Rothschild Analyst Training

Index

Analyst programme 7 August 2006 – 12 September 2006

1. Financial statements

2. Balance sheet

3. Income statement

4. Cash flow statements

5. M&A accounting

6. Enterprise and equity value

7. Accounting & analysis exercises

8. Accounting & analysis solutions

9. Financial maths

10.Valuation

11.Comparable companies analysis (comps)

12.Precedent deals analysis (pre deals)

13.Valuation exercises

14.Valuation solutions

15.Financial modelling

16.Practical investment banking

17.Debt

18.Financial markets

19.Taxation

20.Law

Published financial statements

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Financial statements 1Published accounts 1Components of financial statements 3International comparison 4

Historical development 4International accounting standards 5

Balance sheet 6Assets 6Liabilities 7Shareholders’ funds 7

Income statement 8Revenue 8Expenses 8Exceptional & extraordinary items 9Earnings per share 9Second income statement 10

Cash flow statement 11Cash flow 11Categories 11Methods 12Cash flow links to income statement and balance sheet 13Free cash flow 13


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Financial statements

Published 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. It delineates the enterprise’s:

� resource structure (major classes and amounts of assets); and� financial structure (major classes and amounts of liabilities and equity).

It reflects the accruals concept.

Corporate value

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.


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Going concern

The financial statements are prepared on the assumption that the enterprise will continue in operation for the foreseeable future. It 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. It 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).

It reflects the accruals (or matching) concept.

Accruals 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.

Analysis

Key metrics calculated from the income statement include:

� EBITDA (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. It 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.



Analysis

Key metrics calculated from the cash flow statement include:

� operating cash flow; and� free cash flow.

Components of financial 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.

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.



International 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.

Historical development

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


� accounting standards (FRSs) issued by ASB (private sector)

� few(er) rules, (some) alternative treatments, subjectivity in applying concepts, emphasis on substance

IAS


� accounting standards (IASs) issued by IASC [2001 → IFRSs issued by IASB]

� (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 4th Directive (formats and rules of accounting) was largely based on German law. The 7th Directive (consolidated accounts) was substantially based on UK practice.



International accounting standards

The International Accounting Standards Committee (IASC) was formed in 1973. It aimed to improve and harmonise accounting worldwide by issuing International Accounting Standards (IASs).

The IASC was restructured in 2001 to a newly constituted International Accounting Standards Board (IASB) which has issued International Financial Reporting Standards (IFRSs) from 2002.

The trustees of the IASB, who approve the budget, monitor effectiveness and have responsibility for constitutional changes, in addition to raising funds, are representative of the IASB’s member nations as follows:

� 6 North Americans;� 6 Europeans;� 4 from Asia Pacific; and� 3 from other areas.

IASB (International Accounting Standards Board) members

1. Sir David Tweedie, IASB chairman (formerly UK ASB);2. Tom Jones, IASB 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.

In March 2004 IASB completed the development and enhancement of its core set of IASs and IFRSs (2005 stable platform).

Europe

In 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.



Balance sheet

Assets

Tangible assets

Tangible assets are assets that have physical substance.

Tangible fixed assets (UK) Property, plant 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

Intangible 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.

Inventories 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.



Debtors (UK) Receivables (US)

Assets created by providing money, goods or services directly to a debtor (eg a customer).

Liabilities

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.

Shareholders’ 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)



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

Examples Examples

� Depreciation� Purchase of materials� Wages and salaries� Interest� Taxation

� Cost of sales� Distribution costs� Administrative expenses� Interest� Taxation



Exceptional & extraordinary items

Different countries have different views on what is exceptional, what is extraordinary and how these items should be presented.

Extraordinary items

Examples

� Expropriation of assets� Natural disasters

IAS/IFRS

Under IAS/IFRS, no items are presented as extraordinary.

Exceptional items

Examples

� Restructuring costs� Profits and losses on disposal of PPE

Earnings per share

Earnings per share (EPS) = sharesofNumber

Earnings

Basic EPS

UK US

Earnings

Net profit or loss for the period attributable to ordinary shareholders

Earnings

Income 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



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

In order to facilitate comparability across different accounting regimes and between different companies, the Institute of Investment Managers and Researchers have suggested that a headline EPS figure is additionally calculated using the earnings calculated to

Include

� 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

In 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’).



UK US

Statement of total recognised gains and losses

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 flow statement

Cash flow

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. Investing

3. Financing



Operating

Operating activities are the principal revenue producing activities of the enterprise and other activities that are not investing or financing activities.

Investing

Investing 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.

Examples

� 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.

Examples of adjustments

� Depreciation and amortisation� Changes in (operating) working capital



Cash flow links to income statement and balance 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

In 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 flow

‘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.

In 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. It 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.

Balance sheet issues


Balance sheet 1Components of financial statements 1Components 1Definitions 1Recognition criteria 1

Assets 2Current v non-current 2Intangible assets 2Depreciation 3Impairment 3Revaluations 4Capitalisation of interest 5

Liabilities 6Current v non-current 6Debt 6Convertible bonds 8Leases 11Provisions and contingent liabilities 13Pensions and other post-employment benefits 17

Net debt 23Debt 23Cash equivalents 23Illustration 23

Shareholders' funds (stockholders' equity) 25Components 25Different classes of share 26Share issues 26Bonus / capitalisation / scrip issues 28Rights issues 28



Balance sheet

Components of financial 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).



Reliable measurement

Cost or fair value?

What constitutes reliable measurement can differ between:

� countries; and� asset (or liability) categories.

Assets

Current v non-current

In many countries, assets are distinguished between current and non-current (or fixed).

In some countries the distinction is based on time (realisation expected within or in more than one year). In others, the distinction is based on whether or not the asset will be sold or consumed as part of the operating cycle.

Intangible assets

Intangible 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

If 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

In 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.



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. It is not amortised.

Internally 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

Irrespective of whether there is any indication of impairment, the following are reviewed for impairment annually:

• Intangibles with an indefinite useful life; and

• Goodwill acquired in a business combination.



Measurement

If an asset is impaired, its carrying amount is written down to its recoverable amount. The impairment loss is recognised as an expense.

Recoverable 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.

Revaluations

Initial measurement

In most countries, PPE (or tangible fixed assets) are initially measured at purchase price or production cost.

Revaluation

In 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.



Capitalisation of interest

In 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

€m €mRevenue 48,000 Revenue 48,000Capitalised interest 65

48,065Interest expense (500) Interest expense (435)



Liabilities

Current v non-current

In most countries, liabilities are distinguished between current and non-current (or long-term).

In some countries the distinction is based on time (due to be settled within or in more than one year). In others, the distinction is based on whether or not the liability is expected to be settled as part of the operating cycle.

Debt

Initial 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.

Illustration 1

A company issues a €100m bond at par. The bond pays a coupon of 6% per annum. The bond is redeemable five years later at par. Ignore issue costs.

year BS P&L cash BS@ start charge @ 6% paid end

1 100.00 6.00 (6.00) 100.002 100.00 6.00 (6.00) 100.003 100.00 6.00 (6.00) 100.004 100.00 6.00 (6.00) 100.005 100.00 6.00 (6.00) 100.00

Total 30.00 (30.00)



Issue costs

Illustration 2

A company issues a €100m bond at par. The bond pays a coupon of 6% per annum. The bond is redeemable five years later at par. Issue costs are €2m.

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) 98.352 98.35 6.37 (6.00) 98.723 98.72 6.40 (6.00) 99.124 99.12 6.42 (6.00) 99.545 99.54 6.46 (6.00) 100.00

Total 32.00 30.00

Discounted debt

Illustration 3

A company issues a €100m bond for net proceeds of €83.15m. 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



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) 86.142 86.14 5.17 (2.00) 89.313 89.31 5.36 (2.00) 92.674 92.67 5.56 (2.00) 96.235 96.23 5.77 (2.00) 100.00

Total 26.85 10.00

Convertible 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.



Illustration (IAS)

A company issues €100,000 3% convertible debt at par. Interest 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%.]

Initial recognition

The debt component of the proceeds, calculated by discounting the future cash flows at the market rate of 7%, is €90,729. The balance of the proceeds (€9,271) is deemed to be the fair value of the consideration received for writing a call option on the issuer’s shares.

Balance sheet

€000Cash + 100

Debt (liability) 90.73

Derivative (equity) 9.27


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) 94,08094,080 6,586 (3,000) 97,66697,666 6,836 (3,000) 101,502101,502 7,105 (3,000) 105,607105,607 7,393 (3,000) 110,000

€34,271

At the end of the first year


€000 €000 €000

Debt 94.08 Interest expense (6.35) Interest paid (3.00)

Equity 9.27



US GAAP

FAS 133 requires convertible debt to be classified as a liability. The embedded equity option is not separated.

Initial recognition

Balance sheet

€000

Cash + 100

Debt 100Equity


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) 101,816101,816 4,904 (3,000) 103,720103,720 4,996 (3,000) 105,716105,716 5,092 (3,000) 107,808107,808 5,192 (3,000) 110,000

€25,000

At the end of the first year


€000 €000 €000

Debt 101.82 Interest expense (4.82) Interest paid (3.00)



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 (capital) leases

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 leases

An operating lease is not recognised in the balance sheet. Lease rental payments are recognised as an expense in the income statement.

Measurement


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 leases

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 €120m (payable in arrears). The interest rate implicit in the lease is 8½% (approximately). The present value of the minimum lease payments is €614m.

At the end of the first year of the lease, the financial statements would show:



Finance lease

Balance sheet P&L account Cash flow statement

€m €m €mProperty, plant & equipment 526

Operating expenses (depreciation)

(88)Interest paid (52)

Debt – finance leases (546)

Interest expense (52) Financing repayment (68)

Working

year BS P&L finance cash BS@ start charge @ 8½% paid @ end

1 614 52 (120) 5462 546 46 (120) 4723 472 40 (120) 3924 392 33 (120) 3055 305 26 (120) 2116 211 18 (120) 1097 109 11 (120) 0

Total 226 (840)

Operating lease


€m €m €mOperating expenses (120)

Operating cash flow(120)

Classification


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.



US (FAS 13)

If 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 leases

An operating lease is a lease other than a finance lease.

Provisions and contingent liabilities

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.

Obligating 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.



Probable outflow

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).

Reliable estimate

If 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.



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



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

€m

Provision 442

Closing balance sheet P&L account Cash flow statement

€m €m €mEBIT

Provision 524 Cost of sales (82) Change in provision 82EBIT Operating cash flow

Notes to accounts €m

Opening balance 442

Utilisation (170)

Additions 280

Release (28)

______

Closing balance 524______



Pensions and other post-employment 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

Balance sheet

Many GAAPs (eg US GAAP, IAS) 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.



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 IFRS 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.

It is the increase in the obligation resulting from employee service in the period. It is a deferred wage cost and can be regarded as a genuine operating expense.

Illustration 1

Rhodia has a defined benefit pension scheme. Its consolidated financial statements show:

Balance sheet (extracts) P&L account

€m €m

Net funds/(debt) (2,050) EBITDA 365D&A (524)

Pension liability 431 EBIT (159)Net financial expense (348)

Shareholders equity 252 EBT (507)Minority interests 23

275



Pension liability

Projected benefit obligation

Opening balance 2,056Service cost 33 Interest cost 118Benefits paid (103)Actuarial losses (gains) 170Foreign currency translation differences (124)

_________

Closing balance 2,150_________

Plan assets @ fair value

Opening balance 1,122Actual return on plan assets 123Contributions paid 8Benefits paid (103)Foreign currency translation differences (84)

_________

Closing balance 1,066_________

Projected benefit obligation in excess of plan assets 1,084Unrecognised net gains (losses) (653)

_________

Pension liability recognised 431_________

Net periodic pension cost

Benefits earned during the year (current service cost) 33Interest cost 118Expected return on plan assets (83)Net amortisation and other deferrals 33

_________

101_________

The net periodic pension cost has been deducted in arriving at EBITDA.



Credit metrics

Unadjusted net debt/EBITDA

Net debt/EBITDA = m365€m050,2€ = 5.6

Adjusted net debt/EBITDA

Net debt/EBITDA = m433€m134,3€ = 7.2

Adjusted net debt = 2,050m + 1,084m = €3,134m

Adjusted EBITDA = 365m + 101m – 33m = €433m

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 £mNet debt (4,509) EBITDA 3,118

D&A (838)Pension liability (1,211) EBIT 2,280

Finance income 114Shareholders’ equity 9,380 Finance costs (241)Minority interests 64 EBT 2,153

9,444

Statement of recognised income & expense (extracts)

£mActuarial losses (442)Exchange differences (1)



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 209Interest 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 309Experience 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 SORIE (442)_________

Defined benefit pension plan assets

Opening fair value of plan assets 2,718Expected return 209Actuarial gains 309Contributions by employer 270Actual member contributions 6Foreign currency translation differences -Benefits paid (64)

_________

Closing fair value of plan assets 3,448_________



Defined benefit obligation

Opening defined benefit obligation (3,453)Service cost (328)Interest cost (184)Losses on change of assumptions (727)Experience losses (24)Foreign currency translation differences (1)Benefits paid 64Actual 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 25Contributions 270Foreign currency translation differences (1)Actuarial (loss)/gain (442)

_________

Deficit in schemes at end of the year (1,211)_________



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 equivalents

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.

Illustration

A company’s balance sheet shows:

note €m

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.



Note 5

Liabilities comprise:

€m

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

€m

Bonds 1,812

Due to banks 797

Loan notes 649

Finance leases 2,329

Debt 5,587

Cash and cash equivalents (1,292)

Net debt 4,295



Shareholders' funds (stockholders' 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

In 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%).



Different classes 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. In 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)

In most countries, shares are issued with a par or nominal (or face) value. In 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. In most countries, it can be used to issue (fully paid) bonus shares.

In 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:



� deducted from the fair value of the instrument issued to give the net proceeds of the issue. [In 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.

Illustration

During the period, a company issues shares with a par value of €732m for gross proceeds of €10,613m. Share issue costs were €240m.

Treatment 1

Balance sheet Income statement

€m €m

Common stock + 732Additional paid-in capital + 9,881 Share issue costs (240)Retained earnings - 240

+ 10,373

Treatment 2


€m €m

Common stock + 732Additional paid-in capital + 9,641Retained 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.



Bonus / capitalisation / scrip issues

In 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 €1,528m. 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).

Balance sheet extracts

Before bonus After bonus

€m €m

Net assets y y

_________ _________

Share capital (↑ €220m) 110 330

Share premium account (↓ €220m) 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

In 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. In 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.



Illustration

A company has a 31st December year end. On 1st January there were 300,000 $1 ordinary shares in issue. On 31st August, there was a rights issue of 1 new ordinary share for every 3 shares held at $11 per share. Issue costs are negligible. Immediately prior to becoming ex-rights, the share price was $15. Earnings for the year ended 31st 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 = 619,347000,295$ = 84.9c

No of shares:1 Jan – 31 Aug 300,000 x 8/12 x 15/14 214,2861 Sep – 31 Dec 400,000 x 4/12 133,333

347,619

Commercial 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.



Bonus element of rights issue

3 x $15 $451 x $11 $114 $56

Theoretical ex rights price = 456$ = $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 26,667To 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 400,000/373,333 214,2861 Sep – 31 Dec 400,000 x 4/12 133,333

347,619

Income statement, EPS, EV & ROIC


Income statement & EPS 1Income statement 1

Format 1Second income statement 2Revenue recognition 2Exceptional & extraordinary items 8

Earnings per share 10Accounting standards 10Earnings – basic 11Number of shares - basic 11Diluted EPS 14Restatement 17

Financial assets and liabilities 18Financial assets 18Financial liabilities 19Measurement 20



Income statement & EPS

Income statement

The income statement (or P&L account) is a report of financial performance for a period. It focuses attention on key characteristics of components of performance by:

� classifying revenues and expenses by function (eg operating v financial) or nature (egpersonnel 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).

It reflects the accruals (or matching) concept.

Format

Costs classified by nature Costs classified by function

Income statement Income statement

€m €mRevenue 48,309 Revenue 48,309Change 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 8,311Depreciation & 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)



EBITDA

€3,028m + 5,348m + 15,221m – 65m = €23,532m

€8,311m + 15,221m = €23,532m

Second income statement

In 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; orchanges 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). It 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. It 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.



In some cases, customers pay for goods or services before the goods or services are delivered. In 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 €346m from customers in respect of future flights. During the period the airline:

(1) Received €9,045m from customers in respect of flights booked; and

(2) Delivered flights for which customers had paid €8,912m.

All customers pay in advance.

Balance sheet extract (€m) 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



Customers pay after


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


i Cash increases

ii The asset ‘accounts receivable’ decreases because the business has no further right toreceive cash from customers

Goods

At the beginning of the period, a supplier of office stationery had accounts receivable of €847m. During the period the supplier :

(1) Delivered stationery with selling prices of €9,250m to customers; and

(2) Received €9,154m from customers in respect of stationery sales.

All sales are on credit.

Balance sheet extract (€m) 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



Over a period

Customers pay before


i Cash increases

ii The liability ‘unearned revenue’ increases because the business has an obligation to deliver 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 €840 for the right to use the gym’s facilities for 12 months.

The gym has a 31 December year end.

Balance 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 = €840 x 9/12 = €630



Customers pay after


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


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 €50,000. 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.

Balance sheet extract (€000) 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 = €50,000 x 80% = €40,000



IAS 19

Sale 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).



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

€m

Liability – unearned revenue 570

Closing balance sheet P&L account Cash flow statement

€m €m €mRevenue EBIT

Liability – unearned revenue 670

Change in unearned revenue 100

Exceptional & 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



Exceptional 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.

Exceptional items

Exceptional items are presented either on the face of the P&L account or in the notes to the accounts.

Country specifics

IAS

Items 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).



Earnings per share

Earnings per share (EPS) is a key indicator of financial performance. It 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 IAS33 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

� Issue to the market

� Conversion of debt instrument

� Issue 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



Earnings – basic

Earnings = net income.

For this purpose, net income is the profit earned for equity owners (ordinary shareholders) during the period. It is after:

• Depreciation and amortisation

• Interest

• Tax

• Preference dividends (if any)

Number of shares - basic

Number of shares = weighted average number of ordinary shares outstanding during period.

Change in resources

In 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.

Illustration 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



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 €18,000 in the prior year and has earnings of €22,500 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 = 000,60000,18€ = 30.0c

Reported in current year

Current year EPS = 000,180500,22€ = 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



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:

sharepervaluefairrightsexlTheoreticarightsofexercisethebeforeyimmediatelsharepervalueFair

−

Illustration 3

A company with a 31 December year-end had earnings of €30,000 in the prior year and has earnings of €38,000 in the current year. On 1 January in the current year it had 500,000 ordinary shares outstanding. In February it announced a 1 for 5 rights issue at €5.00 per share. The last date to exercise rights was 1 March. The fair value of 1 share immediately before exercise on 1March was €11.00.

Reported in prior year

EPS = 000,500000,30€ = 6.0c

Reported in current year

Current year EPS = 667,591000,38€ = 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

65€)11€x5( + = €10.00



Diluted EPS

Potential ordinary shares

Potential ordinary shares are financial instruments or other contracts or rights that may entitle the holder to ordinary shares.

Examples

• 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.



Convertible debt

Illustration

Net profit €1,000

Ordinary shares outstanding 10,000

Convertible 10% €1 bonds 1,000

Interest expense for the year relating to the convertible bond €100

Tax relating to interest expense €40

The convertible bonds have been outstanding throughout the period. Each block of 10 bonds is convertible into 15 ordinary shares.

Basic EPS

000,10000,1€

= 10.0c

Fully diluted EPS

500,11060,1€ = 9.2c

Adjusted net profit€1,000 + €100 - €40 €1,060

Number of ordinary shares for diluted EPSOrdinary shares outstanding 10,000

Number of ordinary sharesresulting from bond conversion 1,500 11,500

IAS/IFRS

As IAS 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.



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.

Dilutive 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

IFRS 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.

In 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.

Illustration

A company had earnings of €1,200,000 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 €4.00.

Options to subscribe for 1,000,000 shares at an exercise price of €3.00 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 €0.10 per option.



Basic EPS

000,000,5000,200,1€ = 24.0c

Diluted EPS

000,225000,000,5000,200,1€

+= 23.0c

Issue of shares for no consideration

Number of shares under option 1,000,000

Number of shares that would have beenissued at fair value = (1,000,000 x €3.10) ÷ €4

775,000

Issue of shares for no consideration 225,000

Adjusted exercise price = €3.00 + €0.10 = €3.10

Restatement

If 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.



Financial assets and liabilities

Financial assets

Financial assets include:

• Accounts receivable

• Investments 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)

Financial assets

loans and receivables

held-to-maturity @ fair value through profit or loss

available-for-sale

Balance sheet carrying amount

Amortised cost Amortised cost Fair value Fair value

Gains and losses

N/a N/a In income statement In equity

Examples

Accounts receivable Investment in debt securities

Derivatives Investment 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.



Financial liabilities

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)

Financial liabilities

@ fair value through profit or loss other

Balance sheet carrying amount

Fair value Amortised cost

Gains and losses

In 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.



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. If 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 value @ start

Fair value @ end

1. Trade receivables 200 200 203

2. Purchased option 5 35 45

3. Investment in corporate bond 300 285 289

4. Investment in equities 200 257 265

Requirement

Show the impact of these assets on the income statement and closing balance sheet. Ignore coupon receipts on the corporate bond, dividend receipts on the equities and taxation.



Impact

Closing balance sheet Income statement

Assets

Trade receivables

Purchased option

Investment in corporate bond

Investment in equities

Equity

Retained earnings

Other recognised gains

Other recognised income and expense



Solution

Closing balance sheet Income statement

Assets

Trade receivables 200

Purchased option 45 Gain on purchased option 10

Investment in corporate bond 300

Investment 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


Cash flow statements 1Indirect method 1

Adjusting EBIT 1Adjusting net income 2Depreciation and amortisation 3Working capital adjustments 3

Cash flow for valuation 7Levered free cash flow 7Unlevered free cash flow 7




Indirect method

The indirect method arrives at operating cash flow by adjusting profit for non-cash items which have impacted its calculation.

Adjusting EBIT

EBIT 1,014

Depreciation 405

Amortisation -

EBITDA 1,419

Changes in non-cash working capital

Increase in accounts receivable (328)

Increase in inventories (605)

Increase in accounts payable 798

(135) (135)

Operating cash flow before interest and tax 1,284

Interest paid (184)

Tax paid (221)

Operating cash flow after interest and tax 879

Capital expenditure (995)

Decrease (increase) in net debt (116)



EBIT v net income

Sales 17,204

Cost of sales (15,150)

Other operating expenses (1,040)

Earnings before interest and tax (EBIT) 1,014

Interest (184)

Tax (249)

Net income 581

Adjusting net income

Net income 581

Depreciation 405

Amortisation -





(135) (135)

Change in tax and interest liabilities 28



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.



Depreciation and amortisation

Depreciation is added back to cancel its effect. It has reduced EBIT and is not a cash flow. Amortisation is added back for the same reason.

EBIT 1,014

Depreciation 405

Amortisation -

EBITDA 1,419

Working capital adjustments

Principles

Accounts receivable

Profit must be adjusted for the difference between:

• Sales (in the income statement and impacting EBIT); and

• Receipts from customers (a cash inflow).

Sales 17,204


Receipts from customers 16,876

Adjustment

An increase in accounts receivable is subtracted from EBIT or EBITDA to arrive at operating cash flow. This is because sales increase EBIT (and EBITDA) and receipts from customers are less than sales if accounts receivable have increased.

EBITDA x



Increase in inventories

Increase in accounts payable

Operating cash flow x



Inventories and accounts payable

Profit must be adjusted for the difference between:

• Cost of goods sold (in the income statement and impacting EBIT); 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

Increase in inventories 605

Cost of goods purchased 15,755

Increase 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 EBIT:

• An increase in inventories is subtracted from EBIT or EBITDA to arrive at operating cash flow; and

• An increase in accounts payable is added to EBIT or EBITDA to arrive at operating cash flow.

EBITDA x


Increase in accounts receivable



Operating cash flow x



Practice

In 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.

Illustration

Balance sheet Cash flow statement

end start

Accounts receivable 652 271 Increase 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)

Increase 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 capitalwill not correspond to the working capital adjustments in the cash flow statement.



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 pagerIntegrated balance sheets are not included. Sales growth is a key value driver. Working capital can be assumed to grow in line with sales.

Fully integratedWorking 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 for valuation

Levered free cash flow

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. It is after interest, tax and capital expenditure. It represents the cash available to make payments to equity (dividends or share repurchases) and capital repayments of debt.

Example


Interest paid (180)

Tax paid (228)


Levered free cash flow 297

Unlevered free cash flow

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. It is before interest but after tax and capital expenditure. It represents the cash available to make any payments to equity (dividends or share repurchases) and debt (interest and capital repayments).

Interest tax shield

Interest is tax deductible in most countries – it ‘shields’ tax. If 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.



Given

Interest paid (180)

Tax paid (228)

Tax rate 30%

Interest tax shield

Interest tax shield = 30% x 180 = 54

Adjusted tax

Tax adjusted for interest tax shield = 228 + 54 = 282

Example


Adjusted tax (282)


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.

