) EV/EBITDA (x) EV/EBIT (x) EBITDA margin (%) 2005 2005 2006F 2005 2006F 2005 2006F 2005 2006F Building materials 1.7 1.4 11.8 9.0 17.0 12.3 14.2 15.2 Graboplast 151 1.3 1.0 11.1 7.9 15.5 11.4 11.7 12.6 Pannonplast 165 1.7 1.4 15.5 12.1 28.7 16.9 11.0 11.6 Zalakerámia 147 2.3 2.0 9.7 7.9 12.5 10.0 23.7 25.3 EBITDA margin EBÌTDA margin = EV/sales EV/EBÌTDA. Zalakerámia has the highest EBÌTDA margin. The market is prepared to pay a higher multiple of Zalakerámia's sales than the sector average, as (given the roughly similar growth rates for companies in the sector) Zalakerámia is able to turn a higher proportion of those sales into profit. EBIT growth Pannonplast is expected to demonstrate the most explosive growth in EBÌT, at 70% [28.7 ÷ 16.9 = 170%]. EBITDA growth Graboplast is expected to demonstrate the highest growth in EBÌTDA, at 41% [11.1 ÷ 7.9 = 141%]. Accounting & analysis exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] EXERCISES AND CASE STUDIES Coset pIc 1 Kissat Ltd 5 Potomac 9 Mag Ltd 16 Ourstair Ltd 19 FIash Tuna AG 23 Theramax Ltd 27 Monty, Tiger & Seve 30 EaseI 33 EnteachabIes Inc 34 A BS Inc 39 Erkki, Nuutti and Mikko 42 Primrose pIc 43 Birren pIc 44 OnyaIi pIc 45 Scrutinise DeaI 46 Pearson rights issue 47 Discounted debt 48 ConvertibIe debt 50 King, Wade & Graf 51 Deutsche TeIekom 54 Morientes & FriedeI 56 Pensions 60 PampIe & Mousse (1) 62 Mango & Steen 67 Accounting & analysis exercises The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 Coset pIc Coset plc is a food retailer. The opening balance sheet showed: £m Property, plant and equipment 5,249 Ìnventories 550 Accounts receivable 78 Cash and deposits 65 _______ Total assets 5,942 _______ Accounts payable 826 Tax payable 255 Debt 856 Ordinary share capital 109 Share premium 1,431 Retained earnings 2,465 _______ Liabilities & shareholders' equity 5,942 _______ The following took place during the year: 1. Purchased goods on credit costing £11,100m. Sold on credit for £16,452m goods costing £11,066m. 2. Received £16,397m from customers in respect of sales on credit. Paid £10,954m to suppliers in respect of purchases on credit. 3. Ìncurred and paid store operating costs (to be classified as cost of sales) of £3,851m and administrative expenses (to be classified as administrative expenses) of £384m. 4. Purchased and paid for property, plant and equipment costing £985m. Charged depreciation of £358m (£300m to be charged as cost of sales and £58m to be charged as administrative expenses). 5. Ìssued shares for £131m (nominal value £1m) and raised debt of £183m. 6. Ìncurred and paid interest of £85m, of which £20m was capitalised into property plant and equipment. 7. Paid corporation tax for prior year of £255m. Estimated corporation tax for the current year at £223m. Accounting & analysis exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 2 8. Paid dividends of £233m. Requirements a. Prepare a balance sheet at the end of the year (using the following pro-forma). b. Prepare an income statement and cash flow statement for the year (use the following proformas). c. Prepare a brief commentary on cash flow generation and utilisation in the year. Accounting & analysis exercises The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 BaIance sheet start 1 2 3 4 5 6 7 8 end £m £m £m £m £m £m £m £m £m £m PPE 5,249 Ìnventories 550 A/cs receivable 78 Cash 65 TotaI assets 5,942 A/cs payable 826 Tax payable 255 Debt 856 Ord share cap 109 Share premium 1,431 Retained earnings 2,465 LiabiIities & equity 5,942 Accounting & analysis exercises The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 Kissat Ltd Kissat Ltd operates hotels, casinos and health clubs. The opening balance sheet showed: £m Property, plant and equipment 590 Ìnventories 4 Accounts receivable 16 Cash and deposits 8 _____ TotaI assets 618 _____ Accounts payable 22 Tax payable 9 Debt 354 Ordinary share capital 49 Share premium 113 Retained earnings 71 _____ LiabiIities & sharehoIders' equity 618 _____ The following took place during the year: 1. Made sales on credit of £307m. Received £285m from customers in respect of sales on credit. 2. Purchased on credit supplies costing £59m. Used supplies costing £58m. Paid £55m to suppliers in respect of purchases on credit. 3. Ìncurred, on credit, operating expenses (to be classified as cost of sales) of £162m. Paid £157m to suppliers in respect of operating expenses incurred on credit. 4. Ìssued shares for £232m (nominal value £27m) and raised debt of £143m. 5. Purchased and paid for property, plant and equipment costing £412m. Charged depreciation of £13m (to be classified as administrative expenses). 6. Ìncurred and paid interest of £18m. 7. Paid corporation tax of £8m in full settlement of the prior year amount. Estimated corporation tax for the current year at £18m. 8. Paid dividends of £14m. Accounting & analysis exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 6 Requirements a. Prepare a balance sheet at the end of the year. b. Prepare an income statement and cash flow statement for the year. c. Prepare a brief commentary on cash flow generation and utilisation in the year. Accounting & analysis exercises The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 start 1 2 3 4 5 6 7 8 end £m £m £m £m £m £m £m £m £m £m PPE 590 Ìnventories 4 A/cs receivable 16 Cash 8 TotaI assets 618 A/cs payable 22 Tax payable 9 Debt 354 Ord share cap 49 Share premium 113 Retained earnings 71 LiabiIities & equity 618 Accounting & analysis exercises The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 Potomac Potomac provides international marine transportation, container distribution and shipping agency services. The opening balance sheet showed: $m Property, plant and equipment 1,665 Ìnventories 2 Accounts receivable 50 Cash and deposits 4 _______ Total assets 1,721 _______ Accounts payable 17 Tax payable 41 Debt 621 Ordinary share capital 727 Share premium 76 Retained earnings 239 _______ Liabilities & shareholders' equity 1,721 _______ The following took place during the year: 1. Purchased fuel and other inventories on credit costing $100m. Used fuel and other inventories costing $99m. Paid $97m to suppliers in respect of purchases on credit. 2. Billed customers for services provided of $1,258m. Received $1,250m from customers in respect of services provided on credit. 3. Ìncurred (on credit) transportation and distribution costs (to be classified as cost of sales) of $843m. Paid $835m to suppliers in respect of costs incurred on credit. 4. Ìncurred and paid administrative expenses (to be classified as administrative expenses) of $82m. 5. Purchased and paid for property, plant and equipment costing $75m. Charged depreciation of $115m ($100m to be charged as cost of sales and $15m to be charged as administrative expenses). 6. Ìncurred and paid $13m in respect of major improvements increasing the efficiency or extending the useful lives of plant and equipment. Ìncurred and paid $25m in respect of regular maintenance of and repairs to property, plant and equipment. Accounting & analysis exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 10 7. Disposed of, for $21m, plant and equipment with a carrying amount of $25m. Received $21m in respect of this disposal. 8. Ìncurred and paid interest of $20m, of which $3m was capitalised into property, plant and equipment. 9. Paid corporation tax for prior year of $41m. Estimated corporation tax for the current year at $26m. 10. Paid dividends of £40m. Repaid debt of $44m. Requirements a. Prepare a balance sheet at the end of the year (using the following pro-forma). b. Prepare an income statement and cash flow statement for the year (use the following proformas). c. Prepare a brief commentary on cash flow generation and utilisation in the year. Accounting & analysis exercises The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 BaIance sheet Start 1 2 3 4 5 6 7 8 9 10 end $m $m $m $m $m $m $m $m $m $m $m $m PPE 1,665 Ìnventories 2 A/cs receivable 50 Cash 4 TotaI assets 1,721 A/cs payable 17 Tax payable 41 Debt 621 Ord share cap 727 Share premium 76 Retained earnings 239 LiabiIities & equity 1,721 Accounting & analysis exercises The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 Income statement Sales Cost of sales Administrative expenses Operating profit, before exceptional items Loss on disposal Operating profit, after exceptional items Ìnterest expense Profit before tax Tax Net income Statement of changes in equity Retained earnings @ start of year Net income Dividend Retained earnings @ end of year Accounting & analysis exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 14 Cash fIow statement - direct Receipts from customers Operating expenses paid Operating cash flow (1) Ìnterest paid Tax paid Operating cash flow (2) Capital expenditure Disposal Dividends Debt repaid Change in cash Accounting & analysis exercises The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 Cash fIow statement - indirect Operating profit, before exceptional items Depreciation EBÌTDA Ìncrease in accounts receivable Ìncrease in inventories Ìncrease in accounts payable Operating cash flow (1) Ìnterest paid Tax paid Operating cash flow (2) Capital expenditure Disposal proceeds Dividends Debt repaid Change in cash Accounting & analysis exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 16 Mag Ltd Mag Ltd is a publisher of magazines. The opening balance sheet showed: £'000 Property, plant and equipment 41,441 Ìnventories 13,985 Accounts receivable 25,952 Cash and deposits 3,515 _________ TotaI assets 84,893 _________ Accounts payable 24,128 Tax payable 890 Debt 21,836 Ordinary shares 5,082 Share premium 14,569 Retained earnings 18,388 _________ LiabiIities & sharehoIders' equity 84,893 _________ The following took place during the year: 1. Made sales on credit of £118,113,000. Received £121,665,000 from customers in respect of sales on credit. 2. Purchased on credit paper and printing materials costing £73,097,000. Used paper and printing materials costing £75,064,000. Paid £75,043,000 to suppliers in respect of paper and printing materials purchased on credit. 3. Ìncurred and paid operating expenses of £38,624,000 (£23,729,000 to be classified as cost of sales and the balance as administrative expenses). 4. Repaid debt of £2,833,000. 5. Purchased and paid for property, plant and equipment costing £1,498,000. Charged depreciation of £5,055,000 (£3,709,000 to be classified as cost of sales and the balance as administrative expenses). 6. Ìncurred and paid interest of £1,529,000. 7. Paid corporation tax of £866,000 in full settlement of the prior year amount. Estimated corporation tax for the current year at £196,000. 8. Paid a dividend of £981,000. Accounting & analysis exercises The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 9. Purchased and paid for a magazine title from a small independent publishing company for £2,000,000. The useful life of the title is regarded as indefinite and consequently no amortisation is charged. The title will be reviewed annually for impairment and written down as necessary. Requirements a. Prepare a balance sheet at the end of the year. [A proforma is provided on the following page] b. Prepare an income statement and cash flow statement for the year. c. Prepare a brief commentary on cash flow generation and utilisation in the year. d. Comment briefly on the effect on profit (earnings) and cash flow if the magazine title were to be amortised over 20 years. Accounting, analysis & valuation exercises 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] BaIance sheet start 1 2 3 4 5 6 7 8 9 end £000 £000 £000 £000 £000 £000 £000 £000 £000 £000 £000 PPE 41,441 Ìnventories 13,985 A/cs receivable 25,952 Cash 3,515 TotaI assets 84,893 A/cs payable 24,128 Tax payable 890 Debt 21,836 Ord share cap 5,082 Share premium 14,569 Retained earnings 18,388 LiabiIities & equity 84,893 Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 Ourstair Ltd Ourstair Ltd is a leisure travel operator. The opening balance sheet showed: £m Property, plant and equipment 519.9 Ìnventories 6.4 Cash and deposits 549.2 _______ TotaI assets 1,075.5 _______ Accounts payable and operating accruals 621.4 Tax payable 16.1 Revenue received in advance 199.4 Debt 92.7 Ordinary share capital 20.0 Share premium 32.2 Retained earnings 93.7 _______ LiabiIities & sharehoIders' equity 1,075.5 _______ The following took place during the year: 1. Received £2,717.6m from customers in respect of holidays to be taken in the future. Earned £2,671.3m in respect of holidays taken by customers. 2. Purchased on credit inventories and consumables costing £96.0m. Used consumables costing £85.4m. Paid £90.5m to suppliers in respect of inventories and consumables purchased on credit. 3. Ìncurred on credit operating expenses (to be classified as cost of sales) of £2,265.3m. Paid £2,264.4m to suppliers in respect of operating expenses incurred on credit. Ìncurred and paid for further operating expenses of £252.6m (to be classified as administrative expenses). 4. Ìssued shares for £83.1m (nominal value £27.5m) and raised debt of £5.5m. 5. Purchased and paid for property, plant and equipment costing £110.1m. Charged depreciation of £37.0m (to be classified as other operating expenses). 6. Earned and received interest of £17.1m. 7. Paid corporation tax for prior year of £16.1m. Estimated corporation tax for the current year at £23.1m. 8. Paid dividends of £31.8m. Accounting, analysis & valuation exercises 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Requirements a. Prepare a balance sheet at the end of the year (using the following proforma). b. Prepare an income statement and cash flow statement for the year. c. Prepare a brief commentary on cash flow generation and utilisation in the year. Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 start 1 2 3 4 5 6 7 8 end £m £m £m £m £m £m £m £m £m £m PPE 519.9 Ìnventories 6.4 Cash 549.2 TotaI assets 1,075.5 A/cs payable & accruals 621.4 Tax payable 16.1 Revenue in advance 199.4 Debt 92.7 Ord share cap 20.0 Share premium 32.2 Retained earnings 93.7 LiabiIities & equity 1,075.5 Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 23 FIash Tuna AG Flash Tuna AG operates international and domestic scheduled and charter air services. The opening balance sheet showed: C million Property, plant and equipment - owned 6,944 Property, plant and equipment - leased 2,111 Ìnventories 75 Accounts receivable 1,432 Cash and deposits 738 _________ TotaI assets 11,300 _________ Accounts payable 2,710 Tax payable 65 Debt 5,174 Provisions 30 Ordinary shares 260 Share premium 650 Retained earnings 2,411 _________ LiabiIities & sharehoIders' equity 11,300 _________ The following took place during the year: 1. Made sales on credit of C 8,915m. Received C 9,011m from customers in respect of sales made on credit. 2. Ìncurred on credit fuel costs, landing fees, handling charges and administrative expenses of C 4,967m (to be classified as cost of sales). Paid C 4,859m to suppliers in respect of fuel costs, landing fees, handling charges and administrative expenses incurred on credit. 3. Purchased and paid for raw materials and consumables costing C 390m. Used raw materials and consumables costing C 381m. 4. Ìncurred and paid employment costs of C 2,356m (C 2,179m to be classified as cost of sales and the balance as administrative expenses). 5. Ìncurred and paid operating lease rentals of C 150m (to be classified as cost of sales). 6. Purchased and paid for property, plant and equipment costing C 223m. Charged depreciation of C 352m on owned assets (to be classified as cost of sales). Wrote owned assets down by a further C 50m for impairment. Accounting, analysis & valuation exercises 24 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7. Entered into new finance leases. At inception, the present value of the minimum lease payments was C 1,619m. Charged depreciation of C 217m on leased assets (to be classified as cost of sales). Charged interest of C 290m. Paid C 641m to the lessor. 8. Repaid debt of C 127m and raised new debt of C 237m. 9. Ìncurred and paid interest of C 80m. Capitalised C 13m of this interest into property under construction. 10. Reduced provision for unredeemed frequent flyer liabilities by C 4m. 11. Paid corporation tax for prior year of C 65m. Estimated corporation tax for the current year at C 25m. 12. Paid a dividend of C 191m. Requirements a. Prepare a balance sheet at the end of the year. [A proforma is provided on the following page] b. Prepare an income statement for the year. c. Prepare a cash flow statement for the year, using the indirect method of deriving net cash inflow from operating activities. (Start by adjusting/reconciling operating profit to net cash inflow from operating activities.) d. Prepare a brief commentary on cash flow generation and utilisation in the year and what this may suggest about the future prospects for Flash Tuna AG. Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 25 BaIance sheet start 1 2 3 4 5 6 7 8 9 10 11 12 end Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm PPE - owned 6,944 PPE - Ieased 2,111 Inventories 75 Accounts receivabIe 1,432 Cash 738 TotaI assets 11,300 Accounts payabIe 2,710 Tax payabIe 65 Debt 5,174 Provisions 30 Ordinary shares 260 Share premium 650 Retained earnings 2,411 LiabiIities & equity 11,300 Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 27 Theramax Ltd Theramax Ltd discovers, develops and sells prescription drugs, vaccines and health care products. The opening balance sheet showed: £m Tangible fixed assets 3,635 Stocks - raw materials 283 Stocks - finished goods 572 Operating debtors 1,555 Ìnvestments - liquid funds 1,408 Cash 254 _______ TotaI assets 7,707 _______ Operating creditors and accruals 932 Tax payable 820 Debt 3,145 Provision for compensation 121 Ordinary shares 894 Share premium 805 Retained earnings 990 _______ LiabiIities & sharehoIders' equity 7,707 _______ The following took place during the year: 1. Purchased on credit raw materials costing £2,017m. Used raw materials costing £1,839m in the manufacture of products in the period. Paid £1,993m to suppliers in respect of raw materials purchased on credit. 2. Ìncurred and paid employment costs of £1,808m (manufacturing £610m, selling, general and administration £893m and research and development £305m). 3. Purchased and paid for tangible fixed assets costing £420m. Charged depreciation of £358m (manufacturing £90m, selling, general and administration £214m and research and development £54m). 4. Sold on credit for £7,983m products costing £2,418m to manufacture (raw materials, employment costs and depreciation). Received £7,798m from customers in respect of product sold on credit. 5. Ìncurred on credit other operating costs of £2,385m (selling, general and administration costs £1,581m and research and development £804m). Paid suppliers £2,370m in respect of other operating costs incurred on credit. 6. Ìssued shares for net cash proceeds of £356m (par value £12m). Accounting, analysis & valuation exercises 28 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7. Repaid debt of £58m. Raised new debt of £117m. 8. Ìncurred and paid interest of £152m. Earned and received interest of £61m. Purchased liquid investments costing £209m. 9. Ìncreased provision for compensation by £20m (to be classified as selling, general and administration). 10. Paid corporation tax of £1,007m (£808m in respect of the prior year and £199m on account of the current year). Estimated that additional tax payable for the current year would amount to £416m. 11. Paid dividends of £355m. Requirements a. Prepare a balance sheet at the end of the year. b. Prepare an income statement and cash flow statement for the year. c. Prepare a brief commentary on cash flow generation and utilisation in the year. Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 29 Theramax Ltd start 1 2 3 4 5 6 7 8 9 10 11 end £m £m £m £m £m £m £m £m £m £m £m £m £m Tangible fixed assets 3,635 Stocks - RMs 283 Stocks - FGs 572 Operating debtors 1,555 Ìnvestments - liquid funds 1,408 Cash 254 7,707 Operating creditors 932 Tax payable 820 Debt 3,145 Provision for compensation 121 Ordinary shares 894 Share premium 805 Retained earnings 990 7,707 Accounting, analysis & valuation exercises 30 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Monty, Tiger & Seve Monty pIc $m $m Current Previous BaIance sheet Fixed assets 350 350 Non cash current assets 130 130 Cash 40 27 Current liabilities (63) (62) Debt (290) (290) _______ ______ 167 155 _______ ______ Share capital 20 20 Retained earnings 147 135 _______ ______ 167 155 _______ ______ Profit & Ioss account $m Current Turnover 500 Cost of sales (320) ______ Gross profit 180 Depreciation (70) Other operating costs (30) Ìnterest payable (29) ______ Profit before tax 51 Tax (19) ______ Profit after tax 32 Dividend (20) ______ Retained profit for the year 12 ______ Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 31 Tiger pIc $m $m Current Previous BaIance sheet Fixed assets 450 250 Non cash current assets 250 50 Cash 23 25 Current liabilities (98) (33) Debt (555) (245) _______ ______ 70 47 _______ ______ Share capital 20 20 Retained earnings 50 27 _______ ______ 70 47 _______ ______ Profit & Ioss account $m Current Turnover 500 Cost of sales (320) ______ Gross profit 180 Depreciation (70) Other operating costs (30) Ìnterest payable (40) ______ Profit before tax 40 Tax (17) ______ Profit after tax 23 Dividend - ______ Retained profit for the year 23 ______ Accounting, analysis & valuation exercises 32 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Seve pIc $m $m Current Previous BaIance sheet Fixed assets 300 400 Non cash current assets 62 187 Cash 49 13 Current liabilities (32) (100) Debt (175) (300) _______ ______ 204 200 _______ ______ Share capital 20 20 Retained earnings 184 180 _______ ______ 204 200 _______ ______ Profit & Ioss account $m Current Turnover 450 Cost of sales (320) ______ Gross profit 130 Depreciation (70) Other operating costs (30) Ìnterest payable (24) ______ Profit before tax 6 Tax (2) ______ Profit after tax 4 Dividend - ______ Retained profit for the year 4 ______ Requirement Produce a cash flow statement for the current year, identifying free cash flow for each company. Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 33 EaseI Easel plc enters into a 4 year lease to acquire the use of an asset. Annual instalments are £228,000 (payable in arrears). The interest rate implicit in the lease is 11½%. The present value of the minimum lease payments is approximately £700,000. At the end of the first year of the lease, the financial statements would show: Finance Iease Balance sheet P&L account Cash flow statement £000 £000 £000 Tangible fixed assets Operating expenses (depreciation) Servicing of finance Creditors Ìnterest payable Financing Operating Iease Balance sheet P&L account Cash flow statement £000 £000 £000 Operating expenses Operating cash flow Accounting, analysis & valuation exercises 34 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] EnteachabIes Inc Your client, Cash Driver plc, is looking into the acquisition of Enteachables Ìnc, a US company which publishes insurance and legal journals on subscription. Enteachables Ìnc has the following balance sheet as at the proposed date of acquisition: Balance sheet as at take-over date Assets $000 $000 Current assets Cash 1,343.0 Receivables 5,342.6 Ìnventories 12.9 ______ 6,698.5 Ìnvestments & other assets Ìnvestments 18.0 Ìntangibles 2,324.6 ______ 2,342.6 Property, plant & equipment Tangibles at book value 617.1 _______ 9,658.2 _______ LiabiIities & sharehoIders equity Current Liabilities Trade payables 3,436.8 Accruals & deferred income 1,269.6 Tax 548.1 ______ 5,254.5 Debt 1,271.4 Shareholders' equity Preference stock 1,838.3 Common stock 266.6 Retained earnings 1,027.4 ______ 3,132.3 ________ 9,658.2 ________ Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 35 Based upon prior year figures, and knowledge of Enteachables Ìnc's prospects for income, costs and cash flows, the following forecast figures have been estimated for the 12 month period immediately following the take-over: Forecast Income Statement for 12 months following take-over $000 Revenues 14,850.7 Operating costs (12,647.9) _____________ EBÌTDA 2,202.8 Depreciation ( 268.8) Amortisation ( 128.6) Loss on disposal of PPE ( 10.1) ___________ Operating income / EBÌT 1,795.3 Ìnterest receivable 165.5 Ìnterest payable (197.9) ___________ Ìncome before taxes 1,762.9 Taxation (598.1) ___________ Net income for the year 1,164.8 Preferred stock dividends (221.2) ___________ Earnings on common stock 943.6 ___________ Accounting, analysis & valuation exercises 36 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Forecast cash flows for the 12 months following take-over $000 $000 EBÌT 1,795.3 Loss on disposal of PPE 10.1 _________ Underlying EBÌT 1,805.4 Depreciation 268.8 Amortisation 128.6 _________ EBÌTDA 2,202.8 Decrease in inventories 1.2 Ìncrease in receivables (45.7) Ìncrease in payables & operating accruals 911.9 _________ Operating cash fIow 3,070.2 Ìnterest received 165.5 Ìnterest paid (197.9) Non-equity dividend paid (221.2) _________ Financing fIows (253.6) Tax paid (557.3) Purchase of PPE (581.3) Sale proceeds from disposal of PPE - _________ Net capex (581.3) Equity dividends paid (321.6) _______ Decrease in net debt 1,356.4 Repayment of Ioans (251.4) _______ Ìncrease in cash 1,105.0 _______ Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 37 Requirement Based on the above projections produce a balance sheet showing the position of Enteachables Ìnc at the end of the 12 months following the take-over using the following: Balance sheet 12 months post acquisition Current Forecast $000 $000 Current assets Cash 1,343.0 Receivables 5,342.6 Ìnventories 12.9 _______ ____ 6,698.5 Ìnvestments & other assets Ìnvestments 18.0 Ìntangibles 2,324.6 _______ ____ 2,342.6 Property, plant & equipment Tangibles at book value 617.1 _______ ____ 9,658.2 _______ ____ LiabiIities & sharehoIders equity Current Liabilities Trade payables 3,436.8 Accruals & deferred income 1,269.6 Tax 548.1 _______ ____ 5,254.5 Debt 1,271.4 Shareholders' equity Preference stock 1,838.3 Common stock 266.6 Retained earnings 1,027.4 _______ ____ 3,132.3 _______ ____ 9,658.2 _______ ____ Accounting, analysis & valuation exercises 38 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Requirement Calculate the following ratios to test the reasonableness of the projections: At takeover/12 months pre-takeover 12 months post take-over Underlying EBÌT margin 11.7% EBÌTDA margin 14.1% Capex/depn 1.4 x Ìnterest cover 3.4 x Gearing 57.7% ROCE 53.2% Debtor days 141 days Payables/accrual days 136 days Where: Ìnterest cover = dividend equity - non paid interest received interest EBÌT Net debt = debt + preference stock ÷ cash Equity shareholders' funds = common stock + retained earnings Capital employed = net debt + equity shareholders' funds Gearing = net debt capital employed ROCE = underlying EBÌT capital employed Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 39 A BS Inc A BS Ìnc has a portfolio of businesses principally engaged in meeting beverage consumers' needs. Beer is the major profit contributor, but an important balance is provided by interests in carbonated soft drinks and other complimentary beverages, supplemented by strategic investments in hotels and gaming. Most of the group's activities take place in Africa. An analyst has produced the following forecasts for the group, but has not yet completed the forecast balance sheet. Requirement Using the following information produce a forecast balance sheet of A BS Ìnc. Income statement ActuaI Forecast $m $m Turnover 5,028 4,923 Cost of sales 2,153 2,278 _____ _____ Gross profit 2,875 2,645 Other operating costs 2,010 1,722 Depreciation 226 245 Amortisation 1 2 Exceptional loss ÷ disposal of brewery - 9 Exceptional loss ÷ impairment of brewery - 71 ____ ____ Operating profit 638 596 Share of operating profit of associates 69 121 Net interest payable 59 117 ____ ____ Profit before tax 648 600 Taxation 211 195 ____ ____ Profit after tax 437 405 Minority interests 59 85 ____ ____ Net income 378 320 ____ ____ Accounting, analysis & valuation exercises 40 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Cash fIow statement ActuaI Forecast $m $m Operating profit 638 596 Exceptional loss ÷ disposal of brewery - 9 Exceptional loss ÷ impairment of brewery - 71 Depreciation & amortisation 227 247 ____ ____ EBITDA 865 923 Other non-cash items 42 17 Ìncrease in inventories (33) (10) Ìncrease in accounts receivable (11) (107) Ìncrease in accounts payable 58 65 ____ ____ Operating cash fIow 921 888 Dividends from associates 19 16 Dividends paid to minority interests (37) (57) Ìnterest paid (93) (144) Ìnterest received 56 66 Tax (160) (166) ____ ____ Free cash fIow pre capex 706 603 Purchase of PPE (414) (588) Proceeds from sale of PPE 40 43 Purchase of other long term investments (21) - ____ ____ Free cash fIow pre acquisitive capex 311 58 Purchase of subsidiary (172) (206) Purchase of associates (79) (67) ____ ____ Free cash fIow post aII capex 60 (215) Dividends - - Share issue 1 265 Loans 56 (9) Short-term deposits (152) (419) ____ ____ Cash fIow (35) (378) ____ ____ Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 41 BaIance sheet ActuaI Forecast $m $m Current assets Ìnventories 386 Accounts receivable 620 Ìnvestments 187 Cash 415 ____ ____ 1,608 Fixed assets Ìntangible assets 1 PPE 1,810 Ìnvestments 53 Ìnvestments in associates 340 ____ ____ 2,204 ____ ____ TotaI assets 3,812 ____ ____ Current liabilities Accounts payable 639 Tax 135 Other liabilities 259 ____ ____ 1,033 Debt 1,090 Provisions Deferred tax 41 Other 492 Minority interests 58 Capital & reserves Share capital 2 Additional paid-in capital 40 Retained earnings 1,056 ____ ____ TotaI IiabiIities & equity 3,812 ____ ____ Accounting, analysis & valuation exercises 42 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Erkki, Nuutti and Mikko Erkki Erkki Ìnc has a 31 st December year end. On 1 st January there were 300,000 ordinary shares in issue. On 31 st August, 100,000 new ordinary shares were issued to the market. Earnings for the current year are $315,000. EPS, as reported in the prior year, was 90.0c. Nuutti Nuutti Ìnc has a 31 st December year end. On 1 st January there were 300,000 ordinary shares in issue. On 31 st August, there was a bonus issue of 1 new ordinary share for every 3 shares held. Earnings for the current year are $240,000. EPS, as reported in the prior year, was 76.0c. Mikko Mikko Ìnc has a 31 st December year end. On 1 st January there were 300,000 ordinary shares in issue. On 31 st August, there was a rights issue of 1 new ordinary share for every 3 shares held at $11 per share. Ìmmediately prior to becoming ex-rights, the share price was $15. The rights issue was fully taken up. Earnings for the current year are $295,000. EPS, as reported in the prior year, was 86.6c. Requirement Calculate earnings per share for the current year. Restate EPS for the prior year, where necessary, and calculate the % growth in EPS. Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 43 Primrose pIc On 1 April 2004 Primrose plc had 4,000,000 10p ordinary shares in issue. During the year ended 31 March 2005, the following transactions affected share capital: 1. On 1 August 2004 the company made a 1 for 4 rights issue. The offer price was 45p per share and the fair value of 1 share immediately before exercise was 60p. 2. On 1 January 2005 the company issued 2 million ordinary shares at their full market price. Extracts from the P&L account for the year ended 31 March 2005 are shown below: 2005 2004 £'000 £'000 Profit on ordinary activities before tax 2,705 2,480 Tax on profit on ordinary activities (812) (769) ________ ________ Profit on ordinary activities after tax 1,893 1,711 Dividends (300) (300) ________ ________ Retained earnings for the year 1,593 1,411 ________ ________ Requirement Calculate the earnings per share for the year ended 31 March 2005 and the comparative figure for the year ended 31 March 2004. (Assume that there were no changes to issued share capital during the year ended 31 March 2004). Accounting, analysis & valuation exercises 44 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Birren pIc Birren plc has 3,000,000 ordinary shares in issue. On 1 October 2003 the company issued £1,700,000 5% convertible unsecured loan stock. The terms of conversion for each £100 nominal value of loan stock are as follows: 31 March 2006 140 ordinary shares 31 March 2007 130 ordinary shares 31 March 2008 120 ordinary shares 31 March 2009 110 ordinary shares Extracts from the P&L account of Birren plc for the 2 years ended 31 March 2005 are shown below. 2005 2004 £'000 £'000 Profit on ordinary activities before taxation 1,500 1,300 Tax on profit on ordinary activities (500) (400) _______ _______ Profit on ordinary activities after taxation 1,000 900 Dividends (300) (200) _______ _______ Retained profit for the year 700 700 _______ _______ Assume corporation tax at 30%. Requirement Calculate the earnings per share figures that would appear in the financial statements of Birren plc for the years ended 31 March 2004 and 31 March 2005. Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 45 OnyaIi pIc Onyali Ìnternational plc is listed on the Stock Exchanges of several countries and prepares its financial statements in accordance with Ìnternational Accounting Standards (ÌASs). Earnings for the year ended 31 March are £928,000. Share capital throughout the year comprises 5,000,000 ordinary shares. Also in issue throughout the year are options to subscribe for 750,000 shares at £2.10. Requirement Calculate the basic and fully diluted EPS for the year ended 31 March if the average price of Onyali Ìnternational plc shares during the year was: (i) £2.08; (ii) £3.08. Accounting, analysis & valuation exercises 46 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Scrutinise DeaI Scrutinise Deal had net income for the year of £233.1m and shareholders' funds at the year-end of £6,150.9m. Throughout the year the company had 1.87m share options outstanding, the cumulative proceeds from their exercise being £13.9m over the next 9 years. Additionally the company had in issue throughout the year £260m 6% Guaranteed Convertible Bonds due in 2010 which, due to the fact that it was issued at a discount, was in the books at £246.1m. These bonds: a. At the holder's option may be converted, up to and including 22 nd March 2010, into 2½ % Exchangeable Redeemable Preference Shares in Scrutinise Deal which are exchangeable for up to a maximum of 34,031,414 ordinary shares of £1 in Scrutinise Deal at 764p per share or b. At the option of the issuer may be redeemed on or after 14 th April 2007 at par; earlier redemption can only take place if at least 85% of the bonds have been converted into ordinary shares or have been purchased or redeemed and then cancelled. Scrutinise Deal had 522.4m ordinary shares of £1 in issue at the start of the year and 523.6m in issue by the end of the year - the increase being due to a small placing of shares in the year. The corporate tax rate is 30%. The share price of Scrutinise Deal shares at the end of year was 878p whilst the average for the year had been 1064p. Requirement Calculate both the basic and diluted a. Earnings per share b. Net assets per share Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 47 Pearson rights issue Scenario Pearson plc has a 31 st December year end. On 1 st January 2000 there were 613m shares in issue. On 15 th January 2000, 11m shares were issued under a placing. On 30 th June 2000 3m shares were issued under share option and employee share schemes. Rights issue On 28 th July 2000 Pearson announced a 3 for 11 rights issue* at £10 per share. Ìmmediately prior to the announcement, the share price was £20.10. Ìmmediately subsequent to the announcement, the share price was £19.31. [* in the US, this would be expressed as 14 for 11] On 9 th August 2000 the shares became ex-rights. Ìmmediately prior to becoming ex-rights, the share price was £18.57. The shares were issued on 1 st September 2000. Earnings Earnings for the year ended 31 st December 2000 were £179m. Prior year Earnings for the year ended 31 st December 1999 were £294m. The weighted average number of shares was 615.4m. Requirement Calculate earnings per share for the year ended 31 st December 2000. Assume the rights issue was fully taken up. Accounting, analysis & valuation exercises 48 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Discounted debt Zero coupon On 1 st March 2004 a company issued a £100m zero-coupon bond for net proceeds of £65m. The bond is redeemable on 28 th February 2009 at par. The yield to maturity is 9%. How would the above be represented in the financial statements for the year ended 28 th February 2005? 28 th February 2005 Balance sheet P&L account Cash flow statement £m £m £m Servicing of finance Debt Ìnterest payable Financing Deep discount On 1 st March 2001 a company issued a £125m 4% bond for net proceeds of £76.5m. Ìnterest is payable annually in arrears on 28 th February each year. The bond is redeemable on 28 th February 2011 at par. The yield to maturity is 10.43%. How would the above be represented in the financial statements for the year ended 28 th February 2005? 28 th February 2005 Balance sheet P&L account Cash flow statement £m £m £m Servicing of finance Debt Ìnterest payable Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 49 Index Iinked On 1 st September 2004 a company issued a £200m 4% bond for net proceeds of £200m. Ìnterest is payable semi-annually in arrears on 28 th February and 28 th August each year. The bond is redeemable on 28 th August 2020 at par value indexed for increases in the RPÌ over the life of the bond. The RPÌ for the year to 28 th February 2005 is 3%. How would the above be represented in the financial statements for the year ended 28 th February 2005? 28 th February 2005 Balance sheet P&L account Cash flow statement £m £m £m Servicing of finance Debt Ìnterest payable Financing Index Iinked (coIIar) On 1 st September 2004 a company issued a £160m 3.322% bond for net proceeds of £160m. Ìnterest is payable semi-annually in arrears on 28 th February and 28 th August each year. The bond is redeemable on 28 th August 2026 at par value indexed for increases in the RPÌ over the life of the bond. The maximum indexation of the principal in any one year is 5%, with a minimum of 0%. The RPÌ for the year to 28 th February 2005 is 3%. How would the above be represented in the financial statements for the year ended 28 th February 2005? 28 th February 2005 Balance sheet P&L account Cash flow statement £m £m £m Servicing of finance Debt Ìnterest payable Financing Accounting, analysis & valuation exercises 50 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] ConvertibIe debt On 1 st October 2004 a company issued £300m unsecured 5.75% subordinated convertible bonds, due 2009, at par. Ìssue costs amounted to £9.1m. The bonds are convertible at the option of the bondholder at any time between 31 st January 2005 and 30 th September 2009 into fully paid ordinary shares of 10p each at an initial conversion price of 443p per share. Ìnterest is payable on the bonds at an annual rate of 5.75% per annum, payable annually in arrears. The company may redeem the bonds in whole, but not in part, only at their principal amount with accrued interest: at any time after 30 th September 2007 provided that the average share price within the 30 day period ending on the tenth day prior to the date on which notice of redemption is given to bondholders shall have been at least 130% of the conversion price; or at any time if, prior to the date of notice of such redemption, conversion rights shall have been exercised in respect of 90% or more in principal amount of the bonds originally issued. Unless previously purchased, redeemed or converted the bonds will be redeemed at their principal amount on 30 th September 2009, being the final maturity date. Other information The yield to maturity, building the net proceeds of £290.9m up to £300m over 3 years (when issuer call option is first exercisable) is 6.9038%. Requirement Show how the above would be accounted for in the financial statements for the year ended 30 th September 2005. 30 th September 2005 Balance sheet P&L account Cash flow statement £m £m £m Cash Operating expenses Servicing of finance Debt Ìnterest payable Financing Equity Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 51 King, Wade & Graf King Inc $m $m Current Previous BaIance sheet Ìntangible fixed assets 180 190 Tangible fixed assets 269 240 Ìnventories 40 38 Receivables 123 67 Cash 33 27 Current liabilities (78) (62) Debt (300) (245) _______ ______ 267 255 _______ ______ Share capital 10 10 Additional paid in capital 57 57 Retained earnings 200 188 _______ ______ 267 255 _______ ______ Profit & Ioss account $m Current Turnover 503 Cost of sales (330) ______ Gross profit 173 Depreciation (70) Amortisation (10) Other operating costs (25) Exceptional item - loss on asset disposals (3) Ìnterest payable (26) ______ Profit before tax 39 Tax (15) ______ Profit after tax 24 ______ Ìnterest of $15m was capitalised into tangible fixed assets during the period. Tangible fixed assets with a net book value of $43m were disposed of during the period. Dividends of $12m were paid in the period. Accounting, analysis & valuation exercises 52 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Wade pIc $m $m Current Previous BaIance sheet Ìntangible fixed assets 200 200 Fixed assets 397 260 Ìnventories 43 38 Receivables 123 67 Cash 27 27 Current liabilities (63) (62) Debt (135) (135) _______ ______ 592 395 _______ ______ Share capital 23 20 Share premium 116 67 P&L and revaluation reserves 453 308 _______ ______ 592 395 _______ ______ Profit & Ioss account $m Current Turnover 503 Cost of sales (330) ______ Gross profit 173 Depreciation (60) Other operating costs (10) Exceptional item -loss on asset disposals (5) Ìnterest payable (23) ______ Profit before tax 75 Tax (15) ______ Profit after tax 60 Dividends (15) ______ Profit retained for year 45 ______ Ìnterest of $15m was capitalised into tangible fixed assets and $3m was capitalised into inventories during the period. Tangible fixed assets with a net book value of $45m were disposed of during the period. Tangible fixed assets were revalued upwards by $100m during the period. Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 53 Graf AG $m $m Current Previous BaIance sheet Ìntangible fixed assets 50 150 Tangible fixed assets 120 150 Ìnventories 80 38 Receivables 70 67 Cash 5 27 Current liabilities (92) (62) Debt (120) (120) _______ ______ 113 250 _______ ______ Share capital 20 20 Capital reserve 100 100 Ìncome statement (7) 130 _______ ______ 113 250 _______ ______ Profit & Ioss account $m Current Turnover 450 Cost of sales (290) ______ Gross profit 160 Depreciation (130) Amortisation (100) Other operating costs (39) Ìnterest payable (41) ______ Profit/(loss) before tax (150) Extraordinary income - gain on asset disposals 13 Tax - ______ Profit/(loss) after tax (137) ______ No interest was capitalised during the period. Tangible fixed assets with a net book value of $27m were disposed of during the period. Requirement a. Compare the operating profit and earnings of the 3 companies. b. Produce a cash flow statement for the current year, identifying free cash flow for each. Accounting, analysis & valuation exercises 54 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Deutsche TeIekom EBITDA Gesamtkostenverfahren Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 55 Requirement Calculate EBÌT (or operating profit), EBÌTA and EBÌTDA for the most recent year. Accept the company's classification of 'other operating income'. Cm Sales Net operating costs, excl depreciation EBITDA Depreciation EBITA Amortisation EBIT Accounting, analysis & valuation exercises 56 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Morientes & FriedeI Morientes SA Financial statements BaIance sheet end start Goodwill 31,752 37,044 Property, plant & equipment 53,343 53,738 Ìnventories 21,832 20,389 Accounts receivable 78,972 77,053 185,899 188,224 Current liabilities 66,083 62,580 Net debt 70,161 76,622 Paid in capital 18,171 18,171 Retained earnings 31,484 30,851 185,899 188,224 Income statement (extract) EBÌT 31,923 Ìnterest (6,586) Tax (12,654) Net income 12,683 Statement of changes in equity (extract) Net income 12,683 Dividends (12,050) Equity at start 49,022 Equity at end 49,655 Market capitalisation is 518,245. Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 57 Notes 1. No goodwill was acquired during the period. 2. No property, plant or equipment was disposed of during the period. The depreciation charge for the year was 26,134. 3. Accounts receivable comprise operating receivables and prepayments. 4. Current liabilities comprise: end start Operating accounts payable 53,429 52,792 Current tax payable 12,654 9,788 66,083 62,580 5. Net debt comprises: end start Convertible debt 97,666 94,080 Cash (27,505) (17,458) 70,161 76,622 The convertible debt has a par value of 100,000 and pays a coupon of 3%. Ìt is redeemable at a premium of 10% or convertible into equity shares in 3 year's time. 6. Ìnterest comprises interest on convertible debt (at an effective rate of 7%). Ìnterest is not capitalised. 7. No shares were issued during the period. Requirements Prepare a cash flow statement for the period. Calculate EBÌTDA EV , Ìnterest EBÌT and EBÌTDA debt Net . Accounting, analysis & valuation exercises 58 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] FriedeI Inc Financial statements BaIance sheet end start Goodwill 52,920 52,920 Property, plant & equipment 210,892 243,107 Ìnventories 80,027 78,043 Accounts receivable 76,895 75,774 420,734 449,844 Current liabilities 86,262 97,992 Provisions 25,672 24,329 Net debt 207,425 253,708 Paid in capital 8,900 8,900 Retained earnings 92,475 64,915 420,734 449,844 Income statement (extract) EBÌT 70,371 Ìnterest (16,764) Tax (13,997) Net income 39,610 Statement of changes in equity (extract) Net income 39,610 Dividends (12,050) Equity at start 73,815 Equity at end 101,375 Market capitalisation is 518,245. Notes 1. No goodwill was acquired during the period. Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 59 2. No property, plant or equipment was disposed of during the period. No new finance leases were entered into during the period. Property, plant and equipment comprises: end start Owned assets 87,892 79,107 Assets held under finance leases 123,000 164,000 210,892 243,107 3. The depreciation charge on owned assets was 16,954 for the year. 4. Accounts receivable comprise operating receivables and prepayments. 5. Current liabilities comprise: end start Operating accounts payable 51,765 47,886 Unearned revenue 21,843 40,318 Current tax payable 12,654 9,788 86,262 97,992 6. Provisions comprise provision for deferred tax. 7. Net debt comprises: end start Convertible debt 103,720 101,816 Finance leases 131,210 169,350 Cash (27,505) (17,458) 207,425 253,708 The convertible debt has a par value of 100,000 and pays a coupon of 3%. Ìt is redeemable at a premium of 10% or convertible into equity shares in 3 year's time. 8. Ìnterest comprises: Ìnterest on convertible debt 4,904 Finance charges on finance leases 11,860 16,764 Ìnterest is not capitalised. 9. No shares were issued during the period. Requirement Prepare a cash flow statement for the period. Calculate EBÌTDA FV , Ìnterest EBÌT and EBÌTDA debt Net . Accounting, analysis & valuation exercises 60 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Pensions Siemens AG has a defined benefit pension scheme. Ìt prepares its consolidated financial statements in accordance with US GAAP. The net periodic pension cost for the period of C447m has been charged to operating expenses during the year. The market capitalisation of Siemens AG is C42,250m. Ìts consolidated financial statements show: Balance sheet (extracts) P&L account Cm Cm Cash and cash equivalents 11,196 EBÌTDA 6,058 D&A (4,126) Debt 12,346 EBÌT 1,932 Accrual for pension plans 3,557 Net interest income/(expense) 318 Minority interests 541 Other financial income 1,225 Shareholders equity 23,521 EBT 3,475 Pension plan disclosures Change in projected benefit obIigation Cm Projected benefit obligation at beginning of year 18,544 Service cost 487 Ìnterest cost 1,151 Actuarial losses/(gains) 240 Benefits paid (930) _________ Projected benefit obligation at end of year 19,492 _________ Change in pIan assets Cm Fair value of plan assets at beginning of year 14,625 Actual return on plan assets (1,187) Contributions 2,023 Benefits paid (930) _________ Fair value of plan assets at end of year 14,531 _________ Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 61 Net periodic pension cost Cm Service cost 487 Ìnterest cost 1,151 Expected return on plan assets (1,421) Amortisation of unrecognised net losses 230 _________ Net periodic pension cost 447 _________ Requirements Calculate net debt/EBÌTDA for Siemens AG: using reported data (ignoring pensions disclosures); adjusting for the real pension deficit and service cost. Corporate tax Assume a corporate tax rate of 39%. Accounting, analysis & valuation exercises 62 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] PampIe & Mousse (1) Pample acquires 50% of the shares of Mousse. The consideration given to the shareholders of Mousse comprises shares in Pample with a fair value of C309m and cash of C91m. Acquisition costs (investment banking fees etc) are C8m. Share issue costs are C1m. Both companies have the same year-end. The balance sheet of Mousse reflects fair values. Goodwill is not to be amortised. No impairment write down is anticipated in the year following the transaction. Assume interest at 5% and corporation tax at 40%. Stand aIone baIance sheets immediateIy prior to transaction (Cm) Pample Mousse Net operating assets 1,298 984 ____ ____ 1,298 984 ____ ____ Net debt 450 568 Shares 121 56 Retained earnings 727 360 ____ ____ 1,298 984 ____ ____ Forecast resuIts for the year foIIowing the transaction (Cm) Pample Mousse Sales 1,163 994 Operating costs (959) (820) ____ ____ EBÌT 204 174 Ìnterest (36) (62) Tax (33) (30) ____ ____ Net income 135 82 ____ ____ Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 63 Requirements 1. Calculate goodwill arising on the transaction. 2. Prepare the combined balance sheet immediately after the transaction if Mousse is consolidated as a subsidiary proportionately consolidated as a joint venture equity accounted as an associate 3. Prepare the combined income statement for the year following the transaction if Mousse is: consolidated as a subsidiary proportionately consolidated as a joint venture equity accounted as an associate Proformas are provided on the following pages. Accounting, analysis & valuation exercises 64 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Combined balance sheet: Mousse consolidated as a subsidiary PampIe Mousse Net operating assets 1,298 984 ____ ____ 1,298 984 ____ ____ Net debt 450 568 Shares 121 56 Retained earnings 727 360 ____ ____ 1,298 984 ____ ____ Combined balance sheet: Mousse proportionately consolidated as a JV PampIe Mousse Net operating assets 1,298 984 ____ ____ 1,298 984 ____ ____ Net debt 450 568 Shares 121 56 Retained earnings 727 360 ____ ____ 1,298 984 ____ ____ Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 65 Combined balance sheet: Mousse equity accounted as an associate PampIe Mousse Net operating assets 1,298 984 ____ ____ 1,298 984 ____ ____ Net debt 450 568 Shares 121 56 Retained earnings 727 360 ____ ____ 1,298 984 ____ ____ Combined income statement: Mousse consolidated as a subsidiary PampIe Mousse Sales 1,163 994 Operating costs (959) (820) ____ ____ EBÌT 204 174 Ìnterest (36) (62) Tax (33) (30) ____ ____ Net income 135 82 ____ ____ Accounting, analysis & valuation exercises 66 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Combined income statement: Mousse proportionately consolidated as a JV PampIe Mousse Sales 1,163 994 Operating costs (959) (820) ____ ____ EBÌT 204 174 Ìnterest (36) (62) Tax (33) (30) ____ ____ Net income 135 82 ____ ____ Combined income statement: Mousse equity accounted as an associate Pample Mousse Sales 1,163 994 Operating costs (959) (820) ____ ____ EBÌT 204 174 Ìnterest (36) (62) Tax (33) (30) ____ ____ Net income 135 82 ____ ____ Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 67 Mango & Steen Mango plc is to acquire 100% of the shares of Steen plc. The consideration will comprise either: £2,700m in cash; or £3,100m of shares in Mango plc (comprising 1,525m shares with a fair value of 203¼p each); or £2,250m of shares in Mango plc (comprising 1,107m shares with a fair value of 203¼p each) and £750m in cash. Both companies have the same year-end. The balance sheet of Steen reflects fair values. Goodwill is not to be amortised but is to be reviewed annually for impairment. Assume interest at 6% and corporation tax at 30%. Balance sheets immediately prior to transaction (£m) Mango Steen Net operating assets 1,000 3,267 Net funds/(debt) 115 (1,133) _____ _____ 1,115 2,134 _____ _____ Shares 172 984 Retained earnings 943 1,150 _____ _____ 1,115 2,134 _____ _____ Forecast results for the year following the transaction (£m) Mango Steen Sales 4,384 8,969 Operating costs, excl dep'n (4,017) (8,336) ____ ____ EBÌTDA 367 633 Depreciation (109) (190) ____ ____ EBÌT 258 443 Ìnterest 14 (65) Tax (97) (117) ____ ____ Net income 175 261 ____ ____ Number of shares 1,720m EPS 10.2p Accounting, analysis & valuation exercises 68 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Requirement 1. Calculate goodwill arising on the transaction. 2. Prepare the combined balance sheet immediately after the transaction. 3. Prepare the combined income statement for the year following the transaction. Proformas are provided on the following pages. Other potential points Expected reduction in revenues £150m Expected operating cost savings £250m Additional depreciation on Steen assets £80m Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 69 Combined balance sheet (immediately after acquisition) Mango Steen ConsoIidated Cash Shares Shares & cash Net operating assets 1,000 3,267 Net funds/(debt) 115 (1,133) ____ ____ ____ ____ ____ 1,115 2,134 ____ ____ ____ ____ ____ Shares 172 984 Retained earnings 943 1,150 ____ ____ ____ ____ ____ 1,115 2,134 ____ ____ ____ ____ ____ Accounting, analysis & valuation exercises 70 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Combined income statement (first year after acquisition) Mango Steen Consolidated Cash Shares Shares & cash Sales 4,384 8,969 Operating costs, excl dep'n (4,017) (8,336) ____ ____ ____ ____ ____ EBÌTDA 367 633 Depreciation (109) (190) ____ ____ ____ ____ ____ EBÌT 258 443 Ìnterest 14 (65) Tax (97) (117) ____ ____ ____ ____ ____ Net income 175 261 ____ ____ ____ ____ ____ Number of shares (m) 1,720m EPS 10.2p Accounting, analysis & valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] EXERCISES AND CASE STUDY SOLUTIONS Coset pIc 1 Kissat Ltd 6 Potomac 10 Mag Ltd 17 Ourstair Ltd 21 FIash Tuna AG 25 Theramax Ltd 29 Monty, Tiger & Seve 34 EaseI 36 EnteachabIes Inc 37 A BS Inc 39 Erkki, Nuutti and Mikko 40 Primrose pIc 42 Birren pIc 43 OnyaIi pIc 44 Scrutinise DeaI 45 Pearson rights issue 46 Discounted debt 47 ConvertibIe debt 49 King, Wade & Graf 52 Deutsche TeIekom 60 Morientes & FriedeI 61 Pensions 65 PampIe & Mousse (1) 66 Mango & Steen 70 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 Coset pIc start 1 2 3 4 5 6 7 8 end £m £m £m £m £m £m £m £m £m £m PPE 5,249 985-358 20 5,896 Ìnventories 550 11,100- 11,066 584 A/cs receivable 78 16,452 (16,397) 133 Cash 65 16,397- 10,954 (3,851)+ (384) (985) 183+ 131 (85) (255) (233) 29 TotaI assets 5,942 16,486 (10,954) (4,235) (358) 314 (65) (255) (233) 6,642 A/cs payable 826 11,100 (10,954) 972 Tax payable 255 (255)+ 223 223 Debt 856 183 1,039 Ord share cap 109 1 110 Share premium 1,431 130 1,561 Retained earnings 2,465 16,452- 11,066 (3,851)+ (384) (358) (65) (223) (233) 2,737 LiabiIities & equity 5,942 16,486 (10,954) (4,235) (358) 314 (65) (255) (233) 6,642 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 2 CIosing baIance sheet £m Property, plant and equipment 5,896 Ìnventories 584 Accounts receivable 133 Cash and deposits 29 ____ Total assets 6,642 ____ Accounts payable 972 Tax payable 223 Debt 1,039 Ordinary share capital 110 Share premium 1,561 Retained earnings 2,737 ____ Liabilities & shareholders' equity 6,642 ____ Income statement for the year £m Revenue 16,452 Cost of sales (11,066 + 3,851 + 300) (15,217) _________ 1,235 Administrative expenses (384 + 58) (442) _______ Profit before interest and tax 793 Ìnterest payable and similar charges (65) _______ Profit before tax 728 Taxation (223) _______ Profit after tax 505 _______ Retained earnings at start 2,465 Retained profit 505 Dividends (233) Other reserve movements - _______ Retained earnings at end (per balance sheet) 2,737 _______ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 Cash fIow statement for year - direct £m £m Receipts from customers 16,397 Payments to suppliers (10,954) Operating costs (3,851) Administrative expenses (384) Operating cash flows 1,208 Ìnterest (85) Tax (255) Capital expenditure (985) _______ Free cash flow (117) Dividends (233) Ìssue of shares 131 Ìssue of debt 183 Financing cash flows 314 Decrease in cash and deposits in year (36) Cash fIow statement for year - indirect (1) £m £m Operating profit 793 Depreciation 358 EBITDA 1,151 Increase in inventories (584 - 550) (34) Increase in receivables (133 - 78) (55) Increase in payables (972 - 826) 146 Operating cash flow 1,208 Ìnterest (85) Tax (223 ÷ [255 + 223]) (255) Capital expenditure (5,896 ÷ [5,249 + 20 ÷ 358]) (985) _______ Levered free cash flow (117) Dividends (177 - (155 + 255)) (233) Ìssue of shares (110 + 1,561) - (109 + 1,431) 131 Ìssue of debt (1,039 - 856) 183 Financing cash flows 314 Decrease in cash and deposits in year (36) Here operating cash flow is before interest and tax. Capitalised interest is classified as interest. Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 4 Cash fIow statement for year - indirect (2) £m £m Net income 505 Depreciation 358 Increase in inventories (584 - 550) (34) Increase in receivables (133 - 78) (55) Increase in payables (972 - 826) 146 Decrease in tax payable (32) Operating cash flow 888 Capital expenditure (5,896 ÷ [5,249 ÷ 358]) (1,005) _______ Levered free cash flow (117) Dividends (177- [155 + 255]) (233) Ìssue of shares (110 + 1,561) - (109 + 1,431) 131 Ìssue of debt (1,039 - 856) 183 Financing cash flows 314 Decrease in cash and deposits in year (36) Here operating cash flow is after interest and tax. Capitalised interest is classified as capital expenditure. Commentary Coset is an expanding business with capital expenditure significantly in excess of depreciation. Despite this growth, cash convertibility of EBÌTDA is good (@ 105%) due to good, and improving, working capital management. Working capital is (increasingly) negative as short-term finance provided by suppliers exceeds the company's investment in inventories and receivables. This indicates the strength of the company's relationship with its suppliers and the effectiveness of Coset's management in controlling the working capital cycle through this expansive phase. A cash interest cover of 14 times suggests the company has very low levels of gearing and risk ÷ indicating that the company has an ineffective capital structure but with great flexibility for raising future debt. Operating cash flow is more than adequate to fund interest and tax commitments and replacement capital expenditure highlighting the company's flexibility. A significant dividend has been paid despite the negative free cash flow that indicates the age and maturity of the company. To finance growth capital expenditure and dividends, it has been necessary to raise some new debt and equity finance during the year. This new finance has been used for the current years' activities with no significant excess available for next year. Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 Cash fIows for vaIuation Free cash flow to equity (levered free cash flow) Method 1 Operating cash flow before interest and tax 1,208 Ìnterest (85) Tax (223 ÷ [255 + 223]) (255) Capital expenditure (5,896 ÷ [5,249 + 20 ÷ 358]) (985) _______ Levered FCF/FCF to equity (117) _______ Method 2 Operating cash flow after interest and tax 888 Capital expenditure (5,896 ÷ [5,249 ÷ 358]) (1,005) _______ Levered FCF/FCF to equity (117) _______ Free cash flow to the enterprise or firm (unlevered free cash flow) Operating cash flow before interest and tax 1,208 Adjusted tax (255 + [85 x 33%]) (283) Capital expenditure (5,896 ÷ [5,249 + 20 ÷ 358]) (985) _______ Unlevered FCF/FCF to the enterprise (60) _______ Assumption Rate of corporation tax is 33%. ReconciIiation Unlevered FCF/FCF to the enterprise (60) Ìnterest, net of tax (85 x 67%) (57) _______ Levered FCF/FCF to equity (117) _______ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 6 Kissat Ltd start 1 2 3 4 5 6 7 8 end £m £m £m £m £m £m £m £m £m £m PPE 590 399 989 Ìnventories 4 1 5 A/cs receivable 16 22 38 Cash 8 285 (55) (157) 375 (412) (18) (8) (14) 4 TotaI assets 618 307 (54) (157) 375 (13) (18) (8) (14) 1,036 A/cs payable 22 4 5 31 Tax payable 9 9 18 Debt 354 143 497 Ord share cap 49 27 76 Share premium 113 205 318 Retained earnings 71 307 (58) (162) (13) (18) (17) (14) 96 LiabiIities & equity 618 307 (54) (157) 375 (13) (18) (8) (14) 1,036 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 CIosing baIance sheet £m Property, plant and equipment 989 Ìnventories 5 Accounts receivable 38 Cash and deposits 4 ____ Total assets 1,036 ____ Accounts payable and operating accruals 31 Tax payable 18 Long-term loan 497 Ordinary share capital 76 Share premium 318 Retained earnings 96 ____ Liabilities & shareholders' equity 1,036 ____ Income statement for the year £m Revenue 307 Cost of sales (58 + 162) (220) _______ 87 Administrative expenses (13) _______ Profit before interest and tax 74 Ìnterest payable and similar charges (18) _______ Profit before tax 56 Taxation (18 ÷ 1) (17) _______ Profit after tax 39 _______ Retained earnings at start 71 Profit after tax 39 Dividends (14) Other reserve movements - _______ Retained earnings at end (per balance sheet) 96 _______ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 8 Cash fIow statement for year - direct method £m £m Receipts from customers 285 Payments to suppliers (55) Operating expenses (157) Operating cash flow 73 Ìnterest (18) Tax (8) Capital expenditure (412) _______ Free cash flow (365) Dividends (14) Ìssue of shares 232 Ìssue of debt 143 Financing cash flows 375 Decrease in cash and deposits in year (reconciliation done above) (4) _____ Cash fIow statement for year - indirect method (1) £m £m Operating profit 74 Depreciation 13 EBITDA 87 Increase in inventories (1) Increase in receivables (22) Increase in payables and operating accruals 9 Operating cash flow 73 Ìnterest (18) Tax (8) Capital expenditure (412) _______ Free cash flow (365) Dividends (14) Ìssue of shares 232 Ìssue of debt 143 Financing cash flows __375 Decrease in cash and deposits in year (4) Cash at start of year 8 _____ Cash at end of year 4 _____ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 Commentary Cash convertibility of EBÌTDA is acceptable (@ 84%) with the growth in working capital reflecting growth in the business. Ìnterest, tax and replacement capital expenditure* absorb much of the current operating cash flow and (significant) growth capital expenditure, together with a modest dividend, must be funded by raising new finance (debt and equity). [* Properties in the leisure sector are often not depreciated. Depreciation is likely to understate maintenance or replacement capital expenditure.] Cash fIow statement for year - indirect method (2) £m £m Net income 39 Depreciation 13 Increase in inventories (1) Increase in receivables (22) Increase in payables and operating accruals 9 Increase in tax payable 9 Operating cash flow 47 Capital expenditure (412) _______ Free cash flow (365) Dividends (14) Ìssue of shares 232 Ìssue of debt 143 Financing cash flows __375 Decrease in cash and deposits in year (4) Cash at start of year 8 _____ Cash at end of year 4 _____ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 10 Potomac BaIance sheet $m Property, plant and equipment 1,616 Ìnventories 3 Accounts receivable 58 Cash and deposits 3 _______ Total assets 1,680 _______ Accounts payable 28 Tax payable 26 Debt 577 Ordinary share capital 727 Share premium 76 Retained earnings 246 _______ Liabilities & shareholders' equity 1,680 _______ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 BaIance sheet start 1 2 3 4 5 6 7 8 9 10 end $m $m $m $m $m $m $m $m $m $m $m $m PPE 1,665 - 40 + 13 - 25 + 3 1,616 Ìnventories 2 + 1 3 A/cs receivable 50 + 8 58 Cash 4 - 97 + 1,250 - 835 - 82 - 75 - 38 + 21 - 20 - 41 - 84 3 TotaI assets 1,721 1,680 A/cs payable 17 + 3 + 8 28 Tax payable 41 - 15 26 Debt 621 - 44 577 Ord share cap 727 727 Share premium 76 76 Retained earnings 239 - 99 + 1,258 - 843 - 82 - 115 - 25 - 4 - 17 - 26 - 40 246 LiabiIities & equity 1,721 1,680 Exercises and Case Study Solutions 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Income statement Sales 1,258 Cost of sales [99 + 843 + 100 + 25] (1,067) Administrative expenses [82 + 15] (97) Operating profit, before exceptional items 94 Loss on disposal (4) Operating profit, after exceptional items 90 Ìnterest expense (17) Profit before tax 73 Tax (26) Net income 47 Statement of changes in equity Retained earnings @ start of year 239 Net income 47 Dividend (40) Retained earnings @ end of year 246 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 Cash fIow statement - direct Receipts from customers 1,250 Operating expenses paid [97 + 835 + 82 + 25] (1,039) Operating cash flow (1) 211 Ìnterest paid (20) Tax paid (41) Operating cash flow (2) 150 Capital expenditure [75 + 13] (88) Disposal 21 83 Dividends (40) Debt repaid (44) Change in cash (1) Exercises and Case Study Solutions 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Cash fIow statement - indirect (1) Operating profit, before exceptional items 94 Depreciation 115 EBÌTDA 209 Ìncrease in accounts receivable (8) Ìncrease in inventories (1) Ìncrease in accounts payable 11 Operating cash flow (1) 211 Ìnterest paid (20) Tax paid (41) Operating cash flow (2) 150 Capital expenditure [75 + 13] (88) Disposal proceeds 21 83 Dividends (40) Debt repaid (44) Change in cash (1) Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 Cash fIow statement - indirect (2) Net income 47 Depreciation 115 Loss on disposal 4 Ìncrease in accounts receivable (8) Ìncrease in inventories (1) Ìncrease in accounts payable 11 Decrease in tax payable (15) Ìnterest capitalised (3) Operating cash flow (2) 150 Capital expenditure [75 + 13] (88) Disposal proceeds 21 83 Dividends (40) Debt repaid (44) Change in cash (1) Ratio EBÌTDA debt Net = 209 574 = 2.75 Exercises and Case Study Solutions 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Commentary Capital expenditure is below depreciation which is perhaps an indication of a reduction in operating capacity or that its depreciation policy is too aggressive. The company is also generating cash through asset disposals; however the loss on disposal indicates that the depreciation policy of the company may be too fast. Cash convertibility of EBÌTDA is good (@ 100%) as the company appears to be maintaining its existing level of working capital. The company is generating sufficient cash from operations to easily cover its interest payments (interest cover of 10.5 times) and its tax payments. Future years' interest payments are likely to be reduced as the company has repaid significant amounts of debt in the year, which reinforces the low gearing risk profile of the company. Should the company have growth prospects in the future, its capital structure gives it sufficient flexibility to raise debt as needed. The company has used its free cash flow to: Pay a large dividend to equity providers; and Repay its debt. Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 Mag Ltd Closing balance sheet start 1 2 3 4 5 6 7 8 9 end £000 £000 £000 £000 £000 £000 £000 £000 £000 £000 £000 Magazine titles - 2,000 2,000 Plant 41,441 (3,557) 37,884 Ìnventories 13,985 (1,967) 12,018 A/cs receivable 25,952 (3,552) 22,400 Cash 3,515 121,665 (75,043) (38,624) (2,833) (1,498) (1,529) (866) (981) (2,000) 1,806 TotaI assets 84,893 118,113 77,010 (38,624) (2,833) (5,055) (1,529) (866) (981) - 76,108 A/cs payable 24,128 (1,946) 22,182 Tax payable 890 (694) 196 Debt 21,836 (2,833) 19,003 Ord shares 5,082 5,082 Share premium 14,569 14,569 Retained earnings 18,388 118,113 (75,064) (38,624) (5,055) (1,529) (172) (981) 15,076 LiabiIities & equity 84,893 118,113 77,010 (38,624) (2,833) (5,055) (1,529) (866) (981) - 76,108 Exercises and Case Study Solutions 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Profit & Ioss account for the year £000 Revenue 118,113 Cost of sales (75,064 + 23,729 + 3,709) (102,502) _________ 15,611 Administrative expenses (14,895 + 1,346) (16,241) ________ Operating loss (630) Ìnterest payable & similar charges (1,529) _______ Loss before tax (2,159) Taxation (196 ÷ 24) (172) _______ Loss after tax (2,331) _______ Retained earnings at start 18,388 Loss after tax (2,331) Dividends (981) Other reserve movements - _______ Retained earnings at end (per balance sheet) 15,076 _______ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 Cash fIow statement for year (1) £000 £000 Operating loss (630) Depreciation 5,055 EBITDA 4,425 Decrease in inventories 1,967 Decrease in receivables 3,552 Decrease in payables (1,946) Operating cash flow 7,998 Ìnterest (1,529) Tax (866) _______ 5,603 Capital expenditure - tangibles (1,498) Capital expenditure - intangibles (2,000) _______ Free cash flow 2,105 Dividends (981) Financing cash flows ÷ debt repayment (2,833) _______ Decrease in cash and deposits in year (1,709) Cash at start of year 3,515 ______ Cash at end of year 1,806 ______ Commentary Capital expenditure is significantly below depreciation which is an indication of a reduction in operating capacity. This is reinforced by the fact that cash convertibility of EBÌTDA is high (@ 180%) as the company appears to be reducing the scale of its operations, with a resultant release of working capital. This has been achieved through a mixture of running down its inventories and having fewer customer balances outstanding at the year end. Consequently, the company appears to be cash generative, but in decline. Despite operating losses, operating cash flow is more than adequate to fund interest and tax commitments and capital expenditure. Future years' interest payments are likely to be reduced as the company has repaid significant amounts of debt in the year, which reinforces the low gearing risk profile of the company. Should Exercises and Case Study Solutions 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] the company have growth prospects in the future, its capital structure gives it sufficient flexibility to raise debt as needed. The tax commitment is, similarly, going to reduce unless the company's fortunes change. The company has used its free cash flow to: make significant payments to capital providers (large dividend despite loss making and debt repayment); and acquire a magazine title (which may be an attempt to revive operating results). Acquisition of magazine title Profit would be reduced (or operating loss increased) by £100,000 each year. There would be no effect on EBÌTDA or cash flow. Cash fIow statement for year (2) £000 £000 Net loss (2,331) Depreciation 5,055 Decrease in inventories 1,967 Decrease in receivables 3,552 Decrease in payables (1,946) Decrease in tax payable (694) Operating cash flow 5,603 Capital expenditure - tangibles (1,498) Capital expenditure - intangibles (2,000) _______ Free cash flow 2,105 Dividends (981) Financing cash flows ÷ debt repayment (2,833) _______ Decrease in cash and deposits in year (1,709) Cash at start of year 3,515 ______ Cash at end of year 1,806 ______ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 Ourstair Ltd CIosing baIance sheet start 1 2 3 4 5 6 7 8 end £m £m £m £m £m £m £m £m £m £m PPE 519.9 73.1 593.0 Ìnventories 6.4 10.6 17.0 Cash 549.2 2,717.6 (90.5) (2,517.0) 88.6 (110.1) 17.1 (16.1) (31.8) 607.0 TotaI assets 1,075.5 2,717.6 (79.9) (2,517.0) 88.6 (37.0) 17.1 (16.1) (31.8) 1,217.0 A/cs payable & accruals 621.4 5.5 0.9 627.8 Tax payable 16.1 7.0 23.1 Revenue in advance 199.4 46.3 245.7 Debt 92.7 5.5 98.2 Ord share cap 20.0 27.5 47.5 Share premium 32.2 55.6 87.8 Retained earnings 93.7 2,671.3 (85.4) (2,517.9) (37.0) 17.1 (23.1) (31.8) 86.9 LiabiIities & equity 1,075.5 2,717.6 (79.9) (2,517.0) 88.6 (37.0) 17.1 (16.1) (31.8) 1,217.0 Exercises and Case Study Solutions 22 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Income statement for the year £m Revenue 2,671.3 Cost of sales (85.4 + 2,265.3) (2,350.7) _______ 320.6 Administrative expenses (252.6 + 37.0) (289.6) _______ Earnings before interest & tax 31.0 Ìnterest receivable & similar income 17.1 _______ Profit before tax 48.1 Taxation (23.1) _______ Profit after tax 25.0 _______ Retained earnings at start 93.7 Profit after tax 25.0 Dividends (31.8) Other reserve movements - _______ Retained earnings at end (per balance sheet) 86.9 _______ Cash fIow statement for year - direct £m £m Receipts from customers 2,717.6 Payments to suppliers (90.5) Operating expenses (2,517.0) Operating cash flow 110.1 Ìnterest 17.1 Tax (16.1) Capital expenditure (110.1) _______ Free cash flow 1.0 Dividends (31.8) Ìssue of shares 83.1 Ìssue of debt 5.5 Financing cash flows 88.6 Ìncrease in cash and deposits in year 57.8 Cash at start of year 549.2 _____ Cash at end of year 607.0 _____ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 23 Cash fIow statement for year - indirect (1) £m £m Operating profit 31.0 Depreciation 37.0 EBITDA 68.0 Increase in inventories (10.6) Increase in revenue received in advance 46.3 Increase in payables and operating accruals 6.4 Operating cash flow 110.1 Ìnterest 17.1 Tax (16.1) Capital expenditure (110.1) _______ Free cash flow 1.0 Dividends (31.8) Ìssue of shares 83.1 Ìssue of debt 5.5 Financing cash flows 88.6 _______ Ìncrease in cash and deposits in year 57.8 Cash at start of year 549.2 _____ Cash at end of year 607.0 _____ Commentary Cash convertibility of EBÌTDA is good (@ 1.62x) with the growth in inventories being more than absorbed by that of payables and revenues in advance. Ìndeed, the revenues in advance are a significant source of finance for the company. Capital expenditure absorbs current operating cash flow and tax is funded by interest income. Dividends are funded by raising new (mostly equity) finance. Exercises and Case Study Solutions 24 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Cash fIow statement for year - indirect (2) £m £m Net income 25.0 Depreciation 37.0 Increase in inventories (10.6) Increase in revenue received in advance 46.3 Increase in payables and operating accruals 6.4 Increase in tax payable 7.0 Operating cash flow 111.1 Capital expenditure (110.1) _______ Free cash flow 1.0 Dividends (31.8) Ìssue of shares 83.1 Ìssue of debt 5.5 Financing cash flows 88.6 _______ Ìncrease in cash and deposits in year 57.8 Cash at start of year 549.2 _____ Cash at end of year 607.0 _____ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 25 FIash Tuna AG CIosing baIance sheet start 1 2 3 4 5 6 7 8 9 10 11 12 end Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm PPE - owned 6,944 (179) 13 6,778 PPE - leased 2,111 1,402 3,513 Ìnventories 75 9 84 Accounts receivable 1,432 (96) 1,336 Cash 738 9,011 (4,859) (390) (2,356) (150) (223) (641) 110 (80) (65) (191) 904 Total assets 11,300 8,915 (4,859) (381) (2,356) (150) (402) 761 110 (67) - (65) (191) 12,615 Accounts payable 2,710 108 2,818 Tax payable 65 (40) 25 Debt 5,174 1,268 110 6,552 Provisions 30 (4) 26 Ordinary shares 260 260 Share premium 650 650 Retained earnings 2,411 8,915 (4,967) (381) (2,356) (150) (402) (507) (67) 4 (25) (191) 2,284 Liabilities & equity 11,300 8,915 (4,859) (381) (2,356) (150) (402) 761 110 (67) - (65) (191) 12,615 Exercises and Case Study Solutions 26 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Profit & Ioss account for the year Cm Revenue 8,915 Cost of sales (4,967 + 381 + 2,179 + 150 + 402 + 217 - 4) (8,292) _________ 623 Administrative expenses (177) ________ Operating profit 446 Ìnterest payable & similar charges (290 + 80 - 13) (357) _______ Profit before tax 89 Taxation (25) _______ Profit after tax 64 Dividends (191) _______ Net loss (127) Retained earnings at start 2,411 Other reserve movements - _______ Retained earnings at end (per balance sheet) 2,284 _______ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 27 Cash fIow statement for year (1) Cm Operating profit 446 Depreciation and impairment write down 619 _______ EBITDA 1,065 Increase in inventories (9) Decrease in receivables 96 Increase in payables 108 Decrease in provision (4) _______ Operating cash flow 1,256 Ìnterest (80) Ìnterest paid on finance leases (290) Tax (65) Capital expenditure (223) _______ Free cash flow after capex 598 Dividends (191) Financing cash flows ÷ net issue of debt 110 Financing cash flows - capital element of FL repaid (351) ______ Ìncrease in cash and deposits in year 166 Cash at start of year 738 ______ Cash at end of year 904 ______ Exercises and Case Study Solutions 28 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Commentary Cash convertibility of EBÌTDA is good (@ 118%) - the company appears to be managing its working capital well (increasing payables and reducing receivables). Operating cash flow is more than adequate to fund interest and tax commitments and capital expenditure on owned assets. Cash capital expenditure is significantly below depreciation. However, at C 1,842m (223m + 1,619), total capital expenditure (including assets acquired under finance leases) is almost three times depreciation, indicating net investment for growth. The company has used its free cash flow after capex to make significant payments to capital providers and add to cash balances. However, any assessment of future flexibility must take into account the very significant leasing commitments (both on and off balance sheet) and the resultant drain on future cash flows. Cash fIow statement for year (2) Cm Net income 64 Depreciation and impairment write down 619 Increase in inventories (9) Decrease in receivables 96 Increase in payables 108 Decrease in provision (4) Decrease in tax payable (40) _______ Operating cash flow 834 Capital expenditure (223 + 13) (236) _______ Free cash flow after capex 598 Dividends (191) Financing cash flows ÷ net issue of debt 110 Financing cash flows - capital element of FL repaid (351) ______ Ìncrease in cash and deposits in year 166 Cash at start of year 738 ______ Cash at end of year 904 ______ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 29 Theramax Ltd start 1 2 3 4 5 6 7 8 9 10 11 end £m £m £m £m £m £m £m £m £m £m £m £m £m TangibIe fixed assets 3,635 62 3,697 Stocks - raw materiaIs 283 178 461 Stocks - finished goods 572 1,839 610 90 (2,418) 693 Operating debtors 1,555 185 1,740 Investments - Iiquid funds 1,408 209 1,617 Cash 254 (1,993) (1,808) (420) 7,798 (2,370) 356 59 (300) (1,007) (355) 214 TotaI assets 7,707 24 (1,198) (268) 5,565 (2,370) 356 59 (91) (1,007) (355) 8,422 Operating creditors & accruaIs 932 24 15 971 Tax payabIe 820 (404) 416 Debt 3,145 59 3,204 Provision for compensation 121 20 141 Ordinary shares 894 12 906 Share premium 805 344 1,149 Retained earnings 990 (1,198) (268) 5,565 (2,385) (91) (20) (603) (355) 1,635 LiabiIities & sharehoIders' equity 7,707 24 (1,198) (268) 5,565 (2,370) 356 59 (91) (1,007) (355) 8,422 Exercises and Case Study Solutions 30 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Profit & Ioss account for the year £m Revenue 7,983 Cost of sales (2,418) Selling, general and administrative (893 + 214 +1,581 + 20) (2,708) Research and development (305 + 54 + 804) (1,163) ________ Operating profit 1,694 Net interest payable (152 - 61) (91) _______ Profit on ordinary activities before tax 1,603 Taxation (615 - 12 (over prov'n previous year)) (603) _______ Profit after tax 1,000 _______ Retained earnings at start 990 Profit after tax 1,000 Dividends (355) _______ Retained earnings at end (per balance sheet) 1,635 ____ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 31 Cash flow statement for year - direct £m £m Receipts from customers 7,798 Payments to suppliers (1,993) Payments to and on behalf of employees (1,808) Other cash payments (2,370) Operating cash flows 1,627 Ìnterest paid (152) Ìnterest received 61 Tax (1,007) _______ Free cash flow before capex 529 Capital expenditure (420) _______ Free cash flow after capex 109 Dividends (355) Financing cash flows - debt repaid (58) Financing cash flows - debt raised 117 Financing cash flows - shares issued 356 Management of liquid resources (209) _______ Decrease in cash and deposits in year (40) Cash at start of year 254 ______ Cash at end of year 214 ______ Exercises and Case Study Solutions 32 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Cash flow statement for year - indirect (1) £m £m Operating profit 1,694 Depreciation 358 ____ EBITDA 2,052 Increase in stocks - raw materials (178) Increase in stocks - finished goods (121) Increase in operating debtors (185) Increase in creditors 39 Increase in provision 20 Operating cash flow 1,627 Ìnterest paid (152) Ìnterest received 61 Tax (1,007) _______ Free cash flow before capex 529 Capital expenditure (420) _______ Free cash flow after capex 109 Dividends (355) Financing cash flows - debt repaid (58) Financing cash flows - debt raised 117 Financing cash flows - shares issued 356 Management of liquid resources (209) _______ Decrease in cash and deposits in year (40) Cash at start of year 254 ______ Cash at end of year 214 ______ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 33 Cash flow statement for year - indirect (2) £m £m Net income 1,000 Depreciation 358 Increase in stocks - raw materials (178) Increase in stocks - finished goods (121) Increase in operating debtors (185) Increase in creditors 39 Increase in provision 20 Decrease in tax payable (404) Operating cash flow 529 Capital expenditure (420) _______ Free cash flow after capex 109 Dividends (355) Financing cash flows - debt repaid (58) Financing cash flows - debt raised 117 Financing cash flows - shares issued 356 Management of liquid resources (209) _______ Decrease in cash and deposits in year (40) Cash at start of year 254 ______ Cash at end of year 214 ______ Exercises and Case Study Solutions 34 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Monty, Tiger & Seve Monty pIc 1 2 3 $m $m $m Operating profit 80 80 80 Depreciation 70 70 ___ ___ EBITDA 150 150 Movement in non-cash working capital 1 1 ___ ___ Net cash infIow from operating activities 151 151 Ìnterest paid (29) Tax paid (19) (28) (28) CapitaI expenditure Net (investment)/disinvestment (70) (70) 1 ___ ___ ___ Free cash fIow 33 53 53 Financing [Ìnterest paid (20)] Net borrowing/(repayment) - - Dividend paid (20) (20) ___ ___ Increase in cash 13 13 ___ ___ Tiger pIc 1 2 3 $m $m $m Operating profit 80 80 80 Depreciation 70 70 ___ ___ EBITDA 150 150 Movement in non-cash working capital (135) (135) ___ ___ Net cash infIow from operating activities 15 15 Ìnterest paid (40) Tax paid (17) (29) (29) CapitaI expenditure Net (investment)/disinvestment (270) (270) (335) ___ ___ ___ Free cash fIow (312) (284) (284) Financing [Ìnterest paid (20)] Net borrowing/(repayment) 310 310 Dividend paid - - ___ ___ Decrease in cash (2) (2) ___ ___ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 35 Seve pIc 1 2 3 $m $m $m Operating profit 30 30 30 Depreciation 70 70 ___ ___ EBITDA 100 100 Movement in non-cash working capital 57 57 ___ ___ Net cash infIow from operating activities 157 157 Ìnterest paid (24) Tax paid (2) (9) (9) CapitaI expenditure Net (investment)/disinvestment 30 30 157 ___ ___ ___ Free cash fIow 161 178 178 Financing [Ìnterest paid (17)] Net borrowing/(repayment) (125) (125) Dividend paid - - ___ ___ Increase in cash 36 36 ___ ___ Summary Earnings Free cash fIow Monty plc $32m $33m Tiger plc $23m $(312)m Seve plc $4m $161m Assumption Rate of corporation tax is 33%. Exercises and Case Study Solutions 36 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] EaseI At the end of the first year of the lease, the financial statements would show: Finance Iease Balance sheet P&L account Cash flow statement £000 £000 £000 Tangible fixed assets 525 Operating expenses (depreciation) (175) Servicing of finance (80) Creditors 552 Ìnterest payable (80) Financing (148) Operating Iease Balance sheet P&L account Cash flow statement £000 £000 £000 Operating expenses (228) Operating cash flow (228) Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 37 EnteachabIes Inc BaIance sheet as at 12 months foIIowing take-over Assets $000 $000 Current assets Cash (1,343.0 +1,105.0) 2,448.0 Receivables (5,342.6 + 45.7) 5,388.3 Ìnventories (12.9 ÷ 1.2) 11.7 ______ 7,848.0 Ìnvestments & other assets Ìnvestments 18.0 Ìntangibles (2,324.6 ÷ 128.6) 2,196.0 ______ 2,214.0 Property, plant & equipment Tangibles at book value (617.1 ÷ 268.8 ÷ 10.1 + 581.3) 919.5 _______ 10,981.5 _______ LiabiIities & sharehoIders equity Current liabilities Trade payables & accruals (3,436.8 + 1,269.6 + 911.9) 5,618.3 Tax (548.1 + 598.1 ÷ 557.3) 588.9 ______ 6,207.2 Debt (1,271.4 ÷ 251.4) 1,020.0 Shareholders' equity Preference stock 1,838.3 Common stock 266.6 Retained earnings (1,027.4 + 943.6 ÷ 321.6) 1,649.4 ______ 3,754.3 ________ 10,981.5 ________ Exercises and Case Study Solutions 38 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Ratio caIcuIations At takeover/12 months pre-takeover 12 months post take-over EBÌT margin 11.7% 14,850.7 10.1 1,795.3 = 12.2% EBÌTDA margin 14.1% 14,850.7 2,202.8 = 14.8% Capex/depn 1.4 x 268.8 581.3 = 2.2x Ìnterest cover 3.4 x 221.2 197.9 165.5 1,795.3 = 4.7x Gearing 57.7% 2,326.3 1,649.4 266.6 410.3 410.3 2,448.0 - 1,838.3 1,020.0 = 17.6% ROCE 53.2% 2,326.3 10.1 1,795.3 = 77.6% Debtor days 141 days 65 14,850.7/3 5,388.3 = 132 days Payables /accrual days 136 days 65 12,647.9/3 5,618.3 = 162 days Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 39 A BS Inc BaIance sheet ActuaI P&L Cash Forecast $m $m Current assets Ìnventories 386 10 396 Accounts receivable 620 107 727 Ìnvestments 187 419 606 Cash 415 (378) 37 1,608 1,766 Fixed assets Ìntangible assets 1 (2) 206 205 PPE 1,810 (245) (9) (71) 588 (43) 2,030 Ìnvestments 53 - 53 Ìnvestments in associates 340 121 (16) 67 512 2,204 2,800 TotaI assets 3,812 4,566 Current liabilities Accounts payable 639 65 704 Tax 135 195 (166) 164 Other liabilities 259 117 (144) 66 298 1,033 1,166 Debt 1,090 (9) 1,081 Provisions Deferred tax 41 41 Other 492 17 509 Minority interests 58 85 (57) 86 Capital & reserves Share capital 2 Additional paid-in capital 40 265 307 Retained earnings 1,056 320 1,376 TotaI IiabiIities & equity 3,812 4,566 Exercises and Case Study Solutions 40 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Erkki, Nuutti and Mikko Erkki Erkki Ìnc has a 31 st December year end. On 1 st January there were 300,000 ordinary shares in issue. On 31 st August, 100,000 new ordinary shares were issued to the market. Earnings for the current year are $315,000. EPS, as reported in the prior year, was 90.0c. Current year EPS = 333 , 333 000 , 315 $ = 94.5c Prior year EPS = 90.0c (5% growth). No of shares: 1 Jan ÷ 31 Aug 300,000 x 8/12 200,000 1 Sep ÷ 31 Dec 400,000 x 4/12 133,333 333,333 Nuutti Nuutti Ìnc has a 31 st December year end. On 1 st January there were 300,000 ordinary shares in issue. On 31 st August, there was a bonus issue of 1 new ordinary share for every 3 shares held. Earnings for the current year are $240,000. EPS, as reported in the prior year, was 76.0c. Current year EPS = 000 , 400 000 , 240 $ = 60.0c Prior year EPS = 76.0c x 4 3 = 57.0c (growth 5.3%). No of shares: 1 Jan ÷ 31 Aug 300,000 x 8/12 x 4/3 266,667 1 Sep ÷ 31 Dec 400,000 x 4/12 133,333 400,000 Mikko Mikko Ìnc has a 31 st December year end. On 1 st January there were 300,000 ordinary shares in issue. On 31 st August, there was a rights issue of 1 new ordinary share for every 3 shares held at $11 per share. Ìmmediately prior to becoming ex-rights, the share price was $15. Earnings for the current year are $295,000. EPS, as reported in the prior year, was 86.6c. Current year EPS = 619 , 347 000 , 295 $ = 84.9c Prior year EPS = 86.6c x 15 14 = 80.8c (growth 5.0%) No of shares: 1 Jan ÷ 31 Aug 300,000 x 8/12 x 15/14 214,286 1 Sep ÷ 31 Dec 400,000 x 4/12 133,333 347,619 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 41 Mikko Working Bonus eIement of rights issue 3 x $15 $45 1 x $11 $11 4 $56 Theoretical ex rights price = 4 56 $ = $14 Adjustment = 14 $ 15 $ Alternative answer No of shares: 1 Jan ÷ 31 Aug 300,000 x 8/12 x 400,000 / 373,333 214,286 1 Sep ÷ 31 Dec 400,000 x 4/12 133,333 347,619 Treasury stock method Proceeds of $1,100,000 would buy 73,333 shares @ $15 (full market price) Subscribers to rights issue get 100,000 for $1,100,000 'Free' shares 26,667 To get free shares need to hold 373,333 shares [300,000 + 73,333] After rights issue 400,000 shares in issue Exercises and Case Study Solutions 42 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Primrose pIc 2005 2004 Earnings per share 36.1p 40.6p Workings Number of shares in issue Date No of shares Weighted average 1 April 4,000,000 4/12 60/57 1,403,509 1 August 5,000,000 5/12 2,083,333 1 January 7,000,000 3/12 1,750,000 _____________ 5,236,842 _____________ Number of shares in issue last year = 4,000,000 60/57 = 4,210,526 Theoretical ex rights price 4 shares at 60p cost 2.40 1 share at 45p cost 0.45 ________ 2.85 ________ Theoretical ex rights price = £2.85/5 = 57p Bonus fraction price rights ex l Theoretica price rights cum Actual = Earnings per share 2005 2004 842 , 236 , 5 000 , 893 , 1 36.1p 526 , 210 , 4 000 , 711 , 1 40.6p Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 43 Birren pIc 2005 2004 Basic 33.3p 30.0p Fully diluted 19.7p 22.2p Note Diluted earnings per share is disclosed as the dilution is greater than 5%. Workings Earnings £ £ Basic 1,000,000 900,000 Add: loan stock interest saved (1,700,000 5% 70%) 59,500 29,750 (time apportioned last year) ____________ ___________ Diluted 1,059,500 929,750 ____________ __________ Number of shares Basic 3,000,000 3,000,000 Add: loan stock (17,000 140)/ (17,000 140 6/12) 2,380,000 1,190,000 ____________ ____________ Diluted 5,380,000 4,190,000 ____________ ____________ Earnings per share 2004 2004 Basic 000 , 000 , 3 000 , 000 , 1 33.3p 000 , 000 , 3 000 , 900 30.0p Fully diluted 000 , 380 , 5 500 , 059 , 1 19.7p 000 , 190 , 4 750 , 929 22.2p Exercises and Case Study Solutions 44 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] OnyaIi pIc Basic EPS = £928,000 = 18.6p 5,000,000 FDEPS i) = £928,000 = 18.6p 5,000,000 ii) = £928,000 = 17.7p ___________________________ 5,000,000 + 238,636 Working avge price 208p 308p Proceeds of maximum exercise (750 x 2.10) £1,575,000 £1,575,000 Number of shares from maximum exercise 750,000 750,000 Ìf bought at shares at average price 1,575,000 (2.08 / 3.08) (757,212) (511,364) ________ ________ Free shares nil 238,636 ________ ________ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 45 Scrutinise DeaI EPS NAPS Basic 44.6p 1,175p earnings £233.1m net assets £6,150.9m weighted average shares 523.0m year end shares 523.6m (522.4m + 523.6m)/2 DiIuted 43.8p 1,146p Earnings Net assets basic £233.1m Basic £6,150.9m convertibles £10.9m convertibles £246.1m £260m x 6% x(100-30)% options - Options £13.9m £244.0m £6,410.9m Shares Shares basic 523.0m Basic 523.6m convertibles 34.0m convertibles 34.0m options 0.6m Options 1.9m 1.87m -(£13.9m/£10.64) 557.6m 559.5m Exercises and Case Study Solutions 46 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Pearson rights issue Prior year (as previousIy reported) 47.8p earnings 294 shares (weighted average) 615.4 Current year Earnings (£m) 179 Shares weighting shares bonus frac Weighted shares 1/24 613 1.109745 28.3 11/24 624 1.109745 317.4 4/24 627 1.109745 116.0 8/24 798 266.0 727.7 EPS (p) 24.6p Prior year restated 43.0p Bonus fraction 1.109745 shares price prior to rights 11 18.57 204.27 rights 3 10.00 30.00 14 234.27 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 47 Discounted debt Zero coupon 28 th February 2005 Balance sheet P&L account Cash flow statement £m £m £m Servicing of finance - Debt 70.8 Ìnterest payable (5.8) Financing 65.0 Working year to start interest end 28 Feb @ 9% 2005 65 5.8 70.8 2006 70.8 6.4 77.2 2007 77.2 6.9 84.1 2008 84.1 7.6 91.7 2009 91.7 8.3 100 Deep discount 28 th February 2005 Balance sheet P&L account Cash flow statement £m £m £m Servicing of finance (5.0) Debt 4.0 90.4 Ìnterest payable (9.0) Working year to start interest cash end 28 Feb @ 10.43% 2002 76.5 8.0 (5.0) 79.5 2003 79.5 8.3 (5.0) 82.8 2004 82.8 8.6 (5.0) 86.4 2005 86.4 9.0 (5.0) 90.4 Exercises and Case Study Solutions 48 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Index Iinked 28 February 2005 Balance sheet P&L account Cash flow statement £m £m £m Servicing of finance (4) Debt 203 Ìnterest payable (7) Financing 200 Working year to start interest cash end 28 Feb (mid year) @3.5 % @2 % (6 months) (6 months) 2005 200 7.0 (4.0) 203 Index Iinked (coIIar) 28 th February 2005 Balance sheet P&L account Cash flow statement £m £m £m Servicing of finance (2.7) Debt 162.4 Ìnterest payable (5.1) Financing 160 Working year to start interest cash end 28 Feb (mid year) @3.161 % @1.661 % (6 months) (6 months) 2005 160 5.1 (2.7) 162.4 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 49 ConvertibIe debt US (and UK) GAAP Balance sheet P&L account Cash flow statement £m £m £m Cash 273.6 Operating expenses Servicing of finance (9.1) (17.3) Debt 293.7 293.7 Ìnterest payable (20.1) Financing 300.0 Equity 20.1 Transactions 1. Debt is recognised at net proceeds Cash £290.9m Debt £290.9m 2. Ìnterest for period (incl amortisation of issue costs) P&L account - interest payable £20.1m Cash (£300m x 5.75%) £17.3m Debt £2.8m US GAAP An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument if all the following criteria are met: Criterion Met? Explanation The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics of the host contract. An option based on another entity's stock price is not clearly and closely related to an interest-bearing debt instrument. The contract that embodies both the embedded derivative instrument and the host contract is not remeasured at fair value under GAAP with changes in fair value reported in earnings as they occur. Debt of the issuer is not remeasured at fair value. A separate instrument with the same terms as the embedded derivative would be a derivative under FAS 133. Because it is an equity instrument of the issuer, the written option is not considered a derivative under FAS 133 and is not separated from the host contract. Exercises and Case Study Solutions 50 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] UK GAAP Capital instruments that are issued at the same time in a composite transaction should be considered together. They should be accounted for as a single instrument unless they are capable of being transferred, cancelled or redeemed independently of each other. Working year to start interest cash end 30 Sept @ 6.9% 2005 290.90 20.08 17.25 293.75 2006 293.75 20.28 17.25 296.76 2007 296.76 20.49 17.25 300.00 year to start interest cash end 30 Sept @ 5.75% 2008 300.00 17.25 17.25 300.00 2009 300.00 17.25 17.25 300.00 German GAAP Balance sheet P&L account Cash flow statement £m £m £m Cash 273.6 Servicing of finance (9.1) Ìnterest payable (17.3) (17.3) Debt 300.0 300.0 Exc/ext item (9.1) Financing 300.0 Equity 26.4 Transactions 1. Debt is recognised at gross proceeds Cash £300.0m Debt £300.0m 2. Ìssue costs are paid P&L account - exceptional/extraordinary item £9.1m Cash £9.1m 3. Ìnterest paid in period (£300m x 5.75%) P&L account - interest payable £17.3m Cash £17.3m Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 51 IAS 32 Balance sheet P&L account Cash flow statement £m £m £m Cash 273.6 Servicing of finance (9.1) Ìnterest payable (20.0) (17.3) Debt 287.3 287.3 Financing 300.0 Equity 13.7 Transactions 1. Debt element is recognised (eg at present value [say at 7%] of future cash flows) Cash £284.6m Debt £284.6m 2. Equity element is recognised (eg at balance of net proceeds) Cash [£290.9m - £284.6m] £6.3m Equity (call option issue proceeds) £6.3m 3. Ìnterest incurred and paid in period P&L account - interest payable [£284.6m x 7%] £20.0m Cash [£300m x 5.75%] £17.3m Debt £2.7m Exercises and Case Study Solutions 52 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] King, Wade & Graf King Inc $m Operating profit 68 Depreciation 70 Amortisation 10 EBITDA 148 Increase in inventories (2) Increase in receivables (56) Increase in current liabilities 16 Net cash infIow from operating activities 106 Servicing of finance Ìnterest paid (41) Taxation Tax paid (15) Free cash flow 50 CapitaI expenditure Purchase of tangible fixed assets (127) Sale of tangible fixed assets 40 Free cash flow (37) Equity dividends paid Dividend paid (12) Financing Net borrowing/(repayment) 55 Increase / (decrease) in cash 6 Cash at start 27 Cash at end 33 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 53 Wade pIc $m Operating profit 103 Depreciation 60 Amortisation - EBITDA 163 Increase in inventories, excl interest capitalised (2) Increase in receivables (56) Increase in current liabilities 1 Net cash infIow from operating activities 106 Servicing of finance Ìnterest paid (41) Taxation Tax paid (15) Free cash flow 50 CapitaI expenditure Purchase of tangible fixed assets, excl interest capitalised (127) Sale of tangible fixed assets 40 Free cash flow (37) Equity dividends paid Dividend paid (15) Financing Ìssue of shares 52 Increase / (decrease) in cash - Cash at start 27 Cash at end 27 Exercises and Case Study Solutions 54 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Graf AG $m Operating profit/(loss) (109) Depreciation 130 Amortisation 100 EBITDA 121 Increase in inventories (42) Increase in receivables (3) Increase in current liabilities 30 Net cash infIow from operating activities 106 Servicing of finance Ìnterest paid (41) Taxation Tax paid - Free cash flow 65 CapitaI expenditure Purchase of tangible fixed assets (127) Sale of tangible fixed assets 40 Free cash flow (22) Equity dividends paid Dividend paid - Financing Net borrowing/(repayment) - Increase/(decrease) in cash (22) Cash at start 27 Cash at end 5 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 55 Summary Earnings Free cash fIow (pre capex) Free cash fIow (post capex) King Ìnc +$24m +$50m -$37m Wade plc +$60m +$50m -$37m Graf AG -$137m +$65m -$22m SaIes EBITDA Operating profit Operating cash fIow King Ìnc $503m +$148m +$68m +$106m Wade plc $503m +$163m +$103m +$106m Graf AG $450m +$121m -$109m +$106m Working Movement on tangibIe fixed assets £m King Wade Graf Opening NBV 240 260 150 Additions at cost (µ) 127 127 127 Ìnterest capitalised 15 15 - Revaluation - 100 - Disposals at NBV (43) (45) (27) Depreciation/impairment write down (70) (60) (130) Closing NBV 269 397 120 Possible reasons for earnings differences IntangibIes Different write off periods for goodwill. TangibIes Different depreciation rates. Capitalisation of interest. Long term contracts % completion v completed contracts method. Different revenue recognition policies. Exercises and Case Study Solutions 56 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Inventories Capitalisation of interest. Current IiabiIities Recognition of accruals and provisions. Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 57 AIternative presentation - US GAAP King Inc $m Net income 24 Depreciation 70 Loss on asset disposals 3 Amortisation 10 Increase in inventories (2) Increase in receivables (56) Increase in current liabilities 16 Interest capitalised (15) Net cash infIow from operating activities 50 CapitaI expenditure Purchase of tangible fixed assets (127) Sale of tangible fixed assets 40 Free cash flow (37) Equity dividends paid Dividend paid (12) Financing Net borrowing/(repayment) 55 Increase / (decrease) in cash 6 Cash at start 27 Cash at end 33 Exercises and Case Study Solutions 58 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] AIternative presentation - cash fIow to pay capitaI providers King Inc 1 2 3 $m $m $m Operating profit 68 68 68 Depreciation 70 70 Amortisation 10 10 ___ ___ EBITDA 148 148 Increase in inventories (2) (2) Increase in receivables (56) (56) Increase in current liabilities 16 16 ___ ___ Net cash infIow from operating activities 106 106 Ìnterest paid (41) Tax paid (15) (27) (27) CapitaI expenditure Capex (127) (127) Disposal proceeds 40 40 Net new investment in PPE & WC (49) ___ ___ ___ Free cash fIow (37) (8) (8) Financing [Ìnterest paid (29)] Net borrowing/(repayment) 55 55 Dividend paid (12) (12) ___ ___ Increase in cash 6 6 ___ ___ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 59 Wade plc 1 2 3 $m $m $m Operating profit 103 103 103 Depreciation 60 60 Amortisation - - ___ ___ EBITDA 163 163 Increase in inventories (2) (2) Increase in receivables (56) (56) Increase in current liabilities 1 1 ___ ___ Net cash infIow from operating activities 106 106 Ìnterest paid (41) Tax paid (15) (27) (27) CapitaI expenditure Capex (127) (127) Disposal proceeds 40 40 Net new investment in PPE & WC (84) ___ ___ ___ Free cash fIow (37) (8) (8) Financing [Ìnterest paid (29)] Dividend paid (15) (15) Net equity issue/(repayment) 52 52 ___ ___ Increase in cash - - ___ ___ Exercises and Case Study Solutions 60 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Deutsche TeIekom Deutsche TeIekom 2002 Cm 2001 Cm Sales Net operating costs, excl depreciation (W) EBITDA Depreciation EBITA Amortisation EBIT Net financial expense (W) EBT 53,689 (37,612) 16,077 (9,525) 6,552 (27,355) (20,803) (5,983) (26,786) 48,309 (30,309) 18,000 (9,478) 8,522 (5,743) 2,779 (5,283) (2,504) [Umsatzkostenverfahren] Workings Net operating costs ÷ 3,901 + 14,418 + 289 + 13,480 ÷ (823 ÷ 39) + 14,110 = 37,612 Net financiaI expense 6,022 ÷ 39 = 5,983 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 61 Morientes & FriedeI Cash fIow statements Morientes Friedel EBIT 31,923 70,371 Depreciation 26,134 57,954 Amortisation 5,292 - EBITDA 63,349 128,325 Increase in receivables (1,919) (1,121) Increase in inventories (1,443) (1,984) Increase in payables 637 3,879 Decrease in unearned revenue - (18,475) Operating cash flow 60,624 110,624 Ìnterest paid (3,000) (14,860) Tax paid (9,788) (9,788) Capital expenditure (25,739) (25,739) Dividends (12,050) (12,050) 10,047 48,187 Debt repayment - (38,140) Ìncrease in cash 10,047 10,047 Metrics and ratios Market capitalisation 518,245 518,245 Net debt 70,161 207,425 _ Firm value 588,406 725,670 Exercises and Case Study Solutions 62 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] EBÌTDA FV 349 , 63 406 , 588 = 9.29 325 , 128 670 , 725 = 5.65 Ìnterest EBÌT 586 , 6 923 , 31 = 4.85 764 , 16 371 , 70 = 4.20 EBÌTDA debt Net 349 , 63 161 , 70 = 1.11 325 , 128 425 , 207 = 1.62 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 63 Morientes end start movement Operating Ìnterest Tax Capex Dividends Debt Cash Goodwill 31,752 37,044 (5,292) 5,292 - PPE owned 53,343 53,738 (395) 26,134 (25,739) - PPE leased - - - - Ìnventories 21,832 20,389 1,443 (1,443) - Operating accounts receivable 78,972 77,053 1,919 (1,919) - Cash 27,505 17,458 10,047 10,047 - Convertible debt (97,666) (94,080) (3,586) 3,586 - Finance leases - - - - Current tax (12,654) (9,788) (2,866) 2,866 - Deferred tax - - - - Unearned revenue - - - - Operating accounts payable (53,429) (52,792) (637) 637 - Paid in capital (8,900) (8,900) - - Option proceeds (9,271) (9,271) - - Retained earnings (31,484) (30,851) (633) 31,923 (6,586) (12,654) (12,050) - - - - Cash fIow 60,624 (3,000) (9,788) (25,739) (12,050) - 10,047 Exercises and Case Study Solutions 64 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Friedel end start movement Operating Ìnterest Tax Capex Dividends Debt Cash Goodwill 52,920 52,920 - - - PPE owned 87,892 79,107 8,785 16,954 (25,739) - PPE leased 123,000 164,000 (41,000) 41,000 - Ìnventories 80,027 78,043 1,984 (1,984) - Operating accounts receivable 76,895 75,774 1,121 (1,121) - Cash 27,505 17,458 10,047 10,047 - Convertible debt (103,720) (101,816) (1,904) 1,904 - Finance leases (131,210) (169,350) 38,140 (38,140) - Current tax (12,654) (9,788) (2,866) 2,866 - Deferred tax (25,672) (24,329) (1,343) 1,343 - Unearned revenue (21,843) (40,318) 18,475 (18,475) - Operating accounts payable (51,765) (47,886) (3,879) 3,879 - Paid in capital (8,900) (8,900) - - Option proceeds - - - - Retained earnings (92,475) (64,915) (27,560) 70,371 (16,764) (13,997) (12,050) - - - - Cash fIow 110,624 (14,860) (9,788) (25,739) (12,050) (38,140) 10,047 Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 65 Pensions Net debt/EBITDA Without adjustment EBÌTDA debt Net = m 6,058 C m 150 , 1 C = 0.2 Net debt C12,346m - 11,196m = C1,150m Adjusted, pre tax EBÌTDA debt Net = m 6,018 C m 111 , 6 C = 1.0 Net debt C1,150m + [19,492m - 14,531m] = C6,111m EBITDA EBÌTDA = 6,058m + 447m ÷ 487m = C6,018m Adjusted, post tax EBÌTDA debt Net = m 6,018 C m 176 , 4 C = 0.7 Net debt C1,150m + [(19,492m - 14,531m) x 61%] = C4,176m Exercises and Case Study Solutions 66 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] PampIe & Mousse (1) Goodwill Cost of acquisition 408 less: fair value of identifiable assets less liabilities attributable to 50% stake (208) [50% x 416] Goodwill 200 Cost of acquisition Cash paid 91 Fair value of shares issued 309 Purchase consideration 400 Other direct costs 8 Cost of acquisition 408 Accounting entries Cost of acquisition C408m Net debt [91 + 8 + 1] C100m Shares [309 - 1] C308m Combined balance sheet: Mousse consolidated as a subsidiary PampIe Mousse Combined Goodwill 200 Net operating assets 1,298 984 2,282 ____ ____ ____ 1,298 984 2,482 ____ ____ ____ Net debt 450 568 1,118 Shares 121 56 429 Retained earnings 727 360 727 Minority interests 208 ____ ____ ____ 1,298 984 2,482 ____ ____ ____ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 67 Combined balance sheet: Mousse proportionately consolidated as a joint venture PampIe Mousse Combined Goodwill 200 Net operating assets 1,298 984 1,790 ____ ____ ____ 1,298 984 1,990 ____ ____ ____ Net debt 450 568 834 Shares 121 56 429 Retained earnings 727 360 727 Minority interests ____ ____ ____ 1,298 984 1,990 ____ ____ ____ Combined balance sheet: Mousse equity accounted as an associate PampIe Mousse Combined Ìnvestment in associate 408 Net operating assets 1,298 984 1,298 ____ ____ ____ 1,298 984 1,706 ____ ____ ____ Net debt 450 568 550 Shares 121 56 429 Retained earnings 727 360 727 ____ ____ ____ 1,298 984 1,706 ____ ____ ____ Exercises and Case Study Solutions 68 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Combined income statement: Mousse consolidated as a subsidiary PampIe Mousse adj Combined Sales 1,163 994 2,157 Operating costs (959) (820) (1,779) ____ ____ ____ EBÌT 204 174 378 Ìnterest (36) (62) (5) (103) Tax (33) (30) 2 (61) Minority interests (41) (41) ____ ____ ____ Net income 135 82 173 ____ ____ ____ Combined income statement: Mousse proportionately consolidated as a joint venture PampIe Mousse adj Combined Sales 1,163 994 497 1,660 Operating costs (959) (820) (410) (1,369) ____ ____ ____ EBÌT 204 174 291 Ìnterest (36) (62) (5) (31) (72) Tax (33) (30) 2 (15) (46) ____ ____ ____ Net income 135 82 173 ____ ____ ____ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 69 Combined income statement: Mousse equity accounted as an associate PampIe Mousse adj Combined Sales 1,163 994 1,163 Operating costs (959) (820) (959) ____ ____ ____ EBÌT 204 174 204 Ìnterest (36) (62) (5) (41) Tax (33) (30) 2 (31) Share of associate 41 41 ____ ____ ____ Net income 135 82 173 ____ ____ ____ Workings Interest on additionaI net debt C100m x 5% = C5m Tax shieId on additionaI interest C5m x 40% = C2m Exercises and Case Study Solutions 70 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Mango & Steen Combined balance sheet (immediately after acquisition) Mango Steen ConsoIidated Cash Shares Shares & cash Goodwill 566 966 866 Net operating assets 1,000 3,267 4,267 4,267 4,267 Net funds/(debt) 115 (1,133) (3,718) (1,018) (1,768) ____ ____ ____ ____ ____ 1,115 2,134 1,115 4,215 3,365 ____ ____ ____ ____ ____ Shares 172 984 172 3,272 2,422 Retained earnings 943 1,150 943 943 943 ____ ____ ____ ____ ____ 1,115 2,134 1,115 4,215 3,365 ____ ____ ____ ____ ____ Exercises and Case Study Solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 71 Combined income statement (first year after acquisition) Mango Steen ConsoIidated Cash Shares Shares & cash Sales 4,384 8,969 13,353 13,353 13,353 Operating costs, excl dep'n (4,017) (8,336) (12,353) (12,353) (12,353) ____ ____ ____ ____ ____ EBÌTDA 367 633 1,000 1,000 1,000 Depreciation (109) (190) (299) (299) (299) ____ ____ ____ ____ ____ EBÌT 258 443 701 701 701 Ìnterest 14 (65) (213) (51) (96) Tax (97) (117) (165) (214) (200) ____ ____ ____ ____ ____ Net income 175 261 323 436 405 ____ ____ ____ ____ ____ Number of shares (m) 1,720m 1,720m 3,245m 2,827m EPS 10.2p 18.8p 13.4p 14 Exercises and Case Study Solutions 72 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] FinanciaI maths 1 Discounted cash flow (DCF) 1 Ìntroduction 1 Time value of money 1 Terminal/future values 5 Net terminal/future value 6 Present values 7 Annuities and annuity compound factors 10 Net present values 12 Annuities and annuity discount factors 14 Perpetuities 16 Ìnternal rate of return 17 Annuities and perpetuities not starting at time 1 21 Arithmetic and geometric progressions 24 Arithmetic progressions 24 Geometric progressions 24 Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 FinanciaI maths Discounted cash fIow (DCF) Introduction Discounted cash flow is the recognition of the fact that there is time value of money. What this means is that we would all prefer to receive money sooner rather than later and pay out money later rather than sooner. Why would we prefer to receive money now rather than at some time in the future? There are a number of reasons. Firstly we can spend it now and therefore be gratified by immediate consumption. Also by spending now we do not run the risk that prices will go up due to future inflation. And, by buying what we want now there is no risk that we will not be able to buy it in the future. Why would we prefer to pay money later? By doing this, the money can stay in our bank account earning us interest rather than in someone else's account earning them interest. This idea, of time value of money, is the basis of securities valuation. These ideas are embraced in the dividend valuation (or discount) model which states: 'the value of a security today is the present value of the future expected receipts, discounted at the investor's required rate of return" Time vaIue of money Ìf you lend someone your money, for example you lend it to the bank by depositing money with them, you no longer have the use of this money - the bank does. To compensate you for this the bank pays you interest. This might be very little for a current account (when you can get your money back very quickly) but will generally increase for a deposit account (where you might have to give the bank a minimum notice period before you can withdraw your money). The cost to the bank of borrowing your money is the interest they pay you. This interest is the cost of money. Accounts can pay interest in one of two ways Simple interest Compound interest Financial maths 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Simple interest Simple interest is when interest is only paid on the initial capital invested. Simple interest is what you get if you are quoted a nominal annual interest rate. ExampIe You deposit £1,000 at a simple interest rate of 6% for three years. How much money will you have in your account at the end of the third year? SoIution The interest you will earn each year will be £1,000 x 6%. This is £60. At the end of the first year this will be added to your account so that you start year two with £1,060 in the bank. The interest earned in the second year is still £60 (£1,000 x 6%) even though there is £1,060 on deposit. This is because, with simple interest, interest is only earned on the initial deposit and not on interest subsequently added to the account. Therefore at the end of three years the balance on the account will be £1,000 + [3 x (£1,000 x 6%)] = £1,180. This calculation can be written as a general formula D n = D o [1 + (n x r)] Where D n = value of deposit at end of period (eg year) n D o = initial value of deposit n = no of periods money is on deposit for r = simple interest rate expressed as a decimal For the example D 3 = £1,000 [1 + (3 x 0.06)] = £1,000 x 1.18 = £1,180 From your own experience you will realise that a typical deposit account does not offer simple interest; instead it offers compound interest. Compound interest This is an approach where interest is earned on the value of the deposit at the start of the period in question, not on the initial deposit. Obviously for the first period these two amounts are the same but in subsequent periods the opening balance will include interest added on from previous periods. Compound interest therefore pays 'interest on interest". Compound interest is what you get if you are quoted an effective annual interest rate. Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 Let's rework the above example, remembering that interest is now paid on the balance on deposit at the start of the year Year 1 Balance at start of year = initial deposit = £1,000. Ìnterest earned: £1,000 x 6% = £60 Year 2 Balance at start of year = initial deposit plus interest earned in year 1 = £1,060 Ìnterest earned: £1,060 x 6% = £63.60. This is £3.60 more than with simple interest because interest, in year 2, has also been earned on the £60 interest earned in year 1. The balance at the end of year 2 is therefore £1,060 + £63.60 = £1,123.60 Year 3 Balance at start is £1,123.60 Ìnterest earned: £1,123.60 x 6% = £67.42 Balance at end of year 3 = £1,123.60 + £67.42 = £1,191.02. We could have arrived at the same result by doing the following calculation £1,000 x 1.06 x 1.06 x 1.06 = £1,191.02 or alternatively £1,000 x (1.06) 3 = £1,191.02 This can be written as a general formula D n = D o (1 + r) n We have assumed in the above calculation that interest was only added on at the end of each year. Many accounts, of course, pay interest every six months or semi-annually. Some even pay more frequently than that; possibly paying interest quarterly or even monthly. The more frequently interest is paid, the better off the depositor is, as interest can then be earned on the interest already added to the balance. Using the above example where the interest rate was 6% we will assume that interest is now paid semi-annually. This means that interest of 3% (6% x ½) will be added on to the balance twice a year. Over a three year period interest will be added six times. The balance at the of three years would therefore be £1,000 x (1.03) 6 = £1,194.05 This is more than it was when interest was added annually. Financial maths 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] The formula for calculating the terminal value when interest is not paid annually is D n = D o (1 + r/m) nxm Where m = no of times interest is paid in the period n = no of periods (eg years) r = the annual interest rate Ìf interest was added monthly, the balance at the end of three years would be £1,000 x (1.005) 36 = £1,196.68 This is an even larger value; clearly showing that the frequency of compounding affects the overall return. Return Because interest is being credited more frequently than annually it is a fact that the annual return will be greater than 6%. Because, don't forget, we are earning interest on interest. What therefore is the actual return we are making each year? Assume that the annual rate we are using is 6% and interest is credited twice a year. Ìf we deposited £1,000 at the start of the year we would have £1,000 x 1.03 x 1.03 = £1,060.90 at the end of the year. This is more than a 6% return. (A 6% return would generate a year end balance of £1,060.) The actual return is 1 000 , 1 90 . 060 , 1 = 6.09% We now have two rates. The 6% we started with and the actual return of 6.09% The original rate, which does not take into account the frequency with which interest is added, is the flat rate or nominal rate. The rate which reflects the frequency of compounding and is therefore the actual rate achieved is called the annual percentage rate (APR) or effective annual rate (EAR). Ìn the formulae we have seen so far, r represented the flat rate. Ìf we are given the flat rate and the frequency of compounding then it is possible to calculate the APR, using the following formula. APR = (1 + r/m) m - 1 Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 Applying this formula to our example in which interest is compounded twice a year: APR = (1 + 0.06/2) 2 - 1 = 6.09% TerminaI/future vaIues The terminal or future value of a cash flow or a series of cash flows is the value one would have at some specified time in the future. This future value takes into account the interest that the cash flows earn between depositing them and the specified future date. To correctly calculate the terminal value we need to know The amount of the cash flow/s The timing of the cash flow/s The interest rate. We will assume compound interest in all further examples. Calculating the terminal value of two alternative investment opportunities allows us to consider which is the better of the two. The one that gives a greater terminal value would, every thing else being equal, be the better one to choose. ExampIe Which of the following two investment opportunities is better? Investment 1 This investment will pay £500 at the end of each of the next three years. Investment 2 This investment will pay £200 at the end of the first year and £1,300 at the end of the second year. Which investment has the greatest terminal value at the end of the third year if the appropriate interest rate is 6%? When calculating the terminal value we must take into account the compounded interest that can be earned. We will use the formula previously seen D n = D o (1 + r) n The (1 + r) n part of the expression is referred to as the compound factor Financial maths 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Investment 1 Time (years) Cash fIow £ Compound factor (1 + r) n TerminaI vaIue, £ (at end of yr 3) 1 500 1.06 2 561.80 2 500 1.06 530.00 3 500 1.00 500.00 TerminaI vaIue 1,591.80 Investment 2 Time (years) Cash fIow £ Compound factor (1 + r) n TerminaI vaIue, £ (at end of yr 3) 1 200 1.062 224.72 2 1,300 1.06 1,378.00 3 - 1.00 - TerminaI vaIue 1,602.72 As investment 1 has a terminal value of £1,591.80 and investment 2 has a terminal value of £1,602.72, investment 2 is preferred. The calculations of the terminal value above only considered the cash inflows from the two possible investments. What if investment 1 required an initial cash outlay of £1,300 and investment 2 required an initial cash outlay of £1,400. Would investment 2 still be the preferred investment? Net terminaI/future vaIue When there are both positive and negative cash flows the terminal value will be the netof these flows. We will now rework the previous example but include the initial investments as negative cash flows. Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 Investment 1 Time (years) Cash fIow £ Compound factor (1 + r)n TerminaI vaIue, £ (at end of yr 3) 0 (1,300) 1.06 3 (1,548.32) 1 500 1.06 2 561.80 2 500 1.06 530.00 3 500 1.00 500.00 Net terminaI vaIue 43.48 Investment 2 Time (years) Cash fIow £ Compound factor (1 + r) n TerminaI vaIue, £ (at end of yr 3) 0 (1,400) 1.063 (1,667.42) 1 200 1.062 224.72 2 1,300 1.06 1,378.00 3 - 1.00 - Net terminaI vaIue (64.70) Ìt can now be seen that investment 1 has a terminal value of £43.48. This means that this would be the cash balance at the end of the third year. Ìnvestment 2 now has a negative cash balance (terminal value) of £64.70 at the end of the third year. Ìnvestment 1 is now the preferred investment Present vaIues We have seen that calculating the terminal value of two potential investments might allow us to choose between them. This approach works if the investments we are trying to choose between have the same maturity date; that is they have the same terminal date. How, though, would we choose between investments that had different terminal dates? Ìf for example Ìnvestment A, a four year investment, had a terminal value (in four years) of £550 whilst Ìnvestment B, a six year investment, had a terminal value (at the end of the sixth year) of £725, which would we prefer? The problem is that comparing a value at the end of the fourth year with a different value at the end of the sixth year is not comparing the two on a common basis. To overcome this problem we will change our approach. We will no longer calculate terminal values; we will instead calculate what the values of the future cash flows are worth to us today. That is, we will calculate the present value of the future cash flows. Financial maths 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] By considering the present value of two alternative investments we are comparing them on a common basis. For both we are saying what their value is at the same point in time ie what their value is to us today. So how do we calculate the present value of future cash flows? The key thing is to realise that the present value of any future cash flow is simply the amount you would need to invest today to generate, with compound interest, the value of the future cash flow. ExampIe Ìf interest rates are 10% how much would need to be invested now to produce a balance of £1,500 in three years' time. We can use our knowledge of terminal values to answer this. We know that D n = D o (1 + r) n This formula can now be re-arranged as follows n n 0 ) r 1 ( D D Where D 0 = the amount we need to invest today ie the present value (PV) D n = the future cash flow we want to achieve r = interest rate n =no of periods between now and the future date For our example 3 ) 1 . 1 ( 500 , 1 PV = £1,126.97 This shows us that if we invest £1,126.97 today, at a compound interest rate of 10% this would be worth £1,500 in three years time. Turning this argument around we can say that a receipt of £1,500 in three years time is equivalent to a receipt of £1,126.97 today (assuming we can invest it at 10%). £1,126.97 is the present value of the future receipt of £1,500. The formula used above can be written generally as n ) r 1 ( fIow cash future ) PV ( vaIue esent Pr This is, of course, the same as writing Present value = future cash flow x n ) r 1 ( 1 Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 The term n ) r 1 ( 1 is called the discount factor and is used to calculate the present value of a single future cash flow that occurs at time n, at an interest rate r. The interest rate may be referred to as the discount rate as it is reducing the value of the future cash flow. ExampIe You are offered the choice of £4,000 now or £5,500 in 4 years' time. Assume the appropriate interest rate (discount rate) is 9%. Which is the more valuable sum? We discount the £5,500 back to its value today ie its present value. The calculation would therefore be: 4 (1.09) 5,500 = £3,896.34 As this is a lower sum than £4,000, we would prefer £4,000 now to £5,500 in 4 years' time. ExampIe Ìf the interest rate is8% p.a. d o we prefer: (a) £6,000 now; or (b) £8,000 in 5 years' time? Choice (a) (b) PV £6,000 5 ) 08 . 1 ( 000 , 8 = £5,444.67 We prefer (a), as it has the higher present value. Financial maths 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Annuities and annuity compound factors An annuity is when the same cash flow occurs for a number of periods. ExampIe Ìt is possible to pay £380 now and receive an annuity of £120 at the end of each of the next four years. What is the net terminal value of these cash flows if the interest rate is 8%? Time Cash fIow, £ Compound factor TerminaI vaIue, £ 0 (380) 1.08 4 (516.99) 1 120 1.08 3 151.17 2 120 1.08 2 139.97 3 120 1.08 129.60 4 120 1.00 120.00 Net terminaI vaIue 23.75 Ìmagine reworking the above example if the annuity was going to last for forty years rather than four. Ìt would be very tedious and time consuming! But, don't worry; there is a quicker way. Rather than treat each of the cash flows in the annuity separately and multiply them by the appropriate compound factor for a single flow, we could combine all the compound factors into one and simply multiple one cash flow by the combined compound factor. What we are going to calculate is the annuity compound factor. Annuity compound factor for times 1 to n is r 1 ) r 1 ( n This will give the terminal value, at time n, of an annuity whose cash flows are from time 1 to time n inclusive. For our example the annuity compound factor is 0.08 1 ) 08 . 1 ( 4 = 4.5061 Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 We can now calculate the net terminal value of the annuity, using the annuity compound factor rather than the individual compound factors. Time Cash fIow, £ Compound factor TerminaI vaIue, £ 0 (380) 1.08 4 (516.99) 1 ÷ 4 120 4.5061 540.74 Net terminaI vaIue 23.75 The terminal value arrived at above could be written as [- 380 x (1.08) 4 ] + 120 x [ 1 ) 08 . 1 ( 4 ] = 23.75 The above can be written as a general formula D n = D 0 (1 +r) n + 1 ) 1 ( n r d Where D n = terminal value at time n D 0 = cash flow at time 0 d = annuity cash flow r = interest rate Remember that the annuity formula gives the value of the annuity at time n on the assumption it started at time 1. This formula can now be used to answer various annuity-related questions. ExampIe 1 What is the cost today of a five year annuity paying £600 at the end of each year if interest rates are 6%? The cost today will be the D 0 value in the above formula. The value of D n , as the annuity terminates at the end of the fifth year, will be £0. Financial maths 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Therefore we have the following expression to solve 0 = D 0 (1.06) 5 + 600 x [ 1 ) 06 . 1 ( 5 ] 0 = 1.3382D 0 + 600 x 5.6371 D 0 = - £2,527.47 Ìt would cost £2,527.47 today to buy a five year annuity paying £600 per year, if interest rates are 6%. ExampIe 2 Ìf you take out a 25 year mortgage of £250,000 today at an interest rate of 7.5% what are the annual repayments needed to fully repay the loan by the end of the twenty fifth year? We know that D 0 is £250,000 and that D n is £0 (as the mortgage is repaid). We need to solve for d in the following expression 0 = 250,000(1.075) 25 + 1 ) 075 . 1 ( 25 d 0 = 1,524,584.90 + 67.9779d d = - £22,427.66 The annual repayments would be £22,427.66. ExampIe 3 Having calculated the annual payments, what is the balance outstanding on this mortgage at the end of the twentieth year? D n is now the end of the twentieth year and n = 20. D n = - 250,000(1.075) 20 + 22,427.66 1 ) 075 . 1 ( 20 D n = - 1,061,962.78 + 971,222.67 D n = - £90,740.11 There would still be £90,740.11 owing on the mortgage at the end of the twentieth year. Net present vaIues We saw earlier that the net terminal value was the terminal value when there were both positive and negative cash flows. Ìn the same way, the net present value or NPV is the present value when there are both positive and negative cash flows. Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 ExampIe 1 An investment requires an initial payment today of £1,000 and will pay back £1,650 in three years' time. Ìf the discount rate is 6% what is the NPV of this investment opportunity? Should it be undertaken? Time (years) Cash fIow £ Discount factor 1/(1 + r) n Present vaIue, £ 0 (1,000) 1 (1,000.00) 3 1,650 1/1.06 3 1,385.37 Net present vaIue 385.37 As the investment has a positive NPV it is worth doing. ExampIe 2 An investment requires an initial payment today of £2,000 and will pay back £2,650 in four years' time. Ìf the discount rate is 10% what is the NPV of this investment opportunity? Should it be undertaken? Time (years) Cash fIow £ Discount factor 1/(1 + r)n Present vaIue, £ 0 (2,000) 1 (2,000.00) 4 2,650 1/1.10 4 1,809.99 Net present vaIue (190.01) As the investment has a negative NPV it is not worth doing. Ìt would be equivalent to losing £190.01 today. ExampIe 3 You are required to decide which, if either, of the following two investment opportunities you would undertake. Ìnterest rates are 8%. Opportunity Q requires an investment today of £600 and will pay back £165 in one year's time, £300 in two years' time and £450 in three years' time. Opportunity W requires an investment today of £900 and will pay back £450 at the end of each of the next three years. Financial maths 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Investment Q Time (years) Cash fIow £ Discount factor 1/(1 + r) n Present vaIue, £ (at end of yr 3) 0 (600) 1 (600.00) 1 165 1/1.08 1 152.78 2 300 1/1.08 2 257.20 3 450 1/1.08 3 357.22 Net present vaIue 167.20 Investment W Time (years) Cash fIow £ Discount factor 1/(1 + r) n Present vaIue, £ (at end of yr 3) 0 (900) 1 (900.00) 1 450 1/1.081 416.67 2 450 1/1.082 385.80 3 450 1/1.083 357.22 Net present vaIue 259.69 Both investments have positive NPVs but as investment W has the higher NPV it is the one to choose. Annuities and annuity discount factors Ìnvestment W, above, had the same cash flow for a number of years. This is of course an annuity. Ìn this example we discounted each of the individual cash flows. This approach might, however, be rather tedious if it was, for example, a twenty five year annuity. We have seen that when calculating terminal values it is possible to determine an annuity compound factor that is effectively the sum of all the individual compound factors. A similar thing can be done when calculating present values. That is, an annuity discount factor can be determined that is effectively the sum of the individual discount factors. The annuity discount factor is ) r) + (1 1 - (1 r 1 n For Ìnvestment W ) (1.08) 1 - (1 08 . 0 1 3 = 2.5771 Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 Time, years Cash fIow, £ Discount factor Present vaIue, £ 0 (900) 1 (900.00) 1 - 3 450 2.5771 1,159.69 Net present vaIue 259.69 ExampIe What is the present value of an annuity that pays £850 p.a. for the next fifteen years at a discount rate of 6%? The annuity discount factor is: ) (1.06) 1 - (1 06 . 0 1 15 = 9.7122 Time, years Cash fIow, £ Discount factor Present vaIue, £ 1 - 15 850 9.7122 8,255.37 Present vaIue 8,255.37* *Rounded The annuity formulation may be applied to calculate the equal instalments which must be made on a repayment mortgage. The present value of the repayments (discounted at the mortgage rate) must equate to the present value of the loan (otherwise the loan would not be paid off!). The following example illustrates how the repayments may be determined. IIIustration A 25 year annual instalment repayment mortgage for £100,000 is granted at an interest rate of 6%. Ìf instalments are made at each year end, what is the required annual instalment? SoIution The present value of the mortgage (£100,000) must equate to the present value of the instalments discounted at the mortgage rate of 6%. The instalments (referred to as A in the formulation below) represent a 25 year annuity. Present value of mortgage loan = present value of instalments £100,000 = A x ) (1.06) 1 - (1 06 . 0 1 25 £100,000 = A x 12.78 A = £100,000 / 12.78 = £7,822.67 (or £7,824.73 depending on rounding). Financial maths 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Perpetuities A perpetuity is similar to an annuity except for the fact that the cash flows continue for ever ie into perpetuity. Ìt might at first glance seem impossible to value a cash flow that goes on for ever but the answer is to consider how much would need to be put on deposit now, at a particular interest rate, to generate a fixed amount of interest into perpetuity. Ìf you wished to generate a perpetuity of £10 each year and interest rates were 10% then a deposit made today of £100 would generate (at 10%) interest of £10 every year. Therefore £100 today is equivalent to £10 every year, or £100 is the present value of a perpetuity of £10 at an interest rate of 10% The appropriate discount formula for a perpetuity is ExampIe What is the net present value of an opportunity that requires an investment today of £12,000 and pays £800 into perpetuity if interest rates are 7%? Ìs it worth undertaking? Would it be worth undertaking if interest rates are 6%? Net present value at 7% Time, years Cash fIow, £ Discount factor Present vaIue, £ 0 (12,000) 1 (12,000.00) 1 - × 800 1/0.07 11,428.57 Net present vaIue (571.43) At a discount rate of 7% the investment is not worth undertaking as it has a negative net present value. Net present value at 6% Time, years Cash fIow, £ Discount factor Present vaIue, £ 0 (12,000) 1 (12,000.00) 1 - × 800 1/0.06 13,333.33 Net present vaIue 1,333.33 At a discount rate of 6% the investment is worth doing as it has a positive net present value. r 1 Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 Perpetuities with constant growth The formula for calculating the value of a perpetuity where the cash flows are growing at a constant rate, g, is: n 1 g) - (r Cf , where Cf 1 is the cash flow arising in one period's time and subsequent cash flows grow by g% per period. ExampIe A company is expected to pay a dividend of £200,000 in one year's time. This dividend is expected to grow by 3% per annum in subsequent years. We require a return on our investment of 8% (based on prevailing interest rates, with a premium for risk). The value placed on the company is therefore: 3%) - (8% 200,000 = £4.0 million InternaI rate of return We have seen from the previous examples that, by calculating the net present value of an investment, it is possible to decide whether the investment is worthwhile or not. Ìf an investment has a positive NPV then it is worth doing. Presumably it is worth doing because the return it is generating is greater than the cost of financing it. Ìt follows, therefore, that if an investment generates a negative NPV this is because its return is less than the cost of financing it. The return being generated by the investment's cash flows is the Internal Rate of Return or IRR. This gives another way of appraising whether an investment should be undertaken. Calculate its ÌRR and compare it with the cost of financing the investment. How then is the ÌRR calculated? Financial maths 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Comprehensive iIIustration A new project will cost £250million. We have already spent £30million on market research. The project will provide the following net cash inflows: £'000 At the end of year 1 30,000 At the end of year 2 72,000 At the end of year 3 80,000 At the end of year 4 65,000 At the end of year 5 110,000 _______ Total 357,000 _______ The project has no scrap value at the end of its 5 year life. The current rate of interest used by the company (the company's cost of capital) is 9%. Ìs this project worthwhile? Ìn other words is it generating a positive NPV? Ìs it generating a return (ÌRR) of more than 9%? The project's incremental income is £357million which is greater than the cost of £250million. (We ignore the £30million as a sunk cost.) However, the £250million will be incurred now. The other flows are future flows and we must discount them back (at 9%) to obtain their present value. Thus 09 . 1 000 , 000 , 30 = £27,522,936 in present value terms and 2 ) 09 . 1 ( 000 , 000 , 72 = £60,600,960 (in two year's time), etc. Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 Discount Present Time Narrative Flow factor value £'000 9% £'000 0 Project cost (250,000) 0 09 . 1 1 = 1 (250,000) 1 Ìnflow 30,000 1 09 . 1 1 27,523 2 " 72,000 2 09 . 1 1 60,601 3 " 80,000 3 09 . 1 1 61,775 4 " 65,000 4 09 . 1 1 46,048 5 " 110,000 5 09 . 1 1 71,492 ______ Net present value 17,439 ______ The NPV is positive (ie the cost of the project is less than the revenues as discounted). We should accept the project. Calculating the IRR As mentioned earlier, the return being generated by the investment's cash flows is the Internal Rate of Return or IRR. An alternative way to look at it is to say it is the break even interest rate. Ìt is interest rate (or cost of capital) that gives a net present value of zero. Carrying on the same illustration, we know the project is worthwhile as it has a positive NPV. However, as the cost of capital increases from 9% the later inflows are subject to ever greater discounting, and are worth less and less. Ìn effect the alternative use of the £250 million if invested in the bank, becomes greater and greater. There must, therefore, be a cost of capital at which the project is no longer viable, ie at which we have a negative NPV. Financial maths 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] The NPV of the illustration has been calculated at a variety of discount rates as follows: Discount rate NPV (£'000) 0% 107,000 3.00% 72,843 6.00% 43,236 9.00% 17,439 12.00% (5,148) 15.00% (25,016) 18.00% (42,568) 21.00% (58,139) Diagrammatically, the above schedule looks like this: NPV (£'000) 107,000 17,439 0% 9% 11.28% Discount rate Using Microsoft Excel, which has an iterative function for estimating the internal rate of return, the ÌRR is found to be 11.28%. The ÌRR provides the rate at which the project just breaks even; it gives us the maximum cost of capital the project can endure. This is vitaIIy important; the ÌRR provides the maximum amount that we would be prepared to pay to acquire the funds for the project. The project breaks even at a discount rate of 11.28%. An alternative way to look at it is to say that the project is giving an average annual return of 11.28%. As this exceeds the required return/cost of capital of 9%, the project is acceptable. Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 Ìf the company's cost of capital is above 11.28%, then the project is not worthwhile; ie at 13% we lose money on the project as the project only returns 11.28%. Annuities and perpetuities not starting at time 1 So far, whenever we have dealt with an annuity or a perpetuity we had the situation where the first cash flow started at time 1 ie at the end of the first period (normally a year). We also had discount formulae that gave us the PV of these cash flows:- Annuity discount factor : ) r) + (1 1 - (1 r 1 n Perpetuity discount factor: r 1 We must now consider how we would work out the PV of an annuity or perpetuity that did not start at time 1. There are two possibilities. Firstly, the cash flows start before time 1 ie at time 0 (now). Secondly, they start after time 1. Cash flows starting before time 1 ExampIe What is the PV of a five year annuity paying £500 at the start of the next five years at a discount rate of 6%? Approach 1 - discount all flows individually Cash fIow, £ Discount factor Present vaIue, £ 0 500 1 500.00 1 500 1/1.06 471.70 2 500 1/1.06 2 445.00 3 500 1/1.06 3 419.81 4 500 1/1.06 4 396.05 Net present vaIue 2,232.55 The above approach, although accurate, is rather time consuming. Let's consider a quicker method. Approach 2 ÷ treat the time 0 flow separately and treat the remaining cash flows as a four year annuity starting at time 1. As this is an annuity starting at time 1 we can calculate the discount factor using the annuity discount formula. Financial maths 22 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Time, years Cash fIow, £ Discount factor Present vaIue, £ 0 500 1 500.00 1 - 4 500 3.4651* 1,732.56 Net present vaIue 2,232.55 *annuity discount factor ) (1.06) 1 - (1 06 . 1 4 = 3.4651 Approach 3 - calculate the PV as if it was a five year annuity starting at time 1 and then increase its value by one year as it actually starts at time 0. step 1- value of five year annuity starting at time 1 500 x ) (1.06) 1 - (1 06 . 1 5 = £2,106.18 step 2 - increase value by one year as cash flows start at time 0 (1 year before time1) £2,106.18 x 1.06 = £2,232.55 Yet again, we get the same answer. The third approach highlights a useful technique. Ìf cash flows start before time 1, increase their value. Ìt therefore follows that if cash flows start later than time 1, reduce their value. ExampIe What is the PV of a four year annuity paying £300 p.a. starting at the end of the third year if interest rates are 4%? Approach 1 - discount the individual cash flows Time, years Cash fIow, £ Discount factor Present vaIue, £ 0 - - - 1 - - - 2 - - - 3 300 1/1.04 3 266.70 4 300 1/1.04 4 256.44 5 300 1/1.04 5 246.58 6 300 1/1.04 6 237.09 Net present vaIue 1,006.81 Financial maths © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 23 Approach 2 - value a four year annuity starting at time 1 and then reduce its value by two years by discounting it by the two year discount rate. Step 1 - value of four year annuity starting at time 1 £300 x ) (1.04) 1 - (1 04 . 1 4 = £1,088.97 Step 2 - discount value by two years as cash flows start two years after time 1 (1.04) 1 1,088.97 2 = £1,006.81 The same value is achieved under both methods but the second approach is quicker and far more flexible. Changing discount rates Where discount rates change, it is critical to discount using the appropriate rates. This is best shown by an illustration. IIIustration A £20,000 cashflow is to be received in 3 years' time. The discount rates for the next 3 years are expected to be 7%, 8% and 9% respectively. The discounted cash flow is: .07 1 1 x .08 1 1 x .09 1 1 x £20,000 = £15,878 A common error is to discount the cashflow for three years at the 3-year rate. Financial maths 24 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Arithmetic and geometric progressions Arithmetic and geometric progressions are particular types of sequences of numbers which occur frequently in business calculations. Arithmetic progressions An arithmetic progression (AP) is a sequence of numbers where each new term after the first is formed by adding a fixed amount called the common difference to the previous term in the sequence. For example the sequence: 3, 5, 7, 9, 11 . . . is an arithmetic progression. Note that having chosen the first term to be 3, each new term is found by adding 2 to the previous term, so the common difference is 2. The common difference can be negative: for example the sequence 2,~1,~4,~7, . . .is an arithmetic progression with first term 2 and common difference ~3. Ìn general we can write an arithmetic progression as follows: Arithmetic progression: a, a + d, a + 2d, a + 3d, . . .where the first term is a and the common difference is d. Some important results concerning arithmetic progressions (AP) now follow: The nth term of an AP is given by: a + (n ~ 1)d The sum of the first n terms of an AP is Sn = 2 n (2a + (n ~ 1)d) Geometric progressions A geometric progression (GP) is a sequence of numbers where each term after the first is found by multiplying the previous term by a fixed number called the common ratio. The sequence 1, 3, 9, 27, . . . is a geometric progression with first term 1 and common ratio 3. The common ratio could be a fraction and it might be negative. For example, the geometric progression with first term 2 and common ratio 3 1 is 2, 3 2 , 9 2 , 27 2 , . . . Ìn general we can write a geometric progression as follows: Geometric progression: a, ar, ar 2 , ar 3 , ...where the first term is a and the common ratio is r. Some important results concerning geometric progressions (GP) now follow: The nth term of a GP is given by: ar (n~1) The sum of the first n terms of a GP is Sn = r r a n 1 ) 1 ( (valid only if r 1). Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Introduction to vaIuation 1 Ìntroduction 1 Overview 1 Comps based valuation 1 DCF valuation 2 Comparable companies analysis 3 Why do we do comps? 3 From Equity Value to Enterprise Value 5 Ìllustration 6 Discounted cash flow valuation 8 Key points 8 Cost of debt 10 Cost of equity 13 Dividend valuation model 17 Dividend policy 20 Recognising risk 23 Ìntroduction 23 Traditional theory of gearing 24 Modigliani & Miller (M&M) 25 Gearing Betas 29 Adjusted present value (APV) 31 Weighted average cost of capital (WACC) 32 Cash flow to discount 33 Value drivers 35 What comes before valuation? 37 Growth rates and time period for discounting 39 Terminal values 40 Time period convention 41 Valuing combinations 42 Methodology 42 Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 Introduction to vaIuation Introduction Company valuation techniques can be broadly categorised as: Comparable companies analysis (eg P/E, EV/EBÌTDA); and Discounted cash flow (DCF) analysis. Valuation can be performed at the equity level or the enterprise level and can be based on earnings or cash flows. Overview Comps based vaIuation Key metrics Equity IeveI Enterprise IeveI Earnings based E (earnings after tax) [NOPAT] EBÌT EBÌTDA Cash flow based Levered FCF Unlevered FCF Key multiples Equity IeveI Enterprise IeveI Earnings based P/E EV/EBÌT(DA) Cash flow based P/LFCF EV/UFCF Where P (price) = market capitalisation of equity; and EV (enterprise value) = market capitalisation of equity plus net debt plus or minus corporate adjustments. Ìntroduction to valuation 2 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] The selected multiple for a comparable company (or the sector average) can be applied to the relevant metric of the company to be valued. DCF vaIuation Key metrics Equity IeveI Enterprise IeveI Earnings based not applicable not applicable dividends available Cash flow based Levered FCF Unlevered FCF Discount rate Equity IeveI Enterprise IeveI Earnings based not applicable not applicable Cash flow based cost of equity WACC The key metric must be forecast for the appropriate period (eg 3 years, 5 years, 10 years) and a terminal or residual value at the end of the forecast period must be established. The relevant discount rate is applied to the forecast cash flows to give a present value. Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 ComparabIe companies anaIysis Why do we do comps? Analysing the operating and equity market valuation characteristics of a set of comparable companies with similar operating, financial and ownership profiles provides a useful understanding of: 1. The important operating and financial statistics about the target's industry group (eg growth rates, margin trends, capital spending requirements). This information can be helpful in developing assumptions for a discounted cash flow analysis. 2. The relative valuation of publicly listed companies The resulting multiples guide the user as to the market's perception of the growth and profitability prospects of the companies making up the group. Consequently, comps can be used to gauge if a publicly traded company is over or under valued relative to its peers. 3. A benchmark valuation for target entities Comps valuations are based on: ÷ metrics of target company (eg EBÌTDA) ÷ multiples of similar quoted company(ies) (eg EV/EBÌTDA) Valuation multiples from comparable companies may be applied to the financials of the target entity to be valued to give a theoretical value of the target business. For example: Metric of target earnings $10.0m Multiple of similar quoted company p/e 18.0x TheoreticaI equity vaIue of target $10.0m x 18.0 = $180.0m 4. An indicative market price for a company which is to be floated on the stock market. 5. The validity of terminal DCF assumptions. 6. Ìnvestment returns for financial buyers acquiring assets with the intention of monetising the investment in the public equity market in an ÌPO. Ìntroduction to valuation 4 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Example Tesco Sainsbury Share price (p) 261.5 376.0 Equity value (£m) 18,127 7,260 Enterprise value (£m) 20,967 8,172 Enterprise vaIue I SaIes 2006 (Curr.) 0.86x 0.48x 2007 (Prosp.) 0.74x 0.47x EBITDA 2006 (Curr.) 10.8x 7.6x 2007 (Prosp.) 9.4x 6.6x EBIT 2006 (Curr.) 15.5x 12.4x 2007 (Prosp.) 13.5x 10.4x Equity VaIue / Earnings 2006 (Curr.) 20.8x 17.9x 2007 (Prosp.) 18.5x 15.5x Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 From Equity VaIue to Enterprise VaIue Enterprise value (*) = Equity Value (**) + Net Debt (***) + Minority Ìnterest Example continued - Enterprise value Tesco Share price (p) 261.5 Number of Shares (m) 6,932 _____ Equity VaIue (£m) 18,127 [A] ST Debt (£m) 1,413 [B] LT Debt (£m) 1,925 [C] Cash & equivalents (£m) (534) [D] _____ Net Debt (£m) 2,804 [E]=[B+C+D] Minority Ìnterest (£m) 36 [F] _____ Enterprise vaIue (£m) 20,967 [A + E + F] Enterprise value (EV) Enterprise value is also defined as: Total enterprise value (TEV) Entity value (EV) Gross value (GV) Total capitalisation Firm value (FV) Aggregate value Leveraged market capitalisation (L.MC) The terms are used loosely and are generally interchangeable. Ìf used in a critical context we should define exactly what is meant by them. Equity value (Eq.V) Equity value (Eq.V) is also defined as: Market capitalisation (MC) Ìntroduction to valuation 6 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] IIIustration J Sainsbury is to be valued using, where relevant, Tesco as a comparable company. Tesco Share price 259p EPS 11.53p P/E 22.46x No of shares 6,932m Market capitalisation £17,954m Net debt £2,804m Minority interest £6m Enterprise value £20,794m EBÌTDA £1,642m EV/EBÌTDA £20,794m ÷ £1,642m = 12.7x Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 Comps valuation - earnings based Equity IeveI P/E multiples are easy to calculate and widely understood. However, earnings are after interest and therefore P/E ratios (and P/E based valuations) are affected by capital structure. Enterprise IeveI Enterprise value multiples are regarded as purer than earnings multiples. This is because enterprise value is unaffected by capital structure. Enterprise value can be related to other figures which are independent of the capital structure (eg sales, EBÌT, EBÌTDA, unlevered free cash flow). EBÌTDA is pre tax and EPS is post tax, so EV/EBÌTDA has a larger denominator than PER. Consequently, the EV/EBÌTDA multiple will be smaller than the PER. (Also, EBÌTDA is before depreciation & amortisation.) J Sainsbury Relevant data is: No of shares 1,930.8m Net debt £859m EPS 19.2p Equity level, earnings based Tesco P/E x J Sainsbury EPS 22.46 x 19.2p = 431.2p This gives an equity valuation of 1,930.8m x 431.2p = £8,326m. Enterprise level, earnings based EBÌTDA £961m Tesco EV/EBÌTDA x J Sainsbury EBÌTDA 12.7 x £961m = £12,205m Summary Equity level Enterprise level [EV ÷ net debt = equity value] Earnings based £8,326m £12,205m - £859m = £11,346m Ìntroduction to valuation 8 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Discounted cash fIow vaIuation Key points Analysts tend to forecast profit and derive cash flow (by adjusting for depreciation and changes in working capital). Valuation is very sensitive to assumptions about discount rates and growth into perpetuity. Enterprise level The relevant cash flows are before interest (ie unlevered). The relevant discount rate is the weighted average cost of capital (WACC). Equity level The relevant cash flows are after interest (ie levered). The relevant discount rate is the cost of equity. IIIustration - Enterprise IeveI Cash Flows Actual Estimate Forecast Forecast Forecast Forecast Year to 31 December 2005 2006 2007 2008 2009 2010 £m £m £m £m £m £m 0 1 2 3 4 Turnover 511.0 624.0 780.0 873.6 943.5 990.7 EBÌT 26.1 137.3 202.8 205.3 207.6 198.1 Add: Depreciation 40.0 36.2 45.3 50.7 54.7 57.5 EBÌTDA 66.1 173.5 248.1 256 262.3 255.6 Working capital adjustment 3.2 (26.6) (46.8) (23.4) (12.6) (8.3) Operating cash flow 69.3 146.9 201.3 232.6 249.7 247.3 Sale of fixed assets - - - - - - Ìnvestment income (7.9) 5.0 - - - - Other non-cash items 3.0 - - - - - Less: Capex (39.4) (39.9) (67.9) (60.8) (60.2) (63.2) Tax paid 4.4 29.7 (30.4) (65.7) (66.4) (63.4) Free cash fIow 29.4 141.7 103 106.1 123.1 120.7 Terminal cash flow 123.1 Terminal Value 1,367.9 Discount Factor 0.90 0.81 0.73 0.66 Present Value of Cash Flow 92.8 86.1 90.0 980.6 WACC 11.0% Total discounted cash flows 1,250 Nominal growth post 2010 2.0% Less: Net Debt (163) Equity value (£m) 1,087 Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 The model produces a valuation as at 1 January 2007 (proposed acquisition date). 1 January 2007 is 'time 0'; only cash flows after this date would accrue to the (potential) acquirer. The ability to make specific forecasts for individual future years is crucial; otherwise most of the value lies in the terminal value. The terminal value depends on the forecast (nominal) growth rate post 2010. This and the discount rate (here the WACC) are the most sensitive assumptions in the model. Net debt is deducted from the enterprise value to arrive at an equity value. Equity IeveI The illustration above would be amended as follows: Net interest paid would be deducted in arriving at free cash flow; Resultant cash flows would be discounted at the cost of equity; and Total discounted cash flows would represent the equity value. Ìntroduction to valuation 10 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Cost of debt Theoretical derivation Kd = Rf + credit spread where, Kd in the above formula is the pre tax cost of debt. When plugged in to the WACC formula, Kd should be reduced by the tax shield. Rf (the risk free rate) Theory suggests using the 30 year government bond rate (long term). However, in practice the 10 year rate is often used. Credit spread The company's credit rating can be used to determine the credit premium. Ìf there is no available credit rating for the company, it can be estimated by looking at comparable companies (in terms of credit ratios (for example Debt/EBÌTDA), similar business etc). A rough guide for US companies using a single ratio would be: TotaI debt/ EBITDA Estimated bond rating Credit spread <0.8x AAA 60bp 0.8 - 1.5x AA 80bp 1.5 ÷ 2.2x A 100bp 2.2 ÷ 3.4x BBB 150bp 3.4 - 4.9x BB 350bp > 4.9x B 600bp Market-derived cost of debt The market-derived cost of debt may also be calculated using public debt outstanding, but it should be emphasised that we are looking for a long term forward return required by the investors in the company's senior debt. Irredeemable debentures With irredeemable or undated debt, the company does not undertake to repay at any fixed date. Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 Market vaIue Ìf interest (Ì) is expected in perpetuity, the market value of the debt is MVd and the required return of debt holders is r d , then: MVd = PV of interest Ì in perpetuity = . . . rd) (1 Ì rd 1 Ì 2 + + + = rd Ì By rearranging the equation: r d = interest ex MVd Ì Illustration A company's 7% debentures are quoted at £89 per £100 nominal. Annual interest has just been paid. What is the return (rd) the debenture holders are receiving? r d = 89 7 = 7.86% Tax shield Although the debt holders in the above illustration are receiving a 7.86% return, the cost to the company is less, as interest is deductible for corporation tax purposes. k d = MVd interest t) (1 × ÷ where k d = cost of debt t = corporation tax rate (assume tax effect immediate) The company pays out the whole amount of interest, say £7, but it is allowed the whole amount as a deduction in the corporation tax computation. Ìf we assume a corporation tax rate of 30%, then the cost of debt is: k d = 89 7 x 0.7 = 5.5% (or 0.7 × 7.86 = 5.5%) Chronology - Ìnvestors require a return of 7.86%. - They determine the market value of £89 in order to get their required return of 7.86%. - The cost to the company is based on the market value of £89 fixed by the investors. The interest is deductible for corporation tax which leads to the company cost of debt of 5.5%. Ìntroduction to valuation 12 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Redeemable debt Market vaIue Ìf interest (Ì) is expected for a number of periods and then an amount R on redemption, the market value of the debt is: MVd = = n 3 2 rd) (1 R . . . . . rd) (1 Ì rd) (1 Ì rd 1 Ì + + + + + + The debt holders required return is the internal rate of return of the flows. To compute the cost of debt, the internal rate of return of the flows must be calculated, replacing interest (Ì) with (1 ÷ t) x (Ì) interest. Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 Cost of equity Capital asset pricing model (CAPM) CAPM is a model that provides the required return (cost of equity) which would be suitable to appraise an investment, given knowledge of the business risk of the investment. Key assumption Shareholders are well diversified, i.e. they hold a balanced portfolio of different equities & gilts. This means that the investor does not suffer unsystematic or company specific business risk (in effect his different equities balance out). However, he will still suffer systematic risk. Systematic risk Even if an investor held every investment in the FTSE 100, there would still be fluctuations in return as the market moved up and down, influenced by political and economic factors, etc. The well-diversified shareholder's balanced portfolio represents the FTSE 100 and is subject to the same systematic risk. As the well-diversified investor only suffers systematic business risk, he only requires a return to compensate for the systematic business risk in the investment. Beta (| || |) measures the level of systematic business risk relative to the market risk for any investment. Thus, if an investment has a | of 0.9 we can say that, if the market rises or falls by 10% the investment will rise or fall with the market, but only by 9% (i.e. the investment is slightly less risky than the market as a whole). CAPM gives the following equation: Cost of equity (k e ) = R f + (| L x R m ) ¹ ¹ Risk free Premium return for risk Where: k e = Cost of equity (shareholders' required return) R f = Risk free return (i.e. from government stock or corporate debt) R m = Equity market risk premium | L = Beta leveraged for target level of gearing Ìntroduction to valuation 14 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] ExampIe R f = 6% R m = 7% | L = 1 Cost of equity of an investor will be: 6% + (1 x 7%) =13% This is the same as the expected return on the market. Ìt should be! The | = 1 indicates that the investment moves exactIy in line with the FT 100. Ìf the investment has a | of 1.4, then it moves in line with the market, but to a greater degree. Ìn other words, it is more volatile than the FTSE 100 and the investor will require a greater return. This can be calculated as: 15.8% = 6% + (1.4 x 7%) The cost of equity is 15.8%. Inputs Rf - the risk free rate Ìt is acceptable to use the long term bond rate as the risk free rate, although as the market thins, the yield on blue chip corporate bonds may be used as a replacement. The 10 year bond rate is used more regularly than the 30 year. Rm - the equity market risk premium (EMRP) This is often based on historic data and is the difference between the average return on stocks and the average returns on risk free securities. Period Stocks-T BiIIs Stocks-T BiIIs Stocks-T Bonds Stocks-T Bonds Arithmetic Geometric Arithmetic Geometric 1926-2001 8.09% 6.21% 6.84% 5.17% 1962-2001 5.89% 4.74% 4.68% 3.90% 1981-1990 6.05% 5.38% 0.13% 0.19% 1991-2001 10.62% 9.44% 6.90% 6.17% Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 Calculation of Beta The | of any share or investment is expressed as: o o s m Where, o s = systematic risk of the investment o m = risk of the FTSE 100 This can be calculated as follows: | = m i im r where, r im is the correlation coefficient of the investment with the index, o i is the total business risk in the investment and o m is the risk of the index. Beta can be calculated in many ways, Ìbbotson for example suggests that; 'To estimate the beta of a company, monthly total returns of the company's stock in excess of the 30 day T-bill are regressed against the monthly total returns of the S&P500 in excess of the 30 day T-bill. A sixty month time frame is used for the regression' The Bloomberg default is a twoy ear, weekly regression. The problems of lag (share prices moving after the market) make the daily and even the weekly data more problematic. Adjustments for corporate size are offered, but these are volatile, changing from premia to discounts over relatively short periods and are often ignored. Raw or adjusted Beta As companies and industries mature, the Beta tends to the market (ie. 1) - the adjusted Beta will take account of this. Many argue that this introduces spurious accuracy into the K e (cost of equity) calculation. Large companies such as Nokia, Telecom Ìtalia and even Vodafone can create problems if their stock comprises a disproportionate amount of the index, distorting their beta calculation. ReIevering Beta The service provider's (e.g. Barra) beta will reflect the existing gearing of the target company. This must be unlevered, showing the risk profile of the target company's assets in the absence of leverage: Ìntroduction to valuation 16 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Unlevering formula ( ) ( ¸ ( ¸ ÷ × | . | \ | + | = | t 1 E D 1 L U Current gearing This unlevered beta must then be relevered, based on the target gearing level (if necessary, use the industry average): Relevering formula ( ) ( ¸ ( ¸ ÷ × | . | \ | + × | = | t 1 E D 1 U L Target gearing D = market value of debt capital E = market value of equity capital t = marginal tax rate Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 Dividend vaIuation modeI Constant dividends Ìf expected future dividends in perpetuity are constant at D, the market value of the shares is MV e and the cost of equity is k e , MV e = PV of dividends D in perpetuity = 2 e e ) k 1 ( D k 1 D + + + etc. = D k e e MV shares equity of value Market = ) (k return of rate required rs Shareholde (D) dividend expected Future e Rearranging the model allows us to find (but not, of course, derive) the cost of equity or required return. Ìf D and MV e are known, k e = e MV D ExampIe Assume a C15,000 dividend is expected each year in perpetuity and shareholders require a rate of return of 12% (k e ). What is the PV of this perpetuity? The PV of the returns (from 1 - ·) is as follows: 15,000 × 1/0.12 = 125,000. Ìnvestors should be prepared to pay C125,000 for this perpetuity. Cum div./ ex div. Cum div Cum div. means the purchaser of the share at that price will buy the right to the next dividend. Shares are mostly quoted cum div. Ex div Shares become ex div. just before the next dividend is paid, meaning that the purchaser does not receive the next dividend which is (soon) to be paid. Ìntroduction to valuation 18 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] The dividend valuation model produces an ex dividend market vaIue since the sum of the present values starts with the dividend in 1 year's time (ie. excludes the current dividend). Ìn order to convert from cum dividend to ex dividend for DVM purposes, one deducts the dividend which is about to be paid, ie. Ex div. MV = Cum div. MV ÷ next dividend to be paid. ExampIe Company A has 1 million 50p shares with a cum div. market value of 90p per share. The company is just about to pay (signal of a cum div. value) a dividend of £100,000 and expects dividends to continue at the level. k e = D MV ex div k e = % 12 Div div. cum MV 100,000 - 900,000 100,000 2 1 = + + or per share % 12 10p 90p 10p 2 1 = ÷ Constant growth in dividends Assume dividends are expected to grow at a constant rate g. Let D 0 = current dividend D 1 = next year's dividend MV e = . . . ) k (1 g) (1 D k 1 g) (1 D 2 e 2 0 e 0 + + + + + or = 2 e 1 e 1 ) k (1 g) (1 D k 1 D + + + + etc. The formula for adding up these future dividends discounted is MV e = g k dividend years Next ie g k g) (1 D e e 0 ÷ ÷ + or = g k D e 1 ÷ Ìf dividends, g and MV e are known, the cost of equity can be computed: Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 k e = e 0 MV g) (1 D + + g or g MV D e 1 + Ìn summary, therefore, shareholders will value shares by discounting future expected dividends at their required return. Ìf the company wishes to compute the return that shareholders are requiring, it can use the above formula where dividends are expected to grow at a constant rate, g. Estimation of g Shareholders will have an expectation of dividend growth. They will normally have based this on either what has happened in the past (extrapolation of past dividends) or on an analysis of what will happen to profits, and hence dividends, in the future (by reviewing the company's retention of profit and investment policy). AItering the time horizon The model referred to above is, of course, a simple perpetuity. Ìt is normally amended in accordance with the time horizon of the company such that ) k 1 ( D e 1 + + 2 e 2 ) k 1 ( D + + 3 e 3 ) k 1 ( D + + 4 e 4 ) k 1 ( D + + 5 e 5 ) k 1 ( D + . . . . . . . 10 e 10 ) k 1 ( D + + 10 e ) k 1 ( 1 + ( ¸ ( ¸ ÷ g k D e 11 The calculation is based on a 10 year time horizon, with the 1 st dividend arising at time 1 (i.e. next year). Assumptions of DVM Ìnvestors are a body (ie. same expectations of future returns, same required return for any level of risk) who determine market values. Companies pay dividends forever. Cash flows that concern investors are dividends and interest, paid at the end of each year. The DVM is based on the broader assumptions that investors are rational and capital markets are efficient. Ìntroduction to valuation 20 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Dividend poIicy Introduction Dividends can be thought of as the trade-off between retained earnings and distributing cash or stock to shareholders. Retained earnings can be used to: Fund capital expenditure Make NPV positive investments Keep back for financial flexibility Distribution can be: Share buyback Cash dividend Stock dividend Why are dividends important? SignaIIing tooI Communicates information to the equity market about the strategic direction of a company Signals a company's future operating performance Ìnvestors are inclined to look favourably upon a dividend increase which signals positive information about the company's future earnings potential A dividend cut can send a signal that management lacks confidence in the company's near- term prospects. This effect is greater if a dividend cut is followed by lower earnings results or other unfavourable news SharehoIder preferences Growth oriented investors do not seek out dividend income Some investors (including private investors) may rely on the income generated by dividend payments Some institutional investors may be restricted from investing in shares of non-dividend paying companies Communication Successful execution of a change in dividend policy will require a company to communicate: The existence of value adding investment opportunities Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 The need for additional funding to make those investments The additional flexibility to deploy excess cash flow for share repurchases Factors determining dividend policy SharehoIder preferences Ìnstitutional shareholders (eg pension funds) may require regular cash receipts to meet their commitments (eg to pay pensions). Payout ratio Depends primarily on the preference of the majority of shareholders Consider industry comparables and practices Growth / fIexibiIity Mature, lower growth companies tend to pay high dividends, limiting a company's flexibility with respect to dividend policy changes However, a share repurchase program is easier to cut or discontinue if a more attractive investment opportunity arises or cash conservation is required SignaIIing Experience suggests that investors interpret changes in dividend policy primarily as a signalling mechanism Tax efficiency Dividends can be a less efficient vehicle for shareholder value distribution as they are taxed when the dividend is paid (ie no deferral as with capital gains) and potentially at higher effective rates (as gains often have exemptions and some countries charge lower rates on gains) Characteristics of companies that pay low dividends (0% - 25% payout) Growth companies Volatile earnings Weak credit Excessively leveraged High Beta Highly competitive industry High R&D Technology-oriented Ìntroduction to valuation 22 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Conclusion A company can create value by investing but cannot influence value directly through dividend policy, therefore it should allow its dividend policy to be governed by the cash available after it has made all attractive investments. This is the conclusion that Modigliani and Miller came to in their dividend irrelevance theory. Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 23 Recognising risk Introduction Risk can broadly be split in to 2 types, from the investors' perspective: Business risk or Finance risk or Earnings risk or Gearing risk Operating risk Portfolio theory & CAPM analyse this Traditional theory and Modigliani & Miller analyse this Business risk is addressed by the CAPM. There are a number of views regarding gearing or leverage risk. Gearing/finance risk When funding from debt (or gearing up), there are 2 sides to consider: 1 There will be a higher proportion of cheaper debt finance, which will have a downward pressure on the WACC, and upward pressure on the market value (MV) of the company. 2 Equity investors will be exposed to additional risk, i.e. the spread of their returns will increase. IIIustration Low Average High Earnings = Dividend (in an all equity company) £4,000 £5,000 £6,000 -20% +20% Ìf £5,000 is the average, the earnings, and therefore dividends, can fluctuate by 20% (risk). Ìf the company now has a fixed amount of interest to pay, the following occurs: Ìntroduction to valuation 24 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Low Average High £ £ £ Earnings 4,000 5,000 6,000 Ìnterest (2,000) (2,000) (2,000) _____ _____ _____ Dividend to equity 2,000 3,000 4,000 _____ _____ _____ Fluctuation = ± 33 1 /3% (risk) Therefore, the higher the gearing, the higher the riskiness of the dividends and, therefore, the higher the cost of equity (k e ). This will have an upward pressure on the WACC and a downward pressure on the market value of the company. Various theories suggest how these 2 factors combine and their resultant effect on: - WACC of company - MV of company TraditionaI theory of gearing At low levels of gearing, k e rises slowly and the effect of the cheaper debt outweighs the increase in the k e . The theory therefore predicts that the WACC will fall. However, as gearing increases further, k e increases more sharply and eventually outweighs the cheaper debt effect. Therefore, WACC will start to rise again. Thus, it should be possible to achieve an optimal level of gearing ÷ that there is an ideal point to the trade-off between the cheaper debt and the costs of financial distress where the weighted average cost of capital is minimised and the market value of the company (debt plus equity) is maximised. Cost oI capital ke WACC kd optimal gearing WACC lowest MV highest MV debt MV equity The problem is that this optimal can only be found by trial and error. The traditional theory offers no mathematical route. However, the trade-off theory is not really consistent with the evidence: Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 25 - Tax benefits of debt appear much higher than the costs of financial distress for most companies. - Companies appear to value flexibility of their strategic options highly and thus restrict leverage. - Pricing/marketing strategies have been shown to be partially determined by competitors' capital structure. Ìf it is true that it is possible to find a minimum WACC, it is only true if the operating income is independent of the capital structure. However, in practice this may not be the case for the following reasons: - When debt is raised, there are often debt covenants which prevent the company using its assets as freely as the company would like. - Although some theories disagree, a company taking on new investments could affect existing providers perception of existing activities. ModigIiani & MiIIer (M&M) M&M offer a scientific relationship with equations that link WACC to levels of gearing. The exact nature of the relationships, and hence the equations, will depend upon the tax regime. Proposition I (no tax) 'The market value of any firm is independent of its capital structure', i.e., debt policy is irrelevant. Proposition II (no tax) 'The cost of equity (k e ) increases as the debt:equity ratio increases. However, the increase in cost of equity is offset by an increase in risk.' Overall conclusion There is no difference between the MV of a geared company and the MV of an ungeared company (assuming equivalent business risk and identical sized earnings). Hence, the WACC is independent of the level of gearing. Ìn other words, a company cannot alter its total market value by altering its capital structure. The WACC, argue M&M, is the return required by the providers of capital as a whole. Ìt reflects the risk of total payments to the total providers of capital. Ìntroduction to valuation 26 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] IIIustration Two companies have identical sized earnings and are both in the same business sector. The only difference between them is the way in which they were financed. Ungeared Geared I II I II £ £ £ £ Earnings 10,000 5,000 10,000 5,000 Ìnterest ÷ ÷ (1,000) (1,000) ______ _____ ______ _____ Dividends 10,000 5,000 9,000 4,000 ______ _____ ______ _____ Total return to providers of capital £ £ £ £ Dividend 10,000 5,000 9,000 4,000 Ìnterest 1,000 1,000 ______ _____ ______ _____ 10,000 5,000 10,000 5,000 ______ _____ ______ _____ Providers of capital are getting the same total returns from both companies. Therefore, WACCs must be identical and their MVs must be identical. The only factor which affects the total payout is the risk attaching to the earnings which are identical for both companies. This can be shown diagrammatically. Cost oI capital WACC Gearing B/S ke kd The cost of equity rises steadily as gearing increases but the WACC is constant. i.e. WACC u = WACC g where WACC u is the WACC of an ungeared company and WACC g is the WACC of a geared company. Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 27 For 2 identical companies MV geared = MV ungeared M&M with corporation tax With corporation tax, a geared company will have a lower WACC than an otherwise identical ungeared company. Ìllustration Ungeared Geared I II I II £ £ £ £ Earnings 1,000 500 1,000 500 Ìnterest ÷ ÷ (400) (400) _____ ___ _____ ___ 1,000 500 600 100 Tax 30% (say) (300) (150) (180) (30) _____ ___ _____ ___ 700 350 420 70 _____ ___ _____ ___ Total return to providers of capital are: £ £ £ £ Dividend 700 350 420 70 Ìnterest 400 400 ___ ___ ___ ___ 700 350 820 470 ___ ___ ___ ___ The returns to the geared company's investors are always greater due to the tax shield on the interest (30% x 400 = 120). i.e. tax shield = i × t where i is the interest and t, the corporation tax rate. The market value of the company will reflect this, and increase by the PV of the tax shield. The PV of the tax shield, discounted at the rate required by the debt holders, is: It rd = MVd × t. The value of the geared company will exceed the value of an ungeared company by MVd t. i.e. MVg = MVu + MVd × ×× × t, where MVg is the total value (equity + debt) of a geared company and MVu is the value of an ungeared company. Note that this is a simplified Adjusted Present Value calculation. The simplification assumes - Borrowing at the risk free rate No tax time lags Ìrredeemable debt A diagrammatical representation of M & M, with corporation tax, is as follows: Ìntroduction to valuation 28 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Cost oI capital WACC Gearing B/S kd ke k e increases with increased gearing, though not as sharply as in the 'no tax' situations. WACC falls as the company gears up. The important features of M&M with corporation tax are: 1 Companies should 'gear up' (i.e. take on debt finance) as far as possible as this will lower the WACC and increase the market value of the company. 2 M&M offer a series of equations linking the cost of equity of the geared and ungeared firm. 3 These equations allow the WACC to be predicted given any stated level of gearing. The equation for predicting the WACC is: WACC = Ke ungeared (1 ÷ t × MV debt Total MV of company ) Non-tax benefits to debt Ìn addition to the fact that interest is tax deductible for tax, as is any premium payable on redemption, modern theories of capital structure suggest there are also non-tax benefits which should be considered: - Debt imposes discipline on the company, preventing any wastage of free cash flow. - Debt can act as a deterrent against take-over bids. - Raising debt demonstrates optimism about the company's future. M&M formulae with tax K g = K u + (K u ÷ K b ) ( MV debt MV equity ) (1 ÷ T c ) K = K u (1 - T c ( MV debt Total MV )) | g = | u + | u ( MV debt (1 - Tc) MV equity ) Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 29 MV g = MV u + T c MV debt Where, K g = cost of equity in geared company K = weighted average cost of capital K u = cost of equity in equivalent ungeared company K b = debt holders' required return = risk free rate |g = systematic risk attaching to dividend in geared company | u = systematic risk attaching to dividend in ungeared company Gearing Betas | u The beta factor of an ungeared company or investment (often known as the Asset or Earnings beta) | g The beta factor of a geared company's or project's dividends (often known as the Dividend or Equity beta) K u Cost of equity ungeared K g Cost of equity geared K u = R F + | u (R M ÷ R F ) K g = R F + | g (R M ÷ R F ) i.e. an ungeared beta will provide the ungeared cost of equity a geared beta will provide the geared cost of equity For a geared company, | u measures the systematic risk attaching to the earnings of the company. | g measures the systematic risk attaching to the dividend payout. The relationship linking the 2 beta factors can be expressed as: | g = | u + | u ( MV debt (1 - Tc) MV equity ) or | g = | u ( MV equity u MV equity g ) Illustration A company has pre-tax earnings of £1,000,000, a tax rate of 31% and a | u of 1.5. R F = 5% & R M = 12%. K u = 5% + 1.5 (12 ÷ 5) K u = 15.5% The market value of the company (debt plus equity) will be: Ìntroduction to valuation 30 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] MV u = e/ K u (1,000,000 x (1 ÷ 31%)) / 15.5% £4,451,613 Ìf we introduce £500,000 debt paying 10% interest (the risk free rate). MV g = MV u + T c MV debt MV g = 4,451,613 + (31% x 500,000) MV g = £4,606,613 The market value of the company is now £4,606,613. As the debt has a market value of £500,000, the equity will now have a value of £4,106,613. K g = K u + (K u ÷ K b ) ( MV debt MV equity ) (1 ÷ T c ) = 15.5 + (15.5 ÷ 10) ( 500,000 4,106,613 ) (1 ÷ 31%) = 15.96% | g = | u + | u ( MV debt (1 - Tc) MV equity ) = 1.5 + 1.5 ( 500,000 (1- 31%) 4,106,613 ) = 1.63 or | g = | u ( MV equity u MV equity g ) = 1.5 ( 4,451,613 4,106,613 ) The same value of equity should be able to be computed as the PV of the future dividends in perpetuity. Geared £000 Earnings 1,000 Ìnterest (50) _______ 950 Tax at 31% (294.5) _______ Dividend 655.5 _______ Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 31 MV equity in geared company = £655,500/0.1596 = £4,106,613. Adjusted present vaIue (APV) Most PV models discount future cash flows at the WACC. All financing side effects (eg interest tax shield) must be incorporated into this discount rate. APV discounts future cash flows as if they were entirely equity financed, to produce a 'base case' present value. Specific financing side effects (interest tax shield, issue costs etc) are discounted to present value separately. The base case value and the value of financing side effects are aggregated to give the APV of the enterprise. Note the operating unlevered cash flow should be discounted using the unlevered cost of equity Ku. The financing side effects are discounted at either the risk free rate or at the companies cost of debt. Ìntroduction to valuation 32 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Weighted average cost of capitaI (WACC) Ìf a company is financed by more than one type of capital, the WACC is computed by weighting the individual costs according to their relative market values. ExampIe: k e = 16% k d (post tax) = 12% CapitaI Ex div market vaIue £1 ords 150,000 9% debenture 37,500 WACC = 16% × 5 . 187 150 + 12% × 5 . 187 5 . 37 WACC = 15.2% For WACC purposes, both debt and equity must be valued at market prices and not at the face values at which they have been recorded in the books. Ìt should be the price at which each of these stakeholders should be able to sell their stake in the firm. The weightings for debt and equity to be used in a WACC calculation, while based upon the market price, may either represent the current values of each, or alternatively may represent the target or sector average capital structure that the firm is trying to reach. Therefore, if a firm is in the process of financing its activities with a debt to equity ratio of 1:2, it may use this ratio instead of its actual situation at the time of the calculation. Ìn the above example only 2 forms of finance have been used, but of course, if there were other forms of finance, such as leases, convertibles or preference shares, these would also need to be taken into account. Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 33 Cash fIow to discount Dividend Valuation Model (DVM) The DVM is most appropriate for firms with stable growth rates, paying out dividends and with stable leverage. Ìt is often used for utilities and for financial service companies (free cash flows being notoriously difficult to compute). The basic one stage model can be converted to a 2 or 3 stage model to accommodate high growth. This is best done via spreadsheet analysis. The following table provides a summary of eps growth rates and the associated dividend payout ratios, thereby providing a useful reality check. 1994-1999 EPS growth rate All US companies with Market Cap larger than $5 billion and growth in the ranges noted. 0%-5% 5%-10% 10%-15% 15%-20% 1999 median Div Payout 40.7% 33% 28.8% 0% 1999 median Div YieId 2.4% 2% 1.3% 0% 1999 Median Market/Book 3.2x 4.2x 4.6x 9.8x 1999 Median ROE 17.1% 17.6% 20.6% 21.6% The levered free cash flow model (LFCF) The LFCF measures what a firm could pay out as dividends. The actual payout may be different for a number of reasons. The basic model is straightforward: Net income + depreciation and amortisation - preferred dividends - capital expenditure - working capital changes - principal debt repayments + proceeds from new debt issues = Levered free cash fIow Ìntroduction to valuation 34 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] The basic formuIa is: P o = g r LFCF1 ÷ Eps x - (capex ÷ depn) (1 - debt ratio) = (x) - change in working capital (1 - debt ratio) = (x) LFCF x __ Two and three stage models can be developed using spreadsheet analysis Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 35 VaIue drivers Ìn order to achieve the corporate goal (eg. to increase the share price over the next 5 years by 75%), it is necessary to identify those specific targets through which this corporate goal will be achieved. These value drivers are the key areas in which targets can be set and performance measured. When analysing a company, it is, therefore, the 7 value drivers upon which sensitivity analysis should be based to discover if value is being created or destroyed. VaIue driver goaI 1. Revenue growth rate increase from 12% to 15% 2. Operating margin / EBÌTDA growth increase from 8% to 9% 3. Cash tax rate reduce from 33% to 31% 4. Working capital to sales reduce by 10% 5. Capex to sales reduce from 12% to 8% 6. WACC reduce from 13% to 11% 7. Competitive advantage period extend from 8 to 10 years Operational value drivers Operational value drivers will drive value at the business / operating unit level. These will, in turn, impact on the 7 organisation-wide value drivers above. Consequently, investigation at the micro- level will improve the understanding of the 7 macro-drivers and so the ways in which the organisation is planning to meet its goals. Operational value drivers at the business unit level may include: Unit sales volumes Selling terms Prices Vendor terms Product mix Purchasing policies Labour rate Payment procedures Overhead costs Sourcing strategies Manufacturing Location Productivity Capital budgeting Work schedules Ìnnovation tactics Downtime Funding choices The following are examples of initiatives used to influence the 7 value drivers across an organisation: Ìntroduction to valuation 36 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Organisational value drivers Revenue growth rate 1. Growth ÷ that adds value 2. New market entry 3. New products 4. Globalisation 5. Customer loyalty programmes 6. Pricing advantage 7. Distribution outlets 8. Focused advertising based on differentiation Operating margin growth 1. Modernise working practices 2. Multi-skilling 3. Share services / outsource 4. Consolidate back office functions 5. Spin-offs 6. Business process re-engineering (BPR) Customer care Ìntegrated billing ABC system Data warehousing Data mining Network management Cash tax rate 1. Transfer pricing / management charges 2. Capex timing 3. Locate and exploit intellectual property and brands 4. Holding structure 5. Co-ordination centres Working capitaI 1. Stock eg just-in-time, supply chain management 2. Debtors eg billing system, payment discounts 3. Creditors eg impact on discounts / supplier relationships 4. Cash CapitaI expenditure 1. Develop capital appraisal and utilisation reviews and project finance techniques 2. Lease v buy decisions 3. Treasury hedging and exchange rate management systems Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 37 WACC 1. Build management understanding of cost of capital 2. Gearing optimisation 3. Calculate business unit specific WACC 4. Consider share buy backs and demerger of non-core business Competitive advantage period 1. Ìmprove investor relations ÷ providing predictable and sustainable financial performance 2. Ìmprove business unit cash flow information 3. Return to core competencies 4. Develop executive (and employee) performance reward schemes linked to share price improvements 5. Ìncorporate strong risk management procedures 6. Creation of barriers to Supplier power Customer power Substitute threat New entrants Existing rivalry What comes before vaIuation? Accounting is the key to understanding financial information. Ìf earnings are wrong, the debt service cover ratio is wrong. Ìf cash flow is wrong, DCF is wrong. Consequently, accounting skills need to be developed in order to enable financial analysis, which will then allow sensible estimates to be made before any worthwhile projections are possible. Assuming the financial skills are in place, the following are where it all goes wrong when modelling. Alternative approaches to forecasting The following are alternative approaches to forecasting. These are calculated independently of the value-drivers underlying them. (Additional accuracy can be obtained by analysing the value drivers prior to doing the forecasting). SaIes revenues Production based models Product / market based models ÷ dependent on marketing strategy Growth rate models ÷ inflation, real growth Operating margin Cost structure models ÷ fixed vs variable or more detailed (line by line) Operating profit margin (% of sales) model Ìntroduction to valuation 38 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Movements in working capitaI Balance sheet figures (at start and end of year) for stock, debtors & trade creditors; then take changes Calculate the balance sheet figures (at start and end of year) for stock, debtors and trade creditors by estimating the stock days and creditor days (both based on cost of sales) and debtor days (based on sales); then take the changes Calculate net working capital figure from the ratio of nwc:sales; then take changes Ìf nwc:sales is constant then nwc:sales x increase in sales = nwc movement Depreciation May be a given percentage of fixed assets (forecast fixed assets as a function of sales growth or independently; then depreciate) Grow at a rate reflecting growth in fixed assets ÷ see capex (combination of inflation and real activity-based growth) CapitaI expenditure Direct input from independent information Forecast balance sheet value of fixed assets and annual depreciation charge then capex equals increase in net fixed assets plus depreciation Capex as a multiple of depreciation, depending on real growth vs replacement: (replacement capex = depreciation x inflation over historical life of assets) Interest (received & paid) Function of interest rate and either opening, average or closing balance depending on actual agreement / contract Main problem is circularity (which Excel can generally cope with if set up correctly) Tax Simple model based on historical effective tax rates applied to profit (P&L and cash flow likely to be different due to time lag in paying tax) Calculate tax based profit independently of accounting profit (capital allowances vs depreciation being main difference) and apply actual expected tax rates Complex tax-calculation model ÷ to account for the effect of trading losses and capital gains on the disposal of assets Deferred tax on the timing differences between accounts-based and tax-based profit. Deferred tax will affect earnings and the balance sheet but will have no effect on cash Dividends Direct input from independent information Based on dividend policy (dividend growth or dividend cover) and number of shares Use expected dividend cover & maximum distribution based on P&L and cash balances Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 39 Growth rates and time period for discounting Estimation of g Shareholders will have an expectation of dividend growth. They will normally have based this on either what has happened in the past (extrapolation of past dividends) or on an analysis of what will happen to profits, and hence dividends, in the future (by reviewing the company's retention of profit and investment policy). Extrapolation of past dividends ExampIe 1.1.96 Pay dividend 12,634 1.1.01 Pay dividend 22,265 Ìf it is assumed that the average growth over the five years will be maintained in the future, g can be calculated: 12,634 (1 + g) 5 = 22,265 (1 + g) 5 = 634 , 12 265 , 22 1 + g = 5 634 , 12 265 , 22 1 + g = 1.12 g = 12% Estimation of future growth in profits (and hence dividends) A model for calculating growth in profits is the rb model. Ìf a company can earn an accounting return of r% on new investments and retains a constant proportion b of its annual profits, then growth in profits will approximately equal rb. ExampIe Suppose a company's shares have a cum div market value of C10.25 per share. A dividend per share of C1.25 is about to be paid. The company estimates it will earn 20% on new investments and the current policy (to be maintained) is to pay out 60% of earnings by way of dividend, ie. retain 40%. The company's profits (and therefore dividend) will grow by 8% (40% × 20%). The shareholders' required return (k e ) is k e = % 23 08 . 0 25 . 1 25 . 10 08 . 1 25 . 1 = + ÷ × Ìntroduction to valuation 40 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Estimation issues Historic growth rates Geometric rates are preferred to arithmetic averages Problems in dealing with negative earnings and with the effect of changing size. Analyst projections Fundamentals Expected growth in earnings = Retention ratio *ROE Expected growth in EBÌT = Reinvestment rate *ROC Duration of growth period The greater the current growth rate in earnings relative to the stable growth period, the longer the higher growth will last. The larger the size of the firm relative to the market, the shorter the higher growth period. The greater the barriers to entry, the longer the high growth period Combine the above and use judgement. StabIe growth Ìdeally, investors want growth rate that can be maintained forever. This is normally linked (ie equal to or less than) to the growth rate in the economy, either national or global. TerminaI vaIues Terminal value is the value of the firm after the explicitly forecast growth period (often the high growth phase). Default forecast periods are conventionally 5 or 10 years. The terminal value is normally calculated in one of two ways: 1. Multiple based method PER or EV/EBÌTDA are the most common exit multiples. The problems of selecting the comparable are compounded by the corruption of the DCF by the introduction of relative valuation techniques. Ìn addition, the danger of using current multiples extended 10 years into the future is obvious. 2. Perpetuity growth method Using a stable growth rate into perpetuity the terminal value is: Terminal value in year n = g - r t at dividends or earnings or FCF 1 n + Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 41 Time period convention Ìn reality, cash flows accrue over the course of the year. We make a simplifying assumption that the cash flows occur at a particular point in time. There are two options: That cash flows occur at each year end (i.e. T 1 , T 2 , etc.) That cash flows occur at the mid-point of each year (i.e. T 0.5 , T 1.5 , etc.) The implication for the terminal value is that if it is calculated using the multiple based method, this is assumed to give TV at T10 (assuming we are using a 10 year explicit forecast horizon). Ìf we are using the perpetuity growth method, this is assumed to give the TV at T9.5. Therefore, if these two alternative TVs are to be cross-checked, care must be taken. Ìntroduction to valuation 42 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] VaIuing combinations MethodoIogy Acquisition motive VaIuation methodoIogy Under valuation Value target as stand alone. No acquisition premium. Diversification Value target as stand alone. No acquisition premium. Operating synergy Value the firms independently. Value the firm with the operating synergy. Target firm value = Ìndependent value + synergy. Control Value of target firm run optimally Financial synergy Tax benefits: Value of target firm + PV of tax benefits. Debt capacity: Value of target firm + increase in value from debt. Cash: Value of target + NPV of projects. Ìntroduction to valuation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 43 Illustration Compaq and DigitaI Digital Discounting the FCF of Digital gave an enterprise value of $2.1bn. With a change in control, the value increases by $2.4bn to $4.5bn. Compaq Discounting the FCF of Compaq gave an enterprise value of $38.5bn. Combination Discounting the FCF of the combined firm (at the new WACC, based on weighted average unlevered betas, levered up for the new capital structure) gave an enterprise value of $45.5bn. The value of the standalone firms was $4.5bn + $38.5bn = $43bn. The value of synergy was $1.5bn. Value of Digital with synergy $6bn Value of cash paid in the deal $30 x 147m shares = $4.4bn Digital's outstanding debt $1bn Remaining value to be satisfied by shares $0.6bn Number of shares 147m Value per share $ 0.6bn ÷ $147m = $4.08 Compaq's share price at the time of the offer $27.00 Appropriate exchange ratio 4.08/27 = 0.15 Compaq share for every Digital share. The actual ratio was 0.9. Ìntroduction to valuation 44 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770·
