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AnaIyst programme 7 August 2006 - 12 September 2006

1. FinanciaI statements
2. BaIance sheet
3. Income statement
4. Cash fIow statements
5. M&A accounting
6. Enterprise and equity vaIue
7. Accounting & anaIysis exercises
8. Accounting & anaIysis soIutions
9. FinanciaI maths
10. VaIuation
11. ComparabIe companies anaIysis (comps)
12. Precedent deaIs anaIysis (pre deaIs)
13. VaIuation exercises
14. VaIuation soIutions
15. FinanciaI modeIIing
16. PracticaI investment banking
17. Debt
18. FinanciaI markets
19. Taxation
20. Law
Published financial statements
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FinanciaI statements 1
Published accounts 1
Components of financial statements 3
nternational comparison 4
Historical development 4
nternational accounting standards 5
Balance sheet 6
Assets 6
Liabilities 7
Shareholders' funds 7
ncome statement 8
Revenue 8
Expenses 8
Exceptional & extraordinary items 9
Earnings per share 9
Second income statement 10
Cash flow statement 11
Cash flow 11
Categories 11
Methods 12
Cash flow links to income statement and balance sheet 13
Free cash flow 13
Published financial statements
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FinanciaI statements
PubIished accounts
Companies in most countries publish
a balance sheet; and
an income statement (or profit and loss account).
Most also publish
a cash flow statement.
Primary statements
Balance sheet Income statement Cash flow statement
m m m
'snapshot' for period for period
accruals basis accruals basis cash basis
Balance sheet
The balance sheet is a 'snapshot' of a company's financial position. t delineates the enterprise's:
resource structure (major classes and amounts of assets); and
financial structure (major classes and amounts of liabilities and equity).
t reflects the accruals concept.
Corporate vaIue
The balance sheet does not show the value of a business as:
many assets which are included (eg land and buildings) are not included at market value;
some features which contribute to corporate value (eg internally generated intangibles) are
not recognised as assets; and
expectations about future performance (reflected in share prices) are not reflected.
The balance sheet provides some useful information for those who wish to make their own
assessment of a company's value.
Published financial statements
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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. t 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. t 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).
t reflects the accruals (or matching) concept.
AccruaIs concept
The effects of transactions and other events are:
recognised when they occur, not as cash is received or paid; and
reported in the financial statements of the periods to which they relate.
Revenues are recognised when they are earned. Expenses are recognised when they are
incurred.
AnaIysis
Key metrics calculated from the income statement include:
EBTDA (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. t focuses attention on
key characteristics of components of cash generation and absorption by:
stripping out the effects of the accruals concept;
classifying cash flows by category (eg operating, investing and financing); and
reconciling cash flows to operating profit or net income and (in some countries) net debt.
Published financial statements
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AnaIysis
Key metrics calculated from the cash flow statement include:
operating cash flow; and
free cash flow.
Components of financiaI statements
Components
Asset
Past event present control
future benefit
Liability
Past event present obligation
future outflow
Expense
Benefit used up
Revenue
Benefit earned
Assets
An asset is a resource:
controlled by an enterprise as a result of past events; and
from which future economic benefits are expected to flow to the enterprise.
LiabiIities
A liability is a present obligation:
arising from past events; and
in respect of which economic benefits are expected to flow from the enterprise.
Recognition criteria
Assets and liabilities are only recognised if:
there is sufficient evidence of existence (including evidence that a future inflow or outflow of
benefit will occur); and
the monetary amount can be measured with sufficient reliability.
Published financial statements
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InternationaI comparison
Generally accepted accounting practice (GAAP) can differ from country to country. This affects
the format and content of financial statements; and
measurement of items included in financial statements.
HistoricaI deveIopment
US GAAP
equity market focus, so accounting profit
taxable profit
accounting standards (FASs) issued by FASB
(private sector)
lots of rules, detailed coverage, prescriptive
treatments, emphasis on consistency
UK GAAP, Hong Kong GAAP
equity market focus, so accounting profit
taxable profit
accounting standards (FRSs) issued by ASB
(private sector)
few(er) rules, (some) alternative treatments,
subjectivity in applying concepts, emphasis
on substance
IAS
equity market focus, so accounting profit
taxable profit
accounting standards (ASs) issued by ASC
[2001 FRSs issued by ASB]
(to date) political, incomplete coverage,
alternative treatments
European GAAP, Japanese GAAP
tax driven
Commercial Code (eg HGB, PCG) written by
government
some alternative treatments, emphasis on
prudent calculation of net profit (to protect
lenders and minimise tax)
Europe
Accounting differences are major and deep seated. They are mainly caused by differences in
legal systems
corporate ownership and finance; and
tax systems.
The Commission of European Communities issues Directives on company law to reduce
differences in accounting in member states of the EU. The 4
th
Directive (formats and rules of
accounting) was largely based on German law. The 7
th
Directive (consolidated accounts) was
substantially based on UK practice.
Published financial statements
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InternationaI accounting standards
The nternational Accounting Standards Committee (ASC) was formed in 1973. t aimed to
improve and harmonise accounting worldwide by issuing nternational Accounting Standards
(ASs).
The ASC was restructured in 2001 to a newly constituted nternational Accounting Standards
Board (ASB) which has issued nternational Financial Reporting Standards (FRSs) from 2002.
The trustees of the ASB, who approve the budget, monitor effectiveness and have responsibility
for constitutional changes, in addition to raising funds, are representative of the ASB's member
nations as follows:
6 North Americans;
6 Europeans;
4 from Asia Pacific; and
3 from other areas.
IASB (InternationaI Accounting Standards Board) members
1. Sir David Tweedie, ASB chairman (formerly UK ASB);
2. Tom Jones, ASB 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 Glard (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 Engstrm (formerly Volvo CFO)
A simple majority of member votes will be enough to pass an accounting standard.
n March 2004 ASB completed the development and enhancement of its core set of ASs and
FRSs (2005 stable platform).
Europe
n 2002 the EU adopted a regulation requiring all listed companies to prepare their consolidated
financial statements in accordance with 'adopted international accounting standards' with effect
from 1 January 2005.
Published financial statements
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BaIance sheet
Assets
Tangible assets
Tangible assets are assets that have physical substance.
TangibIe fixed assets (UK) Property, pIant and equipment (US)
Tangible fixed assets are assets that have
physical substance and are held for use on a
continuing basis.
PPE are tangible assets that are held for use
during more than one period.
Depreciation
Depreciation is the systematic allocation of the depreciable amount (cost or carrying amount less
residual value) of a tangible asset to the periods expected to benefit from its use.
Intangible assets
ntangible 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.
nventories are assets:
held for sale in the ordinary course of
business;
in the process of production for such sale;
or
in the form of materials or supplies to be
consumed in production or delivering a
service.
Published financial statements
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Debtors (UK) ReceivabIes (US)
Assets created by providing money, goods or services directly to a debtor (eg a customer).
LiabiIities
Creditors
Creditors (or payables) are liabilities where the timing and amounts are reasonably certain.
Debt
Debt is indebtedness for borrowed money (eg loan stock, bonds, commercial paper) plus certain
other obligations (eg in respect of leases).
Provisions
Provisions are liabilities of uncertain outcome, timing or amount.
SharehoIders' funds
Shareholders' funds (UK) or stockholders' equity (US) represent(s) the residual interest in an
enterprise's assets after liabilities have been deducted. This arises mainly from:
amounts paid in by shareholders; and
earnings which have been retained, rather than paid out as dividends, over time.
Paid in capital
Main components:
UK US
Called up share capital (ords and prefs) Preferred stock
Common stock
Share premium Additional paid in capital
Other reserves (eg merger reserve)
Published financial statements
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Retained earnings
Balance sheet presentation:
UK US
Profit and loss account Retained earnings
Other components
UK US
Revaluation reserve Accumulated other comprehensive income
Other reserves (eg capital redemption reserve)
Income statement
Revenue
Revenue usually arises from:
sale of goods; and/or
rendering of services.
Expenses
Expenses are usually categorised by nature (the total cost method) or by function (the cost of
sales method).
By nature By function
ExampIes ExampIes
Depreciation
Purchase of materials
Wages and salaries
nterest
Taxation
Cost of sales
Distribution costs
Administrative expenses
nterest
Taxation
Published financial statements
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ExceptionaI & extraordinary items
Different countries have different views on what is exceptional, what is extraordinary and how
these items should be presented.
Extraordinary items
ExampIes
Expropriation of assets
Natural disasters
IAS/IFRS
Under AS/FRS, no items are presented as extraordinary.
Exceptional items
ExampIes
Restructuring costs
Profits and losses on disposal of PPE
Earnings per share
Earnings per share (EPS) =
shares of Number
Earnings
Basic EPS
UK US
Earnings
Net profit or loss for the period attributable to
ordinary shareholders
Earnings
ncome attributable to common stock
Number of shares
Weighted average number of ordinary shares
outstanding during the period
Number of shares
Weighted average number of common shares
outstanding
Published financial statements
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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
n order to facilitate comparability across different accounting regimes and between different
companies, the nstitute of nvestment Managers and Researchers have suggested that a
headline EPS figure is additionally calculated using the earnings calculated to
nclude
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
n some countries, some gains and loss are recognised directly in shareholders' funds/equity.
These items are:
excluded from the calculation of earnings
presented in a separate statement ('second income statement').
Published financial statements
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UK US
Statement of totaI recognised gains and
Iosses
Statement of comprehensive income
Profit for the financial year (as reported in the
P&L account)
Unrealised gains and losses (eg on revaluation
of properties and on foreign currency
translation)
Net income (as reported in the income
statement
Unrealised gains and losses (eg on available-
for-sale securities and on foreign currency
translation)
Cash fIow statement
Cash fIow
Some countries report flows of cash. Some countries report flows of cash and cash equivalents.
Cash
Cash comprises cash on hand and demand deposits.
Cash equivalents
Cash equivalents are short term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value.
Categories
UK US
1. Operating activities
2. Dividends from associates and joint
ventures
3. Returns on investments & servicing of
finance
4. Taxation
5. Capital expenditure & financial investment
6. Acquisitions & disposals
7. Equity dividends paid
8. Management of liquid resources
9. Financing
1. Operating
2. nvesting
3. Financing
Published financial statements
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Operating
Operating activities are the principal revenue producing activities of the enterprise and other
activities that are not investing or financing activities.
Investing
nvesting activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents.
Financing
Financing activities are activities that result in changes in the size and composition of the equity
capital and borrowings of the enterprise.
Methods
Cash flows from operating activities are reported using the direct method or the indirect method.
Direct method
Major classes of gross cash receipts and gross cash payments are disclosed.
ExampIes
Receipts from customers
Payments to suppliers
Payments in respect of employees (wages and social security costs paid)
Indirect method
Profit or loss is adjusted for:
the effect of transactions of a non-cash nature;
any deferrals or accruals of past or future operating cash receipts or payments; and
items of income or expense associated with investing or financing cash flows.
ExampIes of adjustments
Depreciation and amortisation
Changes in (operating) working capital
Published financial statements
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Cash fIow Iinks to income statement and baIance sheet
Income statement
UK US
Operating profit (P&L account) is reconciled to
net cash flow from operating activities (CFS).
Reconciling items comprise items which:
have impacted operating profit; and
do not involve a cash inflow or outflow.
Net income (income statement) is reconciled to
net cash flow from operating activities (CFS).
Reconciling items comprise items which:
have impacted net income; and
do not involve an operating cash inflow or
outflow.
Balance sheet
n some countries, the movement in cash in the period (CFS) is reconciled to the movement in
net debt (balance sheet).
Net debt
Net debt comprises debt less (the aggregate of) cash and liquid resources/cash equivalents.
Free cash fIow
'Free' means available. Free cash flow means different things for different purposes.
Enterprise level
Free cash flow is seen as a surplus available to make payments to capital providers (debt and
equity). For this purpose, free cash flow is:
before interest; and
after (adjusted) tax and capital expenditure.
n 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. t is calculated after
cash payments to service existing debt (interest). For this purpose, free cash flow is:
after interest; and
after (actual) tax and capital expenditure.
Practically this means operating cash flow less interest and tax and capital expenditure.
Published financial statements
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Balance sheet issues
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BaIance sheet 1
Components of financial statements 1
Components 1
Definitions 1
Recognition criteria 1
Assets 2
Current v non-current 2
ntangible assets 2
Depreciation 3
mpairment 3
Revaluations 4
Capitalisation of interest 5
Liabilities 6
Current v non-current 6
Debt 6
Convertible bonds 8
Leases 11
Provisions and contingent liabilities 13
Pensions and other post-employment benefits 17
Net debt 23
Debt 23
Cash equivalents 23
llustration 23
Shareholders' funds (stockholders' equity) 25
Components 25
Different classes of share 26
Share issues 26
Bonus / capitalisation / scrip issues 28
Rights issues 28
Balance sheet issues
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BaIance sheet
Components of financiaI statements
Components
Asset
Past event present control
future benefit
Liability
Past event present obligation
future outflow
Expense
Benefit used up
Revenue
Benefit earned
Definitions
Assets
An asset is a resource:
controlled by an enterprise as a result of past events; and
from which future economic benefits are expected to flow to the enterprise.
Liabilities
A liability is a present obligation:
arising from past events; and
in respect of which economic benefits are expected to flow from the enterprise.
Recognition criteria
Assets and liabilities are only recognised if:
there is sufficient evidence of existence (including evidence that a future inflow or outflow of
benefit will occur); and
the monetary amount can be measured with sufficient reliability (eg a cost has been
incurred).
Balance sheet issues
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Reliable measurement
Cost or fair vaIue?
What constitutes reliable measurement can differ between:
countries; and
asset (or liability) categories.
Assets
Current v non-current
n many countries, assets are distinguished between current and non-current (or fixed).
n some countries the distinction is based on time (realisation expected within or in more than
one year). n others, the distinction is based on whether or not the asset will be sold or
consumed as part of the operating cycle.
IntangibIe assets
ntangible 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
f 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
n most countries, internally generated intangible assets are not recognised as assets on the
basis that expenditure on internally generated brands, publishing titles, customer lists etc cannot
be distinguished from the cost of developing the business as a whole.
Balance sheet issues
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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. t is not amortised.
nternally 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
rrespective of whether there is any indication of impairment, the following are reviewed for
impairment annually:
ntangibles with an indefinite useful life; and
Goodwill acquired in a business combination.
Balance sheet issues
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Measurement
f an asset is impaired, its carrying amount is written down to its recoverable amount. The
impairment loss is recognised as an expense.
RecoverabIe amount
Recoverable amount is the higher of an asset's:
net selling price; and
value in use.
Value in use
Value in use is the present value of estimated future cash flows expected to arise from:
continuing use of the asset; and
from its disposal at the end of its useful life.
RevaIuations
Initial measurement
n most countries, PPE (or tangible fixed assets) are initially measured at purchase price or
production cost.
Revaluation
n most countries (incl US), revaluation is prohibited.
Where a policy of revaluation is adopted, revaluations is made with sufficient regularity that the
carrying amount does not differ materially from current value at the balance sheet date. When
an item is revalued, the entire class of PPE to which that asset belongs is revalued.
Balance sheet issues
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CapitaIisation of interest
n some countries, companies add borrowing costs to the cost of assets produced or constructed.
Finance costs which are directly attributable to the construction or production of an asset may be
capitalised as part of the cost of that asset.
Presentation
Method 1 Method 2
Income statement Income statement
Cm Cm
Revenue 48,000 Revenue 48,000
Capitalised interest 65
48,065
nterest expense (500) nterest expense (435)
Balance sheet issues
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LiabiIities
Current v non-current
n most countries, liabilities are distinguished between current and non-current (or long-term).
n some countries the distinction is based on time (due to be settled within or in more than one
year). n others, the distinction is based on whether or not the liability is expected to be settled as
part of the operating cycle.
Debt
InitiaI measurement
Debt instruments issued are recognised initially at cost (fair value of consideration received less
transaction costs).
Subsequent measurement
Debt instruments are measured at amortised cost.
Amortised cost
The initial carrying amount (eg net proceeds) is increased by finance charges in respect of
the period and reduced by payments made in the period.
Finance charges
Finance costs are allocated to periods over the term of the debt at a constant rate on the carrying
amount (the effective interest rate, level yield to maturity or internal rate of return).
Where a debt instrument is issued and redeemed at the same amount, the effective interest rate
is the same as the coupon. Where a debt instrument is issued at a discount, or redeemable at a
premium, the effective interest rate is higher than the coupon.
IIIustration 1
A company issues a C100m bond at par. The bond pays a coupon of 6% per annum. The bond
is redeemable five years later at par. gnore issue costs.
year BS P&L cash BS
@ start charge @ 6% paid end
1 100.00 6.00 (6.00) 100.00
2 100.00 6.00 (6.00) 100.00
3 100.00 6.00 (6.00) 100.00
4 100.00 6.00 (6.00) 100.00
5 100.00 6.00 (6.00) 100.00
TotaI 30.00 (30.00)
Balance sheet issues
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Issue costs
IIIustration 2
A company issues a C100m bond at par. The bond pays a coupon of 6% per annum. The
bond is redeemable five years later at par. ssue costs are C2m.
year BS P&L cash BS
@ start charge ?? paid @ end
1 98.00 (6.00)
2 (6.00)
3 (6.00)
4 (6.00)
5 (6.00) 100.00
Solution
The effective interest rate is 6.48%. This is applied to the opening balance to calculate finance
charges for the period.
year BS P&L cash BS
@ start charge @ 6.48% paid @ end
1 98.00 6.35 (6.00) 98.35
2 98.35 6.37 (6.00) 98.72
3 98.72 6.40 (6.00) 99.12
4 99.12 6.42 (6.00) 99.54
5 99.54 6.46 (6.00) 100.00
TotaI 32.00 30.00
Discounted debt
IIIustration 3
A company issues a C100m bond for net proceeds of C83.15m. The bond pays a coupon of 2%
per annum. The bond is redeemable five years later at par.
year BS P&L cash BS
@ start charge ?? paid @ end
1 83.15 (2.00)
2 (2.00)
3 (2.00)
4 (2.00)
5 (2.00) 100.00
Balance sheet issues
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Solution
The effective interest rate is 6%. This is applied to the opening balance to calculate finance
charges for the period.
year BS P&L cash BS
@ start charge @ 6% paid @ end
1 83.15 4.99 (2.00) 86.14
2 86.14 5.17 (2.00) 89.31
3 89.31 5.36 (2.00) 92.67
4 92.67 5.56 (2.00) 96.23
5 96.23 5.77 (2.00) 100.00
TotaI 26.85 10.00
ConvertibIe bonds
From the perspective of the issuer, a convertible bond comprises two components:
A financial liability (a contractual arrangement to deliver cash or other financial assets);
and
An equity instrument (a call option granting the holder the right, for a specified period, to
convert into common shares of the issuer).
Classification of the liability and equity components of a convertible instrument is not revised as a
result of a change in the likelihood that a conversion option will be exercised.
Measurement
When the initial carrying amount of a compound instrument is allocated to its equity and liability
elements, the equity component is assigned the residual carrying amount after deducting from
the instrument as a whole the amount separately determined for the liability component.
Balance sheet issues
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Illustration (IAS)
A company issues C100,000 3% convertible debt at par. nterest is paid annually in arrears. Five
years later, the debt is redeemable at a premium of 10% or convertible into equity shares of the
issuer. [The effective interest rate on similar non-convertible debt is 7%.]
InitiaI recognition
The debt component of the proceeds, calculated by discounting the future cash flows at the
market rate of 7%, is C90,729. The balance of the proceeds (C9,271) is deemed to be the fair
value of the consideration received for writing a call option on the issuer's shares.
Balance sheet
C000
Cash + 100
Debt (liability) 90.73
Derivative (equity) 9.27
Subsequent measurement
The debt component is measured at amortised cost. The initial carrying amount is increased by
finance charges (at the effective interest rate) in respect of the period and reduced by payments
made in the period.
balance interest cash paid balance
@ 7%
90,729 6,351 (3,000) 94,080
94,080 6,586 (3,000) 97,666
97,666 6,836 (3,000) 101,502
101,502 7,105 (3,000) 105,607
105,607 7,393 (3,000) 110,000
C34,271
At the end of the first year
Balance sheet Income statement Cash flow statement
C000 C000 C000
Debt 94.08 nterest expense (6.35) nterest paid (3.00)
Equity 9.27
Balance sheet issues
10 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
US GAAP
FAS 133 requires convertible debt to be classified as a liability. The embedded equity option is
not separated.
InitiaI recognition
Balance sheet
C000
Cash + 100
Debt 100
Equity
Subsequent measurement
The debt is measured at amortised cost. The initial carrying amount is increased by finance
charges (at the effective interest rate) in respect of the period and reduced by payments made in
the period.
The effective interest rate, treating the whole proceeds as debt, is 4.82%.
balance interest cash paid balance
@ 4.82%
100,000 4,816 (3,000) 101,816
101,816 4,904 (3,000) 103,720
103,720 4,996 (3,000) 105,716
105,716 5,092 (3,000) 107,808
107,808 5,192 (3,000) 110,000
C25,000
At the end of the first year
Balance sheet Income statement Cash flow statement
C000 C000 C000
Debt 101.82 nterest expense (4.82) nterest paid (3.00)
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 11
Leases
A lease is a contract between a lessor and a lessee for the hire of a specific asset. The lessor
retains ownership of the asset but conveys the right to the use of an asset to the lessee for an
agreed period in return for the payment of specified rentals.
Recognition
Finance (capitaI) Ieases
A finance lease should be recorded in the balance sheet of a lessee as an asset and as an
obligation to pay future rentals.
Operating Ieases
An operating lease is not recognised in the balance sheet. Lease rental payments are
recognised as an expense in the income statement.
Measurement
Finance (capitaI) Ieases
At the inception of the lease, the sum to be recorded both as an asset and as a liability is the
lower of:
the present value of the minimum lease payments (derived by discounting at the interest rate
implicit in the lease or, if this cannot be determined reliably, the lessee's incremental
borrowing rate); and
the fair value of the leased asset.
Rentals payments are apportioned between the finance charge and a reduction of the
outstanding obligation for future amounts payable. The total finance charge under a finance
lease is allocated to accounting periods during the lease term so as to produce a constant
periodic rate of charge on the remaining balance of the obligation for each accounting period (or
a reasonable approximation thereto).
Operating Ieases
The rental under an operating lease should be charged on a straight-line basis over the lease
term.
Illustration
A company enters into a 7 year lease to acquire the use of an asset. Annual instalments are
C120m (payable in arrears). The interest rate implicit in the lease is 8% (approximately). The
present value of the minimum lease payments is C614m.
At the end of the first year of the lease, the financial statements would show:
Balance sheet issues
12 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Finance Iease
Balance sheet P&L account Cash flow statement
Cm Cm Cm
Property, plant &
equipment 526
Operating
expenses
(depreciation)
(88)
nterest paid (52)
Debt finance
leases (546)
nterest expense (52) Financing
repayment (68)
Working
year BS P&L finance cash BS
@ start charge @ 8% paid @ end
1 614 52 (120) 546
2 546 46 (120) 472
3 472 40 (120) 392
4 392 33 (120) 305
5 305 26 (120) 211
6 211 18 (120) 109
7 109 11 (120) 0
TotaI 226 (840)
Operating Iease
Balance sheet P&L account Cash flow statement
Cm Cm Cm
Operating
expenses (120)
Operating cash flow
(120)
Classification
Finance (capitaI) Ieases
A finance lease is a lease that transfers substantially all the risks and rewards incident to
ownership of an asset. Title may or may not eventually be transferred.
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 13
US (FAS 13)
f one or more of the following criteria is present at the inception of a lease, it is classified as a
capital lease by the lessee:
1. Ownership is transferred to the lessee by the end of the lease term; or
2. The lease contains a bargain purchase option; or
3. The lease term, at inception, represents 75% or more of the estimated economic life of the
leased asset, including earlier years of use; or
4. At inception, the present value of the minimum lease payments represents 90% or more of
the fair value of the leased asset
Operating Ieases
An operating lease is a lease other than a finance lease.
Provisions and contingent IiabiIities
A provision is a liability of uncertain timing or amount.
Recognition
A provision is recognised when:
an enterprise has a present obligation (legal or constructive) as result of a past event;
it is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; and
a reliable estimate can be made of the amount of the obligation.
ObIigating event
A past event that leads to a present obligation is an obligating event. For an event to be an
obligating event, the enterprise must have no realistic alternative to settling the obligation created
by the event. This is the case only where:
the settlement of the obligation can be enforced by law; or
the event creates valid expectations in other parties that the enterprise will discharge the
obligation (a constructive obligation).
Only those obligations arising from past events existing independently of an enterprise's future
actions (incl the future conduct of its business) are recognised as provisions. A board decision
does not give rise to a constructive obligation at the balance sheet date unless the decision has
been communicated before the balance sheet date to those affected by it in a sufficiently specific
manner to raise a valid expectation in them that the enterprise will discharge its responsibilities.
Balance sheet issues
14 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
ProbabIe outfIow
An outflow is regarded as probable if it is more likely than not to occur (ie the probability that the
outflow will occur is greater that the probability that it will not).
ReIiabIe estimate
f an enterprise can determine a range of possible outcomes, it can make an estimate of the
obligation that is sufficiently reliable to use in recognising a provision.
Measurement
The amount recognised as a provision is the best estimate (eg an expected value) of the
expenditure required to settle the present obligation at the balance sheet date.
Disclosure
Unless the probability of any outflow in settlement is remote, an enterprise discloses a contingent
liability at the balance sheet date.
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 15
Summary

Present
obligation as a
result of an
obligating event?
no
Possible
obligation?
no

yes

yes


Probable
outflow?
no Remote? yes
yes

no

Reliable
estimate? no
yes

Provide Disclose
contingent
liability
Do nothing
Balance sheet issues
16 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Illustration
Lufthansa
Lufthansa operates a customer loyalty programme, 'Miles & More'. Provision is made for
bonus miles granted but unredeemed at the balance sheet date.
Opening balance sheet
Cm
Provision 442
Closing balance sheet P&L account Cash flow statement
Cm Cm Cm
EBT
Provision 524 Cost of sales (82) Change in provision 82
EBT Operating cash flow
Notes to accounts Cm
Opening balance 442
Utilisation (170)
Additions 280
Release (28)
______
Closing balance 524
______
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 17
Pensions and other post-empIoyment benefits
Some companies promise employees benefits which are payable after the completion of
employment. Examples include:
Retirement benefits (pensions); and
Medical care and life insurance.
Defined contribution plans
Under defined contribution plans:
The employer's obligation is limited to the amount that it agrees to contribute to the fund.
The benefits received by the employee are determined by the amount of contributions
paid to the fund (together with investment returns arising from the contributions).
Actuarial risk (that the benefits will be less than expected) and investment risk (that
assets invested will be insufficient to meet expected benefits) fall on the employee.
Defined benefit plans
Under defined benefit plans:
The employer's obligation is to provide the agreed benefits to current and former
employees.
Actuarial risk (that benefits will cost more than expected) and investment risk fall on the
employer.
Accounting
BaIance sheet
Many GAAPs (eg US GAAP, AS) do not require the full pension surplus or deficit to be
recognised as an asset or liability in the balance sheet.
Surplus or deficit
The pension surplus or deficit must be:
disclosed in the notes; and
reconciled to the amount(s) recognised in the balance sheet.
Balance sheet issues
18 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
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 FRS 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.
t is the increase in the obligation resulting from employee service in the period. t is a
deferred wage cost and can be regarded as a genuine operating expense.
Illustration 1
Rhodia has a defined benefit pension scheme. ts consolidated financial statements show:
Balance sheet (extracts) P&L account
Cm Cm
Net funds/(debt) (2,050) EBTDA 365
D&A (524)
Pension liability 431 EBT (159)
Net financial expense (348)
Shareholders equity 252 EBT (507)
Minority interests 23
275
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 19
Pension IiabiIity
Projected benefit obligation
Opening balance 2,056
Service cost 33
nterest cost 118
Benefits paid (103)
Actuarial losses (gains) 170
Foreign currency translation differences (124)
_________
Closing balance 2,150
_________
Plan assets @ fair value
Opening balance 1,122
Actual return on plan assets 123
Contributions paid 8
Benefits paid (103)
Foreign currency translation differences (84)
_________
Closing balance 1,066
_________
Projected benefit obligation in excess of plan assets 1,084
Unrecognised net gains (losses) (653)
_________
Pension liability recognised 431
_________
Net periodic pension cost
Benefits earned during the year (current service cost) 33
nterest cost 118
Expected return on plan assets (83)
Net amortisation and other deferrals 33
_________
101
_________
The net periodic pension cost has been deducted in arriving at EBTDA.
Balance sheet issues
20 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Credit metrics
Unadjusted net debt/EBITDA
Net debt/EBTDA =
m 365 C
m 050 , 2 C
= 5.6
Adjusted net debt/EBITDA
Net debt/EBTDA =
m 433 C
m 134 , 3 C
= 7.2
Adjusted net debt = 2,050m + 1,084m = C3,134m
Adjusted EBTDA = 365m + 101m 33m = C433m
Summary
To adjust metrics and ratios for pensions, find the notes disclosing:
pension deficit (projected benefit obligation in excess of plan assets) or surplus (plan
assets in excess of projected benefit obligation); and
net periodic pension cost and current service cost.
Illustration 2
Tesco operates defined benefit pension schemes. The consolidated financial statements show:
Balance sheet (extracts) Income statement (extracts)
m m
Net debt (4,509) EBTDA 3,118
D&A (838)
Pension liability (1,211) EBT 2,280
Finance income 114
Shareholders' equity 9,380 Finance costs (241)
Minority interests 64 EBT 2,153
9,444
Statement of recognised income &
expense (extracts)
m
Actuarial losses (442)
Exchange differences (1)
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 21
Notes
Charged to income statement
Charged to operating profit
Current service cost 328
_________
Total charge to operating profit 328
_________
Credited/(charged) to finance income
Expected return on pension schemes' assets 209
nterest on pension schemes' liabilities (184)
_________
Net pension finance income 25
_________
Amount recognised in the statement of recognised income and expense
Actual return less expected return on pension schemes' assets 309
Experience gains and losses arising on the schemes' liabilities (24)
Changes in assumptions underlying the present value of liabilities (727)
_________
Total actuarial loss recognised in the SORE (442)
_________
Defined benefit pension pIan assets
Opening fair value of plan assets 2,718
Expected return 209
Actuarial gains 309
Contributions by employer 270
Actual member contributions 6
Foreign currency translation differences -
Benefits paid (64)
_________
Closing fair value of plan assets 3,448
_________
Balance sheet issues
22 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Defined benefit obIigation
Opening defined benefit obligation (3,453)
Service cost (328)
nterest cost (184)
Losses on change of assumptions (727)
Experience losses (24)
Foreign currency translation differences (1)
Benefits paid 64
Actual member contributions (6)
__________
Closing balance (4,659)
__________
Movement in deficit
Deficit in schemes at beginning of the year (735)
Current service cost (328)
Other finance (charge)/income 25
Contributions 270
Foreign currency translation differences (1)
Actuarial (loss)/gain (442)
_________
Deficit in schemes at end of the year (1,211)
_________
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 23
Net debt
Net debt comprises debt less (the aggregate of) cash and cash equivalents.
Debt
Debt comprises:
borrowings (instruments issued as a means of raising finance which are classified as
liabilities); and
obligations under finance leases.
Cash equivaIents
Cash equivalents (or liquid resources) are short term highly liquid investments held as a liquidity
reserve, which are readily convertible into cash and subject to insignificant changes in value.
Money market deposits and certificates of deposit are likely to meet this requirement.
IIIustration
A company's balance sheet shows:
note Cm
Short term securities 1 31
Cash 1,292
Liabilities 5 16,003
Provisions 1,685
The notes to the accounts show:
Note 1
Short term securities comprise investments in equities.
Balance sheet issues
24 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Note 5
Liabilities comprise:
Cm
Bonds 1,812
Due to banks 797
Loan notes 649
Finance leases 2,329
Financial debts 5,587
Trade payables 9,119
Tax liabilities 648
Payroll 649
16,003
Net debt
Cm
Bonds 1,812
Due to banks 797
Loan notes 649
Finance leases 2,329
Debt 5,587
Cash and cash equivaIents (1,292)
Net debt 4,295
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 25
SharehoIders' funds (stockhoIders' equity)
Shareholders' funds (or stockholders' equity) represents the residual interest in an enterprise's
assets after liabilities have been deducted. This arises mainly from:
amounts paid in by shareholders; and
earnings which have been retained, rather than paid out as dividends, over time.
Components
Paid in capital
Main components:
UK US
Called up share capital (ords and prefs) Preferred stock
Common stock
Share premium Additional paid in capital
Other reserves (eg merger reserve)
Retained earnings
Balance sheet presentation:
UK US
Profit and loss account Retained earnings
Other components
UK US
Revaluation reserve Accumulated other comprehensive income
Other reserves (eg capital redemption reserve)
Creditor protection
n some countries, (non-distributable) legal reserves are built up by transferring a % of net profit
each year (eg 10%) to legal reserves until these equal a % of capital stock (eg 20%).
Balance sheet issues
26 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Different cIasses of share
Preference shares (preferred stock)
These shares have preferential rights over ordinary shares. These may include:
a specified, fixed rate of dividend (eg 9% preference shares would pay a dividend of 9%
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. n 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)
n most countries, shares are issued with a par or nominal (or face) value. n 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. n most countries, it can be used to issue
(fully paid) bonus shares.
n many jurisdictions, shares cannot be issued at a discount to par value.
Share issue costs
Costs that are incurred directly in connection with the issue of a capital (or financial) instrument
are:
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 27
deducted from the fair value of the instrument issued to give the net proceeds of the issue.
[n this case, issue costs (or transaction costs) reduce the amount to be recorded as premium
in either the share premium account or the merger reserve.]; or
written off to the P&L account.
IIIustration
During the period, a company issues shares with a par value of C732m for gross proceeds of
C10,613m. Share issue costs were C240m.
Treatment 1
Balance sheet Income statement
Cm Cm
Common stock + 732
Additional paid-in capital + 9,881 Share issue costs (240)
Retained earnings - 240
+ 10,373
Treatment 2
Balance sheet Income statement
Cm Cm
Common stock + 732
Additional paid-in capital + 9,641
Retained earnings
+ 10,373
IAS 32 Financial instruments: disclosure and presentation
An enterprise typically incurs various costs in issuing or acquiring its own equity instruments.
These costs might include registration and other regulatory fees, amounts paid to legal,
accounting and other professional advisors and stamp duties.
The transaction costs of an equity instrument are accounted for as a deduction from equity (net
of any related income tax benefit) to the extent they are incremental costs directly attributable to
the equity transaction that otherwise would have been avoided. The costs of an equity
transaction that is abandoned are treated as an expense.
Transfers
A company makes no accounting entries when its issued shares are transferred between
shareholders (eg when traded on a stock exchange), although it will update its register of
members.
Balance sheet issues
28 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Bonus / capitaIisation / scrip issues
n a bonus issue, a company issues new shares to existing shareholders for no additional
consideration. This may be done to:
reduce the market value per share, thus making the shares more liquid; or
create an additional class of share (eg redeemable shares).
As there is no corresponding change in resources, the issue is recorded at nominal value by
capitalising reserves (eg by reducing the balance on the share premium account).
Illustration
At the beginning of the period, a company had 2,200 million 5p ordinary shares in issue and the
balance on the share premium account was C1,528m. During the period, 2 additional ordinary
shares were issued for every share already in issue (UK: 2 for 1 bonus issue; US: 3 for 1).
BaIance sheet extracts
Before bonus After bonus
Cm Cm
Net assets y y
_________ _________
Share capital ( C220m) 110 330
Share premium account ( C220m) 1,528 1,308
Profit and loss account x x
_________ _________
y y
_________ _________
The market value per share immediately after the bonus issue should be one third of the market
value per share immediately before the bonus issue. Theoretically, total market capitalisation
should remain unchanged.
Rights issues
n 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. n this case, the rights issue includes a bonus
element.
A shareholder who doesn't wish to exercise the right to subscribe for additional shares can
usually sell the right.
Balance sheet issues
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 29
Illustration
A company has a 31
st
December year end. On 1
st
January there were 300,000 $1 ordinary
shares in issue. On 31
st
August, there was a rights issue of 1 new ordinary share for every 3
shares held at $11 per share. ssue costs are negligible. mmediately prior to becoming ex-
rights, the share price was $15. Earnings for the year ended 31
st
December are $295,000.
Accounting impact
Share issue
Cash (100,000 x $11) $1.1m
Share capital (100,000 x $1) $0.1m
Share premium (100,000 x $10) $1.0m
Earnings per share
EPS =
619 , 347
000 , 295 $
= 84.9c
No of shares:
1 Jan 31 Aug 300,000 x 8/12 x 15/14 214,286
1 Sep 31 Dec 400,000 x 4/12 133,333
347,619
CommerciaI effect
The rights issue contains a bonus element (as the exercise price is less than the fair value). This
can be isolated by calculating a theoretical ex-rights fair value per share from:
the exercise price per share; and
the fair value per share before exercise of rights.
Balance sheet issues
30 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Bonus element of rights issue
3 x $15 $45
1 x $11 $11
4 $56
Theoretical ex rights price =
4
56 $
= $14
Adjustment =
14 $
15 $
Treasury stock method
Proceeds of $1,100,000 would buy 73,333 shares @ $15 (full market price)
Subscribers to rights issue get 100,000 for $1,100,000
'Free' shares 26,667
To get free shares need to hold 373,333 shares [300,000 + 73,333]
After rights issue 400,000 shares in issue
No of shares:
1 Jan 31 Aug 300,000 x 8/12 x
400,000
/
373,333
214,286
1 Sep 31 Dec 400,000 x 4/12 133,333
347,619
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Income statement & EPS 1
ncome statement 1
Format 1
Second income statement 2
Revenue recognition 2
Exceptional & extraordinary items 8
Earnings per share 10
Accounting standards 10
Earnings basic 11
Number of shares - basic 11
Diluted EPS 14
Restatement 17
Financial assets and liabilities 18
Financial assets 18
Financial liabilities 19
Measurement 20
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 1
Income statement & EPS
Income statement
The income statement (or P&L account) is a report of financial performance for a period. t
focuses attention on key characteristics of components of performance by:
classifying revenues and expenses by function (eg operating v financial) or nature (eg
personnel costs v depreciation); and
identifying separately items that are unusual in size or incidence (eg exceptional or
extraordinary items) or that have special characteristics (eg interest and taxation).
t reflects the accruals (or matching) concept.
Format
Costs classified by nature Costs classified by function
Income statement Income statement
Cm Cm
Revenue 48,309 Revenue 48,309
Change in inventories (7)
Capitalised wages 821 Cost of sales (30,640)
Capitalised interest 65
49,188 Selling expenses (2,973)
Goods & services purchased (13,477) Administrative expenses (6,385)
Personnel costs (12,114) Operating profit 8,311
Depreciation & amortisation (15,221)
Financial expenses (5,348) Financial expenses (5,283)
Profit before tax 3,028 Profit before tax 3,028
Operating expenses comprise:
Cost of goods sold (13,484)
Personnel costs (11,293)
Depreciation & amortisation (15,221)
(39,998)
Operating expenses are classified as:
Cost of sales (30,640)
Selling expenses (2,973)
Administrative expenses (6,385)
(39,998)
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 2
EBITDA
C3,028m + 5,348m + 15,221m 65m = C23,532m
C8,311m + 15,221m = C23,532m
Second income statement
n some countries, a 'second income statement' reports other gains and losses recognised in the
period but not reflected in the (first) income statement or profit and loss account.
IAS 1
A complete set of financial statements includes:
an income statement
a statement showing either:
all changes in equity; or
changes in equity other than those arising from capital transactions with owners and
distributions to owners.
FAS 130
Entities are required to report comprehensive income.
Comprehensive income is the change in equity of an entity, excluding transactions with
shareholders (eg issue of shares, payment of dividends, purchase of treasury shares). t 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. t 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.
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 3
n some cases, customers pay for goods or services before the goods or services are delivered.
n other cases, customers pay for goods or services after the goods or services have been
delivered.
Critical point
Customers pay before
Receipt of cash from customer
i Cash increases
ii The liability 'unearned revenue' increases because the business has an obligation to
deliver goods or services
Delivery of goods or services
i The liability 'unearned revenue' decreases because the business has fulfilled the
obligation to deliver goods or services
ii Retained earnings increase because the revenue is now earned
Unearned revenue is part of working capital.
Flights
At the beginning of the period, an airline had received C346m from customers in respect of future
flights. During the period the airline:
(1) Received C9,045m from customers in respect of flights booked; and
(2) Delivered flights for which customers had paid C8,912m.
All customers pay in advance.
BaIance sheet extract (Cm) start (1) (2) end
Cash x +9,045 x
x x
Unearned revenue 346 +9,045 -8,912 479
Retained earnings x +8,912 x
x x
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 4
Customers pay after
Delivery of goods or services
i The asset 'accounts receivable' increases because the business has the right to receive
cash from customers
ii Retained earnings increase because the revenue is earned
Receipt of cash from customer
i Cash increases
ii The asset 'accounts receivable' decreases because the business has no further right to
receive cash from customers
Goods
At the beginning of the period, a supplier of office stationery had accounts receivable of C847m.
During the periodthe supplier :
(1) Delivered stationery with selling prices of C9,250m to customers; and
(2) Received C9,154m from customers in respect of stationery sales.
All sales are on credit.
BaIance sheet extract (Cm) start (1) (2) end
Accounts receivable 847 +9,250 -9,154 943
Cash x +9,154 x
x x
Retained earnings x +9,250 x
x x
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 5
Over a period
Customers pay before
Receipt of cash from customer
i Cash increases
ii The liability 'unearned revenue' increases because the business has an obligation to
deliver goods or services
Delivery of goods or services
i The liability 'unearned revenue' decreases because the business has fulfilled the
obligation to deliver goods or services
ii Retained earnings increase because the revenue is now earned
Gym membership
A customer:
joins a gym in early April; and
pays membership fees of C840 for the right to use the gym's facilities for 12 months.
The gym has a 31 December year end.
BaIance sheet extract start cash revenue end
Cash x +840 x
x x
Unearned revenue x +840 -630 210
Retained earnings x +630 x
x x
Revenue for the year ended 31 December = C840 x
9
/
12
= C630
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 6
Customers pay after
Delivery of goods or services
i The asset 'accounts receivable' increases because the business has the right to receive
cash from customers
ii Retained earnings increase because the revenue is earned
Receipt of cash from customer
i Cash increases
ii The asset 'accounts receivable' decreases because the business has no further right to
receive cash from customers
Building works
A builder agrees to build a loft extension for a customer for C50,000. The customer will pay in full
when the work is complete.
The builder has a 30 September year end. At 30 September the loft extension is proceeding to
the customer's satisfaction and is 80% complete.
BaIance sheet extract (C000) start revenue cash end
Accounts receivable x +40 40
Cash x x
x x
Retained earnings x +40 x
x x
Revenue for the year ended 31 September = C50,000 x 80% = C40,000
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 7
IAS 19
SaIe of goods
Revenue from the sale of goods is recognised when all the following conditions have been
satisfied:
the enterprise has transferred to the buyer the significant risks and rewards of ownership of
the goods;
the enterprise retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over goods sold;
the amount of revenue can be measured reliably;
it is probable that the economic benefits associated with the transaction will flow to the
enterprise;
the costs incurred or to be incurred in respect of the transaction can be measured reliably.
Rendering of services
When the outcome of a transaction involving the rendering of services can be estimated reliably,
revenue associated with the transaction is recognised by reference to the stage of completion of
the transaction at the balance sheet date (percentage of completion method).
The outcome of a transaction can be estimated reliably when all the following conditions are
satisfied:
the amount of revenue can be measured reliably;
it is probable that the economic benefits associated with the transaction will flow to the
enterprise;
the stage of completion of the transaction at the balance sheet date can be measured
reliably; and
the costs incurred for the transaction and the costs to complete the transaction can be
measured reliably.
When the outcome of the transaction cannot be reliably estimated, revenue should be
recognised only to the extent of the expenses recognised that are recoverable (ie no profit is
recorded the completed contract method).
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 8
Lufthansa
Revenue is recognised upon the performance of services. Where customers have purchased
and paid for flights not yet taken, a liability ('unearned transportation revenue') is recorded.
Opening balance sheet
Cm
Liability unearned
revenue 570
Closing balance sheet P&L account Cash flow statement
Cm Cm Cm
Revenue EBT
Liability unearned
revenue 670
Change in
unearned revenue 100
ExceptionaI & extraordinary items
Different countries have different views on what is exceptional, what is extraordinary and how
these items should be presented.
Classification
Ordinary activities
Ordinary activities are any activities which are undertaken as part of an enterprise's business and
such related activities in which the enterprise engages in furtherance of, incidental to, or arising
from these activities.
Extraordinary items
Extraordinary items are income or expenses that arise from events or transactions that are
clearly distinct from the ordinary activities of the enterprise and therefore are not expected to
recur frequently or regularly.
Examples
Expropriation of assets
Natural disasters
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 9
ExceptionaI items
Exceptional items are items which arise from events or transactions that fall within the ordinary
activities of the enterprise and which need to be disclosed by virtue of their size or incidence.
Examples
Restructuring costs
Profits and losses on disposal of PPE
Presentation
Extraordinary items
Extraordinary items are presented on the face of the P&L account.
ExceptionaI items
Exceptional items are presented either on the face of the P&L account or in the notes to the
accounts.
Country specifics
IAS
tems 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).
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 10
Earnings per share
Earnings per share (EPS) is a key indicator of financial performance. t 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 AS33
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
ssue to the market
Conversion of debt instrument
ssue 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
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 11
Earnings - basic
Earnings = net income.
For this purpose, net income is the profit earned for equity owners (ordinary shareholders) during
the period. t is after:
Depreciation and amortisation
nterest
Tax
Preference dividends (if any)
Number of shares - basic
Number of shares = weighted average number of ordinary shares outstanding during period.
Change in resources
n most cases, shares are included in the weighted average number of shares from the date
consideration is receivable (which is generally their date of issue), for example:
Ordinary shares issued in exchange for cash are included when cash is receivable; and
Ordinary shares issued as a result of the conversion of a debt instrument to ordinary
shares are included as of the date when interest ceases accruing.
IIIustration 1
A company had 20,000 shares in issue on 1 January. On 1 March it repurchased 3,000 of its
own shares. On 31 May it issued 8,000 new shares for cash to the market.
Time section No of shares Weighting Weighted
average
1 Jan 28 Feb 20,000 2/12 3,333
1 Mar 31 May 17,000 3/12 4,250
1 Jun 31 Dec 25,000 7/12 14,583
22,166
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 12
No change in resources
The weighted average number of ordinary shares outstanding during the period and for all
periods presented should be adjusted for events that have changed the number of ordinary
shares without a corresponding change in resources. These include:
Bonus issues;
Bonus elements of other issues or buy-backs (eg the bonus element in a rights issue to
existing shareholders);
Share splits; and
Share consolidations.
Bonus issues
The number of ordinary shares outstanding before the event is adjusted for the proportionate
change in the number of ordinary shares outstanding as if the event had occurred at the
beginning of the earliest period reported.
Illustration 2
A company with a 31 December year-end had earnings of C18,000 in the prior year and has
earnings of C22,500 in the current year. Until 30 September in the current year, it had 60,000
ordinary shares outstanding. On 1 October, 2 ordinary shares were issued for each ordinary
share outstanding at 30 September.
Reported in prior year
EPS =
000 , 60
000 , 18 C
= 30.0c
Reported in current year
Current year EPS =
000 , 180
500 , 22 C
= 12.5c
Prior year EPS = 30c x 1/3 = 10.0c
Time section No of shares Weighting Adj Weighted
average
1 Jan 30 Sep 60,000 9/12 3/1 135,000
1 Oct 31 Dec 180,000 3/12 45,000
180,000
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 13
Rights issues
The number of shares used in calculating basic EPS for all periods before the rights issue is the
number of ordinary shares outstanding before the issue, multiplied by:
share per value fair rights ex l Theoretica
rights of exercise the before y immediatel share per value Fair