Interest after tax = 180 x 70% = 126

M&A accounting


M&A accounting 1Parent 1Group 1Consolidated financial statements 1

Investments 1Subsidiaries (IAS 27) 2

Recognition 2Measurement 2

Business combinations (IFRS 3) 3Applying the purchase method 3Goodwill 5Illustration – fair values and goodwill 6

Joint ventures (IAS 31) 7Recognition 7Measurement 7Illustration 8

Associates (IAS 28) 9Recognition 9Measurement 9Illustrations 10

Summary 15

M&A accounting


M&A accounting

In most countries, a parent presents consolidated financial statements for its group.

In 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.

Consolidated financial 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

In 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 influence

little significant jointly controlled dominant / controlling

financial asset

cost (subject to impairment) or fair

value (IAS)

associate

equity account

joint venture

proportionately consolidate or equity

account

subsidiary

consolidate(purchase / acquisition

accounting)

M&A accounting


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


Business combinations (IFRS 3)

All business combinations are accounted for by applying the purchase method.

Applying 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:

� If 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.

� If 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.

� If 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


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.

Liabilities 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 directly attributable 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 values

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


Acquiree’s identifiable assets and liabilities

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 intangible 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).

Goodwill

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


Negative goodwill

If 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.

Illustration – fair values and goodwill

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:

£mIntangible assets -Property, plant and equipment @ net book amount 1,043Net working capital 23Net 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.

Goodwill

Cost of acquisition 9,333less: fair value of identifiable assets less liabilities (2,307)Goodwill 7,026

Fair value of identifiable assets less liabilities

£mIntangible assets 552Property, plant and equipment 915Net working capital 40Net funds/(debt) 800

2,307

M&A accounting


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

In 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


Illustration

An investing company has contributed £25m for 50% of the equity of a joint venture company.

JV company

Balance sheet

£mPPE 335.0

Debt 285.0

Share capital 0.2Share premium 49.8

Total finance 335.0

Investing companyOwn financial statements Consolidated financial statements

Equity method Proportionate consoln

Balance sheet(extract)



£m £m £mInvestment (cost) 25.0 Investment 25.0 ↑ PPE 167.5

↑ Debt 142.5

M&A accounting


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

• Interchange of managerial personnel

• Provision of essential technical information

20% stake

If 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


Illustrations

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)

£mPPE 435.0

Debt 285.0

Share capital 0.2Share premium 49.8Retained earnings 100.0Total finance 435.0

Investing company

Own financial statements Consolidated financial statements

Equity method



£m £mInvestment (cost) 15.0 Investment 45.0

(30% x (435 – 285))Retained earnings ↑ 30.0(30% x 100)

Associate company

P&L(extract)

£mOperating profit 90Interest (40)Profit before tax 50Tax (17)Profit after tax 33

M&A accounting



Method 1 Method 2 Method 3

Consolidated P&L(extract)



£m £m £mShare of operating profit

27

Share of interest (12)Share of PBT 15Share 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.]

Calculation 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

£mPPE 435.0

Debt 285.0


M&A accounting


Investing company


Equity method



£m £mInvestment (cost) 25.0 Investment 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)

£mOperating profit 90Interest (40)Profit before tax 50Tax (17)Profit after tax 33







26

Share of interest (12)Share of PBT 14Share of tax (5) Share of tax (5)

Share of PAT 9

Share of profit is reduced by premium amortisation of £1m.

M&A accounting


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

£mPPE 435.0

Debt 305.0


Investing company


Equity method



£m £mInvestment (cost) 15.0 Investment 39.0Cash ↑ 6.0

Retained earnings ↑ 6.0 Retained earnings ↑24.0 Total ↑ 30.0

Consolidated P&L






27

Share of interest (12)Share of PBT

15Share of tax (5) Share of tax (5)

Share of PAT 10

M&A accounting


The consolidated P&L account includes the investor’s share of the associate’s results, whether retained or remitted.

M&A accounting


Summary

Long term investment in equity shares (voting rights)

Indicative ownership < 20% 20% – 50% > 50%

Influence insignificant significant jointly controlled control

Investment type financial asset associate joint venture subsidiary

Accounting Amortised cost or FV

Equity accounting Proportional consolidation Consolidation (purchase/acquisition accounting)

Consolidated income statement

Change in fair value “1 line consolidation”

Our % of A’s PAT(Goodwill impairments)

No MI

(US – 1 lineOther – 2 linesUK – 5 lines)

Line by line our % of JV’s Sales to PAT

(Goodwill impairments)No MI

Line by line 100% of S’sSales to PAT

(Goodwill impairments)MI = MI% x S’s PAT

Consolidated balance sheet

Fair value “1 line consolidation”Our % of A’s net assets

GoodwillNo MI

Line by line our % of JV’snet assetsGoodwillNo MI

Line by line 100% of S’snet assetsGoodwill

MI = MI% x S’s net assets

M&A accounting


Financial asset Associate Joint venture Subsidiary



Sales 0% 0%(although look out for UK’s gross equity method which discloses

share of sales)

Share of sales 100%

EBITDA 0% 0%(assuming EBIT extracted

excluding associate)

Share of EBITDA 100%

EBIT 0% 0%(assuming EBIT extracted

excluding associate)

Share of EBIT 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 flow Dividends received Dividends received from associate Share of cash flows 100%

Assets Fair value Investments 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 liabilities

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

Shareholders’ equity

Incr/decr with adj to FV

Incr/decr from share of net income less goodwill impairment



M&A accounting


Financial asset Associate Joint venture Subsidiary



From equity value to enterprise value (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


Enterprise and equity value

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Enterprise and equity value 1Definitions 1

Enterprise value 1Equity value 1

Multiples 2Enterprise value 2Equity value 2Exercise 1 4Exercise 2 5

Corporate adjustments 6Minority interests 6Associates and equity accounted joint ventures 7Pension obligations 8Operating leases 9

Assessing & comparing corporate performance 10Return on invested capital 10Economic profit (residual income or EVA) 15

Exercise solutions 16Exercise 1 16Exercise 2 18


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Definitions

Enterprise value

Enterprise value is the value available to both debt holders and equity holders regardless of capital structure. It is also known as firm value or aggregate value.

Equity value

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.

EquityEquity

value

Enterprise

value 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.


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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

Multiples

Enterprise value

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

• EBITDA

• EBITA

• EBIT

• Unlevered free cash flow

Sector specific metrics

• Subscribers (media)

• Capex adjusted EBITDA (telecoms, chemicals)

Equity value

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.



Metrics

• Net income

• Levered free cash flow

Sector specific metric

• Net asset value (property, shipping)



Exercise 1

You are given the following data about the pharmaceuticals sector in Hungary:

EV

$m

EV/sales

(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 EBITDA margin from the reconstructed P&L account.

Gedeon Richter

$m

Egis

$m

Sales

Operating costs, excl depreciation

EBITDA

Depreciation

EBIT

� Why might Gedeon Richter have a higher EV/EBITDA ratio than Egis?

� Gedeon Richter’s EV/sales ratio is 2½ times that of Egis but its EV/EBITDA ratio is only just over 1½ times that of Egis. What does this indicate?



Part 2

Reconstruct the 2006 forecast P&L account for Gedeon Richter.

2006

$m

Sales

Operating costs, excl depreciation

EBITDA

Depreciation

EBIT

� 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/sales

(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 EBITDA margin and how is this indicated by the EV ratios above?

2. Which company is expected to demonstrate the most explosive growth in EBIT? Which company is expected to demonstrate the highest growth in EBITDA?




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

Balance sheet

Under IFRS 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, EBITDA and EBIT include 100% of subsidiaries’ revenue, EBITDA and EBIT.

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 (egDCF or book value multiple).

EV = equity value + net debt + minority interests



Associates and equity accounted joint ventures


Balance 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 EBIT.

EV multiples

Denominator

Consolidated revenue, EBITDA and EBIT exclude revenue, EBITDA and EBIT 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



Pension obligations


Balance sheet

Many GAAPs (eg US GAAP, IFRS) 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 IFRS 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. It 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 EBITDA or EBIT. 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

EBIT and EBITDA are adjusted to remove any elements of pension cost apart from current service cost.

EV = equity value + net debt + MI – equity accounted investments + pension deficit



Operating leases


Balance 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 EBITDA and EBIT.

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, EBITDA is adjusted to exclude operating lease rentals. If the leases were finance leases the resultant expenses would be depreciation and interest; EBITDA is before both of these.

EBITDA + rental =EBITDAR

EBIT

For consistency with the numerator, EBIT is adjusted to exclude the interest element of operating lease rentals. EBIT 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 lease rentals



Assessing & comparing corporate performance

Return on invested capital

ROIC = capitalinvested

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

Interest

Profit before tax

Tax

Profit after tax

£m

1,032

(99)

933

(258)

675

The rate of corporation tax is 30%.



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

Interest

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

Interest 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


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Invested capital

Invested 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 capital (£m) 2006 2005

Equity attributable to parent equity holders 9,380 8,603

Minority interests 64 51

Net debt 4,509 3,899

Investments 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)

Intangible assets 1,525 1,408

Property, plant and equipment (incl investment property) 16,627 15,086

Inventories 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



Net operating profit less adjusted taxes (£m) 2006

Operating profit 2,280

Current tax charge (note 6) (664)

Interest tax shield [(232 + 67) x 30%] (notes 5 & 6) (90)

Adjusted tax (754)

NOPLAT 1,526

Return on invested capital

Based on opening invested capital

m377,13£m526,1£ = 11.4%

Based on average invested capital

m161,14£m526,1£ = 10.8%

Enterprise value

Market capitalisation (given) 26,035

Minority interests 64

Net debt 4,509

Investments in joint ventures and associates (476)

Other investments (4)

Held for disposal (82)

Enterprise value 30,046



Economic profit (residual income or EVA)

Economic profit = NOPLAT- (invested capital x cost of capital)

= (ROIC - cost of capital) x invested capital

Enterprise value

£30,046m

ROIC

11.4%

NOPLATP&L

£1,526m

Invested capitalBS

£13,377m

minusEconomic profit

£405m

Cost of capital

7.5%

‘Capital charge’

£1,121m

EV - IC

£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 ROIC > WACC Economic profit is positive

= 1 ROIC = WACC Economic profit is zero

< 1 ROIC < WACC Economic profit is negative

Tesco

ROIC/WACC = %5.7%2.10 = 1.36



Exercise solutions

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 β

EBITDA = EV ÷ 19.4/11.6

Depreciation β

EBIT = 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/EBITDA ratio than Egis as the market expects Gedeon Richter’s future EBITDA to grow more quickly than Egis’.

Gedeon Richter’s EV/sales ratio is 2½ times that of Egis but its EV/EBITDA 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 EBITDA margin.



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 β

EBITDA = EV ÷ 14.9/19.4

Depreciation β

EBIT = 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 EBITDA, 40% in EBIT).

Egis’ EV ratios decline only slightly due to the very modest expectations of growth.



Exercise 2

Solution

EV$m

EV/sales(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

EBITDA margin = EV/sales ÷ EV/EBITDA.

Zalakerámia has the highest EBITDA 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 EBIT, at 70% [28.7 ÷ 16.9 = 170%].

EBITDA growth

Graboplast is expected to demonstrate the highest growth in EBITDA, at 41% [11.1 ÷ 7.9 = 141%].

Accounting & analysis exercises


EXERCISES AND CASE STUDIES

Coset plc 1Kissat Ltd 5Potomac 9Mag Ltd 16Ourstair Ltd 19Flash Tuna AG 23Theramax Ltd 27Monty, Tiger & Seve 30Easel 33Enteachables Inc 34A BS Inc 39Erkki, Nuutti and Mikko 42Primrose plc 43Birren plc 44Onyali plc 45Scrutinise Deal 46Pearson rights issue 47Discounted debt 48Convertible debt 50King, Wade & Graf 51Deutsche Telekom 54Morientes & Friedel 56Pensions 60Pample & Mousse (1) 62Mango & Steen 67


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Coset plc

Coset plc is a food retailer.

The opening balance sheet showed:

£m

Property, plant and equipment 5,249

Inventories 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 suppliersin respect of purchases on credit.

3. Incurred 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 administrativeexpenses).

5. Issued shares for £131m (nominal value £1m) and raised debt of £183m.

6. Incurred 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.



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.



Balance sheet

start 1 2 3 4 5 6 7 8 end£m £m £m £m £m £m £m £m £m £m

PPE 5,249

Inventories 550

A/cs receivable 78

Cash 65

Total assets 5,942

A/cs payable 826

Tax payable 255

Debt 856

Ord share cap 109

Share premium 1,431

Retained earnings 2,465

Liabilities & equity 5,942



Kissat Ltd

Kissat Ltd operates hotels, casinos and health clubs. The opening balance sheet showed:

£m

Property, plant and equipment 590

Inventories 4


Cash and deposits 8_____

Total assets 618_____

Accounts payable 22

Tax payable 9

Debt 354


Share premium 113

Retained earnings 71_____

Liabilities & shareholders’ equity 618_____


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. Incurred, 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. Issued 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. Incurred 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.




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.




PPE 590

Inventories 4

A/cs receivable

16

Cash 8

Total assets 618

A/cs payable 22

Tax payable 9

Debt 354

Ord share cap

49

Share premium

113

Retained earnings

71

Liabilities & equity

618



Potomac

Potomac provides international marine transportation, container distribution and shipping agency services.

The opening balance sheet showed:

$m


Inventories 2


Cash and deposits 4

_______


Accounts payable 17

Tax payable 41

Debt 621


Share premium 76

Retained earnings 239

_______



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. Incurred (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. Incurred 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. Incurred and paid $13m in respect of major improvements increasing the efficiency or extending the useful lives of plant and equipment. Incurred and paid $25m in respect of regular maintenance of and repairs to property, plant and equipment.



7. Disposed of, for $21m, plant and equipment with a carrying amount of $25m. Received $21m in respect of this disposal.

8. Incurred 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.



Balance 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

Inventories 2

A/cs receivable 50

Cash 4

Total assets 1,721

A/cs payable 17

Tax payable 41

Debt 621

Ord share cap 727

Share premium 76





Income statement

Sales

Cost of sales

Administrative expenses

Operating profit, before exceptional items

Loss on disposal

Operating profit, after exceptional items

Interest 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



Cash flow statement – direct

Receipts from customers

Operating expenses paid

Operating cash flow (1)

Interest paid

Tax paid


Capital expenditure

Disposal

Dividends

Debt repaid

Change in cash



Cash flow statement – indirect

Operating profit, before exceptional items

Depreciation

EBITDA

Increase in accounts receivable

Increase in inventories

Increase in accounts payable


Interest paid

Tax paid


Capital expenditure

Disposal proceeds

Dividends

Debt repaid

Change in cash



Mag Ltd

Mag Ltd is a publisher of magazines. The opening balance sheet showed:

£’000


Inventories 13,985

Accounts receivable 25,952

Cash and deposits 3,515_________

Total 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_________

Liabilities & shareholders’ equity 84,893_________


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. Incurred 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. Incurred 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.



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


Balance 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

Inventories 13,985

A/cs receivable

25,952

Cash 3,515

Total 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




Ourstair Ltd

Ourstair Ltd is a leisure travel operator. The opening balance sheet showed:

£m

Property, plant and equipment 519.9

Inventories 6.4

Cash and deposits 549.2_______

Total 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_______

Liabilities & shareholders’ equity 1,075.5_______


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. Incurred 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. Incurred and paid for further operating expenses of £252.6m (to be classified as administrative expenses).

4. Issued 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.



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.




PPE 519.9

Inventories 6.4

Cash 549.2Total 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


1,075.5



Flash Tuna AG

Flash Tuna AG operates international and domestic scheduled and charter air services. The opening balance sheet showed:

€ million

Property, plant and equipment - owned 6,944

Property, plant and equipment - leased 2,111

Inventories 75


Cash and deposits 738_________

Total assets 11,300_________


Tax payable 65

Debt 5,174

Provisions 30

Ordinary shares 260

Share premium 650

Retained earnings 2,411_________

Liabilities & shareholders’ equity 11,300_________


1. Made sales on credit of € 8,915m. Received € 9,011m from customers in respect of sales made on credit.

2. Incurred on credit fuel costs, landing fees, handling charges and administrative expenses of € 4,967m (to be classified as cost of sales). Paid € 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 € 390m. Used raw materials and consumables costing € 381m.

4. Incurred and paid employment costs of € 2,356m (€ 2,179m to be classified as cost of sales and the balance as administrative expenses).

5. Incurred and paid operating lease rentals of € 150m (to be classified as cost of sales).

6. Purchased and paid for property, plant and equipment costing € 223m. Charged depreciation of € 352m on owned assets (to be classified as cost of sales). Wrote owned assets down by a further € 50m for impairment.



7. Entered into new finance leases. At inception, the present value of the minimum lease payments was € 1,619m. Charged depreciation of € 217m on leased assets (to be classified as cost of sales). Charged interest of € 290m. Paid € 641m to the lessor.

8. Repaid debt of € 127m and raised new debt of € 237m.

9. Incurred and paid interest of € 80m. Capitalised € 13m of this interest into property under construction.

10. Reduced provision for unredeemed frequent flyer liabilities by € 4m.

11. Paid corporation tax for prior year of € 65m. Estimated corporation tax for the current year at € 25m.

12. Paid a dividend of € 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.



Balance sheet

start 1 2 3 4 5 6 7 8 9 10 11 12 end

€m €m €m €m €m €m €m €m €m €m €m €m €m €m

PPE – owned 6,944

PPE – leased 2,111

Inventories 75


Cash 738

Total assets 11,300


Tax payable 65

Debt 5,174

Provisions 30

Ordinary shares 260

Share premium 650





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

Investments - liquid funds 1,408

Cash 254_______


Operating creditors and accruals 932

Tax payable 820

Debt 3,145

Provision for compensation 121

Ordinary shares 894

Share premium 805

Retained earnings 990_______



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. Incurred 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. Incurred 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. Issued shares for net cash proceeds of £356m (par value £12m).



7. Repaid debt of £58m. Raised new debt of £117m.

8. Incurred and paid interest of £152m. Earned and received interest of £61m. Purchased liquid investments costing £209m.

9. Increased 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.


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.



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

Investments - 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


7,707



Monty, Tiger & Seve

Monty plc $m $mCurrent Previous

Balance sheet

Fixed assets 350 350Non cash current assets 130 130Cash 40 27Current liabilities (63) (62)Debt (290) (290)

_______ ______167 155

_______ ______Share capital 20 20Retained earnings 147 135

_______ ______167 155

_______ ______

Profit & loss account$m

Current

Turnover 500Cost of sales (320)

______Gross profit 180Depreciation (70)Other operating costs (30)Interest payable (29)

______Profit before tax 51Tax (19)

______Profit after tax 32Dividend (20)

______Retained profit for the year 12

______



Tiger plc $m $mCurrent Previous

Balance sheet


_______ ______70 47

_______ ______

Share capital 20 20Retained earnings 50 27

_______ ______70 47

_______ ______


Current




______Profit after tax 23Dividend -


______



Seve plc $m $m

Current PreviousBalance sheet


_______ ______204 200

_______ ______

Share capital 20 20Retained earnings 184 180

_______ ______204 200

_______ ______


CurrentTurnover 450Cost of sales (320)



______Profit after tax 4Dividend -


______

Requirement

Produce a cash flow statement for the current year, identifying free cash flow for each company.



Easel

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.


Finance lease


£000 £000 £000Tangible fixed assets

Operating expenses (depreciation)

Servicing of finance

Creditors Interest payable Financing

Operating lease


£000 £000 £000Operating expenses

Operating cash flow



Enteachables Inc

Your client, Cash Driver plc, is looking into the acquisition of Enteachables Inc, a US company which publishes insurance and legal journals on subscription.

Enteachables Inc 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 1,343.0Receivables 5,342.6Inventories 12.9

______6,698.5

Investments & other assets

Investments 18.0Intangibles 2,324.6

______2,342.6

Property, plant & equipment

Tangibles at book value 617.1

_______9,658.2_______

Liabilities & shareholders equityCurrent Liabilities

Trade payables 3,436.8Accruals & deferred income 1,269.6Tax 548.1

______5,254.5

Debt 1,271.4Shareholders’ equity

Preference stock 1,838.3Common stock 266.6Retained earnings 1,027.4

______3,132.3

________

9,658.2________



Based upon prior year figures, and knowledge of Enteachables Inc’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)_____________

EBITDA 2,202.8

Depreciation ( 268.8)

Amortisation ( 128.6)

Loss on disposal of PPE ( 10.1)___________

Operating income / EBIT 1,795.3

Interest receivable 165.5

Interest payable (197.9)___________

Income 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___________



Forecast cash flows for the 12 months following take-over

$000 $000

EBIT 1,795.3

Loss on disposal of PPE 10.1_________

Underlying EBIT 1,805.4

Depreciation 268.8

Amortisation 128.6_________

EBITDA 2,202.8

Decrease in inventories 1.2

Increase in receivables (45.7)

Increase in payables & operating accruals 911.9_________

Operating cash flow 3,070.2

Interest received 165.5

Interest paid (197.9)

Non-equity dividend paid (221.2)_________

Financing flows (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 loans (251.4)_______

Increase in cash 1,105.0_______



Requirement

Based on the above projections produce a balance sheet showing the position of Enteachables Inc at the end of the 12 months following the take-over using the following:

Balance sheet 12 months post acquisitionCurrent Forecast$000 $000

Current assetsCash 1,343.0Receivables 5,342.6Inventories 12.9

_______ ____6,698.5

Investments & other assetsInvestments 18.0Intangibles 2,324.6

_______ ____2,342.6

Property, plant & equipmentTangibles at book value 617.1

_______ ____9,658.2_______ ____

Liabilities & shareholders equityCurrent Liabilities

Trade payables 3,436.8Accruals & deferred income 1,269.6Tax 548.1

_______ ____5,254.5

Debt 1,271.4Shareholders’ equity

Preference stock 1,838.3Common stock 266.6Retained earnings 1,027.4

_______ ____3,132.3_______ ____9,658.2_______ ____



Requirement

Calculate the following ratios to test the reasonableness of the projections:

At takeover/12 months pre-takeover 12 months post take-over

Underlying EBIT margin

11.7%

EBITDA margin 14.1%

Capex/depn 1.4 x

Interest cover 3.4 x

Gearing 57.7%

ROCE 53.2%

Debtor days 141 days

Payables/accrual days

136 days

Where: Interest cover = dividendequity -nonpaidinterest

receivedinterestEBIT+

+

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 EBIT ÷ capital employed



A BS Inc

A BS Inc 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 Inc.

Income statementActual 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____ ____



Cash flow statementActual Forecast

$m $mOperating profit 638 596Exceptional loss – disposal of brewery - 9Exceptional loss – impairment of brewery - 71Depreciation & amortisation 227 247

____ ____EBITDA 865 923Other non-cash items 42 17Increase in inventories (33) (10)Increase in accounts receivable (11) (107)Increase in accounts payable 58 65

____ ____Operating cash flow 921 888Dividends from associates 19 16Dividends paid to minority interests (37) (57)Interest paid (93) (144)Interest received 56 66Tax (160) (166)

____ ____Free cash flow pre capex 706 603Purchase of PPE (414) (588)Proceeds from sale of PPE 40 43Purchase of other long term investments (21) -

____ ____Free cash flow pre acquisitive capex 311 58Purchase of subsidiary (172) (206)Purchase of associates (79) (67)

____ ____Free cash flow post all capex 60 (215)Dividends - -Share issue 1 265Loans 56 (9)Short-term deposits (152) (419)

____ ____Cash flow (35) (378)

____ ____



Balance sheetActual Forecast$m $m

Current assetsInventories 386Accounts receivable 620Investments 187Cash 415

____ ____1,608

Fixed assetsIntangible assets 1PPE 1,810Investments 53Investments in associates 340

____ ____2,204____ ____

Total assets 3,812____ ____

Current liabilitiesAccounts payable 639Tax 135Other liabilities 259

____ ____1,033

Debt 1,090Provisions

Deferred tax 41Other 492

Minority interests 58Capital & reserves

Share capital 2Additional paid-in capital 40Retained earnings 1,056

____ ____Total liabilities & equity 3,812

____ ____



Erkki, Nuutti and Mikko

Erkki

Erkki Inc has a 31st December year end. On 1st January there were 300,000 ordinary shares in issue. On 31st 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 Inc has a 31st December year end. On 1st January there were 300,000 ordinary shares in issue. On 31st August, there was a bonus issue of 1 new ordinary share for every 3 shares held.


Mikko

Mikko Inc has a 31st December year end. On 1st January there were 300,000 ordinary shares in issue. On 31st August, there was a rights issue of 1 new ordinary share for every 3 shares held at $11 per share. Immediately prior to becoming ex-rights, the share price was $15. The rights issue was fully taken up.


Requirement

Calculate earnings per share for the current year. Restate EPS for the prior year, where necessary, and calculate the % growth in EPS.



Primrose plc

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).



Birren plc

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 shares31 March 2007 130 ordinary shares31 March 2008 120 ordinary shares31 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.



Onyali plc

Onyali International plc is listed on the Stock Exchanges of several countries and prepares its financial statements in accordance with International Accounting Standards (IASs).

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 International plc shares during the year was:

(i) £2.08;

(ii) £3.08.



Scrutinise Deal

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 22nd 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 14th 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



Pearson rights issue

Scenario

Pearson plc has a 31st December year end. On 1st January 2000 there were 613m shares in issue. On 15th January 2000, 11m shares were issued under a placing. On 30th June 2000 3m shares were issued under share option and employee share schemes.

Rights issue

On 28th July 2000 Pearson announced a 3 for 11 rights issue* at £10 per share. Immediately prior to the announcement, the share price was £20.10. Immediately subsequent to the announcement, the share price was £19.31.