[email protected] ComparabIe company anaIysis (Comps) 1 Why do we do comps? 1 Comparable universe 3 Sources of information 4 From Equity Value to Enterprise Value 5 Enterprise value (EV) 5 Equity value (Eq.V) 5 Net debt 6 When to use Equity Value vs Enterprise Value 8 Ìmpact of capital structures on multiples 9 Which multiple? 10 Using comps 12 Special situations 14 Currency 14 Annualisation 15 LTM 15 Exceptional / extraordinary items 16 Dilution 18 Convertible debt 19 Mezzanine finance 22 Market value of debt and / or preference shares 22 Associates and JVs 22 Minorities 25 Finance and operating leases 26 Unfunded pension obligations 29 Pro forma: Acquisitions and disposals 31 Keys to success 34 Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 ComparabIe company anaIysis (Comps) Why do we do comps? Analysing the operating and equity market valuation characteristics of a set of comparable companies with similar operating, financial and ownership profiles provides a useful understanding of: 1. The important operating and financial statistics about the target's industry group (e.g., growth rates, margin trends, capital spending requirements). This information can be helpful in developing assumptions for a discounted cash flow analysis. 2. The relative valuation of publicly listed companies The resulting multiples guide the user as to the market's perception of the growth and profitability prospects of the companies making up the group. Consequently, comps can be used to gauge if a publicly traded company is over or undervalued relative to its peers. 3. A benchmark valuation for target entities Comps valuations are based on: metrics of target company (eg EBÌTDA) multiples of similar quoted company(ies) (eg EV/EBÌTDA) Valuation multiples from comparable companies may be applied to the financials of the target entity to be valued to give a theoretical value of the target business. For example: Metric of target earnings $10.0m Multiple of similar quoted company p/e 18.0x TheoreticaI equity vaIue of target $10.0m x 18.0 = $180.0m 4. An indicative market price for a company which is to be floated on the stock market. 5. The validity of terminal DCF assumptions. 6. Ìnvestment returns for financial buyers acquiring assets with the intention of monetising the investment in the public equity market in an ÌPO. Comps 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Example Tesco Sainsbury Share price (p) 261.5 376.0 Equity value (£m) 18,127 7,260 Enterprise value (£m) 20,967 8,172 Enterprise vaIue I SaIes 2006 (Curr.) 0.86x 0.48x 2007 (Prosp.) 0.74x 0.47x EBITDA 2006 (Curr.) 10.8x 7.6x 2007 (Prosp.) 9.4x 6.6x EBIT 2006 (Curr.) 15.5x 12.4x 2007 (Prosp.) 13.5x 10.4x Equity VaIue / Earnings 2006 (Curr.) 20.8x 17.9x 2007 (Prosp.) 18.5x 15.5x Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 ComparabIe universe Being a numerically easy exercise, multiples valuation requires in-depth understanding of the target company and its peers. The relative valuation multiples are only useful if the companies are a comparable peer group. Similarly, comps valuations are based on applying the valuation multiples of one company (or a group of companies) to value the target business. As no two companies are exactly the same the most similar companies are sought. The companies (both target and comparable) should have similar: business activities ÷ industry, products and distribution channels geographical location size growth profiles (including seasonality and cyclicality) M&A profiles profitability profiles accounting policies market liquidity of securities breadth of research coverage Additionally, if equity level comps are to be used, similar capital structures are essential. In conclusion Select the universe of comparable companies carefully - more is not necessarily better. Comps 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Sources of information Information Source List of comparable companies Sector brokers' reports Bloomberg Hoovers Prospectuses (often have a "Competition¨ section) Share price Datastream or Bloomberg Shares outstanding Most recent annual report (or interim results or 10Q) updated for any subsequent changes ÷ for UK companies see Regulatory News Service (RNS) for changes Bloomberg Options outstanding and exercise price of options Most recent annual report (or, unusually, interim results or 10Q) updated for any subsequent changes reported Companies reporting under US GAAP will disclose the weighted average exercise price Debt and cash Most recent annual report or more recent interim results or 10Q Preference shares Most recent annual report or more recent interim results or 10Q Minority interests Most recent annual report or more recent interim results or 10Q Ìncome statement information Most recent annual report (or more recent interim results or 10Q if last 12 months [LTM] analysis is to be done) Forecast financials Broker research Ì/B/E/S database (the median of all estimates) General information Extel cards and Datastream 101A Note: All source documentation should be marked to show where information has been extracted from with both a Post-it showing the page and a highlighter showing the numbers used When choosing a broker, make sure the numbers are sanity checked with Global Estimates to make sure the analyst's projections are in line with peers Footnotes should be used for all assumptions and points of interest Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 From Equity VaIue to Enterprise VaIue Enterprise value (*) = Equity Value (**) + Net Debt (***) + Minority Ìnterest 1. Example continued - Enterprise value Tesco Share price (p) 261.5 Number of Shares (m) 6,932 _____ Equity VaIue (£m) 18,127 [A] ST Debt (£m) 1,413 [B] LT Debt (£m) 1,925 [C] Cash & equivalents (£m) (534) [D] _____ Net Debt (£m) 2,804 [E]=[B+C+D] Minority Ìnterest (£m) 36 [F] _____ Enterprise vaIue (£m) 20,967 [A +E + F] Enterprise vaIue (EV) Enterprise value is also referred to as: Total enterprise value (TEV) Entity value (EV) Gross value (GV) Total capitalisation Firm value (FV) Aggregate value Leveraged market capitalisation (L.MC) The terms are used loosely and are generally interchangeable. Ìf used in a critical context we should define exactly what us meant by them. Equity vaIue (Eq.V) Equity value (Eq.V) is also referred to as: Market capitalisation (MC) Comps 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Net debt Net debt = borrowings - (cash + Iiquid resources) Borrowings = instruments issued as a means of raising finance other than those classified in/as shareholders funds + related derivatives + obligations under finance leases Cash = cash in hand + deposits repayable on demand* with any qualifying financial institution - overdrafts from any qualifying financial institution repayable on demand. Liquid resources = current asset investments held as readily disposable stores of value. *On demand = can be withdrawn at any time without notice and without penalty [or where maturity or period of notice of not more than one working day has been agreed in advance] Readily disposable = disposable without curtailing or disrupting business of reporting entity and either readily convertible into known amounts of cash at or close to its carrying amount or traded in an active market Active market = a market of sufficient depth to absorb the investment without a significant effect on the price Net debt components may be spread around the balance sheet in: liabilities due after more than 1 year liabilities due within 1 year cash at bank and in hand investments or marketable securities (held as current assets) UK companies must disclose an analysis of their net debt (typically in a note to the accounts). Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 Preference share capital Despite falling outside the above definition, preference share capital may be included within net debt for analysis purposes as it has many of the attributes of borrowings without meeting the definitional and legal requirements of borrowings. The enterprise value is made up of different elements of the capital structure adopted by a company. The way this EV is used in comps is independent of this capital structure. For example, a company may have an enterprise value of $1bn; this could be made up as follows: Enterprise value $1bn Bonds Bank debt Bonds Bank debt Equity Minority interests Convertible debt Finance leases Equity Minority interests Preference shares Equity $0bn Comps 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] When to use Equity VaIue vs Enterprise VaIue Capital value Turnover Operating costs Enterprise vaIue = EBÌTDA Equity value Depreciation / amortisation + Net debt Operating profits + Minority interest Associates / JV EBÌT Net interest Earnings adjustment for net debt ÷ financial interest PBT Equity vaIue Tax + Minority interest Profit after tax Minority interests Earnings adjustment for minorities - minority interest Net income / earnings Equity vaIue Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 Impact of capitaI structures on muItipIes Company A Company B Capital structure Equity 200 500 Net debt 300 - Minority interest - - P&L Sales 150 150 EBÌT 35 35 Net interest (25) - PBT 10 35 Earnings 7 25 MuItipIes Enterprise vaIue / Sales 3.3x 3.3x EBÌT 14.3x 14.3x Equity vaIue / PBT 20.0x 14.3x Earnings 28.6x 20.0x 2. Example continued - the multiples Tesco (£m - except per share) Enterprise value 20,967 Share price (p) 261.5 2005A 2006E 2007E Sales 20,988 24,306 28,212 Enterprise Value / Sales 1.00x 0.86x 0.74x EBITDA 1,663 1,950 2,230 Enterprise Value / EBÌTDA 12.6x 10.8x 9.4x EBIT 1,187 1,352 1,556 Enterprise Value / EBÌT 17.7x 15.5x 13.5x EPS (p) 11.5 12.6 14.1 P/E (Equity Value / Earnings) 22.7x 20.8x 18.5x Comps 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Which muItipIe? The relevance of the different valuation benchmarks changes over time as business models evolve. Consequently, two key questions must be asked when selecting multiples: What is the development stage of the target company relative to comps? What is the appropriate comps universe trading on? FV/Net PP&E FV/Subscriber FV Revenue (growth) FV Revenues FV/Net PP&E FV/Subscriber FV EBITDA (growth) FV EBITDA Revenue EBITDA EBIT Net Income $ Pros Cons EV / Sales Suitable for companies with similar business model / development stage May be the only performance related multiple available for companies with negative EBÌTDA Sectors where operating margins are broadly similar between companies Companies whose profits have collapsed Sectors where market share is important Limited exposure to accounting differences Does not take into account varying revenue growth rates Does not address the quality of revenues Does not address profitability issues Ìnconsistency of treatment within sales of joint venture in different reporting environments Different revenue recognition rules between companies Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 Pros Cons EV/EBÌTDA Ìncorporates profitability Most businesses are EBÌTDA positive so widening the universe Ìgnores the most significant accounting differences arising from goodwill Relatively limited exposure to accounting differences Ìgnores depreciation / capex Ìgnores tax regimes and tax profiles Does not take into account varying EBÌTDA growth rates Ìnconsistency of treatment within EBÌTDA of joint venture and other unconsolidated affiliates within different reporting environments Other accounting differences such as revenue recognition, capitalisation policies, finance vs operating leases EV/EBÌT Ìncorporates profitability Useful for capital intensive businesses where depreciation is a true economic cost Good for companies within the same reporting environment where accounting differences are minimised Depreciation / amortisation policies may differ Ìgnores tax regimes and tax profiles Does not take into account varying EBÌT growth rates Ìnconsistency of treatment within EBÌT of joint venture and other unconsolidated affiliates within different reporting environments Other accounting differences such as revenue recognition, capitalisation policies, finance vs operating leases P/E Widely used in traditional industries with high visibility of earnings Widely understood Quick and easy calculation Useful to check DCF exit assumptions Depends on corporate structure Accounting policies have a significant impact on earnings In conclusion By understanding the industry through reading analyst reports and news stories it will become clear: What are the most important performance ratios and market multiples to focus on Are there any industry specific statistics (e.g. hotels ÷ price per room)? Comps 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Using comps Illustration Company X is to be valued using Company Y as a comparable company Company X Company Y Capital structure Equity value ? 1,000 Net debt 200 - _____ _____ Enterprise value ? 1,000 P&L EBÌTDA 170.0 170.0 Depreciation & amortisation (22.0) (22.0) _____ _____ Operating profit 148.0 148.0 Net interest (20.0) - _____ _____ PBT 128.0 148.0 Tax at effective rate of 30% (38.4) (44.4) _____ _____ Earnings 89.6 103.6 Multiples Enterprise value / EBÌTDA ? 5.88 Equity value / earnings ? 9.65 Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 Valuing Target - Company X At equity level Metric of target earnings of X 89.6 Multiple of similar quoted company p/e of Y 9.65x TheoreticaI equity vaIue of target (Company X) 89.6 x 9.65 = 865 At enterprise level Metric of target ebitda of X 170 Multiple of similar quoted company ev/ebitda of Y 5.88x Theoretical enterprise value of target 170 x 5.88 = 1,000 Less: net debt & minorities of target (200) TheoreticaI equity vaIue of target (Company X) 800 How to use Comps Comparable Company Entity Net Debt & Equity Companies Financials Value MÌ Value Multiples Range (£m) (£m) (£m) (£m) Sales Curr. 0.50x - 0.85x 100 50 - 85 10 40 - 75 Prosp. 0.47x - 0.75x 106 50 - 80 10 40 - 70 EBÌTDA Curr. 7.5x - 10.5x 7.3 55 - 77 10 45 - 67 Prosp. 6.5x - 9.5x 7.9 51 - 75 10 41 - 65 EBÌT Curr. 12.5x - 15.5x 5.1 64 - 79 10 54 - 69 Prosp. 10.5x - 13.5x 5.5 58 - 74 10 48 - 64 Earnings Curr. 18.0x - 21.0x 3.0 - - 54 - 63 Prosp. 15.5x - 18.5x 3.3 - - 51 - 61 High 75 Low 40 Average 57 Median 58 Estimated Equity VaIue (£m) 55-60 Comps 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] SpeciaI situations Adjustments may be needed to the metrics and/or the resulting equity or enterprise value when the following issues arise in the target and/or the comparable company: 1. Currency 2. Annualisation 3. LTM (last twelve months) 4. Exceptional items 5. Dilution 6. Convertible debt 7. Mezzanine finance 8. Market value of debt and / or preference shares 9. Associates and JVs 10. Minorities 11. Pro forma: disposal, acquisition The over-riding idea behind Comps is to ensure that there are like-for-like comparisons. Consequently, if one of the companies in the Comps group has significant associates whilst its peers do not, then an inconsistency exists amongst the group. The metrics of the company with the associate need to be adjusted to remove the inconsistency and maintain the idea of comparable companies. Currency Multiples (e.g. EV/EBÌT) are independent of currency provided that both numerator (eg EV in $m) and denominator (e.g. EBÌT in $m) are in the same currency. Consequently, keep financials and market capitalisation in the (same) local currency ÷ there is no need to translate to target's currency. For the Euro-zone incorporated companies, convert financials into Euros as the exchange rates have been fixed and the stocks are already trading in Euros. Always use the share price traded on the primary exchange (Bloomberg: RELS). Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 AnnuaIisation Financials should be adjusted for: different year-ends seasonality of business growing / declining activity e.g. to annualise to December a company with a March financial year-end 3/04 3/05 3/06 $80m $100m 3 mths 9mths 12/04 12/05 $95m Alternatively, the annualisation can be done using quarterly or monthly accounts if these are available. For companies quoted in the US, published quarterly information will enable this. LTM LTM (Last Twelve Months) numbers are useful where the profits of the comparable businesses are growing (or declining) significantly and/or are seasonal. Ìn these situations, annualising numbers (by pro-rating on a time basis) may be an over-simplification of the profits generated in a particular time period and may not be indicative of the companies' most recent trading performances. Where companies have produced quarterly or half-yearly accounts, more up-to-date profit figures can be generated. For example, a US company with a year end of 30 November, may have just produced its quarterly results (10Q) for the 3 rd quarter to 31 August 2004. Therefore, to find the most recent trading performance, LTM to 31 August 2004 would be calculated and compared with the LTMs (not necessarily all to 31 August) of comparable businesses. The LTM would be calculated as: AnnuaIs Nov-02 y.e. Nov-03 (A) y.e. Nov-04 (F) 80 100 Nov-02 Aug-03 Nov-03 Aug-04 10Q 45 60 Comps 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Aug-03 Aug-04 LTM = 80 - 45 + 60 95 ExceptionaI / extraordinary items Exceptional and extraordinary items are characterised by: their unusual nature (unrelated to ordinary business activities); and by the infrequency of occurrence (i.e. not expected to happen again). The rules vary in different countries as to what should be classified as exceptional or extraordinary. For example, in the UK it is not possible to have extraordinary items, whilst in France, certain items must be classified as extraordinary. Additionally, companies would prefer losses and charges to be classified as exceptional in order that underlying profits (ie valuation metrics) are unaffected by such bad news. Consequently, the notes to the accounts should be examined to determine which items are true exceptionals / extraordinaries and worthy of exclusion. Exceptional / extraordinary items include: Restructuring charges Profits and losses on disposals Financing one-offs (e.g. debt redemption above book value, etc.) A share in unconsolidated affiliates' exceptional items True exceptional and extraordinary items should be stripped out. Where adjusting net income (for equity level comps) refer to the tax notes in the accounts to find the tax effect of exceptionals. Ìf not available use the effective or marginal tax rate. Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 Example Compco Adjustments Pro forma Sales 100 - 100 ____ ___ ____ Exceptionals (20) 20 - ____ ___ ___ EBÌT 5 20 25 Net Ìnterest (2) - (2) ____ ___ ___ PBT 3 20 23 Tax (*) (1) (6) (7) ____ ___ ___ Earnings 2 14 16 Notes: (*) Tax rate on exceptional items is assumed to be 30%. Not all exceptionals / extraordinaries will have a tax effect. Additionally, the tax effect of like items will be different in different countries. For example: reorganisation / redundancy provisions Ìn the UK it is unlikely that tax relief will arise Ìn Germany it is likely that tax relief will be received property write-downs / impairments Ìn the UK tax relief will not arise Ìn Germany it is likely that tax relief will be received Comps 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] DiIution Earnings per share Within the same sector the same basis should be used, i.e. basic vs diluted. For historic actuals: weighted average number of shares should be used; and the number of shares should be the outstanding number (i.e. the number used to calculate the basic eps) unless the fully diluted share capital gives significant dilution within the sector. For forecast figures: weighted averages should not be used; and the number of shares to be used should be the most up to date outstanding number unless the fully diluted share capital is materially different within the sector. Ìn this case the treasury method should be used for share options. Share valuation When an equity valuation has been derived, the number of shares to be used for calculating value per share should be the most up to date outstanding number unless the fully diluted share capital is materially more, in which case the treasury method should be used for share options. Weighted averages should not be used. The treasury method The treasury method will be used when the company has: a large number of share options and/or the exercise price is significantly lower then the current market price. The treasury method assumes that the proceeds from the exercise of the options are used to buy-back shares at the current share price. Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 Illustration Current share price: 120p Outstanding number of shares: 5.0m Options outstanding: 1.0m Exercise price: 40p Outstanding number of shares: 5.00m ______ Options outstanding: 1.00m Full price shares from proceeds [(1.0m x 40p) 120p] (0.33m) ______ Net dilutions 0.67m ______ Fully diluted number of shares 5.67m Dilution as a % of outstanding number of shares 13.3% ConvertibIe debt Impact on EPS Convertible debt contains an option allowing holders to convert the debt into equity at some future date. Consequently, if there are convertible instruments with significant conversion rights then the number of shares and diluted EPS should take into account the effect of conversion. IIIustration Net profit C1,000 Ordinary shares outstanding 10,000 Number of convertible 10% C100 bonds 12 The convertible bonds have been outstanding throughout the period. Each bond is convertible into 150 ordinary shares. The company suffers tax at the rate of 40%. Basic EPS 000 , 10 000 , 1 C = C0.100 Diluted EPS 800 , 11 072 , 1 C = C0.091 Comps 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Adjusted net profit C1,000 + [C120 x (1 - 40%)] C1,072 Number of ordinary shares for diluted EPS Shares outstanding 10,000 Number of shares resulting from conversion 1,800 11,800 Impact on capital structure Accounting for convertible debt varies. The carrying value of the debt will be different for those companies reporting under ÌFRS, where split accounting is used, to those using US GAAP where the instrument is treated purely as debt. As a result, the net debt and book equity values (and the adjustment to interest for diluted eps) will be different. IIIustration A company issues C100,000 3% convertible debt at par. Ìnterest is paid annually in arrears. Five years later, the debt is redeemable at a premium of 10% or convertible into equity shares of the issuer. [The market interest rate on similar non-convertible debt is 7%.] Under US GAAP, the instrument is treated as pure debt and carried at amortised cost with the finance charges comprising the coupon and the amortisation of the premium (an effective rate of 4.816%). Under ÌFRS, split accounting is adopted ÷ part of the instrument is treated as debt and part equity. The debt component of the proceeds raised is calculated by discounting the future cash flows at the market rate of 7.0%. The balance of the proceeds raised (C9,271) is deemed to be the fair value of the consideration received for writing a call option on the issuer's shares. Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 US GAAP IFRS Start Interest Cash End Start Interest Cash End Year 4.816% 7.000% 1 100.00 4.82 (3.00) 101.82 90.73 6.35 (3.00) 94.08 2 101.82 4.90 (3.00) 103.72 94.08 6.59 (3.00) 97.67 3 103.72 5.00 (3.00) 105.72 97.67 6.84 (3.00) 101.50 4 105.72 5.09 (3.00) 107.81 101.50 7.11 (3.00) 105.61 5 107.81 5.19 (3.00) 110.00 105.61 7.39 (3.00) 110.00 25.00 34.27 At end of first year: BaIance sheet Income statement US GAAP ÌFRS US GAAP ÌFRS Cash 97.00 97.00 Ìnterest expense (4.82) (6.35) Cash fIows Debt 101.82 94.08 US GAAP ÌFRS Equity - 9.27 Ìnterest paid (3.00) (3.00) Retained earnings (4.82) (6.35) Debt raised 100.00 90.73 Equity raised - 9.27 97.00 97.00 Market value vs book value The market values of the bonds (plus the market values of the options to convert) are likely to be different from the book values. For EV purposes, market values should be used. Where the convertibles are traded, this is straightforward. Where information about the market value of the convertibles is not available, find how many shares the bonds convert into (from the financial statements) and apply the current market share price to these. The higher of the market value of the shares and the book value should then be used within the EV calculation. Comps 22 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Mezzanine finance Like convertible debt, mezzanine debt may have elements of both debt and options over shares. Unlike convertibles, the option is a right to buy shares at a fixed price rather then to convert the debt. Consequently, the instrument should be broken down into its two components: the loan element should be valued using the balance sheet carrying value and the options should be valued using the treasury method. Market vaIue of debt and / or preference shares Depending on the sector, preference shares and quoted debt should not be marked to market if the difference between market value and book value is not significant. When a company is in financial distress, debt instruments should be marked to market. This information can be found for traded debt and preference share capital. Additionally in some jurisdictions, the company may disclose this information. For example, in the UK, under FRS 13 Derivatives and Other Financial Ìnstruments Disclosures, market values should be disclosed for all financial instruments. This will be the value as at the last balance sheet date which will need to be updated for current valuations. Associates and JVs Earnings from associates / joint ventures are not always directly comparable. For example, income from associates is reported: in the US, as share of profit after tax (as one line); on the Continent, often as share of profit before tax (although could be share of profit after tax) ÷ as one line; in the UK, as share of EBÌT and proportionally consolidated for the post-EBÌT P&L. Additionally, income from joint ventures is reported: in the US, as per associates in one line; in the UK, as per associates but with additional disclosure about sales of the joint venture; on the Continent, may be proportionally consolidated or as per associates depending on jurisdiction. When material, Associates and JVs should either be: consolidated in proportion (including debt); or excluded and valued on a separate basis When not material, Associates and JVs may just be included in EBÌT. Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 23 Illustration CompCo has a 40% stake in AssocCo. CompCo AssocCo Market value of equity 90 55 Net debt 30 10 Sales 100 50 Operating profit 20 12.5 Associate 5 EBÌT 25 ConsoIidate in proportion (incIuding debt) This method is used if: A joint venture is proportionally consolidated (ie the proforma numbers are already presented in the consolidated accounts); and/or The associate / joint venture has similar activities and growth prospects to the CompCo so that it is appropriate to apply the same multiples to both parts of the business. CompCo Adjustments Pro forma Sales 100 20 120 EBÌT 20 5 25 Equity value 90 - 90 Net debt 30 4 34 ___ __ ___ Enterprise value 120 4 124 EV/ Sales 1.03 EV / EBÌT 4.96 The equity value of CompCo includes the market value of its stake in AssocCo. ExcIude and vaIue on a separate basis The market has valued CompCo's equity value to include that of the associate / joint venture whereas the P&L metrics do not include the associate / joint venture. Where the two companies have different activities or growth prospects the resulting metrics are not appropriate for all parts of the business. Comps 24 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] This method is appropriate where the associate / joint venture has different activities or growth prospects to the CompCo. The multiples that are derived are the multiples of CompCo's business only. CompCo Adjustments Pro forma Sales 100 - 100 EBÌT 20 - 20 Equity value 90 (22) 68 Net debt 30 - 30 ___ __ ___ Enterprise value 120 (22) 98 EV/ Sales 0.98 EV / EBÌT 4.90 Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 25 Minorities Enterprise value is measured at the market value of all its components. Minorities are a constituent part of enterprise value and should, when representing significant value, be valued at market value. Otherwise they should be included at book value. Where the subsidiary in which the minority arises is quoted the market value of the minority can be derived. Practical difficulties in arriving at the market value of minorities exist where the subsidiary in which the minority arises is unquoted. Unquoted minorities will have to be valued on a separate basis. Illustration CompCo has a 75% stake in SubsidCo. CompCo SubsidCo Market value of equity 80 70 Net debt 40 25 Shareholders' funds 30 Minority interest in SubsidCo 7.5 Sales 100 60 EBÌT 20 12 PBT 16 10 PAT 11 6 Minority interest (1.5) - Net income 9.5 6 Using book value Using market value Equity value 80 80 Net debt 40 40 Minority interest 7.5 17.5 (25% x 70) ____ ____ Enterprise value 127.5 137.5 Comps 26 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] EV / sales 1.28x 1.38x EV / EBÌT 6.4x 6.9x Equity value / net income 8.4x 8.4x Finance and operating Ieases To acquire the use of an asset such as an aeroplane, a business may buy the asset or lease the asset. This leads to three distinct ways in which the financing of the operating assets of a business is accounted for: IIIustration 3 airlines have acquired the use of a plane with a cash price of C95m. Company A has bought the plane (10 year life) using cash on which it was earning a 4.0% return. Company B has leased the plane on an 8 year lease paying C16m per annum (the implicit interest rate on the lease is 7.15%) ÷ this will be treated as a finance/capital lease. Company C has leased the plane on a 3 year lease paying C18m per annum ÷ this will be treated as an operating lease. After one year the impact on the financial statements of the acquisition of the asset would be: (borrow to) buy Lease Finance / capital Operating Income statement EBÌTDAR - - - Rental expense - - (18.0) EBÌTDA - - (18.0) Depreciation (9.5) (11.9) - EBÌT (9.5) (11.9) (18.0) Ìnterest expense (3.8) (6.8) - Pre-tax profit (13.3) (18.7) (18.0) BaIance sheet PPE 85.5 83.1 - Cash (98.8) (16.0) (18.0) Debt - (85.8) - Retained earnings (13.3) (18.7) (18.0) Cash fIow Operating - - (18.0) Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 27 Ìnterest paid (3.8) (6.8) - Capex (95.0) - - Debt repaid - (9.2) - Cash flow (98.8) (16.0) (18.0) Consistency of metrics For comps purposes, the above example illustrates that where comparable businesses finance their operational assets using different financing arrangements, the impact on the profit metrics can be significantly different. For example, for airlines, the comparability of EBÌT or even EBÌTDA is limited. EBÌTDAR should be the metric of choice where comparing the underlying trading performances of the business. Alternatively, the operating leases could be converted (mathematically) into finance leases. For example, in the above illustration, the breakdown of the finance lease charge in the income statement is approximately interest and depreciation. This rule of thumb has been identified by the credit rating agencies and so adjusted metrics (e.g. EBÌT) can be calculated. Using Company C in the illustration, the rental expense is removed (and so standardises EBÌTDA) and replaced with a new depreciation charge of 12 (18 x ) and interest of 6 (18 x ). Ìf this simplifying assumption is accepted, then the result is that EBÌT and all subsequent multiples are similarly standardised no matter how the operating assets have been financed. Adjusting EV Ìf EBÌTDAR is the metric of choice (or the adjusted EBÌTDA), then EV/EBÌTDAR should be the multiple. However, EBÌTDAR (by definition before rentals, depreciation and interest) is independent of the method of finance of the asset. Where the asset has been acquired outright or has been finance leased, the net debt (a component of EV) has been increased whilst the operating lease obligation remains off-balance sheet. For consistency between EV and EBÌTDAR, operating leases should be converted into finance leases, by calculating the present value of the minimum lease commitments. A schedule of payments and the appropriate discount rate are needed to do this ÷ neither of which is likely to be presented in financial statements. Comps 28 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] IIIustration A company has a corporate borrowing rate of 7.5% and a disclosed schedule of operating lease payments: Discount rate 7.50% Year 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 20202021 Op. lease payments 75 72 65 60 58 58 51 46 45 45 30 30 18 12 10 Present value 70 62 52 45 40 38 31 26 23 22 14 13 7 4 3 PV of lease payments (capitalised operating leases) 450 The illustration would be difficult to recreate in practice due to a lack of disclosed information. Additionally, the derived value of C450m is very sensitive to the length of the leases and the discount rate: The longer the lease terms, the higher the present value of the lease payments The lower the discount rate, the higher the present value of the lease payments For example, if a company's corporate borrowing rate is assumed to be the applicable rate for refinancing the operating leases then the present value of these commitments will be higher than if the WACC was used. Additionally, as the leases end they may need to be replaced and so the lease terms may be indefinite. As a result, credit rating agencies and analysts simply capitalise operating leases into net debt by multiplying the annual operating lease charge by a factor. This factor varies between 5.5 and 8.5 depending on the sector (due to typical length of leases and discount rates). This factor approximates to an appropriate annuity factor. Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 29 Unfunded pension obIigations Where a business has guaranteed a minimum pension to employees on retirement, it must make payments into the pension scheme to meet these future obligations ÷ a defined benefit scheme. These payments will be invested by the pension scheme with the intention of meeting the future pension requirements when they fall due. As time moves on, employees within the scheme will be getting closer to pensionable age and may also be entitled to greater pension payouts as they continue to work for the business. As a result, it is possible to calculate the pension deficit ÷ the difference between the market value of scheme assets and the present value of liabilities to scheme members. Scheme value of assets 3,921 Present value of scheme liabilities (5,760) Net pension scheme deficit (1,839) Ìn simple terms, if a business has not made sufficient payments to the pension scheme, then the scheme is likely to be in deficit. Comparable companies which have historically made sufficient cash payments into the scheme (no deficit) will consequently have different net debts to companies with deficits. The accounting issues The accounting for defined benefit pension schemes is notoriously varied depending on which accounting regime is followed. Adjusting net debt As defined above, the net pension scheme deficit of C1,839 is unlikely to be recognised on the balance sheet (although some variant of the calculation may be). However, when using either US GAAP, UK GAAP or ÌFRS, this figure is disclosed in the accounts and so international comparability can be achieved. As payments into pension schemes are tax deductible, any payments made to reduce this deficit will reduce taxes payable. Consequently, assuming a corporate tax rate of 30%, the adjustment to net debt would be an extra C1,287 [C1,839 x (1-30%] of "debt¨ to make it comparable to a business which has already made up any deficit. Adjusting profit As with the accounting (or non-accounting) in the balance sheet, internationally the income statement effects will vary. Once more, US GAAP, UK GAAP and ÌFRS disclose (though don't necessarily recognise) similar figures. Where EBÌT or EBÌTDA is the metric of choice, the most relevant element is the current service cost current service cost ÷ being the increase in the projected benefit obligation (present value of scheme liabilities) due to employees working for the company during the period. Comps 30 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Consequently, to calculate EBÌT or EBÌTDA, the existing accounting for pensions in the income statement (which may well have significant international variation) should be removed and replaced with the current service cost (as an operating expense). IIIustration A company with an EBÌTDA of C553m and net debt of C1,938m, and which suffers corporate tax at the rate of 30%, has a provision in its balance sheet for pensions of C57m and a pension charge in operating expenses of C64m. Disclosed in the notes to the accounts is the following information: net pension scheme deficit C1,839m current service cost C92m net pension finance expense C1,255m pension contributions paid to scheme C88m Revised net debt: Net debt as originally stated C1,938m net pension deficit (post tax) [1,839 x (1-30%)] C1,287m Adjusted net debt C3,225m Revised EBITDA EBÌTDA as originally stated C553m Add: original pension charge (C64m) Less: current service cost C92m Adjusted EBÌTDA C581m Note Due to international tax complexities, the tax treatment of the existing and revised accounting may be substantially different and so adjusting post tax profits will prove onerous. Consequently, EPS adjustments are likely to be intricate. Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 31 Pro forma: Acquisitions and disposaIs When a company makes an acquisition / disposal between the latest date of its balance sheet and the day when a comps is done, a pro forma should be constructed. The purpose of the pro forma is to compare "like with like", i.e. an adjusted enterprise value with adjusted financials for the acquisition / disposal. The problem is that you often do not have enough information to make sensible pro-forma adjustments for all line items. US companies tend to give pro-forma revenue, EBÌT and net income. European companies, on the other hand, are likely to be less forthcoming. IIIustration - disposaI CompCo has disposed of DisposeCo since the year end. CompCo DisposeCo Market value of equity (current) 100 Net debt (last balance sheet) 20 5 Disposal price (in cash) 30 Sales 60 40 EBÌT 10 4 Pro forma: disposaI CompCo Adjustments Pro forma Sales 60 (40) 20 EBÌT 10 (4) 6 Equity value 100 - 100 Net debt / (cash) 20 (35) (15) ___ __ ___ Enterprise value 120 (35) 85 EV/ Sales 2.0x 4.3x EV / EBÌT 12.0x 14.2x Comps 32 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] IIIustration - acquisition for cash CompCo has acquired 100% of AcqCo since the year-end for 30 in cash CompCo AcqCo Market value of equity (current) 100 Net debt (last balance sheet) 20 5 Sales 60 40 EBÌT 10 4 Pro forma: acquisition for cash CompCo Adjustments Pro forma Sales 60 40 100 EBÌT 10 4 14 Equity value 100 - 100 Net debt / (cash) 20 35 55 ___ __ ___ Enterprise value 120 35 155 EV/ Sales 2.0x 1.55x EV / EBÌT 12.0x 11.10x Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 33 IIIustration - acquisition for shares Ìn the above example, CompCo has acquired 100% of AcqCo since the year-end for 30 in shares. Pro Forma: acquisition for shares CompCo Adjustments Pro forma Sales 60 40 100 EBÌT 10 4 14 Equity value 100 30 130 Net debt / (cash) 20 5 25 ___ __ ___ Enterprise value 120 35 155 EV/ Sales 2.0x 1.55x EV / EBÌT 12.0x 11.10x Comps 34 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Keys to success 1. Understand the industry by reading analyst reports and news stories What are the industry specific statistics (sales/employee etc)? What are the most important performance ratios? What are the most important market multiples? 2. Select the universe of comparable companies carefully ÷ more is not necessarily better 3. Use the most recent published financials Check the web site and the financial calendar of the individual companies to ensure that the most recent published financial information is used 4. Use only the most appropriate broker Ensure that the research is recent and subsequent to any company result announcements Ensure that the forecast numbers are similar to global estimates 5. All source documentation should be marked to show where information has been extracted from with both a Post-it showing the page and a highlighter showing the numbers used 6. Use footnotes To disclose adjustments made to the numbers To explain unusual operating and financial trends 7. Always reconcile the broker historicals to the published historicals ÷ this will help to understand how the broker has defined key metrics, e.g. EBÌT and EPS, so that the historics and the forecasts can be input using the same adjustments 8. Ensure that the numbers are comparable ÷ potentially, the more adjustments made for special situations (true exceptionals/non-recurring items, dilution, associates etc), the more comparable, but: The more time to input the comps The less likely that all the desired adjustments will be visible in the brokers' research forecasts The more chance of errors 9. Keep the comps analysis up to date Check the web site and the financial calendar of the individual companies to ensure that the most recent published financial information is used Update share prices Update exchange rates Comps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 35 10. Check your work Double check for data entry or other processing mistakes Step back and look at the finished product ÷ do the results make sense? Get someone else to check your work 11. Understand the results of the analysis and be prepared to discuss them. Precedent transactions analysis © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Precedent transactions anaIysis 1 Ìntroduction 1 Relevant transactions 1 Mechanics 2 Summary transaction information 2 Sources of information 3 Equity value vs enterprise value 4 The multiples 5 Output sheet 6 Valuing the target 7 Checking 7 Valuation football field 8 Control premia 9 Synergies 9 Drivers of equity return in an LBO 10 Problems with precedent transactions 10 Precedent transactions analysis © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 Precedent transactions anaIysis Introduction Precedent transactions, also known as comparable transactions, comptrans, transaction comps or premium paid analysis, are used to derive an implied market valuation for a company, either public or private, in an acquisition context. Precedent transactions reflect the market value of a target's income stream in a takeover situation. Precedent transactions look at recent acquisitions in the relevant sector from which valuation multiples can be derived by dividing the transaction value by the target company's financials. These valuation multiples are applied to the company being valued in order to give a theoretical value of the business. ReIevant transactions Precedent transactions look at recent acquisitions in the relevant sector. Comparable transactions are selected to include corporate activity of companies with similar business activities and ideally operating in the same geographical areas. As no two companies or transactions are exactly the same the most similar companies and transactions are sought. The target companies (both precedent and intended target) should have similar profiles, i.e. business activities ÷ industry, products and distribution channels geographical location size growth profiles (including seasonality and cyclicality) profitability profiles accounting policies public vs private Additionally, the transactions should, ideally: be for similar acquisition proportions, the premia for a 30% stake will be lower than for a 100% be for similar considerations (cash vs debt vs equity) it is likely that a 100% cash offer will be at a lower price than a 100% equity offer involve similar bidder companies (trading vs private equity) private equity acquirers do not value synergies in their offer price Precedent transactions analysis 2 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] arise during similar equity market conditions ÷ recent transactions are: a. a more accurate reflection of the values buyers currently are willing to pay since the public equity markets and the availability of acquisition finance can change dramatically in a short time period more relevant than older transactions because more recent transactions are more indicative of the current market environment. However, historical transactions can be used to highlight trends in a particular industry have similar transaction profiles (recommended offer vs hostile bid vs contested) Consequently, it is better to use a small number of relevant comps rather than a large amount of less relevant ones. Mechanics Summary transaction information Data Description Date Announcement and/or closing date of transaction Bidder Bidder name including parent name if bidder is a subsidiary Target Target name including parent name if target is a subsidiary Target ÷ business description Very short description of target's business activity Local currency Currency in which the transaction took place Acquired stake % of the target being acquired (usually 100%) Equity value Equity consideration to be paid by the bidder Grossed-up equity value The equity value adjusted when the acquired stake is less than 100%, to reflect the equity value for 100% of the target Net debt acquired Typically, the net debt of the target. However, special arrangements are possible whereby the acquisition is debt- free or the bidder agrees to take on only part of the target's debt Ìmplied enterprise value Grossed-up equity value plus net debt acquired Precedent transactions analysis © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 Sources of information Information Source List of sector corporate activity SDC M&A Monitor Sector brokers' reports When target is a public company Offer details Offer documents Reuters articles Regulatory News Service (RNS) for UK companies Historic target data Annual report and offer document - last P&L Annual report or interim results - last BS Forecast target data Broker research When target is a private company / division / subsidiary Historic target data Parent annual report - last P&L Press articles and RNS (for UK companies) ÷ sales & profit Note: 1. Historic and forecast data for the target company should be extracted from the most recent relevant research immediately prior to the transaction being announced - the transaction was negotiated based on these numbers and the current transaction will be based on comparable research. 2. All source documentation should be marked to show where information has been extracted from with both a Post-it showing the page and a highlighter showing the numbers used. 3. When choosing a broker, make sure the numbers are sanity checked with Global Estimates to make sure the analyst's projections are in line with peers 4. Footnotes should be used for all assumptions and points of interest Exchange rates Always make sure you are using the same currency in both numerator and denominator: P&L historic ÷ use average exchange rates for the period P&L forecast ÷ use most recent exchange rate B/S ÷ use the exchange rate at the date of the BS Precedent transactions analysis 4 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Deferred payments When acquiring a business, a company may defer part of the consideration it offers, or hold back a proportion of the transaction value. This may arise: Where the management of the target company hold significant stakes in the business, thereby ensuring they continue to work for the company post-acquisition. Where the consideration is withheld and is payable upon the acquired company meeting or exceeding the projections contained within its business plans Tax restructuring reasons When calculating multiples for a transaction in which there is deferred consideration, ensure the terms of how it has been created are noted. Ìnclude both values and the range of multiples if possible. Equity vaIue vs enterprise vaIue The equity and enterprise values are always for 100% of the target company. Ìf Bidder buys 50% of Target, the equity and enterprise values are the implied values for the entire company. Ìf Bidder buys less than 100%, the amount paid represents a portion of the equity value. Enterprise value is calculated by grossing up the equity value to 100% and adding net debt. However, if Bidder buys all of Target, Bidder will also assume all of Target's liabilities, and what is described as "amount paid¨ might or might not include the debt. Ìt is important to understand what the amount paid represents to avoid calculating incorrect transaction multiples. Share options and convertible debt Ìn-the-money share options (and all Long Term Ìncentive Plans, LTÌPs) will be exercisable upon the acquisition and so should be converted (using the treasury method ÷ i.e. after accounting for exercise price) when calculating the equity and enterprise values. Similarly, convertible debt may be convertible into shares. Equity and enterprise value must be adjusted commensurately. Precedent transactions analysis © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 The muItipIes Examples of multiples Sales multiple Enterprise Value / Sales EBÌTDA multiple Enterprise Value / EBÌTDA EBÌTA multiple Enterprise Value / EBÌTA EBÌT multiple Enterprise Value / EBÌT Price / Earnings multiple Equity Value / net income Net assets multiple (Equity Value + Minority Ìnterests) / Net Assets Growth ratios (Yr 0 metric / Yr -1 metric) ÷1 Margins Profit metric / Sales Private transaction multiples By looking at historic precedent transactions, valuation multiples can be derived by dividing the transaction value by the target company's financials. metric ) ifany ( assumed debt paid cash Public transaction multiples As for private transactions, by looking at historic precedent transactions, valuation multiples can be derived by dividing the transaction value by the target company's financials (or other metric such as subscribers, square feet, etc). metric ) ifany ( assumed debt ) shares of number price offer ( For a public company transaction, the premium paid alludes to the fact that a bidder will typically pay a premium above the market valuation to obtain control over the target. Precedent transactions analysis 6 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Output sheet SAMPLE PRECEDENTS OUTPUT SHEET (All amounts in EUR millions, unless otherwise indicated) Firm VaIue LocaI Equity Firm As a MuItipIe of EBITDA EBIT Date Target / Acquiror Business of Target CRY VaIue (a) VaIue (a) SaIes EBITDA EBIT Margin Margin EUR EUR Jun-02 Dunlop Cox (BTR)/ Electrically-powered automotive seating GBP 578 766 1.09x 8.5x 12.9x 12.8° 8.4° Lear mechanisms Nov-01 Valeo/ Automotive parts SEK 29,931 31,431 1.05x 9.0x 12.3x 14.5° 8.5° Investor Group Oct-01 Borealis Industrier/ Instrument panels, door, panels, climate DKK 887 1,288 1.16x 7.5x 17.3x 15.4° 6.7° Lear systems, and exterior trim Nov-00 Prince Automotive/ Automotive overhead systems & consoles, USD 21,936 33,667 1.49x 9.9x 22.4x 15.0° 6.7° Johnson Controls door panels, visors, armrests Median 11,411 16,359 1.12x 8.8x 15.1x 14.8º 7.6º Mean 13,333 16,788 1.20 8.7 16.2 14.4 7.6 ` High 29,931 33,667 1.49 9.9 22.4 15.4 8.5 Low 578 766 1.05 7.5 12.3 12.8 6.7 No te : (a) Equity and Iirm value have been adjusted to reIlect 100° oI entity in cases oI minority positions acquired. SAMPLE PRECEDENTS VALUATIONS: AUTO VALUATION (Euros in Millions) SeIected Precedents' Range Auto ImpIied Auto VaIuation Low High Metric Low High Firm Value / LTM Revenue 1.1x 1.4x t4,510.6 t4,961.7 t6,314.8 LTM EBITDA 8.5 9.9 668.3 5,680.6 6,616.2 LTM EBIT 13.0 17.0 480.8 6,250.4 8,173.6 Selected Auto Firm Value Range f5,630.9 7,034.9 Precedent transactions analysis © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 VaIuing the target The valuation multiples calculated from precedent transaction are applied to the relevant metric of the target company being valued in order to give a theoretical value of the target business. There are a number of different ways to select the appropriate transaction multiple from the transaction database: Average / median of the transactions Average excluding outliers Range around the average Ìdentify highest and lowest likely prices The best method will depend on The quality of the information going into the precedent transactions database Who is the audience What is the situation Checking Always check your work ÷ use a calculator Comparable multiples should be checked with the broker to see if they are in line The completed sheet should be checked by eye to make sure there are no obvious mistakes Footnotes should be used for all assumptions and points of interest ComparabIe Transactions MuItipIes Range Company FinanciaIs (£m) Entity VaIue (£m) Net Debt & Minority Interest (£m) Equity VaIue (£m) Sales hist. 0.90x ÷ 1.20x 100 90 ÷ 120 10 80 ÷ 110 curr. 0.80x ÷ 1.10x 115 92 ÷ 127 10 82 ÷ 117 prosp. 0.70x ÷ 1.00x 125 88 ÷ 125 10 78 ÷ 115 EBÌTDA hist. 10.0x ÷ 16.0x 7.0 70 ÷ 112 10 60 ÷ 102 curr. 9.5x ÷ 15.5x 7.5 71 ÷ 116 10 61 ÷ 106 prosp. 9.0x ÷ 15.0x 8.0 72 ÷ 120 10 62 ÷ 110 EBÌT hist. 14.0x ÷ 20.0x 5.0 70 ÷ 100 10 60 ÷ 90 curr. 13.0x ÷ 19.0x 5.5 72 ÷ 105 10 62 ÷ 95 prosp. 12.0x ÷ 18.0x 6.0 72 ÷ 108 10 62 ÷ 98 Net Ìncome hist. 25.0x ÷ 28.0x 3.0 75 ÷ 84 - 75 ÷ 84 curr. 24.0x ÷ 27.0x 3.5 84 ÷ 95 - 84 ÷ 95 prosp. 23.0x ÷ 26.0x 4.0 92 - 104 - 92 ÷ 104 High 117 Low 60 Average 87 Estimated Equity VaIue (£m) 80 - 95 Precedent transactions analysis 8 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] VaIuation footbaII fieId current share price ÷ 100p 180p 145p 130p 140p 110p 80p 125p 90p 115p 130p 12 month share price performance Control premium (25% - 40%) Comparable company multiples Precedent transaction multiples DCF Summary vaIuation (Cm) 2,610 2,190 2,010 2,130 1,770 1,410 1,950 1,530 1,830 2,010 1,200 1,700 2,200 2,700 12 month share price performance Control premium (25% - 40%) Comparable company multiples Precedent transaction multiples DCF Enterprise vaIue (Cm) current EV Precedent transactions analysis © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 ControI premia Typically, acquisitions in the UK are made at c. 30% premium to the company's quoted value, representing a "premium for control¨ ÷ in certain industries, e.g. technology, this may not be the case. The ability to control a company has a value: Complete control (majority) Partial control (minority, significant influence, joint control) A block of shares providing some level of control must be worth more than the sum of the values of the single shares i.e. 51 shares > 51 x 1 share Consequently, transaction multiples are higher than the trading multiples of the company. Ìt is theoretically not correct to compare an acquisition of 5% of a company with a full take-over since, in the latter case, the Bidder would have to pay a larger premium to gain control. Consequently, purchases of small stakes, i.e. less than 25%, are likely to be excluded from the analysis. Why pay a premium? The ability to control a company has a value, but value in a corporate sense must be represented by future cash flows. When the equity markets value a company, they are assessing the PV of its future cash flows. Synergies The control premium must be justified by higher future cash flows to the new owner. These arise through synergies: How much additional cash can the bidder earn from the target which is not available to: the market; or the current owner (in a private transaction)? Synergies mean that cash flows discounted by bidders are higher than the cash flows being discounted by the market (or current owner). This, therefore, sets a limit on how much the bidder can pay. Ìf the acquisition is going to add any value to the bidder, then the amount actually paid is generally less than this maximum. Consequently, precedent transaction multiples are impacted by the split of value of synergies between target and bidder. Precedent transactions analysis 10 © The Corporate Training Group Ltd - +44 (0)20 7490 4770;