Illustration 3
A company with a 31 December year-end had earnings of C30,000 in the prior year and has
earnings of C38,000 in the current year. On 1 January in the current year it had 500,000 ordinary
shares outstanding. n February it announced a 1 for 5 rights issue at C5.00 per share. The last
date to exercise rights was 1 March. The fair value of 1 share immediately before exercise on 1
March was C11.00.
Reported in prior year
EPS =
000 , 500
000 , 30 C
= 6.0c
Reported in current year
Current year EPS =
667 , 591
000 , 38 C
= 6.4c
Prior year EPS = 6 c x 10/11 = 5.5c
Time section No of shares Weighting Adj Weighted
average
1 Jan 28 Feb 500,000 2/12 11/10 91,667
1 Mar 31 Dec 600,000 10/12 500,000
591,667
Theoretical ex rights value
6
5 C ) 11 C x 5 (
= C10.00
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 14
DiIuted EPS
Potential ordinary shares
Potential ordinary shares are financial instruments or other contracts or rights that may entitle the
holder to ordinary shares.
ExampIes
Convertible debt instruments and preference shares; and
Share warrants and options.
Dilutive potential ordinary shares
Potential ordinary shares should be treated as dilutive when their conversion to ordinary shares
would decrease net profit (or increase net loss) per share from continuing operations.
Earnings - diluted
Earnings = net profit attributable to ordinary shareholders adjusted for effects of all dilutive
potential ordinary shares.
Adjustments
The post-tax effect of:
any dividends on dilutive potential ordinary shares that have been deducted in arriving at
net profit attributable to ordinary shareholders;
interest recognised in the period for the dilutive potential ordinary shares; and
any other changes in income or expense that would result from the conversion of the
dilutive potential ordinary shares.
Number of shares - diluted
Number of shares = weighted average number of ordinary shares outstanding during period plus
weighted average number of ordinary shares that would be issued on conversion of all dilutive
potential ordinary shares into ordinary shares.
Potential ordinary shares are deemed to have been converted into ordinary shares at the
beginning of the period or, if not in existence at the beginning of the period, the date of issue of
the financial instrument or the granting of the rights by which they are generated.
Where more than one basis of conversion exists, the calculation assumes the most
advantageous conversion rate or exercise price from the standpoint of the holder of the potential
ordinary shares.
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 15
Convertible debt
IIIustration
Net profit C1,000
Ordinary shares outstanding 10,000
Convertible 10% C1 bonds 1,000
nterest expense for the year relating to the convertible bond C100
Tax relating to interest expense C40
The convertible bonds have been outstanding throughout the period. Each block of 10 bonds is
convertible into 15 ordinary shares.
Basic EPS
000 , 10
000 , 1 C
= 10.0c
FuIIy diIuted EPS
500 , 11
060 , 1 C
= 9.2c
Adjusted net profit
C1,000 + C100 - C40 C1,060
Number of ordinary shares for diluted EPS
Ordinary shares outstanding 10,000
Number of ordinary shares
resulting from bond conversion 1,500 11,500
IAS/IFRS
As AS 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.
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 16
Share warrants & options
For the purpose of calculating diluted EPS, an entity assumes the exercise of dilutive options and
other dilutive potential ordinary shares. The assumed proceeds from these issues should be
regarded as having been received from the issue of shares at fair value.
The difference between the number of shares issued and the number of shares that would have
been issued at fair value should be treated as an issue of ordinary shares for no consideration.
Fair value is calculated on the basis of the average price of the shares during the reporting
period.
DiIutive arrangements
Options and other share purchase arrangements are dilutive when they would result in the issue
of ordinary shares for less than fair value. The amount of the dilution is fair value less the issue
price. Each such arrangement is treated as consisting of:
1. A contract to issue a certain number of ordinary shares at fair value during the period. The
shares so to be issued are fairly priced and are assumed to be neither dilutive nor anti-
dilutive. They are ignored in the computation of diluted EPS; and
2. A contract to issue the remaining ordinary shares for no consideration. Such ordinary shares
generate no proceeds and have no effect on the net profit attributable to shares outstanding.
Therefore, such shares are dilutive and they are added to the number of ordinary shares
outstanding in the calculation of diluted EPS.
Dilution adjustments
FRS 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.
n calculating diluted EPS the exercise price is adjusted to include the fair value of any goods or
services to be supplied in the future under the share based payment arrangement.
IIIustration
A company had earnings of C1,200,000 for the year ended 31 December. The weighted average
number of shares for the year was 5,000,000. The average fair value of 1 ordinary share during
the year was C4.00.
Options to subscribe for 1,000,000 shares at an exercise price of C3.00 per share were
outstanding throughout the year. These options vest in one year's time. The fair value of
services to be supplied in future years under the option arrangement is C0.10 per option.
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 17
Basic EPS
000 , 000 , 5
000 , 200 , 1 C
= 24.0c
Diluted EPS
000 , 225 000 , 000 , 5
000 , 200 , 1 C