[* in the US, this would be expressed as 14 for 11]

On 9th August 2000 the shares became ex-rights. Immediately prior to becoming ex-rights, the share price was £18.57.

The shares were issued on 1st September 2000.

Earnings

Earnings for the year ended 31st December 2000 were £179m.

Prior year

Earnings for the year ended 31st December 1999 were £294m. The weighted average number of shares was 615.4m.

Requirement

Calculate earnings per share for the year ended 31st December 2000. Assume the rights issue was fully taken up.



Discounted debt

Zero coupon

On 1st March 2004 a company issued a £100m zero-coupon bond for net proceeds of £65m. The bond is redeemable on 28th February 2009 at par. The yield to maturity is 9%.

How would the above be represented in the financial statements for the year ended 28th February 2005?

28th February 2005


£m £m £mServicing of finance

Debt Interest payable Financing

Deep discount

On 1st March 2001 a company issued a £125m 4% bond for net proceeds of £76.5m. Interest is payable annually in arrears on 28th February each year. The bond is redeemable on 28th

February 2011 at par. The yield to maturity is 10.43%.


28th February 2005



Debt Interest payable



Index linked

On 1st September 2004 a company issued a £200m 4% bond for net proceeds of £200m. Interest is payable semi-annually in arrears on 28th February and 28th August each year. The bond is redeemable on 28th August 2020 at par value indexed for increases in the RPI over the life of the bond. The RPI for the year to 28th February 2005 is 3%.


28th February 2005




Index linked (collar)

On 1st September 2004 a company issued a £160m 3.322% bond for net proceeds of £160m. Interest is payable semi-annually in arrears on 28th February and 28th August each year. The bond is redeemable on 28th August 2026 at par value indexed for increases in the RPI over the life of the bond. The maximum indexation of the principal in any one year is 5%, with a minimum of 0%. The RPI for the year to 28th February 2005 is 3%.


28th February 2005






Convertible debt

On 1st October 2004 a company issued £300m unsecured 5.75% subordinated convertible bonds, due 2009, at par. Issue costs amounted to £9.1m.

The bonds are convertible at the option of the bondholder at any time between 31st January 2005 and 30th September 2009 into fully paid ordinary shares of 10p each at an initial conversion price of 443p per share. Interest 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 30th 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 30th 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 30th

September 2005.

30th September 2005


£m £m £mCash Operating

expensesServicing of finance


Equity



King, Wade & Graf

King Inc $m $mCurrent Previous

Balance sheetIntangible fixed assets 180 190Tangible fixed assets 269 240Inventories 40 38Receivables 123 67Cash 33 27 Current liabilities (78) (62)Debt (300) (245)

_______ ______267 255

_______ ______Share capital 10 10Additional paid in capital 57 57Retained earnings 200 188

_______ ______267 255

_______ ______Profit & loss account

$mCurrent


______Gross profit 173Depreciation (70)Amortisation (10)Other operating costs (25)Exceptional item - loss on asset disposals (3)Interest payable (26)


______Profit after tax 24

______

Interest 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.



Wade plc $m $mCurrent Previous

Balance sheetIntangible fixed assets 200 200Fixed assets 397 260Inventories 43 38Receivables 123 67Cash 27 27Current liabilities (63) (62)Debt (135) (135)

_______ ______592 395

_______ ______Share capital 23 20Share premium 116 67P&L and revaluation reserves 453 308

_______ ______592 395


$mCurrent


______Gross profit 173Depreciation (60)Other operating costs (10)Exceptional item -loss on asset disposals (5)Interest payable (23)


______Profit after tax 60Dividends (15)

______Profit retained for year 45

______

Interest 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.



Graf AG $m $mCurrent Previous

Balance sheetIntangible fixed assets 50 150Tangible fixed assets 120 150Inventories 80 38Receivables 70 67Cash 5 27Current liabilities (92) (62)Debt (120) (120)

_______ ______113 250

_______ ______Share capital 20 20Capital reserve 100 100Income statement (7) 130

_______ ______113 250


$mCurrent


______Gross profit 160Depreciation (130)Amortisation (100)Other operating costs (39)Interest payable (41)

______Profit/(loss) before tax (150)Extraordinary income - gain on asset disposals 13Tax -

______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.

Requirementa. 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.



Deutsche Telekom

EBITDA

Gesamtkostenverfahren



Requirement

Calculate EBIT (or operating profit), EBITA and EBITDA for the most recent year. Accept the company’s classification of ‘other operating income’.

€m

Sales

Net operating costs, excldepreciation

EBITDA

Depreciation

EBITA

Amortisation

EBIT



Morientes & Friedel

Morientes SA

Financial statements

Balance sheet

end start

Goodwill 31,752 37,044

Property, plant & equipment 53,343 53,738


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)

EBIT 31,923

Interest (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.



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%. It is redeemable at a premium of 10% or convertible into equity shares in 3 year’s time.

6. Interest comprises interest on convertible debt (at an effective rate of 7%). Interest is not capitalised.

7. No shares were issued during the period.

Requirements

Prepare a cash flow statement for the period.

Calculate EBITDA

EV , InterestEBIT

and EBITDA

debtNet.



Friedel IncFinancial statements

Balance sheet

end start

Goodwill 52,920 52,920

Property, plant & equipment 210,892 243,107


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)

EBIT 70,371

Interest (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.



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 startOwned assets 87,892 79,107Assets 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 47,886Unearned revenue 21,843 40,318Current 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 103,720 101,816Finance leases 131,210 169,350Cash (27,505) (17,458)

207,425 253,708

The convertible debt has a par value of 100,000 and pays a coupon of 3%. It is redeemable at a premium of 10% or convertible into equity shares in 3 year’s time.

8. Interest comprises:Interest on convertible debt 4,904Finance charges on finance leases 11,860

16,764

Interest is not capitalised.

9. No shares were issued during the period.

Requirement

Prepare a cash flow statement for the period. Calculate EBITDA

FV,InterestEBIT

and EBITDA

debtNet.



Pensions

Siemens AG has a defined benefit pension scheme. It prepares its consolidated financial statements in accordance with US GAAP. The net periodic pension cost for the period of €447m has been charged to operating expenses during the year.

The market capitalisation of Siemens AG is €42,250m. Its consolidated financial statements show:


€m €m

Cash and cash equivalents 11,196 EBITDA 6,058D&A (4,126)

Debt 12,346 EBIT 1,932Accrual for pension plans 3,557 Net interest income/(expense) 318Minority interests 541 Other financial income 1,225Shareholders equity 23,521 EBT 3,475

Pension plan disclosures

Change in projected benefit obligation €m

Projected benefit obligation at beginning of year 18,544

Service cost 487

Interest cost 1,151

Actuarial losses/(gains) 240

Benefits paid (930)_________

Projected benefit obligation at end of year 19,492_________

Change in plan assets €m

Fair value of plan assets at beginning of year 14,625

Actual return on plan assets (1,187)

Contributions 2,023


Fair value of plan assets at end of year 14,531_________



Net periodic pension cost €m

Service cost 487

Interest 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/EBITDA 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%.



Pample & 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 €309m and cash of €91m. Acquisition costs (investment banking fees etc) are €8m. Share issue costs are €1m. 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 alone balance sheets immediately prior to transaction (€m)

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 results for the year following the transaction (€m)

Pample Mousse

Sales 1,163 994

Operating costs (959) (820)____ ____

EBIT 204 174

Interest (36) (62)

Tax (33) (30)____ ____

Net income 135 82____ ____



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.



Combined balance sheet: Mousse consolidated as a subsidiary

Pample Mousse


____ ____

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

Pample Mousse


____ ____

1,298 984

____ ____

Net debt 450 568

Shares 121 56


____ ____

1,298 984

____ ____



Combined balance sheet: Mousse equity accounted as an associate

Pample Mousse


____ ____

1,298 984

____ ____

Net debt 450 568

Shares 121 56


____ ____

1,298 984

____ ____

Combined income statement: Mousse consolidated as a subsidiary

Pample Mousse

Sales 1,163 994

Operating costs (959) (820)

____ ____

EBIT 204 174

Interest (36) (62)

Tax (33) (30)

____ ____

Net income 135 82

____ ____



Combined income statement: Mousse proportionately consolidated as a JV

Pample Mousse

Sales 1,163 994

Operating costs (959) (820)____ ____

EBIT 204 174

Interest (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)____ ____

EBIT 204 174

Interest (36) (62)

Tax (33) (30)

____ ____

Net income 135 82____ ____



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 3,267Net funds/(debt) 115 (1,133)

_____ _____

1,115 2,134_____ _____

Shares 172 984Retained earnings 943 1,150

_____ _____

1,115 2,134_____ _____

Forecast results for the year following the transaction (£m)Mango Steen

Sales 4,384 8,969Operating costs, excl dep’n (4,017) (8,336)

____ ____

EBITDA 367 633Depreciation (109) (190)

____ ____

EBIT 258 443Interest 14 (65)Tax (97) (117)

____ ____

Net income 175 261____ ____

Number of shares 1,720mEPS 10.2p



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



Combined balance sheet (immediately after acquisition)

Mango Steen Consolidated

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____ ____ ____ ____ ____



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)____ ____ ____ ____ ____

EBITDA 367 633

Depreciation (109) (190)____ ____ ____ ____ ____

EBIT 258 443

Interest 14 (65)

Tax (97) (117)____ ____ ____ ____ ____

Net income 175 261____ ____ ____ ____ ____

Number of shares (m) 1,720m

EPS 10.2p

Exercises and Case Study Solutions


EXERCISES AND CASE STUDY SOLUTIONS

Coset plc 1Kissat Ltd 6Potomac 10Mag Ltd 17Ourstair Ltd 21Flash Tuna AG 25Theramax Ltd 29Monty, Tiger & Seve 34Easel 36Enteachables Inc 37A BS Inc 39Erkki, Nuutti and Mikko 40Primrose plc 42Birren plc 43Onyali plc 44Scrutinise Deal 45Pearson rights issue 46Discounted debt 47Convertible debt 49King, Wade & Graf 52Deutsche Telekom 60Morientes & Friedel 61Pensions 65Pample & Mousse (1) 66Mango & Steen 70



Coset plc


PPE 5,249 985-358 20 5,896

Inventories 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

Total 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


5,942 16,486 (10,954) (4,235) (358) 314 (65) (255) (233) 6,642



Closing balance sheet £m


Inventories 584


Cash and deposits 29

____

Total assets 6,642____

Accounts payable 972

Tax payable 223

Debt 1,039


Share premium 1,561


____

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

Interest 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_______



Cash flow statement for year - direct

£m £m


Payments to suppliers (10,954)

Operating costs (3,851)

Administrative expenses (384)

Operating cash flows 1,208

Interest (85)

Tax (255)

Capital expenditure (985)_______

Free cash flow (117)

Dividends (233)

Issue of shares 131Issue of debt 183

Financing cash flows 314

Decrease in cash and deposits in year (36)

Cash flow 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

Interest (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)

Issue of shares (110 + 1,561) - (109 + 1,431) 131Issue of debt (1,039 - 856) 183



Here operating cash flow is before interest and tax. Capitalised interest is classified as interest.




£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)

Issue of shares (110 + 1,561) - (109 + 1,431) 131Issue of debt (1,039 - 856) 183



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 EBITDA 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.



Cash flows for valuation

Free cash flow to equity (levered free cash flow)

Method 1


Interest (85)

Tax (223 – [255 + 223]) (255)


Levered FCF/FCF to equity (117)_______

Method 2


Capital expenditure (5,896 – [5,249 – 358]) (1,005)_______


Free cash flow to the enterprise or firm (unlevered free cash flow)


Adjusted tax (255 + [85 x 33%]) (283)


Unlevered FCF/FCF to the enterprise (60)_______

Assumption

Rate of corporation tax is 33%.

Reconciliation

Unlevered FCF/FCF to the enterprise (60)

Interest, net of tax (85 x 67%) (57)_______




Kissat Ltd


PPE 590 399 989

Inventories 4 1 5

A/cs receivable

16 22 38

Cash 8 285 (55) (157) 375 (412) (18) (8) (14) 4

Total 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


618 307 (54) (157) 375 (13) (18) (8) (14) 1,036



Closing balance sheet £m

Property, plant and equipment 989

Inventories 5


Cash and deposits 4

____

Total assets 1,036____

Accounts payable and operating accruals 31

Tax payable 18

Long-term loan 497


Share premium 318


____

Liabilities & shareholders’ equity 1,036____


Revenue 307

Cost of sales (58 + 162) (220)_______

87

Administrative expenses (13)_______

Profit before interest and tax 74

Interest payable and similar charges (18)_______


Taxation (18 – 1) (17)_______

Profit after tax 39_______

Retained earnings at start 71

Profit after tax 39


_______

Retained earnings at end (per balance sheet) 96_______



Cash flow statement for year – direct method£m £m

Receipts from customers 285

Payments to suppliers (55)

Operating expenses (157)


Interest (18)

Tax (8)



Dividends (14)Issue of shares 232

Issue of debt 143


Decrease in cash and deposits in year (reconciliation done above) (4)_____

Cash flow statement for year – indirect method (1)£m £m

Operating profit 74

Depreciation 13

EBITDA 87


Increase in receivables (22)

Increase in payables and operating accruals 9


Interest (18)

Tax (8)



Dividends (14)

Issue of shares 232

Issue of debt 143

Financing cash flows __375


Cash at start of year 8_____

Cash at end of year 4_____



Commentary

Cash convertibility of EBITDA is acceptable (@ 84%) with the growth in working capital reflecting growth in the business. Interest, 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 flow statement for year – indirect method (2)£m £m

Net income 39

Depreciation 13




Increase in tax payable 9




Dividends (14)

Issue of shares 232

Issue of debt 143

Financing cash flows __375


Cash at start of year 8_____

Cash at end of year 4_____



Potomac

Balance sheet

$m


Inventories 3


Cash and deposits 3

_______


Accounts payable 28

Tax payable 26

Debt 577


Share premium 76


_______




Balance 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

Inventories 2 + 1 3

A/cs receivable 50 + 8 58

Cash 4 - 97 + 1,250 - 835 - 82 - 75 - 38 + 21 - 20 - 41 - 84 3

Total 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


1,721 1,680



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

Interest expense (17)


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



Cash flow statement – direct


Operating expenses paid [97 + 835 + 82 + 25] (1,039)

Operating cash flow (1) 211

Interest paid (20)

Tax paid (41)


Capital expenditure [75 + 13] (88)

Disposal 21

83

Dividends (40)

Debt repaid (44)

Change in cash (1)



Cash flow statement – indirect (1)

Operating profit, before exceptional items 94

Depreciation 115

EBITDA 209





Interest paid (20)

Tax paid (41)



Disposal proceeds 21

83

Dividends (40)

Debt repaid (44)

Change in cash (1)



Cash flow statement – indirect (2)

Net income 47

Depreciation 115

Loss on disposal 4





Interest capitalised (3)



Disposal proceeds 21

83

Dividends (40)

Debt repaid (44)

Change in cash (1)

Ratio

EBITDAdebtNet

= 209574

= 2.75



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 EBITDA 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.



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

Inventories 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

Total 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


84,893 118,113 77,010 (38,624) (2,833) (5,055) (1,529) (866) (981) - 76,108



Profit & loss account for the year

£000Revenue 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)

Interest payable & similar charges (1,529)_______

Loss before tax (2,159)

Taxation (196 – 24) (172)_______

Loss after tax (2,331)_______


Loss after tax (2,331)


_______




Cash flow 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)


Interest (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 EBITDA 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



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 EBITDA or cash flow.


£000 £000

Net loss (2,331)

Depreciation 5,055

Decrease in inventories 1,967

Decrease in receivables 3,552

Decrease in payables (1,946)



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______



Ourstair Ltd



PPE 519.9 73.1 593.0

Inventories 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

Total 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


1,075.5 2,717.6 (79.9) (2,517.0) 88.6 (37.0) 17.1 (16.1) (31.8) 1,217.0




Revenue 2,671.3Cost of sales (85.4 + 2,265.3) (2,350.7)

_______

320.6Administrative expenses (252.6 + 37.0) (289.6)

_______

Earnings before interest & tax 31.0Interest receivable & similar income 17.1

_______

Profit before tax 48.1Taxation (23.1)

_______

Profit after tax 25.0_______

Retained earnings at start 93.7Profit after tax 25.0Dividends (31.8)Other reserve movements -

_______

Retained earnings at end (per balance sheet) 86.9_______


£m £mReceipts from customers 2,717.6Payments to suppliers (90.5)Operating expenses (2,517.0)Operating cash flow 110.1Interest 17.1Tax (16.1)Capital expenditure (110.1)

_______

Free cash flow 1.0Dividends (31.8)

Issue of shares 83.1

Issue of debt 5.5

Financing cash flows 88.6

Increase in cash and deposits in year 57.8Cash at start of year 549.2

_____

Cash at end of year 607.0_____




£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

Interest 17.1

Tax (16.1)

Capital expenditure (110.1)_______

Free cash flow 1.0

Dividends (31.8)


Issue of debt 5.5

Financing cash flows 88.6_______

Increase in cash and deposits in year 57.8

Cash at start of year 549.2_____


Commentary

Cash convertibility of EBITDA is good (@ 1.62x) with the growth in inventories being more than absorbed by that of payables and revenues in advance. Indeed, 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.




£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)


Issue of debt 5.5

Financing cash flows 88.6_______

Increase in cash and deposits in year 57.8

Cash at start of year 549.2_____




Flash Tuna AG


start 1 2 3 4 5 6 7 8 9 10 11 12 end€m €m €m €m €m €m €m €m €m €m €m €m €m €m

PPE - owned 6,944 (179) 13 6,778

PPE - leased 2,111 1,402 3,513

Inventories 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


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


11,300 8,915 (4,859) (381) (2,356) (150) (402) 761 110 (67) - (65) (191) 12,615




€m

Revenue 8,915

Cost of sales (4,967 + 381 + 2,179 + 150 + 402 + 217 - 4) (8,292)_________

623

Administrative expenses (177)________


Interest payable & similar charges (290 + 80 - 13) (357)_______


Taxation (25)_______

Profit after tax 64

Dividends (191)_______

Net loss (127)


Other reserve movements -_______





€m


Depreciation and impairment write down 619_______

EBITDA 1,065


Decrease in receivables 96

Increase in payables 108

Decrease in provision (4)_______


Interest (80)Interest paid on finance leases (290)

Tax (65)


Free cash flow after capex 598

Dividends (191)

Financing cash flows – net issue of debt 110Financing cash flows - capital element of FL repaid (351)

______

Increase in cash and deposits in year 166

Cash at start of year 738______

Cash at end of year 904______



Commentary

Cash convertibility of EBITDA 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 € 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.


€m

Net income 64

Depreciation and impairment write down 619


Decrease in receivables 96

Increase in payables 108

Decrease in provision (4)


_______


Capital expenditure (223 + 13) (236)

_______


Dividends (191)

Financing cash flows – net issue of debt 110Financing cash flows - capital element of FL repaid (351)

______

Increase in cash and deposits in year 166





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 62 3,697

Stocks - raw materials 283 178 461

Stocks - finished goods 572 1,839 610 90 (2,418) 693

Operating debtors 1,555 185 1,740

Investments - liquid funds 1,408 209 1,617

Cash 254 (1,993) (1,808) (420) 7,798 (2,370) 356 59 (300) (1,007) (355) 214

Total assets 7,707 24 (1,198) (268) 5,565 (2,370) 356 59 (91) (1,007) (355) 8,422

Operating creditors & accruals 932 24 15 971


Debt 3,145 59 3,204

Provision for compensation 121 20 141

Ordinary shares 894 12 906

Share premium 805 344 1,149Retained earnings 990 (1,198) (268) 5,565 (2,385) (91) (20) (603) (355) 1,635

Liabilities & shareholders' equity

7,707 24 (1,198) (268) 5,565 (2,370) 356 59 (91) (1,007) (355) 8,422




£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)________


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____




£m £m


Payments to suppliers (1,993)

Payments to and on behalf of employees (1,808)

Other cash payments (2,370)

Operating cash flows 1,627

Interest paid (152)

Interest received 61

Tax (1,007)_______

Free cash flow before capex 529



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)_______






Cash flow statement for year - indirect (1)

£m £m


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


Interest paid (152)

Interest received 61

Tax (1,007)_______

Free cash flow before capex 529



Dividends (355)










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





Dividends (355)










Monty, Tiger & Seve

Monty plc

1 2 3$m $m $m

Operating profit 80 80 80Depreciation 70 70

___ ___EBITDA 150 150

Movement in non-cash working capital 1 1___ ___

Net cash inflow from operating activities 151 151Interest paid (29)Tax paid (19) (28) (28)

Capital expenditureNet (investment)/disinvestment (70) (70) 1

___ ___ ___Free cash flow 33 53 53Financing

[Interest paid (20)]Net borrowing/(repayment) - -Dividend paid (20) (20)

___ ___Increase in cash 13 13

___ ___

Tiger plc

1 2 3$m $m $m


___ ___EBITDA 150 150

Movement in non-cash working capital (135) (135)___ ___


Capital expenditureNet (investment)/disinvestment (270) (270) (335)

___ ___ ___Free cash flow (312) (284) (284)Financing

[Interest paid (20)]Net borrowing/(repayment) 310 310Dividend paid - -

___ ___Decrease in cash (2) (2)

___ ___



Seve plc

1 2 3$m $m $m


___ ___EBITDA 100 100

Movement in non-cash working capital 57 57___ ___


Capital expenditureNet (investment)/disinvestment 30 30 157

___ ___ ___Free cash flow 161 178 178Financing

[Interest paid (17)]Net borrowing/(repayment) (125) (125)Dividend paid - -

___ ___Increase in cash 36 36

___ ___

Summary

Earnings Free cash flow

Monty plc $32m $33m

Tiger plc $23m $(312)m

Seve plc $4m $161m

Assumption

Rate of corporation tax is 33%.



Easel


Finance lease


£000 £000 £000

Tangible fixed assets

525 Operating expenses (depreciation)

(175)Servicing of finance (80)

Creditors 552 Interest payable (80) Financing (148)

Operating lease


£000 £000 £000

Operating expenses (228)

Operating cash flow(228)



Enteachables Inc

Balance sheet as at 12 months following take-over

Assets $000 $000

Current assets

Cash (1,343.0 +1,105.0) 2,448.0Receivables (5,342.6 + 45.7) 5,388.3Inventories (12.9 – 1.2) 11.7

______7,848.0

Investments & other assets

Investments 18.0Intangibles (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_______

Liabilities & shareholders equityCurrent liabilities

Trade payables & accruals

(3,436.8 + 1,269.6 + 911.9) 5,618.3Tax (548.1 + 598.1 – 557.3) 588.9

______6,207.2

Debt (1,271.4 – 251.4) 1,020.0Shareholders’ equity

Preference stock 1,838.3Common stock 266.6Retained earnings (1,027.4 + 943.6 – 321.6) 1,649.4

______3,754.3

________

10,981.5________



Ratio calculations

At takeover/12 months pre-takeover 12 months post take-over

EBIT margin 11.7%14,850.7

10.11,795.3 + = 12.2%

EBITDA margin

14.1%14,850.72,202.8 = 14.8%

Capex/depn 1.4 x268.8581.3 = 2.2x

Interest cover 3.4 x221.2197.9165.51,795.3

++ = 4.7x

Gearing 57.7%2,326.31,649.4266.6410.3410.32,448.0-1,838.31,020.0

=++

=+ =

17.6%

ROCE 53.2%2,326.3

10.11,795.3 + = 77.6%

Debtor days 141 days6514,850.7/3

5,388.3 = 132 days

Payables /accrual days

136 days6512,647.9/3

5,618.3 = 162 days



A BS Inc

Balance sheet

Actual P&L Cash Forecast

$m $m

Current assets

Inventories 386 10 396

Accounts receivable 620 107 727

Investments 187 419 606

Cash 415 (378) 37

1,608 1,766

Fixed assets

Intangible assets 1 (2) 206 205

PPE 1,810 (245) (9) (71) 588 (43) 2,030

Investments 53 - 53

Investments in associates 340 121 (16) 67 512

2,204 2,800

Total 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

Total liabilities & equity 3,812 4,566



Erkki, Nuutti and Mikko

Erkki

Erkki Inc has a 31st December year end. On 1st January there were 300,000 ordinary shares in issue. On 31st August, 100,000 new ordinary shares were issued to the market.


Current year EPS = 333,333000,315$ = 94.5c Prior year EPS = 90.0c (5% growth).

No of shares:1 Jan – 31 Aug 300,000 x 8/12 200,0001 Sep – 31 Dec 400,000 x 4/12 133,333

333,333

Nuutti

Nuutti Inc has a 31st December year end. On 1st January there were 300,000 ordinary shares in issue. On 31st August, there was a bonus issue of 1 new ordinary share for every 3 shares held.


Current year EPS = 000,400000,240$ = 60.0c Prior year EPS = 76.0c x

43 = 57.0c (growth 5.3%).


400,000

Mikko

Mikko Inc has a 31st December year end. On 1st January there were 300,000 ordinary shares in issue. On 31st August, there was a rights issue of 1 new ordinary share for every 3 shares held at $11 per share. Immediately prior to becoming ex-rights, the share price was $15.