[email protected] Drivers of equity return in an LBO An investor in an LBO deal does not acquire with the target the benefits of synergies as the target will continue to operate in isolation. Consequently, the LBO team must see different benefits from paying a premium for the target. These generally arise through the benefits of leverage: tax savings from interest downside limited to equity capital injected potentially very high upside for equity holders ProbIems with precedent transactions Relative to public comparables, it is more difficult to conduct a valuation based on precedent transactions. Ìt is usually difficult to get a large enough set of transactions to calculate a meaningful average because: Valuation multiples tend to be widely dispersed between transactions Timing differences between transactions and the different market conditions ÷ recent transactions are a more accurate reflection of the values buyers currently are willing to pay since the public equity markets and the availability of acquisition finance can change dramatically in a short time period Differing stakes (minority vs control acquisitions) Access to information / quality of information The standard of reporting is different in different markets Press reports are generally inaccurate Ìnclusion of assumed debt Acquisition of minority stakes Volatility of public markets Calculating premia to pre-bid share price - getting the most appropriate pre-bid price Had the market already moved on rumours? Use pre-transaction or post-transaction estimates ÷ must compare like with like Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Exercises and case studies Jude Inc 1 DEF Ltd 2 RegaIia pIc 4 Hey pIc 5 Comps 1 6 Comps 2 7 Comps 3 8 Comps 4 9 Comps 5 10 MyTraveI 11 Pensions 12 MegateI pIc 14 Matthews & Ager 15 BIaine pIc 17 Gatsby pIc 18 Fitz Ltd 19 Grupo Cespa 20 Jefferson Smurfit Group 22 Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 Jude Inc Jude Ìnc is to be valued by discounting relevant future forecast cash flows at the weighted average cost of capital. The following information has been forecast for the first future period: $m Depreciation and amortisation 13 EBÌTDA 87 Ìnterest paid 18 Dividends paid 14 Ìncrease in inventories 1 Ìncrease in receivables 22 Ìncrease in payables and operating accruals 9 Tax paid (at rate of 30%) 8 Capital expenditure 412 Ìssue of shares 232 Ìssue of debt 143 Requirement Calculate the relevant free cash flow for the first forecast period. Valuation exercises 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] DEF Ltd Based on the attached information, calculate a value per share for DEF Ltd based on each of the following valuation methods: Net Asset Value Based on both book and independent valuations Dividends Use both the Gordon dividend discount model and the average sector dividend yield applied to DEF What assumptions are you making with each of these methods? Price Earnings Multiple Based on the three comparable companies EV / EBÌT Multiple Based on the three comparable companies a) Latest Balance Sheet (31 st December 2004): $m $m Share Capital 23.3 Fixed Assets 50.5 Retained Earnings 41.7 Ìnvestments 17.6 Borrowings 48.4 Ìnventory 54.3 Other Liabilities 91.4 Receivables 63.3 Cash 13.8 Other Assets 5.3 204.8 204.8 b) Share Ìnformation: Shares in Ìssue: 23.3 million, par value $1.00 EBÌT for 2005F: $12.9m Net Ìncome for 2005F: $ 6.0m Dividend declared (gross): 15.0 cents per share Expected dividend growth 4% c) Ìndependent Valuation of the Assets and Liabilities Fixed Assets $52.3m Ìnvestments $12.9m Provision for Bad Debt $1.0m Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 d) Dividend Yields, P/E and EV/EBÌT ratios for three comparable companies: Dividend Yield P/E Ratio (2005F) EV/EBÌT (2005F) Company 1 5.2% 14.2 10.3 Company 2 3.9% 12.3 8.9 Company 3 4.9% 11.1 8.1 e) Cost of Capital Assume that the company considering acquiring DEF has a cost of equity of 12% and a weighted average cost of capital of 10% and that DEF is an average risk investment for the acquirer. Valuation exercises 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] RegaIia pIc The equity share price of Regalia plc, an unlisted company, is to be estimated, as at the beginning of 2006, based on a discounted cash flow valuation of the enterprise. The relevant components of free cash flows (in Cm) are as follows: Year ending in December 2006 2007 2008 2009 2010 EBÌTDA 2,151 2,390 2,769 3,130 3,474 Working capital (increase) decrease 200 200 (213) (225) (215) Tax paid 325 375 643 739 810 Tax shield on interest expense 75 78 89 86 79 Capital expenditure 1,780 1,780 1,500 1,500 1,200 Other information Number of equity shares in issue (m) 6,932 Risk free rate 5.0% Corporate borrowing margin (over risk free rate) 1.9% Market risk premium 4.5% Appropriate Beta 0.83 Debt:Equity value target (market value) 25% Existing net debt (Cm) 3,033 Minority interest (Cm) 36 JVs and associates (Cm) 340 Corporation tax rate 30% Nominal growth in FCF post 2010 1.2% Terminal EBÌTDA multiple 6.2x There are no preferred shares in issue. Requirement Estimate the price of an equity share in Regalia plc, using a DCF valuation approach, using both a growth in perpetuity and exit multiple methodology to estimate the terminal value. Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 Hey pIc The equity share price of Hey plc is to be estimated based on a discounted cash flow valuation of the firm. The discount rate to be used is the company's weighted average cost of capital. The relevant free cash flows have been calculated as: 2005 2006 2007 2008 2009 £m £m £m £m £m 1 2 3 4 5 Free cash fIow to firm (FCF) 120.0 129.6 137.4 143.6 147.9 Other information Number of equity shares in issue (m) 586.4 Risk free rate 3.5% Credit risk premium (over risk free rate) 1.9% Market return expected 8.7% Appropriate Beta 1.15 Debt:firm value target (market value) 38% Existing net debt £700m Corporation tax rate 30% Nominal growth in FCF post 2009 2.2% There are no preferred shares in issue. Requirement Estimate the price of an equity share in Hey plc. Valuation exercises 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Comps 1 A company has the following information: m C Cm Stock price 30.00 Shares outstanding 40.0 Cash 125 Book value of equity 1,000 Debt 250 Minority interest 35 Preferred stock 50 LTM EBÌTDA 100 2005 EPS 1.00 Requirement CaIcuIate a. market capitalisation; b. enterprise value; c. the 2005 P/E multiple; and d. the LTM enterprise value/EBÌTDA multiple. Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 Comps 2 A company has the following information: m C Cm Stock price 35.00 Shares outstanding 20.0 Cash 400 LTM EBÌTDA 150 LTM EBÌT 100 Minority interest 120 Bank debt at book value 500 C250m 6% subordinated debentures trading at 70 Owns a 20% stake in company with C1,000m market capitalisation Requirement CaIcuIate a. equity value b. enterprise value c. the LTM EBÌTDA multiple and d. the LTM EBÌT multiple. Valuation exercises 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Comps 3 A company has the following information m C Cm Stock price 30.00 Average in-the-money options exercise price 20.00 Shares outstanding 60.0 Ìn-the-money options outstanding 10.0 Cash 500 Preferred stock 500 Minority interests 100 Debt 1,500 Requirement 1. Ìncluding only common stock, calculate equity value enterprise value 2. Ìncluding all equity-linked claims, calculate equity value enterprise value Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 Comps 4 A company has two operating divisions with different growth and profitability profiles, auto and technology. The following information is relevant: x m Cm Auto EBÌT 2,000 Technology sales 4,000 Shares outstanding 100.0 Cash 1,250 Debt 5,000 Unfunded pension liability 300 Comparable auto universe EBÌT multiple 7.0x Comparable technology universe sales multiple 1.00x Requirement Calculate the company's implied: a. enterprise value; b. equity value; and c. equity value per share Valuation exercises 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Comps 5 A company has two operating divisions with different growth and profitability profiles, department stores and supermarkets. The following information is relevant: m C Cm Department store EBÌT 500 Supermarket EBÌTDA 300 Shares outstanding 200.0 Cash 1,000 Debt 2,000 Minority interests 100 Ìn-the-money options outstanding 40.0 Average in-the-money options exercise price 10.00 The most common valuation multiple for department stores used in the market is an EBÌT multiple. The most comparable department store EBÌT multiple is 9.0x. The most common valuation multiple for supermarkets used in the market is an EBÌTDA multiple. The most comparable supermarkets EBÌTDA multiple is 7.0x. Requirement 1. Ìncluding only common stock, calculate the implied enterprise value equity value equity value per share 2. Calculate the above including all equity-linked instruments Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 MyTraveI The market capitalisation of MyTravel plc is £1,203m. Ìts consolidated financial statements show: Balance sheet (extracts) P&L account Cm Cm Lease rentals (222.3) Cash and cash equivalents 378.6 EBÌTDA 200.1 D&A (103.9) Debt 398.6 EBÌT 96.2 Net interest income/(expense) (2.3) Minority interests 209.6 Shareholders' equity 312.3 EBT 93.9 Leases MyTravel plc has significant commitments under non-cancellable operating leases. The average remaining lease term at the balance sheet date is 10 years. The company's average borrowing rate is 8%. The annuity factor for 10 years at 8% is 6.71. Requirement a. Calculate EV/EBÌTDA, without adjusting for off balance sheet operating leases b. Calculate EV/EBÌTDA, adjusting for off balance sheet operating leases Valuation exercises 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Pensions Siemens AG has a defined benefit pension scheme. Ìt prepares its consolidated financial statements in accordance with US GAAP. The net periodic pension cost for the period of C447m has been charged to operating expenses during the year. The market capitalisation of Siemens AG is C42,250m. Ìts consolidated financial statements show: Balance sheet (extracts) P&L account Cm Cm Cash and cash equivalents 11,196 EBÌTDA 6,058 D&A (4,126) Debt 12,346 EBÌT 1,932 Accrual for pension plans 3,557 Net interest income/(expense) 318 Minority interests 541 Other financial income 1,225 Shareholders equity 23,521 EBT 3,475 Pension plan disclosures Change in projected benefit obIigation Cm Projected benefit obligation at beginning of year 18,544 Service cost 487 Ìnterest cost 1,151 Actuarial losses/(gains) 240 Benefits paid (930) _________ Projected benefit obligation at end of year 19,492 _________ Change in pIan assets Cm Fair value of plan assets at beginning of year 14,625 Actual return on plan assets (1,187) Contributions 2,023 Benefits paid (930) _________ Fair value of plan assets at end of year 14,531 _________ Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 Net periodic pension cost Cm Service cost 487 Ìnterest cost 1,151 Expected return on plan assets (1,421) Amortisation of unrecognised net losses 230 _________ Net periodic pension cost 447 _________ Requirements 1. Calculate EV/EBÌTDA for Siemens AG: using reported data (ignoring pensions disclosures); adjusting for the real pension deficit and service cost. 2. Comment on the effect of the actual return on Siemens AG's pension scheme assets for the year. Calculate net debt/EBÌTDA for Siemens AG: using reported data (ignoring pensions disclosures); 3. adjusting for the real pension deficit and service cost. Corporate tax Assume a corporate tax rate of 39%. Valuation exercises 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] MegateI pIc The market capitalisation of Megatel plc is £59,843m. Ìts financial statements show: Balance sheet P&L account Peer comparison £m £m EV/EBITDA Ìnvestments in JVs 2,586 Turnover 18,715 Comp co 1 13.5 Ìnvestments in Operating costs (15,117) Comp co 2 9.0 Associates 2,639 Operating profit 3,598 EV/sales Share of JV (427) Comp co 1 4.5 Net debt 8,700 Share of associate 27 Comp co 2 5.0 Operating profit 3,198 Shareholders Net interest (382) Funds 15,795 Minority interests 498 [Depreciation £2,752m] [Amortisation 89m] An analyst has calculated EV/sales and EV/EBÌTDA for Megatel plc as follows: EV/EBÌTDA = m 439 , 6 £ m 543 , 68 £ = 10.6 EV/sales = m 715 , 18 £ m 543 , 68 £ = 3.7 The analyst has concluded that Megatel plc looks reasonably priced on EV/EBÌTDA and cheap on EV/sales against its peers. Megatel plc has far more unconsolidated joint ventures and associates, and fewer minority interests, than its peers Requirement Suggest how Megatel's EV (and resultant EV multiples) could be adjusted or 'cleaned up' to take minority interests, joint ventures and associates into account. Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 Matthews & Ager The market capitalisation of Matthews plc is to be calculated using comparable company analysis, with Ager plc as the comparable company. Ager pIc The market capitalisation of Ager plc is £14,548m. Ìts consolidated financial statements show: Balance sheet (extracts) P&L account £m £m Ìnvestment in JV (50%) 182 Turnover 22,800 Ìnvestment in associate (30%) 33 Operating costs (21,626) Cash and liquid resources 526 1,174 Share of JV 21 Debt 3,330 Share of associate 3 1,198 Shareholders funds 5,187 Net interest (125) Minority interests 34 [Depreciation £455m] [Amortisation 9m] Joint venture Associate 50% of the equity is owned by Ager plc. 30% of the equity is owned by Ager plc. Balance sheet (extracts) Balance sheet (extracts) £m £m Cash and liquid resources 302 Cash and liquid resources 11 Debt 662 Debt 31 Shareholders funds (equity) 364 Shareholders funds (equity) 110 The market capitalisation of the joint The market capitalisation of the venture is £908m. associate is £130m. Valuation exercises 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Matthews pIc The consolidated financial statements of Matthews plc show: Balance sheet (extracts) P&L account £m £m Ìnvestment in JV (50%) 22 Turnover 17,244 Cash and liquid resources 487 Operating costs (16,711) 533 Debt 1,356 Share of JV (4) 529 Shareholders funds 4,911 Net interest (76) Minority interests 53 [Depreciation £409m] [Amortisation 17m] Joint venture 50% of the equity is owned by Matthews plc. Balance sheet (extracts) £m Cash and liquid resources 42 Debt 80 Shareholders funds (equity) 44 The market capitalisation of the joint venture is £52m. Requirements [The market capitalisation of Matthews plc is to be calculated using comparable company analysis, with Ager plc as the comparable company.] a. Calculate suitable EV/sales and EV/EBÌTDA ratios for Ager plc. b. State, with reasons, which multiple (EV/sales or EV/EBÌTDA) appears most appropriate to value Matthews plc. c. Applying this multiple, estimate the market capitalisation of Matthews plc. Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 BIaine pIc Blaine plc has an authorised share capital of 10 million £1 ordinary shares, of which 4 million are currently in issue. The shares have an ex-div. market value of £3.40. This year the dividend was 35p per share and this is expected to grow at a rate of 5% for the foreseeable future. The company also has £1 million 7% irredeemable debentures in issue which currently stand at £95. Requirement Given a corporate tax rate of 30%, what is Blaine plc's WACC? Valuation exercises 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Gatsby pIc The directors of Gatsby plc are planning a new investment and the following information is relevant: the project is in a different industrial sector; Gatsby's normal activities are in Leisure, whilst the new project is in Retail the project will cost £2 million and will bring in revenue before tax of £400,000 for 8 years starting in one years time tax is payable in the same year as the profits arise at the rate of 30% the leisure industry has an average Beta factor of 1.4 whilst the retail industry is less risky having a Beta of 1.1 the current risk free rate of interest is 7.5% with a market premium of 5% Requirement Should Gatsby plc invest in the new project? Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 Fitz Ltd Fitz Ltd. currently has in issue 3 million £1 shares and has a cost of equity of 14%. A dividend of 20p has just been paid and this is expected to grow at a rate of 3% for the foreseeable future. The company also has £1million 6% loan stock in issue, with investors requiring a risk free return of 7.5%. A new project, to be wholly equity financed, is under investigation (no announcement to the market has yet been made about this) which would cost £700,000 and would provide net revenues in perpetuity of £125,000 per annum. The £125,000 is stated in today's terms, although it would, in fact, start in one year's time. Ìt is assumed that corporation tax of 30% will be paid as net revenue is received. The outlay would have no corporation tax effects. Ìnflation is expected to run at 3% in the future. The project has a Beta of 1.2. The risk free rate is 7.5% and the market premium is 5%. Requirement What is the market value of the company prior to the project and what is the new market value of the company after the project? Valuation exercises 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Grupo Cespa Precedent transactions vaIuation Grupo Cespa S.A. ("Cespa") is the 2nd largest waste management company in Spain. The total estimated size of the European waste management sector is circa C20bn, and the Spanish market represents around 8%. Cespa was created in July 1976 and has since expanded in Spain and Argentina mainly through acquisitions. Cespa is a vertically integrated waste management player involved in: Collection Transfer Disposal / Ìncineration Recycling / Waste to Energy Hazardous waste and has a special focus on municipal waste, although it is also an important player in the industrial & commercial ("Ì&C¨) segments. Cespa was jointly owned (50/50) by two major environmental companies: 1) Aguas de Barcelona, "Agbar¨ (Spanish water company) and 2) SÌTA (waste management company and world wide leader. Subsidiary of French energy group Suez SA). Ìn May 2003 Agbar and Sita decided to sell their stakes in Cespa. Ìn August 2003, a Spanish construction company, Grupo Ferrovial, emerged as the successful bidder after a very competitive process with a wide range of both industrial players and financial investors involved on the buy side. Ferrovial made the acquisition based on the following information: Net Debt Net debt (Dec 2002) C244m Financials (year ending 31 December, in Cm) ActuaI ActuaI 2001 2002 Sales 543 560 EBÌTDA 94 86 EBÌT 53 43 Requirement Based on the above and the attached precedents database and current sector trading multiples, calculate an appropriate takeover equity value. Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 Precedent transaction database Precedent Waste Transactions - Firm VaIuations Firm Firm VaIue Target Acquiror Currency Date VaIue EBIT EBITDA EBITDA EBIT Leigh Interests GU Holdings £ Aug-97 170.1 11.3 26.2 6.5x 15.0x BFI (International ops.) SITA £ Nov-97 1,450.0 115.0 235.0 6.2 12.6 Caird Group Shanks Group £ May-99 54.8 3.2 5.3 10.3 16.9 Superior Services Vivendi US$ Jun-99 993.5 55.4 94.5 10.5 17.9 WMI Finland Lassila Tikanoja t Jan-00 100.0 7.5 13.2 7.6 13.3 WMI Netherlands Shanks Group t Mar-00 207.7 18.7 28.8 7.2 11.1 UK Waste Severn Trent £ Jun-00 380.0 23.0 42.0 9.0 16.5 WMI Denmark Marius Pedersen t Jul-00 120.0 8.8 21.0 5.7 13.7 WMI Sweden Miljoservice SEK Sep-00 2,053.9 NA 285.0 7.2 NA Hanson Waste WRG £ Dec-00 185.0 11.5 20.7 8.9 16.1 WRG Terra Firma £ Jun-03 530.9 NA 96.5 5.5 NA Severn Trent Hales Waste £ Jun-03 167.0 13.0 19.6 8.5 12.8 RWE Umwelt Assets Pennon £ Apr-04 30.5 4.3 7.9 3.9 7.2 High 10.5x 18.4x Mean 7.5 14.3 Median 7.4 14.3 Low 3.9 7.2 Notes: LTM is Latest Twelve Months period (trailing). (1) Market Capitalization equals current shares outstanding times current share price. (2) Net Debt equals total interest-bearing debt plus minority interest and the net eIIect oI dilution Irom options and convertibles, less cash, marketable securities, and investments in unconsolidated aIIiliates. Sector trading muItipIes Country Market Cap (Eur m) 2003A 2004E 2003A 2004E 2003A 2004E 2003A 2004E Shanks UK 409 1.03x 0.95x 5.82x 5.77x 10.24x 10.83x 11.38x 12.66x Severn Trent UK 4,161 2.91 2.70 7.87 7.41 14.02 13.56 19.68 15.22 Séché France 404 1.72 1.56 7.66 6.83 15.19 12.54 144.12 34.20 Lassila & Tikanoja Finland 419 1.59 1.45 8.23 7.14 14.71 13.12 20.97 18.23 VÌVE France 8,976 0.86 0.82 7.22 6.71 15.81 14.54 27.85 21.89 Suez France 16,499 1.22 1.18 7.53 7.31 14.80 13.90 10.91 13.37 AlliedWaste US 2,435 2.16 2.22 7.11 6.86 10.63 10.02 14.14 10.47 Republic US 3,662 2.20 2.12 7.91 7.45 12.27 11.48 18.45 17.21 WasteMngmnt US 13,569 2.10 1.99 8.22 7.67 15.48 13.47 22.71 19.44 Casella US 238 1.38 1.45 6.71 6.24 15.00 15.35 28.69 23.32 Connections US 1,150 3.47 3.00 9.96 8.58 13.03 11.25 20.37 16.71 High 3.47x 3.00x 9.96x 8.58x 15.81x 15.35x 144.12x 34.20x Mean 1.88 1.77 7.66 7.09 13.74 12.73 30.84 18.43 Median 1.72 1.56 7.66 7.14 14.71 13.12 20.37 17.21 Low 0.86 0.82 5.82 5.77 10.24 10.02 10.91 10.47 Notes: All companies Year Ending 31-Dec except Shanks (31-March) PE EV / EBIT EV / EBITDA EV / SaIes Valuation exercises 22 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Jefferson Smurfit Group Precedent transactions vaIuation Jefferson Smurfit Group ("JSG") began as a small Ìrish boxmaker in 1934, becoming a public company in 1964. JSG has grown from its original Ìrish base to be a major international manufacturer and convertor of paper and paperboard. JSG is one of the largest European based manufacturers of: Containerboard Corrugated containers Folding cartons Paper sacks Decor base paper and one of Europe's leading collector of wastepaper for recycling, using much of the material collected in the production of paper and paperboard at its mills. Ìn September 2002, JSG was acquired by Madison Dearborn Partners. As one of the largest and most experienced private equity firms in the USA, MDP have significant expertise in the paper packaging business. The JSG investment is their 5th in the packaging industry and their most significant to date in any sector. MDP made the acquisition based on the following information: Capital structure Net debt C1,778m No of shares 1,126m Financials (in Cm) Actual Actual Pro forma 2000 2001 LTM Sales 4,565 4,512 4,838 EBÌTDA 576 573 631 MDP expected to dispose of some non-core assets following the acquisition. These were valued at C223m. Requirement Based on the above and the attached precedents database, calculate an appropriate takeover share price. Valuation exercises © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 23 Precedent transaction database Firm VaIue Firm VaIue / LTM Date Target/Acquiror (a) (US$MM) (b) SaIes EBITDA Sep-01 Gaylord Container / Temple-Ìnland $859 80% 9.4x Mar-01 AssiDomän Corrugated & Containerboard/Kappa Holdings 1,070 83 6.2 Dec-00 AssiDomän & Stora Enso / Billerud 618 100 5.9 Jul-00 Ìgaras papeis / Klabin 510 228 9.6 Feb-00 St. Laurent / Smurfit-Stone Container 1,333 160 12.0 Jan-99 PCA / Madison Dearborn 2,437 160 7.4 Jan-99 Stone Container / Jefferson Smurfit Corp. 6,500 134 30.6 Oct-97 Cascades Ìnc. / Domtar Ìnc. 698 122 43.9 May-97 Chesapeake (Westpoint) / St. Laurent Paperboard 500 120 10.7 Nov-95 St. Joe Paper / Stone Container 185 80 2.4 Median 121 9.5 Mean 127 13.8 Notes: (a) Source: Schroder Salomon Smith Barney and the Securities Data Company. (b) Exchange rate as at period of the transaction. Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Exercises and case study soIutions Jude Inc 1 DEF Ltd 2 RegaIia pIc 4 Hey pIc 5 Comps 1 6 Comps 2 7 Comps 3 9 Comps 4 10 Comps 5 11 MyTraveI 13 Pensions 16 MegateI pIc 18 Matthews & Ager 20 BIaine pIc 22 Gatsby pIc 23 Fitz Ltd 24 Grupo Cespa 25 Jefferson Smurfit Group 26 Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 Jude Inc Free cash flow for DCF at WACC $m EBÌTDA 87 Working capital adjustments Ìncrease in inventories (1) Ìncrease in receivables (22) Ìncrease in payables and operating accruals 9 (14) Capex (412) Tax paid (8) Ìnterest tax shield (5) ____ Unlevered free cash flow (352) ____ Valuation solutions 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] DEF Ltd 1) Net Asset VaIue Before revaluation $m Total Value Net Assets 65.0 ($2.79 per share) After revaluation: Unadjusted net assets 65.0 Fixed asset revaluation 1.8 Ìnvestment revaluation (4.7) Provision for bad dept (1.0) Adjusted Net Asset VaIue $ 61.1m ($2.62 per share) 2) Dividend YieId: Dividend discount (Gordon Growth Model) assumes value is in dividend stream = Dividend yr1* / (Cost of equity ÷ expected div. growth) * assumes gross Est. share value = (0.15 * 1.04) / (0.12 ÷ 0.04) = $1.95 x 23.3m = $45.4m Price estimated using average sector dividend yield applied to DEF: DEF's gross dividend per share = 15¢ Average comparable gross yield = 4.7% Est. share value = 0.15/0.047 = $3.19 Est. equity value = $3.19 x 23.3m = $74.4m 3) Price Earnings MuItipIe: Average comparable P/E = 12.5 DEF's EPS (forecast) = $6.0m/23.3m = $0.258 Est. share value = 12.5 x $0.258 = $3.22 Est. equity value = $3.22 x 23.3m = $75.0m Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 4) EV / EBIT MuItipIe Average comparable EV / EBÌT = 9.1 DEF's EBÌT (forecast) = $12.9m Est. EV for DEF = $117.4m Deduct market value of debt of $53.1m Add cash (assumed to be excess cash) of $13.8m Est. equity value = $78.1m Est. share value = $3.35 5) Summary of ResuIts Equity Value Per Share Asset Value (before revaluation) $65.0m $2.79 Asset Value (after revaluation) $61.1m $2.62 Dividend discount (Gordon model) $45.4m $1.95 Dividend Yield $74.4m $3.19 PE Multiple $75.0m $3.22 EV / EBIT MULTIPLE $78.1M $3.35 Valuation solutions 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] RegaIia pIc Year ending in December 2006 2007 2008 2009 2010 EBÌTDA 2,151 2,390 2,769 3,130 3,474 Working capital (increase) decrease 200 200 (213) (225) (215) Tax (paid) (325) (375) (643) (739) (810) Tax shield on interest (only forecast periods) (75) (78) (89) (86) (79) Capital expenditure (1,780) (1,780) (1,500) (1,500) (1,200) FCF 171 357 324 580 1,170 TV - using growth in perpetuity 17,531 (w) TV - using EBITDA exit multiple 21,539 Discount factor 0.9263 0.8581 0.7948 0.7363 0.6820 PV - TV - using growth in perpetuity 158 306 258 427 12,755 PV - TV - using EBITDA exit multiple 158 306 258 427 15,488 TV - using growth in perpetuity TV ÷ using EBITDA exit multiple Implied enterprise value 13,904 16,637 Less: Net debt (3,033) (3,033) MI (36) (36) Add JVs etc 340 340 Implied equity value 11,175 13,908 Implied share price (C) 1.61 2.01 Cost of equity Cost of debt Risk free rate 5.00% Risk free rate 5.00% Corporate borrowing margin 1.90% Equity beta 0.83 Corporate borrowing rate 6.90% Market risk premium 4.50% Corporate taxation rate 30% Cost of equity 8.74% Post tax cost of debt 4.83% WACC Cost of equity 8.74% Post tax cost of debt 4.83% target D/EV proportion 20% target D/Equity value proportion 25% WACC 7.95% w ÷ TV using perpetuity growth = 1,170 x (1.012%)/(7.95%-1.2%) = 17,531 Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 Hey pIc DCF valuation Free cash flow 120.0 129.6 137.4 143.6 147.9 Terminal cash flow Terminal value (W) 2,955.7 Cash flows to be discounted 120.0 129.6 137.4 143.6 3,103.6 Discount factor 0.93 0.87 0.81 0.75 0.70 Present vaIue of cash fIow 111.8 112.5 111.2 108.3 2,180.6 Present vaIue of cash fIow (Firm/Enterprise VaIue (£m)) 2,624.4 EV JVs (£m) Current share price (p) Associates (£m) Derived share price (p) 328.2 Minority interests (£m) Derived premium (discount) Net debt (£m) 700.0 NetDebt TotaI equity vaIue (£m) 1,924.4 EqVal Equity market risk premium 5.20% EMRP Cost of equity 9.48% Cost of debt 3.78% Discount rate (WACC) 7.314% Working - Terminal value FCF 2009 * (1+g)/(WACC ÷ g) = 147.9 * (1.022)/(7.314% - 2.2%) = 2,955.7 Valuation solutions 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Comps 1 A company has the following information: m C Cm Stock price 30.00 Shares outstanding 40.0 Cash 125 Book value of equity 1,000 Debt 250 Minority interest 35 Preferred stock 50 LTM EBÌTDA 100 2005 EPS 1.00 Requirement CaIcuIate a. market capitalisation; b. enterprise value; c. the 2005 P/E multiple; and d. the LTM enterprise value/EBÌTDA multiple. (in C millions, except per share): Market capitalisation Stock price 30.00 Shares outstanding (m) x 40.0 Market capitalisation 1,200 Debt + 250 Cash (125) Preferred stock + 50 Minority interest + 35 Enterprise value 1,410 2005 P/E Multiple = 30.00/1.00 30.0x Enterprise Value/LTM EBÌTDA = 1,410/100 14.1x Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 Comps 2 A company has the following information: m C Cm Stock price 35.00 Shares outstanding 20.0 Cash 400 LTM EBÌTDA 150 LTM EBÌT 100 Minority interest 120 Bank debt at book value 500 C250m 6% subordinated debentures trading at 70 Owns a 20% stake in company with C1,000m market capitalisation Requirement CaIcuIate a. equity value b. enterprise value c. the LTM EBÌTDA multiple and d. the LTM EBÌT multiple. Valuation solutions 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] (in C millions, except per share): Equity value Stock price 35.00 Shares outstanding x 20.0 Equity value 700 Debt Bank debt + 500 Sub. debt = 250 x 0.7 + 175 Cash (400) Minority interest + 120 Unconsolidated investment - 20% stake (*) (200) Enterprise Value 895 Enterprise Value/LTM EBÌTDA = 895/150 6.0x Enterprise Value/LTM EBÌT = 895/100 9.0x (*) Assuming EBÌT and EBÌTDA do not include a profit contribution from the unconsolidated investment Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 Comps 3 A company has the following information m C Cm Stock price 30.00 Average in-the-money options exercise price 20.00 Shares outstanding 60.0 Ìn-the-money options outstanding 10.0 Cash 500 Preferred stock 500 Minority interests 100 Debt 1,500 Requirement 1. Ìncluding only common stock, calculate equity value enterprise value 2. Ìncluding all equity-linked claims, calculate equity value enterprise value (in C millions, except per share): Common stock onIy IncIude options Market capitalisation 1,800 1,800 Option value (10m x C30) 0 300 Equity value / Diluted equity value 1,800 2,100 Debt + 1,500 + 1,500 Cash (500) (500) Minority interest + 100 + 100 Preferred stock + 500 + 500 Option proceeds (10m x C20) 0 (200) Enterprise Value 3,400 3,500 Valuation solutions 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Comps 4 A company has two operating divisions with different growth and profitability profiles, auto and technology. The following information is relevant: x m Cm Auto EBÌT 2,000 Technology sales 4,000 Shares outstanding 100.0 Cash 1,250 Debt 5,000 Unfunded pension liability 300 Comparable auto universe EBÌT multiple 7.0x Comparable technology universe sales multiple 1.00x Requirement Calculate the company's implied: a. enterprise value; b. equity value; and c. equity value per share (in C millions, except per share): Ìmplied divisional values: Auto = 7.0 x 2,000 14,000 Technology = 1.00 x 4,000 4,000 Ìmplied Enterprise Value 18,000 Debt (5,000) Cash + 1,250 Unfunded pension liability (300) Ìmplied Equity Value 13,950 Shares outstanding (m) 100.0 Ìmplied equity value per share 139.50 Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 Comps 5 A company has two operating divisions with different growth and profitability profiles, department stores and supermarkets. The following information is relevant: m C Cm Department store EBÌT 500 Supermarket EBÌTDA 300 Shares outstanding 200.0 Cash 1,000 Debt 2,000 Minority interests 100 Ìn-the-money options outstanding 40.0 Average in-the-money options exercise price 10.00 The most common valuation multiple for department stores used in the market is an EBÌT multiple. The most comparable department store EBÌT multiple is 9.0x. The most common valuation multiple for supermarkets used in the market is an EBÌTDA multiple. The most comparable supermarkets EBÌTDA multiple is 7.0x. Requirement 1. Ìncluding only common stock, calculate the implied enterprise value equity value equity value per share 2. Calculate the above including all equity-linked instruments Valuation solutions 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] (in C millions, except per share) Common stock onIy IncIude options Department stores = 9.0 x 500 4,500 4,500 Supermarket = 7.0 x 300 + 2,100 + 2,100 Ìmplied Enterprise Value 6,600 6,600 Debt (2,000) (2,000) Cash + 1,000 + 1,000 Minority interest (100) (100) Option proceeds = 40 x 10.00 0 + 400 Ìmplied Equity Value 5,500 5,900 Shares outstanding 200 240 Ìmplied equity value per share 27.50 24.58 Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 MyTraveI Without adjustment EV/EBÌTDA = m 1 . 200 £ m 6 . 432 , 1 £ = 7.2 x Where: EV = £1,203.0m + 209.6m + 20.0m = £1,432.6m Net debt = £398.6m - 378.6m = £20.0m With adjustment EV/EBÌTDA = m 4 . 422 £ m 2 . 924 , 2 £ = 6.9 x Off baIance sheet debt equivaIent £222.3m x 6.71 = £1,491.6m EV = £1,432.6m + £1,491.6m = £2,924.2m Finance element of lease rental £1,491.6m x 8% = £119.3m Balance of lease rental deemed to be depreciation = £103.0m Adjusted EBITDA [or EBITDAR] £200.1m + 222.3m = £422.4m Conclusion For the impact on EV/EBÌTDA to be significant, the relevant annuity factor needs to be significantly different to the current unadjusted EV/EBÌTDA multiple. The annuity factor increases as: - the lease term increases - the borrowing rate decreases Valuation solutions 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Cover ratios 3 . 2 2 . 96 = 42. EBÌT covers net interest 42 times. 3 . 2 1 . 200 = 87. EBÌTDA covers net interest 87 times. 3 . 2 3 . 222 4 . 422 + = 1.9. EBÌTDAR covers net interest and rentals 1.9 times. P&L account £m EBITDAR 422.4 Lease rentals (222.3) EBÌTDA 200.1 D&A (103.9) EBÌT 96.2 Net interest income/(expense) (2.3) EBT 93.9 Debt repayment 1 . 200 0 . 20 = 0.1. On balance sheet net debt could be repaid out of EBÌTDA in 36 days. 422.4 1,491.6 0 . 20 + = 3.6. Net debt could be repaid out of EBÌTDAR in 3 years and 7 months. Off baIance sheet debt equivaIent £222.3m x 6.71 = £1,491.6m Gearing proportion Treating minority interests as equity: 9 . 541 0 . 20 = 4% on balance sheet. 1,491.6 9 . 541 1,491.6 0 . 20 + + = 74% including operating leases. Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 Balance sheet (extracts) £m Net operating assets 541.9 Net debt 20.0 Minority interests 209.6 Shareholders equity 312.3 CapitaI empIoyed 20.0 + 209.6 + 312.3 = £541.9m on balance sheet. 541.9 + 1,491.6 = £2,033.50 including operating leased assets. Valuation solutions 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Pensions EV/EBITDA Without adjustment EV = 42,250m + 541m + 12,346m - 11,196m = C43,941m EV/EBÌTDA = m 6,058 C m 941 , 43 C = 7.3 Adjusted, pre tax EV = 43,941m + [19,492m - 14,531m] = C48,902m EBÌTDA = 6,058m + 447m ÷ 487m = C6,018m EV/EBÌTDA = m 018 , 6 C m 902 , 48 C = 8.1 Adjusted, post tax EV = 43,941m + [(19,492m - 14,531m) x 61%] = C46,967m EV/EBÌTDA = m 018 , 6 C m 967 , 46 C = 7.8 Net debt/EBITDA Without adjustment EBÌTDA debt Net = m 6,058 C m 150 , 1 C = 0.2 Net debt C12,346m - 11,196m = C1,150m Adjusted, pre tax EBÌTDA debt Net = m 6,018 C m 111 , 6 C = 1.0 Net debt C1,150m + [19,492m - 14,531m] = C6,111m Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 Adjusted, post tax EBÌTDA debt Net = m 6,018 C m 176 , 4 C = 0.7 Net debt C1,150m + [(19,492m - 14,531m) x 61%] = C4,176m Valuation solutions 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] MegateI pIc Dirty muItipIes EV = £59,843m + 8,700m = £68,543m EBÌTDA = £3,598m + 2,752m + 89m = £6,439m EV/EBÌTDA = m 439 , 6 £ m 543 , 68 £ = 10.6 EV/sales = m 715 , 18 £ m 543 , 68 £ = 3.7 [The company looks reasonably priced on EV/EBÌTDA and cheap on EV/sales against its peers.] Clean multiples Approach 1 EV could be cleaned up by: deducting the value of associates and joint ventures (as these are implicit in the investing company's market capitalisation but excluded from consolidated sales and EBÌTDA); and adding the value of minorities (as these are not implicit in the investing company's market capitalisation but included in consolidated sales and EBÌTDA). Where subsidiaries, joint ventures and associates are quoted companies, the group (for associates and joint ventures) or minority (for subsidiaries) share of market capitalisation can be deducted from or added to EV. Using book values (probably significantly lower than market values) to illustrate: 'Clean' EV = £68,543m - 2,586m - 2,639m + 498m = £63,816m EV/EBÌTDA = m 439 , 6 £ m 816 , 63 £ = 9.9 EV/sales = m 715 , 18 £ m 816 , 63 £ = 3.4 The company starts to look undervalued against its peers. Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 Approach 2 Sales could be adjusted by: adding the group's share of associates and joint ventures sales; and deducting minorities share of subsidiaries sales. The former may be disclosed in the P&L account. The latter may be difficult to estimate without referring to the accounts of each individual subsidiary and applying the relevant minority interest %. Ìt will be more difficult to adjust EBÌTDA in this way. EV would have to be adjusted by: adding the group's share of associates net debt; and deducting minorities share of subsidiaries net debt. Valuation solutions 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Matthews & Ager VaIuation ratios for Ager pIc EV/EBÌTDA = 638 , 1 £ 893 , 16 £ = 10.313 EV/sales = 800 , 22 £ 893 , 16 £ = 0.74 EV EV = £14,548m + £34m + £2,804m ÷ £454m - £39m = £16,893m Minority interests Ìnclude in EV as 100% of subsidiaries' sales and EBÌTDA are included in consolidated P&L. No information to calculate MV, so use BV. Net debt £3,330 ÷ £526m = £2,804m. JV and associate Exclude from EV as none of JV's or associate's sales or EBÌTDA are included in consolidated P&L. Market capitalisation reflects MV of equity interests in JV (50%) and associate (30%), so need to remove. EBITDA EBÌTDA = £1,174m + £455m + £9m = £1,638m Appropriate muItipIe EV/EBÌTDA appears more appropriate as the 2 companies have quite different EBÌTDA margins (7.2% for Ager, 5.6% for Matthews). Market capitaIisation of Matthews EV Applying comparable company's EV/EBÌTDA multiple to Matthew's EBÌTDA: EV = £959m x 10.313 = £9,890m. EBITDA EBÌTDA = £533m + £409m + £17m = £959m Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 Market capitalisation Market cap = £9,890m - £869m - £53m + £26m = £8,994m. Net debt £1,356m ÷ £487m = £869m. Valuation solutions 22 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] BIaine pIc Cost of Equity = 5% 340 1.05 x 35 + = 15.8% Cost of Debt = 95 0.3) - (1 x 7 = 5.16% WACC = 1m x 0.95 4m x 40 . 3 £ 5.16% x 1m x 0.95 15.8% x 4m x 40 . 3 £ + + = 15.1% Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 23 Gatsby pIc Discount factor = 7.5% + 1.1 x 5% = 13% Cash flow & Df Discounted cash flow (000's) Ìnvestment -2,000 x1 -2,000 Cash flow 400 x ( ¸ ( ¸ 1.13 1 - 1 13 . 0 1 8 1920 Tax on cash flow -120 x ( ¸ ( ¸ 1.13 1 - 1 13 . 0 1 8 -576 Net present vaIue -656 Valuation solutions 24 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Fitz Ltd Market value prior to project announcement Equity = 03 . 0 14 . 0 1.03 x 20 ÷ = £1.87; £1.87 x 3m = £5.618m Debt = 075 . 0 6 = £80; 0.8m 1m x 100 80 = Therefore market value = £5.61m + 0.8m = £6.418m After project Discount factor = 7.5% + 1.2 x 5% = 13.5% Real (effective) discount factor = 03 . 1 135 . 1 = 1.102; therefore real/effective rate = 10.2% Present value of future cash flows = 102 . 0 .7 x k 125 £ = £858.3k Market value after project = Market value before project + PV of flows of project = £6.418m + £858.3k = £7.276m Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 25 Grupo Cespa Precedent transactions vaIuation Low High Low High 86 86 43 43 5.5x 9.0x 11.1x 16.5x 473 774 477 710 -244 -244 -244 -244 229 530 233 466 475 to 742 231 to 498 ImpIied Equity VaIue range (in C million) ImpIied Firm VaIue range Ìmplied Firm Value Less: net debt acquired Ìmplied equity value EBITDA EBIT Cespa profit metric (LTM) Appropriate multiple Notes: 1. Precedent multiples: a. Pennon / RWE Umwelt ÷ outlier on low multiples b. Caird and Superior precedents ÷ older transactions and outliers on high multiples c. Older transactions removed as less comparable as transactions took place under different market conditions Valuation solutions 26 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Jefferson Smurfit Group Precedent transactions vaIuation in Cm (except per share) EBITDA SaIes Low High Low High JSG profit metric (pro-forma LTM) 631 631 4,838 4,838 Appropriate multiple 5.9x 6.4x 0.80x 0.85x Ìmplied Firm Value 3,723 4,038 3,870 4,112 Less: net debt acquired (1,778) (1,778) (1,778) (1,778) Add: non-core assets acquired 223 223 223 223 Ìmplied equity value 2,168 2,483 2,315 2,557 Number of shares (m) 1,126 1,126 1,126 1,126 Ìmplied takeover share price C 1.93 C 2.21 C 2.06 C 2.27 ImpIied share price range C 2.05 to C 2.20 Notes: 1. Assuming pro-forma suggests excluding the performance of the non-core assets ÷ these will be acquired by MDP (and subsequently disposed of) and so should form part of the acquisition price. Valuation solutions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 27 2. Precedent multiples: a. St Joe Paper ÷ outlier on low multiple b. Stone Container and Cascades Ìnc ÷ outliers on high ebitda multiples c. Older transactions removed as less comparable as transactions took place under different market conditions. ÷ Chesapeake d. Ìgaras Papeis - different margins others 2.28 ÷ 9.6 = 23.75% - whilst average of remainder is 13% (FV/sales ÷ FV/EBÌTDA = EBÌTDA margin) and JSG is 13% e. Weight given to PCA ÷ previous private equity transaction f. Most significant weight given to AssiDomän Corrugated & Containerboard ÷ most similar business and recent Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Best practice financiaI modeIIing 1 Ìntroduction 1 Meeting user needs 1 Excel versus modelling 2 Excel set up for efficient modelling 3 Model set up 6 Design 6 Model structure 8 Sheet consistency 15 Using and managing windows in Excel 16 Referencing 18 Relative versus absolute references 18 Naming (cells & ranges) 19 Transpose 24 Formatting 26 Sign convention 26 Colours, size and number formats 27 Styles 30 Conditional formatting 33 Text strings 34 Regional settings 35 ÌF and some other logical functions 36 Common problems with ÌF statements and some simple solutions 38 Nested statements 39 Data retrieval ÷ the LOOKUP school 41 CHOOSE 41 MATCH 42 ÌNDEX 43 OFFSET 47 VLOOKUP 49 HLOOKUP 52 Dates 54 Date formats 54 Date functions 54 Consolidating time periods 56 Switches 60 Two-way switch 60 Multiple options 61 Formality 63 Sensitivity 64 Goal Seek 64 Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Data Tables 65 Validating data 68 Data Validation - with inputs 68 Data Validation ÷ with outputs 70 Conditional formatting 71 Conditional statements 71 The ÌSERROR function 71 Model completion 73 Group outline 73 Protecting the model 73 Report manager 75 Tracking editing changes 76 Historic financials 77 Forecast financials 79 Ensuring balancing balance sheets 79 Setting up the reconciliation 80 Debt modelling 83 The problem 83 A solution 83 Auditing and error detection tools 85 Auditing a formula 85 Finding links 87 The F5 Special 88 Other auditing tips 89 Auditing a model ÷ a process 91 Upon opening 91 Coding clarity index 92 Troubleshooting 94 Appendix 95 Excel tricks 95 Excel function keys 100 Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 1 Best practice financiaI modeIIing Introduction Modelling must, by its very nature, be a simplification of the real world. The outputs are dependent on these simplifying assumptions, and so the most useful models will have the best assumptions. A financial model should represent the business accurately whilst using these simplifying assumptions to make it workable. A good model must be flexible enough to be expanded quickly to meet changing requirements and to deal with 'what if' sensitivity analysis. These notes set out ways in which Excel can be controlled and exploited enabling users to: be faster and more efficient in the use of the Excel tools used in modelling; understand design principles; have a clear method for building reliable, robust and flexible models; be efficient in spotting inconsistencies when auditing other people's financial models; know how to ensure quality in their models; and have a set of tools for analysing and sensitising financial models. The aim is to provide the practical skills to build, modify and audit an integrated and flexible financial model (or modules there from). Meeting user needs The most common complaints about spreadsheet models are: You can't understand your model in 3 month's time; and No-one can ever understand your model. Many of these problems arise because models: are rarely documented; include cumbersome formulae (difficult to understand, check and modify); include wide and/or long spreadsheets; take a long time to calculate due to iterative calculations (eg interest); are made up of purely numbers (a graph can quickly highlight results); have no consistent format; and mix the assumptions, other inputs, workings and outputs. Useful models are those that can be picked up and easily and quickly understood by a reviewer. The more logical, consistent and rigorous the model, the more confidence will be engendered in the results. Best practice financial modelling 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] These notes should help to ensure that your models are not only logical, but can also be reviewed by others with the minimum of effort. ExceI versus modeIIing A Titleist Pro Titanium 905T (9.5 degrees) driver is effectively a long stick with a big lump on the end. Ìt can be used to push a little white ball along a fairway with varying degrees of success. Even those with little golf experience can use it to fulfil its role ÷ i.e. to prod the ball forward. However, in the hands of a master it can be harnessed to stroke the Titleist ProV1x 350 yards with a gentle draw. Excel is a particularly powerful application which can be used to generate, analyse and present both simple and complex data. With little experience it can be used as a glorified, and very useful, calculator. Many users utilise a very small proportion of Excel's enormous functionality, albeit to very great effect. Like any sophisticated tool, when used properly, it can be harnessed so creating highly efficient, interactive and robust financial spreadsheets ÷ if only we had a structure and could think of a practical application for many of the functions. The skills introduced by financial modelling harness the functionality of Excel within a methodical and rigorous financial framework which can be applied to a large number of different applications. Financial modelling, therefore, combines: 1. Financial skills the strategy of the business or project the product, project or industry competitive dynamics and their value-drivers and key sensitivities accounting, analysis, forecasting, structuring and/or valuation techniques 2. Excel functionality knowledge of the mechanics of functions and tools how to practically apply the functions and tools practical limitations of the functions and tools 3. Robust spreadsheet modelling techniques design principles modularity quality controls and diagnostics version control formulae conventions format conventions logical thought data analysis and sensitivity Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 3 ExceI set up for efficient modeIIing Even Ernie Els requires his Titleist Pro Titanium 905T (9.5 degrees) driver be tailored to make it work to his requirements - Right Set Composition: 9.5 Shaft Type: Speeder X (45") Shaft Length: 45" Grip Type: TV58R Grip Size: 2+1 Swing Weight: D6 ÷ so that he can use it most efficiently. Ìn order to use Excel efficiently, it is worth ensuring your profile (where possible) has been amended for the following: Autosave For users of Excel 2003, Autosave will automatically run in the background and so no action is needed. For users of versions earlier than Excel 2003 Autosave should be available on your Tools menu, but if it is not it must be added in. To do this, select Tools, Add-Ìns and you will see the following dialog box. (You may need your programme disks to do this.) Check the Autosave box and press OK. When complete, click on the Tools menu and you will see a new fourth item: Best practice financial modelling 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] To change the settings for AutoSave or switch it off, click on Tools; AutoSave and a simple dialog box will appear. Autosave, like many Microsoft innovations is controversial amongst modellers and a double edged sword. Ìf you follow the saving procedure, then Autosave is a useful tool. Crashes will not worry you and you won't worry either about saving, only to realise that you accidentally deleted a sheet 10 minutes ago. The worst position you will be in will be to lose a morning's work. Most of the time, you will only lose 5-10 minutes. Analysis ToolPak This must be added in the same way as Autosave: Tools; Add-Ìns; tick the Analysis ToolPak box; OK The standard set-up of Excel is fine for most users. However, in some financial models, some more advanced statistical tools and/or date functions are needed. Ìf you are logged into your network at the time of doing this, your profile will be updated so that these advanced functions are available for all future sessions. Note: if the model is to be sent to others, they may not have incorporated this add-in and so some of the calculated formulae may appear as #NAME?. Ìt may be necessary to indicate that the user must go through the add-in routine to ensure the model works effectively. Calculation settings Tools; Options; Calculation tab 1. Ensure the Ìteration box is not selected Ìf this is selected, Excel will iterate any circularities created within the model. Circularities make the model slower to calculate, unstable and more likely to crash. Often circularities within models are created in error or are unnecessary. Whilst the iteration option remains off, any circularities will be flagged (and can be eliminated). Note: if a circularity exists and the iteration option remains off, the calculated numbers in the model cannot be trusted. 2. Select Automatic except tables The model will calculate automatically as the model is modified, but F9 must be pressed whenever Data Tables are to be calculated (see Data Tables later). Grey background The result of this procedure will be that Excel (together with all other applications) will appear on your screen with a grey background. Ìt is merely the screen colour which has changed ÷ the document will continue to print out and be viewed by other users in the same way as before the change. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5 The benefit of such a change is to allow white text to be used in the model - this can be read on the screen (against the grey background) but will print out as white (probably on white paper) and so be invisible. This can be used for row/column counters, checks etc which may otherwise confuse the reader of the printed model. To set the profile to grey: Start; Settings; Control Panel; Display; Appearance (Advanced Appearance on some versions of Windows). [Alternatively: Right mouse on desktop; Properties; Appearance (Advanced Appearance on some versions of Windows).] Select Desktop, Window, and select colour grey. Alternatively, click on the window text area and then alter the colour below to grey. There will be other ways in which you may choose to change your profile as you will see throughout these notes, for example modifying the toolbar to include the auditing toolbar. Click on this area Change this to grey Best practice financial modelling 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] ModeI set up Design Time spent on design is never wasted and you will recoup it many times over while you are building your model and also when you use it in anger. Clear design objectives at the start (which don't change) will let you build a simple and straightforward model which should also be transparent in structure, helping you find mistakes and making it easy to use. The first step is to scope out the model. The following questionnaire aims to help you uncover the key issues which will drive the way you structure your model and which will also determine the user friendliness and flexibility that you will have to build in. The questionnaire is designed for modellers to sit down with the potential users and consumers of the results (are they different people?) and get them to give you the answers to all of the questions. Scope questionnaire 1. Who is the customer, who wants the outputs and why? What are detailed questions the model will be used to answer? What are the important outputs? Ìs there a mandatory or preferred format for them? What are the key decisions which need to be made based on the outputs? 2. What is the nature and form of the input data? How detailed and how good quality will it be? Can you set the format, or get a commitment to format from the input data's author? 3. What is the legal entity or group being modelled? Ìs this uncertain or likely to change? 4. Will the model be published in printed form in a prospectus or similar? Will it be issued to third parties in electronic form? 5. Will the model be formally audited by a third party? 6. What will the role of the model ultimately be? For example; A "one off¨ piece of analysis as part of a larger study; A standard model to be used as a template for analysis; The main forecasting tool to establish the structure and amount of a public finance raising. 7. What are the critical value drivers which will need to be flexed in the model, and what are the key operating links, e.g. working capital/sales? 8. What is the range of structures of company or transaction which will need to be examined by the model? 9. Are timing assumptions likely to change in the model, e.g. do you plan to still be using the model in a year's time when all forecasts will need to start a year later? Ìs the timing of events in the model likely to change, e.g. an acquisition, a divestment, the start of operation of a project? Ìf in doubt assume the worst. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 7 10. What detailed questions will the model answer? Valuation Financing structure optimisation Liquidity planning 11. Will borrowing or holding assets in foreign currencies need to be modelled? 12. Will there be large changes in the level of debt? 13. Will there be significant seasonality in cash flows or revenues? 14. What will be the inflationary environment of the company being modelled; will real and nominal forecasts be required? The questions regarding objectives are useful to have answers to so that you can do your job in the clear understanding of the levels of usability and professional polish that your model needs. Questions 7-14 are very important, because these are the typical issues of "detail¨ which won't be discussed at an early stage, but which will have a fundamental impact on design approach. Ìt will be difficult to bring these issues into a model which is already well developed. Again planning and providing for a particular development from the start will make a model easier to work with throughout its life. Standard models A model is inevitably a very specific answer to a set of very specific questions. A line of thought that occurs at some stage to anyone involved regularly in modelling is: "A good standard model will simplify my life and instead of building models Ì can focus on analysis.¨ This is perfectly reasonable, but this strategy has practical shortcomings which we must be comfortable with. What we do in creating a standard model is to constrain our analysis. We always make the same implicit assumptions; treat companies/projects/data in the same way; and make the same approximations. Because we don't always want to look at companies/transactions in the same way or because some companies/transactions are very different, our standard models tend to develop in two ways: 1. They become very simple. The result being that we do the analysis largely outside the model and use only a small number of key variables to get our results. The model performs limited analysis and helps us in a limited way with our decision-making. What a good model should do is give integrated and consistent analysis from which we can make decisions. 2. They become complex with lots of flexibility, alternative inputs and calculation sections which we can use as necessary. Best practice financial modelling 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Large, complex models can become unwieldy and, if the users are not trained or don't regularly use all parts, sections fall into disuse because people don't understand them, don't trust them or just don't know what they do. Most modelling groups have one of these "All singing all dancing models¨ and they are often forsaken, not because of any quality problems but because of lack of confidence on the part of users and lack of familiarity. Clear, specific objectives supported by documentation and training is very important for the success of a standard model. For a standard model of any complexity, documentation and training are essential. For any standard model to be accepted the analysis it does and the outputs it produces must be relevant to the decisions to be made by users. This means consultation and clear design scope. ModeI structure The structure of your model will be a function of the results of your earlier work in understanding the modelling needs. Ìn particular, you will have determined the output desired, the level of detail required and the degree of flexibility necessary for a successful model. Good model design has a logical structure in which different modules are separated into separate sheets in a workbook. A standardised rule-book for the creation of the various sheets will aid easy construction and review. The most common structure for financial models is Assumptions; Process; Results: i.e. inputs followed by workings followed by outputs. However, no matter what kind of model you are building, it should have a further three elements giving a minimum structure of six key building blocks: 1. Log sheet; 2. Description sheet; 3. Checks sheet; 4. Assumptions (or input) sheet(s); 5. Workings sheet(s); and 6. Output sheet(s). By creating separate sheets for each of the building blocks of the model, you allow a reviewer to build up their knowledge of the model step-by-step: model genesis, model description, checks, assumptions, process and results. Ìt aids clarity of thought and is easier to maintain, view and print. The twin disadvantages of lengthier formulas and file size are more than outweighed by these advantages. 1. Log sheet Two problems assail every modeller: having different "current¨ copies of the same model; and only having one copy of the model. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 9 Working on the move, at home, on laptops or at clients' offices gives rise to various copies, all with the same name and perhaps with only minor, but significant differences between them. Ìt is very easy in such circumstances, particularly when you are under pressure, to end up wasting time trying to figure out which is the latest version. Put down your model for a week and your problem is you will spend even more time doing this. Keeping only one copy can give problems which are more fundamental. Crashing computers which corrupt your model, bad design or changing design needs may leave you wishing you could go back a day or two to get back to an undamaged copy to avoid unpicking the work you now regret. Ìf you only keep one model, then at best you will one day find yourself praying, perhaps begging and perhaps even being nice to the ÌT Help-desk as you try desperately to get a copy of last week's model from the tape back up. Ìt is at this time that you will probably discover that tape back up is often virtual rather than real. A common practice amongst modellers is to keep a log sheet in each model and to adopt a rigorous saving procedure. A typical log sheet looks like this: Best practice financial modelling 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Saving procedure The log sheet is maintained as part of a saving procedure. 1. When commencing a development session where you will be editing the model, on opening the model, record the name of it in the log sheet on a new line, make some quick notes of what you are planning to do to it and before you commence work, save the model with a new name and use sequential (or date) naming, i.e. give each draft a reference number but otherwise keep the name the same. 2. Switch on Autosave, but leave the prompt checked so that Excel only saves when you want rather than when it wants to. For users of Excel 2003, Autosave will automatically run in the background. 3. Regularly save your material when you are happy with the alterations you have made and keep a record in the log sheet of your work. 4. At a milestone in development, or when you start another session go back to step 1 and start the saving routine again. Although the procedure may seem like a chore, it will significantly improve the simplicity of your job: as well as giving you a clear idea all the time of where you are in development, if you reconsider design or have to make important changes/throw out part of the structure, the log sheet will give you another clear option, i.e. to go back to an older version and start again, instead of "unpicking¨ unwanted code out of your model. 2. Description sheet How often have you picked up a model which opens up in cell BD4765 on sheet 15 and then had to try to work out what is happening. A properly documented model will make this task much easier. Ìt is useful to have a separate worksheet with instructions on how to run the model. This will allow other users to understand how to operate the model, especially when additional or non- conventional procedures are needed to make the model work correctly. Common errors and their solutions should also form a part of this sheet. The genesis of the model can be reviewed by looking at the log sheet (see above) and the checks sheet (see below) should be reviewed in order to verify that there are no red flags. However, additional assistance can be derived from a description sheet containing the following: Description of the proposed transaction / analysis This brief description should: describe the purposes of the model identify the key assumptions and where they are to be found identify the key outputs give instructions as to how to run the model When done properly, this will help set the context for the model and so make it easier to use. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 11 Ìmplicit assumptions/presumptions Certain preconditions exist within each model which may be obvious to the modeller but unknown to subsequent users (e.g. that all cash flows arise at the end of each period; or the model is not time flexible). These implicit assumptions limit the scope of the model and so should be briefly set out on the description sheet Model flow For more complex models, a description of the links within the model (and, better still, flow diagrams) will help users understand the structure of the model and make review and auditing easier. Author / checker By giving details of those who have worked on the model ownership is assigned. Additionally, the name and contact details of the author (and the date of their last efforts) may be useful if questions need to be asked. Ìf the model has been reviewed, similar details for the checker gives a second port of call. Additionally, adding explanatory notes into the model allows other users of the model to understand aspects such as assumptions, formulae etc. that may be neither obvious nor commonly used. Sometimes it may also be useful to explain anything that you would like to be highlighted within the model. Try to keep the explanatory notes up to date as you build the model since it can be hard to remember what you've done when you're nearing the completion of the model. 3. Checks sheet When the model goes wrong Ì want to know about it. Similarly, it would be unprofessional / embarrassing to print / send out a model with errors. To help in quickly identifying these problems a checks area is used. All diagnostic checks from the model are housed in this part of the model. For larger models with significant checks, this will form a sheet in its own right. For smaller models, this may be housed on the output or description sheet ÷ an example of which appears below. Best practice financial modelling 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 4. Inputs & assumptions Keeping all of the inputs and assumptions (i.e. the model drivers) in one place is an essential element to any model. The user needs to be confident that they can control the model from this single assumptions section. Having inputs dotted throughout the model adds to the complexity of using and reviewing the model. Additionally, there are some Excel tools which require like items to be grouped on the same sheet. The most common of these is the Data Table which is used to check the sensitivities of key assumptions to key outputs. Data Tables can only be created on the same sheet as the assumptions. The exception to this idea of keeping all of the inputs in one place is historic (financial) figures. Although inputs should go on the inputs page, historic financials are facts rather than assumptions driving future value, and so it is reasonable to put them on the appropriate sheets (i.e. P&L historics on P&L sheet). ControI paneI Having a separate assumptions sheet (or sheets) is good discipline in any model and a logical development of it is to integrate a control panel into it. A control panel is simply an area of the assumptions sheet (or sheets) where all of the switches, list boxes and other controls which are used to select scenarios and pick particular calculation bases are placed. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 13 Ìt is not unusual for some of the key outputs from the model to be linked back to the control panel area, so that the impact of changing switches or scenarios can be seen immediately. The fundamental design issue here is that once the model is built we want it to be easy to use, and that means that we want it to be easy to input data and to see the results changing as we do that. The following is an example of a control panel on an assumptions sheet from a simple model (no outputs are linked to this control panel in the illustration): Ìn this case there are relatively few controls as the model is quite simple - there is a scenario selector for the debt structure and a switch to allow the valuation basis to be changed from EBÌTDA multiple to perpetuity. 