= 23.0c
Issue of shares for no consideration
Number of shares under option 1,000,000
Number of shares that would have been
issued at fair value = (1,000,000 x C3.10) C4
775,000
ssue of shares for no consideration 225,000
Adjusted exercise price = C3.00 + C0.10 = C3.10
Restatement
f 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.
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 18
FinanciaI assets and IiabiIities
FinanciaI assets
Financial assets include:
Accounts receivable
nvestments in debt or equity securities
Derivatives
Accounting
Financial assets are classified into four categories. These categories determine:
The amounts at which financial assets are carried in the balance sheet
The treatment of gains and losses (if any)
FinanciaI assets
Ioans and
receivabIes
heId-to-maturity @ fair vaIue through
profit or Ioss
avaiIabIe-for-saIe
Balance sheet carrying amount
Amortised cost Amortised cost Fair value Fair value
Gains and losses
N/a N/a n income statement n equity
Examples
Accounts receivable nvestment in debt
securities
Derivatives nvestment 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.
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 19
FinanciaI IiabiIities
Financial liabilities include:
Accounts payable
Debt instruments of an issuer
Derivatives
Accounting
Financial liabilities are classified into two categories. These categories determine:
The amounts at which financial liabilities are carried in the balance sheet
The treatment of gains and losses (if any)
FinanciaI IiabiIities
@ fair vaIue through profit or Ioss other
Balance sheet carrying amount
Fair value Amortised cost
Gains and losses
n 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.
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 20
Measurement
Amortised cost
Amortised cost is:
the amount at which an asset or liability is measured at initial recognition;
minus principal repayments;
plus or minus the cumulative amortisation using the effective interest method of any
difference between that initial amount and the maturity amount (premium or discount on
issue).
Fair value
Fair value is the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable willing parties in an arm's length transaction.
The best indication of fair value is the quoted price in an active market. f the market for a
financial instrument is not active, fair value is established by using a valuation technique (a
model).
Illustration
A company has the following assets:
Amortised cost Fair vaIue @
start
Fair vaIue @
end
1. Trade receivables 200 200 203
2. Purchased option 5 35 45
3. nvestment in corporate bond 300 285 289
4. nvestment in equities 200 257 265
Requirement
Show the impact of these assets on the income statement and closing balance sheet. gnore
coupon receipts on the corporate bond, dividend receipts on the equities and taxation.
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 21
Impact
Closing balance sheet Income statement
Assets
Trade receivables
Purchased option
nvestment in corporate bond
nvestment in equities
Equity
Retained earnings
Other recognised gains
Other recognised income and
expense
ncome statement, EPS, EV & ROC
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 22
SoIution
Closing balance sheet Income statement
Assets
Trade receivables 200
Purchased option 45 Gain on purchased option 10
nvestment in corporate bond 300
nvestment in equities 265
Equity
Retained earnings + 10 Net income + 10
Other recognised gains + 8
Other recognised income and
expense
Gain on equities 8
Cash flow statements
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Cash fIow statements 1
ndirect method 1
Adjusting EBT 1
Adjusting net income 2
Depreciation and amortisation 3
Working capital adjustments 3
Cash flow for valuation 7
Levered free cash flow 7
Unlevered free cash flow 7
Cash flow statements
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 1
Cash fIow statements
Indirect method
The indirect method arrives at operating cash flow by adjusting profit for non-cash items which
have impacted its calculation.
Adjusting EBIT
EBT 1,014
Depreciation 405
Amortisation -
EBTDA 1,419
Changes in non-cash working capital
ncrease in accounts receivable (328)
ncrease in inventories (605)
ncrease in accounts payable 798
(135) (135)
Operating cash flow before interest and tax 1,284
nterest paid (184)
Tax paid (221)
Operating cash flow after interest and tax 879
Capital expenditure (995)
Decrease (increase) in net debt (116)
Cash flow statements
2 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
EBIT v net income
Sales 17,204
Cost of sales (15,150)
Other operating expenses (1,040)
Earnings before interest and tax (EBT) 1,014
nterest (184)
Tax (249)
Net income 581
Adjusting net income
Net income 581
Depreciation 405
Amortisation -
Changes in non-cash working capital
ncrease in accounts receivable (328)
ncrease in inventories (605)
ncrease in accounts payable 798
(135) (135)
Change in tax and interest liabilities 28
Operating cash flow after interest and tax 879
Capital expenditure (995)
Decrease (increase) in net debt (116)
Change in tax and interest liabilities
As net income is after interest and tax, adjustments must be made to reflect any differences
between income statement expenses and cash payments.
Cash flow statements
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 3
Depreciation and amortisation
Depreciation is added back to cancel its effect. t has reduced EBT and is not a cash flow.
Amortisation is added back for the same reason.
EBT 1,014
Depreciation 405
Amortisation -
EBTDA 1,419
Working capitaI adjustments
Principles
Accounts receivabIe
Profit must be adjusted for the difference between:
Sales (in the income statement and impacting EBT); and
Receipts from customers (a cash inflow).
Sales 17,204
ncrease in accounts receivable (328)
Receipts from customers 16,876
Adjustment
An increase in accounts receivable is subtracted from EBT or EBTDA to arrive at operating cash
flow. This is because sales increase EBT (and EBTDA) and receipts from customers are less
than sales if accounts receivable have increased.
EBTDA x
Changes in non-cash working capital
ncrease in accounts receivable (328)
ncrease in inventories
ncrease in accounts payable
Operating cash flow x
Cash flow statements
4 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Inventories and accounts payabIe
Profit must be adjusted for the difference between:
Cost of goods sold (in the income statement and impacting EBT); 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
ncrease in inventories 605
Cost of goods purchased 15,755
ncrease 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 EBT:
An increase in inventories is subtracted from EBT or EBTDA to arrive at operating cash
flow; and
An increase in accounts payable is added to EBT or EBTDA to arrive at operating cash
flow.
EBTDA x
Changes in non-cash working capital
ncrease in accounts receivable
ncrease in inventories (605)
ncrease in accounts payable 798
Operating cash flow x
Cash flow statements
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 5
Practice
n published financial statements the balance sheet changes in working capital may not
correspond to the adjustments for these items shown in the cash flow statement.
IIIustration
BaIance sheet Cash fIow statement
end start
Accounts receivable 652 271 ncrease 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)
ncrease in accounts receivable 381
This analysis is typically not provided in the financial statements.
Unless a company has not acquired or disposed of subsidiaries and has no foreign exchange
differences or similar items, the balance sheet movements in the components of working capital
will not correspond to the working capital adjustments in the cash flow statement.
Cash flow statements
6 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Action points
Historics
When inputting historical data into a cash flow statement proforma, use the working capital
adjustments in the published historical cash flow statement (328 in the illustration above) rather
than the balance sheet movements.
Forecasts
One pager
ntegrated balance sheets are not included. Sales growth is a key value driver. Working capital
can be assumed to grow in line with sales.
Fully integrated
Working capital adjustments link to opening and closing balance sheets. Adjustments are
needed for significant acquisitions and disposals of subsidiaries (and exchange differences, if
relevant).
Cash flow statements
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 7
Cash fIow for vaIuation
Levered free cash fIow
Use
Levered free cash flow (or free cash flow to equity) is forecast and discounted at the cost of
equity to arrive at an equity value.
Calculation
Levered free cash flow is post tax and reflects the company's capital structure. t is after interest,
tax and capital expenditure. t represents the cash available to make payments to equity
(dividends or share repurchases) and capital repayments of debt.
ExampIe
Operating cash flow before interest and tax 1,295
nterest paid (180)
Tax paid (228)
Capital expenditure (590)
Levered free cash flow 297
UnIevered free cash fIow
Use
Unlevered free cash flow (or free cash flow to the enterprise) is forecast and discounted at the
weighted average cost of capital to arrive at an enterprise value.
Calculation
Unlevered free cash flow is post tax and is independent of the company's capital structure. t is
before interest but after tax and capital expenditure. t represents the cash available to make any
payments to equity (dividends or share repurchases) and debt (interest and capital repayments).
Interest tax shieId
nterest is tax deductible in most countries it 'shields' tax. f a company had no net debt and
therefore no interest, its tax bill would be higher. To calculate unlevered free cash flow, tax is
adjusted to remove this interest tax shield.
Cash flow statements
8 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Given
nterest paid (180)
Tax paid (228)
Tax rate 30%
Interest tax shield
nterest tax shield = 30% x 180 = 54
Adjusted tax
Tax adjusted for interest tax shield = 228 + 54 = 282
ExampIe
Operating cash flow before interest and tax 1,295
Adjusted tax (282)
Capital expenditure (590)
Unlevered free cash flow 423
Reconciling levered and unlevered cash flow
Unlevered free cash flow 423
Post tax cost of interest (126)
Levered free cash flow 297
Post tax cost of interest
As interest is tax deductible, the cost to the company is the post tax cost.
nterest after tax = 180 x 70% = 126
M&A accounting
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
M&A accounting 1
Parent 1
Group 1
Consolidated financial statements 1
nvestments 1
Subsidiaries (AS 27) 2
Recognition 2
Measurement 2
Business combinations (FRS 3) 3
Applying the purchase method 3
Goodwill 5
llustration fair values and goodwill 6
Joint ventures (AS 31) 7
Recognition 7
Measurement 7
llustration 8
Associates (AS 28) 9
Recognition 9
Measurement 9
llustrations 10
Summary 15
M&A accounting
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 1
M&A accounting
n most countries, a parent presents consolidated financial statements for its group.
n some countries, a parent also presents its own, legal entity, financial statements.
Parent
A parent is an enterprise that has one or more subsidiaries.
Group
A group is a parent and all its subsidiaries.
ConsoIidated financiaI statements
Consolidated financial statements present financial information about the group as that of a
single enterprise (without regard for the legal boundaries of the separate legal entities).
Investments
n consolidated financial statements, the treatment of long term investments in the equity of other
entities depends on the degree of influence which the group exerts over the other entity.
degree of infIuence
little significant jointly controlled dominant / controlling
financiaI asset
cost (subject to
impairment) or fair
value (AS)
associate
equity account
joint venture
proportionately
consolidate or equity
account
subsidiary
consolidate
(purchase / acquisition
accounting)
M&A accounting
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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).
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Business combinations (IFRS 3)
All business combinations are accounted for by applying the purchase method.
AppIying the purchase method
Applying the purchase method involves:
1. identifying an acquirer;
2. measuring the cost of the business combination; and
3. allocating, at the acquisition date, the cost of the business combination to the assets acquired
and liabilities and contingent liabilities assumed.
Acquisition date
The acquisition date is that on which the acquirer effectively obtains control of the acquiree.
1. Identifying the acquirer
An acquirer is identified for all business combinations. The acquirer is the combining entity that
obtains control of the other combining entities or businesses.
Although sometimes it may be difficult to identify an acquirer, there are usually indications that
one exists. For example:
f 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.
f 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.
f 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.
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Acquisition date/date of exchange
The acquisition date is the date on which the acquirer effectively obtains control of the acquiree.
When this is achieved through a single exchange transaction, the date of exchange coincides
with the acquisition date.
LiabiIities incurred or assumed
Future losses or other costs expected to be incurred as a result of a combination are not
liabilities incurred or assumed by the acquirer in exchange for control of the acquiree, and are
not, therefore, included as part of the cost of the combination.
Costs directIy attributabIe to the combination
The cost of a business combination includes any costs directly attributable to the combination,
such as professional fees paid to accountants, legal advisers, valuers and other consultants to
effect the combination.
General administrative costs, including the costs of maintaining an acquisitions department, and
other costs that cannot be directly attributed to the particular combination being accounted for are
not included in the cost of the combination; they are recognised as an expense when incurred.
Issue costs
Debt issues
The costs of arranging and issuing financial liabilities are an integral part of the liability issue
transaction (even when the liabilities are issued to effect a business combination) rather than
costs directly attributable to the combination. Entities do not include such costs in the cost of a
business combination.
Equity issues
Similarly, the costs of issuing equity instruments are an integral part of the equity issue
transaction (even when the equity instruments are issued to effect a business combination)
rather than costs directly attributable to the combination. Entities do not include such costs in the
cost of a business combination.
3. Allocation of cost of a business combination
The acquirer, at the acquisition date, allocates the cost of a business combination by recognising
separately the acquiree's identifiable assets, liabilities and contingent liabilities that satisfy the
recognition criteria at their fair values at that date.
Fair vaIues
Fair value is the amount for which an asset could be exchanged or a liability settled between
knowledgeable, willing parties in an arm's length transaction.
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Acquiree's identifiabIe assets and IiabiIities
The acquirer recognises liabilities for terminating or reducing the activities of the acquiree as part
of allocating the cost of the combination only when the acquiree has, at the acquisition date, an
existing recognised liability for restructuring.
The acquirer, when allocating the cost of the combination, shall not recognise liabilities for future
losses or other costs expected to be incurred as a result of the business combination.
Acquiree's intangibIe assets
A non-monetary asset without physical substance must be identifiable to meet the definition of an
intangible asset. An asset meets the identifiability criterion only if it:
is separable (ie capable of being separated or divided from the entity and sold, transferred,
licensed, rented or exchanged [either individually or together with a related contract, asset or
liability); or
arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.
Minority interests
Because the acquirer recognises the acquiree's identifiable assets, liabilities and contingent
liabilities which satisfy the recognition criteria at their fair values at the acquisition date, any
minority interests in the acquiree is stated at the minority's proportion of the net fair value of
those items.
Income statement
The acquirer's income statement incorporates the acquiree's profits and losses after the
acquisition date by including the acquiree's income and expenses based on the cost of the
business combination to the acquirer.
eg depreciation expense included after the acquisition date in the acquirer's income
statement that relates to the acquiree's depreciable assets is based on the fair value of
those depreciable assets at the acquisition date (ie their cost to the acquirer).
GoodwiII
At the acquisition date, the acquirer:
recognises goodwill acquired in a business combination as an asset; and
initially measures that goodwill at its cost, being the excess of the cost of the business
combination over the acquirer's interest in the net fair value of the identifiable assets,
liabilities and contingent liabilities recognised.
After initial recognition, the acquirer measures goodwill acquired in a business combination at
cost less any accumulated impairment losses. Goodwill acquired in a business combination is
not amortised.
M&A accounting
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Negative goodwiII
f the acquirer's interest in the net fair value of the identifiable assets, liabilities and contingent
liabilities recognised exceeds the cost of the business combination, the acquirer:
reassesses the identification and measurement of the acquiree's identifiable assets, liabilities
and contingent liabilities and the measurement of the cost of the combination; and
recognises immediately in profit or loss any excess remaining after that reassessment.
IIIustration - fair vaIues and goodwiII
Company G acquired 100% of Company W. The cost of acquisition was 9,333m. The book
value of Company W's net assets at the date of acquisition comprised:
m
ntangible assets -
Property, plant and equipment @ net book amount 1,043
Net working capital 23
Net funds/(debt) 807
1,873
At the date of acquisition:
the fair value of identifiable intangible assets generated internally by Company W (excluding
its assembled workforce) is 552m;
the fair value of property, plant and equipment is 915m;
the fair value of net working capital is 40m;
the fair value of net funds is 800m.
GoodwiII
Cost of acquisition 9,333
less: fair value of identifiable assets less liabilities (2,307)
Goodwill 7,026
Fair vaIue of identifiabIe assets Iess IiabiIities
m
ntangible assets 552
Property, plant and equipment 915
Net working capital 40
Net funds/(debt) 800
2,307
M&A accounting
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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
n 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
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IIIustration
An investing company has contributed 25m for 50% of the equity of a joint venture company.
JV company
Balance sheet
m
PPE 335.0
Debt 285.0
Share capital 0.2
Share premium 49.8
Total finance 335.0
Investing company
Own financiaI statements ConsoIidated financiaI statements
Equity method Proportionate consoI
n
Balance sheet
(extract)
Balance sheet
(extract)
Balance sheet
(extract)
m m m
nvestment (cost) 25.0 nvestment 25.0 PPE 167.5
Debt 142.5
M&A accounting
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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
nterchange of managerial personnel
Provision of essential technical information
20% stake
f 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
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IIIustrations
Base case
Some time ago, an investing company had contributed 15m for 30% of the equity of an
associate company.
Associate company
Balance sheet
(current)
m
PPE 435.0
Debt 285.0
Share capital 0.2
Share premium 49.8
Retained earnings 100.0
Total finance 435.0
Investing company
Own financiaI statements ConsoIidated financiaI statements
Equity method
Balance sheet
(extract)
Balance sheet
(extract)
m m
nvestment (cost) 15.0 nvestment 45.0
(30% x (435 285))
Retained earnings 30.0
(30% x 100)
Associate company
P&L
(extract)
m
Operating profit 90
nterest (40)
Profit before tax 50
Tax (17)
Profit after tax 33
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ConsoIidated financiaI statements
Method 1 Method 2 Method 3
Consolidated P&L
(extract)
Consolidated P&L
(extract)
Consolidated P&L
(extract)
m m m
Share of operating
profit
27
Share of interest (12)
Share of PBT 15
Share of tax (5) Share of tax (5)
Share of PAT 10
Premium on acquisition
An investing company paid 25m for 30% of the equity of an associate company 3 years ago
when the net assets (@ fair value) of that company were 50m. Goodwill is amortised over 10
years. [From the beginning of the first annual period beginning on or after 31 March 2004,
amortisation is discontinued.]
CaIcuIation and treatment
The premium on acquisition is 10m. Amortisation for the year is 1m; amortisation to date is
3m. The unamortised premium at the balance sheet date is 7m.
Associate company
Balance sheet
m
PPE 435.0
Debt 285.0
Share capital 0.2
Share premium 49.8
Retained earnings 100.0
Total finance 435.0
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Investing company
Own financiaI statements ConsoIidated financiaI statements
Equity method
Balance sheet
(extract)
Balance sheet
(extract)
m m
nvestment (cost) 25.0 nvestment 52.0
Retained earnings 27.0
The investment in the consolidated balance sheet comprises unamortised premium 7m plus
share of net assets 45m (30% x (435 285)).
The consolidation adjustment to retained earnings comprises share of post acquisition earnings
30m less premium amortised to date 3m.
Associate company
P&L
(extract)
m
Operating profit 90
nterest (40)
Profit before tax 50
Tax (17)
Profit after tax 33
ConsoIidated financiaI statements
Method 1 Method 2 Method 3
Consolidated P&L
(extract)
Consolidated P&L
(extract)
Consolidated P&L
(extract)
m m m
Share of operating
profit
26
Share of interest (12)
Share of PBT 14
Share of tax (5) Share of tax (5)
Share of PAT 9
Share of profit is reduced by premium amortisation of 1m.
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Distribution by associate
An investing company contributed 15m for 30% of the equity of an associate company when the
net assets (@ fair value) of that company were 50m.
The associate pays a dividend in year 3 of 20m. No dividends have previously been paid.
Associate company
Balance sheet
m
PPE 435.0
Debt 305.0
Share capital 0.2
Share premium 49.8
Retained earnings 80.0
Total finance 435.0
Investing company
Own financiaI statements ConsoIidated financiaI statements
Equity method
Balance sheet
(extract)
Balance sheet
(extract)
m m
nvestment (cost) 15.0 nvestment 39.0
Cash 6.0
Retained earnings 6.0 Retained earnings 24.0 Total 30.0
ConsoIidated P&L
Method 1 Method 2 Method 3
Consolidated P&L
(extract)
Consolidated P&L
(extract)
Consolidated P&L
(extract)
m m m
Share of operating
profit
27
Share of interest (12)
Share of PBT
15
Share of tax (5) Share of tax (5)
Share of PAT 10
M&A accounting
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The consolidated P&L account includes the investor's share of the associate's results, whether
retained or remitted.
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Summary
Long term investment in equity shares (voting rights)
ndicative ownership < 20% 20% 50% > 50%
nfluence insignificant significant jointIy controIIed controI
nvestment type financiaI asset associate joint venture subsidiary
Accounting Amortised cost or
FV
Equity accounting ProportionaI consoIidation ConsoIidation
(purchase/acquisition accounting)
ConsoIidated
income statement
Change in fair value "1 line consolidation
Our % of A's PAT
(Goodwill impairments)
No M
(US 1 line
Other 2 lines
UK 5 lines)
Line by line our % of JV's
Sales to PAT
(Goodwill impairments)
No M
Line by line 100% of S's
Sales to PAT
(Goodwill impairments)
M = M% x S's PAT
ConsoIidated
baIance sheet
Fair value "1 line consolidation
Our % of A's net assets
Goodwill
No M
Line by line our % of JV's
net assets
Goodwill
No M
Line by line 100% of S's
net assets
Goodwill
M = M% x S's net assets
M&A accounting
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FinanciaI asset Associate Joint venture Subsidiary
Accounting Amortised cost or
FV
Equity accounting ProportionaI consoIidation ConsoIidation
(purchase/acquisition accounting)
SaIes 0% 0%
(although look out for UK's gross
equity method which discloses
share of sales)
Share of sales 100%
EBITDA 0% 0%
(assuming EBT extracted
excluding associate)
Share of EBTDA 100%
EBIT 0% 0%
(assuming EBT extracted
excluding associate)
Share of EBT 100%
Net income Change in fair value Share of net income less goodwill
impairment
Share of net income less goodwill
impairment
100% less minority interests less
goodwill impairment
Cash fIow Dividends received Dividends received from associate Share of cash flows 100%
Assets Fair value nvestments in associates @
equity value (1 line)
Goodwill (incl. in above)
Share of assets (line by line)
Goodwill (in intangibles)
100% (line by line)
Goodwill (in intangibles)
Debt 0% 0%
(although may disclose share of
debt)
Share of debt (line by line) 100% (line by line)
Other
IiabiIities
0% 0% Share of other liabilities (line by
line)
100% (line by line)
Minorities 0% 0% 0% Proportion of subsidiary's net assets
Impact
on
SharehoIders'
equity
ncr/decr with adj to
FV
ncr/decr from share of net
income less goodwill impairment
ncr/decr from share of net
income less goodwill impairment
ncr/decr from share of net income less
goodwill impairment
M&A accounting
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FinanciaI asset Associate Joint venture Subsidiary
Accounting
Amortised cost or
FV
Equity accounting ProportionaI consoIidation ConsoIidation
(purchase/acquisition accounting)
From equity vaIue to
enterprise vaIue
(for common multiples)
Subtract investments
(@ market value if
possible)
Subtract investments (@ market
value if possible)
N/a Add minority interests (@ market value if
possible)
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Enterprise and equity value
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Enterprise and equity vaIue 1
Definitions 1
Enterprise value 1
Equity value 1
Multiples 2
Enterprise value 2
Equity value 2
Exercise 1 4
Exercise 2 5
Corporate adjustments 6
Minority interests 6
Associates and equity accounted joint ventures 7
Pension obligations 8
Operating leases 9
Assessing & comparing corporate performance 10
Return on invested capital 10
Economic profit (residual income or EVA) 15
Exercise solutions 16
Exercise 1 16
Exercise 2 18
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1
Enterprise and equity vaIue
Definitions
Enterprise vaIue
Enterprise value is the value available to both debt holders and equity holders regardless of
capital structure. t is also known as firm value or aggregate value.
Equity vaIue
Equity value is the residual value available to equity holders once other providers of capital have
been repaid. For listed companies this is equivalent to market capitalisation.
Equity
Equity
vaIue
Enterprise
vaIue
Net debt
Corporate adjustments
Net debt
Strictly this should be the market value of the company's debt less any cash and liquid
resources.
For bank debt, book value will usually approximate market value. This may not be true for long
term bonds, which may be trading at a premium or discount according to the interest rate
environment and company's credit status.
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Corporate adjustments
When calculating valuation multiples the numerator and denominator must be consistent.
Adjustments may be needed in respect of:
Minority interests
Associates and joint ventures
Pension obligations
Operating leases
Other off balance sheet obligations
MuItipIes
Enterprise vaIue
Enterprise value can be expressed as a multiple of any metric which is capital structure neutral.
For income and cash flow statement metrics, this means before interest.
Metrics
Revenues
EBTDA
EBTA
EBT
Unlevered free cash flow
Sector specific metrics
Subscribers (media)
Capex adjusted EBTDA (telecoms, chemicals)
Equity vaIue
Equity value can be expressed as a multiple of any metric which is after deducting amounts due
to other providers of capital. For income and cash flow statement metrics, this means after
interest.
Enterprise and equity value
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Metrics
Net income
Levered free cash flow
Sector specific metric
Net asset value (property, shipping)
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Exercise 1
You are given the following data about the pharmaceuticals sector in Hungary:
EV
$m
EV/saIes
(x)
EV/EBITDA
(x)
EV/EBIT
(x)
EBITDA
margin
(%)
2005 2005 2006F 2005 2006F 2005 2006F 2005 2006F
Pharmaceuticals
4.7 3.9 17.5 13.9 24.1 17.8 26.8 28.2
Gedeon Richter 1,870 5.9 4.7 19.4 14.9 25.2 18.0 30.4 31.5
Egis 377 2.3 2.2 11.6 10.4 19.5 16.8 19.8 20.8
Part 1
Reconstruct the 2005 P&L accounts for Gedeon Richter and Egis. Prove the EBTDA margin
from the reconstructed P&L account.
Gedeon Richter
$m
Egis
$m
Sales
Operating costs, excl depreciation
EBTDA
Depreciation
EBT
Why might Gedeon Richter have a higher EV/EBTDA ratio than Egis?
Gedeon Richter's EV/sales ratio is 2 times that of Egis but its EV/EBTDA ratio is only just
over 1 times that of Egis. What does this indicate?
Enterprise and equity value
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Part 2
Reconstruct the 2006 forecast P&L account for Gedeon Richter.
2006
$m
Sales
Operating costs, excl depreciation
EBTDA
Depreciation
EBT
Why do Gedeon Richter's EV ratios decline from 2005 to 2006?
How do Egis' EV ratios behave between 2005 and 2006 and what does this indicate?
Exercise 2
You are given the following data about the building materials sector in Hungary:
EV
$m
EV/saIes
(x)
EV/EBITDA
(x)
EV/EBIT
(x)
EBITDA
margin
(%)
2005 2005 2006F 2005 2006F 2005 2006F 2005 2006F
Building materials
1.7 1.4 11.8 9.0 17.0 12.3 14.2 15.2
Graboplast 151 1.3 1.0 11.1 7.9 15.5 11.4
Pannonplast 165 1.7 1.4 15.5 12.1 28.7 16.9
Zalakermia 147 2.3 2.0 9.7 7.9 12.5 10.0
1. Which company has the highest EBTDA margin and how is this indicated by the EV ratios
above?
2. Which company is expected to demonstrate the most explosive growth in EBT? Which
company is expected to demonstrate the highest growth in EBTDA?
Enterprise and equity value
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Corporate adjustments
Minority interests
Minority interests represent the portion of the net income and net assets of a subsidiary
attributable to equity interests that are not owned (directly or indirectly through subsidiaries) by
the parent.
Accounting treatment
BaIance sheet
Under FRS 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, EBTDA and EBT include 100% of subsidiaries' revenue, EBTDA and
EBT.
Numerator
Equity value (ie market capitalisation) includes only the value attributable to equity interests that
are owned by the parent.
Net debt includes 100% of subsidiaries' net debt.
Adjustment
For consistency, the estimated value of minority interests is added to equity value and net debt
to arrive at EV. Market value is used where available, otherwise a best estimate is used (eg
DCF or book value multiple).
EV = equity value + net debt + minority interests
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Associates and equity accounted joint ventures
Accounting treatment
BaIance sheet
Under the equity method, investments are included initially at cost and the carrying amount is
increased or decreased to recognise the investor's share of the investee's net income after the
date of acquisition.
Income statement
The investor's share of the investee's net income is included in the consolidated income
statement. This amount is presented below EBT.
EV multiples
Denominator
Consolidated revenue, EBTDA and EBT exclude revenue, EBTDA and EBT 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
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8
Pension obIigations
Accounting treatment
BaIance sheet
Many GAAPs (eg US GAAP, FRS) 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 FRS 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. t 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 EBTDA or EBT. 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
EBT and EBTDA are adjusted to remove any elements of pension cost apart from current
service cost.
EV = equity value + net debt + M equity accounted investments + pension deficit
Enterprise and equity value
The Corporate Training Group Limited - +44 (0)20 7490 4770; trainers@ctguk.com
9
Operating Ieases
Accounting treatment
BaIance sheet
Obligations under operating leases are off balance sheet. They are not included in net debt as
disclosed in financial statements.
Income statement
Operating lease rentals are charged as operating expenses and reduce EBTDA and EBT.
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, EBTDA is adjusted to exclude operating lease rentals. f
the leases were finance leases the resultant expenses would be depreciation and interest;
EBTDA is before both of these.
EBTDA + rental =EBTDAR
EBIT
For consistency with the numerator, EBT is adjusted to exclude the interest element of
operating lease rentals. EBT is after depreciation but before interest.
The interest element may be estimated by:
applying an interest rate to the present value of the obligation; or
apportioning the rental between depreciation and interest (eg and ).
EV = equity value + net debt + minority interests equity accounted investments + pension
deficit + PV of operating Iease rentaIs
Enterprise and equity value
The Corporate Training Group Limited - +44 (0)20 7490 4770; trainers@ctguk.com
10
Assessing & comparing corporate performance
Return on invested capitaI
ROC =
capital invested
NOPLAT
Net operating profit less adjusted taxes (NOPLAT)
The P&L tax charge is adjusted to remove the impact of the financing structure.
Financing structure
The tax charge is recalculated to remove the interest tax shield which arises if a company
has net debt. The adjusted tax charge represents the tax that would arise if the company
had no net debt, so that NOPLAT is capital structure neutral.
Adjusted taxes
A company's profit and loss account shows the following:
Profit and loss account
Operating profit
nterest
Profit before tax
Tax
Profit after tax
m
1,032
(99)
933
(258)
675
The rate of corporation tax is 30%.
Enterprise and equity value
The Corporate Training Group Limited - +44 (0)20 7490 4770; trainers@ctguk.com
11
Tax Accounts NOPLAT
Adjustments to profit
Profit before tax
Depreciation and amortisation
Capital allowances
Other adjustments
Taxable profit
Tax @ 30%
m
933
?
(?)
(?)
(73)
860
258
Profit and loss account
Operating profit
nterest
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
nterest tax shield (30% x 99m) 30 Profit before tax, if no interest 1,032
Tax on operating profit 288 Adjustments to profit (73)
Taxable profit, if no interest 959
Tax @ 30% 288
Enterprise and equity value
Corporate Training Group Ltd - +44 (0)20 7490 4770; trainers@ctguk.com
13
Invested capital
nvested capital can be calculated as either:
operating working capital + fixed assets + other net assets, excluding cash and liquid
resources; or
net debt + shareholders funds + minority interests.
Tesco 2006
Excluding JVs and associates:
Invested capitaI (m) 2006 2005
Equity attributable to parent equity holders 9,380 8,603
Minority interests 64 51
Net debt 4,509 3,899
nvestments 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)
ntangible assets 1,525 1,408
Property, plant and equipment (incl investment property) 16,627 15,086
nventories 1,464 1,309
Trade and other receivables (excl finance leases) 875 769
Trade and other payables (5,083) (4,974)
Current tax liabilities (462) (221)
Total 14,946 13,377
Average 14,161
Enterprise and equity value
The Corporate Training Group Limited - +44 (0)20 7490 4770; trainers@ctguk.com
14
Net operating profit Iess adjusted taxes (m) 2006
Operating profit 2,280
Current tax charge (note 6) (664)
nterest tax shield [(232 + 67) x 30%] (notes 5 & 6) (90)
Adjusted tax (754)
NOPLAT 1,526
Return on invested capitaI
Based on opening invested capital
m 377 , 13
m 526 , 1
= 11.4%
Based on average invested capital
m 161 , 14
m 526 , 1
= 10.8%
Enterprise vaIue
Market capitalisation (given)
26,035
Minority interests 64
Net debt 4,509
nvestments in joint ventures and associates (476)
Other investments (4)
Held for disposal (82)
Enterprise value 30,046
Enterprise and equity value
Corporate Training Group Ltd - +44 (0)20 7490 4770; trainers@ctguk.com
15
Economic profit (residuaI income or EVA )
Economic profit = NOPLAT- (invested capital x cost of capital)
= (ROC - cost of capital) x invested capital
Enterprise
value
30,046m
ROC
11.4%
NOPLAT
P&L
1,526m
nvested capital
BS
13,377m
minus
Economic
profit
405m
Cost of
capital
7.5%
'Capital
charge'
1,121m
EV - C
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 ROC > WACC Economic profit is positive
= 1 ROC = WACC Economic profit is zero
< 1 ROC < WACC Economic profit is
negative
Tesco
ROC/WACC =
% 5 . 7
% 2 . 10
= 1.36
Enterprise and equity value
The Corporate Training Group Limited - +44 (0)20 7490 4770; trainers@ctguk.com
16
Exercise soIutions
Exercise 1
Part 1 - Solution
2005 P&L accounts for Gedeon Richter and Egis:
EV 1,870m 377m
Gedeon Richter
$m
Egis
$m
Sales = EV 5.9/2.3
Operating costs,
excl depreciation
EBTDA = EV 19.4/11.6
Depreciation
EBT = 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/EBTDA ratio than Egis as the market expects Gedeon
Richter's future EBTDA to grow more quickly than Egis'.
Gedeon Richter's EV/sales ratio is 2 times that of Egis but its EV/EBTDA ratio is only just over
1 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 EBTDA margin.
Enterprise and equity value
Corporate Training Group Ltd - +44 (0)20 7490 4770; trainers@ctguk.com
17
Part 2 - Solution
2006 forecast P&L account for Gedeon Richter:
EV 1,870m 1,870m
2006F
$m
2005
$m
Sales = EV 4.7/5.9
Operating costs,
excl depreciation
EBTDA = EV 14.9/19.4
Depreciation
EBT = 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 EBTDA, 40% in EBT).
Egis' EV ratios decline only slightly due to the very modest expectations of growth.
Enterprise and equity value
The Corporate Training Group Limited - +44 (0)20 7490 4770; trainers@ctguk.com
18
Exercise 2
Solution
EV
$m
EV/saIes
(x)
EV/EBITDA
(x)
EV/EBIT (x) EBITDA
margin (%)
2005 2005 2006F 2005 2006F 2005 2006F 2005 2006F
Building materials
1.7 1.4 11.8 9.0 17.0 12.3 14.2 15.2
Graboplast 151 1.3 1.0 11.1 7.9 15.5 11.4 11.7 12.6
Pannonplast 165 1.7 1.4 15.5 12.1 28.7 16.9 11.0 11.6
Zalakermia 147 2.3 2.0 9.7 7.9 12.5 10.0 23.7 25.3
EBITDA margin
EBTDA margin = EV/sales EV/EBTDA.
Zalakermia has the highest EBTDA margin.
The market is prepared to pay a higher multiple of Zalakermia's sales than the sector average,
as (given the roughly similar growth rates for companies in the sector) Zalakermia is able to
turn a higher proportion of those sales into profit.
EBIT growth
Pannonplast is expected to demonstrate the most explosive growth in EBT, at 70% [28.7 16.9
= 170%].
EBITDA growth
Graboplast is expected to demonstrate the highest growth in EBTDA, at 41% [11.1 7.9 =
141%].
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
EXERCISES AND CASE STUDIES
Coset pIc 1
Kissat Ltd 5
Potomac 9
Mag Ltd 16
Ourstair Ltd 19
FIash Tuna AG 23
Theramax Ltd 27
Monty, Tiger & Seve 30
EaseI 33
EnteachabIes Inc 34
A BS Inc 39
Erkki, Nuutti and Mikko 42
Primrose pIc 43
Birren pIc 44
OnyaIi pIc 45
Scrutinise DeaI 46
Pearson rights issue 47
Discounted debt 48
ConvertibIe debt 50
King, Wade & Graf 51
Deutsche TeIekom 54
Morientes & FriedeI 56
Pensions 60
PampIe & Mousse (1) 62
Mango & Steen 67
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 1
Coset pIc
Coset plc is a food retailer.
The opening balance sheet showed:
m
Property, plant and equipment 5,249
nventories 550
Accounts receivable 78
Cash and deposits 65
_______
Total assets 5,942
_______
Accounts payable 826
Tax payable 255
Debt 856
Ordinary share capital 109
Share premium 1,431
Retained earnings 2,465
_______
Liabilities & shareholders' equity 5,942
_______
The following took place during the year:
1. Purchased goods on credit costing 11,100m. Sold on credit for 16,452m goods costing
11,066m.
2. Received 16,397m from customers in respect of sales on credit. Paid 10,954m to suppliers
in respect of purchases on credit.
3. ncurred and paid store operating costs (to be classified as cost of sales) of 3,851m and
administrative expenses (to be classified as administrative expenses) of 384m.
4. Purchased and paid for property, plant and equipment costing 985m. Charged depreciation
of 358m (300m to be charged as cost of sales and 58m to be charged as administrative
expenses).
5. ssued shares for 131m (nominal value 1m) and raised debt of 183m.
6. ncurred and paid interest of 85m, of which 20m was capitalised into property plant and
equipment.
7. Paid corporation tax for prior year of 255m. Estimated corporation tax for the current year at
223m.
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 2
8. Paid dividends of 233m.
Requirements
a. Prepare a balance sheet at the end of the year (using the following pro-forma).
b. Prepare an income statement and cash flow statement for the year (use the following
proformas).
c. Prepare a brief commentary on cash flow generation and utilisation in the year.
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 3
BaIance sheet
start 1 2 3 4 5 6 7 8 end
m m m m m m m m m m
PPE 5,249
nventories 550
A/cs receivable 78
Cash 65
TotaI assets 5,942
A/cs payable 826
Tax payable 255
Debt 856
Ord share cap 109
Share premium 1,431
Retained earnings 2,465
LiabiIities & equity 5,942
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 5
Kissat Ltd
Kissat Ltd operates hotels, casinos and health clubs. The opening balance sheet showed:
m
Property, plant and equipment 590
nventories 4
Accounts receivable 16
Cash and deposits 8
_____
TotaI assets 618
_____
Accounts payable 22
Tax payable 9
Debt 354
Ordinary share capital 49
Share premium 113
Retained earnings 71
_____
LiabiIities & sharehoIders' equity 618
_____
The following took place during the year:
1. Made sales on credit of 307m. Received 285m from customers in respect of sales on
credit.
2. Purchased on credit supplies costing 59m. Used supplies costing 58m. Paid 55m to
suppliers in respect of purchases on credit.
3. ncurred, 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. ssued 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. ncurred and paid interest of 18m.
7. Paid corporation tax of 8m in full settlement of the prior year amount. Estimated corporation
tax for the current year at 18m.
8. Paid dividends of 14m.
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 6
Requirements
a. Prepare a balance sheet at the end of the year.
b. Prepare an income statement and cash flow statement for the year.
c. Prepare a brief commentary on cash flow generation and utilisation in the year.
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 7
start 1 2 3 4 5 6 7 8 end
m m m m m m m m m m
PPE 590
nventories 4
A/cs
receivable
16
Cash 8
TotaI assets 618
A/cs payable 22
Tax payable 9
Debt 354
Ord share
cap
49
Share
premium
113
Retained
earnings
71
LiabiIities &
equity
618
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 9
Potomac
Potomac provides international marine transportation, container distribution and shipping agency
services.
The opening balance sheet showed:
$m
Property, plant and equipment 1,665
nventories 2
Accounts receivable 50
Cash and deposits 4
_______
Total assets 1,721
_______
Accounts payable 17
Tax payable 41
Debt 621
Ordinary share capital 727
Share premium 76
Retained earnings 239
_______
Liabilities & shareholders' equity 1,721
_______
The following took place during the year:
1. Purchased fuel and other inventories on credit costing $100m. Used fuel and other
inventories costing $99m. Paid $97m to suppliers in respect of purchases on credit.
2. Billed customers for services provided of $1,258m. Received $1,250m from customers in
respect of services provided on credit.
3. ncurred (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. ncurred 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. ncurred and paid $13m in respect of major improvements increasing the efficiency or
extending the useful lives of plant and equipment. ncurred and paid $25m in respect of
regular maintenance of and repairs to property, plant and equipment.
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 10
7. Disposed of, for $21m, plant and equipment with a carrying amount of $25m. Received $21m
in respect of this disposal.
8. ncurred and paid interest of $20m, of which $3m was capitalised into property, plant and
equipment.
9. Paid corporation tax for prior year of $41m. Estimated corporation tax for the current year at
$26m.
10. Paid dividends of 40m. Repaid debt of $44m.
Requirements
a. Prepare a balance sheet at the end of the year (using the following pro-forma).
b. Prepare an income statement and cash flow statement for the year (use the following
proformas).
c. Prepare a brief commentary on cash flow generation and utilisation in the year.
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 11
BaIance sheet
Start 1 2 3 4 5 6 7 8 9 10 end
$m $m $m $m $m $m $m $m $m $m $m $m
PPE 1,665
nventories 2
A/cs receivable 50
Cash 4
TotaI assets 1,721
A/cs payable 17
Tax payable 41
Debt 621
Ord share cap 727
Share premium 76
Retained earnings 239
LiabiIities & equity 1,721
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 13
Income statement
Sales
Cost of sales
Administrative expenses
Operating profit, before exceptional items
Loss on disposal
Operating profit, after exceptional items
nterest expense
Profit before tax
Tax
Net income
Statement of changes in equity
Retained earnings @ start of year
Net income
Dividend
Retained earnings @ end of year
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 14
Cash fIow statement - direct
Receipts from customers
Operating expenses paid
Operating cash flow (1)
nterest paid
Tax paid
Operating cash flow (2)
Capital expenditure
Disposal
Dividends
Debt repaid
Change in cash
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 15
Cash fIow statement - indirect
Operating profit, before exceptional items
Depreciation
EBTDA
ncrease in accounts receivable
ncrease in inventories
ncrease in accounts payable
Operating cash flow (1)
nterest paid
Tax paid
Operating cash flow (2)
Capital expenditure
Disposal proceeds
Dividends
Debt repaid
Change in cash
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 16
Mag Ltd
Mag Ltd is a publisher of magazines. The opening balance sheet showed:
'000
Property, plant and equipment 41,441
nventories 13,985
Accounts receivable 25,952
Cash and deposits 3,515
_________
TotaI assets 84,893
_________
Accounts payable 24,128
Tax payable 890
Debt 21,836
Ordinary shares 5,082
Share premium 14,569
Retained earnings 18,388
_________
LiabiIities & sharehoIders' equity 84,893
_________
The following took place during the year:
1. Made sales on credit of 118,113,000. Received 121,665,000 from customers in respect of
sales on credit.
2. Purchased on credit paper and printing materials costing 73,097,000. Used paper and
printing materials costing 75,064,000. Paid 75,043,000 to suppliers in respect of paper and
printing materials purchased on credit.
3. ncurred 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. ncurred and paid interest of 1,529,000.
7. Paid corporation tax of 866,000 in full settlement of the prior year amount. Estimated
corporation tax for the current year at 196,000.
8. Paid a dividend of 981,000.
Accounting & analysis exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 17
9. Purchased and paid for a magazine title from a small independent publishing company for
2,000,000. The useful life of the title is regarded as indefinite and consequently no
amortisation is charged. The title will be reviewed annually for impairment and written down
as necessary.
Requirements
a. Prepare a balance sheet at the end of the year. [A proforma is provided on the following
page]
b. Prepare an income statement and cash flow statement for the year.
c. Prepare a brief commentary on cash flow generation and utilisation in the year.
d. Comment briefly on the effect on profit (earnings) and cash flow if the magazine title were to
be amortised over 20 years.
Accounting, analysis & valuation exercises
18 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
BaIance sheet
start 1 2 3 4 5 6 7 8 9 end
000 000 000 000 000 000 000 000 000 000 000
PPE 41,441
nventories 13,985
A/cs
receivable
25,952
Cash 3,515
TotaI
assets
84,893
A/cs
payable
24,128
Tax payable 890
Debt 21,836
Ord share
cap
5,082
Share
premium
14,569
Retained
earnings
18,388
LiabiIities &
equity
84,893
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 19
Ourstair Ltd
Ourstair Ltd is a leisure travel operator. The opening balance sheet showed:
m
Property, plant and equipment 519.9
nventories 6.4
Cash and deposits 549.2
_______
TotaI assets 1,075.5
_______
Accounts payable and operating accruals 621.4
Tax payable 16.1
Revenue received in advance 199.4
Debt 92.7
Ordinary share capital 20.0
Share premium 32.2
Retained earnings 93.7
_______
LiabiIities & sharehoIders' equity 1,075.5
_______
The following took place during the year:
1. Received 2,717.6m from customers in respect of holidays to be taken in the future. Earned
2,671.3m in respect of holidays taken by customers.
2. Purchased on credit inventories and consumables costing 96.0m. Used consumables
costing 85.4m. Paid 90.5m to suppliers in respect of inventories and consumables
purchased on credit.
3. ncurred 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. ncurred and paid
for further operating expenses of 252.6m (to be classified as administrative expenses).
4. ssued shares for 83.1m (nominal value 27.5m) and raised debt of 5.5m.
5. Purchased and paid for property, plant and equipment costing 110.1m. Charged
depreciation of 37.0m (to be classified as other operating expenses).
6. Earned and received interest of 17.1m.
7. Paid corporation tax for prior year of 16.1m. Estimated corporation tax for the current year
at 23.1m.
8. Paid dividends of 31.8m.
Accounting, analysis & valuation exercises
20 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Requirements
a. Prepare a balance sheet at the end of the year (using the following proforma).
b. Prepare an income statement and cash flow statement for the year.
c. Prepare a brief commentary on cash flow generation and utilisation in the year.
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 21
start 1 2 3 4 5 6 7 8 end
m m m m m m m m m m
PPE 519.9
nventories 6.4
Cash 549.2
TotaI assets 1,075.5
A/cs payable
& accruals
621.4
Tax payable 16.1
Revenue in
advance
199.4
Debt 92.7
Ord share
cap
20.0
Share
premium
32.2
Retained
earnings
93.7
LiabiIities &
equity
1,075.5
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 23
FIash Tuna AG
Flash Tuna AG operates international and domestic scheduled and charter air services. The
opening balance sheet showed:
C million
Property, plant and equipment - owned 6,944
Property, plant and equipment - leased 2,111
nventories 75
Accounts receivable 1,432
Cash and deposits 738
_________
TotaI assets 11,300
_________
Accounts payable 2,710
Tax payable 65
Debt 5,174
Provisions 30
Ordinary shares 260
Share premium 650
Retained earnings 2,411
_________
LiabiIities & sharehoIders' equity 11,300
_________
The following took place during the year:
1. Made sales on credit of C 8,915m. Received C 9,011m from customers in respect of sales
made on credit.
2. ncurred on credit fuel costs, landing fees, handling charges and administrative expenses of C
4,967m (to be classified as cost of sales). Paid C 4,859m to suppliers in respect of fuel costs,
landing fees, handling charges and administrative expenses incurred on credit.
3. Purchased and paid for raw materials and consumables costing C 390m. Used raw materials
and consumables costing C 381m.
4. ncurred and paid employment costs of C 2,356m (C 2,179m to be classified as cost of sales
and the balance as administrative expenses).
5. ncurred and paid operating lease rentals of C 150m (to be classified as cost of sales).
6. Purchased and paid for property, plant and equipment costing C 223m. Charged depreciation
of C 352m on owned assets (to be classified as cost of sales). Wrote owned assets down by
a further C 50m for impairment.
Accounting, analysis & valuation exercises
24 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
7. Entered into new finance leases. At inception, the present value of the minimum lease
payments was C 1,619m. Charged depreciation of C 217m on leased assets (to be classified
as cost of sales). Charged interest of C 290m. Paid C 641m to the lessor.
8. Repaid debt of C 127m and raised new debt of C 237m.
9. ncurred and paid interest of C 80m. Capitalised C 13m of this interest into property under
construction.
10. Reduced provision for unredeemed frequent flyer liabilities by C 4m.
11. Paid corporation tax for prior year of C 65m. Estimated corporation tax for the current year at
C 25m.
12. Paid a dividend of C 191m.
Requirements
a. Prepare a balance sheet at the end of the year. [A proforma is provided on the following
page]
b. Prepare an income statement for the year.
c. Prepare a cash flow statement for the year, using the indirect method of deriving net cash
inflow from operating activities. (Start by adjusting/reconciling operating profit to net cash
inflow from operating activities.)
d. Prepare a brief commentary on cash flow generation and utilisation in the year and what this
may suggest about the future prospects for Flash Tuna AG.
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 25
BaIance sheet
start 1 2 3 4 5 6 7 8 9 10 11 12 end
Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm
PPE - owned 6,944
PPE - Ieased 2,111
Inventories 75
Accounts receivabIe 1,432
Cash 738
TotaI assets 11,300
Accounts payabIe 2,710
Tax payabIe 65
Debt 5,174
Provisions 30
Ordinary shares 260
Share premium 650
Retained earnings 2,411
LiabiIities & equity 11,300
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 27
Theramax Ltd
Theramax Ltd discovers, develops and sells prescription drugs, vaccines and health care
products. The opening balance sheet showed:
m
Tangible fixed assets 3,635
Stocks - raw materials 283
Stocks - finished goods 572
Operating debtors 1,555
nvestments - liquid funds 1,408
Cash 254
_______
TotaI assets 7,707
_______
Operating creditors and accruals 932
Tax payable 820
Debt 3,145
Provision for compensation 121
Ordinary shares 894
Share premium 805
Retained earnings 990
_______
LiabiIities & sharehoIders' equity 7,707
_______
The following took place during the year:
1. Purchased on credit raw materials costing 2,017m. Used raw materials costing 1,839m in
the manufacture of products in the period. Paid 1,993m to suppliers in respect of raw
materials purchased on credit.
2. ncurred 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. ncurred 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. ssued shares for net cash proceeds of 356m (par value 12m).
Accounting, analysis & valuation exercises
28 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
7. Repaid debt of 58m. Raised new debt of 117m.
8. ncurred and paid interest of 152m. Earned and received interest of 61m. Purchased
liquid investments costing 209m.
9. ncreased provision for compensation by 20m (to be classified as selling, general and
administration).
10. Paid corporation tax of 1,007m (808m in respect of the prior year and 199m on account of
the current year). Estimated that additional tax payable for the current year would amount to
416m.
11. Paid dividends of 355m.
Requirements
a. Prepare a balance sheet at the end of the year.
b. Prepare an income statement and cash flow statement for the year.
c. Prepare a brief commentary on cash flow generation and utilisation in the year.
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 29
Theramax Ltd
start 1 2 3 4 5 6 7 8 9 10 11 end
m m m m m m m m m m m m m
Tangible fixed assets 3,635
Stocks - RMs 283
Stocks - FGs 572
Operating debtors 1,555
nvestments - liquid
funds
1,408
Cash 254
7,707
Operating creditors 932
Tax payable 820
Debt 3,145
Provision for
compensation
121
Ordinary shares 894
Share premium 805
Retained earnings 990
7,707
Accounting, analysis & valuation exercises
30 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Monty, Tiger & Seve
Monty pIc $m $m
Current Previous
BaIance sheet
Fixed assets 350 350
Non cash current assets 130 130
Cash 40 27
Current liabilities (63) (62)
Debt (290) (290)
_______ ______
167 155
_______ ______
Share capital 20 20
Retained earnings 147 135
_______ ______
167 155
_______ ______
Profit & Ioss account
$m
Current
Turnover 500
Cost of sales (320)
______
Gross profit 180
Depreciation (70)
Other operating costs (30)
nterest payable (29)
______
Profit before tax 51
Tax (19)
______
Profit after tax 32
Dividend (20)
______
Retained profit for the year 12
______
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 31
Tiger pIc $m $m
Current Previous
BaIance sheet
Fixed assets 450 250
Non cash current assets 250 50
Cash 23 25
Current liabilities (98) (33)
Debt (555) (245)
_______ ______
70 47
_______ ______
Share capital 20 20
Retained earnings 50 27
_______ ______
70 47
_______ ______
Profit & Ioss account
$m
Current
Turnover 500
Cost of sales (320)
______
Gross profit 180
Depreciation (70)
Other operating costs (30)
nterest payable (40)
______
Profit before tax 40
Tax (17)
______
Profit after tax 23
Dividend -
______
Retained profit for the year 23
______
Accounting, analysis & valuation exercises
32 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Seve pIc $m $m
Current Previous
BaIance sheet
Fixed assets 300 400
Non cash current assets 62 187
Cash 49 13
Current liabilities (32) (100)
Debt (175) (300)
_______ ______
204 200
_______ ______
Share capital 20 20
Retained earnings 184 180
_______ ______
204 200
_______ ______
Profit & Ioss account
$m
Current
Turnover 450
Cost of sales (320)
______
Gross profit 130
Depreciation (70)
Other operating costs (30)
nterest payable (24)
______
Profit before tax 6
Tax (2)
______
Profit after tax 4
Dividend -
______
Retained profit for the year 4
______
Requirement
Produce a cash flow statement for the current year, identifying free cash flow for each company.
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 33
EaseI
Easel plc enters into a 4 year lease to acquire the use of an asset. Annual instalments are
228,000 (payable in arrears). The interest rate implicit in the lease is 11%. The present value
of the minimum lease payments is approximately 700,000.
At the end of the first year of the lease, the financial statements would show:
Finance Iease
Balance sheet P&L account Cash flow statement
000 000 000
Tangible fixed
assets
Operating
expenses
(depreciation)
Servicing of finance
Creditors nterest payable Financing
Operating Iease
Balance sheet P&L account Cash flow statement
000 000 000
Operating
expenses
Operating cash flow
Accounting, analysis & valuation exercises
34 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
EnteachabIes Inc
Your client, Cash Driver plc, is looking into the acquisition of Enteachables nc, a US company
which publishes insurance and legal journals on subscription.
Enteachables nc has the following balance sheet as at the proposed date of acquisition:
Balance sheet as at take-over date
Assets
$000 $000
Current assets
Cash 1,343.0
Receivables 5,342.6
nventories 12.9
______
6,698.5
nvestments & other assets
nvestments 18.0
ntangibles 2,324.6
______
2,342.6
Property, plant & equipment
Tangibles at book value
617.1
_______
9,658.2
_______
LiabiIities & sharehoIders equity
Current Liabilities
Trade payables 3,436.8
Accruals & deferred income 1,269.6
Tax 548.1
______
5,254.5
Debt 1,271.4
Shareholders' equity
Preference stock 1,838.3
Common stock 266.6
Retained earnings 1,027.4
______
3,132.3
________
9,658.2
________
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 35
Based upon prior year figures, and knowledge of Enteachables nc'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)
_____________
EBTDA 2,202.8
Depreciation ( 268.8)
Amortisation ( 128.6)
Loss on disposal of PPE ( 10.1)
___________
Operating income / EBT 1,795.3
nterest receivable 165.5
nterest payable (197.9)
___________
ncome before taxes 1,762.9
Taxation (598.1)
___________
Net income for the year 1,164.8
Preferred stock dividends (221.2)
___________
Earnings on common stock 943.6
___________
Accounting, analysis & valuation exercises
36 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Forecast cash flows for the 12 months following take-over
$000 $000
EBT 1,795.3
Loss on disposal of PPE 10.1
_________
Underlying EBT 1,805.4
Depreciation 268.8
Amortisation 128.6
_________
EBTDA 2,202.8
Decrease in inventories 1.2
ncrease in receivables (45.7)
ncrease in payables & operating accruals 911.9
_________
Operating cash fIow 3,070.2
nterest received 165.5
nterest paid (197.9)
Non-equity dividend paid (221.2)
_________
Financing fIows (253.6)
Tax paid (557.3)
Purchase of PPE (581.3)
Sale proceeds from disposal of PPE -
_________
Net capex (581.3)
Equity dividends paid (321.6)
_______
Decrease in net debt 1,356.4
Repayment of Ioans (251.4)
_______
ncrease in cash 1,105.0
_______
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 37
Requirement
Based on the above projections produce a balance sheet showing the position of Enteachables
nc at the end of the 12 months following the take-over using the following:
Balance sheet 12 months post acquisition
Current Forecast
$000 $000
Current assets
Cash 1,343.0
Receivables 5,342.6
nventories 12.9
_______ ____
6,698.5
nvestments & other assets
nvestments 18.0
ntangibles 2,324.6
_______ ____
2,342.6
Property, plant & equipment
Tangibles at book value 617.1
_______ ____
9,658.2
_______ ____
LiabiIities & sharehoIders equity
Current Liabilities
Trade payables 3,436.8
Accruals & deferred income 1,269.6
Tax 548.1
_______ ____
5,254.5
Debt 1,271.4
Shareholders' equity
Preference stock 1,838.3
Common stock 266.6
Retained earnings 1,027.4
_______ ____
3,132.3
_______ ____
9,658.2
_______ ____
Accounting, analysis & valuation exercises
38 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Requirement
Calculate the following ratios to test the reasonableness of the projections:
At takeover/12 months pre-takeover 12 months post take-over
Underlying EBT
margin
11.7%
EBTDA margin 14.1%
Capex/depn 1.4 x
nterest cover 3.4 x
Gearing 57.7%
ROCE 53.2%
Debtor days 141 days
Payables/accrual
days
136 days
Where: nterest cover =
dividend equity - non paid interest
received interest EBT