Current year EPS = 619,347000,295$ = 84.9c Prior year EPS = 86.6c x

1514 = 80.8c (growth 5.0%)


347,619



Mikko

Working

Bonus element of rights issue

3 x $15 $45

1 x $11 $11

4 $56

Theoretical ex rights price = 456$ = $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



Primrose plc

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 1,403,5091 August 5,000,000 × 5/12 2,083,3331 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 2.401 share at 45p cost 0.45

________

2.85________

Theoretical ex rights price = £2.85/5 = 57p

Bonus fraction

pricerightsexlTheoreticapricerightscumActual

−− =

6057

Earnings per share

2005 2004

842,236,5000,893,1 36.1p

526,210,4000,711,1 40.6p



Birren plc

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

Basic000,000,3000,000,1 33.3p

000,000,3000,900 30.0p

Fully diluted000,380,5500,059,1 19.7p

000,190,4750,929 22.2p



Onyali plc

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

If bought at shares at average price

1,575,000 ÷ (2.08 / 3.08) (757,212) (511,364)

________ ________

Free shares nil 238,636

________ ________



Scrutinise Deal

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

Diluted 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



Pearson rights issue

Prior year (as previously reported) 47.8p

earnings 294

shares (weighted average) 615.4

Current year

Earnings (£m) 179

Shares

weighting shares bonus fracWeighted

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



Discounted debt

Zero coupon

28th February 2005


£m £m £mServicing of finance -

Debt 70.8 Interest 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

28th February 2005



(5.0)

Debt ↑ 4.0 90.4 Interest payable (9.0)

Working

year to start interest cash end28 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



Index linked

28 February 2005



(4)

Debt 203 Interest payable (7) Financing 200

Working

year to start interest cash end28 Feb (mid year) @3.5 % @2 %

(6 months) (6 months)

2005 200 7.0 (4.0) 203

Index linked (collar)

28th February 2005



(2.7)

Debt 162.4 Interest payable (5.1) Financing 160

Working

year to start interest cash end28 Feb (mid year) @3.161 % @1.661 %

(6 months) (6 months)

2005 160 5.1 (2.7) 162.4



Convertible debt

US (and UK) GAAP


£m £m £mCash ↑ 273.6 Operating

expensesServicing of finance

(9.1)(17.3)

Debt ↑ 293.7 293.7 Interest payable (20.1) Financing 300.0Equity ↓ 20.1

Transactions

1. Debt is recognised at net proceeds

↑ Cash £290.9m

↑ Debt £290.9m

2. Interest 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 aderivative 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.



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 end30 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 end30 Sept @ 5.75%

2008 300.00 17.25 17.25 300.00

2009 300.00 17.25 17.25 300.00

German GAAP


£m £m £mCash ↑ 273.6 Servicing of finance

(9.1)Interest payable (17.3) (17.3)

Debt ↑ 300.0 300.0 Exc/ext item (9.1) Financing 300.0Equity ↓ 26.4

Transactions

1. Debt is recognised at gross proceeds

↑ Cash £300.0m

↑ Debt £300.0m

2. Issue costs are paid

↓ P&L account - exceptional/extraordinary item £9.1m

↓ Cash £9.1m

3. Interest paid in period (£300m x 5.75%)

↓ P&L account - interest payable £17.3m

↓ Cash £17.3m



IAS 32


£m £m £mCash ↑ 273.6 Servicing of finance

(9.1)Interest payable (20.0) (17.3)

Debt ↑ 287.3 287.3 Financing 300.0Equity ↓ 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. Interest 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



King, Wade & Graf

King Inc

$m

Operating profit 68

Depreciation 70

Amortisation 10

EBITDA 148



Increase in current liabilities 16

Net cash inflow from operating activities 106

Servicing of financeInterest paid (41)

TaxationTax paid (15)

Free cash flow 50

Capital expenditurePurchase of tangible fixed assets (127)

Sale of tangible fixed assets 40

Free cash flow (37)

Equity dividends paidDividend paid (12)

FinancingNet borrowing/(repayment) 55

Increase / (decrease) in cash 6Cash at start 27

Cash at end 33



Wade plc

$m


Depreciation 60

Amortisation -

EBITDA 163

Increase in inventories, excl interest capitalised (2)





TaxationTax paid (15)

Free cash flow 50

Capital expenditurePurchase of tangible fixed assets, excl interest capitalised (127)


Free cash flow (37)


FinancingIssue of shares 52

Increase / (decrease) in cash -Cash at start 27

Cash at end 27



Graf AG

$m

Operating profit/(loss) (109)

Depreciation 130

Amortisation 100

EBITDA 121






TaxationTax paid -

Free cash flow 65



Free cash flow (22)

Equity dividends paidDividend paid -

FinancingNet borrowing/(repayment) -

Increase/(decrease) in cash (22)Cash at start 27

Cash at end 5



Summary

Earnings Free cash flow (pre capex)

Free cash flow (post capex)

King Inc +$24m +$50m -$37m

Wade plc +$60m +$50m -$37m

Graf AG -$137m +$65m -$22m

Sales EBITDA Operating profit

Operating cash flow

King Inc $503m +$148m +$68m +$106m

Wade plc $503m +$163m +$103m +$106m

Graf AG $450m +$121m -$109m +$106m

Working

Movement on tangible fixed assets

£m King Wade GrafOpening NBV 240 260 150Additions at cost (β) 127 127 127Interest 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

Intangibles

Different write off periods for goodwill.

Tangibles

Different depreciation rates. Capitalisation of interest.

Long term contracts

% completion v completed contracts method. Different revenue recognition policies.



Inventories

Capitalisation of interest.

Current liabilities

Recognition of accruals and provisions.



Alternative presentation - US GAAP

King Inc

$m

Net income 24

Depreciation 70

Loss on asset disposals 3

Amortisation 10




Interest capitalised (15)




Free cash flow (37)


FinancingNet borrowing/(repayment) 55

Increase / (decrease) in cash 6Cash at start 27

Cash at end 33



Alternative presentation - cash flow to pay capital 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 inflow from operating activities 106 106Interest paid (41)

Tax paid (15) (27) (27)

Capital expenditureCapex (127) (127)

Disposal proceeds 40 40

Net new investment in PPE & WC (49)

___ ___ ___

Free cash flow (37) (8) (8)Financing

[Interest paid (29)]

Net borrowing/(repayment) 55 55

Dividend paid (12) (12)

___ ___

Increase in cash 6 6___ ___



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 inflow from operating activities 106 106Interest paid (41)

Tax paid (15) (27) (27)

Capital expenditureCapex (127) (127)

Disposal proceeds 40 40

Net new investment in PPE & WC (84)

___ ___ ___

Free cash flow (37) (8) (8)Financing

[Interest paid (29)]

Dividend paid (15) (15)

Net equity issue/(repayment) 52 52

___ ___

Increase in cash - -___ ___



Deutsche Telekom

Deutsche Telekom

2002

€m

2001

€m

SalesNet operating costs, excl depreciation (W)EBITDADepreciationEBITAAmortisationEBITNet 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 financial expense

6,022 – 39 = 5,983



Morientes & Friedel


Morientes FriedelEBIT 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

Interest 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)

Increase in cash 10,047 10,047

Metrics and ratiosMarket capitalisation 518,245 518,245

Net debt 70,161 207,425_

Firm value 588,406 725,670



EBITDAFV

349,63406,588

= 9.29325,128670,725

= 5.65

InterestEBIT

586,6923,31

= 4.85764,16371,70

= 4.20

EBITDAdebtNet

349,63161,70

= 1.11325,128425,207

= 1.62



Morientes

end start movement Operating Interest 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 - - - -

Inventories 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 flow 60,624 (3,000) (9,788) (25,739) (12,050) - 10,047



Friedel

end start movement Operating Interest 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 -

Inventories 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 flow 110,624 (14,860) (9,788) (25,739) (12,050) (38,140) 10,047



Pensions

Net debt/EBITDA

Without adjustment

EBITDAdebtNet

= m6,058€m150,1€

= 0.2

Net debt

€12,346m - 11,196m = €1,150m

Adjusted, pre tax

EBITDAdebtNet

= m6,018€m111,6€

= 1.0

Net debt

€1,150m + [19,492m - 14,531m] = €6,111m

EBITDA

EBITDA = 6,058m + 447m – 487m = €6,018m

Adjusted, post tax

EBITDAdebtNet

= m6,018€m176,4€

= 0.7

Net debt

€1,150m + [(19,492m - 14,531m) x 61%] = €4,176m



Pample & Mousse (1)

Goodwill

Cost of acquisition 408less: fair value of identifiable assets less liabilities attributable to 50% stake (208)[50% x 416]

Goodwill 200

Cost of acquisitionCash paid 91Fair value of shares issued 309

Purchase consideration 400Other direct costs 8

Cost of acquisition 408

Accounting entries

↑ Cost of acquisition €408m

↑ Net debt [91 + 8 + 1] €100m

↑ Shares [309 - 1] €308m

Combined balance sheet: Mousse consolidated as a subsidiary

Pample Mousse CombinedGoodwill 200Net operating assets 1,298 984 2,282

____ ____ ____1,298 984 2,482____ ____ ____

Net debt 450 568 1,118Shares 121 56 429Retained earnings 727 360 727Minority interests 208

____ ____ ____1,298 984 2,482____ ____ ____



Combined balance sheet: Mousse proportionately consolidated as a joint venture

Pample Mousse CombinedGoodwill 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

Pample Mousse CombinedInvestment 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____ ____ ____



Combined income statement: Mousse consolidated as a subsidiary

Pample Mousse adj CombinedSales 1,163 994 2,157

Operating costs (959) (820) (1,779)

____ ____ ____

EBIT 204 174 378

Interest (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

Pample Mousse adj CombinedSales 1,163 994 497 1,660

Operating costs (959) (820) (410) (1,369)____ ____ ____

EBIT 204 174 291

Interest (36) (62) (5)(31) (72)

Tax (33) (30) 2(15) (46)

____ ____ ____


____ ____ ____



Combined income statement: Mousse equity accounted as an associate

Pample Mousse adj CombinedSales 1,163 994 1,163

Operating costs (959) (820) (959)

____ ____ ____

EBIT 204 174 204

Interest (36) (62) (5) (41)

Tax (33) (30) 2 (31)

Share of associate 41 41

____ ____ ____


____ ____ ____

Workings

Interest on additional net debt

€100m x 5% = €5m

Tax shield on additional interest

€5m x 40% = €2m



Mango & Steen

Combined balance sheet (immediately after acquisition)

Mango Steen ConsolidatedCash 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

____ ____ ____ ____ ____



Combined income statement (first year after acquisition)

Mango Steen ConsolidatedCash 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)

____ ____ ____ ____ ____

EBITDA 367 633 1,000 1,000 1,000

Depreciation (109) (190) (299) (299) (299)

____ ____ ____ ____ ____

EBIT 258 443 701 701 701

Interest 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

Financial maths


Financial maths 1Discounted cash flow (DCF) 1

Introduction 1Time value of money 1Terminal/future values 5Net terminal/future value 6Present values 7Annuities and annuity compound factors 10Net present values 12Annuities and annuity discount factors 14Perpetuities 16Internal rate of return 17Annuities and perpetuities not starting at time 1 21

Arithmetic and geometric progressions 24Arithmetic progressions 24Geometric progressions 24

Financial maths


Financial maths

Discounted cash flow (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 value of money

If 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


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.

Example

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?

Solution

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

Dn = Do [1 + (n x r)]

Where

Dn = value of deposit at end of period (eg year) n

Do = initial value of deposit

n = no of periods money is on deposit for

r = simple interest rate expressed as a decimal

For the example

D3 = £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


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.

Interest earned: £1,000 x 6% = £60

Year 2

Balance at start of year = initial deposit plus interest earned in year 1 = £1,060

Interest 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

Interest 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

Dn = Do (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


The formula for calculating the terminal value when interest is not paid annually is

Dn = Do (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

If 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 returnwill 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. If 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

1000,190.060,1

−−−− = 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 istherefore the actual rate achieved is called the annual percentage rate (APR) or effective annual rate (EAR).

In the formulae we have seen so far, r represented the flat rate.

If 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


Applying this formula to our example in which interest is compounded twice a year:

APR = (1 + 0.06/2)2 - 1 = 6.09%

Terminal/future values

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 considerwhich 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.

Example

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

Dn = Do (1 + r)n

The (1 + r)n part of the expression is referred to as the compound factor

Financial maths


Investment 1

Time(years)

Cash flow£

Compound factor(1 + r)n

Terminal value, £(at end of yr 3)

1 500 1.062 561.80

2 500 1.06 530.00

3 500 1.00 500.00

Terminal value 1,591.80

Investment 2

Time(years)

Cash flow£



1 200 1.062 224.72

2 1,300 1.06 1,378.00

3 - 1.00 -

Terminal value 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 terminal/future value

When there are both positive and negative cash flows the terminal value will be the net of these flows.

We will now rework the previous example but include the initial investments as negative cash flows.

Financial maths


Investment 1

Time(years)

Cash flow£



0 (1,300) 1.063 (1,548.32)

1 500 1.062 561.80

2 500 1.06 530.00

3 500 1.00 500.00

Net terminal value 43.48

Investment 2

Time(years)

Cash flow£



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 terminal value (64.70)

It 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. Investment 2 now has a negative cash balance (terminal value) of £64.70 at the end of the third year. Investment 1 is now the preferred investment

Present values

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?

If for example Investment A, a four year investment, had a terminal value (in four years) of £550 whilst Investment 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


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.

Example

If 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

Dn = Do (1 + r)n

This formula can now be re-arranged as follows

nn

0 )r1(DD++++

====

Where

D0 = the amount we need to invest today ie the present value (PV)

Dn = 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)r1(flowcashfuture

)PV(valueesentPr++++

====

This is, of course, the same as writing

Present value = future cash flow x n)r1(1++++

Financial maths


The term n)r1(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.

Example

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.

Example

If the interest rate is 8% p.a. d o we prefer:

(a) £6,000 now; or

(b) £8,000 in 5 years’ time?

Choice (a) (b)

PV £6,0005)08.1(

000,8 = £5,444.67

We prefer (a), as it has the higher present value.

Financial maths


Annuities and annuity compound factors

An annuity is when the same cash flow occurs for a number of periods.

Example

It 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 flow, £ Compound factor Terminal value, £

0 (380) 1.084 (516.99)

1 120 1.083 151.17

2 120 1.082 139.97

3 120 1.08 129.60

4 120 1.00 120.00


Imagine reworking the above example if the annuity was going to last for forty years rather than four. It 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

r1)r1( 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

0.081)08.1( 4 − = 4.5061

Financial maths


We can now calculate the net terminal value of the annuity, using the annuity compound factor rather than the individual compound factors.

Time Cash flow, £ Compound factor Terminal value, £

0 (380) 1.084 (516.99)

1 – 4 120 4.5061 540.74


The terminal value arrived at above could be written as

[- 380 x (1.08)4] + 120 x [.08

1)08.1( 4 − ] = 23.75

The above can be written as a general formula

Dn = D0 (1 +r)n +r

1)1( −+ nr d

Where

Dn = terminal value at time n

D0 = 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.

Example 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 D0 value in the above formula. The value of Dn, as the annuity terminates at the end of the fifth year, will be £0.

Financial maths


Therefore we have the following expression to solve

0 = D0(1.06)5 + 600 x [.06

1)06.1( 5 − ]

0 = 1.3382D0 + 600 x 5.6371

D0 = - £2,527.47

It would cost £2,527.47 today to buy a five year annuity paying £600 per year, if interest rates are 6%.

Example 2

If 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 D0 is £250,000 and that Dn is £0 (as the mortgage is repaid). We need to solve for d in the following expression

0 = 250,000(1.075)25 + .075

1)075.1( 25 − d

0 = 1,524,584.90 + 67.9779d

d = - £22,427.66

The annual repayments would be £22,427.66.

Example 3

Having calculated the annual payments, what is the balance outstanding on this mortgage at the end of the twentieth year?

Dn is now the end of the twentieth year and n = 20.

Dn = - 250,000(1.075)20 + 22,427.66 .075

1)075.1( 20 −

Dn = - 1,061,962.78 + 971,222.67

Dn = - £90,740.11

There would still be £90,740.11 owing on the mortgage at the end of the twentieth year.

Net present values

We saw earlier that the net terminal value was the terminal value when there were both positive and negative cash flows. In the same way, the net present value or NPV is the present value when there are both positive and negative cash flows.

Financial maths


Example 1

An investment requires an initial payment today of £1,000 and will pay back £1,650 in three years’ time. If the discount rate is 6% what is the NPV of this investment opportunity? Should it be undertaken?

Time(years)

Cash flow£

Discount factor1/(1 + r)n

Present value, £

0 (1,000) 1 (1,000.00)

3 1,650 1/1.063 1,385.37

Net present value 385.37

As the investment has a positive NPV it is worth doing.

Example 2

An investment requires an initial payment today of £2,000 and will pay back £2,650 in four years’ time. If the discount rate is 10% what is the NPV of this investment opportunity? Should it be undertaken?

Time(years)

Cash flow£


Present value, £

0 (2,000) 1 (2,000.00)

4 2,650 1/1.104 1,809.99

Net present value (190.01)

As the investment has a negative NPV it is not worth doing. It would be equivalent to losing £190.01 today.

Example 3

You are required to decide which, if either, of the following two investment opportunities you would undertake. Interest 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


Investment Q

Time(years)

Cash flow£


Present value, £(at end of yr 3)

0 (600) 1 (600.00)

1 165 1/1.081 152.78

2 300 1/1.082 257.20

3 450 1/1.083 357.22


Investment W

Time(years)

Cash flow£


Present value, £(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


Both investments have positive NPVs but as investment W has the higher NPV it is the one to choose.

Annuities and annuity discount factors

Investment W, above, had the same cash flow for a number of years. This is of course an annuity. In 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)+(11-(1

r1

n×

For Investment W

)(1.08)

1-(108.01

3× = 2.5771

Financial maths


Time, years Cash flow, £ Discount factor Present value, £

0 (900) 1 (900.00)

1 - 3 450 2.5771 1,159.69


Example

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-(106.01

15× = 9.7122


1 - 15 850 9.7122 8,255.37

Present value 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.

Illustration

A 25 year annual instalment repayment mortgage for £100,000 is granted at an interest rate of 6%. If instalments are made at each year end, what is the required annual instalment?

Solution

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-(106.01

25×

£100,000 = A x 12.78

A = £100,000 / 12.78 = £7,822.67 (or £7,824.73 depending on rounding).

Financial maths


Perpetuities

A perpetuity is similar to an annuity except for the fact that the cash flows continue for ever ieinto perpetuity. It 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.

If 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

Example

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%? Is it worth undertaking? Would it be worth undertaking if interest rates are 6%?

Net present value at 7%


0 (12,000) 1 (12,000.00)

1 - ∞ 800 1/0.07 11,428.57

Net present value (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%


0 (12,000) 1 (12,000.00)

1 - ∞ 800 1/0.06 13,333.33

Net present value 1,333.33

At a discount rate of 6% the investment is worth doing as it has a positive net present value.

r1

Financial maths


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:

n1

g)-(rCf

, where Cf1 is the cash flow arising in one period’s time and subsequent cash flows grow

by g% per period.

Example

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

Internal 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. If 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. It 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 IRR and compare it with the cost of financing the investment.

How then is the IRR calculated?

Financial maths


Comprehensive illustration

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





_______

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%.

Is this project worthwhile? In other words is it generating a positive NPV? Is it generating a return (IRR) 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.

Thus09.1000,000,30 = £27,522,936 in present value terms

and2)09.1(000,000,72 = £60,600,960 (in two year's time), etc.

Financial maths


Discount PresentTime Narrative Flow factor value

£’000 9% £’000

0 Project cost (250,000)009.1

1 = 1 (250,000)

1 Inflow 30,000109.1

1 27,523

2 " 72,000209.1

1 60,601

3 " 80,000309.1

1 61,775

4 " 65,000 409.11 46,048

5 " 110,000509.1

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. It 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. In 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


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 IRR is found to be 11.28%.

The IRR provides the rate at which the project just breaks even; it gives us the maximum cost of capital the project can endure. This is vitally important; the IRR 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


If 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)+(11-(1

r1

n×

Perpetuity discount factor: r1

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

Example

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 flow, £ Discount factor Present value, £

0 500 1 500.00

1 500 1/1.06 471.70

2 500 1/1.062 445.00

3 500 1/1.063 419.81

4 500 1/1.064 396.05


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



0 500 1 500.00

1 - 4 500 3.4651* 1,732.56


*annuity discount factor )(1.06)

1-(106.1

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-(106.1

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. If cash flows start before time 1, increasetheir value. It therefore follows that if cash flows start later than time 1, reduce their value.

Example

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


0 - - -

1 - - -

2 - - -

3 300 1/1.043 266.70

4 300 1/1.044 256.44

5 300 1/1.045 246.58

6 300 1/1.046 237.09


Financial maths


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-(104.1

4× = £1,088.97

Step 2 - discount value by two years as cash flows start two years after time 1

(1.04)11,088.97 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.

Illustration

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:

.0711

x .0811

x .0911

x £20,000 = £15,878

A common error is to discount the cashflow for three years at the 3-year rate.

Financial maths


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.

In 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 = 2n (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 31

− is

2,32

− , 92 ,

272

− , . . .

In general we can write a geometric progression as follows:

Geometric progression: a, ar, ar2, ar3, ...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 = rra n

−−

1)1( (valid only if r ≥ 1).

Introduction to valuation


Introduction to valuation 1Introduction 1Overview 1

Comps based valuation 1DCF valuation 2

Comparable companies analysis 3Why do we do comps? 3From Equity Value to Enterprise Value 5Illustration 6

Discounted cash flow valuation 8Key points 8Cost of debt 10Cost of equity 13Dividend valuation model 17Dividend policy 20

Recognising risk 23Introduction 23Traditional theory of gearing 24Modigliani & Miller (M&M) 25Gearing Betas 29Adjusted present value (APV) 31

Weighted average cost of capital (WACC) 32Cash flow to discount 33

Value drivers 35What comes before valuation? 37Growth rates and time period for discounting 39Terminal values 40Time period convention 41

Valuing combinations 42Methodology 42




Introduction

Company valuation techniques can be broadly categorised as:

� Comparable companies analysis (eg P/E, EV/EBITDA); 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 valuation

Key metrics

Equity level Enterprise level

Earnings based E (earnings after tax)

[NOPAT]

EBIT

EBITDA

Cash flow based Levered FCF Unlevered FCF

Key multiples


Earnings based P/E EV/EBIT(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.


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 valuation

Key metrics


Earnings based not applicable not applicable

dividends available

Cash flow based Levered FCF Unlevered FCF

Discount rate


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.



Comparable companies analysis

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 EBITDA)− multiples of similar quoted company(ies) (eg EV/EBITDA)

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

Theoretical equity value 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. Investment returns for financial buyers acquiring assets with the intention of monetising the investment in the public equity market in an IPO.



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 value I

Sales

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 Value / Earnings

2006 (Curr.) 20.8x 17.9x

2007 (Prosp.) 18.5x 15.5x



From Equity Value to Enterprise Value

Enterprise value (*) = Equity Value (**) + Net Debt (***) + Minority Interest

Example continued – Enterprise value

Tesco

Share price (p) 261.5

Number of Shares (m) 6,932

_____

Equity Value (£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 Interest (£m) 36 [F]

_____

Enterprise value (£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 capitalisationFirm value (FV)Aggregate valueLeveraged market capitalisation (L.MC)

The terms are used loosely and are generally interchangeable. If 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)



Illustration

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

EBITDA £1,642m

∴ EV/EBITDA £20,794m ÷ £1,642m

= 12.7x



Comps valuation – earnings based

Equity level

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 level

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 (egsales, EBIT, EBITDA, unlevered free cash flow). EBITDA is pre tax and EPS is post tax, so EV/EBITDA has a larger denominator than PER. Consequently, the EV/EBITDA multiple will be smaller than the PER. (Also, EBITDA 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

EBITDA £961m

Tesco EV/EBITDA x J Sainsbury EBITDA

12.7 x £961m = £12,205m

Summary


[EV – net debt = equity value]

Earnings based £8,326m £12,205m - £859m = £11,346m



Discounted cash flow valuation

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.

Illustration – Enterprise level

Cash FlowsActual 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 4Turnover 511.0 624.0 780.0 873.6 943.5 990.7

EBIT 26.1 137.3 202.8 205.3 207.6 198.1Add: Depreciation 40.0 36.2 45.3 50.7 54.7 57.5

EBITDA 66.1 173.5 248.1 256 262.3 255.6Working capital adjustment 3.2 (26.6) (46.8) (23.4) (12.6) (8.3)

Operating cash flow 69.3 146.9 201.3 232.6 249.7 247.3Sale of fixed assets - - - - - -Investment 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 flow 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 1,250Nominal growth post 2010 2.0% Less: Net Debt (163)

Equity value (£m) 1,087



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 level

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.



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.

If 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/EBITDA), similar business etc).

A rough guide for US companies using a single ratio would be:

Total 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.



Market value

If interest (I) is expected in perpetuity, the market value of the debt is MVd and the required return of debt holders is rd, then:

MVd = PV of interest I in perpetuity

= ...rd)(1I

rd1I

2++

+=

rdI

By rearranging the equation:

rd = interestex MVdI

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?

rd = 897

= 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.

kd = MVdinterestt)(1 ×−

where kd = 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. If we assume a corporation tax rate of 30%, then the cost of debt is:

kd = 897 x 0.7 = 5.5% (or 0.7 × 7.86 = 5.5%)

Chronology

• Investors 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%.



Redeemable debt

Market value

If interest (I) is expected for a number of periods and then an amount R on redemption, the market value of the debt is:

MVd = = n32 rd)(1R.....

rd)(1I

rd)(1I

rd1I

+++

++

+

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 (I) with (1 – t) x (I) interest.