5. Workings The workings (like the outputs) are merely calculations based on the inputs and other workings. They are most easily built up on a modular basis and for navigation purposes it is easier if each module is located on a separate sheet. For example, capital expenditure, depreciation and book value calculations are inter-dependent and should, therefore, be together on one sheet. Some common best practice rules for all components of workings are: Never use hard-wired (input) numbers within formulae. Permitted exceptions are: 1 and 0 ÷ used as flags in ÌF statements, and for starting row and column counters 100 ÷ if using £ and p, $ and c, C and c etc Best practice financial modelling 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 12 and 7 ÷ there will always be 12 months in a calendar year and 7 days in a week (my understanding is that there are not always 360 or 365 days in a year nor 30 days in a month) The rule of two-thirds: if the formula takes up more than 2/3 of the formula bar, then it is too long We are not short of cells in a worksheet: 256 cells wide and 65,536 cells deep - over 16.7 million cells to play with per sheet Breaking down long formulae into several steps makes them easier to understand and edit Where possible, use logical operators (AND, OR, etc.) rather than nested ÌF functions Use flags (e.g. for dates, event triggers) where possible to shorten formulae Avoid the macho The shortest formula is often, though not always, the best. '=MAX(0,D16)' and '=ÌF(D16<0,0,D16)' do exactly the same thing. However, the first belongs to the macho school of modelling (adopt a clever formula whenever possible), whilst the second is widely understood Develop a consistent sign convention across all workings Ìnsert notes/comments where it may not be obvious what the logic is (for easy review) Do not create circular references They slow down calculations and may cause Excel to crash Results depend on Excel settings (in the Tools; Options; Calculations menu), i.e., maximum iterations and maximum change Once a circular reference has been created, it is very easy to add further circular references without being aware of it They can always be avoided with more careful formulation or automated goal seeks. However, in the interests of time you may be able to tolerate it if you close the circularity whilst editing the model (for example by having some sort of switch) (see later) Shade areas in different colours for ease of navigation (some sheets may be large) Row consistency: where possible, avoid changing formulae across a single row (see F5- Special later) Try to keep to one row / one formula Ìf unavoidable, highlight the non-standard cells A reviewer needs to be confident that there are no hidden fixes in individual cells Format consistency: consistent number styles (see Styles later) and sheet set-up (see Sheet consistency later) enables quick interpretation of the results Only name those ranges/cells that will be used away from the near vicinity (see Names later) Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 15 6. Outputs Depending on the size of the model, the outputs may be the same as the workings or, more often, a summary of the workings (and inputs). Here, format matters. Outputs should require little calculation other than totals The most important figures (e.g. debt service coverage, NPV etc) should be formatted to give them the importance they deserve Pictures speak a thousand words - diagrams and charts often clarify the results and flows better than pure numbers Text strings may be useful to put the output numbers into meaningful sentences Sheet consistency The more consistent the format (colours, numbers, columns, titles, headings, footers, views, etc) between sheets, the easier the construction and review. Hence a lot of the formatting of the entire model can (and should) be done up front. There are two methods to arrive at the same result of consistent formatting throughout the model: group the sheets and format them all together; or set up one sheet and then copy it the requisite number of times. The first method could be dangerous as data on other sheets may be overwritten, whilst the second method is slightly more fiddly when trying to get the correct number of properly named sheets. When used with the care, the first group edit option is the more straightforward. The steps 1. Assess how many sheets are needed (and add one ÷ it can always be removed) The easiest way is to name each sheet that you think you will need Use abbreviated sheet names ÷ the shortest name that is understandable it is very useful to be able to see all of the sheet tabs at once short sheet names make shorter cell addresses when used across sheets ÷ making formulae shorter and easier to interpret 2. Select all sheets to do consistent formatting (to set up group editing) Control-Shift-Page Down; or Right mouse on a sheet tab - Select All Sheets 3. Size the columns Column A (small); Column B (small); Column C (big) Natural indents for ease of reading text/headings To allow sufficient "space¨ should it be needed Column D (very small) For check digits Allows the data to be selected more efficiently if there is a natural break Best practice financial modelling 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Makes naming ranges easier Enables creation of consistent formulae on corkscrews Put in all the years (and currency) - i.e. column headings Column E is the 1st period and then copy the sequence across all relevant columns Only if a period (eg y/e31/8/07) is in the same column in every sheet throughout the model can the range name tool be used effectively Leave a blank column at the end of the final period (make it small) Allows easy insertion of further periods if they are subsequently needed Allows the data to be selected more efficiently if there is a natural break The final column after the blank will be used for recording range names 4. Fit the spreadsheet to the appropriate size Highlight the next column (after the range names column); and then Control-Shift-(selects the remaining columns on the sheet); Format; Column; Hide (or right mouse followed by H) (hides all the highlighted columns) 5. Formatting numbers and text (see Formatting later) ÷ if Styles are to be used, then this can be done following the group edit phase 6. Print set-up (so it is ready to go from the start) Landscape or portrait? Default margins are often too large Headers & footers to include file name (and location if using Excel 2003); sheet name; date and time; and page of page (page &[Page] of &[Pages]) Print titles (probably the periods) ÷ will have to be done outside of the group edit Remove the gridlines Using and managing windows in ExceI Using more than one window When reviewing a model it is often useful to be able to see two parts of the model simultaneously. This can be achieved by opening a second window and viewing both of them at the same time. Ìn this way, as we make changes in one part of the model, we can look at the impact of those changes in a completely different and, possibly, distant part of the model. With the current model visible: select Window; New Window ÷ there are now 2 windows open, both looking onto the same file ÷ Filename.xls:1 and Filename.xls:2 To see them simultaneously, select Window; Arrange; Horizontal (or vertical or cascade) and ensure 'Windows of active workbook' is checked Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 17 Amending either window will update the model in the normal way. When 2 windows are no longer required, one of them (preferably the new window opened) can be closed and the original version will still be open. Switching between windows is very straightforward: through the Window menu by selecting the relevant window from the list, or by using the shortcuts Ctrl÷F6 or Ctrl÷Tab. Using this shortcut repeatedly will take you consecutively from one window to another window. Freezing panes The Window Freeze Panes command "freezes¨ the rows and columns above and to the right of the selected cells. This is very useful as it results in the row and column titles always being visible on the screen. Ìn this case, the freeze panes command was used in cell C4. Best practice financial modelling 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Referencing ReIative versus absoIute references Excel calculates in terms of the relative position of an item ÷ i.e. cell C4 is 3 columns and 4 rows into the sheet. Fortunately, to ease interpretation, the references in Excel use the column letter and row number address (i.e. C4). A B C D E 1 147 852 654 2 741 951 357 3 753 258 456 4 5 6 7 Ìf we placed the formula '=A1' in cell C4 this is interpreted by Excel as entering the value from 3 cells above and 2 columns to the left, i.e. 147 from cell A1. Ìf we copy the formula in C4 to: D4, we are still trying to pick up the value from 3 cells above and 2 columns to the left (of D4 this time) ÷ i.e. 852 from B1 C6, we are still trying to pick up the value from 3 cells above and 2 columns to the left (of C6 this time) ÷ i.e. 753 from A3 By default Excel works in this relative way. F4 - absolute referencing 'Dollarising' the cell reference in a formula (press F4 whilst the cell reference is input or edited) will add dollars to a reference. Ìf we placed the formula "=$A$1¨ in cell C4 this fixes the address as always column A and always row 1. This is still interpreted by Excel as the 147 from cell A1. However, if we copy the formula in C4 to: D4, we are still trying to pick up the value from column A and row 1 ÷ i.e. 147 C6, we are still trying to pick up the value from column A and row 1 ÷ i.e. 147 Alternatively we can partly dollarise or fix the reference. When entering or editing a formula, pressing F4 repeatedly will toggle through the fixing options. $A1 fixes the column A with the row number remaining relative A$1 fixes the row 1 with the column remaining relative. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 19 A rule of thumb: if you are trying to fix a reference to a cell which is to the side of your formula ÷ the $ is to the side above or below your formula ÷ the $ is in the middle Naming (ceIIs & ranges) Cells and ranges can be named ÷ that is, they can be referenced in terms of a name rather than its column and row position within the model. A name may only be defined once per sheet ÷ i.e. the name relates to a unique cell or range on that sheet. However, the same name can be defined across different sheets, eg 3 different cells named TaxRate can be created as cell E30 on Sheet 1; as E45 on Sheet 2; and as F10 on Sheet 5. F3 is the function key which triggers most of the functionality, i.e. the third function key. This indicates that Microsoft thinks that the use of names is only behind Help and formula editing (F1 and F2 respectively) as functions which are important to the smooth running of Excel. Why name? 1. CIarity and speed Using the F4 dollarising option is quick and widely understood and so has its advantages. However, where the cell or cell-range is to be used in calculations: On a number of occasions At a distance from where it is situated On different sheets Ìn different models As part of a complex formula or function Within a macro then naming the cell or cell-range is a better solution. Applying a name to a cell or range can make model construction and review quicker and easier. 2. Auditing As we will see, all the auditing tools work in exactly the same way for both cell references and names. However, if names are used then additional auditing approaches can be introduced. 3. FunctionaIity Additionally, Excel was created with the intention that names would be used. Consequently, some functions require the use of names, particularly across sheets (e.g. conditional formatting and data validation). Best practice financial modelling 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Creating names There are a number of ways to name cells or ranges. The following are the two most widely used. 1. Insert; Name; Create The Name Create command uses labels at the end of a range, or beside a cell, to name the range or cell respectively. By using this standard referencing approach and formatting these labels (red, italic) the named cells and ranges are clearly identified. This can be automated: 1. Type the name to the right (we suggest) of the cell or range you wish to name. 2. Highlight the cell containing the name that you have typed in; 3. Control-Shift- this will highlight all the cells, which may just be one, with contents to the left of the name; 4. Control-Shift-F3 - should see the following dialog box: 5. Check the Right column box (Excel may have already checked it); 6. Press Return. The real value of this function is that all of the row ranges in a sheet can be named simultaneously by highlighting all required ranges or cells and the cells containing their names and then following the above steps. Ìf the name is typed to the Right of the cell or range, ensure only Right column is checked. 2. Quick and dirty 1. Highlight the range or cell to be named; 2. Click in the name box at the top left; 3. Type in the name (with no spaces); and 4. Press Return. To check the name just click on the down arrow by the name box and the names which have been defined in your model will be listed. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 21 The Ctrl-Shift-F3 method has a formality to the method (so reducing modelling errors) and visibly identifies the named cells and ranges immediately to the right (so helping use and review). However it cannot be used for two-dimensional ranges, which is where this second method proves useful. Changing or 'stretching" a range which has already got a name Where a row of data for a number of periods is to be named, leave a blank cell between the data and the name and follow the Ctrl-Shift-F3 naming procedure. This allows additional periods to be added (as per best practice model set-up procedures) with the named range automatically extending as new periods are inserted. However, it is not unusual to want to extend a range after it has already been created. Ìf the above has not been done or a two-dimensional data range is to be changed, the only practical way to do this, without deleting the name and recreating it, is as follows: Ìnsert; Name; Define (or Ctrl-F3); Select the name from the list which you want to attach to the new or stretched range; Press the browse button . Excel will display and highlight the range that is attached to the name. Now click and drag to highlight the new range you want to attach. Press the finish selection button , you will now return to the Define Name dialog box; Click on the Add button. This overwrites the old definition of the name and range with the new one you have just selected. Using names Names can be used in formulae in the same way as other references. To use a name in a formula: Click on the named cell; or Type in the name (it is not case sensitive); or Press F3 and the names listed alphabetically will be available for selection. When a cell name is used, it is used as an absolute reference ÷ as if it were fully dollarised. Name box This is the range which will be called "RatesÌn¨ Best practice financial modelling 22 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] When a range name relating to a row of data is used in a particular cell, the data, within the range which is in the same column as the particular cell, will be returned. For example, if the range named "Sales¨ is defined on Sheet1 as E6:N6 and if the formula in cell G72 on any sheet is "=Sales¨, the value returned will be that from column G in the named range (i.e. cell G6 on Sheet1). A typical spreadsheet will look like this (Note, only those ranges which will be used extensively elsewhere on the model have been named): Pasting the Iist of names This feature is used to create a checklist of all the names and the number of names used within the model by listing the names and their location. Select the place where the first name is to be listed and then Ìnsert; Name; Paste; Paste List; or F3, Paste List The names will be in the first column and the location will be in the next column. Cell K28 is easy to review due to the use of names Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 23 When to use a name Naming rules Don't name everything Despite all the advantages of naming cells and ranges, too many names cloud the model (a list of 237 names is not easy to use or review). Only name those cells or ranges which will be used extensively and at some distance from their current location ÷ be systematic but not out of control. Range names - aII sheets must be consistent Ìf rows of data are named, Excel interprets the reference in subsequent formulae in relation to the columns. As we have seen, if the range named "Sales¨ is defined on Sheet1 as E6:N6 and if the formula in cell G72 on any sheet is "=Sales¨, the value in this cell will be that from column G in the named range (i.e. cell G6 on Sheet1). Where range names are used, all sheets must be consistent ÷ column G in the source sheet must relate to the same time period, for example, as on the target sheet. Ìf new columns are to be added on any sheet, then they must be added to all sheets in order to allow named ranges to be used. Naming conventions The name labels should be formatted as Red and Ìtalic and should lie directly to the right of the cell or range to which it relates. The shorter the name the better ÷ as long as it is understandable to the user and reviewer. Avoid spaces ÷ Excel will interpret these as "_¨ making unwieldy names such as Costs_gas_in rather than the more refined CostsGasÌn (i.e. capital letters can be used to separate words instead). CostsGas, PriceGas, DepnTax, etc - i.e. begin name by category or by most important word first for ease of use later. CostsTot is better than TotCosts ÷ otherwise searching for total costs may require trawling through 30 names in the list starting with total. WkCapÌncr is better than WkCapChange ÷ it is easier to understand the sign convention: a positive number must be an increase. Those on the inputs page should end with "Ìn¨, e.g. CostsGasÌn, PriceGasÌn, etc for ease of review. Don't over-engineer A name should be used in a formula when it is helpful and not too onerous to do so. For example, if sales is calculated as a function of three names and EBÌTDA is calculated as a (named) percentage of sales, it would be over-engineered to calculate the EBÌTDA Best practice financial modelling 24 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] based on four names rather than the more straightforward named percentage x (the previously calculated) sales. Subtotals on workings and outputs can be calculated in two ways - by reference to a (possibly named) cell elsewhere in the model or by summing the nearby cells. The latter method is the preferred route as this checks that the current region is populated with only appropriate values - particularly important on outputs. For example, if EBÌTDA has been calculated in a working (as above) and is then used as part of the income statement ÷ the EBÌTDA on the income statement should be re-calculated using the details on the income statement (sales less costs) rather than referred back to the original working. The MAX MIN issue When the MAX and MÌN functions are being used with named ranges, the maximum (or minimum) number in the range is returned rather than those relative to the column we are interested in. This is avoided by including a + sign in front of the named range when coding the formula. For example: =MAX(+PAT,+RetainedProfits) Copying to other modeIs As long as the inputs to the tax sheet, for example, are defined in the destination model (i.e. using the same names) then the tax workings sheet can be easily inserted into the destination model. Click right mouse button on the tax sheet's tab in the source model Move or Copy Define the destination model Check the copy box This can be useful, but can also cause problems if there is not complete rigour in naming ÷ the more rigour incorporated in naming and model set-up, the easier the copying of modules between models. Transpose Occasionally numbers appear horizontally in a row when it would be useful to have them vertically in a column or vice versa. Ìf these are numbers (rather than formulae), then the solution is straightforward: Copy the relevant range Go to the first of the cells where the range is to be copied to Edit, Paste Special, Transpose The transpose function can be combined with other functions in paste special. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 25 More likely, the range to be transposed is made up of formulae. The paste special transpose will only be suitable if all formulae contain only constants and absolute references (i.e. named cells or cells of the type $D$4). Where more complex formulae exist which have relative references, the TRANSPOSE function can be used. For example, it would be useful to show the formulae from the range D3:J3 vertically in D10:D16 Count the numbers of cells in the range to be copied (7) Select the cells in the range to be copied to (D10:D16) Type: =TRANSPOSE(D3:J3) Press Control-Shift-Enter By pressing Control-Shift-Enter, you have created an array (as shown by the { } around the equation). Deleting the whole array rather than any one individual cell is the only way to modify this. Best practice financial modelling 26 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Formatting Some formats and formatting conventions (for example, outputs) will be pre-defined to adhere to corporate templates which will have their own logic. The more logical and consistent all formats, the easier the model is to use and review. Sign convention Choose a sign convention, stick with it and explain it. Negatives are difficult to work with and you may find it easier to avoid them. All inputs and workings should therefore be positive, unless they are unusual. For example, interest in the income statement is mostly an expense but should be entered and calculated as a positive. To ensure that this is clearly understood it is necessary to describe the line as "Net interest expense (income)¨. Ìn this way, the user of the model understands that a positive number refers to an expense whilst a negative implies net interest income. The downside to this is that users misunderstand the sign convention (through not reading the description carefully) and the simple =Sum() calculations may not be possible. The major advantage is that the logic of the model is uncluttered by thoughts of sign convention ÷ everything is positive. The exceptions Outputs This may be governed by the corporate style rules. Ordinarily the sign convention on the outputs is the one which is most easily understood by the reviewer. Ìf it is easier to understand an income statement if expenses are negatives, then expenses should be negatives. Specifics Some workings, for example cash flows, may be easier to work with if the sign convention follows the cash flows. An increase in working capital will reduce cash flow ÷ trying to explain this in words as "Decrease (increase) in working capital¨ may prove cumbersome whereas having the increase as a negative (and all other cash flows following this convention) is likely to be easier. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 27 CoIours, size and number formats Text & data Feature Setting Justification Size Default ÷ probably 8 point Change the view settings if this is too small on the screen Anything smaller than 8 point will default to Times New Roman when pasted into other applications Ìf elements are to be pasted into other applications such as PowerPoint, it is easier to expand than contract the selection once it is in PowerPoint. For example, a sheet using 14 point when pasted into PowerPoint may miss some data. When using 8 point, more data can be trapped (and dragged to expand if needed) Ìnputs Blue text, pale yellow background and underlined To stand out ÷ underlining stands out even if printed in black and white Names Red and italic To stand out Workings sheets Different backgrounds to highlight different sections and summaries To help navigation Totals, sub- totals Bold, italic, borders - use sparingly Used to emphasise Headings & outputs To highlight key rows, columns and cells Format is a personal / corporate decision Everything else Default settings So that all outputs and inputs stand out Numbers Number Format Comments Decimal points & commas 12,345.6 Align with negatives Negatives (12,345.6) Bracket (parenthesis) stands out more than a minus sign Zeros - Stands out more in a list of figures than 0.0 Unfortunately, rounding errors will still appear as 0.0 which may be misleading Thousands & millions May take out the 000s and millions Ìn the outputs only Best practice financial modelling 28 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Formatting numbers To format the numbers: Format; Cells; Custom; or Control-1; Custom The sections, separated by semi-colons, define the formats (in order) for: 1. Positive numbers; 2. Negative numbers; 3. Zero values; and 4. Text. Ìf you specify less than 4 sections then the text will have a standard format. e.g. Format for positive Format for zeros #,##0.0_);[Red](#,##0.0);-??_) Format of negatives # displays only significant digits; does not display insignificant zeros. 0 displays insignificant zeros if a number has fewer digits than there are zeros in the format. [the above would show 1234.56 as 1,234.6; .123456 as 0.1; and 0.0 as -] , adds a comma to separate 000s. Additionally, it can scale a number by a multiple of one thousand (useful for the output sheets) e.g. 1234567890 as 1,234,567,890.0 #,##0.0 1234567890 as 1,234,567.9 #,##0.0, 1234567890 as 1,234.6 #,##0.0,, 1234567890 as 1,234.6m #,##0.0,,¨m¨ _ aligns the numbers with the character following the underscore. For example, when an underscore is followed by a closing parenthesis " _)¨, positive numbers line up correctly with negative numbers that are enclosed in parentheses. ? adds a space a character wide ÷ used to indent (normally from the right) * put at the front, a format will add the next character to fill the cell. e.g. 123 as -------123.0 *-0.0 Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 29 [Red] also available in black, blue, cyan, green, magenta, white and yellow. Only used for outputs as may undermine default colour conventions. (See later for date formats.) Numbers (with text for presentation) Sometimes it is useful for a number to be followed by the units, e.g. p, years, cents, x. For example, if an input in a model is the number of years on which a valuation is to be based, the number of years can be entered, say 7, and it will appear in the cell as '7 years'. As before, Control-1; Custom, choose the number format (e.g. 0) and then leave a space followed by "years¨ - i.e. 0 "years¨ Combined with knowledge of other number formatting rules, this can be very useful. For example, Ìf a company has a price per share of 36.50 and an earnings per share of ÷1.25 and 3.30 in year 1 and 2 respectively, its P/E ratio (price ÷ earnings) can be easily calculated. The results are ÷29.2 and 11.0606 for years 1 and 2 respectively. The result in year 2 should appear as 11.1x (format "0.0x¨), whilst that for year 1 is not meaningful or "nm¨ ÷ all negative results from such an equation are not meaningful. Armed with this the following number format can be applied to the P/E cells: Format for positive Format for negative 0.0x_);"nm ¨ Note that the "nm ¨ has a space at the end to align it with the positive. White text Ìt will often be necessary to use white text where certain cells are not to be part of the presentation. Not only can this be done using conditional formatting, where data is to be hidden on the output pages if certain conditions are fulfilled (i.e. through conditional formatting), but also there will be cells used as counters (maybe linked to switches or as part of VLOOKUP or ÌNDEX) which you do not want to be part of any presentation. For these cells select the white font. The main problem now is that with a white background, these cells cannot be seen. Ìt is therefore recommended that the background be altered to grey: ÷ see Excel set-up earlier in the notes. Best practice financial modelling 30 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] StyIes The use of styles within Excel, as within Word, enables quick and easy changing of all the formats within the whole model. Headings, dates, subtotals, percentages and others can be selected (and globally modified) quickly. At set-up it is worth defining the styles (i.e. the formats) that may be used in the current model ÷ consequently, formatting need only be done once and then quickly and easily applied elsewhere. For example, it is often worth having the font size as 8 pt for easy transfer to presentations. By defining styles up front the default can be changed for the whole model. As within Word, to apply a defined style ÷ use the styles drop-down box for the selected cell(s). Adding styles to the toolbar Ìn order to use styles efficiently, add the styles drop-down box to the toolbar ÷ the style in use will then be listed. The Styles drop-down box should be added to the toolbar Tools; Customize; Commands ÷ The Style drop-down box is part of the Formats category Drag the drop-down box into the toolbar Once the drop-down box has been placed in the toolbar it can be accessed by Alt ' followed by Alt + either the up or down arrow key to scroll through the styles. The Style drop-down box in the The Style drop- down box to drag to the toolbar Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 31 To change / add a style The Comma, Currency and Percent styles exist by default in Excel to support the corresponding toolbar buttons and should not be deleted. Additionally, the default setting for all cells is Normal. 1. To change, for example, Normal: Format; Style ÷ Normal should appear in the Style name box Modify ÷ after which the normal Format Cells dialogue box appears Format, as required, the Number format (e.g. #,##0.0_);(#,##0.0);-_) Alignment (e.g. vertically Center (sic) Aligned) Font (e.g. Automatic, Arial 8) Select Add and then OK The formats of all (previously unformatted) cells within the model will change to this new default normal. 2. Ìf you wish to create a format, e.g. dates, to be used as a standard to be applied elsewhere: Format; Style Ìn the Style name box, type a name for the new style ÷ e.g. "Dates¨ (without the quotation marks) Modify On any of the tabs in the dialog box, select the formats you want, and then click OK ÷ e.g. number to custom "dd-mmm-yy¨ (without the quotation marks) etc To define and apply the style to the selected cells, click OK To define the style but not apply it to the selected cell, click Add, and then click Close. 3. Ìf you wish to choose the format of a particular, previously formatted, cell, e.g. a multiple, as a standard to be applied elsewhere: Ìn the Style drop down box type in the name ÷ eg "Multiple¨ ÷ and press Enter Number format selected Styles drop- down box Best practice financial modelling 32 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Alternatively: Format; Style Ìn the Style name box, type a name for the new style - e.g. "Multiple¨ (without the quotation marks) To define the style, click Add, and then click Close. To check the boxes or not A cell can have more than one style applied to it. As a result, a cell may have the Dates style applied and then another style laid on top ÷ where there are any conflicts in styles the second style will take precedence. For example in the following, the Dates style has been defined using only Number format. All other Cell formats in the Dates style have not been defined. Cells E3, F3 and E8 have this format. Ìnput cells should be differentiated from calculation cells by format (and protection) and so an input style should be defined. As there are likely to be a number of different input types it is useful to have the common features of an input style superimposed onto other styles. For example, cell E8 is both a date and input: Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 33 As the number format in the Ìnput style is not defined it will follow the previously selected number format for all cells. The components of the Ìnput style which are applied are: Font ÷ Underlined, Blue Patterns ÷ Pale yellow background Protection ÷ No protection As the Date and Ìnput styles do not conflict, cell E8 therefore has both styles applied. Copy styles from another workbook Once you have taken the time to define a set of styles in a model, these can be used as the template for future models. Open the model that contains the styles you want to copy; Open the model in which you want to insert the styles, and then click Style on the Format menu; Merge; Double-click the workbook that contains the styles you want to copy. To replace the styles in the active workbook with the copied styles, click Yes. To keep the styles in the active workbook, click No. This warning occurs only once, regardless of the number of conflicting style names. CoIour Note, the colour template used on the source document may be different to that in the destination file ÷ so that when styles are merged, the text, borders and background colours are not as required. To apply the colours from the source document, ensure that both models are open and in the destination model: Tools, Options, Color; Ìn the "Copy colors from¨ box select the workbook that contains the colours you want to copy; OK. Ìn this way a template model with all necessary styles and colours can be easily created (and updated) for quick merging into all future models. ConditionaI formatting Conditional formatting applies a defined format to cells which fulfil a condition. To conditionally format the numbers (for example, where a negative result should not be possible, or should be flagged, or where a balance sheet doesn't balance) Format; Conditional Formatting The more obvious the formatting (size, colour etc) the more useful the result. Best practice financial modelling 34 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] There are two condition (logical argument) options: Cell Value Ìs the value of the current cell fulfils the criteria Formula Ìs the result of the formula (which may not refer to the current cell) fulfils the criteria Conditional formatting to hide cells There will be occasions where it will be useful for cells to be hidden. For example, if a discounted cash flow (DCF) valuation model has been set up for a maximum of 10 years, but 7 years has been input as the project length (named "length¨), from a presentation perspective, it would be good to hide the 3 years which are now not part of the output. (Ìt is assumed that there is appropriate coding to calculate the valuation based on 7 years!). Ìf the year counters are in row 2 with column D containing the first period, go to Format; Conditional Formatting; enter the appropriate formula (essentially the logical test of an ÌF statement); then choose Format and select white font and no borders from the menus. Text strings Text strings allow phrases, sentences, labels and headings within a model to be automatically updated for changes in assumptions or outputs. For example, it may be useful to have a standard header in B2 with the company name (Bigco defined in cell E5) and currency (Cm defined in cell E6) ÷ both of which are inputs which may change. The ampersand [&] is the key to linking different bits of text: The formula in B2 =E5&" in "&E6 results in Bigco in Cm Ìn the above example, there are three bits of text (the company name, the word "in¨ with spaces around it and the currency) each connected using the ampersand. The TEXT function Text and numbers which use the default format settings can be linked with the use of the ampersand. However, where numbers form part of the text string, they may need to be formatted. This is when the TEXT function needs to be added to the text string. To have white text, click on the Format button and change the font colour to white. Also click on the Borders tab and click on the 'No borders button'. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 35 For instance, a model may be titled "Year ended 31 December 2006". Assumptions within the model may change the year-end which has been defined in cell G4. Without a text string, whenever the date in G4 changes the model will have to be updated cell by cell, a tedious task! Alternatively, the text can be coded as: ="Year ended "&TEXT(G4,"dd mmmm yyyy"). The TEXT function picks up cell G4 (assumed to contain the year-end information) and then formats the number contained within this cell into the date format dd mmmm yyyy (which must be put within quotation marks). Similar things can be done for multiples [=TEXT(G6,"0.0x;¨nm "¨)] and percentages [=TEXT(G7,"0.0%;(0.0%)¨)] etc. Note that where more than one format is to be chosen in a TEXT function (for positives and negatives), they must be separated by a semi-colon within the format text part of the function. RegionaI settings To change/view your profile for regional settings: Start; Settings; Control Panel; Regional and language options; Regional options This is a profile setting rather than merely an Excel setting ÷ it has applicability across all applications. Often there are company policies on regional settings ÷ all staff in all locations have the same regional setting, e.g. English (United States). However, it may be useful from time to time to alter this for local language, currency and formatting idiosyncrasies. Where a cell is formatted using the number formats and the users regional settings are English (United Kingdom) then the language (d for day, m for month, etc) and settings (e.g. commas as thousand dividers, etc) will be used. Ìf the model is then passed onto someone with a French (France) regional setting, then the language (j for day, m for month, etc) and settings (space as thousand dividers, etc) will automatically update even if formats have been customised. However, the regional settings do not update the formats contained within a TEXT function. The result is that Excel is unable to interpret the TEXT function. Care must be taken when using the TEXT function if it is likely that a model will be accessed by users with different regional settings. Best practice financial modelling 36 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] IF and some other IogicaI functions A fundamental function to add flexibility to models is the ÌF statement. ÌF can most simply be thought of as a switch. Excel carries out a test and depending on the result chooses between two answers, TRUE and FALSE. The syntax of an ÌF statement is as follows: =ÌF(logical_test,value_if_true,value_if_false) Excel evaluates the test and if it is true it returns the value_if_true, otherwise it returns the value_if_false. The following extract shows a simple example: The formula in the formula bar at the top has been copied across the row: The result of D48 is greater than 3.5 and so the result of the test is TRUE: Excel therefore returns "in breach of covenant¨. The ratio in E48 is less than 3.5, and so the result of the test is FALSE. Excel therefore chooses the value_if_false, i.e. "OK¨. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 37 Logical test Any formula or cell result which yields TRUE or FALSE is a test. When the test is in the form of a formula, Excel evaluates it and produces the result TRUE or FALSE. There are a number of "operators¨ we can use to create different logical tests: = Equals > Greater than < Less than >= Greater than or equal to <= Less than or equal to <> Not equal to Excel is capable of evaluating logical statements. Try typing in 1=2 and look at the result: the result is FALSE. The words TRUE and FALSE in Excel have a special status, in that Excel understands them in the same way that it understands a number or a formula. Excel also understands TRUE as the number 1 and FALSE as a zero. Ìn the above 1=2 equation, the result of this cell could either be regarded as FALSE or 0 for further calculations. Value arguments The arguments value_if_true and value_if_false can be given any of a number of different types of statements, for example: 1. numbers ÷ commonly 0 and 1 for use in flags. 2. formulae ÷ for example =ÌF((C5/C17)>=3.75,C5/C17,¨N/A¨) Note: it is not necessary to put an equals sign immediately before the logical test formula (C5/C17)>=3.75, nor before the value_if_true argument formula C5/C17. 3. comments or "labels¨ ÷ you will notice that the label N/A is enclosed in inverted commas. Ìf not in inverted commas, Excel will try to interpret your message as one of the following: a formula name; the name of a range; the address of a cell; or a logical value such as TRUE or FALSE. N/A is none of these and your formula will produce an error when Excel tries to return this as a result. Best practice financial modelling 38 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Common probIems with IF statements and some simpIe soIutions Using equals in a test 1. Although ÌFs are very useful, they can easily break down. Ìf we are testing for a particular numerical value from a formula, =0 can give spurious results because Excel shortens decimals to store them and therefore cannot calculate exactly. As a result of Excel's rounding, a formula which logically should give exactly zero as a result will often give a very small number, typically of approximately 0.000000000001 in value. This problem can easily be solved by using an AND statement to test to see if a number is nearly zero, i.e. =ÌF(AND(cell<0.001,cell>-0.001),¨Effectively zero¨,¨Not zero¨) Alternatively one of Excel's rounding or other functions, such as ROUND(), ROUNDDOWN() or ABS() can be used instead. =ÌF(ABS(cell)>0.001, "Not zero¨ , "Effectively zero¨) 2. Another potential problem in using equals is where the ÌF statement refers to a user input; for example where the user has to type "yes¨ or "no¨ into a cell and then using ÌF to switch to the relevant formula. Simple typing errors can cause big problems here: a typo in the cell entry will result in the second choice, i.e. the value if false being selected in error. This is a particularly insidious type of mistake because it will usually not result in an error message, but the wrong data or a wrong calculation being used in the model. Using data validation to limit data entry into the 'switch' input cell, so only the specific alternatives (for example, "yes¨ or "no¨) can be selected, will solve this problem. The AND and OR Statements Suppose we want to choose an option if two tests are passed. To deal with these more complex problems there are two other useful tools, the AND and OR function. These functions are often used as the logical test of ÌF statements. The syntax of an AND statement is as follows: =AND(test 1 ,test 2 , test 3 ..test n ) Ìn the case of the AND statement, Excel evaluates all of the tests in the formula (and there may be up to 30 of these) to see if they are TRUE or FALSE. Ìf they are all TRUE, then the AND statement will give TRUE as a result. Otherwise it will give a FALSE. Ìn the following illustration, C45m of debt is raised (DebtÌnitialÌn) on 31 December 2005 and then is to be repaid following a 2 year grace period (DebtGraceÌn) over the remaining 5 years of its 7 year term (DebtTermÌn). One solution is to use AND as the logical argument, using the year counters to decide whether it is after 2 years and also within the 7 year period: Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 39 The syntax of an OR statement is the same: =OR(test 1 ,test 2 , test 3 ..test n ) Ìn the case of the OR statement, if any of the tests are TRUE, the statement will result in TRUE. Another solution to the debt problem above is to decide whether the year is within the grace period or after the debt term. Ìf this is the case, no payment is made: Whether to use AND or OR depends on your thought process. Ìf you are an inclusive modeller, then your thought process is to define everything that falls within boundaries ÷ AND is your solution. Ìn the above illustration, the logical argument is to require all the criteria to be met / to fall within the boundaries. Ìf you are an exclusive modeller, then your thought process is to define anything that falls outside boundaries ÷ OR is your solution. Ìn the above illustration, the logical arguments were written so that if any were outside the limits, then no payment was made and if 'value_if_false' was returned, payments were made. Nested statements Excel is a very simple and flexible language and it is very easy to combine formulae to write quite complex programmes in a single cell. For example, a corporate tax formula: Ìf we make a loss, we don't pay tax, if we make a profit, then if our profit is less than 300,000, we will have a tax rate of 19%, if we have profit of 300,000 or more, we will be charged at 30%. Best practice financial modelling 40 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] This would be written as follows: Tax charge = ÌF(profit<0,0,ÌF(profit<300,000,profit*19%,profit*30%)) Here the "value if false¨ of the first ÌF statement is another ÌF, and both of the results from the second ÌF are formulae too. The main thing to be aware of here is that as the formula gets longer, it becomes harder to work out what the formula is trying to achieve. Test Value if true Value if false Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 41 Data retrievaI - the LOOKUP schooI ÌF, although perhaps the most useful function for creating flexibility in models, is limited in its applications. Ìf we have a problem involving a selection of possible answers, rather than a simple yes/no, then ÌF rapidly becomes difficult to use. Excel will allow us to use a maximum of 7 ÌFs in a statement. This is very hard work to both code and audit. The following functions can help resolve this problem. CHOOSE MATCH ÌNDEX OFFSET VLOOKUP HLOOKUP They can all be found in Ìnsert; Function; Lookup & Reference. Which function to use depends on the flexibility required; the way the data is sorted; and the sort of information that needs to be returned CHOOSE A CHOOSE function takes the role of up to 29 embedded ÌF statements and is used widely in scenario management. Ìt is driven by a selector cell which must be an integer between 1 and 29 and consequently requires references to up to 29 different target cells. =CHOOSE (index_num,value1,value2,...) Best practice financial modelling 42 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Ìn the above illustration, the scenario to be used to drive the income statement sales figure is selected using C10 ÷ known as the index_num in the CHOOSE function. Ìn order to use CHOOSE, this must be a positive integer (not text) ÷ value of 2 in this case. The reference of the cell to be used if the selector cell (or index_num) is 1 is the next argument in the function (value1 - if C10 is 1 this indicates that the first or "Management case¨ has been chosen and so the 342 in cell D4 should be referenced), and then 2 (second scenario and so D5), etc up to the number of options (maximum 29, although only 5 used in the above). The CHOOSE function is easy to use, but requires a significant amount of input - i.e. if 10 options are to be used, then the CHOOSE function requires reference to the selector cell and the cell to be returned for each of these 10 options in the correct order. This, together with the manual nature of extending the CHOOSE function for, say, adding new scenarios, may cause modelling errors to creep in. Consequently, where the data to be selected is large and/or will be extended, then other functions may prove more flexible and robust. MATCH MATCH is a much under-used and relatively straightforward function. Ìt returns the relative position of an item in a 1-dimensional data area - i.e. the output is a number referring to the position within a series. As a result, it is often used to identify coordinates for use in other lookups - namely ÌNDEX, OFFSET, VLOOKUP and HLOOKUP. Ìn the above illustration, the MATCH function is used to indicate the period number in which the semi-annual sales finish. 30 June is the 4 th monthly period in the sequence and so the MATCH function is used to calculate this. The function is of the form: =MATCH(lookup_value,lookup_array,match_type) lookup_value The value we want to find the relative position of. This is the semi-annual period end (30 June in cell D15) above. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 43 lookup_array The one-dimensional data area in which the lookup_value can be found. This area (D11:AE11) has been named DatesMonthly for ease of reference. 30 June appears in cell G11 ÷ the 4th item in the data area. match_type A key element in many lookup formulae, not just MATCH. The reference 0 has been used above to indicate that only an exact match is possible. Ìf the value in D15 were anything other than a month end (say 28 June) then the MATCH equation would not be able to find that value in DatesMonthly resulting in #N/A. The other possibilities for match_type are 1 or ÷1. These require the data area (lookup_array) to be sorted in ascending order or descending order respectively. Ìf match_type is 1, MATCH finds the largest value that is less than or equal to lookup_value. Ìf the value in D15 is 28 June then MATCH returns 3: 31 May is the next lowest value. Ìf match_type is -1, MATCH finds the smallest value that is greater than or equal to lookup_value. Ìf the value in D15 is 28 June then MATCH returns #N/A: the DatesMonthly are not sorted in descending order. INDEX There are two forms of ÌNDEX: 1. =ÌNDEX(array,row_num,column_num) 2. =ÌNDEX(reference,row_num,column_num,area_num) Both are used to return the contents (or position) of a cell as defined by its coordinates from within a data area (or data areas for the reference version). ÌNDEX is a highly flexible and robust function as long as the coordinates (row and column position) can be identified. The array version =ÌNDEX(array,row_num,column_num) Ìf a data area is 5 rows deep by 6 columns across and we wish to extract the value in the 3 rd row and 6 th column. The formula becomes: = ÌNDEX ( DataArea, 3, 6) The row_num and column_num are often found by use of the MATCH function. For example, in the following illustration we are trying to find the charge out rate for a director in Hong Kong. The data area has been set up so that it is easy to interpret, using text as row and column headers. Similarly, the way to select the data is based on these headings (selected in cells E14 and E15). Only once these selections of Hong Kong and director have been turned into numbers can we use an ÌNDEX function. Best practice financial modelling 44 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] One dimensionaI data Often, the trick with such functions is finding a way in which it will help. The following is an asset schedule for one class of assets which calculates the depreciation charge (in row 13) based on the cumulative cost at the end of the year (in row 9). The key is to ensure that assets which have been fully depreciated drop out of the calculation ÷ which is where row 8 comes in. Ìf the asset life (in E3) was to always stay the same at 4 years, then we could merely link cell J8 to F2. However, to ensure a fully flexible solution the equation in row 8 needs to be flexible also. The trick with ÌNDEX, as with many functions, is to know what the answer should be. Ìn cell J8 (in year 6) we want to eliminate the assets acquired in year 2 ÷ the 324. This is the number which appears in the second column of the data area in E2:L2 (named Capex). As we know the Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 45 coordinates of this within the data area (row number irrelevant as it is a one row data area; and second column) we can use ÌNDEX to pick up the required cell. Analysing the above formula but ignoring the ÌF statement: array The data area from which the target value of 324 is to be extracted - E2:L2 (named Capex). row_num The row number within the data area where the target value of 324 is situated. Ìn the above, the data area (Capex) is a one row array and so it can be ignored. column_num The column number within the data area where the target value of 324 is situated. Ìn the above, the 324 is in the second column of the data area and so the column number coordinate should be 2. The "J$1-Life¨ [6-4] is merely a way of ensuring we have the appropriate column counter as the formula is copied along row 8. Ìn summary, the formula is: = ÌNDEX ( E2:L2, leave blank, 2) which returns the value in the second column of the range contained in E2:L2. The reference version =ÌNDEX(reference,row_num,column_num,area_num) The reference version comes into its own when we have different versions of the same data. Ìt could be that we have: the input assumptions based on three different options; the income statement of 10 different companies / divisions; the costing structure for 25 different products; etc. The key is to ensure that each data area is set up in the same way and that row and column counters are introduced. Ìn the following illustration, there are operating contribution calculations set out in the same way for each of 4 regions (North, South, East and West), each of which has been appropriately named (e.g. North is the name for the range E13:J19). We wish to select one of these regions (using cell C2) as the output in rows 3 to 9. Best practice financial modelling 46 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] reference (North, South, East, West) This defines the various data areas from which the data is to be retrieved. Each of the data areas is the same size and has been named for ease of identification. Note: all the data areas must be contained within a set of parentheses inside the ÌNDEX function. row_num $A6 We are trying to return wages which is in the 4th row of the data area called South. As the data area is of the same dimensions as the summary, we can put in row counters in column A to help. column_num E$2 We are trying to return the result for April which is in the first column of the data area called South. As the data area is of the same dimensions as the summary, we can put in column counters in row 2 to help. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 47 area_num $B$2 This identifies which of the data areas (defined in reference) is to be used. As South is the second in the list, then we need to convert the selector word "South¨ into the number 2. MATCH again comes in handy. For three parts of the function, numbers have been used to identify the row, column and data area. Ìf we are concerned about presentation, these counters could be hidden using white text. OFFSET Like the ÌNDEX function, the OFFSET function uses row and column coordinates to identify the value (or position) of the target cell. Ìn simple terms, the OFFSET function identifies the target cell in relation to how many rows and columns it is positioned away from a starter cell ÷ the data area does not need to be identified. Using the same example as for the ÌNDEX function, the charge out rate for a director in Hong Kong can be found using OFFSET. =OFFSET(reference,rows,cols) reference $C$2 This is the "starter cell¨ or the reference point from which the OFFSET rows and columns are counted. To make the row and column counting easier, with two-dimensional data areas it is usually best to have this cell immediately above and to the left of the data area as the reference cell. rows, cols F14, F15 As with the ÌNDEX function, we need to turn the row and column selectors (in E14 and E15 respectively) into numbers so that they can be used within OFFSET. Hong Kong is in the seventh row of the city names and Director is in the fourth column of job titles ÷ MATCH has Best practice financial modelling 48 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] been used to identify these. Likewise, they are 7 rows and 4 columns respectively away from the reference cell C2. The row and column numbers can be negative, in which case the target cell will be above and/or to the left of the reference cell. Identifying the reference OFFSET is often used to locate the contents of a target cell. However, it can also be used to identify the position of a cell from within a range, or a range from within a range for use in other functions. Ìn the charge out illustration, OFFSET can be used to identify the charge out rates for all of the Directors or the Hong Kong office using the extended version: =OFFSET(reference,rows,cols,height,width) Using the extended function to find the reference of the Director charge out rates: = OFFSET($C$2,1,F15,9,1) The range we are looking for starts 1 row (rows) below the starter cell C2 (reference) and 4 columns to the right (cols ÷ using F15). Ìt is 9 rows deep (height) and 1 column wide (width). An alternative is: = OFFSET(C3,,F15,9) This time the starter cell (C3) is in the same row as the start of the range. Consequently, we do not need to define how many rows away the range starts (the second argument, rows, is left blank). Additionally, as the default (height and) width is 1 then we do not need to populate the final (width) argument. The above formulae have identified a reference and are only of use when incorporated within another function. For example: = AVERAGE(OFFSET(C3,,F15,9)) will return the average charge out rate for the directors. INDEX vs OFFSET ÌNDEX and OFFSET both require column and row coordinates to identify the target cell or cells. However, they both have their idiosyncrasies: 1. Defining ranges for use in other functions Ìf a range from within a range is to be defined for use in other functions then the full version of OFFSET has been created for this purpose. However, two ÌNDEX functions can be used to define the start and end positions of a range. The start and end point can be used to define Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 49 the range for a function if the two ÌNDEX functions are separated by a colon within the equation. For example, = SUM (ÌNDEX (DataArea,3,6) : ÌNDEX (DataArea,4,10)) 2. Auditing An ÌNDEX function is easier to audit. Ìf F2, the trace precedents or the Ctrl-[ is pressed, then the components of the formula are shown. Ìf the OFFSET function is used, then the data area from which the target cell or range is to be retrieved, is not shown as it is not part of the function. Additionally, if we are trying to find the dependents of a cell, it will not be identified as a precedent of an OFFSET whereas it will indicate the relationship with the ÌNDEX. This can cause problems as whole tracts of data may appear to have no links with any other parts of the model if OFFSET is used ÷ and could, therefore be changed or deleted without understanding the impact until it is too late. This may prove difficult to audit for those users of the model who are unfamiliar with OFFSET. 3. Volatility OFFSET is volatile whilst ÌNDEX is not. Volatile functions always recalculate when the model is calculated, even if their components have not changed. For most users this is whenever anything is changed anywhere in the model. This means that if the model is heavily populated with OFFSET functions, it will take a long time to recalculate. 4. Macros The OFFSET function is a fundamental tool in visual basic. VLOOKUP A flexible solution for multiple option selection is VLOOKUP. However, it may require some planning as VLOOKUP requires the data to be set out in a specific way. Ìf we take the simple case of recommending whether to buy, sell etc a stock based on the target price generated by the model, then we see how simple a VLOOKUP solution can be. The value of a share is computed using a DCF valuation approach and then this value is compared to the current share price, The threshold for a "buy¨ recommendation is that the current share price is at a discount of up to 15% to the DCF share valuation, up to no premium for an "Add¨ recommendation and so on. Best practice financial modelling 50 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] This is easier to think about if we know what the answer should be. Our model suggests that the current share price undervalues Carrefour shares by 22%. Looking at the decision box would indicate -100% to -15% is a Buy; -15% to 0% is Add; 0% to 10% is a Hold etc. Consequently, we think that Carrefour should be a Buy. The VLOOKUP formula at its simplest has three components: =VLOOKUP(lookup_value,table_array,col_index_num) lookup_value B7 This is the output driver (the -22% premium to DCF implied price target for Carrefour in cell B7) table_arrayE5:F9 ÷ named DecisionBox The data area where the required result is located (the decision box with the grid of premia and investor action). The lookup_value will be checked against the values in the first column of the table_array ÷ i.e. the values to be checked must be in the first column. col_index_num 2 The column number of the required result (the investor action) within the lookup table (i.e. the second column of the DecisionBox). The first two arguments of the equation have narrowed the result down to the specific row in the specific data area. The col_index_num indicates which column in that data area to then select from. How VLOOKUP works is very simple: Excel takes the lookup_value (-22%) and looks down the first column of the table_array (-100%, -15%, 0%, 10%, 20%) until it finds a match. Ìf it can't find an exact match, then Excel chooses the next nearest lower number instead (i.e. the last number it is bigger than on the way down: -100% in this case). Ìn the case of Tesco, it will get to the last line of the table before it stops. Having chosen a line in this way, Excel then chooses the result from the column number (2) you have specified. The lookup table ÷ named DecisionBox Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 51 Beware 1. The data in the first column must be in ascending order down the table for this kind of VLOOKUP to work properly. 2. The column number is just that. Excel will consider the first column of the lookup table as column 1, the second column as 2 and so on. Ìf the lookup table does not have enough columns, i.e. the column number is bigger than the total number of columns in the table, you will get an error message. The final argument - TRUE/FALSE Ìn the example above, we have not included a final fourth argument. The final argument is TRUE or FALSE. Ìf we put TRUE or omit the last argument, then VLOOKUP works as in the above example. Ìf we enter FALSE, then VLOOKUP accepts only exact matches. Ìf an exact match cannot be found, then a #N/A error message will be returned. This form of VLOOKUP must be used when the selector cell is text (or if column 1 is not in ascending order). The result of the formula in cell D14 is C89.10 (the value in the 4 th column of the Casino row). The selector cell is B14, which this time is text (Casino). Additionally, the data in the first column of the data area (named Data in cells B2:F10) is not sorted in any particular order. Consequently, the last argument in the VLOOKUP must be FALSE (or 0). Strangely, if FALSE was missed off, the VLOOKUP may give 1. the right answer 2. another erroneous value or 3. #N/A Ìt is the second one of these which is the dangerous one ÷ a number appears and so it is assumed that it must be right, but it may not be. Therefore, when using text as a selector in VLOOKUPs, ALWAYS USE FALSE. Best practice financial modelling 52 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] HLOOKUP VLOOKUP and HLOOKUP work in very similar ways. The difference in their use depends on the way the data is arranged: VLOOKUP requires the lookup_value to be represented in the first coIumn of the data area (or table_array) ÷ that is, the lookup is driven by verticaIIy looking down the first coIumn of the data area to find the correct row (and then finding the appropriate coIumn). HLOOKUP requires the lookup_value to be represented in the first row of the data area (or table_array) ÷ that is, the lookup is driven by horizontaIIy looking across the first row of the data area to find the correct column (and then finding the appropriate row). Ìn the comparable company table below, supposing the company (Ahold ÷ in row 7) was a given and we wanted a formula that would return Netherlands if Country was chosen, C23.95 if Price was chosen and so on. =HLOOKUP(lookup_value,table_array,row_index_num,range_lookup) =HLOOKUP(C12,Data,7,false). lookup_value C12 (Country in this case) As with VLOOKUP, this is the output driver (the word Country). This points to which type of output value we are looking for. table_arrayB2:F10, named Data The data area where the required result (Netherlands) is located. The lookup_value, Country, will be checked against the values in the first row of the table_array ÷ i.e. the values to be checked must be in the first row / header of the data area. row_index_num 7 The first two arguments have narrowed it down so that the lookup is looking down the Country column of the range named Data. The 7 indicates that we are looking for the 7th row in that column ÷ that relating to Ahold. The 7 has been hard-wired into the formula for illustration only. Ìt should not be a hard input number but related to a row counter which could be derived using MATCH to find where Ahold is positioned. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 53 range_lookup false (or 0) As the first row is not sorted in any particular order and the lookup_value is text, we want an exact match only (not the closest approximation). As we have seen with VLOOKUP, if the FALSE argument is not added the HLOOKUP may give: 1. the right answer 2. another erroneous value or 3. #N/A Best practice financial modelling 54 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Dates When a date is used in Excel, it is identified as a number. For example, 30 July 1966 is a famous day. According to Microsoft, that is the 24,318 th day of the world, i.e. it has been given the unique number 24,318. So when did the world begin? The first day of the world (according to Microsoft), i.e. number 1, is 1 January 1900, despite a sizeable body of evidence to suggest otherwise. This is an important date: if Excel knew that the world started on that date then any other date is merely a number of days from 1 January 1900. Hence, a unique number can be allocated. Date formats 1 January 1900 was, of course, a Sunday (which Excel, by default, treats as the first day of the week). Consequently, not only can Excel count the number of days from 1 January 1900, but also can very easily work out which day of the week it is. As dates are numbered, they can be formatted in the same way as other numbers. For example, to format the date 4 July 2006 (number 38,537): Control-1, Number and Custom d dd Ddd dddd Days 4 04 Mon Monday m mm Mmm mmmm Months 7 07 Jul July y yy Yyy yyy Years 06 06 2006 2006 Date functions Appreciating that a date is a number adds a lot of functionality. Some of these functions are not in the standard set-up of Excel and may need to be added: Tools, Add-ins Select Analysis Toolpak YEAR, MONTH, DAY etc Where the data is in 3 different cells, being day of the month (28), number of month (2 for February), and year (2004), this can all be combined into '28 February 2004' by the Date function: =DATE(year,month,day) The result in the cell is now the unique number for 28 February 2004 which can be formatted as appropriate. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 55 The YEAR, MONTH and DAY functions can be used to reverse this process to find the component parts of a particular date. WEEKDAY can be used to find out which day of the week a date is from 1-7 (although this could also be done by formatting the number with enough "d¨s). Note: because 1 January 1900 was a Sunday, then by default, Sunday is assumed to be the first day of the week, whilst Saturday is the 7 th . By changing the return type, the start of the week can be altered to, say, Monday. Defining time periods Ìf the start date is 31 January 2004 (say in cell D1), then to link other cells (to create more dates) to the start date can be done in a number of different ways: 1. =D1+365 As all dates are numbers, and years are 365 days, this will generally work. Ìn the above example, the result will be 30 January 2005 because 2004 is a leap year. This method is good but not great. 2. =EDATE(D1,12) EDATE adds the full number of months (in this case 12) to the starting number. Ìn the above example, the result will be the correct date, 31 January 2005. 3. =EOMONTH(D1,12) EOMONTH puts in the last day of the month specified (in this case 12 months later) after the starting month. Ìn the above example, the result will be the correct date, 31 January 2005. This method always works ÷ but is less useful if the month end is not the relevant date. Ìf monthly or quarterly dates are to be used, method 1 is not suitable but either method 2 or 3 can be used. Ìf the relevant date is to be, say, the 5 th (of each month, quarter or year) then EDATE is the appropriate function. Ìf the month end is the relevant date then EOMONTH always works. By comparison, EDATE will always add on the relevant number of months from a given date - if quarterly dates are needed and the last day of February is to be used, then 3 months after that is 28 May rather than 31 May. The same issues can arise with other month ends as some months have 30 days and some 31. Best practice financial modelling 56 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Length of periods As dates are numbers, then by subtracting one date from another generates the number of days between the dates. Consequently, to count the number of days in a month, quarter or in fact between any 2 dates is easy. The YEARFRAC function looks at the proportion of a year between 2 given dates: =YEARFRAC(start_date,end_date,basis) The basis should be one of the following, each giving a slightly different outcome 0 or omitted US (NASD) 30/360 1 Actual/actual 2 Actual/360 3 Actual/365 4 European 30/360 Note: the function only gives positive results and so care should be taken in ensuring that the start date is the earlier date as it will not be apparent from the output. ConsoIidating time periods Ìt is possible to consolidate monthly, quarterly or semi-annual workings into annuals. There are a number of fully flexible approaches to this, the most straightforward of which depends on the modeller and users' Excel proficiency and preferences. The coding can be simplified by the use of range names. However, care must be taken when using range names when the model contains different time frames. For example, the data in column H may relate to a quarter in one part of the model, whilst referring to an annual period elsewhere. Range names such as DatesQ, SalesQ could be used to contrast with DatesY etc to help identify quarterly and annual data so that only the appropriate ranges are used. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 57 IIIustration The quarterly and annual dates have both been created using EOMONTH with 3 and 12 being the number of months respectively. We are trying to sum the quarterly sales which fall between the year ends - note the first year is not a full 4 quarters. SUMIF =SUMÌF(range,criteria,sum_range) The SUMÌF function requires data (the range) to fulfil a criterion (criteria). Ìf it does fulfil this requirement, then a corresponding set of data (sum_range) can be summed. As dates are numbers (masquerading in a text format), the quarterly dates are the data which must be less than or equal to the annual date (which must be the criteria). Unfortunately, by default, the data must equal the criteria. Ìt is only by adding the text string component ("<="&F6) to the criteria that we can get around this restriction within SUMÌF. Once the quarterly dates have been identified as being less than or equal to the respective year end, then the corresponding sales data to be summed must be chosen (from the same columns as the quarterly dates). As the criteria is to be less than or equal to the respective year end then the function will sum all sales up to that date. Consequently, a further line, which eliminates all previous year's sales, can be easily added to create only the relevant sales. in F9 =SUMÌF(DatesQ,"<="&DatesY,SalesQ) or =SUMÌF($E$2:$AA$2,"<="&F6,$E$3:$AA$3) in F10 =F9-E9 Best practice financial modelling 58 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] SUM OFFSET OFFSET can be used to identify a single cell or a range. Ìt is the latter which we are interested in here. The address of the range is identified and then the contents summed. The trick is to identify the starting and finishing point of the range. PreIiminary step - period counters Ìn the above illustration, the first year's sales are for the first 3 quarters (i.e. the 1 st to 3 rd sales figures) and the second year is from the 4 th to 7 th figures etc. The start and end point in the sales range can be identified in the following corkscrew: The end position within the range can be identified using the MATCH function to find the relevant year end in the range of quarterly dates (using the exact [0] matching criteria): in F16 =MATCH(DatesY,DatesQ,0), or =MATCH(F6,$E$2:$AA$2,0) The start is merely 1 period after the previous ending period in F15 =E16+1 The OFFSET The OFFSET function identifies a cell or range which is a specified position away from a starter cell. The sales data is a 1-dimensional (1 row) range and so only the column and width criteria are required (together with the required starter cell). Ìt is cleaner to use a cell outside the data area as the starter cell (in this case D3 - immediately to the left of the data to be summed) as the address of the target area is always offset a given number of cells from this point. The OFFSET function then identifies the relevant range as starting so many columns (1, 4, 7 etc) away from the starter cell (D3) and being 3, 4, 4 etc cells wide (being the difference between the end position for the relevant year and that of the previous year). As a result, the OFFSET function has identified E3:G3 for year 1 and H3:K3 for year 2 etc. By placing a SUM around this range, the relevant consolidated sales is returned: in F11 =SUM(OFFSET($D$3,,F15,,F16-E16)) SUM INDEX ÌNDEX can be used to identify, from within a specified data area, a cell value or address. Ìt is the latter which we are interested in here. The addresses of the start and end of a range are identified and then the contents summed. As with OFFSET, we need to identify the starting and finishing point of the range - done using the same preliminary step as for OFFSET. 2 similar ÌNDEX functions are used to identify the addresses of the start and end of a range. As the sales data area is a 1-dimensional (1 row) range then only the sales data area and the start (or end) column number within this area need be identified. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 59 Ìn cell F15, the starter cell address is identified by =ÌNDEX(SalesQ,,F15) where SalesQ is the sales data area and F15 indicates that the cell we are interested in is in the 4th column of this data. On its own, the result of this function would be the sales in the 4th quarter. However, when combined with another function, Excel knows to use the address result instead. Similarly, the end cell address is identified by =ÌNDEX(SalesQ,,F16). By combining the results of the 2 ÌNDEX functions a range can be identified and then placed within a SUM: in F12 =SUM(ÌNDEX(SalesQ,,F15):(SalesQ,,F16)) or =SUM(ÌNDEX($E$3:$AA$3,,F15):ÌNDEX($E$3:$AA$3,,F16)) Best practice financial modelling 60 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Switches A switch can be created to allow a model to alternate between different sets of criteria. This allows Excel to model different potential outcomes. For example, if the funding for the project / acquisition will be either 75% or 100% debt, then a switch can be used to highlight the 2 alternatives; or where Monte Carlo simulation is used so that the model shows either the expected or the Monte Carlo output results. The Forms toolbar is used to create boxes and buttons which enable the user to quickly select between the various options. All items within the Forms toolbar are created and amended in the same way. The common theme is that the buttons/boxes all sit on top of the model and require some link between the model and the box/button through a cell link ÷ a previously blank cell - which is then used to drive further equations. Two-way switch For example, to create a two-way switch Open the Forms toolbar (View; Toolbars; Forms) Select the Check Box, move the cursor onto the model where you want the check box to appear (the cursor now becomes a crosshair) and create the check box by dragging with the left mouse button held down Using the right mouse button, click on the check box and select Format Control; Control; Cell Link (type or go to the cell reference for an unused cell) Click outside the check box to finish A ticked checkbox will return TRUE in the linked cell, whilst an un-ticked checkbox will result in FALSE in the linked cell. An ÌF statement based on whether the switch is TRUE or FALSE can be used to alternate the model assumptions. When using the ÌF statement it is useful to name the linked cell containing the TRUE/FALSE statement. For example, if the switch is to be used to alternate between equity accounting and proportional consolidation as the two options, then =ÌF(Switch=TRUE,"Equity accounting¨,"Proportional consolidation"); or, more simply =ÌF(Switch,"Equity accounting¨,"Proportional consolidation") would change the cell text from Equity accounting to Proportional consolidation. Check box Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 61 The check box can be formatted for colour, using the right mouse button, Format Control; Colours and Lines. MuItipIe options These buttons/boxes are created and amended and then linked to further formulae in the same way as the Check Box. Option button When an option button is created and linked to a cell (B3 below), 1 appears in the linked cell. Ìf a further option button is created and clicked, the number 2 will appear in the linked cell, and so on. The number allocated to each option button is the order in which they are created (the first created is allocated value 1, the second value 2,.). The option button is useful where there are several different possibilities allowed. The linked cell could then be used with an embedded ÌF function (or a lookup function such as CHOOSE). For example, if the calculation of interest on an overdraft balance could be performed on either the opening, average or closing balance, the following formula would generate the appropriate text. =CHOOSE($B$3,"opening","average","closing") The CHOOSE function returns a value from a list of arguments, which could be text, references, calculations etc. Ìn the above formula, B3 returns a value between 1 and 3. Ìf, say, option button 2 is chosen, then the formula would generate the result average. Option button List box Combo box Here, three option buttons have been created. The three buttons will automatically be linked to the same linked cell (B3 in this case), unless a group box is used. Group box Best practice financial modelling 62 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Option button with group box As more option buttons are created on the same sheet, they are automatically linked to the original linked cell. Ìf more than one set of option buttons is required on the same sheet, it is necessary to use the group box. Ìn the above, two different sets of option buttons are being used to drive different scenarios. Ìf the group box was not used, all the options buttons would have the same cell link (ether A3 or A9) which would count between 1 and 6. List box The list box generates a drop-down list box. The item that is selected in the list box appears in the text box. The linked cell generates a number, being the numerical position of the selected item within the list. Third argument chosen as A3 contains 3 Once in format control, enter the input range (in this example A1:A12) and the cell link (C1). Ìf November is now selected, cell link shows 11, being the 11 th item in the list. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 63 Combo box The combo box works in broadly the same way as the list box, requiring the same inputs as the list box. The key difference is in the appearance ÷ a drop-down box with the options will appear when the combo box is selected; whilst only the item menu item selected will show when the box is not selected. FormaIity As we have seen, the boxes and buttons sit on top of the model and then are linked to the model by use of cell links (and extract data from the model, for combo and list boxes, through the input range). Consequently, they result in the cell link values changing as the different options are selected. Therefore, despite the user not physically using the keyboard to type in a hard-wired number (or TRUE/FALSE), the cell link changes. The consequence of this is that all cell links MUST be situated on the Ìnputs sheet ÷ the home of all other hard-wired inputs. The switches should, therefore, also appear on the Ìnputs sheet as they are the way in which the user effects the change in the hard-wired cell link. However, this can be inconvenient. For example, if we wish to see the impact on the key outputs of changing an option, then we may wish to have the switches on the key workings/outputs sheet. Switches can be copied ÷ the key is to ensure that the cell link (and input range, if relevant) refers to the same cell in both locations. The result will be that the options can be changed simultaneously: on the input sheet using the switch; on the workings/output sheet using the copied switch; or on the input sheet by changing the value in the cell link. Best practice financial modelling 64 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Sensitivity GoaI Seek Goal Seek is a simple but powerful sensitivity and testing tool. Goal Seek can be used for "break even¨ analysis and to answer many typical questions that you would ask of a model for example: 'how much growth will Ì need in order to achieve the target return?'. Goal Seek is very easy to use: 1. Select the cell containing the formula whose result you wish to calculate (in this case D23), then select Tools; Goal seek. The following dialog box will be displayed: 2. Ìn the second (To value) box enter the value you would like the Set cell to equal; 3. Ìn the third (By changing cell) box input the address of the cell containing the input you wish to vary. Ìn the case of the question above it would be the cell containing the growth rate assumed in the model. This must be an input ÷ it cannot be a formula; 4. Press OK. Excel will then vary the value in the input cell until the value in the target cell reaches the target value. Ìf the target cell is formatted to a number of decimal places, you will notice that Excel usually does not exactly hit the target. Excel stops the iteration process when it meets the target value set +/- the iteration limit set in the model. To change the iteration limit to get Excel to get closer to the target, go to Tools; Options; and select the Calculation tab. Set the iteration limit to an appropriate number of decimal places. Goal Seek, like the Data Table tool which follows, is very powerful, but both rely on a simple set of single parameter inputs and key results. Both of these tools lend themselves very well to simple broad brush models. The more that inputs can be simplified, for example using a single interest rate, sales growth rate or inflation rate for the whole forecast, the more useful simple powerful tools like Goal Seek will be. Target cell Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 65 Data TabIes Data Tables are sensitivity tables by another name and they are brilliant as they are highly effective tools in assessing which are the most sensitive inputs (ie have the greatest impact on outputs) of the model. Sadly they use up a lot of memory and so it is essential that the Tools; Options; Calculation tab is checked for a manual (F9) calculation (or automatic except tables). Otherwise, after each new entry anywhere on the model, Excel will try to recalculate the table ÷ which will take a particularly irritating amount of time. The sensitivity table can look at variations of up to 2 variables. Unfortunately, Excel requires that the 2 variables are on the same sheet as the sensitivity table. Ìt is likely, therefore, that the table will need to be on the input sheet (although the tables' contents can be referred to an output page for printing purposes). To set up a data table to check the sensitivity of the Enterprise Value for changes in the EBÌTDA exit multiple and equity discount rate, the following steps must be followed: 1. Select the value upon which the sensitivity is to be performed (the Enterprise Value) and place the reference for this in the cell to the top left hand corner of the table; 2. Choose the inputs to be varied (e.g. EBÌTDA exit multiple and equity discount rate) and input a series of values in the row across the top of the table (e.g. EBÌTDA exit multiple) and a series down the left hand column of the table (e.g. equity discount rate). Note: these series of inputs must NOT be linked to the inputs that you are looking to vary; 3. The ranges in the top row and left column are generally driven from the centre values (7.0 and 13.0% respectively in the following illustration) with equal increments from this centre value. 4. Highlight all the entries thus made which will, therefore, require a rectangular table to be highlighted; 5. Using the Data; Table function the row input cell reference (being the input varying across the top row of the table) ÷ will be the input for EBÌTDA exit multiple which drives the rest of the model; and column input cell (being the input varying in the left column of the table) ÷ will be the input for equity discount rate which drives the rest of the model. 6. Using F9 a data table will be produced which highlights the sensitivity of the Enterprise Value to the changing EBÌTDA exit multiple and varying equity discount rate. Best practice financial modelling 66 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Enterprise VaIue - £m sensitivity EBITDA exit muItipIe 147.7 5.0 6.0 7.0 8.0 9.0 12.0% 133.0 143.7 154.3 165.0 175.7 Equity 12.5% 130.2 140.6 151.0 161.4 171.7 discount 13.0% 127.5 137.6 147.7 157.8 167.9 rate 13.5% 124.8 134.7 144.5 154.4 164.2 14.0% 122.3 131.8 141.4 151.0 160.6 Ìn the above table, the model output for Enterprise Value is £147.7m when the inputs (assuming EBÌTDA exit multiple of 7.0x and equity discount rate of 13.0%). This is the value at the centre of the sensitivity table and in the top left corner. Ìf the EBÌTDA exit multiple were to be 5.0x and the equity discount rate became 13.5%, on the assumption that all other inputs remained unchanged, then the Enterprise Value would be £124.8m ÷ i.e. £22.9m of value has been destroyed. Making the table more flexible To make tables more flexible and more useful to review, it is sensible for the middle of the series of values across the top of the table (7.0 above) and the middle of the series of values down the left hand side (13.0% above) to be equal to the actual inputs in the model. However as said above, the table will not work if these are linked to the actual inputs. Therefore a sensitivity range schedule can be set up as follows; Link to actual inputs This is middle value Ìncremental change EBÌTDA exit multiple (x) 7.00 7.00 1.00 Equity discount rate 13.0% 13.00% 0.50% The first column is directly linked to the actual inputs. The second and third columns are entered as hard numbers. The number input in the second column must be the same value as that in the first column (but not linked). Ìt is this cell which is linked into the centre of the top row/left column of the sensitivity table. The values either side of the middle values can be controlled by setting the increment (in the third column) by which the values should increase or decrease. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 67 Error diagnostics Often the model works in the way it should and the user concentrates on the key outputs. Sometimes, however, due to changes made to inputs, the sensitivity tables do not represent the values appearing in the rest of the model. Sadly, this is often only spotted once the model has been printed. Error messages can be used to flag up problems with sensitivity tables. These errors are of two types: 1. When inappropriate values are being input into the top rows/left columns of the tables which do not coincide with those of the inputs used in the rest of the model. By setting up a sensitivity range table (as above), the values in column 1 (based on the numbers driving the rest of the model) and column 2 (used to drive the sensitivity tables) can be compared. Any differences should be flagged and all differences summed. An error message can be driven from this sum of the differences. 2. The sensitivity tables may not have recalculated as F9 may not have been pressed. When the sensitivity tables are working, the value in the centre of the table and that in the top left corner should be the same. By comparing these two numbers and driving an error message from this, we can alert the user to press F9. Best practice financial modelling 68 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] VaIidating data A major problem of financial modelling is controlling the quality of inputs and the results. Data validation is tremendously useful because it allows you to limit data entry, cell by cell, within your model. Data VaIidation - with inputs Where the cell is an input cell, invalid inputs will not be allowed (and a prompt will indicate why). This is particularly useful if dates, currencies or text are to be entered in a precise format or to ensure that an input is within an allowable range. For example, assume that only a date lying between today and the next year end (which is in cell E17) can be chosen. Select Data; Validation Click on the down arrow by the Allow box and a list of options will be displayed. Allow Date, between, and then either enter the start and end date or link to dates within the model. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 69 This above Allow list shows the different ways in which the inputs can be constrained, e.g. whole numbers only, dates, values from a list and so on. The Data box gives you a series of choices about how you can limit the data (between, not between, greater than etc) once you've chosen your category. The illustration shows the relevant entries to constrain date entry to the range described above. Ìf it is necessary to control the denomination entered to, say, bn, m, or '000, Select Data; Validation; select List ÷ either enter the data as shown below in the source box or put the source data somewhere within the Excel model and then click on the arrow and highlight the area where the source data is entered. Note. Ìf the source data is on another sheet, then it is necessary to name the source data. Input message Ìnput messages can appear at the same time as the cell with the data validation is selected. This should give instructions as to what to enter in the cell. Where a dropdown (list) box has been chosen in the settings it is unlikely that an input message will be necessary. However, where the user has to enter, for example, a forecast date, then by selecting the Ìnput Message tab, a message can be composed so that the following instruction will appear: "The forecast date entered must be within the next 12 months¨ This source can be typed in as shown. Alternatively select the area on the same sheet where the source data is located. Ìf the source data is on another sheet, then the source data must be named. Best practice financial modelling 70 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Error alert Data validation is best used to make inputting easy and to ensure robust inputs drive the model. Ìt is imperative that inappropriate inputs are blocked ÷ which is what data validation does. When entries are blocked the following default message appears: As this does not indicate how to solve the problem, it is useful to change the message. By selecting the Error Alert tab, a message can be composed so that the above message is replaced by "Must enter a forecast date within the next 12 months¨. Data VaIidation - with outputs Additionally, data validation of outputs can be used to "sense check¨ results: Ìf we apply data validation to a range of cells containing formulae, Excel will not stop the results of the formulae from being outside the required range, but if we press the "Circle Ìnvalid Data¨ button on the Auditing toolbar, then cells with results outside the required range will be highlighted: This is the circle invalid data button. The cells in the highlighted area have been constrained to a value greater than 2.95 Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 71 ConditionaI formatting Conditional formats can be used to validate results. We could conditionally format so that those cells which are not valid / do not fulfil the benchmark criteria appear as a different colour, with borders, with a coloured background, etc. The advantage of this is that the problems are highlighted without the use of other functions (i.e. the auditing toolbar for data validation above). The disadvantage of this method is that these cells are merely formatted without having any other functional implication - i.e. the fact that a cell fails a test does not prevent that cell from being used elsewhere. ConditionaI statements The use of flags (0 and 1) through ÌF statements can add functionality if the result of an equation is not valid / does not meet the benchmark criteria. Ìf, for example, a project has to fulfil 4 out of 5 criteria to get funding then conditional formatting and data validation can still be used to identify whether the benchmarks have been reached on each criteria. However, if we want to then indicate that some of the inputs need to be changed as they do not fulfil 4 criteria, then we can put in a series of ÌF statements with 1 or 0 as the values if TRUE or FALSE respectively. Ìf the sum of these statements is greater than 1 then the tests have failed (and so a message stating that inputs should be changed should appear). Ìf the sum comes to 1 or less then the project can get the funding. The ISERROR function Ìt can be irritating when #DÌV/0! appears in a cell, not because a genuine error has been made but because one of its precedents has not yet been completed. Ìt then has a knock-on effect to all the current cell's dependents, so making the model ugly. This function effectively eliminates errors from the formula and also stops its spread to any of its dependents. For example, Ìf the contents of A1 were 187; A2 were 0; and those of A3 were =A1/A2 the result would be #DÌV/0!. By amending the formula in A3 to =ÌSERROR(A1/A2) the result would be TRUE (i.e. there has been an error). This has its uses, but could be made more useful by adding a logical test to the function: =ÌF(ÌSERROR(A1/A2),0,A1/A2) Best practice financial modelling 72 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] The result being 0 this time rather than TRUE. Note: the ÌSERROR function should be used with care. Sometimes when an error occurs it is because something has gone wrong with the model. This error needs to be fixed. The ÌSERROR function will cover up any errors and so can undermine the controls put in the model. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 73 ModeI compIetion Group outIine When printing or presenting the model, there may be parts of the model which you do not want to print ÷ e.g. historic periods, detailed calculations for check balances etc. Ìn this case, the relevant rows or columns can be hidden: Select the column(s) or row(s) Right mouse Hide This is quick, but is shoddy practice: Ìt is not always obvious that column L and M are hidden; why are they hidden? do they have any effect on any other parts of the model? do they contain fixes for the rest of the model?... There may be perfectly good reasons for doing it but many users would be suspicious as it is seen as a way to hide things that are suspicious. A far better way is to: Select a cell(s) in the relevant column(s) or row(s) Data; Group and Outline; Group ÷ Alt-D-G-G Select either rows or columns The selected area can now be hidden but with the use of a column or row bar (to the top or left hand side of the window respectively). Ìf the bar outline symbol is "+¨ then the user can click this to show the hidden area. Ìf the "-¨ symbol appears in the outline bar then a defined area can be hidden. Different levels within the group and outline can be used ÷ for example, the breakdown of sales may be at one level, with the next level up from that being the P&L down to EBÌT. By selecting the long section (1), then the first number to be visible is EBÌT. By selecting the shorter section (2), then the sales information is hidden but the remainder of the P&L is visible. Protecting the modeI Once the model is complete and everything works, then it is worth protecting the model to ensure you don't (or the reviewer doesn't) amend the formulae and corrupt your hard work. Ìt is unlikely that the inputs and assumptions should be protected, but all other sheets are formula-driven and these are the ones that need protecting. Note: Ìf report manager is used, at least one sheet must remain unprotected in order to allow report manager to be activated. Best practice financial modelling 74 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Whole sheets can be protected by: Tools; Protection; Protect sheet. Leave the default boxes in the dialog box ticked, The use of a password is optional - without a good reason, don't use one, unless you agree to be contacted at any time of the day or night by any subsequent user for the rest of the model's life. Selective protection The default setting within Excel is that all cells will be protected when a sheet is protected. Ìf you want to protect a sheet, but allow some specific cells to be changed, then cells and ranges can be "selectively unprotected¨ using the following procedure (note: this will only work if the sheet is unprotected first): Highlight the cells which you want to be able to amend; Format; Cells; Protection, untick the "Locked¨ box. Press OK. Protect the sheet (as above). You have created "windows¨ in the locked sheet where you can still manipulate the sheet. StyIes and protection Selective protection can be done through the use of Styles. The last of the Style options is "Protection¨. All input styles should have this box checked and then modified (protection ÷ locked box is NOT checked) to be "No protection¨. As the default setting for cells is to be Locked when the sheet is protected, by leaving the "Protection¨ style option unticked for all other styles, the result will be that only those cells with the input style can be changed once the sheet is protected Hiding Ìf you wish to hide all (or some) of the formulae and only allow the user to have access to the results of the cell(s), ensure the sheet is unprotected and then: Format; Cells; Protection, tick the "Hidden¨ box. Press OK. Protect the sheet (as above). What you have created is a sheet which looks the same, but is protected and the user cannot see the formulae that underlie each cell. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 75 Report manager Report manager (one of the Excel add-ins) is Excel's built-in print macro ÷ it allows reports to be created and saved, and hence printed out whenever required. View (if report manager has been added from Tools, Add-Ìns), Report Manager. Click on the sheets that you want to include and click Add. This must be done one at a time. Further down the box the sections entered in the report are shown. Ìf the order needs to be changed or something deleted, buttons allow this. Ìt is essential that each sheet (and pages within sheets) is set up (as regards margins, page breaks etc) separately as report manager will then pick up the specific way each sheet is set up. This should have been done when the model was set-up originally. Note: Ìn order to activate the report manager, the sheet in use must be unprotected (although the sheets which are to be printed need not be). Used to select sheets to print ÷ then press Add The order of the selection to be printed Best practice financial modelling 76 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Tracking editing changes The track changes function will provide a clear trail of amendments made to a model from a specified date using comment boxes. The comment will detail the nature of the change, the date and its time. For example: Tools; Track Changes; Highlight changes Tick checkbox for track changes while editing Excel will save a temporary file - maintaining a record of the model pre changes. Any editing changes made will be noted in a comment box providing a full trail of amendments. To subsequently accept or reject the changes: Tools; Track changes; Accept or reject changes (Excel will save a temporary file maintaining a record of all changes made) Select changes to Accept or Reject; OK Review proposed changes selecting from the menu whether to accept or reject changes Once the work has been reviewed, the original model can be updated with the reviewed changes by: Tools; Merge workbooks To switch off the track changes function: Tools; Track changes; Highlight changes Remove tick checkbox for track changes while editing This function is also very useful if you are making changes to or reviewing somebody else's model and you are required to explain or provide detail about your amendments. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 77 Historic financiaIs Decide which historics are necessary ÷ ie income statement, cash flow statement and balance sheet. Ìnputs should go on the inputs page, but historics are facts rather than assumptions driving future results or value and so it is reasonable to put them on the appropriate sheets (ie income statement historics on ÌS sheet, etc.). Think about the structure of the financials: Decide on which headings are necessary in each ÷ for example, in an income statement it may be that we are interested in Sales, EBÌTDA, EBÌT and net income with all other numbers being of limited interest to the output. Alternatively, we may decide that a detailed income statement is necessary for the required output ÷ here we may be limited by the level of detail in the historic financials, or more likely, by the forecast assumptions available (e.g. from brokers or management). Ìn the balance sheet, a detailed breakdown is lovely, but realistically, it is often only the capital structure that is necessary for most outputs ÷ many of the other categories can be combined. The income statement Put in the necessary headings ÷ and the other figures between these are "noise¨ to make the statements reconcile. Ensure that the bottom line figure ties in with the source ÷ and put in a check to ensure this. Ìt will be necessary to tie some of these numbers into the other financials ÷ a profit figure (one of EBÌTDA, EBÌT or net income depending on preference) to start the cash flow and the cumulative reserves (or equity) for the balance sheet (see below). The cash flow Put in the necessary headings (probably operating cash flow and pre-financing cash flow) ÷ and the other figures between these are "noise¨ to make the statements reconcile. The starting point for the operating cash flow is likely to have been fed from the income statement sheet (one of EBÌTDA, EBÌT or net income depending on preference). Ensure that the bottom line figure ties in with the source ÷ and put in a check to ensure this. Ìt will be necessary to tie the cumulative cash (or net debt) into the balance sheet (see below) Best practice financial modelling 78 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] The balance sheet Put in the necessary headings (probably capital structure, PPE and working capital) ÷ and the other figures between these are "noise¨ to make the statements reconcile. The source for the equity (or retained earnings) should come from the income statement sheet: On the ÌS sheet, reconcile the bottom line to the equity (or retained earnings) from the balance sheet using: Start of year X Net income X Less: Dividends (X) Other additions (deductions) X End of year X The category "Other¨ should be explainable (e.g. equity raised, other recognised gains or losses), but some adjustments may not always be laid out in the source. The source for debt, cash or net debt should come from the cash flow sheet: On the cash flow sheet, reconcile the bottom line to the net debt (or cash) from the balance sheet using: Start of year X Cash flow (pre net debt flows for net debt reconciliation) X Other additions (deductions) ÷ e.g. foreign exchange X End of year X The category "Other¨ should be explainable, but some adjustments may not always be laid out in the source. Put in some checks to ensure that the balance sheet balances and put the result on the Checks sheet. The historic balance sheet from the source will always balance and so must the balance sheet in the model before moving on ÷ and should be done without the need for a fudge figure. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 79 Forecast financiaIs To make life easier, the first step must be to get the forecast balance sheet to balance. Ensuring baIancing baIance sheets This is done by: 1. Filling in all the totals and subtotals in all the forecast financial statements (including the retained earnings/equity and cash/net debt reconciliations together with the balance sheet check calculations). Ìf the historic financial statements have been set up correctly, then all these formulae can be copied from the historics. Ìn order to ensure that the forecast financials continue to integrate, the retained earnings/equity will be fed from the retained earnings/equity reconciliation in the income statement workings and the cash/net debt from the cash/net debt reconciliation. As profits are inserted into the forecast income statement and cash flows into the cash flows statement then the balance sheet will update. On setting these up in the forecast periods, there will, initially, be no movement. 2. The balance sheet will not currently balance. By linking each value in the balance sheet (other than retained earnings/equity and cash/net debt) to the value in the previous year, the balance sheet should initially balance (at the same value as the last historic year). 3. All movements in other categories within the balance sheet will be updated on a module by module basis. For example, if capex is forecast, formulae should be updated to accommodate this - capex will reduce cash in the cash flow and increase assets in the balance sheet. When adding the results of the forecast workings, the financial statements should then automatically update and any errors will immediately be revealed through the checks you put in earlier ÷ if they don't, you shouldn't move on. Your objective is to create all the individual lines which will make up the income statement, cash flow and balance sheet. The usual minimum requirements in terms of the number of modules is three and the components are as follows: a) Operations and working capitaI Sales EBÌTDA margin Working capital balances b) PPE / fixed assets Net book value Annual depreciation charge Aggregate annual capital expenditure Best practice financial modelling 80 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] c) Debt Closing debt balances Ìnterest costs Fees payable Aggregate drawdown and repayment assumptions Repayments of overdrafts or revolving credits from free cash flow Error identification After each module, the outputs from the workings should be tied into the financials, so creating a balancing balance sheet at each stage of building up the model. For example, if the balance sheet does not balance after processing the operations and working capital numbers, then the error must have occurred in that module and so the error should be easier to track. Find the difference in the balance sheet in the first period of imbalance: Ìf the difference is recognisable ÷ error of omission ÷ the entry has not been entered in all the appropriate places; Ìf the difference 2 is recognisable ÷ the entry has been made but added rather than taken away or vice versa. For example, to tie in the operations and working capital numbers: Sales, operating costs (excl. depreciation & amortisation) & EBÌTDA ÌS Working capital increase (add to appropriate brought forward figure) BS EBÌTDA & working capital increase CFS Setting up the reconciIiation P&L BaIance sheet CFS opening forecast Sales EBÌTDA - Operating costs PPE 600 600 Wking cap incr EBÌTDA - other net assets 300 300 Operating CF - Dep & amort cash 50 50 Capex EBÌT - 950 950 Tax Ìnterest Pre-financing CF - Tax Debt 625 625 Dividends Net income - Shares 75 75 Ìnterest Dividends Retained earnings 250 250 Equity Retained earnings - 950 950 Net debt flow - Debt check - - Cash flow - Ret earnings Cash Start 250 (BOLD numbers - inputs this moduIe) Start 50 Retained earnings - Cash flow - Other Other End 250 End 50 Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 81 Operations and working capital P&L BaIance sheet CFS opening forecast Sales 750 EBÌTDA 350 Operating costs 400 PPE 600 600 Wking cap incr (40) EBÌTDA 350 other net assets 300 340 Operating CF 310 Dep & amort cash 50 360 Capex EBÌT 350 950 1,300 Tax Ìnterest Pre-financing CF 310 Tax Debt 625 625 Dividends Net income 350 Shares 75 75 Ìnterest Dividends Retained earnings 250 600 Equity Retained earnings 350 950 1,300 Net debt flow 310 Debt check - - Cash flow 310 Ret earnings Cash Start 250 (BOLD numbers - inputs this moduIe) Start 50 Retained earnings 350 Cash flow 310 Other Other End 600 End 360 PPE P&L BaIance sheet CFS opening forecast Sales 750 EBÌTDA 350 Operating costs 400 PPE 600 625 Wking cap incr (40) EBÌTDA 350 other net assets 300 340 Operating CF 310 Dep & amort 150 cash 50 185 Capex (175) EBÌT 200 950 1,150 Tax Ìnterest Pre-financing CF 135 Tax Debt 625 625 Dividends Net income 200 Shares 75 75 Ìnterest Dividends Retained earnings 250 450 Equity Retained earnings 200 950 1,150 Net debt flow 135 Debt check - - Cash flow 135 Ret earnings Cash Start 250 (BOLD numbers - inputs this moduIe) Start 50 Retained earnings 200 Cash flow 135 Other Other End 450 End 185 Best practice financial modelling 82 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Debt and interest P&L BaIance sheet CFS opening forecast Sales 750 EBÌTDA 350 Operating costs 400 PPE 600 625 Wking cap incr (40) EBÌTDA 350 other net assets 300 340 Operating CF 310 Dep & amort 150 cash 50 225 Capex (175) EBÌT 200 950 1,190 Tax Ìnterest 60 Pre-financing CF 135 Tax Debt 625 725 Dividends Net income 140 Shares 75 75 Ìnterest (60) Dividends Retained earnings 250 390 Equity Retained earnings 140 950 1,190 Net debt flow 75 Debt 100 check - - Cash flow 175 Ret earnings Cash Start 250 (BOLD numbers - inputs this moduIe) Start 50 Retained earnings 140 Cash flow 175 Other Other End 390 End 225 Tax and dividends P&L BaIance sheet CFS opening forecast Sales 750 EBÌTDA 350 Operating costs 400 PPE 600 625 Wking cap incr (40) EBÌTDA 350 other net assets 300 340 Operating CF 310 Dep & amort 150 cash 50 115 Capex (175) EBÌT 200 950 1,080 Tax (40) Ìnterest 60 Pre-financing CF 95 Tax 40 Debt 625 725 Dividends (70) Net income 100 Shares 75 75 Ìnterest (60) Dividends 70 Retained earnings 250 280 Equity Retained earnings 30 950 1,080 Net debt flow (35) Debt 100 check - - Cash flow 65 Ret earnings Cash Start 250 (BOLD numbers - inputs this moduIe) Start 50 Retained earnings 30 Cash flow 65 Other Other End 280 End 115 Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 83 Debt modeIIing The big problem when modelling debt is the ease with which circularities can be created. As a model is a simplification of the world, then the circularity problem can be circumvented by use of appropriate simplifying assumptions. The probIem Tax is often calculated using the following: EBÌTDA X Depreciation (tax based) (X) Net interest expense (X) Taxable profit X Net interest expense is interest on debt less (add) interest on cash (revolver) respectively. Ìnterest on cash / revolver balances is calculated using the following: Opening cash (revolver) balance X Cash increase /(decrease) in year X Cash (revolver) at end of year X Cash increase in the year is a post-tax, post-interest figure and so, therefore, is the cash at the end of the year. Consequently, the tax expense is dependent on interest on cash and interest on cash is dependent on both tax expense and interest on cash. i.e. a circularity has been created. A soIution (Assumption: the debt instruments have a structured repayment profile and any shortfalls or spare cash goes to the cash/revolver) 1. Build up the individual debt schedules with structured repayments 2. Calculate the interest arising on debt instruments 3. Set up the cash/revolver schedule as: Opening cash (revolver) balance X Cash increase /(decrease) in year (leave blank for now) Cash (revolver) at end of year (opening +/- increase/(decrease)) X 4. Calculate interest on cash/revolver based on OPENÌNG balance (to avoid circularity). Best practice financial modelling 84 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 5. Sum up all interest to find net interest expense 6. Do tax working (including the net interest from above) 7. Put tax expense into both the P&L and the cash flow (and balance sheet if it is not all to be paid in the year) 8. Fill in the "Cash increase/(decrease) in year¨ line above as Net debt decrease (increase) in year X Scheduled debt repayments (X) Cash increase/(decrease) in year X Where net debt decrease (increase) in the year is the post-tax (but not yet post interest) cash flow. 9. All the debt (and cash) and interest information is now calculated and so can be put into the financial statements 10. Put a check to ensure that the net debt (or cash) from the debt sheet equates to that in the balance sheet (which already equates to that in the cash flow). The interest on cash/revolver uses a simplifying assumption to get around the circularity problem. However, if there are significant movements in cash then the interest may not be accurate enough. Ìn this case it would be useful to build a switch which would vary the way the interest was calculated: if the switch was on, interest would be calculated on average balance (and hence circularity); if it were off, then interest would be calculated on opening balance (no circularity). The settings should be set to allow iteration in the calculations (Tools, Options, Calculation, Ìteration). The model will work but is less stable - and so the switch should be on only when there are few amendments left to be made to the model in order to avoid the model crashing. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 85 Auditing and error detection tooIs Auditing a formuIa F2 The F2 button, when on a cell, edits a formula. Excel will highlight the cells in coloured boxes which are precedents of the cell that is being edited. Consequently, F2 is the quickest way to audit a formula when the precedents are located close to the formula, but of limited use when they are elsewhere. Control-[ Control-[ Goes to all the precedent cells on the same sheet (goes to first precedent only if on different sheets) Control-] Dependent cells (on same sheet only) F5 When the precedents are elsewhere in the model, highlighting the cell reference or name in the formula and pressing F5 (the Go To command) will go to the relevant cell (or range). Unfortunately each component of the equation needs to be done in isolation. Often the best use of this function is when switching between 2 parts of the model. By going to a cell (possibly by using the auditing toolbar or Control-[), F5-Enter will return you to the original cell. Auditing toolbar The auditing toolbar is a powerful tool and should form part of the main toolbar for any Excel user. Ìt can be used to: Trace all the precedents of a cell (and their precedents, and their precedents . if needed) in order to find what a cell is dependent upon. This is particularly useful for identifying where the coding has gone wrong (a negative has been formed when it shouldn't have been, or worse a #REF! or #DÌV/0!) or when you are trying to follow someone else's model. Trace all the dependents of a cell (and their dependents .) in order to find what effect the cell has elsewhere. Particularly useful for finding out if, by the end of model, a cell is not referred to something. Ìf this is the case, it is either an output or rubbish. The tool is also useful for finding out why a cell is used when picking up someone else's model. Best practice financial modelling 86 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Trace errors. Where a cell has an error in it (such as #VALUE! or #NAME!), the use of this function selects the cell that contains the original formula that has an error and has all that cell's direct precedents arrowed. Double clicking on the trace precedents / dependents tool will show both direct and the next indirect precedent / dependent. Double clicking on the arrows takes the cursor to the end of the arrow. Where an arrow points to another sheet, double click on the dotted arrow which then returns the relevant locations in the Go To dialog box. Summary Order Pros Cons 1. F2 Highlights precedents Quickest when precedents are near Only useful if precedents are near 2. Control-[ Go to precedents Quick Only goes to first precedent on other sheets 3. Auditing toolbar Traces precedents Easy visual reference Double clicking on precedent line takes you to other end of line Requires significant mouse action 4. F5 Go to precedents Can go to specified precedents Better as a way to get back to original cell Only goes to one precedent at a time Requires significant mouse action AdditionaIIy, if names have been used: 5. The name means something to the reviewer 6. Name (drop-down) box - top left of spreadsheet ÷ can be used to go to the named cell/range 7. F5 (all names are listed) ÷ can be used to go to the named cell/range Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 87 Finding Iinks When reviewing a model from a third party or when trying to fix your own model, locating and understanding the links is a very important task. Excel does not have any built in tools to help you analyse them, but this can be easily done: Firstly, to find the name of any linked files, open the Edit menu and select Links. A dialog box will be displayed showing the names of linked files and allowing you to update the links. The address of the linked cell(s) will appear as ='[Big and Clever.xls]Ìnput'!$P$134 Finding the cells containing links in the workbook requires the following method: 1. Go to the first sheet in the model, go to the Edit menu and select Find 2. As the [ is a bit of a give away in the above address, insert a square bracket, [, into the find box and press return. Excel will take the cursor to the first linked cell in the sheet and further linked cells can be found by pressing the find next button in the Find dialog box. The shortcomings of this method are that it is laborious: if there are a lot of links in a sheet this process can take a long time and secondly, Excel will only reliably search to find links if we search sheet by sheet. Contained in oId names A source of spurious links is the copying of data between models where the copied cells use a range name. This can lead to a range name being included in the list of range names in a workbook, where the cells in that range are in another workbook. These can be found by going to the Ìnsert menu and selecting Name and Define (or Ctrl-F3). Selection of the names in the list one by one will show up any ranges defined in other workbooks. Best practice financial modelling 88 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] The F5 SpeciaI The Go To Special is a very powerful auditing and orientation tool. Ìt can be activated by selecting a single cell for most of the options in which case the whole sheet is searched (not possible for Row and Column differences), selecting an area in which case only the selection is searched; or highlighting the whole sheet in which case the whole sheet is searched (very useful for Row and Column differences). When the cell or area is selected: press F5 and then Special and then the following box appears: Finds what Finds what Both can be specified more by using the 4 sub- categories ÷ for example, will go to a constant or formula result that is a number or text etc All cells with comments Any single inputs Any result of a formulae Ìnconsistent formulae across a row Ìnconsistent formulae down a column Direct precedents Direct dependents (unless All levels chosen below), current sheet only Though not named range All empty cells (but not "¨ cells) Same as Ctrl-* The array containing the cell Any pictures / objects Same as Ctrl-End All non-hidden cells ÷ for formatting or chart source Cells with conditional formatting Any (or specified) data validation Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 89 Auditing for consistency over columns A good model should have the contents of column E (assuming this is the first period of data) copied to each subsequent column on all sheets (other than inputs, of course). This will ensure that each period is calculated consistently and that the same assumptions are being used in each period. The F5 Special function can highlight rows where there are inconsistencies across the periods. Select the appropriate columns (probably from column E to the end period); F5 (Go To); Special; Row differences. The inconsistent rows are highlighted for further investigation. To move between the differences use the Tab function. (Ìf there are inconsistencies which are quite spread out, then whilst they are highlighted, fill the selected cells with a colour so that it is easy to identify the inconsistencies. Each inconsistency can then be examined individually.) Other auditing tips Unknown functions Ìf a formula contains a function which needs some explanation, by pressing the "=¨ button (edit formula, immediately to the left of the formula bar [f x button in Excel 2003]) when editing the formula, then Excel will take you to the dialogue box for that function. Ìn the following, as the CHOOSE function is selected from within the ÌF statement (cursor flashing on that part of the equation), then the dialogue box for CHOOSE will be shown. Best practice financial modelling 90 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Alt-Return Although formulae should never be long and complicated, occasionally someone else's model has these features. When auditing the formula it is useful to break it down. For example, the following formula has no complex functions but is not easy to decipher: =-((PP/(PP+'Ìnputs & Results'!$F$25+AStart))*((SUM(F76:F81)+SUM(F84:F93))*(1-tax)- (Crate_monthly *Cstart*(F29/F30))))/(1-((PP/(PP+ 'Ìnputs & Results'!$F$25+AStart)*tax))) By pressing Alt-Return at the appropriate breaks in the formula, the formula will read as: =-( (PP/(PP+'Ìnputs & Results'!$F$25+AStart)) *( (SUM(F76:F81)+SUM(F84:F93)) *(1-tax)- (Crate_monthly *Cstart*(F29/F30)) ) ) /(1-((PP/(PP+ 'Ìnputs & Results'!$F$25+AStart)*tax))) The formula will remain in this form for subsequent users. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 91 Auditing a modeI - a process Upon opening Does it contain macros (message when opening re. enable / disable macros)? Does it have links to other models? Message on opening states "The workbook you opened contains links to information in another workbook. Do you want to update .¨ Ìt is unlikely that you will be able to update the links as the file path of the linked file(s) are likely to be different to your path. To find the links, select all sheets and Control F (find) Ìn the dialogue box window for "Find what¨ type [ (all references to file locations have square brackets) Alternatively, on the bottom of one of the sheets F3 Paste List Review the addresses of the names for any that have links to other models What size is it? File, Properties, General Are the sheets protected? Tools, Protection and then one of the options available is Unprotect sheet (alternatively, have the protection icon in the toolbar ÷ it will state "Unprotect sheet¨ if the sheet is protected) Are there any hidden sheets? Format, Sheet And then one of the options available is Unhide Best practice financial modelling 92 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Coding cIarity index The coding clarity index is a scoring system to quickly assess the quality of the code in a model. The purpose of the index is to give an "objective¨, or at least independent, basis for assessing quality in the model and give a guide as to the ease with which the model will be audited. Using the index is very simple. 1. Choose 50-60 lines of code in total from 3-4 different areas in the forecasts and review the code. 2. Review the whole model to get a feel for the layout and structure and review any documentation, help or notes that come with it. 3. Review the questions in the questionnaire and score the model. Ìf the answer to the question has a score against it, score the relevant marks for that question. Ìt does not matter how many times or how few times the design problem has occurred. 4. Add up the scores and look up the score in the results table. Coding clarity results table Score ConcIusion 0-6 This is a good score, and the model should be straightforward, clear and simple. As a general rule, this is easy to achieve in simple small models but more difficult as models grow. 7-10 This score should be readily achievable in most models and is a reasonable level to set as a minimum quality standard. Ìt is important to consider when reviewing scores to see if a score in this range has been achieved without answering yes to question 1 or 2. These are much higher scoring than the other questions because the implication of them is poor discipline and structure. Ìf these are the problem, then they should be resolved before the model is used. 11 & above The model will have scored on question 1 or 2 and on most of the other questions too. This suggests that the model has been put together in a hurry or that the design scope has changed as the model has developed. Ìt also suggests that the discipline and structure, which ensure quality, are missing. The obvious quick test of quality on a model like this is to look at the balance sheet and whether it balances. Whilst the model may appear alright now, it is unlikely to have a clear structure and is likely to have hidden implicit assumptions not explained in notes. Ìt will be difficult to work with and develop later if it is not "polished¨ now. There will be big concerns about the internal consistency of the model and of its ability to produce sensible representative forecasts. Ìt will be very difficult to be confident as to what the shortcomings and approximations are which will affect how the model's results will change as it is sensitised. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 93 Coding clarity questionnaire Score for a yes Score for a no ModeI score 1. Are any numbers hard coded or embedded into formulae? Even just for the conversion of units? 5 2. Are formulae inconsistent across the rows in the forecast area? 5 3. Are assumptions spread around the various schedules of the model and not in a separate Assumptions sheet or sheets? 3 4. Are inputs colour coded? 1 5. Are complex formulae used where more than 2 formulae are nested inside each other? 1 6. Ìs switching done by multiplying formulae by statements like (c3=1), instead of using Ìf statement? 1 7. Are complex formulae annotated with "post-it¨ notes or clear labels or explained in model documentation? 1 8. Are dynamic labels used if relevant? 1 9. Are data tables annotated? 1 10. Are range names used for key assumptions? 1 11. Does the model have diagnostic calculations to flag inconsistencies? 1 12. Does the model have documentation, User instructions or Help? 2 Total Best practice financial modelling 94 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] TroubIeshooting The steps for spotting errors in models: 1. Find and correct errors Find and correct the original source of any of the following (i.e. the location of where the original problem started), by use of the "Control-[" or the auditing toolbar: #N/A #VALUE! #REF! #DÌV/0! #NUM! #NAME? Until these are corrected the model will continue to have errors. 2. Find any inconsistencies in the sheets Use the F5-Special-Row differences on each sheet to highlight where different formulae have been used across a row. Find what is the appropriate formula to apply all the way across the row and then copy this across for consistency. 3. Balance sheet not balancing Find the difference in the balance sheet in the first period of imbalance: Ìf the difference is recognisable ÷ error of omission ÷ the entry has not been entered in all the appropriate places; Ìf the difference 2 is recognisable ÷ the entry has been made but added rather than taken away or vice versa. 4. Check specific diagnostics A good model should have specific diagnostics telling the user when errors/inconsistencies have occurred, such as the need to press F9 to recalculate the data tables. Ensure that all these diagnostics have appropriate messages. 5. Sense checks By eye and calculator, check as to whether the output numbers are sensible. Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 95 Appendix ExceI tricks Auditing consistency over columns (highlights rows that are inconsistent) Select the appropriate columns; F5; Special; Row differences (or Constants if inputs / hard-wired numbers are to be identified) F5, Special can also be used to find conditional formatting, data validation, row differences . Auditing toolbar Ensure this forms part of your toolbar to enable inconsistencies to be spotted quickly Double clicking on the trace precedents / dependents tool will show both direct and the next indirect precedent / dependent Double clicking on the arrow takes the cursor to the end of the arrow Where an arrow points to another sheet, double click on the dotted arrow which gives the relevant locations in the Go To dialog box Column selection Control-space bar; or Place cursor on column header - Left mouse button Control-- to then delete selected column; or Control-+ to then insert a column Comment insertion (descriptive labels for more complex calculations) Shift-F2; or right mouse button Shift-F10; Ìnsert comment Conditional formatting Cells; Conditional Formatting; (Alt-O; D) and then follow the prompts F5, Special can also be used to find conditional formatting on selected sheet Constants creation (dollarising) F4 - pressing F4 toggles between the various dollar options Data validation (to ensure only valid results can be input) Data; Validation; and then follow the prompts Find Shift-F5 or Ctrl-F Best practice financial modelling 96 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Format painter Put the paint-brush symbol on the toolbar to allow for easy copying of formats. Double clicking on the paint-brush symbol retains the copied format, so that it can be applied to further cells straight after. Press Esc key when finished with copying formats Alternatively: Ctrl-C on the cell(s) with the appropriate format; go to target cell(s) and Alt-E; S; T (paste special, formats) Formatting numbers for consistency Control-1 For use of _ #; , see Formatting section Function wizard fx button to use function wizard type in name of function preceded by =; press Ctrl-A to go directly into the function wizard for that function Go To F5 Control-Home Top of sheet Control-End End of active part of sheet, i.e. the junction of last row and column used Control + any arrow Goes to the start/end of the block of formulae/data that the cursor is in Control-Page Up/Page-Down Previous/next sheet Control-F6 or Control-Tab Switch between open workbooks Shift-F6 Switch to other window when screen is split Control-[ Moves the cursor to the precedent cells (on same sheet); Moves to the first precedent cell in formulae if on different sheets Control-] Moves the cursor to the dependent cells (on same sheet) Graphs F11 produces instant best fit graphs for selected data Try dragging the lines to see what then happens Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 97 Hide extraneous columns to fit sheet to appropriate width Select the first column to be hidden (either by mouse or Control-Spacebar) Control-Shift- (selects the remaining columns on the sheet) Format; Column; Hide (hides all the highlighted columns) Alternatively, select columns to be hidden, Right mouse; Hide, or Select columns to be hidden, Shift-F10; Hide. Ìnsert Shift-F11 New sheet Alt-Ì; R or C New row or column Control-+ New row or column when column or row selected F3 name into a formula Listing names Ìnsert; Name; Paste; Paste List Alternatively, F3, Paste List Menu selection Alt followed by underlined letter to get to first level (e.g. Alt-F to enter File menu); To get to next level merely press the letter (e.g. U to enter Page Setup) Naming a cell/range Type in text in cell to the right of cell or range Control-Shift- ; then F3 (whilst Control-Shift still held); check the right box; Return Protecting the contents Tools; Protection, Protect sheets ÷ leave the default boxes ticked and don't bother with a password. This stops any editing of the sheet. Selective protection ÷ see Protecting the model Repeat previous action Control-Y, or F4 Replace Control-H Reveal / hide formulas Control-` (i.e. the top left key on the standard UK keyboard). This toggles between showing the results of formulae in the cells and the formulae themselves Best practice financial modelling 98 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] Right click mouse button menu Shift-F10 (often there is a right click mouse button on the bottom row of keyboard) Row selection Shift-space bar Place cursor on row header - left mouse button Control-- to then delete selected row; or Control-+ to then insert a row Save model (often) Control-S Save model as. F12 ÷ useful to do at the start of each major change as a new version Select Control-Shift + any arrow Selects cells to start/end of next/current series Shift + any arrow increase the selection one cell at a time in that direction Control-A; or All of current sheet Control-shift; space bar; All of current sheet Control-space bar; Column Shift-space bar Row Control-Page Down/Up Select next sheet/previous sheet Control-Shift-Page Down/Up Select sheets (file name now includes [group]) Alternatively, Right mouse on a sheet tab - Select All Sheets Sensitivity table creation Ensure it is on the same sheet as the inputs to be varied Data; Table (see notes) Best practice financial modelling © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] 99 Switch creation For example Open the Forms toolbar (View; Toolbars; Forms) Select the check-box and create its text Using the right mouse, Format Control; Control; Cell Link (giving cell reference for an unused cell which will now switch between reading either TRUE or FALSE) Switching between sheets Control-Page Up/Down Switching between split sheets Shift-F6 Switch to other open workbooks/documents Control-F6 Spell-check F7 View multiple workbook/sheets Open required workbook(s) Window; New window ÷ more than one version of the current model has been created Window; Arrange; Horizontal (if only want views of current model ensure "Windows of active workbook¨ is selected) Control-F6 switch between workbooks/sheets Best practice financial modelling 100 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 ·