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 EBT capital employed
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 39
A BS Inc
A BS nc 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 nc.
Income statement
ActuaI Forecast
$m $m
Turnover 5,028 4,923
Cost of sales 2,153 2,278
_____ _____
Gross profit 2,875 2,645
Other operating costs 2,010 1,722
Depreciation 226 245
Amortisation 1 2
Exceptional loss disposal of brewery - 9
Exceptional loss impairment of brewery - 71
____ ____
Operating profit 638 596
Share of operating profit of associates 69 121
Net interest payable 59 117
____ ____
Profit before tax 648 600
Taxation 211 195
____ ____
Profit after tax 437 405
Minority interests 59 85
____ ____
Net income 378 320
____ ____
Accounting, analysis & valuation exercises
40 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Cash fIow statement
ActuaI Forecast
$m $m
Operating profit 638 596
Exceptional loss disposal of brewery - 9
Exceptional loss impairment of brewery - 71
Depreciation & amortisation 227 247
____ ____
EBITDA 865 923
Other non-cash items 42 17
ncrease in inventories (33) (10)
ncrease in accounts receivable (11) (107)
ncrease in accounts payable 58 65
____ ____
Operating cash fIow 921 888
Dividends from associates 19 16
Dividends paid to minority interests (37) (57)
nterest paid (93) (144)
nterest received 56 66
Tax (160) (166)
____ ____
Free cash fIow pre capex 706 603
Purchase of PPE (414) (588)
Proceeds from sale of PPE 40 43
Purchase of other long term investments (21) -
____ ____
Free cash fIow pre acquisitive capex 311 58
Purchase of subsidiary (172) (206)
Purchase of associates (79) (67)
____ ____
Free cash fIow post aII capex 60 (215)
Dividends - -
Share issue 1 265
Loans 56 (9)
Short-term deposits (152) (419)
____ ____
Cash fIow (35) (378)
____ ____
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 41
BaIance sheet
ActuaI Forecast
$m $m
Current assets
nventories 386
Accounts receivable 620
nvestments 187
Cash 415
____ ____
1,608
Fixed assets
ntangible assets 1
PPE 1,810
nvestments 53
nvestments in associates 340
____ ____
2,204
____ ____
TotaI assets 3,812
____ ____
Current liabilities
Accounts payable 639
Tax 135
Other liabilities 259
____ ____
1,033
Debt 1,090
Provisions
Deferred tax 41
Other 492
Minority interests 58
Capital & reserves
Share capital 2
Additional paid-in capital 40
Retained earnings 1,056
____ ____
TotaI IiabiIities & equity 3,812
____ ____
Accounting, analysis & valuation exercises
42 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Erkki, Nuutti and Mikko
Erkki
Erkki nc has a 31
st
December year end. On 1
st
January there were 300,000 ordinary shares in
issue. On 31
st
August, 100,000 new ordinary shares were issued to the market.
Earnings for the current year are $315,000. EPS, as reported in the prior year, was 90.0c.
Nuutti
Nuutti nc has a 31
st
December year end. On 1
st
January there were 300,000 ordinary shares in
issue. On 31
st
August, there was a bonus issue of 1 new ordinary share for every 3 shares held.
Earnings for the current year are $240,000. EPS, as reported in the prior year, was 76.0c.
Mikko
Mikko nc has a 31
st
December year end. On 1
st
January there were 300,000 ordinary shares in
issue. On 31
st
August, there was a rights issue of 1 new ordinary share for every 3 shares held at
$11 per share. mmediately prior to becoming ex-rights, the share price was $15. The rights
issue was fully taken up.
Earnings for the current year are $295,000. EPS, as reported in the prior year, was 86.6c.
Requirement
Calculate earnings per share for the current year. Restate EPS for the prior year, where
necessary, and calculate the % growth in EPS.
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 43
Primrose pIc
On 1 April 2004 Primrose plc had 4,000,000 10p ordinary shares in issue.
During the year ended 31 March 2005, the following transactions affected share capital:
1. On 1 August 2004 the company made a 1 for 4 rights issue. The offer price was 45p per
share and the fair value of 1 share immediately before exercise was 60p.
2. On 1 January 2005 the company issued 2 million ordinary shares at their full market price.
Extracts from the P&L account for the year ended 31 March 2005 are shown below:
2005 2004
'000 '000
Profit on ordinary activities before tax 2,705 2,480
Tax on profit on ordinary activities (812) (769)
________ ________
Profit on ordinary activities after tax 1,893 1,711
Dividends (300) (300)
________ ________
Retained earnings for the year 1,593 1,411
________ ________
Requirement
Calculate the earnings per share for the year ended 31 March 2005 and the comparative figure
for the year ended 31 March 2004.
(Assume that there were no changes to issued share capital during the year ended 31 March
2004).
Accounting, analysis & valuation exercises
44 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Birren pIc
Birren plc has 3,000,000 ordinary shares in issue. On 1 October 2003 the company issued
1,700,000 5% convertible unsecured loan stock. The terms of conversion for each 100
nominal value of loan stock are as follows:
31 March 2006 140 ordinary shares
31 March 2007 130 ordinary shares
31 March 2008 120 ordinary shares
31 March 2009 110 ordinary shares
Extracts from the P&L account of Birren plc for the 2 years ended 31 March 2005 are shown
below.
2005 2004
'000 '000
Profit on ordinary activities before taxation 1,500 1,300
Tax on profit on ordinary activities (500) (400)
_______ _______
Profit on ordinary activities after taxation 1,000 900
Dividends (300) (200)
_______ _______
Retained profit for the year 700 700
_______ _______
Assume corporation tax at 30%.
Requirement
Calculate the earnings per share figures that would appear in the financial statements of Birren
plc for the years ended 31 March 2004 and 31 March 2005.
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 45
OnyaIi pIc
Onyali nternational plc is listed on the Stock Exchanges of several countries and prepares its
financial statements in accordance with nternational Accounting Standards (ASs).
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 nternational plc shares during the year was:
(i) 2.08;
(ii) 3.08.
Accounting, analysis & valuation exercises
46 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Scrutinise DeaI
Scrutinise Deal had net income for the year of 233.1m and shareholders' funds at the year-end
of 6,150.9m.
Throughout the year the company had 1.87m share options outstanding, the cumulative proceeds
from their exercise being 13.9m over the next 9 years.
Additionally the company had in issue throughout the year 260m 6% Guaranteed Convertible
Bonds due in 2010 which, due to the fact that it was issued at a discount, was in the books at
246.1m. These bonds:
a. At the holder's option may be converted, up to and including 22
nd
March 2010, into 2 %
Exchangeable Redeemable Preference Shares in Scrutinise Deal which are exchangeable for
up to a maximum of 34,031,414 ordinary shares of 1 in Scrutinise Deal at 764p per share or
b. At the option of the issuer may be redeemed on or after 14
th
April 2007 at par; earlier
redemption can only take place if at least 85% of the bonds have been converted into
ordinary shares or have been purchased or redeemed and then cancelled.
Scrutinise Deal had 522.4m ordinary shares of 1 in issue at the start of the year and 523.6m in
issue by the end of the year - the increase being due to a small placing of shares in the year.
The corporate tax rate is 30%.
The share price of Scrutinise Deal shares at the end of year was 878p whilst the average for the
year had been 1064p.
Requirement
Calculate both the basic and diluted
a. Earnings per share
b. Net assets per share
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 47
Pearson rights issue
Scenario
Pearson plc has a 31
st
December year end. On 1
st
January 2000 there were 613m shares in
issue. On 15
th
January 2000, 11m shares were issued under a placing. On 30
th
June 2000 3m
shares were issued under share option and employee share schemes.
Rights issue
On 28
th
July 2000 Pearson announced a 3 for 11 rights issue* at 10 per share. mmediately
prior to the announcement, the share price was 20.10. mmediately subsequent to the
announcement, the share price was 19.31.
[* in the US, this would be expressed as 14 for 11]
On 9
th
August 2000 the shares became ex-rights. mmediately prior to becoming ex-rights, the
share price was 18.57.
The shares were issued on 1
st
September 2000.
Earnings
Earnings for the year ended 31
st
December 2000 were 179m.
Prior year
Earnings for the year ended 31
st
December 1999 were 294m. The weighted average number of
shares was 615.4m.
Requirement
Calculate earnings per share for the year ended 31
st
December 2000. Assume the rights issue
was fully taken up.
Accounting, analysis & valuation exercises
48 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Discounted debt
Zero coupon
On 1
st
March 2004 a company issued a 100m zero-coupon bond for net proceeds of 65m. The
bond is redeemable on 28
th
February 2009 at par. The yield to maturity is 9%.
How would the above be represented in the financial statements for the year ended 28
th
February
2005?
28
th
February 2005
Balance sheet P&L account Cash flow statement
m m m
Servicing of finance
Debt nterest payable Financing
Deep discount
On 1
st
March 2001 a company issued a 125m 4% bond for net proceeds of 76.5m. nterest is
payable annually in arrears on 28
th
February each year. The bond is redeemable on 28
th
February 2011 at par. The yield to maturity is 10.43%.
How would the above be represented in the financial statements for the year ended 28
th
February
2005?
28
th
February 2005
Balance sheet P&L account Cash flow statement
m m m
Servicing of finance
Debt nterest payable
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 49
Index Iinked
On 1
st
September 2004 a company issued a 200m 4% bond for net proceeds of 200m.
nterest is payable semi-annually in arrears on 28
th
February and 28
th
August each year. The
bond is redeemable on 28
th
August 2020 at par value indexed for increases in the RP over the
life of the bond. The RP for the year to 28
th
February 2005 is 3%.
How would the above be represented in the financial statements for the year ended 28
th
February
2005?
28
th
February 2005
Balance sheet P&L account Cash flow statement
m m m
Servicing of finance
Debt nterest payable Financing
Index Iinked (coIIar)
On 1
st
September 2004 a company issued a 160m 3.322% bond for net proceeds of 160m.
nterest is payable semi-annually in arrears on 28
th
February and 28
th
August each year. The
bond is redeemable on 28
th
August 2026 at par value indexed for increases in the RP over the
life of the bond. The maximum indexation of the principal in any one year is 5%, with a minimum
of 0%. The RP for the year to 28
th
February 2005 is 3%.
How would the above be represented in the financial statements for the year ended 28
th
February
2005?
28
th
February 2005
Balance sheet P&L account Cash flow statement
m m m
Servicing of finance
Debt nterest payable Financing
Accounting, analysis & valuation exercises
50 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
ConvertibIe debt
On 1
st
October 2004 a company issued 300m unsecured 5.75% subordinated convertible
bonds, due 2009, at par. ssue costs amounted to 9.1m.
The bonds are convertible at the option of the bondholder at any time between 31
st
January 2005
and 30
th
September 2009 into fully paid ordinary shares of 10p each at an initial conversion price
of 443p per share. nterest is payable on the bonds at an annual rate of 5.75% per annum,
payable annually in arrears.
The company may redeem the bonds in whole, but not in part, only at their principal amount with
accrued interest:
at any time after 30
th
September 2007 provided that the average share price within the 30 day
period ending on the tenth day prior to the date on which notice of redemption is given to
bondholders shall have been at least 130% of the conversion price; or
at any time if, prior to the date of notice of such redemption, conversion rights shall have been
exercised in respect of 90% or more in principal amount of the bonds originally issued.
Unless previously purchased, redeemed or converted the bonds will be redeemed at their
principal amount on 30
th
September 2009, being the final maturity date.
Other information
The yield to maturity, building the net proceeds of 290.9m up to 300m over 3 years (when
issuer call option is first exercisable) is 6.9038%.
Requirement
Show how the above would be accounted for in the financial statements for the year ended 30
th
September 2005.
30
th
September 2005
Balance sheet P&L account Cash flow statement
m m m
Cash Operating
expenses
Servicing of finance
Debt nterest payable Financing
Equity
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 51
King, Wade & Graf
King Inc $m $m
Current Previous
BaIance sheet
ntangible fixed assets 180 190
Tangible fixed assets 269 240
nventories 40 38
Receivables 123 67
Cash 33 27
Current liabilities (78) (62)
Debt (300) (245)
_______ ______
267 255
_______ ______
Share capital 10 10
Additional paid in capital 57 57
Retained earnings 200 188
_______ ______
267 255
_______ ______
Profit & Ioss account
$m
Current
Turnover 503
Cost of sales (330)
______
Gross profit 173
Depreciation (70)
Amortisation (10)
Other operating costs (25)
Exceptional item - loss on asset disposals (3)
nterest payable (26)
______
Profit before tax 39
Tax (15)
______
Profit after tax 24
______
nterest of $15m was capitalised into tangible fixed assets during the period. Tangible fixed
assets with a net book value of $43m were disposed of during the period. Dividends of $12m
were paid in the period.
Accounting, analysis & valuation exercises
52 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Wade pIc $m $m
Current Previous
BaIance sheet
ntangible fixed assets 200 200
Fixed assets 397 260
nventories 43 38
Receivables 123 67
Cash 27 27
Current liabilities (63) (62)
Debt (135) (135)
_______ ______
592 395
_______ ______
Share capital 23 20
Share premium 116 67
P&L and revaluation reserves 453 308
_______ ______
592 395
_______ ______
Profit & Ioss account
$m
Current
Turnover 503
Cost of sales (330)
______
Gross profit 173
Depreciation (60)
Other operating costs (10)
Exceptional item -loss on asset disposals (5)
nterest payable (23)
______
Profit before tax 75
Tax (15)
______
Profit after tax 60
Dividends (15)
______
Profit retained for year 45
______
nterest of $15m was capitalised into tangible fixed assets and $3m was capitalised into
inventories during the period. Tangible fixed assets with a net book value of $45m were disposed
of during the period. Tangible fixed assets were revalued upwards by $100m during the period.
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 53
Graf AG $m $m
Current Previous
BaIance sheet
ntangible fixed assets 50 150
Tangible fixed assets 120 150
nventories 80 38
Receivables 70 67
Cash 5 27
Current liabilities (92) (62)
Debt (120) (120)
_______ ______
113 250
_______ ______
Share capital 20 20
Capital reserve 100 100
ncome statement (7) 130
_______ ______
113 250
_______ ______
Profit & Ioss account
$m
Current
Turnover 450
Cost of sales (290)
______
Gross profit 160
Depreciation (130)
Amortisation (100)
Other operating costs (39)
nterest payable (41)
______
Profit/(loss) before tax (150)
Extraordinary income - gain on asset disposals 13
Tax -
______
Profit/(loss) after tax (137)
______
No interest was capitalised during the period. Tangible fixed assets with a net book value of
$27m were disposed of during the period.
Requirement
a. Compare the operating profit and earnings of the 3 companies.
b. Produce a cash flow statement for the current year, identifying free cash flow for each.
Accounting, analysis & valuation exercises
54 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Deutsche TeIekom
EBITDA
Gesamtkostenverfahren
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 55
Requirement
Calculate EBT (or operating profit), EBTA and EBTDA for the most recent year. Accept the
company's classification of 'other operating income'.
Cm
Sales
Net operating costs, excl
depreciation
EBITDA
Depreciation
EBITA
Amortisation
EBIT
Accounting, analysis & valuation exercises
56 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Morientes & FriedeI
Morientes SA
Financial statements
BaIance sheet
end start
Goodwill 31,752 37,044
Property, plant & equipment 53,343 53,738
nventories 21,832 20,389
Accounts receivable 78,972 77,053
185,899 188,224
Current liabilities 66,083 62,580
Net debt 70,161 76,622
Paid in capital 18,171 18,171
Retained earnings 31,484 30,851
185,899 188,224
Income statement (extract)
EBT 31,923
nterest (6,586)
Tax (12,654)
Net income 12,683
Statement of changes in equity (extract)
Net income 12,683
Dividends (12,050)
Equity at start 49,022
Equity at end 49,655
Market capitalisation is 518,245.
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 57
Notes
1. No goodwill was acquired during the period.
2. No property, plant or equipment was disposed of during the period. The depreciation charge
for the year was 26,134.
3. Accounts receivable comprise operating receivables and prepayments.
4. Current liabilities comprise:
end start
Operating accounts payable 53,429 52,792
Current tax payable 12,654 9,788
66,083 62,580
5. Net debt comprises:
end start
Convertible debt 97,666 94,080
Cash (27,505) (17,458)
70,161 76,622
The convertible debt has a par value of 100,000 and pays a coupon of 3%. t is
redeemable at a premium of 10% or convertible into equity shares in 3 year's time.
6. nterest comprises interest on convertible debt (at an effective rate of 7%). nterest is not
capitalised.
7. No shares were issued during the period.
Requirements
Prepare a cash flow statement for the period.
Calculate
EBTDA
EV
,
nterest
EBT
and
EBTDA
debt Net
.
Accounting, analysis & valuation exercises
58 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
FriedeI Inc
Financial statements
BaIance sheet
end start
Goodwill 52,920 52,920
Property, plant & equipment 210,892 243,107
nventories 80,027 78,043
Accounts receivable 76,895 75,774
420,734 449,844
Current liabilities 86,262 97,992
Provisions 25,672 24,329
Net debt 207,425 253,708
Paid in capital 8,900 8,900
Retained earnings 92,475 64,915
420,734 449,844
Income statement (extract)
EBT 70,371
nterest (16,764)
Tax (13,997)
Net income 39,610
Statement of changes in equity (extract)
Net income 39,610
Dividends (12,050)
Equity at start 73,815
Equity at end 101,375
Market capitalisation is 518,245.
Notes
1. No goodwill was acquired during the period.
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 59
2. No property, plant or equipment was disposed of during the period. No new finance leases
were entered into during the period. Property, plant and equipment comprises:
end start
Owned assets 87,892 79,107
Assets held under finance leases 123,000 164,000
210,892 243,107
3. The depreciation charge on owned assets was 16,954 for the year.
4. Accounts receivable comprise operating receivables and prepayments.
5. Current liabilities comprise:
end start
Operating accounts payable 51,765 47,886
Unearned revenue 21,843 40,318
Current tax payable 12,654 9,788
86,262 97,992
6. Provisions comprise provision for deferred tax.
7. Net debt comprises:
end start
Convertible debt 103,720 101,816
Finance leases 131,210 169,350
Cash (27,505) (17,458)
207,425 253,708
The convertible debt has a par value of 100,000 and pays a coupon of 3%. t is
redeemable at a premium of 10% or convertible into equity shares in 3 year's time.
8. nterest comprises:
nterest on convertible debt 4,904
Finance charges on finance leases 11,860
16,764
nterest is not capitalised.
9. No shares were issued during the period.
Requirement
Prepare a cash flow statement for the period. Calculate
EBTDA
FV
,
nterest
EBT
and
EBTDA
debt Net
.
Accounting, analysis & valuation exercises
60 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Pensions
Siemens AG has a defined benefit pension scheme. t prepares its consolidated financial
statements in accordance with US GAAP. The net periodic pension cost for the period of C447m
has been charged to operating expenses during the year.
The market capitalisation of Siemens AG is C42,250m. ts consolidated financial statements
show:
Balance sheet (extracts) P&L account
Cm Cm
Cash and cash equivalents 11,196 EBTDA 6,058
D&A (4,126)
Debt 12,346 EBT 1,932
Accrual for pension plans 3,557 Net interest income/(expense) 318
Minority interests 541 Other financial income 1,225
Shareholders equity 23,521 EBT 3,475
Pension plan disclosures
Change in projected benefit obIigation Cm
Projected benefit obligation at beginning of year 18,544
Service cost 487
nterest cost 1,151
Actuarial losses/(gains) 240
Benefits paid (930)
_________
Projected benefit obligation at end of year 19,492
_________
Change in pIan assets Cm
Fair value of plan assets at beginning of year 14,625
Actual return on plan assets (1,187)
Contributions 2,023
Benefits paid (930)
_________
Fair value of plan assets at end of year 14,531
_________
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 61
Net periodic pension cost Cm
Service cost 487
nterest 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/EBTDA for Siemens AG:
using reported data (ignoring pensions disclosures);
adjusting for the real pension deficit and service cost.
Corporate tax
Assume a corporate tax rate of 39%.
Accounting, analysis & valuation exercises
62 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
PampIe & Mousse (1)
Pample acquires 50% of the shares of Mousse. The consideration given to the shareholders of
Mousse comprises shares in Pample with a fair value of C309m and cash of C91m. Acquisition
costs (investment banking fees etc) are C8m. Share issue costs are C1m. Both companies have
the same year-end. The balance sheet of Mousse reflects fair values.
Goodwill is not to be amortised. No impairment write down is anticipated in the year following the
transaction.
Assume interest at 5% and corporation tax at 40%.
Stand aIone baIance sheets immediateIy prior to transaction (Cm)
Pample Mousse
Net operating assets 1,298 984
____ ____
1,298 984
____ ____
Net debt 450 568
Shares 121 56
Retained earnings 727 360
____ ____
1,298 984
____ ____
Forecast resuIts for the year foIIowing the transaction (Cm)
Pample Mousse
Sales 1,163 994
Operating costs (959) (820)
____ ____
EBT 204 174
nterest (36) (62)
Tax (33) (30)
____ ____
Net income 135 82
____ ____
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 63
Requirements
1. Calculate goodwill arising on the transaction.
2. Prepare the combined balance sheet immediately after the transaction if Mousse is
consolidated as a subsidiary
proportionately consolidated as a joint venture
equity accounted as an associate
3. Prepare the combined income statement for the year following the transaction if Mousse is:
consolidated as a subsidiary
proportionately consolidated as a joint venture
equity accounted as an associate
Proformas are provided on the following pages.
Accounting, analysis & valuation exercises
64 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Combined balance sheet: Mousse consolidated as a subsidiary
PampIe Mousse
Net operating assets 1,298 984
____ ____
1,298 984
____ ____
Net debt 450 568
Shares 121 56
Retained earnings 727 360
____ ____
1,298 984
____ ____
Combined balance sheet: Mousse proportionately consolidated as a JV
PampIe Mousse
Net operating assets 1,298 984
____ ____
1,298 984
____ ____
Net debt 450 568
Shares 121 56
Retained earnings 727 360
____ ____
1,298 984
____ ____
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 65
Combined balance sheet: Mousse equity accounted as an associate
PampIe Mousse
Net operating assets 1,298 984
____ ____
1,298 984
____ ____
Net debt 450 568
Shares 121 56
Retained earnings 727 360
____ ____
1,298 984
____ ____
Combined income statement: Mousse consolidated as a subsidiary
PampIe Mousse
Sales 1,163 994
Operating costs (959) (820)
____ ____
EBT 204 174
nterest (36) (62)
Tax (33) (30)
____ ____
Net income 135 82
____ ____
Accounting, analysis & valuation exercises
66 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Combined income statement: Mousse proportionately consolidated as a JV
PampIe Mousse
Sales 1,163 994
Operating costs (959) (820)
____ ____
EBT 204 174
nterest (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)
____ ____
EBT 204 174
nterest (36) (62)
Tax (33) (30)
____ ____
Net income 135 82
____ ____
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 67
Mango & Steen
Mango plc is to acquire 100% of the shares of Steen plc. The consideration will comprise either:
2,700m in cash; or
3,100m of shares in Mango plc (comprising 1,525m shares with a fair value of 203p each);
or
2,250m of shares in Mango plc (comprising 1,107m shares with a fair value of 203p each)
and 750m in cash.
Both companies have the same year-end. The balance sheet of Steen reflects fair values.
Goodwill is not to be amortised but is to be reviewed annually for impairment.
Assume interest at 6% and corporation tax at 30%.
Balance sheets immediately prior to transaction (m)
Mango Steen
Net operating assets 1,000 3,267
Net funds/(debt) 115 (1,133)
_____ _____
1,115 2,134
_____ _____
Shares 172 984
Retained earnings 943 1,150
_____ _____
1,115 2,134
_____ _____
Forecast results for the year following the transaction (m)
Mango Steen
Sales 4,384 8,969
Operating costs, excl dep'n (4,017) (8,336)
____ ____
EBTDA 367 633
Depreciation (109) (190)
____ ____
EBT 258 443
nterest 14 (65)
Tax (97) (117)
____ ____
Net income 175 261
____ ____
Number of shares 1,720m
EPS 10.2p
Accounting, analysis & valuation exercises
68 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Requirement
1. Calculate goodwill arising on the transaction.
2. Prepare the combined balance sheet immediately after the transaction.
3. Prepare the combined income statement for the year following the transaction.
Proformas are provided on the following pages.
Other potential points
Expected reduction in revenues 150m
Expected operating cost savings 250m
Additional depreciation on Steen assets 80m
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 69
Combined balance sheet (immediately after acquisition)
Mango Steen ConsoIidated
Cash Shares Shares & cash
Net operating assets 1,000 3,267
Net funds/(debt) 115 (1,133)
____ ____ ____ ____ ____
1,115 2,134
____ ____ ____ ____ ____
Shares 172 984
Retained earnings 943 1,150
____ ____ ____ ____ ____
1,115 2,134
____ ____ ____ ____ ____
Accounting, analysis & valuation exercises
70 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
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)
____ ____ ____ ____ ____
EBTDA 367 633
Depreciation (109) (190)
____ ____ ____ ____ ____
EBT 258 443
nterest 14 (65)
Tax (97) (117)
____ ____ ____ ____ ____
Net income 175 261
____ ____ ____ ____ ____
Number of shares (m) 1,720m
EPS 10.2p
Accounting, analysis & valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com

Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
EXERCISES AND CASE STUDY SOLUTIONS
Coset pIc 1
Kissat Ltd 6
Potomac 10
Mag Ltd 17
Ourstair Ltd 21
FIash Tuna AG 25
Theramax Ltd 29
Monty, Tiger & Seve 34
EaseI 36
EnteachabIes Inc 37
A BS Inc 39
Erkki, Nuutti and Mikko 40
Primrose pIc 42
Birren pIc 43
OnyaIi pIc 44
Scrutinise DeaI 45
Pearson rights issue 46
Discounted debt 47
ConvertibIe debt 49
King, Wade & Graf 52
Deutsche TeIekom 60
Morientes & FriedeI 61
Pensions 65
PampIe & Mousse (1) 66
Mango & Steen 70
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 1
Coset pIc
start 1 2 3 4 5 6 7 8 end
m m m m m m m m m m
PPE 5,249 985-358 20 5,896
nventories 550 11,100-
11,066
584
A/cs
receivable
78 16,452 (16,397) 133
Cash 65 16,397-
10,954
(3,851)+
(384)
(985) 183+
131
(85) (255) (233) 29
TotaI assets 5,942 16,486 (10,954) (4,235) (358) 314 (65) (255) (233) 6,642
A/cs payable 826 11,100 (10,954) 972
Tax payable 255 (255)+
223
223
Debt 856 183 1,039
Ord share cap 109 1 110
Share
premium
1,431 130 1,561
Retained
earnings
2,465 16,452-
11,066
(3,851)+
(384)
(358) (65) (223) (233) 2,737
LiabiIities &
equity
5,942 16,486 (10,954) (4,235) (358) 314 (65) (255) (233) 6,642
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 2
CIosing baIance sheet m
Property, plant and equipment 5,896
nventories 584
Accounts receivable 133
Cash and deposits 29
____
Total assets 6,642
____
Accounts payable 972
Tax payable 223
Debt 1,039
Ordinary share capital 110
Share premium 1,561
Retained earnings 2,737
____
Liabilities & shareholders' equity 6,642
____
Income statement for the year m
Revenue 16,452
Cost of sales (11,066 + 3,851 + 300) (15,217)
_________
1,235
Administrative expenses (384 + 58) (442)
_______
Profit before interest and tax 793
nterest payable and similar charges (65)
_______
Profit before tax 728
Taxation (223)
_______
Profit after tax 505
_______
Retained earnings at start 2,465
Retained profit 505
Dividends (233)
Other reserve movements -
_______
Retained earnings at end (per balance sheet) 2,737
_______
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 3
Cash fIow statement for year - direct
m m
Receipts from customers 16,397
Payments to suppliers (10,954)
Operating costs (3,851)
Administrative expenses (384)
Operating cash flows 1,208
nterest (85)
Tax (255)
Capital expenditure (985)
_______
Free cash flow (117)
Dividends (233)
ssue of shares 131
ssue of debt 183
Financing cash flows 314
Decrease in cash and deposits in year (36)
Cash fIow statement for year - indirect (1)
m m
Operating profit 793
Depreciation 358
EBITDA 1,151
Increase in inventories (584 - 550) (34)
Increase in receivables (133 - 78) (55)
Increase in payables (972 - 826) 146
Operating cash flow 1,208
nterest (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)
ssue of shares (110 + 1,561) - (109 + 1,431) 131
ssue of debt (1,039 - 856) 183
Financing cash flows 314
Decrease in cash and deposits in year (36)
Here operating cash flow is before interest and tax. Capitalised interest is classified as interest.
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 4
Cash fIow statement for year - indirect (2)
m m
Net income 505
Depreciation 358
Increase in inventories (584 - 550) (34)
Increase in receivables (133 - 78) (55)
Increase in payables (972 - 826) 146
Decrease in tax payable (32)
Operating cash flow 888
Capital expenditure (5,896 [5,249 358]) (1,005)
_______
Levered free cash flow (117)
Dividends (177- [155 + 255]) (233)
ssue of shares (110 + 1,561) - (109 + 1,431) 131
ssue of debt (1,039 - 856) 183
Financing cash flows 314
Decrease in cash and deposits in year (36)
Here operating cash flow is after interest and tax. Capitalised interest is classified as capital
expenditure.
Commentary
Coset is an expanding business with capital expenditure significantly in excess of depreciation.
Despite this growth, cash convertibility of EBTDA is good (@ 105%) due to good, and improving,
working capital management. Working capital is (increasingly) negative as short-term finance
provided by suppliers exceeds the company's investment in inventories and receivables. This
indicates the strength of the company's relationship with its suppliers and the effectiveness of
Coset's management in controlling the working capital cycle through this expansive phase.
A cash interest cover of 14 times suggests the company has very low levels of gearing and risk
indicating that the company has an ineffective capital structure but with great flexibility for raising
future debt.
Operating cash flow is more than adequate to fund interest and tax commitments and
replacement capital expenditure highlighting the company's flexibility.
A significant dividend has been paid despite the negative free cash flow that indicates the age
and maturity of the company.
To finance growth capital expenditure and dividends, it has been necessary to raise some new
debt and equity finance during the year. This new finance has been used for the current years'
activities with no significant excess available for next year.
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 5
Cash fIows for vaIuation
Free cash flow to equity (levered free cash flow)
Method 1
Operating cash flow before interest and tax 1,208
nterest (85)
Tax (223 [255 + 223]) (255)
Capital expenditure (5,896 [5,249 + 20 358]) (985)
_______
Levered FCF/FCF to equity (117)
_______
Method 2
Operating cash flow after interest and tax 888
Capital expenditure (5,896 [5,249 358]) (1,005)
_______
Levered FCF/FCF to equity (117)
_______
Free cash flow to the enterprise or firm (unlevered free cash flow)
Operating cash flow before interest and tax 1,208
Adjusted tax (255 + [85 x 33%]) (283)
Capital expenditure (5,896 [5,249 + 20 358]) (985)
_______
Unlevered FCF/FCF to the enterprise (60)
_______
Assumption
Rate of corporation tax is 33%.
ReconciIiation
Unlevered FCF/FCF to the enterprise (60)
nterest, net of tax (85 x 67%) (57)
_______
Levered FCF/FCF to equity (117)
_______
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 6
Kissat Ltd
start 1 2 3 4 5 6 7 8 end
m m m m m m m m m m
PPE 590 399 989
nventories 4 1 5
A/cs
receivable
16 22 38
Cash 8 285 (55) (157) 375 (412) (18) (8) (14) 4
TotaI assets 618 307 (54) (157) 375 (13) (18) (8) (14) 1,036
A/cs payable 22 4 5 31
Tax payable 9 9 18
Debt 354 143 497
Ord share
cap
49 27 76
Share
premium
113 205 318
Retained
earnings
71 307 (58) (162) (13) (18) (17) (14) 96
LiabiIities &
equity
618 307 (54) (157) 375 (13) (18) (8) (14) 1,036
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 7
CIosing baIance sheet m
Property, plant and equipment 989
nventories 5
Accounts receivable 38
Cash and deposits 4
____
Total assets 1,036
____
Accounts payable and operating accruals 31
Tax payable 18
Long-term loan 497
Ordinary share capital 76
Share premium 318
Retained earnings 96
____
Liabilities & shareholders' equity 1,036
____
Income statement for the year m
Revenue 307
Cost of sales (58 + 162) (220)
_______
87
Administrative expenses (13)
_______
Profit before interest and tax 74
nterest payable and similar charges (18)
_______
Profit before tax 56
Taxation (18 1) (17)
_______
Profit after tax 39
_______
Retained earnings at start 71
Profit after tax 39
Dividends (14)
Other reserve movements -
_______
Retained earnings at end (per balance sheet) 96
_______
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 8
Cash fIow statement for year - direct method
m m
Receipts from customers 285
Payments to suppliers (55)
Operating expenses (157)
Operating cash flow 73
nterest (18)
Tax (8)
Capital expenditure (412)
_______
Free cash flow (365)
Dividends (14)
ssue of shares 232
ssue of debt 143
Financing cash flows 375
Decrease in cash and deposits in year (reconciliation done above) (4)
_____
Cash fIow statement for year - indirect method (1)
m m
Operating profit 74
Depreciation 13
EBITDA 87
Increase in inventories (1)
Increase in receivables (22)
Increase in payables and operating accruals 9
Operating cash flow 73
nterest (18)
Tax (8)
Capital expenditure (412)
_______
Free cash flow (365)
Dividends (14)
ssue of shares 232
ssue of debt 143
Financing cash flows __375
Decrease in cash and deposits in year (4)
Cash at start of year 8
_____
Cash at end of year 4
_____
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 9
Commentary
Cash convertibility of EBTDA is acceptable (@ 84%) with the growth in working capital reflecting
growth in the business. nterest, tax and replacement capital expenditure* absorb much of the
current operating cash flow and (significant) growth capital expenditure, together with a modest
dividend, must be funded by raising new finance (debt and equity).
[* Properties in the leisure sector are often not depreciated. Depreciation is likely to understate
maintenance or replacement capital expenditure.]
Cash fIow statement for year - indirect method (2)
m m
Net income 39
Depreciation 13
Increase in inventories (1)
Increase in receivables (22)
Increase in payables and operating accruals 9
Increase in tax payable 9
Operating cash flow 47
Capital expenditure (412)
_______
Free cash flow (365)
Dividends (14)
ssue of shares 232
ssue of debt 143
Financing cash flows __375
Decrease in cash and deposits in year (4)
Cash at start of year 8
_____
Cash at end of year 4
_____
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 10
Potomac
BaIance sheet
$m
Property, plant and equipment 1,616
nventories 3
Accounts receivable 58
Cash and deposits 3
_______
Total assets 1,680
_______
Accounts payable 28
Tax payable 26
Debt 577
Ordinary share capital 727
Share premium 76
Retained earnings 246
_______
Liabilities & shareholders' equity 1,680
_______
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 11
BaIance sheet
start 1 2 3 4 5 6 7 8 9 10 end
$m $m $m $m $m $m $m $m $m $m $m $m
PPE 1,665 - 40 + 13 - 25 + 3 1,616
nventories 2 + 1 3
A/cs receivable 50 + 8 58
Cash 4 - 97 + 1,250 - 835 - 82 - 75 - 38 + 21 - 20 - 41 - 84 3
TotaI assets 1,721 1,680
A/cs payable 17 + 3 + 8 28
Tax payable 41 - 15 26
Debt 621 - 44 577
Ord share cap 727 727
Share premium 76 76
Retained earnings 239 - 99 + 1,258 - 843 - 82 - 115 - 25 - 4 - 17 - 26 - 40 246
LiabiIities &
equity
1,721 1,680
Exercises and Case Study Solutions
12 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
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
nterest expense (17)
Profit before tax 73
Tax (26)
Net income 47
Statement of changes in equity
Retained earnings @ start of year 239
Net income 47
Dividend (40)
Retained earnings @ end of year 246
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 13
Cash fIow statement - direct
Receipts from customers 1,250
Operating expenses paid [97 + 835 + 82 + 25] (1,039)
Operating cash flow (1) 211
nterest paid (20)
Tax paid (41)
Operating cash flow (2) 150
Capital expenditure [75 + 13] (88)
Disposal 21
83
Dividends (40)
Debt repaid (44)
Change in cash (1)
Exercises and Case Study Solutions
14 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Cash fIow statement - indirect (1)
Operating profit, before exceptional items 94
Depreciation 115
EBTDA 209
ncrease in accounts receivable (8)
ncrease in inventories (1)
ncrease in accounts payable 11
Operating cash flow (1) 211
nterest paid (20)
Tax paid (41)
Operating cash flow (2) 150
Capital expenditure [75 + 13] (88)
Disposal proceeds 21
83
Dividends (40)
Debt repaid (44)
Change in cash (1)
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 15
Cash fIow statement - indirect (2)
Net income 47
Depreciation 115
Loss on disposal 4
ncrease in accounts receivable (8)
ncrease in inventories (1)
ncrease in accounts payable 11
Decrease in tax payable (15)
nterest capitalised (3)
Operating cash flow (2) 150
Capital expenditure [75 + 13] (88)
Disposal proceeds 21
83
Dividends (40)
Debt repaid (44)
Change in cash (1)
Ratio
EBTDA
debt Net
=
209
574
= 2.75
Exercises and Case Study Solutions
16 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
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 EBTDA is good (@ 100%) as the company appears to be maintaining its
existing level of working capital.
The company is generating sufficient cash from operations to easily cover its interest payments
(interest cover of 10.5 times) and its tax payments.
Future years' interest payments are likely to be reduced as the company has repaid significant
amounts of debt in the year, which reinforces the low gearing risk profile of the company. Should
the company have growth prospects in the future, its capital structure gives it sufficient flexibility
to raise debt as needed.
The company has used its free cash flow to:
Pay a large dividend to equity providers; and
Repay its debt.
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 17
Mag Ltd
Closing balance sheet
start 1 2 3 4 5 6 7 8 9 end
000 000 000 000 000 000 000 000 000 000 000
Magazine titles - 2,000 2,000
Plant 41,441 (3,557) 37,884
nventories 13,985 (1,967) 12,018
A/cs receivable 25,952 (3,552) 22,400
Cash 3,515 121,665 (75,043) (38,624) (2,833) (1,498) (1,529) (866) (981) (2,000) 1,806
TotaI assets 84,893 118,113 77,010 (38,624) (2,833) (5,055) (1,529) (866) (981) - 76,108
A/cs payable 24,128 (1,946) 22,182
Tax payable 890 (694) 196
Debt 21,836 (2,833) 19,003
Ord shares 5,082 5,082
Share premium 14,569 14,569
Retained
earnings
18,388 118,113 (75,064) (38,624) (5,055) (1,529) (172) (981) 15,076
LiabiIities &
equity
84,893 118,113 77,010 (38,624) (2,833) (5,055) (1,529) (866) (981) - 76,108
Exercises and Case Study Solutions
18 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Profit & Ioss account for the year
000
Revenue 118,113
Cost of sales (75,064 + 23,729 + 3,709) (102,502)
_________
15,611
Administrative expenses (14,895 + 1,346) (16,241)
________
Operating loss (630)
nterest payable & similar charges (1,529)
_______
Loss before tax (2,159)
Taxation (196 24) (172)
_______
Loss after tax (2,331)
_______
Retained earnings at start 18,388
Loss after tax (2,331)
Dividends (981)
Other reserve movements -
_______
Retained earnings at end (per balance sheet) 15,076
_______
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 19
Cash fIow statement for year (1)
000 000
Operating loss (630)
Depreciation 5,055
EBITDA 4,425
Decrease in inventories 1,967
Decrease in receivables 3,552
Decrease in payables (1,946)
Operating cash flow 7,998
nterest (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 EBTDA is high (@ 180%) as the company
appears to be reducing the scale of its operations, with a resultant release of working capital.
This has been achieved through a mixture of running down its inventories and having fewer
customer balances outstanding at the year end.
Consequently, the company appears to be cash generative, but in decline.
Despite operating losses, operating cash flow is more than adequate to fund interest and tax
commitments and capital expenditure.
Future years' interest payments are likely to be reduced as the company has repaid significant
amounts of debt in the year, which reinforces the low gearing risk profile of the company. Should
Exercises and Case Study Solutions
20 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
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 EBTDA or cash flow.
Cash fIow statement for year (2)
000 000
Net loss (2,331)
Depreciation 5,055
Decrease in inventories 1,967
Decrease in receivables 3,552
Decrease in payables (1,946)
Decrease in tax payable (694)
Operating cash flow 5,603
Capital expenditure - tangibles (1,498)
Capital expenditure - intangibles (2,000)
_______
Free cash flow 2,105
Dividends (981)
Financing cash flows debt repayment (2,833)
_______
Decrease in cash and deposits in year (1,709)
Cash at start of year 3,515
______
Cash at end of year 1,806
______
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 21
Ourstair Ltd
CIosing baIance sheet
start 1 2 3 4 5 6 7 8 end
m m m m m m m m m m
PPE 519.9 73.1 593.0
nventories 6.4 10.6 17.0
Cash 549.2 2,717.6 (90.5) (2,517.0) 88.6 (110.1) 17.1 (16.1) (31.8) 607.0
TotaI assets 1,075.5 2,717.6 (79.9) (2,517.0) 88.6 (37.0) 17.1 (16.1) (31.8) 1,217.0
A/cs payable
& accruals
621.4 5.5 0.9 627.8
Tax payable 16.1 7.0 23.1
Revenue in
advance
199.4 46.3 245.7
Debt 92.7 5.5 98.2
Ord share
cap
20.0 27.5 47.5
Share
premium
32.2 55.6 87.8
Retained
earnings
93.7 2,671.3 (85.4) (2,517.9) (37.0) 17.1 (23.1) (31.8) 86.9
LiabiIities &
equity
1,075.5 2,717.6 (79.9) (2,517.0) 88.6 (37.0) 17.1 (16.1) (31.8) 1,217.0
Exercises and Case Study Solutions
22 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Income statement for the year m
Revenue 2,671.3
Cost of sales (85.4 + 2,265.3) (2,350.7)
_______
320.6
Administrative expenses (252.6 + 37.0) (289.6)
_______
Earnings before interest & tax 31.0
nterest receivable & similar income 17.1
_______
Profit before tax 48.1
Taxation (23.1)
_______
Profit after tax 25.0
_______
Retained earnings at start 93.7
Profit after tax 25.0
Dividends (31.8)
Other reserve movements -
_______
Retained earnings at end (per balance sheet) 86.9
_______
Cash fIow statement for year - direct
m m
Receipts from customers 2,717.6
Payments to suppliers (90.5)
Operating expenses (2,517.0)
Operating cash flow 110.1
nterest 17.1
Tax (16.1)
Capital expenditure (110.1)
_______
Free cash flow 1.0
Dividends (31.8)
ssue of shares 83.1
ssue of debt 5.5
Financing cash flows 88.6
ncrease in cash and deposits in year 57.8
Cash at start of year 549.2
_____
Cash at end of year 607.0
_____
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 23
Cash fIow statement for year - indirect (1)
m m
Operating profit 31.0
Depreciation 37.0
EBITDA 68.0
Increase in inventories (10.6)
Increase in revenue received in advance 46.3
Increase in payables and operating accruals 6.4
Operating cash flow 110.1
nterest 17.1
Tax (16.1)
Capital expenditure (110.1)
_______
Free cash flow 1.0
Dividends (31.8)
ssue of shares 83.1
ssue of debt 5.5
Financing cash flows 88.6
_______
ncrease in cash and deposits in year 57.8
Cash at start of year 549.2
_____
Cash at end of year 607.0
_____
Commentary
Cash convertibility of EBTDA is good (@ 1.62x) with the growth in inventories being more than
absorbed by that of payables and revenues in advance. ndeed, the revenues in advance are a
significant source of finance for the company. Capital expenditure absorbs current operating
cash flow and tax is funded by interest income. Dividends are funded by raising new (mostly
equity) finance.
Exercises and Case Study Solutions
24 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Cash fIow statement for year - indirect (2)
m m
Net income 25.0
Depreciation 37.0
Increase in inventories (10.6)
Increase in revenue received in advance 46.3
Increase in payables and operating accruals 6.4
Increase in tax payable 7.0
Operating cash flow 111.1
Capital expenditure (110.1)
_______
Free cash flow 1.0
Dividends (31.8)
ssue of shares 83.1
ssue of debt 5.5
Financing cash flows 88.6
_______
ncrease in cash and deposits in year 57.8
Cash at start of year 549.2
_____
Cash at end of year 607.0
_____
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 25
FIash Tuna AG
CIosing baIance sheet
start 1 2 3 4 5 6 7 8 9 10 11 12 end
Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm Cm
PPE - owned 6,944 (179) 13 6,778
PPE - leased 2,111 1,402 3,513
nventories 75 9 84
Accounts
receivable
1,432 (96) 1,336
Cash 738 9,011 (4,859) (390) (2,356) (150) (223) (641) 110 (80) (65) (191) 904
Total assets 11,300 8,915 (4,859) (381) (2,356) (150) (402) 761 110 (67) - (65) (191) 12,615
Accounts
payable
2,710 108 2,818
Tax payable 65 (40) 25
Debt 5,174 1,268 110 6,552
Provisions 30 (4) 26
Ordinary shares 260 260
Share premium 650 650
Retained
earnings
2,411 8,915 (4,967) (381) (2,356) (150) (402) (507) (67) 4 (25) (191) 2,284
Liabilities &
equity
11,300 8,915 (4,859) (381) (2,356) (150) (402) 761 110 (67) - (65) (191) 12,615
Exercises and Case Study Solutions
26 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Profit & Ioss account for the year
Cm
Revenue 8,915
Cost of sales (4,967 + 381 + 2,179 + 150 + 402 + 217 - 4) (8,292)
_________
623
Administrative expenses (177)
________
Operating profit 446
nterest payable & similar charges (290 + 80 - 13) (357)
_______
Profit before tax 89
Taxation (25)
_______
Profit after tax 64
Dividends (191)
_______
Net loss (127)
Retained earnings at start 2,411
Other reserve movements -
_______
Retained earnings at end (per balance sheet) 2,284
_______
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 27
Cash fIow statement for year (1)
Cm
Operating profit 446
Depreciation and impairment write down 619
_______
EBITDA 1,065
Increase in inventories (9)
Decrease in receivables 96
Increase in payables 108
Decrease in provision (4)
_______
Operating cash flow 1,256
nterest (80)
nterest paid on finance leases (290)
Tax (65)
Capital expenditure (223)
_______
Free cash flow after capex 598
Dividends (191)
Financing cash flows net issue of debt 110
Financing cash flows - capital element of FL repaid (351)
______
ncrease in cash and deposits in year 166
Cash at start of year 738
______
Cash at end of year 904
______
Exercises and Case Study Solutions
28 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Commentary
Cash convertibility of EBTDA is good (@ 118%) - the company appears to be managing its
working capital well (increasing payables and reducing receivables).
Operating cash flow is more than adequate to fund interest and tax commitments and capital
expenditure on owned assets. Cash capital expenditure is significantly below depreciation.
However, at C 1,842m (223m + 1,619), total capital expenditure (including assets acquired under
finance leases) is almost three times depreciation, indicating net investment for growth.
The company has used its free cash flow after capex to make significant payments to capital
providers and add to cash balances.
However, any assessment of future flexibility must take into account the very significant leasing
commitments (both on and off balance sheet) and the resultant drain on future cash flows.
Cash fIow statement for year (2)
Cm
Net income 64
Depreciation and impairment write down 619
Increase in inventories (9)
Decrease in receivables 96
Increase in payables 108
Decrease in provision (4)
Decrease in tax payable (40)