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 (ββββ) measures the level of systematic business risk relative to the market risk for any investment.

Thus, if an investment has a β 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 (ke) = Rf + (βL x Rm)⇓ ⇓

Risk free Premiumreturn for risk

Where:

ke = Cost of equity (shareholders’ required return)Rf = Risk free return (i.e. from government stock or corporate debt)Rm = Equity market risk premiumβL = Beta leveraged for target level of gearing



Example

Rf = 6%

Rm = 7%

βL = 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. It should be! The β = 1 indicates that the investment moves exactly in line with the FT 100.

If the investment has a β of 1.4, then it moves in line with the market, but to a greater degree. In 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

It 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 Bills Stocks-T Bills 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%



Calculation of Beta

The β of any share or investment is expressed as: σσ

s

m

Where, σs = systematic risk of the investment

σm = risk of the FTSE 100

This can be calculated as follows:

β = m

iimr

where, rim is the correlation coefficient of the investment with the index, σi is the total businessrisk in the investment and σm is the risk of the index.

Beta can be calculated in many ways, Ibbotson 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 two y 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 Ke (cost of equity) calculation.

Large companies such as Nokia, Telecom Italia and even Vodafone can create problems if their stock comprises a disproportionate amount of the index, distorting their beta calculation.

Relevering 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:



Unlevering formula

( )

−×

+

β=β

t1ED1

LU

Current gearing

This unlevered beta must then be relevered, based on the target gearing level (if necessary, use the industry average):

Relevering formula

( )

−×

+×β=β t1ED1UL

Target gearing

D = market value of debt capitalE = market value of equity capitalt = marginal tax rate



Dividend valuation model

Constant dividends

If expected future dividends in perpetuity are constant at D, the market value of the shares is MVe and the cost of equity is ke,

MVe = PV of dividends D in perpetuity

= 2ee )k1(

Dk1

D+

++

etc.

= Dke

eMVsharesequity

ofvalueMarket=

)(kreturnofraterequiredrsShareholde

(D)dividendexpectedFuture

e

Rearranging the model allows us to find (but not, of course, derive) the cost of equity or required return. If D and MVe are known,

ke = eMV

D

Example

Assume a €15,000 dividend is expected each year in perpetuity and shareholders require a rate of return of 12% (ke).

What is the PV of this perpetuity?

The PV of the returns (from 1 - ∞) is as follows:

15,000 × 1/0.12 = 125,000.

Investors should be prepared to pay €125,000 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.



The dividend valuation model produces an ex dividend market value since the sum of the present values starts with the dividend in 1 year's time (ie. excludes the current dividend).

In 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.

Example

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.

ke = D

MV ex div

ke = %12

Divdiv.cumMV

100,000-900,000100,000

21=

↓↓

or per share %1210p90p

10p21=

−

Constant growth in dividends

Assume dividends are expected to grow at a constant rate g.

Let D0 = current dividend

D1 = next year’s dividend

MVe = ...)k(1g)(1D

k1g)(1D

2e

20

e

0

++

+++

or = 2e

1

e

1

)k(1g)(1D

k1D

++

++

etc.

The formula for adding up these future dividends discounted is

MVe = gkdividend yearsNextie

gkg)(1D

ee

0

−−+

or = gk

D

e

1

−

If dividends, g and MVe are known, the cost of equity can be computed:



ke = e

0

MVg)(1D + + g or g

MVD

e

1 +

In summary, therefore, shareholders will value shares by discounting future expected dividends at their required return. If 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).

Altering the time horizon

The model referred to above is, of course, a simple perpetuity.

It is normally amended in accordance with the time horizon of the company such that

)k1(D

e

1

+ + 2

e

2

)k1(D+

+ 3e

3

)k1(D+

+ 4e

4

)k1(D+

+ 5e

5

)k1(D+

. . . .

. . . 10e

10

)k1(D+

+ 10e )k1(

1+

− gk

D

e

11

The calculation is based on a 10 year time horizon, with the 1st dividend arising at time 1 (i.e. next year).

Assumptions of DVM

� Investors 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.



Dividend policy

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?

Signalling tool

� Communicates information to the equity market about the strategic direction of a company

� Signals a company’s future operating performance

� Investors 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

Shareholder 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



� The need for additional funding to make those investments

� The additional flexibility to deploy excess cash flow for share repurchases

Factors determining dividend policy

Shareholder preferences

Institutional 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 / flexibility

� 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

Signalling

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



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.



Recognising risk

IntroductionRisk 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.

Illustration

Low Average High

Earnings = Dividend (in an all equity company) £4,000 £5,000 £6,000

-20% +20%

If £5,000 is the average, the earnings, and therefore dividends, can fluctuate by 20% (risk).

If the company now has a fixed amount of interest to pay, the following occurs:



Low Average High£ £ £

Earnings 4,000 5,000 6,000Interest (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 (ke).

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

Traditional theory of gearing

At low levels of gearing, ke rises slowly and the effect of the cheaper debt outweighs the increase in the ke. The theory therefore predicts that the WACC will fall.

However, as gearing increases further, ke 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 ofcapital

ke

WACC

kd

optimal gearingWACC lowestMV highest

MV debtMV 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:



• 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.

If 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.

Modigliani & Miller (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 (ke) 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.

In 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. It reflects the risk of total payments to the total providers of capital.



Illustration

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 5,000Interest – – (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 4,000Interest 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.

Costof capital

WACC

Gearing B/S

ke

kd

The cost of equity rises steadily as gearing increases but the WACC is constant.

i.e. WACCu = WACCgwhere WACCu is the WACC of an ungeared company and WACCg is the WACC of a geared company.



For 2 identical companies

MVgeared = MVungeared

M&M with corporation tax

With corporation tax, a geared company will have a lower WACC than an otherwise identical ungeared company.

Illustration

Ungeared Geared

I II I II

£ £ £ £

Earnings 1,000 500 1,000 500Interest – – (400) (400)_____ ___ _____ ___

1,000 500 600 100Tax 30% (say) (300) (150) (180) (30)_____ ___ _____ ___

700 350 420 70_____ ___ _____ ___

Total return to providers of capital are:

£ £ £ £

Dividend 700 350 420 70Interest 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:

Itrd

= 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

Irredeemable debt

A diagrammatical representation of M & M, with corporation tax, is as follows:



Costof capital

WACC

Gearing B/S

kd

ke

ke 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 debtTotal MV of company

)

Non-tax benefits to debt

In 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

Kg = Ku + (Ku – Kb) (MV debtMV equity

) (1 – Tc)

K = Ku (1 - Tc (MV debtTotal MV

))

βg = βu + βu (MV debt (1 - Tc)

MV equity)



MVg = MVu + Tc MV debt

Where,

Kg = cost of equity in geared company

K = weighted average cost of capital

Ku = cost of equity in equivalent ungeared company

Kb = debt holders’ required return = risk free rate

βg = systematic risk attaching to dividend in geared company

βu = systematic risk attaching to dividend in ungeared company

Gearing Betas

βu The beta factor of an ungeared company or investment (often known as the Asset or Earnings beta)

βg The beta factor of a geared company’s or project’s dividends (often known as the Dividend or Equity beta)

Ku Cost of equity ungeared

Kg Cost of equity geared

Ku = RF + βu (RM – RF)

Kg = RF + βg (RM – RF)

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, βu measures the systematic risk attaching to the earnings of the company.

βg measures the systematic risk attaching to the dividend payout. The relationship linking the 2 beta factors can be expressed as:


MV equity)

or

βg = βu (MV equity uMV equity g

)

Illustration

A company has pre-tax earnings of £1,000,000, a tax rate of 31% and a βu of 1.5. RF = 5% & RM = 12%.

Ku = 5% + 1.5 (12 – 5)Ku = 15.5%

The market value of the company (debt plus equity) will be:



MVu = e/ Ku

(1,000,000 x (1 – 31%)) / 15.5%

£4,451,613

If we introduce £500,000 debt paying 10% interest (the risk free rate).

MVg = MVu + Tc MV debt

MVg = 4,451,613 + (31% x 500,000)

MVg = £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.

Kg = Ku + (Ku – Kb) (MV debtMV equity

) (1 – Tc)

= 15.5 + (15.5 – 10) (500,0004,106,613

) (1 – 31%)

= 15.96%


MV equity)

= 1.5 + 1.5 (500,000 (1- 31%)

4,106,613)

= 1.63

or

βg = βu (MV equity uMV equity g

)

= 1.5 (4,451,6134,106,613

)

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

Interest (50)

_______

950

Tax at 31% (294.5)

_______

Dividend 655.5

_______



MV equity in geared company = £655,500/0.1596

= £4,106,613.

Adjusted present value (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.



Weighted average cost of capital (WACC)

If 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.

Example:

ke = 16%

kd (post tax) = 12%

Capital Ex div market value

£1 ords 150,000

9% debenture 37,500

WACC = 16% ×5.187

150 + 12% ×

5.1875.37

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. It 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.

In 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.



Cash flow to discount

Dividend Valuation Model (DVM)

The DVM is most appropriate for firms with stable growth rates, paying out dividends and with stable leverage.

It 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 rateAll 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 Yield 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 flow



The basic formula is:

Po = grLFCF1

−

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



Value drivers

In 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.

Value driver goal

1. Revenue growth rate increase from 12% to 15%

2. Operating margin / EBITDA 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

Innovation tactics Downtime Funding choices

The following are examples of initiatives used to influence the 7 value drivers across an organisation:



Organisational value drivers

Revenue growth rate

1. Growth → that adds value2. New market entry3. New products4. Globalisation5. Customer loyalty programmes6. Pricing advantage7. Distribution outlets8. Focused advertising based on differentiation

Operating margin growth

1. Modernise working practices2. Multi-skilling3. Share services / outsource4. Consolidate back office functions5. Spin-offs6. Business process re-engineering (BPR)

� Customer care� Integrated billing� ABC system� Data warehousing� Data mining� Network management

Cash tax rate

1. Transfer pricing / management charges2. Capex timing3. Locate and exploit intellectual property and brands4. Holding structure5. Co-ordination centres

Working capital

1. Stock eg just-in-time, supply chain management2. Debtors eg billing system, payment discounts3. Creditors eg impact on discounts / supplier relationships4. Cash

Capital expenditure

1. Develop capital appraisal and utilisation reviews and project finance techniques2. Lease v buy decisions3. Treasury hedging and exchange rate management systems



WACC

1. Build management understanding of cost of capital2. Gearing optimisation3. Calculate business unit specific WACC4. Consider share buy backs and demerger of non-core business

Competitive advantage period

1. Improve investor relations → providing predictable and sustainable financial performance2. Improve business unit cash flow information3. Return to core competencies4. Develop executive (and employee) performance reward schemes linked to share price

improvements5. Incorporate strong risk management procedures6. Creation of barriers to

� Supplier power� Customer power� Substitute threat� New entrants� Existing rivalry

What comes before valuation?

Accounting is the key to understanding financial information. If earnings are wrong, the debt service cover ratio is wrong. If 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).

Sales 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



Movements in working capital

� 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� If 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)

Capital 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



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

Example

1.1.96 Pay dividend 12,6341.1.01 Pay dividend 22,265

If 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 = 634,12265,22

1 + g = 5634,12265,22

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.

If 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.

Example

Suppose a company’s shares have a cum div market value of €10.25 per share. A dividend per share of €1.25 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 (ke) is

ke = %2308.025.125.1008.125.1

=+−×



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 EBIT = 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.

Stable growth

� Ideally, investors want growth rate that can be maintained forever. This is normally linked (ieequal to or less than) to the growth rate in the economy, either national or global.

Terminal values

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/EBITDA 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. In 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

tatdividendsorearningsorFCF 1n +



Time period convention

In 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. T1, T2, etc.)� That cash flows occur at the mid-point of each year (i.e. T0.5, T1.5, 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). If 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.



Valuing combinations

Methodology

Acquisition motive Valuation methodology

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 = Independent 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.



Illustration

Compaq and Digital

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 $6bnValue of cash paid in the deal $30 x 147m shares = $4.4bnDigital's outstanding debt $1bnRemaining value to be satisfied by shares $0.6bnNumber of shares 147mValue per share $ 0.6bn ÷ $147m = $4.08Compaq'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.

Comps

© The Corporate Training Group Ltd • +44 (0)20 7490 4770• [email protected]

Comparable company analysis (Comps) 1Why do we do comps? 1Comparable universe 3Sources of information 4From Equity Value to Enterprise Value 5

Enterprise value (EV) 5Equity value (Eq.V) 5Net debt 6When to use Equity Value vs Enterprise Value 8Impact of capital structures on multiples 9

Which multiple? 10Using comps 12Special situations 14

Currency 14Annualisation 15LTM 15Exceptional / extraordinary items 16Dilution 18Convertible debt 19Mezzanine finance 22Market value of debt and / or preference shares 22Associates and JVs 22Minorities 25Finance and operating leases 26Unfunded pension obligations 29Pro forma: Acquisitions and disposals 31

Keys to success 34

Comps


Comparable company analysis (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 EBITDA)− multiples of similar quoted company(ies) (eg EV/EBITDA)

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

Theoretical equity value 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. Investment returns for financial buyers acquiring assets with the intention of monetising the investment in the public equity market in an IPO.

Comps


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 value ISales

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 Value / Earnings

2006 (Curr.) 20.8x 17.9x

2007 (Prosp.) 18.5x 15.5x

Comps


Comparable 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


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

Income 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

I/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


From Equity Value to Enterprise Value

Enterprise value (*) = Equity Value (**) + Net Debt (***) + Minority Interest

1. Example continued – Enterprise value

Tesco


Number of Shares (m) 6,932

_____

Equity Value (£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 Interest (£m) 36 [F]

_____

Enterprise value (£m) 20,967 [A +E + F]

Enterprise value (EV)

Enterprise value is also referred to as:

Total enterprise value (TEV)Entity value (EV)Gross value (GV)Total capitalisationFirm value (FV)Aggregate valueLeveraged market capitalisation (L.MC)

The terms are used loosely and are generally interchangeable. If used in a critical context we should define exactly what us meant by them.

Equity value (Eq.V)

Equity value (Eq.V) is also referred to as:

Market capitalisation (MC)

Comps


Net debt

Net debt = borrowings - (cash + liquid 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


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


When to use Equity Value vs Enterprise Value

Capital value

Turnover

Operating costs Enterprise value =

EBITDA Equity value

Depreciation / amortisation + Net debt

Operating profits + Minority interest

Associates / JV

EBIT

Net interest Earnings adjustment for net debt – financial interest

PBT Equity value

Tax + Minority interest

Profit after tax

Minority interests Earnings adjustment for minorities - minority interest

Net income / earnings Equity value

Comps


Impact of capital structures on multiples

Company A Company B

Capital structure

Equity 200 500

Net debt 300 -

Minority interest - -

P&L

Sales 150 150

EBIT 35 35

Net interest (25) -

PBT 10 35

Earnings 7 25

Multiples

Enterprise value / Sales 3.3x 3.3x

EBIT 14.3x 14.3x

Equity value / PBT 20.0x 14.3x

Earnings 28.6x 20.0x

2. Example continued - the multiples

Tesco

(£m - except per share)



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 / EBITDA 12.6x 10.8x 9.4x

EBIT 1,187 1,352 1,556

Enterprise Value / EBIT 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


Which multiple?

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&EFV/Subscriber

FVRevenue (growth)

FVRevenues

FV/Net PP&EFV/Subscriber

FVEBITDA (growth)

FVEBITDA

Revenue

EBITDA

EBIT

Net Income

Time

$

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 EBITDA

� 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

× Inconsistency of treatment within sales of joint venture in different reporting environments

× Different revenue recognition rules between companies

Comps


Pros ConsEV/EBITDA � Incorporates profitability

� Most businesses are EBITDA positive so widening the universe

� Ignores the most significant accounting differences arising from goodwill

� Relatively limited exposure to accounting differences

× Ignores depreciation / capex

× Ignores tax regimes and tax profiles

× Does not take into account varying EBITDA growth rates

× Inconsistency of treatment within EBITDA 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/EBIT � Incorporates 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

× Ignores tax regimes and tax profiles

× Does not take into account varying EBIT growth rates

× Inconsistency of treatment within EBIT 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


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

EBITDA 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 / EBITDA ? 5.88

Equity value / earnings ? 9.65

Comps


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

Theoretical equity value 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)

Theoretical equity value of target (Company X) 800

How to use Comps

Comparable Company Entity Net Debt & EquityCompanies Financials Value MI 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

EBITDA Curr. 7.5x - 10.5x 7.3 55 - 77 10 45 - 67

Prosp. 6.5x - 9.5x 7.9 51 - 75 10 41 - 65

EBIT 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 Value (£m) 55-60

Comps


Special 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. Currency2. Annualisation3. LTM (last twelve months)4. Exceptional items5. Dilution6. Convertible debt7. Mezzanine finance8. Market value of debt and / or preference shares9. Associates and JVs10. Minorities11. 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/EBIT) are independent of currency provided that both numerator (eg EV in $m) and denominator (e.g. EBIT 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


Annualisation

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. In 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 3rd 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:

Annuals 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


Aug-03 Aug-04

LTM = 80 - 45 + 60

95

Exceptional / 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. If not available use the effective or marginal tax rate.

Comps


Example

Compco Adjustments Pro forma

Sales 100 - 100____ ___ ____

Exceptionals (20) 20 -____ ___ ___

EBIT 5 20 25Net Interest (2) - (2)

____ ___ ___PBT 3 20 23Tax (*) (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− In the UK it is unlikely that tax relief will arise− In Germany it is likely that tax relief will be received

− property write-downs / impairments− In the UK tax relief will not arise− In Germany it is likely that tax relief will be received

Comps


Dilution

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. In 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


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%

Convertible 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.

Illustration

Net profit €1,000

Ordinary shares outstanding 10,000

Number of convertible 10% €100 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 EPS000,10000,1€ = €0.100

Diluted EPS800,11072,1€ = €0.091

Comps


� Adjusted net profit

€1,000 + [€120 x (1 - 40%)] €1,072

� 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 IFRS, 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.

Illustration

A company issues €100,000 3% convertible debt at par. Interest 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 IFRS, 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 (€9,271) is deemed to be the fair value of the consideration received for writing a call option on the issuer’s shares.

Comps


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:


US GAAP IFRS US GAAP IFRS

Cash 97.00 97.00 Interest expense (4.82) (6.35)

Cash flows

Debt 101.82 94.08 US GAAP IFRS

Equity - 9.27 Interest 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


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 value 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 Instruments 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 EBIT and proportionally consolidated for the post-EBIT 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 EBIT.

Comps


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

EBIT 25

Consolidate in proportion (including 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

EBIT 20 5 25

Equity value 90 - 90

Net debt 30 4 34___ __ ___

Enterprise value 120 4 124

EV/ Sales 1.03

EV / EBIT 4.96

The equity value of CompCo includes the market value of its stake in AssocCo.

Exclude and value 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


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.


Sales 100 - 100

EBIT 20 - 20

Equity value 90 (22) 68

Net debt 30 - 30

___ __ ___

Enterprise value 120 (22) 98

EV/ Sales 0.98

EV / EBIT 4.90

Comps


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

EBIT 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


EV / sales 1.28x 1.38x

EV / EBIT 6.4x 6.9x

Equity value / net income 8.4x 8.4x

Finance and operating leases

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:

Illustration

3 airlines have acquired the use of a plane with a cash price of €95m.

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 €16m 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 €18m 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

EBITDAR - - -

Rental expense - - (18.0)

EBITDA - - (18.0)

Depreciation (9.5) (11.9) -

EBIT (9.5) (11.9) (18.0)

Interest expense (3.8) (6.8) -

Pre-tax profit (13.3) (18.7) (18.0)

Balance 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 flow

Operating - - (18.0)

Comps


Interest 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 EBIT or even EBITDA is limited. EBITDAR 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 3

1 interest and 32 depreciation. This rule of thumb has been

identified by the credit rating agencies and so adjusted metrics (e.g. EBIT) can be calculated.

Using Company C in the illustration, the rental expense is removed (and so standardises EBITDA) and replaced with a new depreciation charge of 12 (18 x 3

2 ) and interest of 6 (18 x

31 ). If this simplifying assumption is accepted, then the result is that EBIT and all subsequent

multiples are similarly standardised no matter how the operating assets have been financed.

Adjusting EV

If EBITDAR is the metric of choice (or the adjusted EBITDA), then EV/EBITDAR should be the multiple. However, EBITDAR (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 EBITDAR, 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


Illustration

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 €450m 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


Unfunded pension obligations

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)

In 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 €1,839 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 IFRS, 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 €1,287 [€1,839 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 IFRS disclose (though don’t necessarily recognise) similar figures.

Where EBIT or EBITDA 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


Consequently, to calculate EBIT or EBITDA, 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).

Illustration

A company with an EBITDA of €553m and net debt of €1,938m, and which suffers corporate tax at the rate of 30%, has a provision in its balance sheet for pensions of €57m and a pension charge in operating expenses of €64m.

Disclosed in the notes to the accounts is the following information:

net pension scheme deficit €1,839m

current service cost €92m

net pension finance expense €1,255m

pension contributions paid to scheme €88m

Revised net debt:

Net debt as originally stated €1,938m

net pension deficit (post tax) [1,839 x (1-30%)] €1,287m

Adjusted net debt €3,225m

Revised EBITDA

EBITDA as originally stated €553m

Add: original pension charge (€64m)

Less: current service cost €92m

Adjusted EBITDA €581m

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


Pro forma: Acquisitions and disposals

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, EBIT and net income. European companies, on the other hand, are likely to be less forthcoming.

Illustration - disposal

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

EBIT 10 4

Pro forma: disposal


Sales 60 (40) 20

EBIT 10 (4) 6


Net debt / (cash) 20 (35) (15)___ __ ___

Enterprise value 120 (35) 85

EV/ Sales 2.0x 4.3xEV / EBIT 12.0x 14.2x

Comps


Illustration – 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

EBIT 10 4

Pro forma: acquisition for cash


Sales 60 40 100

EBIT 10 4 14


Net debt / (cash) 20 35 55___ __ ___


EV/ Sales 2.0x 1.55x

EV / EBIT 12.0x 11.10x

Comps


Illustration – acquisition for shares

In the above example, CompCo has acquired 100% of AcqCo since the year-end for 30 in shares.

Pro Forma: acquisition for shares


Sales 60 40 100

EBIT 10 4 14

Equity value 100 30 130

Net debt / (cash) 20 5 25___ __ ___


EV/ Sales 2.0x 1.55x

EV / EBIT 12.0x 11.10x

Comps


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. EBIT 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


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


Precedent transactions analysis 1Introduction 1

Relevant transactions 1Mechanics 2

Summary transaction information 2Sources of information 3Equity value vs enterprise value 4The multiples 5Output sheet 6

Valuing the target 7Checking 7Valuation football field 8

Control premia 9Synergies 9Drivers of equity return in an LBO 10

Problems with precedent transactions 10




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.

Relevant 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



� 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

Implied enterprise value Grossed-up equity value plus net debt acquired



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



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. Include both values and the range of multiples if possible.

Equity value vs enterprise value

The equity and enterprise values are always for 100% of the target company. If Bidder buys 50% of Target, the equity and enterprise values are the implied values for the entire company.

If 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. It is important to understand what the amount paid represents to avoid calculating incorrect transaction multiples.

Share options and convertible debt

In-the-money share options (and all Long Term Incentive Plans, LTIPs) 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.



The multiples

Examples of multiples

Sales multiple Enterprise Value / Sales

EBITDA multiple Enterprise Value / EBITDA

EBITA multiple Enterprise Value / EBITA

EBIT multiple Enterprise Value / EBIT

Price / Earnings multiple Equity Value / net income

Net assets multiple (Equity Value + Minority Interests) / Net Assets

Growth ratios (Yr0 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(assumeddebtpaidcash +

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(assumeddebt)sharesofnumberpriceoffer( +×

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.



Output sheet

SAMPLE PRECEDENTS OUTPUT SHEET(All amounts in EUR millions, unless otherwise indicated) Firm Value

Local Equity Firm As a Multiple of EBITDA EBITDate Target / Acquiror Business of Target CRY Value(a) Value(a) Sales 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 14.8% 7.6%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 8.5Low 578 766 1.05 7.5 12.3 12.8 6.7

No te : (a) Equity and firm value have been adjusted to reflect 100% of entity in cases of minority positions acquired.