[email protected] ExceI function keys Key Function Shift CTRL CTRL-Shift ALT ALT-Shift F1 Get help. Displays the assistant balloon For help on an option, select the option, and press shift F1 Create a chart that uses the current range Ìnsert a new worksheet F2 Edit the active cell Ìnsert comment Save active workbook Display the save as dialog box F3 Paste a defined name into a formula Paste a function into a formula Define a name Create names from row and column labels F4 Repeat the last function Dollarises cell (creates constant) Repeat the last find action Close the active workbook window F5 Display the Go To dialog box Display the Find dialog box Restore the active workbook window size F6 Move to the next pane in a workbook that has been split Move to the previous pane in a workbook that has been split Move to the next workbook or window Move to the previous workbook or window F7 Display the spelling dialog box F8 Turn on extending a selection by using the arrow key Add another range of cells to the selection; or use the arrow keys to move to the start of the range you want to add, and press F8 and the arrow keys to select the next range Carry out the size command (workbook), or use the arrow keys to size the window Display the macro dialog box F9 Calculate all sheets in all open workbooks Calculate the active worksheet Minimise the workbook window into an icon F10 To make the menu bar active, or close a visible menu and submenu at the same time Show a shortcut menu Maximise or restore the workbook window F11 Create a chart that uses the current range Ìnsert a new worksheet Ìnsert a Microsoft Excel macro sheet Display the visual basic editor F12 Display the save as dialog box Display the save as dialog box Display the open file dialog box Display the print dialog box 1 The Corporate Training Group Debt Capital Markets Fixed Ìncome The Corporate Training Group 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Risk and reward Despite all evidence to the contrary.... ....risk and reward will dominate in the end. © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com CTG Risk-o-Meter 1982-2002 0% 5% 10% 15% 20% -10% -5% 25% -15% -20% 4.8% Money Market Government Bonds 6.6% Equity 8.2% 3 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Bonds 7% £ 100 Company A will pay: 7% 7% 7% 7% 7% 7% 6 Years Who? Compensation? How long? © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Bonds key features Specified issuer/guarantor Specified interest payments Fixed maturity Final repayment dates Typically bullet Early redemption possibilities Ìndenture provisions Covenants Events of default Seniority/security 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ìnterest types © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Bonds 2 Risks? Time Credit Liquidity 1 2 3 5 6 4 5 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Borrowers © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Bio-diversity Variable cashflow structures Puts and Calls Premiums and Discounts Floaters and Ìndex Linked Convertibles Exchangeables Asset backed Pass Thru, CMOs and CDOs Exotics Credit Linked Notes 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Corporate issuance Limited Regulation Rule 144 a SEC Bearer Private Placement Registered Gross Yankee Eurobonds Domestic $ is the most complicated market © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Medium Term Note (MTN) programmes Used to save time and costs for a regular issuer Ìssuer: Appoints mandated lead arrangers ("MLAs¨) / book runners / dealers (usually the same banks) Agrees size and scope of programme Negotiates content of common documentation Announces programme & issues Offering Circular Offering Circular is updated annually 7 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What is an MTN (programme)? A customer driven private bond transaction A Medium term note is a private bond issue using standard "shelf¨ style bond documentation Although programmes can lead off with a public issue, most trades are "Reverse enquiry¨ ÷ an investor makes a specific credit and maturity enquiry © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com (MTN) process When an issue is required: Ìnvestor enquires with MLA MLAs contact issuer with details of requirements and agree pricing MLAs send out latest annual documentation After the deal is closed, MLAs send out a pricing supplement for each tranche with full details of the issue 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com MTNs ÷ Why do they work? Ìnvestors Yield enhancement Credit diversification Fill duration gaps Tailored to meet currency needs Exposure to alternative markets/instruments Ìssuers Lower cost Documentation efficiency Broaden investor base Continuous market access Liability profile management Discreet market access © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Government bond markets Large Liquid Simple 9 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Government bond markets Authorities Ìssuing Agency Official Statistics Central Bank Primary Market Auctions Timetable Transparency © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Government bond markets Authorities Ìssuing Agency Official Statistics Central Bank Primary Market Secondary Market Cash Market Repo Market Futures Market Strips Market 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Corporate bonds Required return? Ìssuer quality Maturity Ìnterest rates Coupon frequency © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Pricing process Name Maturity Spread history Ratings Comparables Coupon frequency 11 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The issuance process Ìssuer Ìnvestors Sales Team Origination Co-Iead Co-Iead Lead Manager/ Book-runner © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The issuance process Beauty parade Due diligence Research Prospectus Roadshow Bookbuilding and allocation 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Secondary market in corporate debt Historically limited Growing Coredeal MTS Other systems © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What is the yield? Measure of return Variety of simple measures The most complete is the Gross Redemption Yield (GRY) or Yield to Maturity (YTM) 13 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The time value of money £1,000 or £1,000 Now In one year Why? Choice Ìnflation Credit = Interest Rate © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The time value of money 1 2 3 4 (1+r) (1+r) 2 (1+r) 3 (1+r) 4 P r e s e n t V a I u e period 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Yield and price Bond Price $ Bond Yield % But different bonds exhibit different levels of sensitivity © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Accrued interest Monday 21 st ÷ Friday 25th 15 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What does yield represent? + Credit spread Risk free rate © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Monetary and fiscal policy Fiscal Policy Taxation Rates Government Spending Monetary Policy Ìnterest Rates 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ìndicators Gross Domestic Product Consumer Ìnflation Retail Sales Ìnternational Trade Public Spending Private Ìnvestment Consumer Confidence Consumer Credit & Money Supply Business Confidence Asset Prices Commodity Prices Earnings The Global Economy Unemployment Exchange Rate © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Conventional Bond Analysis The Real Yield Expected Ìnflation NominaI YieId Historically the source of much of the volatility 17 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The yield curve GRY Maturity The Coupon Effect Special Features Tax Distortion Curve Fitting Techniques © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Expectations and the yield Ìnitially flat term structure but economic news implies an expected rates rise Ìnvestors? Speculators? Borrowers? What is the impact on the term structure? 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com But dominant theory is expectations Other factors that will affect yield Maturity Liquidity premium and uncertainty Supply and demand Segmentation Theory Preferred Habitat Theory 1 The Corporate Training Group Ratings © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Moody's Standard & Poor's Smallest degree of risk Aaa AAA Highest rating: capacity to pay interest and repay principal extremely strong High quality Aa AA Strong capacity to service debt Upper medium grade: elements suggest possible future weakness A A Strong capacity to service debt but susceptible to adverse changes in circumstances or economic conditions Adequate security at present but may be unreliable over time: has speculative characteristics Baa BBB Adequate capacity to service debt over time but adverse conditions likely to weaken capacity to service debt Ìnvestment grade ÷ long term 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Moodys Standard & Poors Speculative: uncertain future Ba BB Lowest degree of speculation Generally lack characteristics of desirable investments B B Speculative Poor standing: in default or in danger of going into default Caa CCC Speculative Highly speculative, often in default Ca CC Highly speculative Lowest rated: poor prospect of ever attaining investment grade C C No interest is being paid Below investment grade ÷ long term © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ratings hierarchies S&P Ratings from AA to CCC are often modified with a + or - to show their relative standing within a rating category Moody's modifies its ratings with a: 1 - high end 2 - mid-range 3 - lower end 3 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What are the two basic types of credit rating? Ìssue-specific credit rating measures the credit risk of a specific debt issue bonds; notes; commercial paper preferred stock municipal notes measures the creditworthiness of an entity with respect to the specific debt issue the likelihood of default on a specific debt issue © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What are the two basic types of credit rating? Ìssuer credit rating also called the counterparty, corporate, sovereign credit rating measures the credit risk of an entire organisation: corporation governments counterparties 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What qualitative factors are evaluated in the credit rating process? Ìndustry risk & market position Accounting quality Management © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What quantitative factors are evaluated in the credit rating process? Financial characteristics and policy Profitability Capital structure Cash flow protection Financial flexibility Ratio analysis is used to help judge the company's financial strength and ability to repay its debt & to gauge the company's relative strength within its industry 5 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ratings are ratio driven (key S&P industrial ratios) 87.7 74.8 62.6 48.2 42.5 37.7 22.9 TotaI Debt/ CapitaIisation 68.8 69.7 57.2 42.5 33.9 28.2 13.3 Long Term Debt/CapitaI 87.7 74.8 62.6 48.2 42.5 37.7 22.9 TotaI Debt/CapitaI 6.3 4.9 3.4 2.3 1.6 1.2 0.6 TotaI Debt/EBITDA 15.4 13.6 30.8 8.5 5.8 3.7 BBB 15.9 11.6 18.8 2.6 3.4 2.1 BB 11.8 6.6 7.8 (3.2) 1.8 0.8 B 11.9 1.0 1.6 (12.9) 1.3 0.1 CCC 18.6 19.4 43.2 15.0 9.1 6.1 A 22.1 27.0 Operating Income/SaIes 21.7 34.9 Return on CapitaI 55.4 128.8 Funds From Ops /TotaI Debt 25.2 84.2 Free Operating CF/TotaI Debt 12.9 26.5 EBITDA Interest Cover 10.1 21.4 EBIT Interest Cover AA AAA © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What are ratings used for? Most ratings requests come from companies that want to establish a dialogue with their investors The investors can use the rating to price & compare debt issues The investors are therefore asking an independent & impartial organisation to conduct their credit analysis The issuer receives financing in line with its credit rating Both the issuer and investor compensate the ratings agency 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The need for a rating ÷ rating agency evaluation Request for rating Assign analytical team and conduct basic research Meet issuer Rating Committee Meeting Appeals Process Ìssue Rating Surveillance © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Quantitative rating factors Financial characteristics and policy Profitability Capital structure Cash flow protection Financial flexibility Ratio analysis is used to help judge the company's financial strength and ability to repay its debt & to gauge the company's relative strength within its industry 7 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Well below average Below average Average Above average Well above average business position Company business risk profiIe 45 65 25 40 85 20 35 60 105 15 30 50 80 150 10 25 40 60 80 BB BBB A AA AAA Rating category Qualitative analysis Sainsbury, hmm.... Moderately leveraged. (FFO/Total debt of 60%) but how should Ì rate it ? Rating process Funds from Operations/TotaI Debt GuideIines 1 The Corporate Training Group Securitisation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com A definition The transfer and pooling of cash flows and assets to remove operating risks of the originator from issued securities 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com True Sale structure Special Purpose Vehicle Bond holders Credit Enhancement Liquidity provider Security Trustee Swap provider True Sale Mortgage Loans Halifax B.Soc Original contracts Grant of security Benefit of security Principal and interest Purchase price Issue Proceeds © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Positives Allows the originator to: reduce its risk weighted assets improve return on assets and return on equity improve asset and liability matching manage its portfolio diversify funding sources get cheaper funding 3 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Negatives However can be inflexible may crystallise VAT , CGT, stamp duty. assets must be assignable unsuitable for "whole business¨ securitisation © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com An example of a true sale structure The Government National Mortgage Association, (Ginnie Mae) The Federal National Mortgage Association and (Fannie Mae) The Federal Home Loans Mortgage Corporation (Freddie Mac) These all issue "Mortgage Passthrough¨ securities - a pool of mortgages is formed and investors buy participation certificates which buy them a pro rata share in the pooled assets. The coupon rate on the securities is lower than the weighted average interest rate on the mortgages, the difference being paid to the servicer and any guarantor as a fee. US Mortgage backed bonds 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What can be Securitised? Corporate Loans Consumer Loans Credit Card Receivables Residential Mortgages Commercial Mortgages Auto Leases Office Equipment Leases Aircraft Leases Small Business Loans Student Loans Future Export Receivables Ìnsurance Premium Receivables Marine Loans Oil/Gas Contract Receivables Property Rental Ìncome Railcar Leases Toll road Receivables Utility Receivables Public Houses Care Homes Motorway Service Stations Assets are commercial or consumer related © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com But are they a significant market segment? US Bond Market US Treasuries C 3.3 trillion US Mortgage backed C 4.5 trillion US other asset backed C 1.4 trillion UK ÷ Bigger than Gilt Market Germany - equal to Bunds EU doubling every 2 years As important as corporate bond marke 5 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Secured Loan Securitisation Structures Special Purpose Vehicle Bond holders Credit Enhancement Liquidity provider Security Trustee Swap provider Grant of security Loans Originator Original contracts Sub charge of security Benefit of security Principal and interest Loan of issue proceeds Issue Proceeds © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com A definition The pooling of cash flows and/or assets which may or may not be transferred and may or may not remove the operating risk of the originator from issued securities 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Beware operator risk Ìn secured loan type structures we may be exposed to the ongoing business risk of the underlying business. The focus of risk analysis will be more focused on the underlying business Static CDO Managed CDO Canary Wharf Punch Taverns Tussauds Leeds United Secured Corporate Debt Operator Risk © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Credit Enhancement - Subordination AAA 85% A 10% BBB 5% 15% Credit Support 5% Credit Support 7 The Corporate Training Group CDOs © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com A CDO Structure PortfoIio Assets Cash Payment ASSETS High YieId Bonds Leveraged Loans Investment Grade CDS High Grade ABS Mezzanine ABS CDOs Private Equity Hedge Funds Emerging Markets Subordinated Mezzanine Senior NOTES Pays ScheduIed Cash FIows to Investors Cash Payment Service Providers (e.g. Management, Liquidity, Hedging) SPV, Limited Partnership or Fund ExternaI Trustee HandIes Reporting and Protects Investors Assets are purchased from the market: asset profile must fit within certain investment parameters defined in the transaction documents Cash flows from the assets are used to pay down investments sequentially 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Classic CLO Portfolio Ramp-Up and Amortization Reinvestment period Amortization Period AccumuIatio n Period Reinvestment Period Transaction wind-down PortfoIio ramp-up and amortization [12] months [7] Years 60% 100% [5] Years Closing1Q 2005 20% discretionary trading [9] Years 0% Ramp up for CDOs of other asset classes (ie ABS, corporates etc) will have varying degrees of ramp up periods. © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ìnterest & Principal Waterfall CIass A Note Interest Senior IC/OC Tests Senior Fees & Expenses Redemption to the extent necessary to satisfy the IC and OC tests CIass A Notes Junior Expenses ResiduaI to Subordinated Notes Reinvestment in new coIIateraI To the payment of senior expenses, interest and curing of coverage tests to the extent not previousIy paid using interest Proceeds During Reinvestment Period Senior Fees & Expenses CIass A Note PrincipaI ResiduaI to Subordinated Notes During Amortization Period Interest WaterfaII PrincipaI WaterfaII Junior Expenses Senior note holders benefit from the credit enhancement created by the subordination of other tranches Equity holders benefit from any upside resulting in lower than expected default rates or higher recovery rates, in the portfolio 9 The Corporate Training Group Derivatives An overview of derivatives market 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What size is the market? Over the counter (OTC) derivatives (Approx 80% notional value) Exchange traded derivatives (Approx 20% notional value) Source: BIS and ISDA www.bis.org or www.isda.org © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The basic concept Derivatives Package and Transfer Risk Two types of contract onIy: 1. Forward / future 2. Option 3. Swaps 11 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Forwards and futures contracts An obligation between two parties to buy or sell an asset at a price agreed today, for delivery on a future date. © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Options contracts Buyer has choice i.e. right but not obligation to perform . Seller has no choice ÷ potential obligation . at a certain price in the future Buyer pays premium for this right Seller receives premium for this obligation 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What are swaps? OTC product Swap one series of cash flows for another over a set period Both parties having an obligation to perform e.g. interest rate, currency, etc. © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com OTC or exchange traded Exchange Standardised Liquid Centrally cleared Heavily regulated Few products OTC Bespoke Less liquid No clearing house Lightly regulated Product proliferation 13 Forwards and futures © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com An obligation between two parties to buy or sell an asset at a price agreed today, for delivery on a future date. Forwards and futures contracts Forwards normally OTC Futures normally exchange Forwards normally mark-to-market once Futures normally mark-to-market daily (and more) 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Major forward/future products Ìnterest rate Currency Equity shares Ìndices Commodities © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Money market quotes 15 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Forward rate agreement The Bloomberg screen is telling us: 2 x 5 3.490 3.496 Ìnvestor Borrower The swap desk will lend (receive interest) © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Futures The buyer of a future is obligated to take delivery/cash settle at the delivery date The seller of a future is obligated to make delivery/cash settle at the delivery date These obligations are commonly offset (closed out) prior to delivery by undertaking an equal and opposite trade 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Profit Loss Price 1000 0 profit loss Unlimited -1000 Long future ÷ payoff diagram © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Profit Loss 0 Price 1000 1000 Unlimited Profit Loss Short future ÷ payoff diagram 17 Fair value of futures © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Pricing a future Cash Price + Cost of Carry 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Pricing futures (2) Futures are more likely to trade at close to fair value if the following apply Easy to short sell Liquid underlying Non seasonal production Non seasonal consumption Ease of storage © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Today Time Delivery Price Cash Future Basis Basis varies over time i.e interest rates change therefore cost of carry alters Basis 19 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Counter party risk Forwards are OTC products therefore suffer counter party risk Futures are exchange traded therefore reduced counter party risk Clearing house Margin © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com STÌR DeIivery month Price June 93.13 (6.87%) September 92.78 (7.22%) December 92.47 (7.53%) Buyer of a September future would be fixing an interest rate receivabIe of 7.22% on a 3-month deposit of 1 million from delivery day in September 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Why use futures? Synthetic performance Perform as cash without buying shares Hedging Protecting value against adverse movements in prices Speculation Leveraged, liquid, standardised Arbitrage Simultaneous purchase or sale of underlying to capture price differences (beyond transactions costs) Arbitrage with futures 21 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Arbitrage Future trading above fair value Cash & carry, i.e. sell future and buy underlying Future trading below fair value Reverse cash & carry, i.e. sell underlying and buy future © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The arbitrage channel Fair vaIue Futures price 22 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Price and trade information Bid & offer prices This information will be displayed on screens as well as the highest and lowest price traded that day and the price of the most recent trade Volume This is the number of contracts traded during the day. Ìt is the number of longs OR the number of shorts Open interest This is the number of open contracts at any time. Ìt is the number of open longs OR the number of open shorts © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Day 1 Day 2 Day 3 A B C Volume Open interest L5 - S5 - L5 S5 Volume & open interest S3 L3 - 5 5 5 3 2 5 23 The Corporate Training Group Options © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Working definition An agreement between Two counterparties that Gives the holder the right but not the obligation Ìn return for a premium To buy (a caII option) or to sell (a put option) An agreed quantity of An underlying item At an agreed price, (strike price or exercise price) 24 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Understanding the terms Buyer ÷ Right not obligation (long/holder) Seller ÷ Obligation not right (short/writer) Call / put Strike price Expiry date Premium © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Strike price and premium The price at which the option holder can buy (call option) or sell (put option) the underlying instrument is called the strike price The premium is what the buyer of the option pays to the seller (writer) of the option 25 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Time and intrinsic values Strike Premium Ìntrinsic Time 80 25 20 5 90 17 100 9 110 5 120 3 CaII option premiums, underIying @ 100 Option strategies 26 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Long call What is the pay-off at maturity for a long call with a strike price of 100p and a premium of 10p? -60 -40 -20 0 20 40 60 80 0 5 0 1 0 0 1 5 0 2 0 0 P r o f i t L o s s © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Short call What is the pay-off at maturity for a short call with a strike price of 100p and a premium of 10p? -60 -40 -20 0 20 40 60 80 0 5 0 1 0 0 1 5 0 2 0 0 27 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Long put What is the pay-off at maturity for a long put with a strike price of 100p and a premium of 10p? -60 -40 -20 0 20 40 60 80 0 5 0 1 0 0 1 5 0 2 0 0 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Short put What is the pay-off at maturity for a short put with a strike price of 100p and a premium of 10p? -60 -40 -20 0 20 40 60 80 0 5 0 1 0 0 1 5 0 2 0 0 28 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com A recent option price Wondafone LIFFE equity option Underlying @ 122 120 strike Expiry in one month Call price = 7 Put price = 4.5 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Vanilla option strategies Using these prices consider four "vanilla¨ positions: Long Call Long Put Short Call Short Put Structure your answer by considering: 1. What would your view of the stock be? 2. What is the maximum risk of the position? 3. What is the breakeven position? 29 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Vanilla option strategies Long Call Short Call View Maximum risk/share Breakeven Maximum profit/share Long Put Short Put View Maximum risk/share Breakeven Maximum profit/share © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Option types American Exercise at any time European Exercise at expiry 30 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Option value Time value Ìntrinsic value Premium value = + © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Close out or exercise Close out Take an equal and opposite position to your existing position Exercise (only available to holder) Exercise your right to buy/sell the underlying at the strike price 31 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ìn-, at- and out-of-the-money Options with intrinsic value are described as in- the-money Options with no intrinsic value are known as out- of-the-money Options whose strikes are close to the underlying are at-the-money © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The erosion of time value 0 Profit Loss UnIimited 32 The Greeks © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What will happen to the option price if .? Moves Call Put Price Price Asset Price Rises ? ? FaIIs ? ? Volatility Rises ? ? FaIIs ? ? Time to Expiry FaIIs ? ? 33 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Sensitivity ÷ the Greeks Each Greek captures and measures a dimension of the risk in an option position . The Major Greeks Delta . underlying asset price Gamma . change of delta Vega . volatility The Minor Greeks Theta . time Rho . interest rate Collars 34 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Collar Borrowing money over 5 years Long borrowers option Downside protected Short lenders option Upside capped Premiums reduced The Corporate Training Group Swaps 35 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Types of swap Ìnterest rate swaps Asset swaps Currency swaps Equity swaps Credit default swaps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ìnterest rate swap A B Fixed Rate Payer Fixed Rate Receiver (Floating Rate Receiver) (Floating Rate Payer) 5% LÌBOR 36 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ìnterest rate swap One party pays fixed to receive floating from the counterparty Principal not exchanged Fixed rate constant over life of swap Floating rate LÌBOR flat Rates set in advance paid in arrears Cash flows netted © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ìnterest rate swaps ? 37 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Money market quotes © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The workings of a swap Fixed @ 5% Floating @ Libor + 25bp Pay Libor Receive 4.79% Pay 4.83% Receive Libor 38 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Uses of swaps? Comparative advantage? Re-engineering/hedging Speculation Arbitrage © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The pricing logic 39 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Swaps Swap Desk Fixed Leg = Floating Leg © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Swap pricing What is fair fixed rate for a 2 year swap vs. 6 month LÌBOR? 6 18 12 24 F s % F 12 % F 6 % F 18 % X% X% X% X% PV float PV fixed 40 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Pricing spreadsheet today 23-JuI-05 23-Jan-06 23-Jul-06 23-Jan-07 23-Jul-07 Discount factor 1 0.9665 0.9345 0.9025 0.8712 Days 184 181 184 181 Year basis 365 365 365 365 Year proportion 50.4% 49.6% 50.4% 49.6% Forward 6 month Libor 6.87% 6.90% 7.05% 7.25% Cash fIows Nominal 10,000,000 FIoating Cash (346,323) (342,164) (355,397) (359,521) Present Value (334,731) (319,770) (320,738) (313,199) PV Floating (1,288,437) Fixed 6.00% Cash 300,000 300,000 300,000 300,000 Present Value 289,958 280,365 270,743 261,347 PV Fixed 1,102,413 NPV (186,023.8) © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Swap pricing What is fair fixed rate for a 2 year swap vs. 6 month LÌBOR? 6 18 12 24 6.87% 7.05 % 6.90% 7.25% X% X% X% X% (£1,288,437) £1,288,437 41 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Pricing spreadsheet today 23-JuI-05 23-Jan-06 23-Jul-06 23-Jan-07 23-Jul-07 Discount factor 1 0.9665 0.9345 0.9025 0.8712 Days 184 181 184 181 Year basis 365 365 365 365 Year proportion 50.4% 49.6% 50.4% 49.6% Forward 6 month Libor 6.87% 6.90% 7.05% 7.25% Cash fIows Nominal 10,000,000 FIoating Cash (346,323) (342,164) (355,397) (359,521) Present Value (334,731) (319,770) (320,738) (313,199) PV Floating (1,288,437) Fixed 7.01% Cash 350,623 350,623 350,623 350,623 Present Value 338,886 327,674 316,429 305,447 PV Fixed 1,288,437 NPV - © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Swap pricing What is fair fixed rate for a 2 year swap vs. 6 month LÌBOR? 6 18 12 24 6.87% 7.05 % 6.90% 7.25% 7.01% 7.01% 7.01% 7.01% (£1,288,437) £1,288,437 42 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Subsequent valuation Present value of remaining streams Cancellation? Offsetting swaps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Present value of remaining streams today 23-Jan-06 23-Jul-06 23-Jan-07 23-Jul-07 Discount factor 1 0.9711 0.9431 0.9167 Days 181 184 181 Year basis 365 365 365 Year proportion 49.6% 50.4% 49.6% Forward 6 month Libor 6.00% 5.90% 5.80% Cash fIows Nominal 10,000,000 FIoating Cash (297,534) (297,425) (287,616) Present Value (288,937) (280,489) (263,656) PV Floating (833,082) Fixed 7.01% Cash 350,623 350,623 350,623 Present Value 340,492 330,657 321,413 PV Fixed 992,562 NPV 159,480.8 43 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The swap curve Maturity GRY Gov Swap © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Special types of interest rate swaps Amortising Accreting Rollercoaster Forward start Basis swap 44 Currency swaps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Simple definition A plain vanilla swap involves a party that holds a particular currency wishing to exchange for another currency for a period of time Ìnterest is paid by swap parties on the currency received 45 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Outline 1 X delivers an agreed amount of $'s to Y and receives an agreed amount of £'s from Y (exchange of principals) 2 X pays Y interest on the £'s Y pays X interest on the $'s 3 X returns the £'s to Y and receives the $'s back he delivered in step 1 X Y $ principal £ principal X Y £ interest $ Libor X Y £ principal $ principal © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Agreement Currency swaps are an OTC product. However a 'Vanilla' currency swap; Exchange rate agreed and static Principal exchanged at beginning and end of swap (risk?) $ leg floating rate other leg fixed rate 46 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com CÌRCUS 'Combined Ìnterest Rate and Currency Swap' Example: A UK company wishes to raise variable rate £ funds by accessing the Japanese bond market © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Outline 1 Ìssue a fixed rate bond in Japan. Receives Yen fixed 2 Yen/£ cross currency swap 3 ÌRS UK Co Yen fixed coupon Yen principal £ fixed interest £ principal UK Co £ Libor interest Net: Receive £ principal paying £ floating rate £ fixed interest UK Co Yen principal Yen fixed interest 47 Equity swaps © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What is an equity swap? An equity swap is an agreement between two counterparties to swap the returns on an instrument for a stream of payments based on a floating rate of interest such as LÌBOR Pay performance Receive Interest LIBOR + Spread Credit Suisse Client 48 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What are the risks? Ìn order to eliminate the market risk CS will hold the underlying instrument as a hedge CS has NO MARKET RISK as the performance on the cash hedge will offset the performance payable on the swap CS has INTEREST RATE RISK Ìnternal funding rates are reset daily, interest rates on the swaps can be reset monthly CREDIT RISK The movement in the underlying instrument between reset dates Credit swaps 49 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Protection buyer Protection seller Basically like an insurance policy Premium Payment (if default) Single name credit default swap © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Credit default swaps Premium payments Quotation What constitutes default? Termination payment Deliverable obligations Physical or cash settled CTD Transaction size Choosing a protection seller 50 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Basket CDS Basket CDS Four names £5m each Notional £20m Corp X 40bps £5m Corp y 25bps £5mn Corp Z 15bps £5mn Corp a 24bps £5mn Basket CDS 21bps £20m Premium for 4 individual CDS = 104bps Average = 26bps Premium = £20m x 21bps £42,000 pa © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Basket CDS after default Basket CDS Corp X defaults Pay £5m ÷ recovery value Corp X 40bps £5m Corp y 25bps £5mn Corp Z 15bps £5mn Corp a 24bps £5mn Basket CDS 21bps £15m Premium = £15m x 21bps £31,500 pa 51 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com First to default CDS FtD CDS Four names £5m each Notional £20m Corp X 40bps £5m Corp y 25bps £5mn Corp Z 15bps £5mn Corp a 24bps £5mn Ftd CDS 60bps £5m Premium for 4 individual CDS = 104bps Premium = £5m x 60bps £30,000 pa © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com FtD CDS after default Corp X 40bps £5m Corp y 25bps £5mn Corp Z 15bps £5mn Corp a 24bps £5mn FtD CDS 60bps £5m FtD CDS Corp X defaults Pay £5m ÷ recovery value CDS terminates 52 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com CDS summary Buy a CDS Buy protection Pay premium Receive on default Short credit Sell a CDS Sell protection Receive premium Pay on default Long credit 1 The Corporate Training Group Syndicated Loans © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What is a Syndicated Loan? A loan made by two or more lending institutions on common terms and conditions using common documentation and administered by a common agent 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What is a Syndication? Ìdentical documentation Pro rata drawings All banks are on an equal footing Larger amounts involved Administration achieved through an Agent Borrower Agent Bank A Bank B Bank C Bank D © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicate vs Bilaterals Syndication One (big) agreement Agent & fees Many banks, but Few relationships Formality Procedure Group decisions Bilateral Simple documents Few fees(?) One bank One relationship Ìnformal 3 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Key Players in a Deal Borrower Mandated Lead Arranger (MLA) Financial commitment Participating Bank Book Runner (usually one or more of the MLA's) Co-ordinate the MLA group Agent Administration/Ìnformation distribution © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Role of the Book Runner (Arranger & Underwriter) Determining the Syndication strategy Which banks How many banks Size/price considerations Joint book running Strategy must be agreed But division of labour is useful if there are a large number of banks to contact Managing the investor base 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Role of the Agent Post signing management Ìnformation distribution Monitoring of covenants and collateral Dealing with amendments, waivers and payments © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicated Lending Borrower Lead Arranger Co-Arranger Lead Manager Agent Manager 5 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com 300 89 89 80 42 AIIocation (Cm) Total Manager Lead Manager Co-arranger Lead arranger TitIe 19 10 5 3 1 No. 335 100 100 90 45 Bid/PIanned finaI take (Cm) 100 40 50 60 Fee Rate (bps) 3.00 0.36 0.45 0.48 Fees (£m) Allocation ÷ a Typical Outturn © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Abertis Loan for Purchase of SANEF C750m 364 day tranche (364 day extension) Euribor + 40bps C2.66bn 364 day tranche (3 year extension) Euribor + 75bps C150m 364 day revolver (3 year term out) Euribor + 75 bps Margins ratchet upwards over time to encourage a capital markets take-out 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com C3.5 bn Syndication RBS C200m MLA La Caixa C200m MLA Barclays C200m MLA HSBC C200m MLA JPMorgan C130m MLA Ahorro Corporacion Financiera C102m . . C81m 28 Banks . . C40m 5 Banks . . © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Eiffage & Macquarie Loan for 70% SAPPR C5.85bn 7 year term loan Euribor + 90bps C1.8bn 7 year revolver Libor + 30 bps Commitment fee of 30% of margin C1bn one year cash bridge with leads will not be syndicating 7 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Where are the Opportunities? Syndicated loans have many applications: Acquisition & event finance Refinancing of maturing syndicated credits Replacing bilateral lines New borrowers e.g. arising from spin-offs, buy-outs etc. Bridge capital markets General financing © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Key Phases of a Syndication - Ìnformation Flow - Credit Event e.g. acquisition - Ìnformation package - Exchange of ideas - Credit approval - Finalise syndication strategy - Structure/Price - Loan Documentation - Approach Banks/Presentation - Agree Ìndicative term Sheet - Underwritten Offer - Credit Approvals - Ìnitial Syndication Strategy - Closing - Documentation - Signing in Banks Pre-Mandate Underwriting Syndication MANDATED SYNDICATION SYNDICATION COMPLETE 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Underwriting Commitment to provide funds Certainty to the borrower Strong message to the market Alternatives are 'Best Efforts' and Club deals © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicated Loan Structures Term loan Revolving Standby loan Multi÷ currency loan Evergreen loan 9 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Term Loan Availability period/fixed drawdown schedule Preconditions to drawdown Bullet/scheduled repayment Re-statement of representations & warranties on each roll-over date of the advance Can have different tranches © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Term Loan Time maturity Commitment £ millions Outstandings End of availability 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Uses of Term Loans Permanent capital Just because debt is a good thing Long term financing of acquisitions Long term financing of capital assets- property, equipment Refinancing risk management is a big issue for companies- Short term debt is cheap, but it can evaporate if a company gets into operating difficulties Ìf debt is generally expensive today, your debt cost will be high today. Long term committed financing together with tools like swaps can remove these big risks- fixing rates. © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Revolving Credit Facility The key difference between a term loan and a revolving credit is that: Ìn a revolving credit, amounts repaid are available for re-drawing With a revolving credit, each rollover represents a separate advance Commitment fee is essential 11 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Revolving Commitment Time End of availability - maturity Outstandings Commitment £ millions © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Uses of Revolving Credits Working capital finance ÷seasonal or intra-month Standby facilities Backstop facilities Acquisition "war-chest¨ 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Standby Facility Backstop to a commercial paper programme Short term Small commitment fee if undrawn High interest rate if utilised © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Price FaciIity Size Sector Bank ReIationships FinanciaI Covenants Term Current State of Bank Market QuaIity of the Credit Purpose of Ioan Pricing Factors 13 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Pricing Before any indicative pricing is given to the client, the Syndications Originator must present the transaction to 'Pricing Committee' Pricing Committee consists of the Originator & the Distribution team Distribution team sets the pricing level Pricing is often linked/ratcheted with the Credit Rating of the client 150-250 50-100 25-50 20-35 Margin (bp) BB BBB A AA Rating © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicated Loan Fees Front-end fee Arrangement fee Participation fee Underwriting fee Commitment fee Utilisation fee Agency fee 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicated Loan Fees Front-end fee A one-off amount payable up front to the arranging banks and to be shared between them and the syndicate banks (according to roles and level of commitment) Quoted as a flat % or b.p based on final facility amount Normally paid on signing date, date of first drawing or within 30 days of signing Arrangement fee/ Participation fee/ Underwriting fee © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicated Loan Fees Arrangement Fee Arranging bank normally keeps a portion of the front- end fee as an arrangement fee Considered to be the arranging banks 'reward' for winning and arranging the deal 15 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicated Loan Fees Participation Fee Ìs the portion paid out of the front-end fee to participating banks in a primary syndication Ìt is a credit-related fee calculated on each bank's allocated commitment, which is normally paid within 30 days of signing © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicated Loan Fees Underwriting Fee Ìf the deal is underwritten, this will be included in the front-end fee Ìt is the fee required by the arranging bank for assuming the risk of underwriting Calculated as a flat % based upon the initial or allocated amount of the underwriting commitment The underwritten commitment can be less than the total amount as the facility can be partially underwritten 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicated Loan Fees Commitment Fee Refers to the payment to the banks for making a credit facility available to a borrower over a specified period Exist in 2 forms: Facility fee calculated as an annual % or bp of the full amount of the committed facility & payable to all banks committed to the facility based on their level of participation Payable in arrears, at fixed intervals for the duration of the facility Size of the fee is related to the financial strength of the borrower Non-Utilisation fee An annual % fee based on the undrawn portion of the committed facility for the duration of the facility Payable quarterly in arrears © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicated Loan Fees Utilisation Fee Payment to the lender based on the average level of utilisation during a specified period Designed as a margin enhancement Agency Fee An annual fee Calculated as a fixed lump ÷ sufficient to cover at least the administrative and money transfer costs of the bank Ìt is not shared with any of the other banks 17 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Documentation Requirements To potential Participating Banks Ìnformation memoranda Ìnvitations for banks to participate To the Client Term sheets and Offer letters Loan agreements Key legal clauses & agreements © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Term Sheet A comprehensive schedule which sets out the terms and conditions of the proposal and which will, when agreed by the borrower, form the basis of the mandate Ìt should contain all the material requirements of the arranging banks(s) 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What makes an Effective Term Sheet? Borrower name, Description of facility, Amount & Purpose Maturity, conditions of availability and repayment Arrangers, lenders, agent Fees and interest rates (& definition of cost of funds rate) and when they are payable Representations & warranties, Covenants & undertakings and Conditions precedent Cancellation and Events of default Ìllegality, Taxes, Ìncreased costs and Expenses Transferability, documentation and governing law Clear market and Market flex 1 Equity © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What is equity? Part ownership Permanent capital Risk capital No guarantees 2 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Equity © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Types of equity Ordinary Preference shares Depository receipt (ADR/GDR) Convertible/Exchangeable 3 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Share rights Voting rights Pre-emptive rights Cash dividends Stock dividends Stock splits Key Participants Ìn The Global Equity Markets 4 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Twelve 'players' 1 2 3 4 5 6 7 8 9 10 11 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Key Participants Corporates Investment Banks New Shares Pension Fund Insurance Group Money Manager "Secondary¨ ÷ Ìnvestment Banks Ìntermediate Ìnstitutions "Primary¨ Distribution Process 5 Key roles in the equity division © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Ìnteraction in Equity Division Research ECMG GeneraI SaIes Trader SaIes Trading Proprietary Trading SpeciaIist SaIes 6 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Key Roles in 'Cash' Trader - firm's capital for client liquidity Sales traders - execute client business Prop traders ÷ trade with firm's capital Sales - account manages clients Research ÷ product ideas ECMG ÷ originates and processes primary © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The Typical Client Management CEO/CIO etc Equity Investment Committees / Asset AIIocation PM PM PM PM PM PM Other Assets Debt Sector AnaIysts DeaIers 7 The secondary market © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Market choices Physical Quote Driven Electronic Order Matching 8 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com LSE UK trading services Domestic securities with less than two Market Makers Quotes with exposure orders SEATS plus All other domestic securities with at least two Market Makers Competing quotes SEAQ FTSE 250 not on SETS, midcaps, some small caps, AÌM 50 & leading Ìrish Order book with Market Makers SETSmm Most liquid securities incl. FTSE 100, liquid FTSE 250 Order book SETS Securities traded Trading structure System © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Key features of SETS Stock Exchange Electronic Trading Service Automatic matching for most liquid shares Automatic trade reporting LSE members place orders (agent / principal) All orders firm (no errors!) Orders ranked by price, then time of input Partial execution possible, no priority for volume Anonymous order book 9 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com A SETS screen BUY SELL Time Volume Price Price Volume Time 11:03 14,000 254 255 3,100 11:15 12:08 7,000 254 256 3,400 11:12 11:31 13,000 253 256 15,530 11:45 11:32 6,500 253 256 5,721 11:52 11:20 10,350 252 257 15,000 12:00 11:24 14,050 252 257 7,290 12:02 11:40 6,933 252 Highest buy price Then time of entry Lowest sell price 10 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Key features of SETS Normally standard settlement ÷ T + 3 Whole market views entire order book Tick sizes: Below 500p = ¼ p 500p to 1000p (incl) = ½ p Above 1000p = 1 p © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com SETS order types Limit At best Fill or kill Execute and eliminate Ìceberg Market 11 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com "Dealing away¨ Order book accounts for about 70% of London liquidity Can deal away and report to LSE Mainly at or close to SETS price © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Key features of SEAQ Mandatory two-way quotes 'All weather' prices Prices firm to brokers up to quoted size Minimum size Trades reported within 3 minutes Protection available on largest blocks 12 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com SETSmm A hybrid system Market makers must submit two way prices as in SEAQ, these prices are submitted as orders as opposed to quotes Ìn addition brokers can submit orders to the order book as in SETS 13 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com SEATS plus Another hybrid system Allows a maximum of one Market Maker to offer a firm quote, trading is completed in the same method as on SEAQ Brokers can submit orders onto the system which other brokers can then see and select to 'hit' Trade reporting is automatic for 'hit orders 14 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The US market 15 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The US markets AMEX Small Caps. ETFs & Options NASDAQ shares on auction basis Exchanges NYSE, American, Regional OTC NASDAQ ("merged¨ with AMEX in 1998) OTCBB (penny stocks) © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com NYSE versus NASDAQ Auction Market Order driven 75% trades with other investors Priority for public over specialists Centralised order flow DeaIer Market Quote driven ÷ MM Market makers trade against public orders No priority for public Dispersed order flow among MMs and ECNs 16 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com NYSE versus NASDAQ Auction Market Specialists ÷ must provide liquidity / dampen volatility Specialists evaluated Single opening price ÷ no trade ahead of opening DeaIer Market MMs ÷ minimal size obligation, no obligation on volatility No evaluation of MMs No single opening price ÷ MMs can trade ahead of opening © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com ECN ÷ Electronic Communications Networks Electronic trading access levels SOES - Small Order Execution System NASDAQ ÷ more information 17 The primary market © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Focus on ÌPO distribution Book build Modern structure ÷ US origins No underwriting syndicate ÷ maximise fees Generate demand then price Client "at risk¨ ÷ price set at end Underwriting Traditional structure ÷ UK origins Underwritten by syndicate ÷ split fees Generate price ÷ then demand Broker at risk ÷ demand finalised at end 18 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Key phases in an ÌPO Winning and understanding the deal Establish the selling proposition Distribution ÷ position deal, generate demand Distribution ÷ generate momentum, fill orders Trading and completing the deal © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Parties involved in ÌPO Ìssuer Selling shareholders Bankers Legal advisors Accountants Public relations Stock exchange Printers 19 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Syndicate structure 70-90% of the gross fees Leads process - allocates stock at pricing The Key Role Status for relationship banks not playing bookrunner role Use research and sales penetration Bulge only if C1m+ fees available / key strategic client Underwriting fees only - little chance of receiving stock Bookrunner Joint Lead Co-Iead Co-manager © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Sample new issue timetable CompIetion of offer Commence preparation of Offering CircuIar T-3 months AnaIyst briefing T-7 weeks PubIication of research, start pre- marketing T-4 weeks Offer Iaunched T-2 weeks Pricing & aIIocation T 6 weeks Appointment of advisors Financial due diligence Legal due diligence Drafting of offering circular and Listing Particulars Preparation of Research 3 weeks Syndicate analysts briefed on ÌPO All syndicate participants publish research Research reports form the main marketing documents Pre-marketing 2 weeks Research analysts approach key institutions Pre-marketing feedback critical to finalise management roadshow programme Roadshow & BookbuiIding 2 weeks Price range announced Management meets institutions in key financial centres Syndicate members build a book of demand Due DiIigence and preparation of Offering CircuIar / Listing ParticuIars StabiIisation 4 weeks Bookrunner stabilises price in immediate aftermarket On-going research coverage and investor relations programme Start of Process T-3/4 months 20 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Follow on offerings Sale on open market Full book build AEO Block trade Rights issue Rights issue 21 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Rights Ìssue Fundamentals Lead managers will sell the shares on their behalf at the end of the offer period Shareholders normally receive cash equivalent to the difference between the price received for the unsubscribed shares sold and the rights issue price (which goes to the issuer) SharehoIder Options Take up rights SeII niI paid rights Do nothing Shareholders exercise their rights by paying subscription price Normally an active trading market for nil paid rights Theoretical value = the difference between the theoretical ex rights price ('TERP') and the rights issue price Listed and traded independently for up to 3 weeks AEO and block trade 22 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Provide a "Quick-to-Market¨ solution to vendors or issuers of substantial equity stakes wishing to monetise their positions through access to the Equity Capital Markets Typically, these transactions are launched, executed and priced on a fast track basis, usually within a 24 hour period Block Trades and AEO Disposal of : i. Cross/Non-Strategic Shareholdings (Secondary) ii. Own Shares (follow on) Monetisation through : a. Block Trade b. Accelerated Bookbuild The equity-linked market ÷ convertible bonds 23 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Convertible bonds What are they Mandatories Exchangeables Hybrids Ìssuer perspective - impact on equity and senior debt Ìnvestor Perspective Different investors Arbitrage © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What is a Convertible? THE DEBT PERSPECTIVE ON A CONVERTIBLE BOND Has par vaIue Pays coupon Maturity date Senior to equity in event of Iiquidation Exchange for NEW shares (conversion ratio) Option of hoIder ConvertibIe Bond CaII Option Straight Bond 24 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com The jargon A "balanced convertible¨ "Equity like¨, high parity "Low parity¨, bond like Bond floor Parity Share price Convertible value Recovery vaIue © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com What is a Convertible Bond? Unsecured lending with (fixed) coupon Can be subordinated to existing bonds (or in form of a preference share) Embedded option - right (but not obligation) to convert to shares Flexible, specified terms and conditions Ìf not converted then redeemable at maturity 25 © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com Additional Features On top of conversion option . Many CBs have call and put features Callable = issuer announces call and holder has right to convert Call feature mainly used to force early conversion Putable = holder sells back for put price Put feature usually used where interest rates rise and if convertible falls deeply out of the money. Puts are potentially very dangerous for issuers © The Corporate Training Group Ltd · +44 (0)20 7490 4770 · www.ctguk.com A Case study Issuer: Versatel Telecom Ìnt'l N.V. Security Type: Unsubordinated ConvertibIe Bond Rating: Unrated TotaI Proceeds: C125mm Greenshoe yes Issue Price: 100% CIosing Date: 28 Oct 2004 Coupon: 3.875% YieId To Maturity: 4.63% Conversion Premium: 28% Conversion Price: C2.033 Share Price at issue: C1.588 Maturity: 7 years CaII Option: After 5 years subject to a 130% hurdIe Redemption Price at Maturity: 100% Use of Proceeds: Refinancing bank faciIity / Iengthening debt maturity Listing: Euronext (Amsterdam)