_______
Operating cash flow 834
Capital expenditure (223 + 13) (236)

_______
Free cash flow after capex 598
Dividends (191)
Financing cash flows net issue of debt 110
Financing cash flows - capital element of FL repaid (351)
______
ncrease in cash and deposits in year 166
Cash at start of year 738
______
Cash at end of year 904
______
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 29
Theramax Ltd
start 1 2 3 4 5 6 7 8 9 10 11 end
m m m m m m m m m m m m m
TangibIe fixed assets 3,635 62 3,697
Stocks - raw materiaIs 283 178 461
Stocks - finished goods 572 1,839 610 90 (2,418) 693
Operating debtors 1,555 185 1,740
Investments - Iiquid funds 1,408 209 1,617
Cash 254 (1,993) (1,808) (420) 7,798 (2,370) 356 59 (300) (1,007) (355) 214
TotaI assets 7,707 24 (1,198) (268) 5,565 (2,370) 356 59 (91) (1,007) (355) 8,422
Operating creditors & accruaIs 932 24 15 971
Tax payabIe 820 (404) 416
Debt 3,145 59 3,204
Provision for compensation 121 20 141
Ordinary shares 894 12 906
Share premium 805 344 1,149
Retained earnings 990 (1,198) (268) 5,565 (2,385) (91) (20) (603) (355) 1,635
LiabiIities & sharehoIders'
equity
7,707 24 (1,198) (268) 5,565 (2,370) 356 59 (91) (1,007) (355) 8,422
Exercises and Case Study Solutions
30 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Profit & Ioss account for the year
m
Revenue 7,983
Cost of sales (2,418)
Selling, general and administrative (893 + 214 +1,581 + 20) (2,708)
Research and development (305 + 54 + 804) (1,163)
________
Operating profit 1,694
Net interest payable (152 - 61) (91)
_______
Profit on ordinary activities before tax 1,603
Taxation (615 - 12 (over prov'n previous year)) (603)
_______
Profit after tax 1,000
_______
Retained earnings at start 990
Profit after tax 1,000
Dividends (355)
_______
Retained earnings at end (per balance sheet) 1,635
____
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 31
Cash flow statement for year - direct
m m
Receipts from customers 7,798
Payments to suppliers (1,993)
Payments to and on behalf of employees (1,808)
Other cash payments (2,370)
Operating cash flows 1,627
nterest paid (152)
nterest received 61
Tax (1,007)
_______
Free cash flow before capex 529
Capital expenditure (420)
_______
Free cash flow after capex 109
Dividends (355)
Financing cash flows - debt repaid (58)
Financing cash flows - debt raised 117
Financing cash flows - shares issued 356
Management of liquid resources (209)
_______
Decrease in cash and deposits in year (40)
Cash at start of year 254
______
Cash at end of year 214
______
Exercises and Case Study Solutions
32 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Cash flow statement for year - indirect (1)
m m
Operating profit 1,694
Depreciation 358
____
EBITDA 2,052
Increase in stocks - raw materials (178)
Increase in stocks - finished goods (121)
Increase in operating debtors (185)
Increase in creditors 39
Increase in provision 20
Operating cash flow 1,627
nterest paid (152)
nterest received 61
Tax (1,007)
_______
Free cash flow before capex 529
Capital expenditure (420)
_______
Free cash flow after capex 109
Dividends (355)
Financing cash flows - debt repaid (58)
Financing cash flows - debt raised 117
Financing cash flows - shares issued 356
Management of liquid resources (209)
_______
Decrease in cash and deposits in year (40)
Cash at start of year 254
______
Cash at end of year 214
______
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 33
Cash flow statement for year - indirect (2)
m m
Net income 1,000
Depreciation 358
Increase in stocks - raw materials (178)
Increase in stocks - finished goods (121)
Increase in operating debtors (185)
Increase in creditors 39
Increase in provision 20
Decrease in tax payable (404)
Operating cash flow 529
Capital expenditure (420)
_______
Free cash flow after capex 109
Dividends (355)
Financing cash flows - debt repaid (58)
Financing cash flows - debt raised 117
Financing cash flows - shares issued 356
Management of liquid resources (209)
_______
Decrease in cash and deposits in year (40)
Cash at start of year 254
______
Cash at end of year 214
______
Exercises and Case Study Solutions
34 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Monty, Tiger & Seve
Monty pIc
1 2 3
$m $m $m
Operating profit 80 80 80
Depreciation 70 70
___ ___
EBITDA 150 150
Movement in non-cash working capital 1 1
___ ___
Net cash infIow from operating activities 151 151
nterest paid (29)
Tax paid (19) (28) (28)
CapitaI expenditure
Net (investment)/disinvestment (70) (70) 1
___ ___ ___
Free cash fIow 33 53 53
Financing
[nterest paid (20)]
Net borrowing/(repayment) - -
Dividend paid (20) (20)
___ ___
Increase in cash 13 13
___ ___
Tiger pIc
1 2 3
$m $m $m
Operating profit 80 80 80
Depreciation 70 70
___ ___
EBITDA 150 150
Movement in non-cash working capital (135) (135)
___ ___
Net cash infIow from operating activities 15 15
nterest paid (40)
Tax paid (17) (29) (29)
CapitaI expenditure
Net (investment)/disinvestment (270) (270) (335)
___ ___ ___
Free cash fIow (312) (284) (284)
Financing
[nterest paid (20)]
Net borrowing/(repayment) 310 310
Dividend paid - -
___ ___
Decrease in cash (2) (2)
___ ___
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 35
Seve pIc
1 2 3
$m $m $m
Operating profit 30 30 30
Depreciation 70 70
___ ___
EBITDA 100 100
Movement in non-cash working capital 57 57
___ ___
Net cash infIow from operating activities 157 157
nterest paid (24)
Tax paid (2) (9) (9)
CapitaI expenditure
Net (investment)/disinvestment 30 30 157
___ ___ ___
Free cash fIow 161 178 178
Financing
[nterest paid (17)]
Net borrowing/(repayment) (125) (125)
Dividend paid - -
___ ___
Increase in cash 36 36
___ ___
Summary
Earnings Free cash fIow
Monty plc $32m $33m
Tiger plc $23m $(312)m
Seve plc $4m $161m
Assumption
Rate of corporation tax is 33%.
Exercises and Case Study Solutions
36 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
EaseI
At the end of the first year of the lease, the financial statements would show:
Finance Iease
Balance sheet P&L account Cash flow statement
000 000 000
Tangible fixed
assets
525 Operating
expenses
(depreciation)
(175)
Servicing of finance (80)
Creditors 552 nterest payable (80) Financing (148)
Operating Iease
Balance sheet P&L account Cash flow statement
000 000 000
Operating
expenses (228)
Operating cash flow
(228)
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 37
EnteachabIes Inc
BaIance sheet as at 12 months foIIowing take-over
Assets
$000 $000
Current assets
Cash (1,343.0 +1,105.0) 2,448.0
Receivables (5,342.6 + 45.7) 5,388.3
nventories (12.9 1.2) 11.7
______
7,848.0
nvestments & other assets
nvestments 18.0
ntangibles (2,324.6 128.6) 2,196.0
______
2,214.0
Property, plant & equipment
Tangibles at book value (617.1 268.8 10.1 + 581.3) 919.5
_______
10,981.5
_______
LiabiIities & sharehoIders equity
Current liabilities
Trade payables & accruals
(3,436.8 + 1,269.6 + 911.9) 5,618.3
Tax (548.1 + 598.1 557.3) 588.9
______
6,207.2
Debt (1,271.4 251.4) 1,020.0
Shareholders' equity
Preference stock 1,838.3
Common stock 266.6
Retained earnings (1,027.4 + 943.6 321.6) 1,649.4
______
3,754.3
________
10,981.5
________
Exercises and Case Study Solutions
38 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Ratio caIcuIations
At takeover/12 months pre-takeover 12 months post take-over
EBT margin 11.7%
14,850.7
10.1 1,795.3
= 12.2%
EBTDA
margin
14.1%
14,850.7
2,202.8
= 14.8%
Capex/depn 1.4 x
268.8
581.3
= 2.2x
nterest cover 3.4 x
221.2 197.9
165.5 1,795.3

= 4.7x
Gearing 57.7%
2,326.3 1,649.4 266.6 410.3
410.3 2,448.0 - 1,838.3 1,020.0


=
17.6%
ROCE 53.2%
2,326.3
10.1 1,795.3
= 77.6%
Debtor days 141 days
65 14,850.7/3
5,388.3
= 132 days
Payables
/accrual days
136 days
65 12,647.9/3
5,618.3
= 162 days
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 39
A BS Inc
BaIance sheet
ActuaI P&L Cash Forecast
$m $m
Current assets
nventories 386 10 396
Accounts receivable 620 107 727
nvestments 187 419 606
Cash 415 (378) 37
1,608 1,766
Fixed assets
ntangible assets 1 (2) 206 205
PPE 1,810 (245) (9) (71) 588 (43) 2,030
nvestments 53 - 53
nvestments in associates 340 121 (16) 67 512
2,204 2,800
TotaI assets 3,812 4,566
Current liabilities
Accounts payable 639 65 704
Tax 135 195 (166) 164
Other liabilities 259 117 (144) 66 298
1,033 1,166
Debt 1,090 (9) 1,081
Provisions
Deferred tax 41 41
Other 492 17 509
Minority interests 58 85 (57) 86
Capital & reserves
Share capital 2
Additional paid-in capital 40
265 307
Retained earnings 1,056 320 1,376
TotaI IiabiIities & equity 3,812 4,566
Exercises and Case Study Solutions
40 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Erkki, Nuutti and Mikko
Erkki
Erkki nc has a 31
st
December year end. On 1
st
January there were 300,000 ordinary shares in
issue. On 31
st
August, 100,000 new ordinary shares were issued to the market.
Earnings for the current year are $315,000. EPS, as reported in the prior year, was 90.0c.
Current year EPS =
333 , 333
000 , 315 $
= 94.5c Prior year EPS = 90.0c (5% growth).
No of shares:
1 Jan 31 Aug 300,000 x 8/12 200,000
1 Sep 31 Dec 400,000 x 4/12 133,333
333,333
Nuutti
Nuutti nc has a 31
st
December year end. On 1
st
January there were 300,000 ordinary shares in
issue. On 31
st
August, there was a bonus issue of 1 new ordinary share for every 3 shares held.
Earnings for the current year are $240,000. EPS, as reported in the prior year, was 76.0c.
Current year EPS =
000 , 400
000 , 240 $
= 60.0c Prior year EPS = 76.0c x
4
3
= 57.0c (growth 5.3%).
No of shares:
1 Jan 31 Aug 300,000 x 8/12 x 4/3 266,667
1 Sep 31 Dec 400,000 x 4/12 133,333
400,000
Mikko
Mikko nc has a 31
st
December year end. On 1
st
January there were 300,000 ordinary shares in
issue. On 31
st
August, there was a rights issue of 1 new ordinary share for every 3 shares held at
$11 per share. mmediately prior to becoming ex-rights, the share price was $15.
Earnings for the current year are $295,000. EPS, as reported in the prior year, was 86.6c.
Current year EPS =
619 , 347
000 , 295 $
= 84.9c Prior year EPS = 86.6c x
15
14
= 80.8c (growth 5.0%)
No of shares:
1 Jan 31 Aug 300,000 x 8/12 x 15/14 214,286
1 Sep 31 Dec 400,000 x 4/12 133,333
347,619
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 41
Mikko
Working
Bonus eIement of rights issue
3 x $15 $45
1 x $11 $11
4 $56
Theoretical ex rights price =
4
56 $
= $14
Adjustment =
14 $
15 $
Alternative answer
No of shares:
1 Jan 31 Aug 300,000 x 8/12 x
400,000
/
373,333
214,286
1 Sep 31 Dec 400,000 x 4/12 133,333
347,619
Treasury stock method
Proceeds of $1,100,000 would buy 73,333 shares @ $15 (full market price)
Subscribers to rights issue get 100,000 for $1,100,000
'Free' shares 26,667
To get free shares need to hold 373,333 shares [300,000 + 73,333]
After rights issue 400,000 shares in issue
Exercises and Case Study Solutions
42 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Primrose pIc
2005 2004
Earnings per share 36.1p 40.6p
Workings
Number of shares in issue
Date No of shares Weighted average
1 April 4,000,000 4/12 60/57 1,403,509
1 August 5,000,000 5/12 2,083,333
1 January 7,000,000 3/12 1,750,000
_____________
5,236,842
_____________
Number of shares in issue last year = 4,000,000 60/57 = 4,210,526
Theoretical ex rights price
4 shares at 60p cost 2.40
1 share at 45p cost 0.45
________
2.85
________
Theoretical ex rights price = 2.85/5 = 57p
Bonus fraction
price rights ex l Theoretica
price rights cum Actual

Earnings per share


2005 2004
842 , 236 , 5
000 , 893 , 1
36.1p
526 , 210 , 4
000 , 711 , 1
40.6p
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 43
Birren pIc
2005 2004
Basic 33.3p 30.0p
Fully diluted 19.7p 22.2p
Note
Diluted earnings per share is disclosed as the dilution is greater than 5%.
Workings
Earnings
Basic 1,000,000 900,000
Add: loan stock interest saved (1,700,000 5% 70%) 59,500 29,750
(time apportioned last year)
____________ ___________
Diluted 1,059,500 929,750
____________ __________
Number of shares
Basic 3,000,000 3,000,000
Add: loan stock (17,000 140)/ (17,000 140 6/12) 2,380,000 1,190,000
____________ ____________
Diluted 5,380,000 4,190,000
____________ ____________
Earnings per share
2004 2004
Basic
000 , 000 , 3
000 , 000 , 1
33.3p
000 , 000 , 3
000 , 900
30.0p
Fully diluted
000 , 380 , 5
500 , 059 , 1
19.7p
000 , 190 , 4
750 , 929
22.2p
Exercises and Case Study Solutions
44 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
OnyaIi pIc
Basic EPS = 928,000 = 18.6p
5,000,000
FDEPS
i) = 928,000 = 18.6p
5,000,000
ii) = 928,000 = 17.7p
___________________________
5,000,000 + 238,636
Working
avge price
208p 308p
Proceeds of maximum exercise (750 x 2.10) 1,575,000 1,575,000
Number of shares
from maximum exercise 750,000 750,000
f bought at shares at average price
1,575,000 (2.08 / 3.08) (757,212) (511,364)
________ ________
Free shares nil 238,636
________ ________
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 45
Scrutinise DeaI
EPS NAPS
Basic 44.6p 1,175p
earnings 233.1m net assets 6,150.9m
weighted average shares 523.0m year end shares 523.6m
(522.4m + 523.6m)/2
DiIuted 43.8p 1,146p
Earnings Net assets
basic 233.1m Basic 6,150.9m
convertibles 10.9m convertibles 246.1m
260m x 6% x(100-30)%
options - Options 13.9m
244.0m 6,410.9m
Shares Shares
basic 523.0m Basic 523.6m
convertibles 34.0m convertibles 34.0m
options 0.6m Options 1.9m
1.87m -(13.9m/10.64)
557.6m 559.5m
Exercises and Case Study Solutions
46 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Pearson rights issue
Prior year (as previousIy reported)
47.8p
earnings 294
shares (weighted average) 615.4
Current year
Earnings (m) 179
Shares
weighting shares bonus frac
Weighted
shares
1/24 613 1.109745 28.3
11/24 624 1.109745 317.4
4/24 627 1.109745 116.0
8/24 798 266.0
727.7
EPS (p) 24.6p
Prior year restated 43.0p
Bonus fraction 1.109745
shares price
prior to rights 11 18.57 204.27
rights 3 10.00 30.00
14 234.27
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 47
Discounted debt
Zero coupon
28
th
February 2005
Balance sheet P&L account Cash flow statement
m m m
Servicing of finance -
Debt 70.8 nterest payable (5.8) Financing 65.0
Working
year to start interest end
28 Feb @ 9%
2005 65 5.8 70.8
2006 70.8 6.4 77.2
2007 77.2 6.9 84.1
2008 84.1 7.6 91.7
2009 91.7 8.3 100
Deep discount
28
th
February 2005
Balance sheet P&L account Cash flow statement
m m m
Servicing of finance
(5.0)
Debt 4.0 90.4 nterest payable (9.0)
Working
year to start interest cash end
28 Feb @ 10.43%
2002 76.5 8.0 (5.0) 79.5
2003 79.5 8.3 (5.0) 82.8
2004 82.8 8.6 (5.0) 86.4
2005 86.4 9.0 (5.0) 90.4
Exercises and Case Study Solutions
48 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Index Iinked
28 February 2005
Balance sheet P&L account Cash flow statement
m m m
Servicing of finance
(4)
Debt 203 nterest payable (7) Financing 200
Working
year to start interest cash end
28 Feb (mid year) @3.5 % @2 %
(6 months) (6 months)
2005 200 7.0 (4.0) 203
Index Iinked (coIIar)
28
th
February 2005
Balance sheet P&L account Cash flow statement
m m m
Servicing of finance
(2.7)
Debt 162.4 nterest payable (5.1) Financing 160
Working
year to start interest cash end
28 Feb (mid year) @3.161 % @1.661 %
(6 months) (6 months)
2005 160 5.1 (2.7) 162.4
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 49
ConvertibIe debt
US (and UK) GAAP
Balance sheet P&L account Cash flow statement
m m m
Cash 273.6 Operating
expenses
Servicing of finance
(9.1)
(17.3)
Debt 293.7 293.7 nterest payable (20.1) Financing 300.0
Equity 20.1
Transactions
1. Debt is recognised at net proceeds
Cash 290.9m
Debt 290.9m
2. nterest for period (incl amortisation of issue costs)
P&L account - interest payable 20.1m
Cash (300m x 5.75%) 17.3m
Debt 2.8m
US GAAP
An embedded derivative shall be separated from the host contract and accounted for as a
derivative instrument if all the following criteria are met:
Criterion Met? Explanation
The economic characteristics and risks
of the embedded derivative are not
clearly and closely related to the
economic characteristics of the host
contract.

An option based on another entity's


stock price is not clearly and closely
related to an interest-bearing debt
instrument.
The contract that embodies both the
embedded derivative instrument and
the host contract is not remeasured at
fair value under GAAP with changes in
fair value reported in earnings as they
occur.

Debt of the issuer is not remeasured at


fair value.
A separate instrument with the same
terms as the embedded derivative
would be a derivative under FAS 133.

Because it is an equity instrument of


the issuer, the written option is not
considered a derivative under FAS 133
and is not separated from the host
contract.
Exercises and Case Study Solutions
50 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
UK GAAP
Capital instruments that are issued at the same time in a composite transaction should be
considered together. They should be accounted for as a single instrument unless they are
capable of being transferred, cancelled or redeemed independently of each other.
Working
year to start interest cash end
30 Sept @ 6.9%
2005 290.90 20.08 17.25 293.75
2006 293.75 20.28 17.25 296.76
2007 296.76 20.49 17.25 300.00
year to start interest cash end
30 Sept @ 5.75%
2008 300.00 17.25 17.25 300.00
2009 300.00 17.25 17.25 300.00
German GAAP
Balance sheet P&L account Cash flow statement
m m m
Cash 273.6 Servicing of finance
(9.1)
nterest payable (17.3) (17.3)
Debt 300.0 300.0 Exc/ext item (9.1) Financing 300.0
Equity 26.4
Transactions
1. Debt is recognised at gross proceeds
Cash 300.0m
Debt 300.0m
2. ssue costs are paid
P&L account - exceptional/extraordinary item 9.1m
Cash 9.1m
3. nterest paid in period (300m x 5.75%)
P&L account - interest payable 17.3m
Cash 17.3m
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 51
IAS 32
Balance sheet P&L account Cash flow statement
m m m
Cash 273.6 Servicing of finance
(9.1)
nterest payable (20.0) (17.3)
Debt 287.3 287.3 Financing 300.0
Equity 13.7
Transactions
1. Debt element is recognised (eg at present value [say at 7%] of future cash flows)
Cash 284.6m
Debt 284.6m
2. Equity element is recognised (eg at balance of net proceeds)
Cash [290.9m - 284.6m] 6.3m
Equity (call option issue proceeds) 6.3m
3. nterest incurred and paid in period
P&L account - interest payable [284.6m x 7%] 20.0m
Cash [300m x 5.75%] 17.3m
Debt 2.7m
Exercises and Case Study Solutions
52 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
King, Wade & Graf
King Inc
$m
Operating profit 68
Depreciation 70
Amortisation 10
EBITDA 148
Increase in inventories (2)
Increase in receivables (56)
Increase in current liabilities 16
Net cash infIow from operating activities 106
Servicing of finance
nterest paid (41)
Taxation
Tax paid (15)
Free cash flow 50
CapitaI expenditure
Purchase of tangible fixed assets (127)
Sale of tangible fixed assets 40
Free cash flow (37)
Equity dividends paid
Dividend paid (12)
Financing
Net borrowing/(repayment) 55
Increase / (decrease) in cash 6
Cash at start 27
Cash at end 33
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 53
Wade pIc
$m
Operating profit 103
Depreciation 60
Amortisation -
EBITDA 163
Increase in inventories, excl interest capitalised (2)
Increase in receivables (56)
Increase in current liabilities 1
Net cash infIow from operating activities 106
Servicing of finance
nterest paid (41)
Taxation
Tax paid (15)
Free cash flow 50
CapitaI expenditure
Purchase of tangible fixed assets, excl interest capitalised (127)
Sale of tangible fixed assets 40
Free cash flow (37)
Equity dividends paid
Dividend paid (15)
Financing
ssue of shares 52
Increase / (decrease) in cash -
Cash at start 27
Cash at end 27
Exercises and Case Study Solutions
54 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Graf AG
$m
Operating profit/(loss) (109)
Depreciation 130
Amortisation 100
EBITDA 121
Increase in inventories (42)
Increase in receivables (3)
Increase in current liabilities 30
Net cash infIow from operating activities 106
Servicing of finance
nterest paid (41)
Taxation
Tax paid -
Free cash flow 65
CapitaI expenditure
Purchase of tangible fixed assets (127)
Sale of tangible fixed assets 40
Free cash flow (22)
Equity dividends paid
Dividend paid -
Financing
Net borrowing/(repayment) -
Increase/(decrease) in cash (22)
Cash at start 27
Cash at end 5
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 55
Summary
Earnings Free cash
fIow (pre
capex)
Free cash
fIow (post
capex)
King nc
+$24m +$50m -$37m
Wade plc +$60m
+$50m
-$37m
Graf AG -$137m
+$65m
-$22m
SaIes EBITDA Operating
profit
Operating
cash fIow
King nc $503m
+$148m +$68m +$106m
Wade plc $503m
+$163m
+$103m +$106m
Graf AG $450m
+$121m
-$109m +$106m
Working
Movement on tangibIe fixed assets
m King Wade Graf
Opening NBV 240 260 150
Additions at cost () 127 127 127
nterest capitalised 15 15 -
Revaluation - 100 -
Disposals at NBV (43) (45) (27)
Depreciation/impairment write down (70) (60) (130)
Closing NBV 269 397 120
Possible reasons for earnings differences
IntangibIes
Different write off periods for goodwill.
TangibIes
Different depreciation rates. Capitalisation of interest.
Long term contracts
% completion v completed contracts method. Different revenue recognition policies.
Exercises and Case Study Solutions
56 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Inventories
Capitalisation of interest.
Current IiabiIities
Recognition of accruals and provisions.
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 57
AIternative presentation - US GAAP
King Inc
$m
Net income 24
Depreciation 70
Loss on asset disposals 3
Amortisation 10
Increase in inventories (2)
Increase in receivables (56)
Increase in current liabilities 16
Interest capitalised (15)
Net cash infIow from operating activities 50
CapitaI expenditure
Purchase of tangible fixed assets (127)
Sale of tangible fixed assets 40
Free cash flow (37)
Equity dividends paid
Dividend paid (12)
Financing
Net borrowing/(repayment) 55
Increase / (decrease) in cash 6
Cash at start 27
Cash at end 33
Exercises and Case Study Solutions
58 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
AIternative presentation - cash fIow to pay capitaI providers
King Inc
1 2 3
$m $m $m
Operating profit 68 68 68
Depreciation 70 70
Amortisation 10 10
___ ___
EBITDA 148 148
Increase in inventories (2) (2)
Increase in receivables (56) (56)
Increase in current liabilities 16 16
___ ___
Net cash infIow from operating activities 106 106
nterest paid (41)
Tax paid (15) (27) (27)
CapitaI expenditure
Capex (127) (127)
Disposal proceeds 40 40
Net new investment in PPE & WC (49)
___ ___ ___
Free cash fIow (37) (8) (8)
Financing
[nterest paid (29)]
Net borrowing/(repayment) 55 55
Dividend paid (12) (12)
___ ___
Increase in cash 6 6
___ ___
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 59
Wade plc
1 2 3
$m $m $m
Operating profit 103 103 103
Depreciation 60 60
Amortisation - -
___ ___
EBITDA 163 163
Increase in inventories (2) (2)
Increase in receivables (56) (56)
Increase in current liabilities 1 1
___ ___
Net cash infIow from operating activities 106 106
nterest paid (41)
Tax paid (15) (27) (27)
CapitaI expenditure
Capex (127) (127)
Disposal proceeds 40 40
Net new investment in PPE & WC (84)
___ ___ ___
Free cash fIow (37) (8) (8)
Financing
[nterest paid (29)]
Dividend paid (15) (15)
Net equity issue/(repayment) 52 52
___ ___
Increase in cash - -
___ ___
Exercises and Case Study Solutions
60 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Deutsche TeIekom
Deutsche TeIekom
2002
Cm
2001
Cm
Sales
Net operating costs, excl
depreciation (W)
EBITDA
Depreciation
EBITA
Amortisation
EBIT
Net financial expense (W)
EBT
53,689
(37,612)
16,077
(9,525)
6,552
(27,355)
(20,803)
(5,983)
(26,786)
48,309
(30,309)
18,000
(9,478)
8,522
(5,743)
2,779
(5,283)
(2,504)
[Umsatzkostenverfahren]
Workings
Net operating costs
3,901 + 14,418 + 289 + 13,480 (823 39) + 14,110 = 37,612
Net financiaI expense
6,022 39 = 5,983
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 61
Morientes & FriedeI
Cash fIow statements
Morientes Friedel
EBIT 31,923 70,371
Depreciation 26,134 57,954
Amortisation 5,292 -
EBITDA 63,349 128,325
Increase in receivables (1,919) (1,121)
Increase in inventories (1,443) (1,984)
Increase in payables 637 3,879
Decrease in unearned revenue - (18,475)
Operating cash flow 60,624 110,624
nterest 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)
ncrease in cash 10,047 10,047
Metrics and ratios
Market capitalisation 518,245 518,245
Net debt 70,161 207,425
_
Firm value 588,406 725,670
Exercises and Case Study Solutions
62 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
EBTDA
FV
349 , 63
406 , 588
= 9.29
325 , 128
670 , 725
= 5.65
nterest
EBT
586 , 6
923 , 31
= 4.85
764 , 16
371 , 70
= 4.20
EBTDA
debt Net
349 , 63
161 , 70
= 1.11
325 , 128
425 , 207
= 1.62
Exercises and Case Study Solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 63
Morientes
end start movement Operating nterest 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 - - - -
nventories 21,832 20,389 1,443 (1,443) -
Operating accounts receivable 78,972 77,053 1,919 (1,919) -
Cash 27,505 17,458 10,047 10,047
-
Convertible debt (97,666) (94,080) (3,586) 3,586 -
Finance leases - - - -
Current tax (12,654) (9,788) (2,866) 2,866 -
Deferred tax - - - -
Unearned revenue - - - -
Operating accounts payable (53,429) (52,792) (637) 637 -
Paid in capital (8,900) (8,900) - -
Option proceeds (9,271) (9,271) - -
Retained earnings (31,484) (30,851) (633) 31,923 (6,586) (12,654) (12,050) -
- - -
Cash fIow 60,624 (3,000) (9,788) (25,739) (12,050) - 10,047
Exercises and Case Study Solutions
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Friedel
end start movement Operating nterest 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 -
nventories 80,027 78,043 1,984 (1,984) -
Operating accounts receivable 76,895 75,774 1,121 (1,121) -
Cash 27,505 17,458 10,047 10,047
-
Convertible debt (103,720) (101,816) (1,904) 1,904 -
Finance leases (131,210) (169,350) 38,140 (38,140) -
Current tax (12,654) (9,788) (2,866) 2,866 -
Deferred tax (25,672) (24,329) (1,343) 1,343 -
Unearned revenue (21,843) (40,318) 18,475 (18,475) -
Operating accounts payable (51,765) (47,886) (3,879) 3,879 -
Paid in capital (8,900) (8,900) - -
Option proceeds - - - -
Retained earnings (92,475) (64,915) (27,560) 70,371 (16,764) (13,997) (12,050) -
- - -
Cash fIow 110,624 (14,860) (9,788) (25,739) (12,050) (38,140) 10,047
Exercises and Case Study Solutions
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Pensions
Net debt/EBITDA
Without adjustment
EBTDA
debt Net
=
m 6,058 C
m 150 , 1 C
= 0.2
Net debt
C12,346m - 11,196m = C1,150m
Adjusted, pre tax
EBTDA
debt Net
=
m 6,018 C
m 111 , 6 C
= 1.0
Net debt
C1,150m + [19,492m - 14,531m] = C6,111m
EBITDA
EBTDA = 6,058m + 447m 487m = C6,018m
Adjusted, post tax
EBTDA
debt Net
=
m 6,018 C
m 176 , 4 C
= 0.7
Net debt
C1,150m + [(19,492m - 14,531m) x 61%] = C4,176m
Exercises and Case Study Solutions
66 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
PampIe & Mousse (1)
Goodwill
Cost of acquisition 408
less: fair value of identifiable assets less liabilities attributable to 50% stake (208)
[50% x 416]
Goodwill 200
Cost of acquisition
Cash paid 91
Fair value of shares issued 309
Purchase consideration 400
Other direct costs 8
Cost of acquisition 408
Accounting entries
Cost of acquisition C408m
Net debt [91 + 8 + 1] C100m
Shares [309 - 1] C308m
Combined balance sheet: Mousse consolidated as a subsidiary
PampIe Mousse Combined
Goodwill 200
Net operating assets 1,298 984 2,282
____ ____ ____
1,298 984 2,482
____ ____ ____
Net debt 450 568 1,118
Shares 121 56 429
Retained earnings 727 360 727
Minority interests 208
____ ____ ____
1,298 984 2,482
____ ____ ____
Exercises and Case Study Solutions
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Combined balance sheet: Mousse proportionately consolidated as a joint
venture
PampIe Mousse Combined
Goodwill 200
Net operating assets 1,298 984 1,790
____ ____ ____
1,298 984 1,990
____ ____ ____
Net debt 450 568 834
Shares 121 56 429
Retained earnings 727 360 727
Minority interests
____ ____ ____
1,298 984 1,990
____ ____ ____
Combined balance sheet: Mousse equity accounted as an associate
PampIe Mousse Combined
nvestment in associate 408
Net operating assets 1,298 984 1,298
____ ____ ____
1,298 984 1,706
____ ____ ____
Net debt 450 568 550
Shares 121 56 429
Retained earnings 727 360 727
____ ____ ____
1,298 984 1,706
____ ____ ____
Exercises and Case Study Solutions
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Combined income statement: Mousse consolidated as a subsidiary
PampIe Mousse adj Combined
Sales 1,163 994 2,157
Operating costs (959) (820) (1,779)
____ ____ ____
EBT 204 174 378
nterest (36) (62) (5) (103)
Tax (33) (30) 2 (61)
Minority interests (41) (41)
____ ____ ____
Net income 135 82 173
____ ____ ____
Combined income statement: Mousse proportionately consolidated as a joint
venture
PampIe Mousse adj Combined
Sales 1,163 994 497 1,660
Operating costs (959) (820) (410) (1,369)
____ ____ ____
EBT 204 174 291
nterest (36) (62) (5)
(31) (72)
Tax (33) (30) 2
(15) (46)
____ ____ ____
Net income 135 82 173
____ ____ ____
Exercises and Case Study Solutions
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Combined income statement: Mousse equity accounted as an associate
PampIe Mousse adj Combined
Sales 1,163 994 1,163
Operating costs (959) (820) (959)
____ ____ ____
EBT 204 174 204
nterest (36) (62) (5) (41)
Tax (33) (30) 2 (31)
Share of associate 41 41
____ ____ ____
Net income 135 82 173
____ ____ ____
Workings
Interest on additionaI net debt
C100m x 5% = C5m
Tax shieId on additionaI interest
C5m x 40% = C2m
Exercises and Case Study Solutions
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Mango & Steen
Combined balance sheet (immediately after acquisition)
Mango Steen ConsoIidated
Cash Shares Shares & cash
Goodwill 566 966 866
Net operating assets 1,000 3,267 4,267 4,267 4,267
Net funds/(debt) 115 (1,133) (3,718) (1,018) (1,768)
____ ____ ____ ____ ____
1,115 2,134 1,115 4,215 3,365
____ ____ ____ ____ ____
Shares 172 984 172 3,272 2,422
Retained earnings 943 1,150 943 943 943
____ ____ ____ ____ ____
1,115 2,134 1,115 4,215 3,365
____ ____ ____ ____ ____
Exercises and Case Study Solutions
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Combined income statement (first year after acquisition)
Mango Steen ConsoIidated
Cash Shares Shares & cash
Sales 4,384 8,969 13,353 13,353 13,353
Operating costs, excl dep'n (4,017) (8,336) (12,353) (12,353) (12,353)
____ ____ ____ ____ ____
EBTDA 367 633 1,000 1,000 1,000
Depreciation (109) (190) (299) (299) (299)
____ ____ ____ ____ ____
EBT 258 443 701 701 701
nterest 14 (65) (213) (51) (96)
Tax (97) (117) (165) (214) (200)
____ ____ ____ ____ ____
Net income 175 261 323 436 405
____ ____ ____ ____ ____
Number of shares (m) 1,720m 1,720m 3,245m 2,827m
EPS 10.2p 18.8p 13.4p 14
Exercises and Case Study Solutions
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Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
FinanciaI maths 1
Discounted cash flow (DCF) 1
ntroduction 1
Time value of money 1
Terminal/future values 5
Net terminal/future value 6
Present values 7
Annuities and annuity compound factors 10
Net present values 12
Annuities and annuity discount factors 14
Perpetuities 16
nternal rate of return 17
Annuities and perpetuities not starting at time 1 21
Arithmetic and geometric progressions 24
Arithmetic progressions 24
Geometric progressions 24
Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 1
FinanciaI maths
Discounted cash fIow (DCF)
Introduction
Discounted cash flow is the recognition of the fact that there is time value of money.
What this means is that we would all prefer to receive money sooner rather than later and pay
out money later rather than sooner.
Why would we prefer to receive money now rather than at some time in the future?
There are a number of reasons. Firstly we can spend it now and therefore be gratified by
immediate consumption. Also by spending now we do not run the risk that prices will go up due
to future inflation. And, by buying what we want now there is no risk that we will not be able to
buy it in the future.
Why would we prefer to pay money later? By doing this, the money can stay in our bank
account earning us interest rather than in someone else's account earning them interest.
This idea, of time value of money, is the basis of securities valuation.
These ideas are embraced in the dividend valuation (or discount) model which states:
'the value of a security today is the present value of the future expected receipts,
discounted at the investor's required rate of return"
Time vaIue of money
f 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
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Simple interest
Simple interest is when interest is only paid on the initial capital invested. Simple interest is what
you get if you are quoted a nominal annual interest rate.
ExampIe
You deposit 1,000 at a simple interest rate of 6% for three years. How much money will you
have in your account at the end of the third year?
SoIution
The interest you will earn each year will be 1,000 x 6%. This is 60. At the end of the first year
this will be added to your account so that you start year two with 1,060 in the bank. The interest
earned in the second year is still 60 (1,000 x 6%) even though there is 1,060 on deposit.
This is because, with simple interest, interest is only earned on the initial deposit and not on
interest subsequently added to the account.
Therefore at the end of three years the balance on the account will be 1,000 + [3 x (1,000 x
6%)] = 1,180.
This calculation can be written as a general formula
D
n
= D
o
[1 + (n x r)]
Where
D
n
= value of deposit at end of period (eg year) n
D
o
= initial value of deposit
n = no of periods money is on deposit for
r = simple interest rate expressed as a decimal
For the example
D
3
= 1,000 [1 + (3 x 0.06)] = 1,000 x 1.18 = 1,180
From your own experience you will realise that a typical deposit account does not offer simple
interest; instead it offers compound interest.
Compound interest
This is an approach where interest is earned on the value of the deposit at the start of the period
in question, not on the initial deposit. Obviously for the first period these two amounts are the
same but in subsequent periods the opening balance will include interest added on from
previous periods. Compound interest therefore pays 'interest on interest". Compound
interest is what you get if you are quoted an effective annual interest rate.
Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 3
Let's rework the above example, remembering that interest is now paid on the balance on
deposit at the start of the year
Year 1
Balance at start of year = initial deposit = 1,000.
nterest earned: 1,000 x 6% = 60
Year 2
Balance at start of year = initial deposit plus interest earned in year 1 = 1,060
nterest 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
nterest earned: 1,123.60 x 6% = 67.42
Balance at end of year 3 = 1,123.60 + 67.42 = 1,191.02.
We could have arrived at the same result by doing the following calculation
1,000 x 1.06 x 1.06 x 1.06 = 1,191.02 or alternatively
1,000 x (1.06)
3
= 1,191.02
This can be written as a general formula
D
n
= D
o
(1 + r)
n
We have assumed in the above calculation that interest was only added on at the end of each
year. Many accounts, of course, pay interest every six months or semi-annually. Some even
pay more frequently than that; possibly paying interest quarterly or even monthly. The more
frequently interest is paid, the better off the depositor is, as interest can then be earned on the
interest already added to the balance.
Using the above example where the interest rate was 6% we will assume that interest is now
paid semi-annually. This means that interest of 3% (6% x ) 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
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The formula for calculating the terminal value when interest is not paid annually is
D
n
= D
o
(1 + r/m)
nxm
Where
m = no of times interest is paid in the period
n = no of periods (eg years)
r = the annual interest rate
f interest was added monthly, the balance at the end of three years would be
1,000 x (1.005)
36
= 1,196.68
This is an even larger value; clearly showing that the frequency of compounding affects the
overall return.
Return
Because interest is being credited more frequently than annually it is a fact that the annual return
will be greater than 6%. Because, don't forget, we are earning interest on interest.
What therefore is the actual return we are making each year?
Assume that the annual rate we are using is 6% and interest is credited twice a year. f we
deposited 1,000 at the start of the year we would have 1,000 x 1.03 x 1.03 = 1,060.90 at the
end of the year. This is more than a 6% return. (A 6% return would generate a year end
balance of 1,060.)
The actual return is
1
000 , 1
90 . 060 , 1
= 6.09%
We now have two rates. The 6% we started with and the actual return of 6.09%
The original rate, which does not take into account the frequency with which interest is added, is
the flat rate or nominal rate. The rate which reflects the frequency of compounding and is
therefore the actual rate achieved is called the annual percentage rate (APR) or effective
annual rate (EAR).
n the formulae we have seen so far, r represented the flat rate.
f we are given the flat rate and the frequency of compounding then it is possible to calculate the
APR, using the following formula.
APR = (1 + r/m)
m
- 1
Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 5
Applying this formula to our example in which interest is compounded twice a year:
APR = (1 + 0.06/2)
2
- 1 = 6.09%
TerminaI/future vaIues
The terminal or future value of a cash flow or a series of cash flows is the value one would have
at some specified time in the future. This future value takes into account the interest that the
cash flows earn between depositing them and the specified future date. To correctly calculate
the terminal value we need to know
The amount of the cash flow/s
The timing of the cash flow/s
The interest rate.
We will assume compound interest in all further examples.
Calculating the terminal value of two alternative investment opportunities allows us to consider
which is the better of the two. The one that gives a greater terminal value would, every thing
else being equal, be the better one to choose.
ExampIe
Which of the following two investment opportunities is better?
Investment 1
This investment will pay 500 at the end of each of the next three years.
Investment 2
This investment will pay 200 at the end of the first year and 1,300 at the end of the second
year.
Which investment has the greatest terminal value at the end of the third year if the appropriate
interest rate is 6%?
When calculating the terminal value we must take into account the compounded interest that can
be earned. We will use the formula previously seen
D
n
= D
o
(1 + r)
n
The (1 + r)
n
part of the expression is referred to as the compound factor
Financial maths
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Investment 1
Time
(years)
Cash fIow