SAMPLE PRECEDENTS VALUATIONS: AUTO VALUATION

(Euros in Millions) Selected Precedents’ Range Auto Implied Auto Valuation

Low High Metric Low High

Firm Value /LTM Revenue 1.1x 1.4x €4,510.6 €4,961.7 €6,314.8LTM EBITDA 8.5 9.9 668.3 5,680.6 6,616.2LTM EBIT 13.0 17.0 480.8 6,250.4 8,173.6

Selected Auto Firm Value Range €5,630.9 7,034.9



Valuing 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� Identify 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

Comparable Transactions

Multiples Range

Company Financials

(£m)

EntityValue(£m)

Net Debt & Minority

Interest (£m)

EquityValue(£m)

Sales hist. 0.90x – 1.20x 100 90 – 120 10 80 – 110curr. 0.80x – 1.10x 115 92 – 127 10 82 – 117prosp. 0.70x – 1.00x 125 88 – 125 10 78 – 115

EBITDA hist. 10.0x – 16.0x 7.0 70 – 112 10 60 – 102curr. 9.5x – 15.5x 7.5 71 – 116 10 61 – 106prosp. 9.0x – 15.0x 8.0 72 – 120 10 62 – 110

EBIT hist. 14.0x – 20.0x 5.0 70 – 100 10 60 – 90curr. 13.0x – 19.0x 5.5 72 – 105 10 62 – 95prosp. 12.0x – 18.0x 6.0 72 – 108 10 62 – 98

Net Income hist. 25.0x – 28.0x 3.0 75 – 84 - 75 – 84curr. 24.0x – 27.0x 3.5 84 – 95 - 84 – 95prosp. 23.0x – 26.0x 4.0 92 - 104 - 92 – 104

High 117Low 60Average 87Estimated Equity Value (£m) 80 - 95



Valuation football field

current shareprice – 100p

180p

145p

130p

140p

110p80p

125p

90p

115p

130p

12 month share priceperformance

Control premium (25% -40%)

Comparable companymultiples

Precedent transactionmultiples

DCF

Summary valuation (€m)

2,610

2,190

2,010

2,130

1,7701,410

1,950

1,530

1,830

2,010

1,200 1,700 2,200 2,700

12 month share priceperformance

Control premium (25% -40%)

Comparable companymultiples

Precedent transactionmultiples

DCF

Enterprise value (€m)

current EV



Control 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.

It 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. If 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.



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

Problems with precedent transactions

Relative to public comparables, it is more difficult to conduct a valuation based on precedent transactions. It 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

� Inclusion 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


Exercises and case studies

Jude Inc 1DEF Ltd 2Regalia plc 4Hey plc 5Comps 1 6Comps 2 7Comps 3 8Comps 4 9Comps 5 10MyTravel 11Pensions 12Megatel plc 14Matthews & Ager 15Blaine plc 17Gatsby plc 18Fitz Ltd 19Grupo Cespa 20Jefferson Smurfit Group 22

Valuation exercises


Jude Inc

Jude Inc 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

EBITDA 87

Interest paid 18

Dividends paid 14

Increase in inventories 1

Increase in receivables 22


Tax paid (at rate of 30%) 8

Capital expenditure 412

Issue of shares 232

Issue of debt 143

Requirement

Calculate the relevant free cash flow for the first forecast period.

Valuation exercises


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 / EBIT Multiple

Based on the three comparable companies

a) Latest Balance Sheet (31st December 2004):

$m $m

Share Capital 23.3 Fixed Assets 50.5Retained Earnings 41.7 Investments 17.6

Borrowings 48.4 Inventory 54.3Other Liabilities 91.4 Receivables 63.3

Cash 13.8

Other Assets 5.3

204.8 204.8

b) Share Information:

Shares in Issue: 23.3 million, par value $1.00 EBIT for 2005F: $12.9mNet Income for 2005F: $ 6.0mDividend declared (gross): 15.0 cents per shareExpected dividend growth 4%

c) Independent Valuation of the Assets and Liabilities

Fixed Assets $52.3m Investments $12.9mProvision for Bad Debt $1.0m

Valuation exercises


d) Dividend Yields, P/E and EV/EBIT ratios for three comparable companies:

Dividend Yield P/E Ratio (2005F) EV/EBIT (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


Regalia plc

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 €m) are as follows:

Year ending in December 2006 2007 2008 2009 2010

EBITDA 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 810Tax 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 (€m) 3,033

Minority interest (€m) 36

JVs and associates (€m) 340

Corporation tax rate 30%

Nominal growth in FCF post 2010 1.2%

Terminal EBITDA 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


Hey plc

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 £m1 2 3 4 5

Free cash flow 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


Comps 1

A company has the following information:

m € €m

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 EBITDA 100

2005 EPS 1.00

Requirement

Calculate

a. market capitalisation;b. enterprise value;c. the 2005 P/E multiple; and d. the LTM enterprise value/EBITDA multiple.

Valuation exercises


Comps 2


m € €m

Stock price 35.00


Cash 400

LTM EBITDA 150

LTM EBIT 100


Bank debt at book value 500

€250m 6% subordinated debentures trading at 70

Owns a 20% stake in company with €1,000m market capitalisation

Requirement

Calculate

a. equity value b. enterprise valuec. the LTM EBITDA multiple andd. the LTM EBIT multiple.

Valuation exercises


Comps 3

A company has the following information

m € €m

Stock price 30.00

Average in-the-money options exercise price 20.00


In-the-money options outstanding 10.0

Cash 500

Preferred stock 500


Debt 1,500

Requirement

1. Including only common stock, calculate� equity value � enterprise value

2. Including all equity-linked claims, calculate� equity value � enterprise value

Valuation exercises


Comps 4

A company has two operating divisions with different growth and profitability profiles, auto and technology. The following information is relevant:

x m €m

Auto EBIT 2,000

Technology sales 4,000


Cash 1,250

Debt 5,000

Unfunded pension liability 300

Comparable auto universe EBIT multiple 7.0x

Comparable technology universe sales multiple 1.00x

Requirement

Calculate the company’s implied:

a. enterprise value;b. equity value; andc. equity value per share

Valuation exercises


Comps 5

A company has two operating divisions with different growth and profitability profiles, department stores and supermarkets. The following information is relevant:

m € €m

Department store EBIT 500

Supermarket EBITDA 300


Cash 1,000

Debt 2,000




The most common valuation multiple for department stores used in the market is an EBIT multiple. The most comparable department store EBIT multiple is 9.0x.

The most common valuation multiple for supermarkets used in the market is an EBITDA multiple. The most comparable supermarkets EBITDA multiple is 7.0x.

Requirement

1. Including 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


MyTravel

The market capitalisation of MyTravel plc is £1,203m. Its consolidated financial statements show:


€m €m

Lease rentals (222.3)Cash and cash equivalents 378.6 EBITDA 200.1

D&A (103.9)Debt 398.6 EBIT 96.2

Net interest income/(expense) (2.3)Minority interests 209.6Shareholders’ 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/EBITDA, without adjusting for off balance sheet operating leasesb. Calculate EV/EBITDA, adjusting for off balance sheet operating leases

Valuation exercises


Pensions

Siemens AG has a defined benefit pension scheme. It prepares its consolidated financial statements in accordance with US GAAP. The net periodic pension cost for the period of €447m has been charged to operating expenses during the year.

The market capitalisation of Siemens AG is €42,250m. Its consolidated financial statements show:


€m €m

Cash and cash equivalents 11,196 EBITDA 6,058D&A (4,126)

Debt 12,346 EBIT 1,932Accrual for pension plans 3,557 Net interest income/(expense) 318Minority interests 541 Other financial income 1,225Shareholders equity 23,521 EBT 3,475

Pension plan disclosures

Change in projected benefit obligation €m

Projected benefit obligation at beginning of year 18,544

Service cost 487

Interest cost 1,151

Actuarial losses/(gains) 240


Projected benefit obligation at end of year 19,492_________

Change in plan assets €m

Fair value of plan assets at beginning of year 14,625

Actual return on plan assets (1,187)

Contributions 2,023


Fair value of plan assets at end of year 14,531_________

Valuation exercises


Net periodic pension cost €m

Service cost 487

Interest 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/EBITDA 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/EBITDA 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


Megatel plc

The market capitalisation of Megatel plc is £59,843m. Its financial statements show:

Balance sheet P&L account Peer comparison

£m £m EV/EBITDAInvestments in JVs 2,586 Turnover 18,715 Comp co 1 13.5Investments in Operating costs (15,117) Comp co 2 9.0Associates 2,639 Operating profit 3,598 EV/sales

Share of JV (427) Comp co 1 4.5Net debt 8,700 Share of associate 27 Comp co 2 5.0

Operating profit 3,198Shareholders Net interest (382)Funds 15,795Minority interests 498

[Depreciation £2,752m][Amortisation 89m]

An analyst has calculated EV/sales and EV/EBITDA for Megatel plc as follows:

EV/EBITDA = m439,6£m543,68£ = 10.6

EV/sales = m715,18£m543,68£ = 3.7

The analyst has concluded that Megatel plc looks reasonably priced on EV/EBITDA 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


Matthews & Ager

The market capitalisation of Matthews plc is to be calculated using comparable company analysis, with Ager plc as the comparable company.

Ager plc

The market capitalisation of Ager plc is £14,548m. Its consolidated financial statements show:


£m £mInvestment in JV (50%) 182 Turnover 22,800Investment in associate (30%) 33 Operating costs (21,626)Cash and liquid resources 526 1,174

Share of JV 21Debt 3,330 Share of associate 3

1,198Shareholders 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 £mCash 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


Matthews plc

The consolidated financial statements of Matthews plc show:


£m £mInvestment in JV (50%) 22 Turnover 17,244Cash and liquid resources 487 Operating costs (16,711)

533Debt 1,356 Share of JV (4)

529Shareholders 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)

£mCash and liquid resources 42

Debt 80

Shareholders funds (equity) 44

The market capitalisation of the jointventure 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/EBITDA ratios for Ager plc.b. State, with reasons, which multiple (EV/sales or EV/EBITDA) appears most appropriate to

value Matthews plc.c. Applying this multiple, estimate the market capitalisation of Matthews plc.

Valuation exercises


Blaine plc

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


Gatsby plc

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


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.

It is assumed that corporation tax of 30% will be paid as net revenue is received. The outlay would have no corporation tax effects.

Inflation 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


Grupo Cespa

Precedent transactions valuation

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 €20bn, 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 / Incineration� 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 (“I&C”) segments.

Cespa was jointly owned (50/50) by two major environmental companies: 1) Aguas de Barcelona, “Agbar” (Spanish water company) and 2) SITA (waste management company and world wide leader. Subsidiary of French energy group Suez SA). In May 2003 Agbar and Sita decided to sell their stakes in Cespa. In 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) €244m

Financials (year ending 31 December, in €m)

Actual Actual

2001 2002

Sales 543 560

EBITDA 94 86

EBIT 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


Precedent transaction database

Precedent Waste Transactions - Firm ValuationsFirm Firm Value

Target Acquiror Currency Date Value 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 € Jan-00 100.0 7.5 13.2 7.6 13.3

WMI Netherlands Shanks Group € 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 € 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 14.3Median 7.4 14.3Low 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 effect of dilution from options and convertibles, less cash, marketable securities, and investments in unconsolidated affiliates.

Sector trading multiples

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 12.66xSevern Trent UK 4,161 2.91 2.70 7.87 7.41 14.02 13.56 19.68 15.22Séché France 404 1.72 1.56 7.66 6.83 15.19 12.54 144.12 34.20Lassila & Tikanoja Finland 419 1.59 1.45 8.23 7.14 14.71 13.12 20.97 18.23VIVE France 8,976 0.86 0.82 7.22 6.71 15.81 14.54 27.85 21.89Suez France 16,499 1.22 1.18 7.53 7.31 14.80 13.90 10.91 13.37AlliedWaste US 2,435 2.16 2.22 7.11 6.86 10.63 10.02 14.14 10.47Republic US 3,662 2.20 2.12 7.91 7.45 12.27 11.48 18.45 17.21WasteMngmnt US 13,569 2.10 1.99 8.22 7.67 15.48 13.47 22.71 19.44Casella US 238 1.38 1.45 6.71 6.24 15.00 15.35 28.69 23.32Connections 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 34.20xMean 1.88 1.77 7.66 7.09 13.74 12.73 30.84 18.43Median 1.72 1.56 7.66 7.14 14.71 13.12 20.37 17.21Low 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)

PEEV / EBITEV / EBITDAEV / Sales

Valuation exercises


Jefferson Smurfit Group


Jefferson Smurfit Group ("JSG") began as a small Irish boxmaker in 1934, becoming a public company in 1964. JSG has grown from its original Irish 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.

In 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 €1,778m

No of shares 1,126m

Financials (in €m)

Actual Actual Pro forma

2000 2001 LTM

Sales 4,565 4,512 4,838

EBITDA 576 573 631

MDP expected to dispose of some non-core assets following the acquisition. These were valued at €223m.

Requirement

Based on the above and the attached precedents database, calculate an appropriate takeover share price.

Valuation exercises


Precedent transaction database

Firm Value Firm Value / LTMDate Target/Acquiror (a) (US$MM) (b) Sales EBITDA

Sep-01 Gaylord Container / Temple-Inland $859 80% 9.4xMar-01 AssiDomän Corrugated & Containerboard/Kappa Holdings 1,070 83 6.2Dec-00 AssiDomän & Stora Enso / Billerud 618 100 5.9Jul-00 Igaras papeis / Klabin 510 228 9.6Feb-00 St. Laurent / Smurfit-Stone Container 1,333 160 12.0Jan-99 PCA / Madison Dearborn 2,437 160 7.4Jan-99 Stone Container / Jefferson Smurfit Corp. 6,500 134 30.6Oct-97 Cascades Inc. / Domtar Inc. 698 122 43.9May-97 Chesapeake (Westpoint) / St. Laurent Paperboard 500 120 10.7Nov-95 St. Joe Paper / Stone Container 185 80 2.4

Median 121 9.5Mean 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


Exercises and case study solutions

Jude Inc 1DEF Ltd 2Regalia plc 4Hey plc 5Comps 1 6Comps 2 7Comps 3 9Comps 4 10Comps 5 11MyTravel 13Pensions 16Megatel plc 18Matthews & Ager 20Blaine plc 22Gatsby plc 23Fitz Ltd 24Grupo Cespa 25Jefferson Smurfit Group 26

Valuation solutions


Jude Inc

Free cash flow for DCF at WACC

$m

EBITDA 87

Working capital adjustments




(14)

Capex (412)

Tax paid (8)

Interest tax shield (5)

____

Unlevered free cash flow (352)

____

Valuation solutions


DEF Ltd

1) Net Asset Value

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

Investment revaluation (4.7)

Provision for bad dept (1.0)

Adjusted Net Asset Value $ 61.1m ($2.62 per share)

2) Dividend Yield:

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 Multiple:

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


4) EV / EBIT Multiple

Average comparable EV / EBIT = 9.1

DEF’s EBIT (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 Results 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


Regalia plc

Year ending in December 2006 2007 2008 2009 2010

EBITDA 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 perpetuity17,531

(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 12,755PV - 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 16,637Less:

Net debt (3,033) (3,033)MI (36) (36)Add

JVs etc 340 340 Implied equity value 11,175 13,908

Implied share price (€) 1.61 2.01

Cost of equity Cost of debtRisk 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 premium4.50%

Corporate taxation rate

30%

Cost of equity 8.74% Post tax cost of debt 4.83%

WACCCost 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


Hey plc

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 value of cash flow 111.8 112.5 111.2 108.3 2,180.6

Present value of cash flow (Firm/Enterprise Value (£m))

2,624.4 EV

JVs (£m) Current share price (p)Associates (£m) Derived share price (p) 328.2Minority interests (£m)

Derived premium (discount)

Net debt (£m) 700.0 NetDebtTotal equity value (£m) 1,924.4 EqVal

Equity market risk premium 5.20% EMRPCost of equity 9.48%Cost of debt 3.78%Discount rate (WACC) 7.314%

Working - Terminal valueFCF2009 * (1+g)/(WACC – g)= 147.9 * (1.022)/(7.314% - 2.2%)= 2,955.7

Valuation solutions


Comps 1


m € €m

Stock price 30.00


Cash 125

Book value of equity 1,000

Debt 250


Preferred stock 50

LTM EBITDA 100

2005 EPS 1.00

Requirement

Calculate

a. market capitalisation;b. enterprise value;c. the 2005 P/E multiple; and d. the LTM enterprise value/EBITDA multiple.

(in € 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


2005 P/E Multiple = 30.00/1.00 30.0x

Enterprise Value/LTM EBITDA = 1,410/100 14.1x

Valuation solutions


Comps 2


m € €m

Stock price 35.00


Cash 400

LTM EBITDA 150

LTM EBIT 100


Bank debt at book value 500

€250m 6% subordinated debentures trading at 70

Owns a 20% stake in company with €1,000m market capitalisation

Requirement

Calculate

a. equity value b. enterprise valuec. the LTM EBITDA multiple andd. the LTM EBIT multiple.

Valuation solutions



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 EBITDA = 895/150 6.0x

Enterprise Value/LTM EBIT = 895/100 9.0x

(*) Assuming EBIT and EBITDA do not include a profit contribution from theunconsolidated investment

Valuation solutions


Comps 3

A company has the following information

m € €m

Stock price 30.00




Cash 500

Preferred stock 500


Debt 1,500

Requirement

1. Including only common stock, calculate� equity value � enterprise value

2. Including all equity-linked claims, calculate� equity value � enterprise value


Common stock only

Include options

Market capitalisation 1,800 1,800

Option value (10m x €30) 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 €20) 0 (200)

Enterprise Value 3,400 3,500

Valuation solutions


Comps 4

A company has two operating divisions with different growth and profitability profiles, auto and technology. The following information is relevant:

x m €m

Auto EBIT 2,000

Technology sales 4,000


Cash 1,250

Debt 5,000

Unfunded pension liability 300

Comparable auto universe EBIT multiple 7.0x

Comparable technology universe sales multiple 1.00x

Requirement

Calculate the company’s implied:

a. enterprise value;b. equity value; andc. equity value per share


Implied divisional values:

Auto = 7.0 x 2,000 14,000

Technology = 1.00 x 4,000 4,000

Implied Enterprise Value 18,000

Debt (5,000)

Cash + 1,250

Unfunded pension liability (300)

Implied Equity Value 13,950

Shares outstanding (m) 100.0

Implied equity value per share 139.50

Valuation solutions


Comps 5

A company has two operating divisions with different growth and profitability profiles, department stores and supermarkets. The following information is relevant:

m € €m

Department store EBIT 500

Supermarket EBITDA 300


Cash 1,000

Debt 2,000




The most common valuation multiple for department stores used in the market is an EBIT multiple. The most comparable department store EBIT multiple is 9.0x.

The most common valuation multiple for supermarkets used in the market is an EBITDA multiple. The most comparable supermarkets EBITDA multiple is 7.0x.

Requirement

1. Including 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


(in € millions, except per share) Common stock only

Include options

Department stores = 9.0 x 500 4,500 4,500

Supermarket = 7.0 x 300 + 2,100 + 2,100

Implied 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

Implied Equity Value 5,500 5,900

Shares outstanding 200 240

Implied equity value per share 27.50 24.58

Valuation solutions


MyTravel

Without adjustment

EV/EBITDA = m1.200£m6.432,1£

= 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/EBITDA = m4.422£m2.924,2£

= 6.9 x

Off balance sheet debt equivalent

£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/EBITDA to be significant, the relevant annuity factor needs to be significantly different to the current unadjusted EV/EBITDA multiple.

The annuity factor increases as:

• the lease term increases

• the borrowing rate decreases

Valuation solutions


Cover ratios

3.22.96 = 42. EBIT covers net interest 42 times.

3.21.200 = 87. EBITDA covers net interest 87 times.

3.23.2224.422+

= 1.9. EBITDAR covers net interest and rentals 1.9 times.

P&L account

£m

EBITDAR 422.4Lease rentals (222.3)EBITDA 200.1D&A (103.9)EBIT 96.2Net interest income/(expense) (2.3)

EBT 93.9

Debt repayment

1.2000.20

= 0.1. On balance sheet net debt could be repaid out of EBITDA in 36 days.

422.41,491.60.20 +

= 3.6. Net debt could be repaid out of EBITDAR in 3 years and 7 months.

Off balance sheet debt equivalent

£222.3m x 6.71 = £1,491.6m

Gearing proportion

Treating minority interests as equity:

9.5410.20

= 4% on balance sheet.

1,491.69.5411,491.60.20++ = 74% including operating leases.

Valuation solutions


Balance sheet (extracts)

£m

Net operating assets 541.9

Net debt 20.0

Minority interests 209.6Shareholders equity 312.3

Capital employed

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


Pensions

EV/EBITDA

Without adjustment

EV = 42,250m + 541m + 12,346m - 11,196m = €43,941m

EV/EBITDA = m6,058€m941,43€

= 7.3

Adjusted, pre tax

EV = 43,941m + [19,492m - 14,531m] = €48,902m

EBITDA = 6,058m + 447m – 487m = €6,018m

EV/EBITDA = m018,6€m902,48€

= 8.1

Adjusted, post tax

EV = 43,941m + [(19,492m - 14,531m) x 61%] = €46,967m

EV/EBITDA = m018,6€m967,46€

= 7.8

Net debt/EBITDA

Without adjustment

EBITDAdebtNet

= m6,058€m150,1€

= 0.2

Net debt

€12,346m - 11,196m = €1,150m

Adjusted, pre tax

EBITDAdebtNet

= m6,018€m111,6€

= 1.0

Net debt

€1,150m + [19,492m - 14,531m] = €6,111m

Valuation solutions


Adjusted, post tax

EBITDAdebtNet

= m6,018€m176,4€

= 0.7

Net debt

€1,150m + [(19,492m - 14,531m) x 61%] = €4,176m

Valuation solutions


Megatel plc

Dirty multiples

EV = £59,843m + 8,700m = £68,543m

EBITDA = £3,598m + 2,752m + 89m = £6,439m

EV/EBITDA = m439,6£m543,68£

= 10.6

EV/sales = m715,18£m543,68£

= 3.7

[The company looks reasonably priced on EV/EBITDA 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 EBITDA); and

� adding the value of minorities (as these are not implicit in the investing company’s market capitalisation but included in consolidated sales and EBITDA).

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/EBITDA = m439,6£m816,63£

= 9.9

EV/sales = m715,18£m816,63£

= 3.4

The company starts to look undervalued against its peers.

Valuation solutions


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 %. It will be more difficult to adjust EBITDA 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


Matthews & Ager

Valuation ratios for Ager plc

EV/EBITDA = mm

638,1£893,16£

= 10.313 EV/sales = mm

800,22£893,16£

= 0.74

EV

EV = £14,548m + £34m + £2,804m – £454m - £39m = £16,893m

Minority interests

Include in EV as 100% of subsidiaries’ sales and EBITDA 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 EBITDA are included in consolidated P&L. Market capitalisation reflects MV of equity interests in JV (50%) and associate (30%), so need to remove.

EBITDA

EBITDA = £1,174m + £455m + £9m = £1,638m

Appropriate multiple

EV/EBITDA appears more appropriate as the 2 companies have quite different EBITDA margins (7.2% for Ager, 5.6% for Matthews).

Market capitalisation of Matthews

EV

Applying comparable company’s EV/EBITDA multiple to Matthew’s EBITDA:

EV = £959m x 10.313 = £9,890m.

EBITDA

EBITDA = £533m + £409m + £17m = £959m

Valuation solutions


Market capitalisation

Market cap = £9,890m - £869m - £53m + £26m = £8,994m.

Net debt

£1,356m – £487m = £869m.

Valuation solutions


Blaine plc

Cost of Equity = 5%3401.05x35

+ = 15.8%

Cost of Debt = 95

0.3)-(1 x 7 = 5.16%

WACC = 1m x 0.954m x 40.3£

5.16% x 1m x 0.9515.8% x 4m x 40.3£++

= 15.1%

Valuation solutions


Gatsby plc

Discount factor = 7.5% + 1.1 x 5% = 13%

Cash flow & Df Discounted

cash flow

(000’s)

Investment -2,000 x1 -2,000

Cash flow 400 x

1.131-1

13.01

81920

Tax on cash flow -120 x

1.131-1

13.01

8-576

Net present value -656

Valuation solutions


Fitz Ltd

Market value prior to project announcement

Equity = 03.014.0

1.03x20−

= £1.87; £1.87 x 3m = £5.618m

Debt = 075.06 = £80; 0.8m1mx

10080

=

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 = 03.1135.1 = 1.102; therefore real/effective rate = 10.2%

Present value of future cash flows = 102.0

.7 x k125£ = £858.3k

Market value after project = Market value before project + PV of flows of project

= £6.418m + £858.3k

= £7.276m

Valuation solutions


Grupo Cespa


Low High Low High

86 86 43 435.5x 9.0x 11.1x 16.5x

473 774 477 710

-244 -244 -244 -244

229 530 233 466

475 to 742231 to 498Implied Equity Value range

(in € million)

Implied Firm Value range

Implied Firm Value

Less: net debt acquired

Implied 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


Jefferson Smurfit Group


in €m (except per share)

EBITDA Sales

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

Implied 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

Implied equity value 2,168 2,483 2,315 2,557

Number of shares (m) 1,126 1,126 1,126 1,126

Implied takeover share price € 1.93 € 2.21 € 2.06 € 2.27

Implied share price range € 2.05 to € 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


2. Precedent multiples:

a. St Joe Paper – outlier on low multiple

b. Stone Container and Cascades Inc – outliers on high ebitda multiples

c. Older transactions removed as less comparable as transactions took place under different market conditions. – Chesapeake

d. Igaras Papeis - different margins others 2.28 ÷ 9.6 = 23.75% - whilst average of remainder is 13% (FV/sales ÷ FV/EBITDA = EBITDA 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


Best practice financial modelling 1Introduction 1

Meeting user needs 1Excel versus modelling 2Excel set up for efficient modelling 3

Model set up 6Design 6Model structure 8Sheet consistency 15Using and managing windows in Excel 16

Referencing 18Relative versus absolute references 18Naming (cells & ranges) 19Transpose 24

Formatting 26Sign convention 26Colours, size and number formats 27Styles 30Conditional formatting 33Text strings 34Regional settings 35

IF and some other logical functions 36Common problems with IF statements and some simple solutions 38Nested statements 39

Data retrieval – the LOOKUP school 41CHOOSE 41MATCH 42INDEX 43OFFSET 47VLOOKUP 49HLOOKUP 52

Dates 54Date formats 54Date functions 54Consolidating time periods 56

Switches 60Two-way switch 60Multiple options 61Formality 63

Sensitivity 64Goal Seek 64



Data Tables 65Validating data 68

Data Validation - with inputs 68Data Validation – with outputs 70Conditional formatting 71Conditional statements 71The ISERROR function 71

Model completion 73Group outline 73Protecting the model 73Report manager 75

Tracking editing changes 76Historic financials 77Forecast financials 79

Ensuring balancing balance sheets 79Setting up the reconciliation 80

Debt modelling 83The problem 83A solution 83

Auditing and error detection tools 85Auditing a formula 85Finding links 87The F5 Special 88Other auditing tips 89

Auditing a model – a process 91Upon opening 91Coding clarity index 92Troubleshooting 94

Appendix 95Excel tricks 95Excel function keys 100




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.