Compound factor
(1 + r)
n
TerminaI vaIue,
(at end of yr 3)
1 500 1.06
2
561.80
2 500 1.06 530.00
3 500 1.00 500.00
TerminaI vaIue 1,591.80
Investment 2
Time
(years)
Cash fIow

Compound factor
(1 + r)
n
TerminaI vaIue,
(at end of yr 3)
1 200 1.062 224.72
2 1,300 1.06 1,378.00
3 - 1.00 -
TerminaI vaIue 1,602.72
As investment 1 has a terminal value of 1,591.80 and investment 2 has a terminal value of
1,602.72, investment 2 is preferred.
The calculations of the terminal value above only considered the cash inflows from the two
possible investments. What if investment 1 required an initial cash outlay of 1,300 and
investment 2 required an initial cash outlay of 1,400. Would investment 2 still be the preferred
investment?
Net terminaI/future vaIue
When there are both positive and negative cash flows the terminal value will be the netof
these flows.
We will now rework the previous example but include the initial investments as negative cash
flows.
Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 7
Investment 1
Time
(years)
Cash fIow

Compound factor
(1 + r)n
TerminaI vaIue,
(at end of yr 3)
0 (1,300) 1.06
3
(1,548.32)
1 500 1.06
2
561.80
2 500 1.06 530.00
3 500 1.00 500.00
Net terminaI vaIue 43.48
Investment 2
Time
(years)
Cash fIow

Compound factor
(1 + r)
n
TerminaI vaIue,
(at end of yr 3)
0 (1,400) 1.063 (1,667.42)
1 200 1.062 224.72
2 1,300 1.06 1,378.00
3 - 1.00 -
Net terminaI vaIue
(64.70)
t 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. nvestment 2 now has a negative cash balance
(terminal value) of 64.70 at the end of the third year. nvestment 1 is now the preferred
investment
Present vaIues
We have seen that calculating the terminal value of two potential investments might allow us to
choose between them. This approach works if the investments we are trying to choose between
have the same maturity date; that is they have the same terminal date. How, though, would we
choose between investments that had different terminal dates?
f for example nvestment A, a four year investment, had a terminal value (in four years) of 550
whilst nvestment B, a six year investment, had a terminal value (at the end of the sixth year) of
725, which would we prefer?
The problem is that comparing a value at the end of the fourth year with a different value at the
end of the sixth year is not comparing the two on a common basis. To overcome this problem
we will change our approach. We will no longer calculate terminal values; we will instead
calculate what the values of the future cash flows are worth to us today. That is, we will
calculate the present value of the future cash flows.
Financial maths
8 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
By considering the present value of two alternative investments we are comparing them on a
common basis. For both we are saying what their value is at the same point in time ie what their
value is to us today. So how do we calculate the present value of future cash flows? The key
thing is to realise that the present value of any future cash flow is simply the amount you would
need to invest today to generate, with compound interest, the value of the future cash flow.
ExampIe
f interest rates are 10% how much would need to be invested now to produce a balance of
1,500 in three years' time.
We can use our knowledge of terminal values to answer this.
We know that
D
n
= D
o
(1 + r)
n
This formula can now be re-arranged as follows
n
n
0
) r 1 (
D
D


Where
D
0
= the amount we need to invest today ie the present value (PV)
D
n
= the future cash flow we want to achieve
r = interest rate
n =no of periods between now and the future date
For our example
3
) 1 . 1 (
500 , 1
PV = 1,126.97
This shows us that if we invest 1,126.97 today, at a compound interest rate of 10% this would
be worth 1,500 in three years time. Turning this argument around we can say that a receipt of
1,500 in three years time is equivalent to a receipt of 1,126.97 today (assuming we can invest
it at 10%). 1,126.97 is the present value of the future receipt of 1,500.
The formula used above can be written generally as
n
) r 1 (
fIow cash future
) PV ( vaIue esent Pr


This is, of course, the same as writing
Present value = future cash flow x
n
) r 1 (
1

Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 9
The term
n
) r 1 (
1

is called the discount factor and is used to calculate the present value of a
single future cash flow that occurs at time n, at an interest rate r. The interest rate may be
referred to as the discount rate as it is reducing the value of the future cash flow.
ExampIe
You are offered the choice of 4,000 now or 5,500 in 4 years' time. Assume the appropriate
interest rate (discount rate) is 9%. Which is the more valuable sum?
We discount the 5,500 back to its value today ie its present value.
The calculation would therefore be:
4
(1.09)
5,500
= 3,896.34
As this is a lower sum than 4,000, we would prefer 4,000 now to 5,500 in 4 years' time.
ExampIe
f the interest rate is8% p.a. d o we prefer:
(a) 6,000 now; or
(b) 8,000 in 5 years' time?
Choice (a) (b)
PV 6,000
5
) 08 . 1 (
000 , 8
= 5,444.67
We prefer (a), as it has the higher present value.
Financial maths
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Annuities and annuity compound factors
An annuity is when the same cash flow occurs for a number of periods.
ExampIe
t is possible to pay 380 now and receive an annuity of 120 at the end of each of the next four
years. What is the net terminal value of these cash flows if the interest rate is 8%?
Time Cash fIow, Compound factor TerminaI vaIue,
0 (380) 1.08
4
(516.99)
1 120 1.08
3
151.17
2 120 1.08
2
139.97
3 120 1.08 129.60
4 120 1.00 120.00
Net terminaI vaIue 23.75
magine reworking the above example if the annuity was going to last for forty years rather than
four. t would be very tedious and time consuming! But, don't worry; there is a quicker way.
Rather than treat each of the cash flows in the annuity separately and multiply them by the
appropriate compound factor for a single flow, we could combine all the compound factors into
one and simply multiple one cash flow by the combined compound factor. What we are going to
calculate is the annuity compound factor.
Annuity compound factor for times 1 to n is
r
1 ) r 1 (
n

This will give the terminal value, at time n, of an annuity whose cash flows are from time 1 to
time n inclusive.
For our example the annuity compound factor is
0.08
1 ) 08 . 1 (
4

= 4.5061
Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 11
We can now calculate the net terminal value of the annuity, using the annuity compound factor
rather than the individual compound factors.
Time Cash fIow, Compound factor TerminaI vaIue,
0 (380) 1.08
4
(516.99)
1 4 120 4.5061 540.74
Net terminaI vaIue 23.75
The terminal value arrived at above could be written as
[- 380 x (1.08)
4
] + 120 x [

1 ) 08 . 1 (
4

] = 23.75
The above can be written as a general formula
D
n
= D
0
(1 +r)
n
+

1 ) 1 (
n
r
d
Where
D
n
= terminal value at time n
D
0
= cash flow at time 0
d = annuity cash flow
r = interest rate
Remember that the annuity formula gives the value of the annuity at time n on the assumption it
started at time 1.
This formula can now be used to answer various annuity-related questions.
ExampIe 1
What is the cost today of a five year annuity paying 600 at the end of each year if interest rates
are 6%?
The cost today will be the D
0
value in the above formula. The value of D
n
, as the annuity
terminates at the end of the fifth year, will be 0.
Financial maths
12 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Therefore we have the following expression to solve
0 = D
0
(1.06)
5
+ 600 x [

1 ) 06 . 1 (
5

]
0 = 1.3382D
0
+ 600 x 5.6371
D
0
= - 2,527.47
t would cost 2,527.47 today to buy a five year annuity paying 600 per year, if interest rates are
6%.
ExampIe 2
f you take out a 25 year mortgage of 250,000 today at an interest rate of 7.5% what are the
annual repayments needed to fully repay the loan by the end of the twenty fifth year?
We know that D
0
is 250,000 and that D
n
is 0 (as the mortgage is repaid). We need to solve for
d in the following expression
0 = 250,000(1.075)
25
+

1 ) 075 . 1 (
25

d
0 = 1,524,584.90 + 67.9779d
d = - 22,427.66
The annual repayments would be 22,427.66.
ExampIe 3
Having calculated the annual payments, what is the balance outstanding on this mortgage at the
end of the twentieth year?
D
n
is now the end of the twentieth year and n = 20.
D
n
= - 250,000(1.075)
20
+ 22,427.66

1 ) 075 . 1 (
20

D
n
= - 1,061,962.78 + 971,222.67
D
n
= - 90,740.11
There would still be 90,740.11 owing on the mortgage at the end of the twentieth year.
Net present vaIues
We saw earlier that the net terminal value was the terminal value when there were both positive
and negative cash flows. n the same way, the net present value or NPV is the present value
when there are both positive and negative cash flows.
Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 13
ExampIe 1
An investment requires an initial payment today of 1,000 and will pay back 1,650 in three
years' time. f the discount rate is 6% what is the NPV of this investment opportunity? Should it
be undertaken?
Time
(years)
Cash fIow

Discount factor
1/(1 + r)
n
Present vaIue,
0 (1,000) 1 (1,000.00)
3 1,650 1/1.06
3
1,385.37
Net present vaIue 385.37
As the investment has a positive NPV it is worth doing.
ExampIe 2
An investment requires an initial payment today of 2,000 and will pay back 2,650 in four years'
time. f the discount rate is 10% what is the NPV of this investment opportunity? Should it be
undertaken?
Time
(years)
Cash fIow

Discount factor
1/(1 + r)n
Present vaIue,
0 (2,000) 1 (2,000.00)
4 2,650 1/1.10
4
1,809.99
Net present vaIue (190.01)
As the investment has a negative NPV it is not worth doing. t would be equivalent to losing
190.01 today.
ExampIe 3
You are required to decide which, if either, of the following two investment opportunities you
would undertake. nterest rates are 8%.
Opportunity Q requires an investment today of 600 and will pay back 165 in one year's time,
300 in two years' time and 450 in three years' time.
Opportunity W requires an investment today of 900 and will pay back 450 at the end of each
of the next three years.
Financial maths
14 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Investment Q
Time
(years)
Cash fIow

Discount factor
1/(1 + r)
n
Present vaIue,
(at end of yr 3)
0 (600) 1 (600.00)
1 165 1/1.08
1
152.78
2 300 1/1.08
2
257.20
3 450 1/1.08
3
357.22
Net present vaIue 167.20
Investment W
Time
(years)
Cash fIow

Discount factor
1/(1 + r)
n
Present vaIue,
(at end of yr 3)
0 (900) 1 (900.00)
1 450 1/1.081 416.67
2 450 1/1.082 385.80
3 450 1/1.083 357.22
Net present vaIue 259.69
Both investments have positive NPVs but as investment W has the higher NPV it is the one to
choose.
Annuities and annuity discount factors
nvestment W, above, had the same cash flow for a number of years. This is of course an
annuity. n this example we discounted each of the individual cash flows. This approach might,
however, be rather tedious if it was, for example, a twenty five year annuity. We have seen that
when calculating terminal values it is possible to determine an annuity compound factor that is
effectively the sum of all the individual compound factors. A similar thing can be done when
calculating present values. That is, an annuity discount factor can be determined that is
effectively the sum of the individual discount factors.
The annuity discount factor is
)
r) + (1
1
- (1
r
1
n

For nvestment W
)
(1.08)
1
- (1
08 . 0
1
3
= 2.5771
Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 15
Time, years Cash fIow, Discount factor Present vaIue,
0 (900) 1 (900.00)
1 - 3 450 2.5771 1,159.69
Net present vaIue 259.69
ExampIe
What is the present value of an annuity that pays 850 p.a. for the next fifteen years at a
discount rate of 6%?
The annuity discount factor is:
)
(1.06)
1
- (1
06 . 0
1
15
= 9.7122
Time, years Cash fIow, Discount factor Present vaIue,
1 - 15 850 9.7122 8,255.37
Present vaIue 8,255.37*
*Rounded
The annuity formulation may be applied to calculate the equal instalments which must be made
on a repayment mortgage. The present value of the repayments (discounted at the mortgage
rate) must equate to the present value of the loan (otherwise the loan would not be paid off!).
The following example illustrates how the repayments may be determined.
IIIustration
A 25 year annual instalment repayment mortgage for 100,000 is granted at an interest rate of
6%. f instalments are made at each year end, what is the required annual instalment?
SoIution
The present value of the mortgage (100,000) must equate to the present value of the
instalments discounted at the mortgage rate of 6%. The instalments (referred to as A in the
formulation below) represent a 25 year annuity.
Present value of mortgage loan = present value of instalments
100,000 = A x )
(1.06)
1
- (1
06 . 0
1
25

100,000 = A x 12.78
A = 100,000 / 12.78 = 7,822.67 (or 7,824.73 depending on rounding).
Financial maths
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Perpetuities
A perpetuity is similar to an annuity except for the fact that the cash flows continue for ever ie
into perpetuity. t 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.
f you wished to generate a perpetuity of 10 each year and interest rates were 10% then a
deposit made today of 100 would generate (at 10%) interest of 10 every year. Therefore 100
today is equivalent to 10 every year, or 100 is the present value of a perpetuity of 10 at an
interest rate of 10%
The appropriate discount formula for a perpetuity is
ExampIe
What is the net present value of an opportunity that requires an investment today of 12,000 and
pays 800 into perpetuity if interest rates are 7%? s it worth undertaking? Would it be worth
undertaking if interest rates are 6%?
Net present value at 7%
Time, years Cash fIow, Discount factor Present vaIue,
0 (12,000) 1 (12,000.00)
1 - 800 1/0.07 11,428.57
Net present vaIue (571.43)
At a discount rate of 7% the investment is not worth undertaking as it has a negative net present
value.
Net present value at 6%
Time, years Cash fIow, Discount factor Present vaIue,
0 (12,000) 1 (12,000.00)
1 - 800 1/0.06 13,333.33
Net present vaIue 1,333.33
At a discount rate of 6% the investment is worth doing as it has a positive net present value.
r
1
Financial maths
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Perpetuities with constant growth
The formula for calculating the value of a perpetuity where the cash flows are growing at a
constant rate, g, is:
n
1
g) - (r
Cf
, where Cf
1
is the cash flow arising in one period's time and subsequent cash flows grow
by g% per period.
ExampIe
A company is expected to pay a dividend of 200,000 in one year's time. This dividend is
expected to grow by 3% per annum in subsequent years.
We require a return on our investment of 8% (based on prevailing interest rates, with a premium
for risk).
The value placed on the company is therefore:
3%) - (8%
200,000
= 4.0 million
InternaI rate of return
We have seen from the previous examples that, by calculating the net present value of an
investment, it is possible to decide whether the investment is worthwhile or not. f 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. t 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
RR and compare it with the cost of financing the investment.
How then is the RR calculated?
Financial maths
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Comprehensive iIIustration
A new project will cost 250million.
We have already spent 30million on market research. The project will provide the following net
cash inflows:
'000
At the end of year 1 30,000
At the end of year 2 72,000
At the end of year 3 80,000
At the end of year 4 65,000
At the end of year 5 110,000
_______
Total 357,000
_______
The project has no scrap value at the end of its 5 year life. The current rate of interest used by
the company (the company's cost of capital) is 9%.
s this project worthwhile? n other words is it generating a positive NPV? s it generating a
return (RR) of more than 9%?
The project's incremental income is 357million which is greater than the cost of 250million.
(We ignore the 30million as a sunk cost.)
However, the 250million will be incurred now. The other flows are future flows and we must
discount them back (at 9%) to obtain their present value.
Thus
09 . 1
000 , 000 , 30
= 27,522,936 in present value terms
and
2
) 09 . 1 (
000 , 000 , 72
= 60,600,960 (in two year's time), etc.
Financial maths
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Discount Present
Time Narrative Flow factor value
'000 9% '000
0 Project cost (250,000)
0
09 . 1
1
= 1 (250,000)
1 nflow 30,000
1
09 . 1
1
27,523
2 " 72,000
2
09 . 1
1
60,601
3 " 80,000
3
09 . 1
1
61,775
4 " 65,000
4
09 . 1
1
46,048
5 " 110,000
5
09 . 1
1
71,492
______
Net present value 17,439
______
The NPV is positive (ie the cost of the project is less than the revenues as discounted).
We should accept the project.
Calculating the IRR
As mentioned earlier, the return being generated by the investment's cash flows is the Internal
Rate of Return or IRR. An alternative way to look at it is to say it is the break even interest rate.
t 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. n 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
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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 RR is found to be 11.28%.
The RR provides the rate at which the project just breaks even; it gives us the maximum cost of
capital the project can endure. This is vitaIIy important; the RR provides the maximum amount
that we would be prepared to pay to acquire the funds for the project. The project breaks even
at a discount rate of 11.28%.
An alternative way to look at it is to say that the project is giving an average annual return of
11.28%. As this exceeds the required return/cost of capital of 9%, the project is acceptable.
Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 21
f the company's cost of capital is above 11.28%, then the project is not worthwhile; ie at 13% we
lose money on the project as the project only returns 11.28%.
Annuities and perpetuities not starting at time 1
So far, whenever we have dealt with an annuity or a perpetuity we had the situation where the
first cash flow started at time 1 ie at the end of the first period (normally a year). We also had
discount formulae that gave us the PV of these cash flows:-
Annuity discount factor : )
r) + (1
1
- (1
r
1
n

Perpetuity discount factor:


r
1
We must now consider how we would work out the PV of an annuity or perpetuity that did not
start at time 1. There are two possibilities. Firstly, the cash flows start before time 1 ie at time 0
(now). Secondly, they start after time 1.
Cash flows starting before time 1
ExampIe
What is the PV of a five year annuity paying 500 at the start of the next five years at a discount
rate of 6%?
Approach 1 - discount all flows individually
Cash fIow, Discount factor Present vaIue,
0 500 1 500.00
1 500 1/1.06 471.70
2 500 1/1.06
2
445.00
3 500 1/1.06
3
419.81
4 500 1/1.06
4
396.05
Net present vaIue 2,232.55
The above approach, although accurate, is rather time consuming. Let's consider a quicker
method.
Approach 2 treat the time 0 flow separately and treat the remaining cash flows as a four year
annuity starting at time 1. As this is an annuity starting at time 1 we can calculate the discount
factor using the annuity discount formula.
Financial maths
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Time, years Cash fIow, Discount factor Present vaIue,
0 500 1 500.00
1 - 4 500 3.4651* 1,732.56
Net present vaIue 2,232.55
*annuity discount factor )
(1.06)
1
- (1
06 .
1
4
= 3.4651
Approach 3 - calculate the PV as if it was a five year annuity starting at time 1 and then
increase its value by one year as it actually starts at time 0.
step 1- value of five year annuity starting at time 1
500 x )
(1.06)
1
- (1
06 .
1
5
= 2,106.18
step 2 - increase value by one year as cash flows start at time 0 (1 year before time1)
2,106.18 x 1.06 = 2,232.55
Yet again, we get the same answer.
The third approach highlights a useful technique. f cash flows start before time 1, increase
their value. t therefore follows that if cash flows start later than time 1, reduce their value.
ExampIe
What is the PV of a four year annuity paying 300 p.a. starting at the end of the third year if
interest rates are 4%?
Approach 1 - discount the individual cash flows
Time, years Cash fIow, Discount factor Present vaIue,
0 - - -
1 - - -
2 - - -
3 300 1/1.04
3
266.70
4 300 1/1.04
4
256.44
5 300 1/1.04
5
246.58
6 300 1/1.04
6
237.09
Net present vaIue 1,006.81
Financial maths
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 23
Approach 2 - value a four year annuity starting at time 1 and then reduce its value by two years
by discounting it by the two year discount rate.
Step 1 - value of four year annuity starting at time 1
300 x )
(1.04)
1
- (1
04 .
1
4
= 1,088.97
Step 2 - discount value by two years as cash flows start two years after time 1
(1.04)
1
1,088.97
2
= 1,006.81
The same value is achieved under both methods but the second approach is quicker and far
more flexible.
Changing discount rates
Where discount rates change, it is critical to discount using the appropriate rates. This is best
shown by an illustration.
IIIustration
A 20,000 cashflow is to be received in 3 years' time. The discount rates for the next 3 years
are expected to be 7%, 8% and 9% respectively. The discounted cash flow is:
.07 1
1
x
.08 1
1
x
.09 1
1
x 20,000 = 15,878
A common error is to discount the cashflow for three years at the 3-year rate.
Financial maths
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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.
n general we can write an arithmetic progression as follows:
Arithmetic progression: a, a + d, a + 2d, a + 3d, . . .where the first term is a and the common
difference is d. Some important results concerning arithmetic progressions (AP) now follow:
The nth term of an AP is given by: a + (n ~ 1)d
The sum of the first n terms of an AP is Sn =
2
n
(2a + (n ~ 1)d)
Geometric progressions
A geometric progression (GP) is a sequence of numbers where each term after the first is
found by multiplying the previous term by a fixed number called the common ratio. The
sequence 1, 3, 9, 27, . . . is a geometric progression with first term 1 and common ratio 3. The
common ratio could be a fraction and it might be negative.
For example, the geometric progression with first term 2 and common ratio
3
1
is
2,
3
2
,
9
2
,
27
2
, . . .
n general we can write a geometric progression as follows:
Geometric progression: a, ar, ar
2
, ar
3
, ...where the first term is a and the common ratio is r.
Some important results concerning geometric progressions (GP) now follow:
The nth term of a GP is given by: ar
(n~1)
The sum of the first n terms of a GP is Sn =
r
r a
n

1
) 1 (
(valid only if r 1).
ntroduction to valuation
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Introduction to vaIuation 1
ntroduction 1
Overview 1
Comps based valuation 1
DCF valuation 2
Comparable companies analysis 3
Why do we do comps? 3
From Equity Value to Enterprise Value 5
llustration 6
Discounted cash flow valuation 8
Key points 8
Cost of debt 10
Cost of equity 13
Dividend valuation model 17
Dividend policy 20
Recognising risk 23
ntroduction 23
Traditional theory of gearing 24
Modigliani & Miller (M&M) 25
Gearing Betas 29
Adjusted present value (APV) 31
Weighted average cost of capital (WACC) 32
Cash flow to discount 33
Value drivers 35
What comes before valuation? 37
Growth rates and time period for discounting 39
Terminal values 40
Time period convention 41
Valuing combinations 42
Methodology 42
ntroduction to valuation
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Introduction to vaIuation
Introduction
Company valuation techniques can be broadly categorised as:
Comparable companies analysis (eg P/E, EV/EBTDA); and
Discounted cash flow (DCF) analysis.
Valuation can be performed at the equity level or the enterprise level and can be based on
earnings or cash flows.
Overview
Comps based vaIuation
Key metrics
Equity IeveI Enterprise IeveI
Earnings based E (earnings after tax)
[NOPAT]
EBT
EBTDA
Cash flow based Levered FCF Unlevered FCF
Key multiples
Equity IeveI Enterprise IeveI
Earnings based P/E EV/EBT(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.
ntroduction to valuation
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The selected multiple for a comparable company (or the sector average) can be applied to the
relevant metric of the company to be valued.
DCF vaIuation
Key metrics
Equity IeveI Enterprise IeveI
Earnings based not applicable not applicable
dividends available
Cash flow based Levered FCF Unlevered FCF
Discount rate
Equity IeveI Enterprise IeveI
Earnings based not applicable not applicable
Cash flow based cost of equity WACC
The key metric must be forecast for the appropriate period (eg 3 years, 5 years, 10 years) and a
terminal or residual value at the end of the forecast period must be established. The relevant
discount rate is applied to the forecast cash flows to give a present value.
ntroduction to valuation
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ComparabIe companies anaIysis
Why do we do comps?
Analysing the operating and equity market valuation characteristics of a set of comparable
companies with similar operating, financial and ownership profiles provides a useful
understanding of:
1. The important operating and financial statistics about the target's industry group (eg growth
rates, margin trends, capital spending requirements).
This information can be helpful in developing assumptions for a discounted cash flow
analysis.
2. The relative valuation of publicly listed companies
The resulting multiples guide the user as to the market's perception of the growth and
profitability prospects of the companies making up the group. Consequently, comps can
be used to gauge if a publicly traded company is over or under valued relative to its peers.
3. A benchmark valuation for target entities
Comps valuations are based on:
metrics of target company (eg EBTDA)
multiples of similar quoted company(ies) (eg EV/EBTDA)
Valuation multiples from comparable companies may be applied to the financials of the
target entity to be valued to give a theoretical value of the target business.
For example:
Metric of target earnings $10.0m
Multiple of similar quoted company p/e 18.0x
TheoreticaI equity vaIue of target $10.0m x 18.0 = $180.0m
4. An indicative market price for a company which is to be floated on the stock market.
5. The validity of terminal DCF assumptions.
6. nvestment returns for financial buyers acquiring assets with the intention of monetising the
investment in the public equity market in an PO.
ntroduction to valuation
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Example
Tesco Sainsbury
Share price (p) 261.5 376.0
Equity value (m) 18,127 7,260
Enterprise value (m) 20,967 8,172
Enterprise vaIue I
SaIes
2006 (Curr.) 0.86x 0.48x
2007 (Prosp.) 0.74x 0.47x
EBITDA
2006 (Curr.) 10.8x 7.6x
2007 (Prosp.) 9.4x 6.6x
EBIT
2006 (Curr.) 15.5x 12.4x
2007 (Prosp.) 13.5x 10.4x
Equity VaIue / Earnings
2006 (Curr.) 20.8x 17.9x
2007 (Prosp.) 18.5x 15.5x
ntroduction to valuation
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From Equity VaIue to Enterprise VaIue
Enterprise value (*) = Equity Value (**) + Net Debt (***) + Minority nterest
Example continued - Enterprise value
Tesco
Share price (p) 261.5
Number of Shares (m) 6,932
_____
Equity VaIue (m) 18,127 [A]
ST Debt (m) 1,413 [B]
LT Debt (m) 1,925 [C]
Cash & equivalents (m) (534) [D]
_____
Net Debt (m) 2,804 [E]=[B+C+D]
Minority nterest (m) 36 [F]
_____
Enterprise vaIue (m) 20,967 [A + E + F]
Enterprise value (EV)
Enterprise value is also defined as:
Total enterprise value (TEV)
Entity value (EV)
Gross value (GV)
Total capitalisation
Firm value (FV)
Aggregate value
Leveraged market capitalisation (L.MC)
The terms are used loosely and are generally interchangeable. f 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)
ntroduction to valuation
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IIIustration
J Sainsbury is to be valued using, where relevant, Tesco as a comparable
company.
Tesco
Share price 259p
EPS 11.53p
P/E 22.46x
No of shares 6,932m
Market capitalisation 17,954m
Net debt 2,804m
Minority interest 6m
Enterprise value 20,794m
EBTDA 1,642m
EV/EBTDA 20,794m 1,642m
= 12.7x
ntroduction to valuation
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Comps valuation - earnings based
Equity IeveI
P/E multiples are easy to calculate and widely understood. However, earnings are after interest
and therefore P/E ratios (and P/E based valuations) are affected by capital structure.
Enterprise IeveI
Enterprise value multiples are regarded as purer than earnings multiples. This is because
enterprise value is unaffected by capital structure.
Enterprise value can be related to other figures which are independent of the capital structure (eg
sales, EBT, EBTDA, unlevered free cash flow). EBTDA is pre tax and EPS is post tax, so
EV/EBTDA has a larger denominator than PER. Consequently, the EV/EBTDA multiple will be
smaller than the PER. (Also, EBTDA 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
EBTDA 961m
Tesco EV/EBTDA x J Sainsbury EBTDA
12.7 x 961m = 12,205m
Summary
Equity level Enterprise level
[EV net debt = equity value]
Earnings based 8,326m 12,205m - 859m = 11,346m
ntroduction to valuation
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Discounted cash fIow vaIuation
Key points
Analysts tend to forecast profit and derive cash flow (by adjusting for depreciation and changes in
working capital). Valuation is very sensitive to assumptions about discount rates and growth into
perpetuity.
Enterprise level
The relevant cash flows are before interest (ie unlevered). The relevant discount rate is the
weighted average cost of capital (WACC).
Equity level
The relevant cash flows are after interest (ie levered). The relevant discount rate is the cost of
equity.
IIIustration - Enterprise IeveI
Cash Flows
Actual Estimate Forecast Forecast Forecast Forecast
Year to 31 December 2005 2006 2007 2008 2009 2010
m m m m m m
0 1 2 3 4
Turnover 511.0 624.0 780.0 873.6 943.5 990.7
EBT 26.1 137.3 202.8 205.3 207.6 198.1
Add: Depreciation 40.0 36.2 45.3 50.7 54.7 57.5
EBTDA 66.1 173.5 248.1 256 262.3 255.6
Working capital adjustment 3.2 (26.6) (46.8) (23.4) (12.6) (8.3)
Operating cash flow 69.3 146.9 201.3 232.6 249.7 247.3
Sale of fixed assets - - - - - -
nvestment income (7.9) 5.0 - - - -
Other non-cash items 3.0 - - - - -
Less: Capex (39.4) (39.9) (67.9) (60.8) (60.2) (63.2)
Tax paid 4.4 29.7 (30.4) (65.7) (66.4) (63.4)
Free cash fIow 29.4 141.7 103 106.1 123.1 120.7
Terminal cash flow 123.1
Terminal Value 1,367.9
Discount Factor 0.90 0.81 0.73 0.66
Present Value of Cash Flow 92.8 86.1 90.0 980.6
WACC 11.0% Total discounted cash flows 1,250
Nominal growth post 2010 2.0% Less: Net Debt (163)
Equity value (m) 1,087
ntroduction to valuation
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The model produces a valuation as at 1 January 2007 (proposed acquisition date). 1 January
2007 is 'time 0'; only cash flows after this date would accrue to the (potential) acquirer.
The ability to make specific forecasts for individual future years is crucial; otherwise most of the
value lies in the terminal value. The terminal value depends on the forecast (nominal) growth
rate post 2010. This and the discount rate (here the WACC) are the most sensitive assumptions
in the model.
Net debt is deducted from the enterprise value to arrive at an equity value.
Equity IeveI
The illustration above would be amended as follows:
Net interest paid would be deducted in arriving at free cash flow;
Resultant cash flows would be discounted at the cost of equity; and
Total discounted cash flows would represent the equity value.
ntroduction to valuation
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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.
f 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/EBTDA), similar business
etc).
A rough guide for US companies using a single ratio would be:
TotaI debt/
EBITDA
Estimated
bond rating
Credit spread
<0.8x AAA 60bp
0.8 - 1.5x AA 80bp
1.5 2.2x A 100bp
2.2 3.4x BBB 150bp
3.4 - 4.9x BB 350bp
> 4.9x B 600bp
Market-derived cost of debt
The market-derived cost of debt may also be calculated using public debt outstanding, but it
should be emphasised that we are looking for a long term forward return required by the
investors in the company's senior debt.
Irredeemable debentures
With irredeemable or undated debt, the company does not undertake to repay at any fixed date.
ntroduction to valuation
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Market vaIue
f interest () is expected in perpetuity, the market value of the debt is MVd and the required
return of debt holders is r
d
, then:
MVd = PV of interest in perpetuity
= . . .
rd) (1

rd 1

2
+
+
+
=
rd

By rearranging the equation:


r
d
=
interest ex MVd

Illustration
A company's 7% debentures are quoted at 89 per 100 nominal. Annual interest has just been
paid. What is the return (rd) the debenture holders are receiving?
r
d
=
89
7
= 7.86%
Tax shield
Although the debt holders in the above illustration are receiving a 7.86% return, the cost to the
company is less, as interest is deductible for corporation tax purposes.
k
d
=
MVd
interest t) (1
where k
d
= cost of debt
t = corporation tax rate (assume tax effect immediate)
The company pays out the whole amount of interest, say 7, but it is allowed the whole amount
as a deduction in the corporation tax computation. f we assume a corporation tax rate of 30%,
then the cost of debt is:
k
d
=
89
7 x 0.7
= 5.5% (or 0.7 7.86 = 5.5%)
Chronology
- nvestors 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%.
ntroduction to valuation
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Redeemable debt
Market vaIue
f interest () is expected for a number of periods and then an amount R on redemption, the
market value of the debt is:
MVd = =
n 3 2
rd) (1
R
. . . . .
rd) (1

rd) (1

rd 1

+ +
+
+
+
+
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 () with (1 t) x () interest.
ntroduction to valuation
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Cost of equity
Capital asset pricing model (CAPM)
CAPM is a model that provides the required return (cost of equity) which would be suitable to
appraise an investment, given knowledge of the business risk of the investment.
Key assumption
Shareholders are well diversified, i.e. they hold a balanced portfolio of different equities & gilts.
This means that the investor does not suffer unsystematic or company specific business risk (in
effect his different equities balance out). However, he will still suffer systematic risk.
Systematic risk
Even if an investor held every investment in the FTSE 100, there would still be fluctuations in
return as the market moved up and down, influenced by political and economic factors, etc. The
well-diversified shareholder's balanced portfolio represents the FTSE 100 and is subject to the
same systematic risk.
As the well-diversified investor only suffers systematic business risk, he only requires a return to
compensate for the systematic business risk in the investment.
Beta (| || |) measures the level of systematic business risk relative to the market risk for any
investment.
Thus, if an investment has a | of 0.9 we can say that, if the market rises or falls by 10% the
investment will rise or fall with the market, but only by 9% (i.e. the investment is slightly less risky
than the market as a whole).
CAPM gives the following equation:
Cost of equity (k
e
) = R
f
+ (|
L
x R
m
)

Risk free Premium
return for risk
Where:
k
e
=
Cost of equity (shareholders' required return)
R
f
= Risk free return (i.e. from government stock or corporate debt)
R
m
= Equity market risk premium
|
L
= Beta leveraged for target level of gearing
ntroduction to valuation
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ExampIe
R
f
= 6%
R
m
= 7%
|
L
= 1
Cost of equity of an investor will be:
6% + (1 x 7%) =13%
This is the same as the expected return on the market. t should be! The | = 1 indicates that the
investment moves exactIy in line with the FT 100.
f the investment has a | of 1.4, then it moves in line with the market, but to a greater degree. n
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
t is acceptable to use the long term bond rate as the risk free rate, although as the market thins,
the yield on blue chip corporate bonds may be used as a replacement. The 10 year bond rate is
used more regularly than the 30 year.
Rm - the equity market risk premium (EMRP)
This is often based on historic data and is the difference between the average return on stocks
and the average returns on risk free securities.
Period Stocks-T BiIIs Stocks-T BiIIs Stocks-T
Bonds
Stocks-T
Bonds
Arithmetic Geometric Arithmetic Geometric
1926-2001 8.09% 6.21% 6.84% 5.17%
1962-2001 5.89% 4.74% 4.68% 3.90%
1981-1990 6.05% 5.38% 0.13% 0.19%
1991-2001 10.62% 9.44% 6.90% 6.17%
ntroduction to valuation
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Calculation of Beta
The | of any share or investment is expressed as:
o
o
s
m
Where, o
s
= systematic risk of the investment
o
m
= risk of the FTSE 100
This can be calculated as follows:
| =
m
i im
r
where, r
im
is the correlation coefficient of the investment with the index, o
i
is the total business
risk in the investment and o
m
is the risk of the index.
Beta can be calculated in many ways, bbotson for example suggests that;
'To estimate the beta of a company, monthly total returns of the company's stock in excess
of the 30 day T-bill are regressed against the monthly total returns of the S&P500 in
excess of the 30 day T-bill.
A sixty month time frame is used for the regression'
The Bloomberg default is a twoy ear, weekly regression.
The problems of lag (share prices moving after the market) make the daily and even the weekly
data more problematic.
Adjustments for corporate size are offered, but these are volatile, changing from premia to
discounts over relatively short periods and are often ignored.
Raw or adjusted Beta
As companies and industries mature, the Beta tends to the market (ie. 1) - the adjusted Beta will
take account of this. Many argue that this introduces spurious accuracy into the K
e
(cost of
equity) calculation.
Large companies such as Nokia, Telecom talia and even Vodafone can create problems if their
stock comprises a disproportionate amount of the index, distorting their beta calculation.
ReIevering Beta
The service provider's (e.g. Barra) beta will reflect the existing gearing of the target company.
This must be unlevered, showing the risk profile of the target company's assets in the absence of
leverage:
ntroduction to valuation
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Unlevering formula
( )
(

|
.
|

\
|
+
|
= |
t 1
E
D
1
L
U
Current gearing
This unlevered beta must then be relevered, based on the target gearing level (if necessary, use
the industry average):
Relevering formula
( )
(

|
.
|

\
|
+ | = | t 1
E
D
1
U L
Target gearing
D = market value of debt capital
E = market value of equity capital
t = marginal tax rate
ntroduction to valuation
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Dividend vaIuation modeI
Constant dividends
f expected future dividends in perpetuity are constant at D, the market value of the shares is
MV
e
and the cost of equity is k
e
,
MV
e
= PV of dividends D in perpetuity
=
2
e e
) k 1 (
D
k 1
D
+
+
+
etc.
=
D
k
e
e
MV
shares equity
of value Market
=
) (k return of rate
required rs Shareholde
(D) dividend expected Future
e
Rearranging the model allows us to find (but not, of course, derive) the cost of equity or required
return. f D and MV
e
are known,
k
e
=
e
MV
D
ExampIe
Assume a C15,000 dividend is expected each year in perpetuity and shareholders require a rate
of return of 12% (k
e
).
What is the PV of this perpetuity?
The PV of the returns (from 1 - ) is as follows:
15,000 1/0.12 = 125,000.
nvestors should be prepared to pay C125,000 for this perpetuity.
Cum div./ ex div.
Cum div
Cum div. means the purchaser of the share at that price will buy the right to the next dividend.
Shares are mostly quoted cum div.
Ex div
Shares become ex div. just before the next dividend is paid, meaning that the purchaser does not
receive the next dividend which is (soon) to be paid.
ntroduction to valuation
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The dividend valuation model produces an ex dividend market vaIue since the sum of the
present values starts with the dividend in 1 year's time (ie. excludes the current dividend).
n order to convert from cum dividend to ex dividend for DVM purposes, one deducts the dividend
which is about to be paid, ie.
Ex div. MV = Cum div. MV next dividend to be paid.
ExampIe
Company A has 1 million 50p shares with a cum div. market value of 90p per share.
The company is just about to pay (signal of a cum div. value) a dividend of 100,000 and expects
dividends to continue at the level.
k
e
=
D
MV ex div
k
e
= % 12
Div div. cum MV
100,000 - 900,000
100,000
2
1
=
+ +
or per share % 12
10p 90p
10p
2
1
=

Constant growth in dividends


Assume dividends are expected to grow at a constant rate g.
Let D
0
= current dividend
D
1
= next year's dividend
MV
e =
. . .
) k (1
g) (1 D
k 1
g) (1 D
2
e
2
0
e
0
+
+
+
+
+
or =
2
e
1
e
1
) k (1
g) (1 D
k 1
D
+
+
+
+
etc.
The formula for adding up these future dividends discounted is
MV
e
=
g k
dividend years Next
ie
g k
g) (1 D
e e
0

+
or =
g k
D
e
1

f dividends, g and MV
e
are known, the cost of equity can be computed:
ntroduction to valuation
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 19
k
e
=
e
0
MV
g) (1 D +
+ g or g
MV
D
e
1
+
n summary, therefore, shareholders will value shares by discounting future expected dividends
at their required return. f the company wishes to compute the return that shareholders are
requiring, it can use the above formula where dividends are expected to grow at a constant rate,
g.
Estimation of g
Shareholders will have an expectation of dividend growth. They will normally have based this on
either what has happened in the past (extrapolation of past dividends) or on an analysis of what
will happen to profits, and hence dividends, in the future (by reviewing the company's retention of
profit and investment policy).
AItering the time horizon
The model referred to above is, of course, a simple perpetuity.
t is normally amended in accordance with the time horizon of the company such that
) k 1 (
D
e
1
+
+
2
e
2
) k 1 (
D
+
+
3
e
3
) k 1 (
D
+
+
4
e
4
) k 1 (
D
+
+
5
e
5
) k 1 (
D
+
. . . .
. . .
10
e
10
) k 1 (
D
+
+
10
e
) k 1 (
1
+
(

g k
D
e
11
The calculation is based on a 10 year time horizon, with the 1
st
dividend arising at time 1 (i.e.
next year).
Assumptions of DVM
nvestors 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.
ntroduction to valuation
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Dividend poIicy
Introduction
Dividends can be thought of as the trade-off between retained earnings and distributing cash or
stock to shareholders.
Retained earnings can be used to:
Fund capital expenditure
Make NPV positive investments
Keep back for financial flexibility
Distribution can be:
Share buyback
Cash dividend
Stock dividend
Why are dividends important?
SignaIIing tooI
Communicates information to the equity market about the strategic direction of a company
Signals a company's future operating performance
nvestors are inclined to look favourably upon a dividend increase which signals positive
information about the company's future earnings potential
A dividend cut can send a signal that management lacks confidence in the company's near-
term prospects. This effect is greater if a dividend cut is followed by lower earnings results or
other unfavourable news
SharehoIder preferences
Growth oriented investors do not seek out dividend income
Some investors (including private investors) may rely on the income generated by dividend
payments
Some institutional investors may be restricted from investing in shares of non-dividend paying
companies
Communication
Successful execution of a change in dividend policy will require a company to communicate:
The existence of value adding investment opportunities
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The need for additional funding to make those investments
The additional flexibility to deploy excess cash flow for share repurchases
Factors determining dividend policy
SharehoIder preferences
nstitutional shareholders (eg pension funds) may require regular cash receipts to meet their
commitments (eg to pay pensions).
Payout ratio
Depends primarily on the preference of the majority of shareholders
Consider industry comparables and practices
Growth / fIexibiIity
Mature, lower growth companies tend to pay high dividends, limiting a company's flexibility
with respect to dividend policy changes
However, a share repurchase program is easier to cut or discontinue if a more attractive
investment opportunity arises or cash conservation is required
SignaIIing
Experience suggests that investors interpret changes in dividend policy primarily as a signalling
mechanism
Tax efficiency
Dividends can be a less efficient vehicle for shareholder value distribution as they are taxed
when the dividend is paid (ie no deferral as with capital gains) and potentially at higher effective
rates (as gains often have exemptions and some countries charge lower rates on gains)
Characteristics of companies that pay low dividends (0% - 25% payout)
Growth companies
Volatile earnings
Weak credit
Excessively leveraged
High Beta
Highly competitive industry
High R&D
Technology-oriented
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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.
ntroduction to valuation
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 23
Recognising risk
Introduction
Risk can broadly be split in to 2 types, from the investors' perspective:
Business risk or Finance risk or
Earnings risk or Gearing risk
Operating risk
Portfolio theory &
CAPM analyse this
Traditional theory and Modigliani
& Miller analyse this
Business risk is addressed by the CAPM. There are a number of views regarding gearing or
leverage risk.
Gearing/finance risk
When funding from debt (or gearing up), there are 2 sides to consider:
1 There will be a higher proportion of cheaper debt finance, which will have a downward
pressure on the WACC, and upward pressure on the market value (MV) of the company.
2 Equity investors will be exposed to additional risk, i.e. the spread of their returns will
increase.
IIIustration
Low Average High
Earnings = Dividend (in an all equity company) 4,000 5,000 6,000
-20% +20%
f 5,000 is the average, the earnings, and therefore dividends, can fluctuate by 20% (risk).
f the company now has a fixed amount of interest to pay, the following occurs:
ntroduction to valuation
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Low Average High

Earnings 4,000 5,000 6,000
nterest (2,000) (2,000) (2,000)
_____ _____ _____
Dividend to equity 2,000 3,000 4,000
_____ _____ _____
Fluctuation = 33
1
/3% (risk)
Therefore, the higher the gearing, the higher the riskiness of the dividends and, therefore, the
higher the cost of equity (k
e
).
This will have an upward pressure on the WACC and a downward pressure on the market value
of the company.
Various theories suggest how these 2 factors combine and their resultant effect on:
- WACC of company
- MV of company
TraditionaI theory of gearing
At low levels of gearing, k
e
rises slowly and the effect of the cheaper debt outweighs the
increase in the k
e
. The theory therefore predicts that the WACC will fall.
However, as gearing increases further, k
e
increases more sharply and eventually outweighs
the cheaper debt effect. Therefore, WACC will start to rise again.
Thus, it should be possible to achieve an optimal level of gearing that there is an ideal
point to the trade-off between the cheaper debt and the costs of financial distress where the
weighted average cost of capital is minimised and the market value of the company (debt
plus equity) is maximised.
Cost oI
capital
ke
WACC
kd
optimal gearing
WACC lowest
MV highest
MV debt
MV equity
The problem is that this optimal can only be found by trial and error. The traditional theory
offers no mathematical route.
However, the trade-off theory is not really consistent with the evidence:
ntroduction to valuation
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 25
- Tax benefits of debt appear much higher than the costs of financial distress for most
companies.
- Companies appear to value flexibility of their strategic options highly and thus restrict
leverage.
- Pricing/marketing strategies have been shown to be partially determined by
competitors' capital structure.
f it is true that it is possible to find a minimum WACC, it is only true if the operating income
is independent of the capital structure. However, in practice this may not be the case for the
following reasons:
- When debt is raised, there are often debt covenants which prevent the company
using its assets as freely as the company would like.
- Although some theories disagree, a company taking on new investments could affect
existing providers perception of existing activities.
ModigIiani & MiIIer (M&M)
M&M offer a scientific relationship with equations that link WACC to levels of gearing. The exact
nature of the relationships, and hence the equations, will depend upon the tax regime.
Proposition I (no tax)
'The market value of any firm is independent of its capital structure', i.e., debt policy is
irrelevant.
Proposition II (no tax)
'The cost of equity (k
e
) increases as the debt:equity ratio increases. However, the
increase in cost of equity is offset by an increase in risk.'
Overall conclusion
There is no difference between the MV of a geared company and the MV of an ungeared
company (assuming equivalent business risk and identical sized earnings). Hence, the WACC is
independent of the level of gearing.
n 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. t reflects
the risk of total payments to the total providers of capital.
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IIIustration
Two companies have identical sized earnings and are both in the same business sector. The
only difference between them is the way in which they were financed.
Ungeared Geared
I II I II

Earnings 10,000 5,000 10,000 5,000
nterest (1,000) (1,000)
______ _____ ______ _____
Dividends 10,000 5,000 9,000 4,000
______ _____ ______ _____
Total return to providers of capital

Dividend 10,000 5,000 9,000 4,000
nterest 1,000 1,000
______ _____ ______ _____
10,000 5,000 10,000 5,000
______ _____ ______ _____
Providers of capital are getting the same total returns from both companies. Therefore, WACCs
must be identical and their MVs must be identical. The only factor which affects the total payout
is the risk attaching to the earnings which are identical for both companies.
This can be shown diagrammatically.
Cost
oI capital
WACC
Gearing B/S
ke
kd
The cost of equity rises steadily as gearing increases but the WACC is constant.
i.e. WACC
u
= WACC
g
where WACC
u
is the WACC of an ungeared company and WACC
g
is the WACC of a geared
company.
ntroduction to valuation
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For 2 identical companies
MV
geared
= MV
ungeared
M&M with corporation tax
With corporation tax, a geared company will have a lower WACC than an otherwise identical
ungeared company.
llustration
Ungeared Geared
I II I II

Earnings 1,000 500 1,000 500
nterest (400) (400)
_____ ___ _____ ___
1,000 500 600 100
Tax 30% (say) (300) (150) (180) (30)
_____ ___ _____ ___
700 350 420 70
_____ ___ _____ ___
Total return to providers of capital are:

Dividend 700 350 420 70
nterest 400 400
___ ___ ___ ___
700 350 820 470
___ ___ ___ ___
The returns to the geared company's investors are always greater due to the tax shield on the
interest (30% x 400 = 120).
i.e. tax shield = i t where i is the interest and t, the corporation tax
rate.
The market value of the company will reflect this, and increase by the PV of the tax shield.
The PV of the tax shield, discounted at the rate required by the debt holders, is:
It
rd
= MVd t.
The value of the geared company will exceed the value of an ungeared company by MVd t.
i.e. MVg = MVu + MVd t,
where MVg is the total value (equity + debt) of a geared company and MVu is the value of an
ungeared company.
Note that this is a simplified Adjusted Present Value calculation. The simplification assumes -
Borrowing at the risk free rate
No tax time lags
rredeemable debt
A diagrammatical representation of M & M, with corporation tax, is as follows:
ntroduction to valuation
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Cost
oI capital
WACC
Gearing B/S
kd
ke
k
e
increases with increased gearing, though not as sharply as in the 'no tax' situations. WACC
falls as the company gears up.
The important features of M&M with corporation tax are:
1 Companies should 'gear up' (i.e. take on debt finance) as far as possible as this will lower
the WACC and increase the market value of the company.
2 M&M offer a series of equations linking the cost of equity of the geared and ungeared
firm.
3 These equations allow the WACC to be predicted given any stated level of gearing. The
equation for predicting the WACC is:
WACC = Ke ungeared (1 t
MV debt
Total MV of company
)
Non-tax benefits to debt
n addition to the fact that interest is tax deductible for tax, as is any premium payable on
redemption, modern theories of capital structure suggest there are also non-tax benefits which
should be considered:
- Debt imposes discipline on the company, preventing any wastage of free cash flow.
- Debt can act as a deterrent against take-over bids.
- Raising debt demonstrates optimism about the company's future.
M&M formulae with tax
K
g
= K
u
+ (K
u
K
b
) (
MV debt
MV equity
) (1 T
c
)
K = K
u
(1 - T
c
(
MV debt
Total MV
))
|
g
= |
u
+ |
u
(
MV debt (1 - Tc)
MV equity
)
ntroduction to valuation
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 29
MV
g
= MV
u
+ T
c
MV debt
Where,
K
g
= cost of equity in geared company
K = weighted average cost of capital
K
u
= cost of equity in equivalent ungeared company
K
b
= debt holders' required return = risk free rate
|g = systematic risk attaching to dividend in geared company
|
u
= systematic risk attaching to dividend in ungeared company
Gearing Betas
|
u
The beta factor of an ungeared company or investment (often known as the
Asset or Earnings beta)
|
g
The beta factor of a geared company's or project's dividends (often known as the
Dividend or Equity beta)
K
u
Cost of equity ungeared
K
g
Cost of equity geared
K
u
= R
F
+ |
u
(R
M
R
F
)
K
g
= R
F
+ |
g
(R
M
R
F
)
i.e. an ungeared beta will provide the ungeared cost of equity
a geared beta will provide the geared cost of equity
For a geared company, |
u
measures the systematic risk attaching to the earnings of the
company.
|
g
measures the systematic risk attaching to the dividend payout. The relationship linking the 2
beta factors can be expressed as:
|
g
= |
u
+ |
u
(
MV debt (1 - Tc)
MV equity
)
or
|
g
= |
u
(
MV equity u
MV equity g
)
Illustration
A company has pre-tax earnings of 1,000,000, a tax rate of 31% and a |
u
of 1.5.
R
F
= 5% & R
M
= 12%.
K
u
= 5% + 1.5 (12 5)
K
u
= 15.5%
The market value of the company (debt plus equity) will be:
ntroduction to valuation
30 The Corporate Training Group Ltd - +44 (0)20 7490 4770; trainers@ctguk.com
MV
u
= e/ K
u
(1,000,000 x (1 31%)) / 15.5%
4,451,613
f we introduce 500,000 debt paying 10% interest (the risk free rate).
MV
g
= MV
u
+ T
c
MV debt
MV
g
= 4,451,613 + (31% x 500,000)
MV
g
= 4,606,613
The market value of the company is now 4,606,613. As the debt has a market value of
500,000, the equity will now have a value of 4,106,613.
K
g
= K
u
+ (K
u
K
b
) (
MV debt
MV equity
) (1 T
c
)
= 15.5 + (15.5 10) (
500,000
4,106,613
) (1 31%)
= 15.96%
|
g
= |
u
+ |
u
(
MV debt (1 - Tc)
MV equity
)
= 1.5 + 1.5 (
500,000 (1- 31%)
4,106,613
)
= 1.63
or
|
g
= |
u
(
MV equity u
MV equity g
)
= 1.5 (
4,451,613
4,106,613
)
The same value of equity should be able to be computed as the PV of the future dividends in
perpetuity.
Geared
000
Earnings 1,000
nterest (50)
_______
950
Tax at 31% (294.5)
_______
Dividend 655.5
_______
ntroduction to valuation
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MV equity in geared company = 655,500/0.1596
= 4,106,613.
Adjusted present vaIue (APV)
Most PV models discount future cash flows at the WACC. All financing side effects (eg interest
tax shield) must be incorporated into this discount rate.
APV discounts future cash flows as if they were entirely equity financed, to produce a 'base case'
present value. Specific financing side effects (interest tax shield, issue costs etc) are discounted
to present value separately. The base case value and the value of financing side effects are
aggregated to give the APV of the enterprise.
Note the operating unlevered cash flow should be discounted using the unlevered cost of equity
Ku.
The financing side effects are discounted at either the risk free rate or at the companies cost of
debt.
ntroduction to valuation
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Weighted average cost of capitaI (WACC)
f a company is financed by more than one type of capital, the WACC is computed by weighting
the individual costs according to their relative market values.
ExampIe:
k
e
= 16%
k
d
(post tax) = 12%
CapitaI Ex div market vaIue
1 ords 150,000
9% debenture 37,500
WACC = 16%
5 . 187
150
+ 12%
5 . 187
5 . 37
WACC = 15.2%
For WACC purposes, both debt and equity must be valued at market prices and not at the face
values at which they have been recorded in the books. t 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.
n 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.
ntroduction to valuation
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Cash fIow to discount
Dividend Valuation Model (DVM)
The DVM is most appropriate for firms with stable growth rates, paying out dividends and with
stable leverage.
t is often used for utilities and for financial service companies (free cash flows being notoriously
difficult to compute).
The basic one stage model can be converted to a 2 or 3 stage model to accommodate high
growth. This is best done via spreadsheet analysis.
The following table provides a summary of eps growth rates and the associated dividend payout
ratios, thereby providing a useful reality check.
1994-1999 EPS growth rate All US companies with Market
Cap larger than $5 billion and
growth in the ranges noted.
0%-5% 5%-10% 10%-15% 15%-20%
1999 median Div Payout 40.7% 33% 28.8% 0%
1999 median Div YieId 2.4% 2% 1.3% 0%
1999 Median Market/Book 3.2x 4.2x 4.6x 9.8x
1999 Median ROE 17.1% 17.6% 20.6% 21.6%
The levered free cash flow model (LFCF)
The LFCF measures what a firm could pay out as dividends. The actual payout may be different
for a number of reasons.
The basic model is straightforward:
Net income
+
depreciation and amortisation
-
preferred dividends
-
capital expenditure
-
working capital changes
-
principal debt repayments
+
proceeds from new debt issues
=
Levered free cash fIow
ntroduction to valuation
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The basic formuIa is:
P
o
=
g r
LFCF1

Eps x
- (capex depn) (1 - debt ratio) = (x)
- change in working capital (1 - debt ratio) = (x)
LFCF x
__
Two and three stage models can be developed using spreadsheet analysis
ntroduction to valuation
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VaIue drivers
n order to achieve the corporate goal (eg. to increase the share price over the next 5 years by
75%), it is necessary to identify those specific targets through which this corporate goal will be
achieved. These value drivers are the key areas in which targets can be set and performance
measured.
When analysing a company, it is, therefore, the 7 value drivers upon which sensitivity analysis
should be based to discover if value is being created or destroyed.
VaIue driver goaI
1. Revenue growth rate increase from 12% to 15%
2. Operating margin / EBTDA 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
nnovation tactics Downtime Funding choices
The following are examples of initiatives used to influence the 7 value drivers across an
organisation:
ntroduction to valuation
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Organisational value drivers
Revenue growth rate
1. Growth that adds value
2. New market entry
3. New products
4. Globalisation
5. Customer loyalty programmes
6. Pricing advantage
7. Distribution outlets
8. Focused advertising based on differentiation
Operating margin growth
1. Modernise working practices
2. Multi-skilling
3. Share services / outsource
4. Consolidate back office functions
5. Spin-offs
6. Business process re-engineering (BPR)
Customer care
ntegrated billing
ABC system
Data warehousing
Data mining
Network management
Cash tax rate
1. Transfer pricing / management charges
2. Capex timing
3. Locate and exploit intellectual property and brands
4. Holding structure
5. Co-ordination centres
Working capitaI
1. Stock eg just-in-time, supply chain management
2. Debtors eg billing system, payment discounts
3. Creditors eg impact on discounts / supplier relationships
4. Cash
CapitaI expenditure
1. Develop capital appraisal and utilisation reviews and project finance techniques
2. Lease v buy decisions
3. Treasury hedging and exchange rate management systems
ntroduction to valuation
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 37
WACC
1. Build management understanding of cost of capital
2. Gearing optimisation
3. Calculate business unit specific WACC
4. Consider share buy backs and demerger of non-core business
Competitive advantage period
1. mprove investor relations providing predictable and sustainable financial performance
2. mprove business unit cash flow information
3. Return to core competencies
4. Develop executive (and employee) performance reward schemes linked to share price
improvements
5. ncorporate strong risk management procedures
6. Creation of barriers to
Supplier power
Customer power
Substitute threat
New entrants
Existing rivalry
What comes before vaIuation?
Accounting is the key to understanding financial information. f earnings are wrong, the debt
service cover ratio is wrong. f cash flow is wrong, DCF is wrong.
Consequently, accounting skills need to be developed in order to enable financial analysis, which
will then allow sensible estimates to be made before any worthwhile projections are possible.
Assuming the financial skills are in place, the following are where it all goes wrong when
modelling.
Alternative approaches to forecasting
The following are alternative approaches to forecasting. These are calculated independently of
the value-drivers underlying them. (Additional accuracy can be obtained by analysing the value
drivers prior to doing the forecasting).
SaIes revenues
Production based models
Product / market based models dependent on marketing strategy
Growth rate models inflation, real growth
Operating margin
Cost structure models fixed vs variable or more detailed (line by line)
Operating profit margin (% of sales) model
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Movements in working capitaI
Balance sheet figures (at start and end of year) for stock, debtors & trade creditors; then take
changes
Calculate the balance sheet figures (at start and end of year) for stock, debtors and trade
creditors by estimating the stock days and creditor days (both based on cost of sales) and
debtor days (based on sales); then take the changes
Calculate net working capital figure from the ratio of nwc:sales; then take changes
f nwc:sales is constant then nwc:sales x increase in sales = nwc movement
Depreciation
May be a given percentage of fixed assets (forecast fixed assets as a function of sales
growth or independently; then depreciate)
Grow at a rate reflecting growth in fixed assets see capex (combination of inflation and real
activity-based growth)
CapitaI expenditure
Direct input from independent information
Forecast balance sheet value of fixed assets and annual depreciation charge then capex
equals increase in net fixed assets plus depreciation
Capex as a multiple of depreciation, depending on real growth vs replacement:
(replacement capex = depreciation x inflation over historical life of assets)
Interest (received & paid)
Function of interest rate and either opening, average or closing balance depending on actual
agreement / contract
Main problem is circularity (which Excel can generally cope with if set up correctly)
Tax
Simple model based on historical effective tax rates applied to profit (P&L and cash flow
likely to be different due to time lag in paying tax)
Calculate tax based profit independently of accounting profit (capital allowances vs
depreciation being main difference) and apply actual expected tax rates
Complex tax-calculation model to account for the effect of trading losses and capital gains
on the disposal of assets
Deferred tax on the timing differences between accounts-based and tax-based profit.
Deferred tax will affect earnings and the balance sheet but will have no effect on cash
Dividends
Direct input from independent information
Based on dividend policy (dividend growth or dividend cover) and number of shares
Use expected dividend cover & maximum distribution based on P&L and cash balances
ntroduction to valuation
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Growth rates and time period for discounting
Estimation of g
Shareholders will have an expectation of dividend growth. They will normally have based this on
either what has happened in the past (extrapolation of past dividends) or on an analysis of what
will happen to profits, and hence dividends, in the future (by reviewing the company's retention of
profit and investment policy).
Extrapolation of past dividends
ExampIe
1.1.96 Pay dividend 12,634
1.1.01 Pay dividend 22,265
f it is assumed that the average growth over the five years will be maintained in the future, g can
be calculated:
12,634 (1 + g)
5
= 22,265
(1 + g)
5
=
634 , 12
265 , 22
1 + g =
5
634 , 12
265 , 22
1 + g = 1.12
g = 12%
Estimation of future growth in profits (and hence dividends)
A model for calculating growth in profits is the rb model.
f a company can earn an accounting return of r% on new investments and retains a constant
proportion b of its annual profits, then growth in profits will approximately equal rb.
ExampIe
Suppose a company's shares have a cum div market value of C10.25 per share. A dividend per
share of C1.25 is about to be paid. The company estimates it will earn 20% on new investments
and the current policy (to be maintained) is to pay out 60% of earnings by way of dividend, ie.
retain 40%.
The company's profits (and therefore dividend) will grow by 8% (40% 20%).
The shareholders' required return (k
e
) is
k
e
= % 23 08 . 0
25 . 1 25 . 10
08 . 1 25 . 1
= +

ntroduction to valuation
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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 EBT = Reinvestment rate *ROC
Duration of growth period
The greater the current growth rate in earnings relative to the stable growth period, the longer
the higher growth will last.
The larger the size of the firm relative to the market, the shorter the higher growth period.
The greater the barriers to entry, the longer the high growth period
Combine the above and use judgement.
StabIe growth
deally, investors want growth rate that can be maintained forever. This is normally linked (ie
equal to or less than) to the growth rate in the economy, either national or global.
TerminaI vaIues
Terminal value is the value of the firm after the explicitly forecast growth period (often the high
growth phase). Default forecast periods are conventionally 5 or 10 years.
The terminal value is normally calculated in one of two ways:
1. Multiple based method
PER or EV/EBTDA 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. n addition, the danger of using current
multiples extended 10 years into the future is obvious.
2. Perpetuity growth method
Using a stable growth rate into perpetuity the terminal value is:
Terminal value in year n =
g - r
t at dividends or earnings or FCF 1 n +
ntroduction to valuation
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Time period convention
n reality, cash flows accrue over the course of the year. We make a simplifying assumption that
the cash flows occur at a particular point in time. There are two options:
That cash flows occur at each year end (i.e. T
1
, T
2
, etc.)
That cash flows occur at the mid-point of each year (i.e. T
0.5
, T
1.5
, etc.)
The implication for the terminal value is that if it is calculated using the multiple based method,
this is assumed to give TV at T10 (assuming we are using a 10 year explicit forecast horizon). f
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.
ntroduction to valuation
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VaIuing combinations
MethodoIogy
Acquisition motive VaIuation methodoIogy
Under valuation Value target as stand alone. No acquisition
premium.
Diversification Value target as stand alone. No acquisition
premium.
Operating synergy Value the firms independently.
Value the firm with the operating synergy.
Target firm value = ndependent 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.
ntroduction to valuation
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Illustration
Compaq and DigitaI
Digital
Discounting the FCF of Digital gave an enterprise value of $2.1bn.
With a change in control, the value increases by $2.4bn to $4.5bn.
Compaq
Discounting the FCF of Compaq gave an enterprise value of $38.5bn.
Combination
Discounting the FCF of the combined firm (at the new WACC, based on weighted average
unlevered betas, levered up for the new capital structure) gave an enterprise value of $45.5bn.
The value of the standalone firms was $4.5bn + $38.5bn = $43bn. The value of synergy was
$1.5bn.
Value of Digital with synergy $6bn
Value of cash paid in the deal $30 x 147m shares = $4.4bn
Digital's outstanding debt $1bn
Remaining value to be satisfied by shares $0.6bn
Number of shares 147m
Value per share $ 0.6bn $147m = $4.08
Compaq's share price at the time of the offer $27.00
Appropriate exchange ratio 4.08/27 = 0.15 Compaq share for every Digital share. The actual
ratio was 0.9.
ntroduction to valuation
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Comps
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ComparabIe company anaIysis (Comps) 1
Why do we do comps? 1
Comparable universe 3
Sources of information 4
From Equity Value to Enterprise Value 5
Enterprise value (EV) 5
Equity value (Eq.V) 5
Net debt 6
When to use Equity Value vs Enterprise Value 8
mpact of capital structures on multiples 9
Which multiple? 10
Using comps 12
Special situations 14
Currency 14
Annualisation 15
LTM 15
Exceptional / extraordinary items 16
Dilution 18
Convertible debt 19
Mezzanine finance 22
Market value of debt and / or preference shares 22
Associates and JVs 22
Minorities 25
Finance and operating leases 26
Unfunded pension obligations 29
Pro forma: Acquisitions and disposals 31
Keys to success 34
Comps
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ComparabIe company anaIysis
(Comps)
Why do we do comps?
Analysing the operating and equity market valuation characteristics of a set of comparable
companies with similar operating, financial and ownership profiles provides a useful
understanding of:
1. The important operating and financial statistics about the target's industry group (e.g., growth
rates, margin trends, capital spending requirements).
This information can be helpful in developing assumptions for a discounted cash flow
analysis.
2. The relative valuation of publicly listed companies
The resulting multiples guide the user as to the market's perception of the growth and
profitability prospects of the companies making up the group. Consequently, comps can be
used to gauge if a publicly traded company is over or undervalued relative to its peers.
3. A benchmark valuation for target entities
Comps valuations are based on:
metrics of target company (eg EBTDA)
multiples of similar quoted company(ies) (eg EV/EBTDA)
Valuation multiples from comparable companies may be applied to the financials of the
target entity to be valued to give a theoretical value of the target business.
For example:
Metric of target earnings $10.0m
Multiple of similar quoted company p/e 18.0x
TheoreticaI equity vaIue of target $10.0m x 18.0 = $180.0m
4. An indicative market price for a company which is to be floated on the stock market.
5. The validity of terminal DCF assumptions.
6. nvestment returns for financial buyers acquiring assets with the intention of monetising the
investment in the public equity market in an PO.
Comps
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Example
Tesco Sainsbury
Share price (p) 261.5 376.0
Equity value (m) 18,127 7,260
Enterprise value (m) 20,967 8,172
Enterprise vaIue I
SaIes
2006 (Curr.) 0.86x 0.48x
2007 (Prosp.) 0.74x 0.47x
EBITDA
2006 (Curr.) 10.8x 7.6x
2007 (Prosp.) 9.4x 6.6x
EBIT
2006 (Curr.) 15.5x 12.4x
2007 (Prosp.) 13.5x 10.4x
Equity VaIue / Earnings
2006 (Curr.) 20.8x 17.9x
2007 (Prosp.) 18.5x 15.5x
Comps
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ComparabIe universe
Being a numerically easy exercise, multiples valuation requires in-depth understanding of the
target company and its peers. The relative valuation multiples are only useful if the companies
are a comparable peer group. Similarly, comps valuations are based on applying the valuation
multiples of one company (or a group of companies) to value the target business.
As no two companies are exactly the same the most similar companies are sought. The
companies (both target and comparable) should have similar:
business activities industry, products and distribution channels
geographical location
size
growth profiles (including seasonality and cyclicality)
M&A profiles
profitability profiles
accounting policies
market liquidity of securities
breadth of research coverage
Additionally, if equity level comps are to be used, similar capital structures are essential.
In conclusion
Select the universe of comparable companies carefully - more is not necessarily better.
Comps
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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
ncome 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
/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
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From Equity VaIue to Enterprise VaIue
Enterprise value (*) = Equity Value (**) + Net Debt (***) + Minority nterest
1. Example continued - Enterprise value
Tesco
Share price (p) 261.5
Number of Shares (m) 6,932
_____
Equity VaIue (m) 18,127 [A]
ST Debt (m) 1,413 [B]
LT Debt (m) 1,925 [C]
Cash & equivalents (m) (534) [D]
_____
Net Debt (m) 2,804 [E]=[B+C+D]
Minority nterest (m) 36 [F]
_____
Enterprise vaIue (m) 20,967 [A +E + F]
Enterprise vaIue (EV)
Enterprise value is also referred to as:
Total enterprise value (TEV)
Entity value (EV)
Gross value (GV)
Total capitalisation
Firm value (FV)
Aggregate value
Leveraged market capitalisation (L.MC)
The terms are used loosely and are generally interchangeable. f used in a critical context we
should define exactly what us meant by them.
Equity vaIue (Eq.V)
Equity value (Eq.V) is also referred to as:
Market capitalisation (MC)
Comps
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Net debt
Net debt = borrowings - (cash + Iiquid resources)
Borrowings = instruments
issued as a means of
raising finance other than
those classified in/as
shareholders funds
+ related derivatives
+ obligations under finance
leases
Cash = cash in hand
+ deposits repayable on
demand* with any qualifying
financial institution
- overdrafts from any
qualifying financial
institution repayable on
demand.
Liquid resources = current
asset investments held as
readily disposable stores of
value.
*On demand = can be
withdrawn at any time
without notice and without
penalty [or where maturity
or period of notice of not
more than one working day
has been agreed in
advance]
Readily disposable =
disposable without
curtailing or disrupting
business of reporting entity
and either
readily convertible into
known amounts of cash
at or close to its
carrying amount or
traded in an active
market
Active market = a market of
sufficient depth to absorb
the investment without a
significant effect on the
price
Net debt components may be spread around the balance sheet in:
liabilities due after more than 1 year
liabilities due within 1 year
cash at bank and in hand
investments or marketable securities (held as current assets)
UK companies must disclose an analysis of their net debt (typically in a note to the accounts).
Comps
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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
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When to use Equity VaIue vs Enterprise VaIue
Capital value
Turnover
Operating costs Enterprise vaIue =
EBTDA Equity value
Depreciation / amortisation + Net debt
Operating profits + Minority interest
Associates / JV
EBT
Net interest Earnings adjustment for net debt financial
interest
PBT Equity vaIue
Tax + Minority interest
Profit after tax
Minority interests Earnings adjustment for minorities - minority
interest
Net income / earnings Equity vaIue
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 9
Impact of capitaI structures on muItipIes
Company A Company B
Capital structure
Equity 200 500
Net debt 300 -
Minority interest - -
P&L
Sales 150 150
EBT 35 35
Net interest (25) -
PBT 10 35
Earnings 7 25
MuItipIes
Enterprise vaIue / Sales 3.3x 3.3x
EBT 14.3x 14.3x
Equity vaIue / PBT 20.0x 14.3x
Earnings 28.6x 20.0x
2. Example continued - the multiples
Tesco
(m - except per share)
Enterprise value 20,967
Share price (p) 261.5
2005A 2006E 2007E
Sales 20,988 24,306 28,212
Enterprise Value / Sales 1.00x 0.86x 0.74x
EBITDA 1,663 1,950 2,230
Enterprise Value / EBTDA 12.6x 10.8x 9.4x
EBIT 1,187 1,352 1,556
Enterprise Value / EBT 17.7x 15.5x 13.5x
EPS (p) 11.5 12.6 14.1
P/E (Equity Value / Earnings) 22.7x 20.8x 18.5x
Comps
10 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Which muItipIe?
The relevance of the different valuation benchmarks changes over time as business models
evolve. Consequently, two key questions must be asked when selecting multiples:
What is the development stage of the target company relative to comps?
What is the appropriate comps universe trading on?
FV/Net PP&E
FV/Subscriber
FV
Revenue (growth)
FV
Revenues
FV/Net PP&E
FV/Subscriber
FV
EBITDA (growth)
FV
EBITDA
Revenue
EBITDA
EBIT
Net Income