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.

Excel versus modelling

A Titleist Pro Titanium 905T (9.5 degrees) driver is effectively a long stick with a big lump on the end. It 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

sensitivitiesaccounting, 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 toolspractical 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 thoughtdata analysis and sensitivity



Excel set up for efficient modelling

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.

In 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-Ins 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:



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. If 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-Ins; 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. If 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?. It 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 Iteration box is not selected

If 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. It 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.



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



Model 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? Is 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? Is 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? Is the timing ofevents in the model likely to change, e.g. an acquisition, a divestment, the start of operation of a project? If in doubt assume the worst.



10. What detailed questions will the model answer?

� Valuation � Financing structure optimisationLiquidity 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. It 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 I 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.



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 andtraining 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.

Model structure

The structure of your model will be a function of the results of your earlier work in understanding the modelling needs. In 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); and6. 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. It 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.



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. It 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.

If you only keep one model, then at best you will one day find yourself praying, perhaps begging and perhaps even being nice to the IT Help-desk as you try desperately to get a copy of last week’s model from the tape back up. It 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:



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 newname 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.

It 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 outputsgive 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.



� Implicit 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. If 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 I 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.



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).

Control panel

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.



It 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):

In 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 EBITDA 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 IF statements, and for starting row and column counters� 100 – if using £ and p, $ and c, € and c etc



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 IF functionsUse 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 ‘=IF(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

� Insert 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 itThey 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� If unavoidable, highlight the non-standard cellsA 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)



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; orRight 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



� 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 editRemove the gridlines

Using and managing windows in Excel

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. In 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



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.

In this case, the freeze panes command was used in cell C4.



Referencing

Relative versus absolute 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 6542 741 951 3573 753 258 4564567

If 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.

If 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. If 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.



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 (cells & 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. Clarity 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� In 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. Functionality

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).



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.

If 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.



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. If 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:

� Insert; 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 “RatesIn”



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 list 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

� Insert; 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



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 – all sheets must be consistent

If 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.

If 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 Italic 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 CostsGasIn (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.

� WkCapIncr 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 “In”, e.g. CostsGasIn, PriceGasIn, 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 EBITDA is calculated as a (named) percentage of sales, it would be over-engineered to calculate the EBITDA



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 EBITDA has been calculated in a working (as above) and is then used as part of the income statement – the EBITDA 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 MIN 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 models

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.

If 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.



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.



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)”. In 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. If 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.



Colours, 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

If 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)

Inputs 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 In the outputs only



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; and4. Text.

If 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



[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,

If 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

It 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 INDEX) 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. It is therefore recommended that the background be altered to grey: – see Excel set-up earlier in the notes.



Styles

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

In 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



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. If you wish to create a format, e.g. dates, to be used as a standard to be applied elsewhere:

� Format; Style� In 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 OKTo define the style but not apply it to the selected cell, click Add, and then click Close.

3. If you wish to choose the format of a particular, previously formatted, cell, e.g. a multiple, as a standard to be applied elsewhere:

In the Style drop down box type in the name – eg “Multiple” – and press Enter

Number format selected

Styles drop-down box



Alternatively:

Format; StyleIn 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.

Input 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:



As the number format in the Input style is not defined it will follow the previously selected number format for all cells. The components of the Input style which are applied are:

� Font – Underlined, Blue� Patterns – Pale yellow background� Protection – No protection

As the Date and Input 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.

Colour

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;� In the “Copy colors from” box select the workbook that contains the colours you want to copy;� OK.

In this way a template model with all necessary styles and colours can be easily created (and updated) for quick merging into all future models.

Conditional 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.



There are two condition (logical argument) options:

� Cell Value Is the value of the current cell fulfils the criteria� Formula Is 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. (It is assumed that there is appropriate coding to calculate the valuation based on 7 years!).

If 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 IF 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 (€m 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 €m

In 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’.



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.

Regional 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. If 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.



IF and some other logical functions

A fundamental function to add flexibility to models is the IF statement. IF 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 IF statement is as follows:

=IF(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”.



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. In 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

=IF((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. If 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.



Common problems with IF statements and some simple solutions

Using equals in a test

1. Although IFs are very useful, they can easily break down. If 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.

=IF(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.

=IF(ABS(cell)>0.001, “Not zero” , “Effectively zero”)

2. Another potential problem in using equals is where the IF statement refers to a user input; for example where the user has to type “yes” or “no” into a cell and then using IF 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 IF statements. The syntax of an AND statement is as follows:

=AND(test1,test2, test3….testn)

In 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. If they are all TRUE, then the AND statement will give TRUE as a result. Otherwise it will give a FALSE.

In the following illustration, €45m of debt is raised (DebtInitialIn) on 31 December 2005 and then is to be repaid following a 2 year grace period (DebtGraceIn) over the remaining 5 years of its 7 year term (DebtTermIn).

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:



The syntax of an OR statement is the same:

=OR(test1,test2, test3….testn)

In 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. If this is the case, no payment is made:

Whether to use AND or OR depends on your thought process.

� If you are an inclusive modeller, then your thought process is to define everything that falls within boundaries – AND is your solution.

In the above illustration, the logical argument is to require all the criteria to be met / to fall within the boundaries.

� If you are an exclusive modeller, then your thought process is to define anything that falls outside boundaries – OR is your solution.

In 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:

If 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%.



This would be written as follows:

Tax charge = IF(profit<0,0,IF(profit<300,000,profit*19%,profit*30%))

Here the “value if false” of the first IF statement is another IF, and both of the results from the second IF 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.

TestValue if true Value if false



Data retrieval – the LOOKUP school

IF, although perhaps the most useful function for creating flexibility in models, is limited in its applications. If we have a problem involving a selection of possible answers, rather than a simple yes/no, then IF rapidly becomes difficult to use.

Excel will allow us to use a maximum of 7 IFs in a statement. This is very hard work to both code and audit.

The following functions can help resolve this problem.

� CHOOSE

� MATCH

� INDEX

� OFFSET

� VLOOKUP

� HLOOKUP

They can all be found in Insert; 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 IF statements and is used widely in scenario management. It 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,...)



In 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. In 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. It 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 INDEX, OFFSET, VLOOKUP and HLOOKUP.

In the above illustration, the MATCH function is used to indicate the period number in which the semi-annual sales finish. 30 June is the 4th 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.



� 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. If 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. If match_type is 1, MATCH finds the largest value that is less than or equal to lookup_value. If the value in D15 is 28 June then MATCH returns 3: 31 May is the next lowest value. If match_type is -1, MATCH finds the smallest value that is greater than or equal to lookup_value. If 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 INDEX:

1. =INDEX(array,row_num,column_num)

2. =INDEX(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). INDEX is a highly flexible and robust function as long as the coordinates (row and column position) can be identified.

The array version

=INDEX(array,row_num,column_num)

If a data area is 5 rows deep by 6 columns across and we wish to extract the value in the 3rd row and 6th column. The formula becomes:

= INDEX ( 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 INDEX function.



One dimensional 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. If 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 INDEX, as with many functions, is to know what the answer should be. In 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



coordinates of this within the data area (row number irrelevant as it is a one row data area; and second column) we can use INDEX to pick up the required cell.

Analysing the above formula but ignoring the IF 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. In 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. In 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.

In summary, the formula is:

= INDEX ( E2:L2, leave blank, 2)

which returns the value in the second column of the range contained in E2:L2.

The reference version

=INDEX(reference,row_num,column_num,area_num)

The reference version comes into its own when we have different versions of the same data. It 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.

In 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.



� 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 INDEX 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.



� 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. If we are concerned about presentation, these counters could be hidden using white text.

OFFSET

Like the INDEX function, the OFFSET function uses row and column coordinates to identify the value (or position) of the target cell. In 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 INDEX 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 INDEX 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



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.

In 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). It 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

INDEX 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

If 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 INDEX functions can be used to define the start and end positions of a range. The start and end point can be used to define



the range for a function if the two INDEX functions are separated by a colon within the equation. For example,

= SUM (INDEX (DataArea,3,6) : INDEX (DataArea,4,10))

2. Auditing

An INDEX function is easier to audit. If F2, the trace precedents or the Ctrl-[ is pressed, then the components of the formula are shown. If 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 INDEX. 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 INDEX 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.

If 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.



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. If 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).

In 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



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. If 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

In the example above, we have not included a final fourth argument. The final argument is TRUE or FALSE. If we put TRUE or omit the last argument, then VLOOKUP works as in the above example.

If we enter FALSE, then VLOOKUP accepts only exact matches. If 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 €89.10 (the value in the 4th 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 answer2. another erroneous value or 3. #N/A

It 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.



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 column of the data area (or table_array) – that is, the lookup is driven by vertically looking down the first column of the data area to find the correct row (and then finding the appropriate column).

� 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 horizontally looking across the first row of the data area to find the correct column (and then finding the appropriate row).

In 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, €23.95 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. It 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.



� 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 answer2. another erroneous value or 3. #N/A



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 24,318th 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 ddddDays 4 04 Mon Monday

m mm Mmm mmmmMonths 7 07 Jul July

y yy Yyy yyyYears 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.



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 7th. By changing the return type, the start of the week can be altered to, say, Monday.

Defining time periods

If 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. In 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. In 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. In 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.

If monthly or quarterly dates are to be used, method 1 is not suitable but either method 2 or 3 can be used.

If the relevant date is to be, say, the 5th (of each month, quarter or year) then EDATE is the appropriate function.

If 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.



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.

Consolidating time periods

It 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.



Illustration

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

=SUMIF(range,criteria,sum_range)

The SUMIF function requires data (the range) to fulfil a criterion (criteria). If 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. It is only by adding the text string component ("<="&F6) to the criteria that we can get around this restriction within SUMIF.

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 =SUMIF(DatesQ,"<="&DatesY,SalesQ)

or =SUMIF($E$2:$AA$2,"<="&F6,$E$3:$AA$3)

in F10 =F9-E9



SUM OFFSET

OFFSET can be used to identify a single cell or a range. It 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.

Preliminary step - period counters

In the above illustration, the first year's sales are for the first 3 quarters (i.e. the 1st to 3rd sales figures) and the second year is from the 4th to 7th 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). It 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

INDEX can be used to identify, from within a specified data area, a cell value or address. It 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 INDEX 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.



In cell F15, the starter cell address is identified by =INDEX(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 =INDEX(SalesQ,,F16).

By combining the results of the 2 INDEX functions a range can be identified and then placed within a SUM:

in F12 =SUM(INDEX(SalesQ,,F15):(SalesQ,,F16))

or =SUM(INDEX($E$3:$AA$3,,F15):INDEX($E$3:$AA$3,,F16))



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 IF statement based on whether the switch is TRUE or FALSE can be used to alternate the model assumptions. When using the IF 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

=IF(Switch=TRUE,"Equity accounting”,“Proportional consolidation");

or, more simply

=IF(Switch,"Equity accounting”,“Proportional consolidation")

would change the cell text from Equity accounting to Proportional consolidation.

Check box



The check box can be formatted for colour, using the right mouse button, Format Control; Colours and Lines.

Multiple 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. If 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 IF 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. In the above formula, B3 returns a value between 1 and 3. If, 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



Option button with group box

As more option buttons are created on the same sheet, they are automatically linked to the original linked cell. If more than one set of option buttons is required on the same sheet, it is necessary to use the group box.

In the above, two different sets of option buttons are being used to drive different scenarios. If 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). If November is now selected, cell link shows 11, being the 11th item in the list.



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.

Formality

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 Inputs sheet – the home of all other hard-wired inputs.

The switches should, therefore, also appear on the Inputs 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.



Sensitivity

Goal 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 I 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. In the second (To value) box enter the value you would like the Set cell to equal;

3. In the third (By changing cell) box input the address of the cell containing the input you wish to vary. In 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.

If 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



Data Tables

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. It 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 EBITDA 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. EBITDA exit multiple and equity discount rate) and input a series of values in the row across the top of the table (e.g. EBITDA 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 functionthe row input cell reference (being the input varying across the top row of the table) – will

be the input for EBITDA 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

F9a data table will be produced which highlights the sensitivity of the Enterprise Value to the changing EBITDA exit multiple and varying equity discount rate.



Enterprise Value - £m sensitivity

EBITDA exit multiple

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

In the above table, the model output for Enterprise Value is £147.7m when the inputs (assuming EBITDA 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.

If the EBITDA 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

Incremental change

EBITDA 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). It 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.



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.



Validating dataA 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 Validation - 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.



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.

If 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. If the source data is on another sheet, then it is necessary to name the source data.

Input message

Input 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 Input 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. If the source data is on another sheet, then the source data must be named.



Error alert

Data validation is best used to make inputting easy and to ensure robust inputs drive the model. It 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 Validation – with outputs

Additionally, data validation of outputs can be used to “sense check” results: If 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 Invalid 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



Conditional 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.

Conditional statements

The use of flags (0 and 1) through IF statements can add functionality if the result of an equation is not valid / does not meet the benchmark criteria.

If, 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 IF statements with 1 or 0 as the values if TRUE or FALSE respectively. If 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). If the sum comes to 1 or less then the project can get the funding.

The ISERROR function

It can be irritating when #DIV/0! appears in a cell, not because a genuine error has been made but because one of its precedents has not yet been completed. It 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,

If the contents of A1 were 187; A2 were 0; and those of A3 were =A1/A2 the result would be #DIV/0!.

By amending the formula in A3 to

=ISERROR(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:

=IF(ISERROR(A1/A2),0,A1/A2)



The result being 0 this time rather than TRUE.

Note: the ISERROR 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 ISERROR function will cover up any errors and so can undermine the controls put in the model.



Model completion

Group outline

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. In 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:

� It 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). If the bar outline symbol is “+” then the user can click this to show the hidden area. If 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 EBIT. By selecting the long section (1), then the first number to be visible is EBIT. By selecting the shorter section (2), then the sales information is hidden but the remainder of the P&L is visible.

Protecting the model

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.

It 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: If report manager is used, at least one sheet must remain unprotected in order to allow report manager to be activated.



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.

If 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.

Styles 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

If 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.



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-Ins), 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. If the order needs to be changed or something deleted, buttons allow this.

It 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: In 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



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.



Historic financials

Decide which historics are necessary – ie income statement, cash flow statement and balance sheet.

Inputs 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 IS 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, EBITDA, EBIT 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).

• In 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.

It will be necessary to tie some of these numbers into the other financials – a profit figure (one of EBITDA, EBIT 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 statementsheet (one of EBITDA, EBIT 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.

It will be necessary to tie the cumulative cash (or net debt) into the balance sheet (see below)



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 IS 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.



Forecast financials

To make life easier, the first step must be to get the forecast balance sheet to balance.

Ensuring balancing balance 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).

If the historic financial statements have been set up correctly, then all these formulae can be copied from the historics.

In 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 capital

• Sales

• EBITDA margin

• Working capital balancesb) PPE / fixed assets

• Net book value

• Annual depreciation charge

• Aggregate annual capital expenditure



c) Debt

• Closing debt balances

• Interest 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:

• If the difference is recognisable – error of omission – the entry has not been entered in all the appropriate places;

• If 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) & EBITDA IS

Working capital increase (add to appropriate brought forward figure) BS

EBITDA & working capital increase CFS

Setting up the reconciliation

P&L Balance sheet CFSopening forecast

Sales EBITDA -Operating costs PPE 600 600 Wking cap incr

EBITDA - other net assets 300 300 Operating CF -Dep & amort cash 50 50 Capex

EBIT - 950 950 TaxInterest Pre-financing CF -Tax Debt 625 625 Dividends

Net income - Shares 75 75 InterestDividends Retained earnings 250 250 Equity

Retained earnings - 950 950 Net debt flow -Debt

check - - Cash flow -

Ret earnings CashStart 250 (BOLD numbers - inputs this module) Start 50Retained earnings - Cash flow -Other OtherEnd 250 End 50



Operations and working capital


Sales 750 EBITDA 350Operating costs 400 PPE 600 600 Wking cap incr (40)

EBITDA 350 other net assets 300 340 Operating CF 310Dep & amort cash 50 360 Capex

EBIT 350 950 1,300 TaxInterest Pre-financing CF 310Tax Debt 625 625 Dividends

Net income 350 Shares 75 75 InterestDividends Retained earnings 250 600 Equity

Retained earnings 350 950 1,300 Net debt flow 310Debt

check - - Cash flow 310

Ret earnings CashStart 250 (BOLD numbers - inputs this module) Start 50Retained earnings 350 Cash flow 310Other OtherEnd 600 End 360

PPE



EBITDA 350 other net assets 300 340 Operating CF 310Dep & amort 150 cash 50 185 Capex (175)

EBIT 200 950 1,150 TaxInterest Pre-financing CF 135Tax Debt 625 625 Dividends

Net income 200 Shares 75 75 InterestDividends Retained earnings 250 450 Equity

Retained earnings 200 950 1,150 Net debt flow 135Debt





Debt and interest




EBIT 200 950 1,190 TaxInterest 60 Pre-financing CF 135Tax Debt 625 725 Dividends

Net income 140 Shares 75 75 Interest (60)Dividends Retained earnings 250 390 Equity

Retained earnings 140 950 1,190 Net debt flow 75Debt 100



Tax and dividends




EBIT 200 950 1,080 Tax (40)Interest 60 Pre-financing CF 95Tax 40 Debt 625 725 Dividends (70)

Net income 100 Shares 75 75 Interest (60)Dividends 70 Retained earnings 250 280 Equity

Retained earnings 30 950 1,080 Net debt flow (35)Debt 100





Debt modelling

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 problem

Tax is often calculated using the following:

EBITDA 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.

Interest 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 solution

(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 OPENING balance (to avoid circularity).



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.

In 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, Iteration). 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.



Auditing and error detection tools

Auditing a formula

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. It 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 #DIV/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. If 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.



� 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

Additionally, 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



Finding links

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]Input'!$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 old 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 Insert 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.



The F5 Special

The Go To Special is a very powerful auditing and orientation tool.

It 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 commentsAny single inputs

Any result of a formulae

Inconsistent formulae across a rowInconsistent formulae down a columnDirect 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 cellAny pictures / objects

Same as Ctrl-End All non-hidden cells – for formatting or chart sourceCells with conditional formattingAny (or specified) data validation



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.

(If 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

If a formula contains a function which needs some explanation, by pressing the “=” button (edit formula, immediately to the left of the formula bar [fx button in Excel 2003]) when editing the formula, then Excel will take you to the dialogue box for that function.

In the following, as the CHOOSE function is selected from within the IF statement (cursor flashing on that part of the equation), then the dialogue box for CHOOSE will be shown.



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+'Inputs & Results'!$F$25+AStart))*((SUM(F76:F81)+SUM(F84:F93))*(1-tax)-(Crate_monthly *Cstart*(F29/F30))))/(1-((PP/(PP+ 'Inputs & Results'!$F$25+AStart)*tax)))

By pressing Alt-Return at the appropriate breaks in the formula, the formula will read as:

=-(

(PP/(PP+'Inputs & Results'!$F$25+AStart))

*(

(SUM(F76:F81)+SUM(F84:F93))

*(1-tax)-

(Crate_monthly *Cstart*(F29/F30))

)

)

/(1-((PP/(PP+ 'Inputs & Results'!$F$25+AStart)*tax)))

The formula will remain in this form for subsequent users.



Auditing a model – 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 …”

It 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)

In 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



Coding clarity 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. If the answer to the question has a score against it, score the relevant marks for that question. It 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 Conclusion

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.

It 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. If 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. It 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. It 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. It 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.



Coding clarity questionnaire

Score for a yes

Score for a no

Model 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. Is switching done by multiplying formulae by statements like (c3=1), instead of using If 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



Troubleshooting

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! #DIV/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:

If the difference is recognisable – error of omission – the entry has not been entered in all the appropriate places;

If 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.



Appendix

Excel 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; Insert 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



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



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.

Insert� Shift-F11 New sheet

� Alt-I; R or C New row or column

� Control-+ New row or column when column or row selected

� F3 name into a formula

Listing names� Insert; 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



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)



Switch creationFor 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



Excel 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

Insert a new worksheet

F2 Edit the active cell Insert 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

Insert a new worksheet

Insert 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 Income


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.


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


Bonds

7%

£ 100Company A will pay:

7%

7%

7%

7%

7%

7%

6 Years

Who?

Compensation?

How long?


Bonds key features

Specified issuer/guarantorSpecified interest paymentsFixed maturity

Final repayment datesTypically bulletEarly redemption possibilities

Indenture provisionsCovenantsEvents of defaultSeniority/security

4


Interest types


Bonds 2

Risks?

Time

Credit

Liquidity

1 2 3 5 64

5


Borrowers


Bio-diversity

Variable cashflow structuresPuts and CallsPremiums and DiscountsFloaters and Index Linked

ConvertiblesExchangeables

Asset backedPass Thru, CMOs and CDOs

ExoticsCredit Linked Notes

6


Corporate issuance

Limited RegulationRule 144 aSEC

BearerPrivate PlacementRegistered

GrossYankee

EurobondsDomestic

$ is the most complicated market


Medium Term Note (MTN) programmes

Used to save time and costs for a regular issuer

Issuer: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


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


(MTN) process

When an issue is required:Investor 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


MTNs – Why do they work?

InvestorsYield enhancement

Credit diversification

Fill duration gaps

Tailored to meet currency needs

Exposure to alternative markets/instruments

IssuersLower cost

Documentation efficiency

Broaden investor base

Continuous market access

Liability profile management

Discreet market access


Government bond markets

Large

Liquid

Simple

9



Authorities

Issuing Agency Official Statistics Central Bank

Primary Market

Auctions

Timetable

Transparency



Authorities

Issuing Agency Official Statistics Central Bank

Primary Market

Secondary Market

Cash MarketRepo Market Futures Market

Strips Market

10


Corporate bonds

Required return?

Issuer quality

Maturity

Interest rates

Coupon frequency


Pricing process

Name

Maturity

Spread history

Ratings

Comparables

Coupon frequency

11


The issuance process

Issuer

Investors

Sales Team

Origination

Co-lead Co-lead

Lead Manager/ Book-runner


The issuance process

Beauty parade

Due diligence

Research

Prospectus

Roadshow

Bookbuilding and allocation

12


Secondary market in corporate debt

Historically limited

GrowingCoredeal MTS

Other systems


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 time value of money

£1,000 or £1,000

Now In one year

�� Why?

Choice

Inflation

Credit= Interest Rate


The time value of money

1 2 3 4

(1+r)

(1+r)2

(1+r)3

(1+r)4

Present V

alue

period

14


Yield and price

Bond Price $

Bond Yield %

But different bonds exhibit different levels of sensitivity


Accrued interest

Monday 21st – Friday 25th

15


What does yield represent?

+ Credit spreadRisk free rate


Monetary and fiscal policy

Fiscal PolicyTaxation Rates

Government Spending

Monetary PolicyInterest Rates

16


Indicators

Gross Domestic Product

Consumer Inflation

Retail Sales

International Trade

Public Spending

Private Investment

Consumer Confidence

Consumer Credit &

Money Supply

Business Confidence

Asset Prices

Commodity Prices

Earnings

The Global Economy

Unemployment

Exchange Rate


Conventional Bond Analysis

The Real Yield

Expected Inflation

Nominal Yield

Historically the source of much of the volatility

17


The yield curve

GRY

Maturity

The Coupon Effect

Special Features

Tax Distortion

Curve Fitting Techniques


Expectations and the yield

Initially flat term structure but economic news implies an expected rates rise

Investors?

Speculators?

Borrowers?

What is the impact on the term structure?

18


But dominant theory is expectations

Other factors that will affect yield

MaturityLiquidity premium and uncertainty

Supply and demandSegmentation Theory

Preferred Habitat Theory

1


Ratings


Moody’s Standard & Poor'sSmallest 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

Investment grade – long term

2


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


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


What are the two basic types of credit rating?

Issue-specific credit ratingmeasures the credit risk of a specific debt issue

bonds; notes; commercial paper

preferred stock

municipal notes

measuresthe creditworthiness of an entity with respect to the specific debt issue

the likelihood of default on a specific debt issue


What are the two basic types of credit rating?

Issuer credit ratingalso called the counterparty, corporate, sovereign credit rating

measures the credit risk of an entire organisation:corporation

governments

counterparties

4


What qualitative factors are evaluated in the credit rating process?

Industry risk & market position

Accounting quality

Management


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


Ratings are ratio driven (key S&P industrial ratios)

87.774.862.648.242.537.722.9Total Debt/Capitalisation

68.869.757.242.533.928.213.3Long Term Debt/Capital

87.774.862.648.242.537.722.9Total Debt/Capital

6.34.93.42.31.61.20.6Total 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

22.127.0Operating Income/Sales

21.734.9Return on Capital

55.4128.8Funds From Ops /Total Debt

25.284.2Free Operating CF/Total Debt

12.926.5EBITDA Interest Cover

10.121.4EBIT Interest Cover

AAAAA


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 need for a rating – rating agency evaluation

Request for rating

Assign analytical team and conduct basic research

Meet issuer

Rating Committee MeetingAppeals Process

Issue Rating

Surveillance


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


Well below average

Below average

Average

Above average

Well above average business position

Company business risk profile

4565———

254085——

203560105—

15305080150

1025406080

BBBBBAAAAAA

—Rating category—

Qualitative analysis

Sainsbury, hmm.... Moderately leveraged. (FFO/Total debt of 60%) but how should I rate it ?

Rating process

Funds from Operations/Total Debt Guidelines

1


Securitisation


A definition

The transfer and pooling of cash flows and assets to remove operating risks of the originator from issued securities

2


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


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


Negatives

However

can be inflexible

may crystallise VAT , CGT, stamp duty…

assets must be assignable

unsuitable for “whole business” securitisation


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 certificateswhich 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


What can be Securitised?

Corporate LoansConsumer LoansCredit Card ReceivablesResidential MortgagesCommercial MortgagesAuto LeasesOffice Equipment Leases

Aircraft Leases Small Business LoansStudent Loans

Future Export ReceivablesInsurance Premium ReceivablesMarine LoansOil/Gas Contract ReceivablesProperty Rental IncomeRailcar LeasesToll road ReceivablesUtility ReceivablesPublic HousesCare HomesMotorway Service Stations

Assets are commercial or consumer related


But are they a significant market segment?

US Bond MarketUS Treasuries € 3.3 trillionUS Mortgage backed € 4.5 trillionUS other asset backed € 1.4 trillion

UK – Bigger than Gilt MarketGermany - equal to Bunds EU doubling every 2 yearsAs important as corporate bond marke

5


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


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


Beware operator risk

In 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


Credit Enhancement - Subordination

AAA

85%

A 10%

BBB 5%

15% Credit Support

5% Credit Support

7


CDOs


A CDO Structure

Portfolio Assets

Cash Payment

ASSETS

High Yield BondsLeveraged LoansInvestment Grade CDSHigh Grade ABSMezzanine ABSCDOsPrivate EquityHedge FundsEmerging Markets Subordinated

Mezzanine

Senior

NOTES

Pays Scheduled Cash Flows to Investors

Cash Payment

Service Providers(e.g. Management, Liquidity, Hedging)

SPV,Limited

Partnershipor Fund

External TrusteeHandles 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


Classic CLO Portfolio Ramp-Up and Amortization

Reinvestment period

Amortization PeriodAccumulation Period Reinvestment Period Transaction

wind-down

Portfolio ramp-up and amortization

[12] months [7] Years

60%

100%

[5] YearsClosing1Q 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.


Interest & Principal Waterfall

Class A Note Interest

Senior IC/OC Tests

Senior Fees & Expenses

Redemption to the extent necessary to satisfy the IC and OC tests

Class A NotesJunior Expenses

Residual to Subordinated Notes

Reinvestment in new collateral

To the payment of senior expenses, interest and curing of coverage tests to the extent not previously paid using

interest Proceeds

During Reinvestment Period

Senior Fees & Expenses

Class A Note Principal

Residual to Subordinated Notes

During Amortization Period

Interest Waterfall Principal Waterfall

Junior Expenses

Senior note holders benefit from the credit enhancement created by the subordination of other tranchesEquity holders benefit from any upside resulting in lower than expected default rates or higher recovery rates, in the portfolio

9


Derivatives

An overview of derivatives market

10


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 basic concept

Derivatives Package and Transfer Risk

Two types of contract only:1. Forward / future

2. Option3. Swaps

11


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.


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


What are swaps?

OTC product

Swap one series of cash flows for another over a set period

Both parties having an obligation to performe.g. interest rate, currency, etc.


OTC or exchange traded

ExchangeStandardised

Liquid

Centrally cleared

Heavily regulated

Few products

OTCBespoke

Less liquid

No clearing house

Lightly regulated

Product proliferation

13

Forwards and futures


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


Major forward/future products

Interest rate

Currency

Equity shares

Indices

Commodities


Money market quotes

15


Forward rate agreement

The Bloomberg screen is telling us:

2 x 5 3.490 3.496

Investor Borrower

The swap desk will lend (receive interest)


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


Profit

Loss

Price

1000

0

profit

loss

Unlimited

-1000

Long future – payoff diagram


Profit

Loss

0 Price1000

1000

Unlimited

Profit

Loss

Short future – payoff diagram

17

Fair value of futures


Pricing a future

Cash Price + Cost of Carry

18


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


Today

Time Delivery

Price

Cash

Future

Basis

Basis varies over time i.e interest rates change therefore cost of carry alters

Basis

19


Counter party risk

Forwards are OTC products therefore suffer counter party risk

Futures are exchange traded therefore reduced counter party risk

Clearing house

Margin


STIR

Delivery month PriceJune 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 receivable of 7.22% on a 3-month deposit of 1 million from delivery day in September

20


Why use futures?

Synthetic performancePerform as cash without buying shares

HedgingProtecting value against adverse movements in prices

SpeculationLeveraged, liquid, standardised

ArbitrageSimultaneous purchase or sale of underlying to capture price differences (beyond transactions costs)

Arbitrage with futures

21


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 arbitrage channel

Fair value

Futures price

22


Price and trade information

Bid & offer pricesThis 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

VolumeThis is the number of contracts traded during the day. It is thenumber of longs OR the number of shorts

Open interestThis is the number of open contracts at any time. It is the number of open longs OR the number of open shorts


Day 1 Day 2 Day 3ABC

VolumeOpen interest

L5

-S5

-L5S5

Volume & open interest

S3

L3-

55

53

25

23


Options


Working definition

An agreement betweenTwo counterparties that

Gives the holder the right but not the obligation

In return for a premiumTo buy (a call option) or to sell (a put option)

An agreed quantity of

An underlying item

At an agreed price, (strike price or exercise price)

24


Understanding the terms

Buyer – Right not obligation (long/holder)

Seller – Obligation not right (short/writer)

Call / put

Strike price

Expiry date

Premium


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


Time and intrinsic values

Strike Premium Intrinsic Time

80 25 20 590 17100 9110 5120 3

Call option premiums, underlying @ 100

Option strategies

26


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

800 50 100

150

200

Pro

fitL o

s s


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 50 100

150

200

27


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

800 50 100

150

200


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 50 100

150

200

28


A recent option price

Wondafone LIFFE equity option

Underlying @ 122120 strike Expiry in one month

Call price = 7Put price = 4.5


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


Vanilla option strategies

Long Call Short CallViewMaximum risk/shareBreakevenMaximum profit/share

Long Put Short PutViewMaximum risk/shareBreakevenMaximum profit/share


Option types

AmericanExercise at any time

EuropeanExercise at expiry

30


Option value

Timevalue

Intrinsicvalue

Premiumvalue = +


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


In-, 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 erosion of time value

0

Profit

Loss

Unlimited

32

The Greeks


What will happen to the option price if …?

Moves Call PutPrice Price

Asset Price Rises ? ?Falls ? ?

Volatility Rises ? ?Falls ? ?

Time to Expiry Falls ? ?

33


Sensitivity – the Greeks

Each Greek captures and measures a dimension of the risk in an option position …The Major GreeksDelta … underlying asset priceGamma … change of deltaVega … volatility The Minor GreeksTheta … timeRho … interest rate

Collars

34


Collar

Borrowing money over 5 years

Long borrowers option

Downside protected

Short lenders option

Upside capped

Premiums reduced


Swaps

35


Types of swap

Interest rate swaps

Asset swaps

Currency swaps

Equity swaps

Credit default swaps


Interest rate swap

A B

Fixed Rate Payer Fixed Rate Receiver(Floating Rate Receiver) (Floating Rate Payer)

5%

LIBOR

36


Interest rate swap

One party pays fixed to receive floating from the counterparty

Principal not exchanged

Fixed rate constant over life of swap

Floating rate LIBOR flat

Rates set in advance paid in arrears

Cash flows netted


Interest rate swaps

?

37


Money market quotes


The workings of a swap

Fixed @ 5% Floating @ Libor + 25bp

Pay Libor Receive 4.79%

Pay 4.83% Receive Libor

38


Uses of swaps?

Comparative advantage?

Re-engineering/hedging

Speculation

Arbitrage


The pricing logic

39


Swaps

Swap Desk

Fixed Leg = Floating Leg


Swap pricing

What is fair fixed rate for a 2 year swap vs. 6 month LIBOR?

6 1812 24

Fs% F12 %F6 % F18 %

X% X%X% X%

PVfloat

PVfixed

40


Pricing spreadsheet

today23-Jul-05 23-Jan-06 23-Jul-06 23-Jan-07 23-Jul-07

Discount factor 1 0.9665 0.9345 0.9025 0.8712Days 184 181 184 181Year basis 365 365 365 365Year proportion 50.4% 49.6% 50.4% 49.6%Forward 6 month Libor 6.87% 6.90% 7.05% 7.25%

Cash flowsNominal 10,000,000

FloatingCash (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 300,000 300,000 300,000 300,000Present Value 289,958 280,365 270,743 261,347PV Fixed 1,102,413

NPV (186,023.8)


Swap pricing


6 1812 24

6.87% 7.05 %6.90% 7.25%

X% X%X% X%

(£1,288,437)

£1,288,437

41


Pricing spreadsheet

today23-Jul-05 23-Jan-06 23-Jul-06 23-Jan-07 23-Jul-07

Discount factor 1 0.9665 0.9345 0.9025 0.8712Days 184 181 184 181Year basis 365 365 365 365Year proportion 50.4% 49.6% 50.4% 49.6%Forward 6 month Libor 6.87% 6.90% 7.05% 7.25%


FloatingCash (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 350,623 350,623 350,623 350,623Present Value 338,886 327,674 316,429 305,447PV Fixed 1,288,437

NPV -


Swap pricing


6 1812 24

6.87% 7.05 %6.90% 7.25%

7.01% 7.01%7.01% 7.01%

(£1,288,437)

£1,288,437

42


Subsequent valuation

Present value of remaining streams

Cancellation?

Offsetting swaps


Present value of remaining streams

today23-Jan-06 23-Jul-06 23-Jan-07 23-Jul-07

Discount factor 1 0.9711 0.9431 0.9167Days 181 184 181Year basis 365 365 365Year proportion 49.6% 50.4% 49.6%Forward 6 month Libor 6.00% 5.90% 5.80%


FloatingCash (297,534) (297,425) (287,616)Present Value (288,937) (280,489) (263,656)PV Floating (833,082)

Fixed 7.01%Cash 350,623 350,623 350,623Present Value 340,492 330,657 321,413PV Fixed 992,562

NPV 159,480.8

43


The swap curve

Maturity

GRY

GovSwap


Special types of interest rate swaps

Amortising

Accreting

Rollercoaster

Forward start

Basis swap

44

Currency swaps


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

Interest is paid by swap parties on the currency received

45


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


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


CIRCUS

‘Combined Interest Rate and Currency Swap’

Example:

A UK company wishes to raise variable rate £ funds by accessing the Japanese bond market


Outline

1 Issue a fixed rate bond in Japan. Receives Yen fixed

2 Yen/£ cross currency swap

3 IRS

UK CoYen fixed coupon

Yen principal

£ fixed interest

£ principal

UK Co£ Libor interest

Net: Receive £ principal paying £ floating rate

£ fixed interest

UK CoYen principal

Yen fixed interest

47

Equity swaps


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 LIBOR

Pay performance

Receive Interest LIBOR + Spread

Credit Suisse Client

48


What are the risks?

In order to eliminate the market risk CS will hold the underlying instrument as a hedgeCS has NO MARKET RISK as the performance on the cash hedge will offset the performance payable on the swapCS has INTEREST RATE RISK Internal funding rates are reset daily, interest rates on the swaps can be reset monthlyCREDIT RISK The movement in the underlying instrument between reset dates

Credit swaps

49


Protection buyer

Protection seller

Basically like an

insurance policy

Premium

Payment (if default)

Single name credit default swap


Credit default swaps

Premium paymentsQuotation

What constitutes default?

Termination paymentDeliverable obligations

Physical or cash settled

CTD

Transaction size

Choosing a protection seller

50


Basket CDS

Basket CDS

Four names £5m each

Notional £20m

Corp X40bps£5mCorp y25bps£5mnCorp Z15bps£5mnCorp a24bps£5mn

Basket CDS

21bps

£20mPremium for 4 individual CDS = 104bpsAverage = 26bps

Premium = £20m x 21bps

£42,000 pa


Basket CDS after default

Basket CDS

Corp X defaults

Pay £5m – recovery value


Basket CDS

21bps

£15mPremium = £15m x 21bps

£31,500 pa

51


First to default CDS

FtD CDS

Four names £5m each

Notional £20m


Ftd CDS

60bps

£5mPremium for 4 individual CDS = 104bps

Premium = £5m x 60bps

£30,000 pa


FtD CDS after default


FtD CDS

60bps

£5m

FtD CDS

Corp X defaults

Pay £5m – recovery value

CDS terminates

52


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


Syndicated Loans


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


What is a Syndication?

Identical documentationPro rata drawingsAll banks are on an equal footingLarger amounts involvedAdministration achieved through an Agent

Borrower

Agent

Bank A Bank B Bank C Bank D


Syndicate vs Bilaterals

SyndicationOne (big) agreement

Agent & fees

Many banks, but

Few relationships

Formality

Procedure

Group decisions

BilateralSimple documents

Few fees(?)

One bank

One relationship

Informal

3


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

AgentAdministration/Information distribution


Role of the Book Runner (Arranger & Underwriter)

Determining the Syndication strategyWhich banks

How many banks

Size/price considerations

Joint book runningStrategy must be agreed

But division of labour is useful if there are a large number of banks to contact

Managing the investor base

4


Role of the Agent

Post signing managementInformation distribution

Monitoring of covenants and collateral

Dealing with amendments, waivers and payments


Syndicated Lending

Borrower

Lead Arranger

Co-Arranger

Lead Manager

Agent

Manager

5


300

89

89

80

42

Allocation(€m)

Total

Manager

Lead Manager

Co-arranger

Lead arranger

Title

19

10

5

3

1

No.

335

100

100

90

45

Bid/Planned final take (€m)

410410410410

100

40

50

60

Fee Rate (bps)

3.00

0.36

0.45

0.48

Fees (£m)

1.721.721.721.72

Allocation – a Typical Outturn


Abertis Loan for Purchase of SANEF

€750m 364 day tranche (364 day extension)Euribor + 40bps

€2.66bn 364 day tranche (3 year extension)Euribor + 75bps

€150m 364 day revolver (3 year term out)Euribor + 75 bps

Margins ratchet upwards over time to encourage a capital markets take-out

6


€3.5 bn Syndication

RBS€200mMLA

La Caixa€200mMLA

Barclays€200mMLA

HSBC€200mMLA

JPMorgan€130mMLA

Ahorro Corporacion Financiera€102m

… … €81m28 Banks … …

€40m5 Banks… …


Eiffage & Macquarie Loan for 70% SAPPR

€5.85bn 7 year term loanEuribor + 90bps

€1.8bn 7 year revolverLibor + 30 bps

Commitment fee of 30% of margin

€1bn one year cash bridge with leads will not be syndicating

7


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


Key Phases of a Syndication

- Information Flow - Credit Event e.g. acquisition - Information package

- Exchange of ideas - Credit approval - Finalise syndication strategy

- Structure/Price - Loan Documentation - Approach Banks/Presentation

- Agree Indicative term Sheet - Underwritten Offer - Credit Approvals

- Initial Syndication Strategy - Closing - Documentation

- Signing in Banks

Pre-Mandate Underwriting Syndication

MANDATED SYNDICATION SYNDICATIONCOMPLETE

8


Underwriting

Commitment to provide fundsCertainty to the borrower

Strong message to the market

Alternatives are ‘Best Efforts’ and Club deals


Syndicated Loan Structures

Term loan

Revolving

Standby loan

Multi– currency loan

Evergreen loan

9


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


Term Loan

Time

maturity

Commitment

£ millions

Outstandings

End of availability

10


Uses of Term Loans

Permanent capitalJust because debt is a good thingLong term financing of acquisitionsLong 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 getsinto operating difficultiesIf debt is generally expensive today, your debt cost will be high today.Long term committed financing together with tools like swaps canremove these big risks- fixing rates.


Revolving Credit Facility

The key difference between a term loan and a revolving credit is that:

In 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


Revolving Commitment

Time

End of availability - maturity

Outstandings

Commitment£ millions


Uses of Revolving Credits

Working capital finance –seasonal or intra-month

Standby facilities

Backstop facilities

Acquisition “war-chest”

12


Standby Facility

Backstop to a commercial paper programme

Short term

Small commitment fee if undrawn

High interest rate if utilised


Price

Facility Size Sector

Bank Relationships

Financial Covenants

Term Current State of Bank Market

Quality of the Credit

Purpose of loan

Pricing Factors

13


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

150-25050-10025-5020-35Margin (bp)

BBBBBAAARating


Syndicated Loan Fees

Front-end fee

Arrangement fee

Participation fee

Underwriting fee

Commitment fee

Utilisation fee

Agency fee

14



Front-end feeA 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



Arrangement FeeArranging 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



Participation FeeIs the portion paid out of the front-end fee to participating banks in a primary syndication

It is a credit-related fee calculated on each bank’s allocated commitment, which is normally paid within 30 days of signing



Underwriting FeeIf the deal is underwritten, this will be included in the front-end fee

It 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



Commitment FeeRefers to the payment to the banks for making a credit facility available to a borrower over a specified periodExist 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 participationPayable in arrears, at fixed intervals for the duration of the facilitySize of the fee is related to the financial strength of the borrower

Non-Utilisation feeAn annual % fee based on the undrawn portion of the committed facility for the duration of the facilityPayable quarterly in arrears



Utilisation FeePayment to the lender based on the average level of utilisation during a specified period

Designed as a margin enhancement

Agency FeeAn annual fee

Calculated as a fixed lump – sufficient to cover at least the administrative and money transfer costs of the bank

It is not shared with any of the other banks

17


Documentation Requirements

To potential Participating Banks

Information memoranda Invitations for banks to participate

To the Client

Term sheets and Offer letters

Loan agreementsKey legal clauses & agreements


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

It should contain all the material requirements of the arranging banks(s)

18


What makes an Effective Term Sheet?

Borrower name, Description of facility, Amount & PurposeMaturity, conditions of availability and repaymentArrangers, lenders, agentFees and interest rates (& definition of cost of funds rate) and when they are payableRepresentations & warranties, Covenants & undertakings and Conditions precedentCancellation and Events of defaultIllegality, Taxes, Increased costs and ExpensesTransferability, documentation and governing lawClear market and Market flex

1

Equity


What is equity?

Part ownership

Permanent capital

Risk capital

No guarantees

2


Equity


Types of equity

Ordinary

Preference shares

Depository receipt (ADR/GDR)

Convertible/Exchangeable

3


Share rights

Voting rights

Pre-emptive rights

Cash dividends

Stock dividends

Stock splits

Key Participants In The Global Equity Markets

4


Twelve ‘players’

12 3 4 5 6 7 8 9 101112


Key Participants

Corporates Investment BanksNew

Shares

Pension Fund

Insurance Group

Money Manager“Secondary” –

Investment BanksIntermediate Institutions

“Primary” Distribution Process

5

Key roles in the equity division


Interaction in Equity Division

Research

ECMG

General Sales

Trader

Sales Trading

Proprietary Trading

Specialist Sales

6


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 Typical ClientManagementCEO/CIO etc

Equity

Investment Committees / Asset Allocation

PM PM PM

PM PM PM

Other AssetsDebt

Sector AnalystsDealers

7

The secondary market


Market choices

Physical

Quote Driven

Electronic

Order Matching

8


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 quotesSEAQ

FTSE 250 not on SETS, midcaps, some small caps, AIM 50 & leading Irish

Order book with Market Makers

SETSmm

Most liquid securities incl. FTSE 100, liquid FTSE 250

Order bookSETS

Securities tradedTrading structureSystem


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



A SETS screen

BUY SELLTime

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

Highestbuy price

Then timeof entry

Lowestsell price

10


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


SETS order types

Limit

At best

Fill or kill

Execute and eliminate

Iceberg

Market

11


“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


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



SETSmm

A hybrid system

Market makers must submit two way prices as in SEAQ, these prices are submitted as orders as opposed to quotes

In addition brokers can submit orders to the order book as in SETS

13



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 US market

15


The US markets

AMEXSmall Caps. ETFs & OptionsNASDAQ shares on auction basis

Exchanges NYSE, American, RegionalOTC NASDAQ (“merged” with

AMEX in 1998)OTCBB (penny stocks)


NYSE versus NASDAQ

Auction MarketOrder driven

75% trades with other investors

Priority for public over specialists

Centralised order flow

Dealer MarketQuote driven – MM

Market makers trade against public orders

No priority for public

Dispersed order flow among MMs and ECNs

16


NYSE versus NASDAQ

Auction MarketSpecialists – must provide liquidity / dampen volatility

Specialists evaluated

Single opening price– no trade ahead of opening

Dealer MarketMMs – minimal size obligation, no obligation on volatility

No evaluation of MMs

No single opening price –MMs can trade ahead of opening


ECN – Electronic Communications Networks

Electronic trading access levelsSOES - Small Order Execution System

NASDAQ – more information

17

The primary market


Focus on IPO distribution

Book buildModern structure – US origins

No underwriting syndicate – maximise fees

Generate demand then price

Client “at risk” – price set at end

UnderwritingTraditional structure – UK origins

Underwritten by syndicate – split fees

Generate price – then demand

Broker at risk – demand finalised at end

18


Key phases in an IPO

Winning and understanding the deal

Establish the selling proposition

Distribution – position deal, generate demand

Distribution – generate momentum, fill orders

Trading and completing the deal


Parties involved in IPO

Issuer

Selling shareholders

Bankers

Legal advisors

Accountants

Public relations

Stock exchange

Printers

19


Syndicate structure

70-90% of the gross feesLeads process - allocates stock at pricingThe Key Role

Status for relationship banks not playing bookrunner role

Use research and sales penetration

Bulge only if €1m+ fees available / key strategic client

Underwriting fees only - little chance of receiving stock

Bookrunner

Joint Lead

Co-lead

Co-manager


Sample new issue timetable

Completion of offer

Commence preparation of

Offering Circular

T-3 months

Analyst briefing

T-7 weeks

Publication of research, start pre-

marketing

T-4 weeks

Offer launched

T-2 weeks

Pricing & allocation

T

6 weeksAppointment of advisorsFinancial due diligenceLegal due diligenceDrafting of offering circular and Listing Particulars

Preparation of Research

3 weeksSyndicate analysts briefed on IPOAll syndicate participants publish researchResearch reports form the main marketing documents

Pre-marketing

2 weeksResearch analysts approach key institutionsPre-marketing feedback critical to finalise management roadshow programme

Roadshow & Bookbuilding

2 weeksPrice range announcedManagement meets institutions in key financial centresSyndicate members build a book of demand

Due Diligence and preparation of Offering Circular / Listing Particulars

Stabilisation

4 weeksBookrunner stabilises price in immediate aftermarketOn-going research coverage and investor relations programme

Start of ProcessT-3/4 months

20


Follow on offerings

Sale on open market

Full book build

AEO

Block trade

Rights issue

Rights issue

21


Rights Issue Fundamentals

Lead managers will sell the shares on their behalf at the end of the offer periodShareholders 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)

Shareholder Options

Take up rights

Sell nil paid rights

Do nothing

Shareholders exercise their rights by paying subscription price

Normally an active trading market for nil paid rightsTheoretical value = the difference between the theoretical ex rights price (‘TERP’) and the rights issue priceListed and traded independently for up to 3 weeks

AEO and block trade

22


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)

Monetisationthrough :

a. Block Trade

b. Accelerated Bookbuild

The equity-linked market –convertible bonds

23


Convertible bonds

What are theyMandatories

Exchangeables

Hybrids

Issuer perspective - impact on equity and senior debt

Investor PerspectiveDifferent investors

Arbitrage


What is a Convertible?

THE DEBT PERSPECTIVE ON A CONVERTIBLE BOND

� Has par value� Pays coupon� Maturity date� Senior to equity in

event ofliquidation

� Exchange for NEW shares (conversion ratio)

� Option of holder

ConvertibleBond

CallOption

StraightBond

24


The jargon

A “balanced convertible”

“Equity like”, high parity

“Low parity”, bond like

Bond floor

Parity

Share price

Convertible value

“Busted”

Recovery value


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

If not converted then redeemable at maturity

25


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 pricePut feature usually used where interest rates rise and if convertible falls deeply out of the money. Puts are potentially very dangerous for issuers


A Case studyIssuer: Versatel Telecom Int’l N.V.Security Type: Unsubordinated Convertible Bond Rating: UnratedTotal Proceeds: €125mmGreenshoe yesIssue Price: 100%Closing Date: 28 Oct 2004 Coupon: 3.875%Yield To Maturity: 4.63%Conversion Premium: 28%Conversion Price: €2.033Share Price at issue: €1.588Maturity: 7 yearsCall Option: After 5 years subject to a 130% hurdleRedemption Price at Maturity: 100%Use of Proceeds: Refinancing bank facility / lengthening debt maturityListing: Euronext (Amsterdam)

Rothschild Analyst Training

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