$
Pros Cons
EV / Sales Suitable for companies with similar
business model / development
stage
May be the only performance
related multiple available for
companies with negative EBTDA
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
nconsistency of treatment within
sales of joint venture in different
reporting environments
Different revenue recognition rules
between companies
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 11
Pros Cons
EV/EBTDA
ncorporates profitability
Most businesses are EBTDA
positive so widening the universe
gnores the most significant
accounting differences arising
from goodwill
Relatively limited exposure to
accounting differences
gnores depreciation / capex
gnores tax regimes and tax
profiles
Does not take into account varying
EBTDA growth rates
nconsistency of treatment within
EBTDA 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/EBT
ncorporates 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
gnores tax regimes and tax
profiles
Does not take into account varying
EBT growth rates
nconsistency of treatment within
EBT of joint venture and other
unconsolidated affiliates within
different reporting environments
Other accounting differences such
as revenue recognition,
capitalisation policies, finance vs
operating leases
P/E
Widely used in traditional
industries with high visibility of
earnings
Widely understood
Quick and easy calculation
Useful to check DCF exit
assumptions
Depends on corporate structure
Accounting policies have a
significant impact on earnings
In conclusion
By understanding the industry through reading analyst reports and news stories it will become
clear:
What are the most important performance ratios and market multiples to focus on
Are there any industry specific statistics (e.g. hotels price per room)?
Comps
12 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
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
EBTDA 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 / EBTDA ? 5.88
Equity value / earnings ? 9.65
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 13
Valuing Target - Company X
At equity level
Metric of target earnings of X 89.6
Multiple of similar quoted company p/e of Y 9.65x
TheoreticaI equity vaIue of target (Company X) 89.6 x 9.65 = 865
At enterprise level
Metric of target ebitda of X 170
Multiple of similar quoted company ev/ebitda of Y 5.88x
Theoretical enterprise value of target 170 x 5.88 = 1,000
Less: net debt & minorities of target (200)
TheoreticaI equity vaIue of target (Company X) 800
How to use Comps
Comparable Company Entity Net Debt & Equity
Companies Financials Value M 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
EBTDA Curr. 7.5x - 10.5x 7.3 55 - 77 10 45 - 67
Prosp. 6.5x - 9.5x 7.9 51 - 75 10 41 - 65
EBT Curr. 12.5x - 15.5x 5.1 64 - 79 10 54 - 69
Prosp. 10.5x - 13.5x 5.5 58 - 74 10 48 - 64
Earnings Curr. 18.0x - 21.0x 3.0 - - 54 - 63
Prosp. 15.5x - 18.5x 3.3 - - 51 - 61
High 75
Low 40
Average 57
Median 58
Estimated Equity VaIue (m) 55-60
Comps
14 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
SpeciaI situations
Adjustments may be needed to the metrics and/or the resulting equity or enterprise value when
the following issues arise in the target and/or the comparable company:
1. Currency
2. Annualisation
3. LTM (last twelve months)
4. Exceptional items
5. Dilution
6. Convertible debt
7. Mezzanine finance
8. Market value of debt and / or preference shares
9. Associates and JVs
10. Minorities
11. Pro forma: disposal, acquisition
The over-riding idea behind Comps is to ensure that there are like-for-like comparisons.
Consequently, if one of the companies in the Comps group has significant associates whilst its
peers do not, then an inconsistency exists amongst the group. The metrics of the company with
the associate need to be adjusted to remove the inconsistency and maintain the idea of
comparable companies.
Currency
Multiples (e.g. EV/EBT) are independent of currency provided that both numerator (eg EV in $m)
and denominator (e.g. EBT in $m) are in the same currency. Consequently, keep financials and
market capitalisation in the (same) local currency there is no need to translate to target's
currency.
For the Euro-zone incorporated companies, convert financials into Euros as the exchange rates
have been fixed and the stocks are already trading in Euros.
Always use the share price traded on the primary exchange (Bloomberg: RELS).
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 15
AnnuaIisation
Financials should be adjusted for:
different year-ends
seasonality of business
growing / declining activity
e.g. to annualise to December a company with a March financial year-end
3/04 3/05 3/06
$80m $100m
3 mths 9mths
12/04 12/05
$95m
Alternatively, the annualisation can be done using quarterly or monthly accounts if these are
available. For companies quoted in the US, published quarterly information will enable this.
LTM
LTM (Last Twelve Months) numbers are useful where the profits of the comparable businesses
are growing (or declining) significantly and/or are seasonal. n these situations, annualising
numbers (by pro-rating on a time basis) may be an over-simplification of the profits generated in a
particular time period and may not be indicative of the companies' most recent trading
performances.
Where companies have produced quarterly or half-yearly accounts, more up-to-date profit figures
can be generated. For example, a US company with a year end of 30 November, may have just
produced its quarterly results (10Q) for the 3
rd
quarter to 31 August 2004. Therefore, to find the
most recent trading performance, LTM to 31 August 2004 would be calculated and compared with
the LTMs (not necessarily all to 31 August) of comparable businesses. The LTM would be
calculated as:
AnnuaIs Nov-02 y.e. Nov-03 (A) y.e. Nov-04 (F)
80 100
Nov-02 Aug-03 Nov-03 Aug-04
10Q 45 60
Comps
16 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Aug-03 Aug-04
LTM = 80 - 45 + 60
95
ExceptionaI / extraordinary items
Exceptional and extraordinary items are characterised by:
their unusual nature (unrelated to ordinary business activities); and
by the infrequency of occurrence (i.e. not expected to happen again).
The rules vary in different countries as to what should be classified as exceptional or
extraordinary. For example, in the UK it is not possible to have extraordinary items, whilst in
France, certain items must be classified as extraordinary.
Additionally, companies would prefer losses and charges to be classified as exceptional in order
that underlying profits (ie valuation metrics) are unaffected by such bad news. Consequently, the
notes to the accounts should be examined to determine which items are true exceptionals /
extraordinaries and worthy of exclusion.
Exceptional / extraordinary items include:
Restructuring charges
Profits and losses on disposals
Financing one-offs (e.g. debt redemption above book value, etc.)
A share in unconsolidated affiliates' exceptional items
True exceptional and extraordinary items should be stripped out.
Where adjusting net income (for equity level comps) refer to the tax notes in the accounts to find
the tax effect of exceptionals. f not available use the effective or marginal tax rate.
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 17
Example
Compco Adjustments Pro forma
Sales 100 - 100
____ ___ ____
Exceptionals (20) 20 -
____ ___ ___
EBT 5 20 25
Net nterest (2) - (2)
____ ___ ___
PBT 3 20 23
Tax (*) (1) (6) (7)
____ ___ ___
Earnings 2 14 16
Notes: (*) Tax rate on exceptional items is assumed to be 30%.
Not all exceptionals / extraordinaries will have a tax effect. Additionally, the tax effect of
like items will be different in different countries. For example:
reorganisation / redundancy provisions
n the UK it is unlikely that tax relief will arise
n Germany it is likely that tax relief will be received
property write-downs / impairments
n the UK tax relief will not arise
n Germany it is likely that tax relief will be received
Comps
18 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
DiIution
Earnings per share
Within the same sector the same basis should be used, i.e. basic vs diluted.
For historic actuals:
weighted average number of shares should be used; and
the number of shares should be the outstanding number (i.e. the number used to calculate
the basic eps) unless the fully diluted share capital gives significant dilution within the sector.
For forecast figures:
weighted averages should not be used; and
the number of shares to be used should be the most up to date outstanding number unless
the fully diluted share capital is materially different within the sector. n this case the treasury
method should be used for share options.
Share valuation
When an equity valuation has been derived, the number of shares to be used for calculating
value per share should be the most up to date outstanding number unless the fully diluted share
capital is materially more, in which case the treasury method should be used for share options.
Weighted averages should not be used.
The treasury method
The treasury method will be used when the company has:
a large number of share options and/or
the exercise price is significantly lower then the current market price.
The treasury method assumes that the proceeds from the exercise of the options are used to
buy-back shares at the current share price.
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 19
Illustration
Current share price: 120p
Outstanding number of shares: 5.0m
Options outstanding: 1.0m
Exercise price: 40p
Outstanding number of shares: 5.00m
______
Options outstanding: 1.00m
Full price shares from proceeds [(1.0m x 40p) 120p] (0.33m)
______
Net dilutions 0.67m
______
Fully diluted number of shares 5.67m
Dilution as a % of outstanding number of shares 13.3%
ConvertibIe debt
Impact on EPS
Convertible debt contains an option allowing holders to convert the debt into equity at some future
date. Consequently, if there are convertible instruments with significant conversion rights then
the number of shares and diluted EPS should take into account the effect of conversion.
IIIustration
Net profit C1,000
Ordinary shares outstanding 10,000
Number of convertible 10% C100 bonds 12
The convertible bonds have been outstanding throughout the period. Each bond is convertible
into 150 ordinary shares. The company suffers tax at the rate of 40%.
Basic EPS
000 , 10
000 , 1 C
= C0.100
Diluted EPS
800 , 11
072 , 1 C
= C0.091
Comps
20 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Adjusted net profit
C1,000 + [C120 x (1 - 40%)] C1,072
Number of ordinary shares for diluted EPS
Shares outstanding 10,000
Number of shares resulting from conversion 1,800 11,800
Impact on capital structure
Accounting for convertible debt varies. The carrying value of the debt will be different for those
companies reporting under FRS, where split accounting is used, to those using US GAAP where
the instrument is treated purely as debt.
As a result, the net debt and book equity values (and the adjustment to interest for diluted eps)
will be different.
IIIustration
A company issues C100,000 3% convertible debt at par. nterest 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 FRS, split accounting is adopted part of the instrument is treated as debt and part
equity. The debt component of the proceeds raised is calculated by discounting the future cash
flows at the market rate of 7.0%. The balance of the proceeds raised (C9,271) is deemed to be
the fair value of the consideration received for writing a call option on the issuer's shares.
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 21
US GAAP IFRS
Start Interest Cash End Start Interest Cash End
Year 4.816% 7.000%
1 100.00 4.82 (3.00) 101.82 90.73 6.35 (3.00) 94.08
2 101.82 4.90 (3.00) 103.72 94.08 6.59 (3.00) 97.67
3 103.72 5.00 (3.00) 105.72 97.67 6.84 (3.00) 101.50
4 105.72 5.09 (3.00) 107.81 101.50 7.11 (3.00) 105.61
5 107.81 5.19 (3.00) 110.00 105.61 7.39 (3.00) 110.00
25.00 34.27
At end of first year:
BaIance sheet Income statement
US GAAP FRS US GAAP FRS
Cash 97.00 97.00 nterest expense (4.82) (6.35)
Cash fIows
Debt 101.82 94.08 US GAAP FRS
Equity - 9.27 nterest paid (3.00) (3.00)
Retained earnings (4.82) (6.35) Debt raised 100.00 90.73
Equity raised - 9.27
97.00 97.00
Market value vs book value
The market values of the bonds (plus the market values of the options to convert) are likely to be
different from the book values. For EV purposes, market values should be used. Where the
convertibles are traded, this is straightforward.
Where information about the market value of the convertibles is not available, find how many
shares the bonds convert into (from the financial statements) and apply the current market share
price to these. The higher of the market value of the shares and the book value should then be
used within the EV calculation.
Comps
22 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Mezzanine finance
Like convertible debt, mezzanine debt may have elements of both debt and options over shares.
Unlike convertibles, the option is a right to buy shares at a fixed price rather then to convert the
debt.
Consequently, the instrument should be broken down into its two components: the loan element
should be valued using the balance sheet carrying value and the options should be valued using
the treasury method.
Market vaIue of debt and / or preference shares
Depending on the sector, preference shares and quoted debt should not be marked to market if
the difference between market value and book value is not significant.
When a company is in financial distress, debt instruments should be marked to market.
This information can be found for traded debt and preference share capital. Additionally in some
jurisdictions, the company may disclose this information.
For example, in the UK, under FRS 13 Derivatives and Other Financial nstruments 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 EBT and proportionally consolidated for the post-EBT 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 EBT.
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 23
Illustration
CompCo has a 40% stake in AssocCo.
CompCo AssocCo
Market value of equity 90 55
Net debt 30 10
Sales 100 50
Operating profit 20 12.5
Associate 5
EBT 25
ConsoIidate in proportion (incIuding debt)
This method is used if:
A joint venture is proportionally consolidated (ie the proforma numbers are already presented
in the consolidated accounts); and/or
The associate / joint venture has similar activities and growth prospects to the CompCo so
that it is appropriate to apply the same multiples to both parts of the business.
CompCo Adjustments Pro forma
Sales 100 20 120
EBT 20 5 25
Equity value 90 - 90
Net debt 30 4 34
___ __ ___
Enterprise value 120 4 124
EV/ Sales 1.03
EV / EBT 4.96
The equity value of CompCo includes the market value of its stake in AssocCo.
ExcIude and vaIue on a separate basis
The market has valued CompCo's equity value to include that of the associate / joint venture
whereas the P&L metrics do not include the associate / joint venture. Where the two companies
have different activities or growth prospects the resulting metrics are not appropriate for all parts
of the business.
Comps
24 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
This method is appropriate where the associate / joint venture has different activities or growth
prospects to the CompCo. The multiples that are derived are the multiples of CompCo's
business only.
CompCo Adjustments Pro forma
Sales 100 - 100
EBT 20 - 20
Equity value 90 (22) 68
Net debt 30 - 30
___ __ ___
Enterprise value 120 (22) 98
EV/ Sales 0.98
EV / EBT 4.90
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 25
Minorities
Enterprise value is measured at the market value of all its components. Minorities are a
constituent part of enterprise value and should, when representing significant value, be valued at
market value. Otherwise they should be included at book value.
Where the subsidiary in which the minority arises is quoted the market value of the minority can
be derived.
Practical difficulties in arriving at the market value of minorities exist where the subsidiary in
which the minority arises is unquoted. Unquoted minorities will have to be valued on a separate
basis.
Illustration
CompCo has a 75% stake in SubsidCo.
CompCo SubsidCo
Market value of equity 80 70
Net debt 40 25
Shareholders' funds 30
Minority interest in SubsidCo 7.5
Sales 100 60
EBT 20 12
PBT 16 10
PAT 11 6
Minority interest (1.5) -
Net income 9.5 6
Using book value Using market value
Equity value 80 80
Net debt 40 40
Minority interest 7.5 17.5 (25% x 70)
____ ____
Enterprise value 127.5 137.5
Comps
26 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
EV / sales 1.28x 1.38x
EV / EBT 6.4x 6.9x
Equity value / net income 8.4x 8.4x
Finance and operating Ieases
To acquire the use of an asset such as an aeroplane, a business may buy the asset or lease the
asset. This leads to three distinct ways in which the financing of the operating assets of a
business is accounted for:
IIIustration
3 airlines have acquired the use of a plane with a cash price of C95m.
Company A has bought the plane (10 year life) using cash on which it was earning a 4.0% return.
Company B has leased the plane on an 8 year lease paying C16m per annum (the implicit interest
rate on the lease is 7.15%) this will be treated as a finance/capital lease.
Company C has leased the plane on a 3 year lease paying C18m per annum this will be treated
as an operating lease.
After one year the impact on the financial statements of the acquisition of the asset would be:
(borrow to) buy Lease
Finance / capital Operating
Income statement
EBTDAR - - -
Rental expense - - (18.0)
EBTDA - - (18.0)
Depreciation (9.5) (11.9) -
EBT (9.5) (11.9) (18.0)
nterest expense (3.8) (6.8) -
Pre-tax profit (13.3) (18.7) (18.0)
BaIance sheet
PPE 85.5 83.1 -
Cash (98.8) (16.0) (18.0)
Debt - (85.8) -
Retained earnings (13.3) (18.7) (18.0)
Cash fIow
Operating - - (18.0)
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 27
nterest 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 EBT or even EBTDA
is limited. EBTDAR should be the metric of choice where comparing the underlying trading
performances of the business.
Alternatively, the operating leases could be converted (mathematically) into finance leases. For
example, in the above illustration, the breakdown of the finance lease charge in the income
statement is approximately

interest and

depreciation. This rule of thumb has been


identified by the credit rating agencies and so adjusted metrics (e.g. EBT) can be calculated.
Using Company C in the illustration, the rental expense is removed (and so standardises
EBTDA) and replaced with a new depreciation charge of 12 (18 x

) and interest of 6 (18 x

). f this simplifying assumption is accepted, then the result is that EBT and all subsequent
multiples are similarly standardised no matter how the operating assets have been financed.
Adjusting EV
f EBTDAR is the metric of choice (or the adjusted EBTDA), then EV/EBTDAR should be the
multiple. However, EBTDAR (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 EBTDAR, operating leases should be converted into finance
leases, by calculating the present value of the minimum lease commitments. A schedule of
payments and the appropriate discount rate are needed to do this neither of which is likely to be
presented in financial statements.
Comps
28 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
IIIustration
A company has a corporate borrowing rate of 7.5% and a disclosed schedule of operating lease
payments:
Discount rate 7.50%
Year 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 20202021
Op. lease payments 75 72 65 60 58 58 51 46 45 45 30 30 18 12 10
Present value 70 62 52 45 40 38 31 26 23 22 14 13 7 4 3
PV of lease payments
(capitalised operating
leases) 450
The illustration would be difficult to recreate in practice due to a lack of disclosed information.
Additionally, the derived value of C450m is very sensitive to the length of the leases and the
discount rate:
The longer the lease terms, the higher the present value of the lease payments
The lower the discount rate, the higher the present value of the lease payments
For example, if a company's corporate borrowing rate is assumed to be the applicable rate for
refinancing the operating leases then the present value of these commitments will be higher than
if the WACC was used. Additionally, as the leases end they may need to be replaced and so the
lease terms may be indefinite.
As a result, credit rating agencies and analysts simply capitalise operating leases into net debt by
multiplying the annual operating lease charge by a factor. This factor varies between 5.5 and 8.5
depending on the sector (due to typical length of leases and discount rates). This factor
approximates to an appropriate annuity factor.
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 29
Unfunded pension obIigations
Where a business has guaranteed a minimum pension to employees on retirement, it must make
payments into the pension scheme to meet these future obligations a defined benefit scheme.
These payments will be invested by the pension scheme with the intention of meeting the future
pension requirements when they fall due. As time moves on, employees within the scheme will
be getting closer to pensionable age and may also be entitled to greater pension payouts as they
continue to work for the business.
As a result, it is possible to calculate the pension deficit the difference between the market
value of scheme assets and the present value of liabilities to scheme members.
Scheme value of assets 3,921
Present value of scheme liabilities (5,760)
Net pension scheme deficit (1,839)
n simple terms, if a business has not made sufficient payments to the pension scheme, then the
scheme is likely to be in deficit. Comparable companies which have historically made sufficient
cash payments into the scheme (no deficit) will consequently have different net debts to
companies with deficits.
The accounting issues
The accounting for defined benefit pension schemes is notoriously varied depending on which
accounting regime is followed.
Adjusting net debt
As defined above, the net pension scheme deficit of C1,839 is unlikely to be recognised on the
balance sheet (although some variant of the calculation may be). However, when using either US
GAAP, UK GAAP or FRS, this figure is disclosed in the accounts and so international
comparability can be achieved.
As payments into pension schemes are tax deductible, any payments made to reduce this deficit
will reduce taxes payable. Consequently, assuming a corporate tax rate of 30%, the adjustment
to net debt would be an extra C1,287 [C1,839 x (1-30%] of "debt to make it comparable to a
business which has already made up any deficit.
Adjusting profit
As with the accounting (or non-accounting) in the balance sheet, internationally the income
statement effects will vary. Once more, US GAAP, UK GAAP and FRS disclose (though don't
necessarily recognise) similar figures.
Where EBT or EBTDA is the metric of choice, the most relevant element is the current service
cost current service cost being the increase in the projected benefit obligation (present value of
scheme liabilities) due to employees working for the company during the period.
Comps
30 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Consequently, to calculate EBT or EBTDA, the existing accounting for pensions in the income
statement (which may well have significant international variation) should be removed and
replaced with the current service cost (as an operating expense).
IIIustration
A company with an EBTDA of C553m and net debt of C1,938m, and which suffers corporate tax
at the rate of 30%, has a provision in its balance sheet for pensions of C57m and a pension
charge in operating expenses of C64m.
Disclosed in the notes to the accounts is the following information:
net pension scheme deficit C1,839m
current service cost C92m
net pension finance expense C1,255m
pension contributions paid to scheme C88m
Revised net debt:
Net debt as originally stated C1,938m
net pension deficit (post tax) [1,839 x (1-30%)] C1,287m
Adjusted net debt C3,225m
Revised EBITDA
EBTDA as originally stated C553m
Add: original pension charge (C64m)
Less: current service cost C92m
Adjusted EBTDA C581m
Note
Due to international tax complexities, the tax treatment of the existing and revised accounting
may be substantially different and so adjusting post tax profits will prove onerous. Consequently,
EPS adjustments are likely to be intricate.
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 31
Pro forma: Acquisitions and disposaIs
When a company makes an acquisition / disposal between the latest date of its balance sheet
and the day when a comps is done, a pro forma should be constructed.
The purpose of the pro forma is to compare "like with like", i.e. an adjusted enterprise value with
adjusted financials for the acquisition / disposal.
The problem is that you often do not have enough information to make sensible pro-forma
adjustments for all line items. US companies tend to give pro-forma revenue, EBT and net
income. European companies, on the other hand, are likely to be less forthcoming.
IIIustration - disposaI
CompCo has disposed of DisposeCo since the year end.
CompCo DisposeCo
Market value of equity (current) 100
Net debt (last balance sheet) 20 5
Disposal price (in cash) 30
Sales 60 40
EBT 10 4
Pro forma: disposaI
CompCo Adjustments Pro forma
Sales 60 (40) 20
EBT 10 (4) 6
Equity value 100 - 100
Net debt / (cash) 20 (35) (15)
___ __ ___
Enterprise value 120 (35) 85
EV/ Sales 2.0x 4.3x
EV / EBT 12.0x 14.2x
Comps
32 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
IIIustration - acquisition for cash
CompCo has acquired 100% of AcqCo since the year-end for 30 in cash
CompCo AcqCo
Market value of equity (current) 100
Net debt (last balance sheet) 20 5
Sales 60 40
EBT 10 4
Pro forma: acquisition for cash
CompCo Adjustments Pro forma
Sales 60 40 100
EBT 10 4 14
Equity value 100 - 100
Net debt / (cash) 20 35 55
___ __ ___
Enterprise value 120 35 155
EV/ Sales 2.0x 1.55x
EV / EBT 12.0x 11.10x
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 33
IIIustration - acquisition for shares
n the above example, CompCo has acquired 100% of AcqCo since the year-end for 30 in
shares.
Pro Forma: acquisition for shares
CompCo Adjustments Pro forma
Sales 60 40 100
EBT 10 4 14
Equity value 100 30 130
Net debt / (cash) 20 5 25
___ __ ___
Enterprise value 120 35 155
EV/ Sales 2.0x 1.55x
EV / EBT 12.0x 11.10x
Comps
34 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
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. EBT and EPS, so that the historics
and the forecasts can be input using the same adjustments
8. Ensure that the numbers are comparable potentially, the more adjustments made for
special situations (true exceptionals/non-recurring items, dilution, associates etc), the more
comparable, but:
The more time to input the comps
The less likely that all the desired adjustments will be visible in the brokers' research
forecasts
The more chance of errors
9. Keep the comps analysis up to date
Check the web site and the financial calendar of the individual companies to ensure that
the most recent published financial information is used
Update share prices
Update exchange rates
Comps
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 35
10. Check your work
Double check for data entry or other processing mistakes
Step back and look at the finished product do the results make sense?
Get someone else to check your work
11. Understand the results of the analysis and be prepared to discuss them.
Precedent transactions analysis
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Precedent transactions anaIysis 1
ntroduction 1
Relevant transactions 1
Mechanics 2
Summary transaction information 2
Sources of information 3
Equity value vs enterprise value 4
The multiples 5
Output sheet 6
Valuing the target 7
Checking 7
Valuation football field 8
Control premia 9
Synergies 9
Drivers of equity return in an LBO 10
Problems with precedent transactions 10
Precedent transactions analysis
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 1
Precedent transactions anaIysis
Introduction
Precedent transactions, also known as comparable transactions, comptrans, transaction comps
or premium paid analysis, are used to derive an implied market valuation for a company, either
public or private, in an acquisition context.
Precedent transactions reflect the market value of a target's income stream in a takeover
situation.
Precedent transactions look at recent acquisitions in the relevant sector from which valuation
multiples can be derived by dividing the transaction value by the target company's financials.
These valuation multiples are applied to the company being valued in order to give a theoretical
value of the business.
ReIevant transactions
Precedent transactions look at recent acquisitions in the relevant sector. Comparable
transactions are selected to include corporate activity of companies with similar business
activities and ideally operating in the same geographical areas.
As no two companies or transactions are exactly the same the most similar companies and
transactions are sought. The target companies (both precedent and intended target) should have
similar profiles, i.e.
business activities industry, products and distribution channels
geographical location
size
growth profiles (including seasonality and cyclicality)
profitability profiles
accounting policies
public vs private
Additionally, the transactions should, ideally:
be for similar acquisition proportions,
the premia for a 30% stake will be lower than for a 100%
be for similar considerations (cash vs debt vs equity)
it is likely that a 100% cash offer will be at a lower price than a 100% equity offer
involve similar bidder companies (trading vs private equity)
private equity acquirers do not value synergies in their offer price
Precedent transactions analysis
2 The Corporate Training Group Ltd - +44 (0)20 7490 4770; trainers@ctguk.com
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
mplied enterprise value Grossed-up equity value plus net debt acquired
Precedent transactions analysis
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 3
Sources of information
Information Source
List of sector corporate activity SDC
M&A Monitor
Sector brokers' reports
When target is a public company
Offer details Offer documents
Reuters articles
Regulatory News Service (RNS) for UK companies
Historic target data Annual report and offer document - last P&L
Annual report or interim results - last BS
Forecast target data Broker research
When target is a private company / division / subsidiary
Historic target data Parent annual report - last P&L
Press articles and RNS (for UK companies) sales & profit
Note:
1. Historic and forecast data for the target company should be extracted from the most recent
relevant research immediately prior to the transaction being announced - the transaction was
negotiated based on these numbers and the current transaction will be based on comparable
research.
2. All source documentation should be marked to show where information has been extracted
from with both a Post-it showing the page and a highlighter showing the numbers used.
3. When choosing a broker, make sure the numbers are sanity checked with Global Estimates
to make sure the analyst's projections are in line with peers
4. Footnotes should be used for all assumptions and points of interest
Exchange rates
Always make sure you are using the same currency in both numerator and denominator:
P&L historic use average exchange rates for the period
P&L forecast use most recent exchange rate
B/S use the exchange rate at the date of the BS
Precedent transactions analysis
4 The Corporate Training Group Ltd - +44 (0)20 7490 4770; trainers@ctguk.com
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. nclude both values and the range of multiples if
possible.
Equity vaIue vs enterprise vaIue
The equity and enterprise values are always for 100% of the target company. f Bidder buys 50%
of Target, the equity and enterprise values are the implied values for the entire company.
f 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. t is important to understand
what the amount paid represents to avoid calculating incorrect transaction multiples.
Share options and convertible debt
n-the-money share options (and all Long Term ncentive Plans, LTPs) will be exercisable upon
the acquisition and so should be converted (using the treasury method i.e. after accounting for
exercise price) when calculating the equity and enterprise values.
Similarly, convertible debt may be convertible into shares. Equity and enterprise value must be
adjusted commensurately.
Precedent transactions analysis
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 5
The muItipIes
Examples of multiples
Sales multiple Enterprise Value / Sales
EBTDA multiple Enterprise Value / EBTDA
EBTA multiple Enterprise Value / EBTA
EBT multiple Enterprise Value / EBT
Price / Earnings multiple Equity Value / net income
Net assets multiple (Equity Value + Minority nterests) / Net Assets
Growth ratios (Yr
0
metric / Yr
-1
metric) 1
Margins Profit metric / Sales
Private transaction multiples
By looking at historic precedent transactions, valuation multiples can be derived by dividing the
transaction value by the target company's financials.
metric
) ifany ( assumed debt paid cash
Public transaction multiples
As for private transactions, by looking at historic precedent transactions, valuation multiples can
be derived by dividing the transaction value by the target company's financials (or other metric
such as subscribers, square feet, etc).
metric
) ifany ( assumed debt ) shares of number price offer (
For a public company transaction, the premium paid alludes to the fact that a bidder will typically
pay a premium above the market valuation to obtain control over the target.
Precedent transactions analysis
6 The Corporate Training Group Ltd - +44 (0)20 7490 4770; trainers@ctguk.com
Output sheet
SAMPLE PRECEDENTS OUTPUT SHEET
(All amounts in EUR millions, unless otherwise indicated) Firm VaIue
LocaI Equity Firm As a MuItipIe of EBITDA EBIT
Date Target / Acquiror Business of Target CRY VaIue
(a)
VaIue
(a)
SaIes EBITDA EBIT Margin Margin
EUR EUR
Jun-02 Dunlop Cox (BTR)/ Electrically-powered automotive seating GBP 578 766 1.09x 8.5x 12.9x 12.8 8.4
Lear mechanisms
Nov-01 Valeo/ Automotive parts SEK 29,931 31,431 1.05x 9.0x 12.3x 14.5 8.5
Investor Group
Oct-01 Borealis Industrier/ Instrument panels, door, panels, climate DKK 887 1,288 1.16x 7.5x 17.3x 15.4 6.7
Lear systems, and exterior trim
Nov-00 Prince Automotive/ Automotive overhead systems & consoles, USD 21,936 33,667 1.49x 9.9x 22.4x 15.0 6.7
Johnson Controls door panels, visors, armrests
Median 11,411 16,359 1.12x 8.8x 15.1x 14.8 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 8.5
Low 578 766 1.05 7.5 12.3 12.8 6.7
No te : (a) Equity and Iirm value have been adjusted to reIlect 100 oI entity in cases oI minority positions acquired.
SAMPLE PRECEDENTS VALUATIONS: AUTO VALUATION
(Euros in Millions)
SeIected Precedents' Range Auto ImpIied Auto VaIuation
Low High Metric Low High
Firm Value /
LTM Revenue 1.1x 1.4x t4,510.6 t4,961.7 t6,314.8
LTM EBITDA 8.5 9.9 668.3 5,680.6 6,616.2
LTM EBIT 13.0 17.0 480.8 6,250.4 8,173.6
Selected Auto Firm Value Range f5,630.9 7,034.9
Precedent transactions analysis
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 7
VaIuing the target
The valuation multiples calculated from precedent transaction are applied to the relevant metric of
the target company being valued in order to give a theoretical value of the target business.
There are a number of different ways to select the appropriate transaction multiple from the
transaction database:
Average / median of the transactions
Average excluding outliers
Range around the average
dentify highest and lowest likely prices
The best method will depend on
The quality of the information going into the precedent transactions database
Who is the audience
What is the situation
Checking
Always check your work use a calculator
Comparable multiples should be checked with the broker to see if they are in line
The completed sheet should be checked by eye to make sure there are no obvious mistakes
Footnotes should be used for all assumptions and points of interest
ComparabIe
Transactions
MuItipIes Range
Company
FinanciaIs
(m)
Entity
VaIue
(m)
Net Debt &
Minority
Interest (m)
Equity
VaIue
(m)
Sales hist. 0.90x 1.20x 100 90 120 10 80 110
curr. 0.80x 1.10x 115 92 127 10 82 117
prosp. 0.70x 1.00x 125 88 125 10 78 115
EBTDA hist. 10.0x 16.0x 7.0 70 112 10 60 102
curr. 9.5x 15.5x 7.5 71 116 10 61 106
prosp. 9.0x 15.0x 8.0 72 120 10 62 110
EBT hist. 14.0x 20.0x 5.0 70 100 10 60 90
curr. 13.0x 19.0x 5.5 72 105 10 62 95
prosp. 12.0x 18.0x 6.0 72 108 10 62 98
Net ncome hist. 25.0x 28.0x 3.0 75 84 - 75 84
curr. 24.0x 27.0x 3.5 84 95 - 84 95
prosp. 23.0x 26.0x 4.0 92 - 104 - 92 104
High 117
Low 60
Average 87
Estimated Equity VaIue (m) 80 - 95
Precedent transactions analysis
8 The Corporate Training Group Ltd - +44 (0)20 7490 4770; trainers@ctguk.com
VaIuation footbaII fieId
current share
price 100p
180p
145p
130p
140p
110p 80p
125p
90p
115p
130p
12 month share price
performance
Control premium (25% -
40%)
Comparable company
multiples
Precedent transaction
multiples
DCF
Summary vaIuation (Cm)
2,610
2,190
2,010
2,130
1,770 1,410
1,950
1,530
1,830
2,010
1,200 1,700 2,200 2,700
12 month share price
performance
Control premium (25% -
40%)
Comparable company
multiples
Precedent transaction
multiples
DCF
Enterprise vaIue (Cm)
current EV
Precedent transactions analysis
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 9
ControI premia
Typically, acquisitions in the UK are made at c. 30% premium to the company's quoted value,
representing a "premium for control in certain industries, e.g. technology, this may not be the
case.
The ability to control a company has a value:
Complete control (majority)
Partial control (minority, significant influence, joint control)
A block of shares providing some level of control must be worth more than the sum of the values
of the single shares
i.e. 51 shares > 51 x 1 share
Consequently, transaction multiples are higher than the trading multiples of the company.
t 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. f the acquisition is going to add any value to the bidder, then the amount actually paid
is generally less than this maximum.
Consequently, precedent transaction multiples are impacted by the split of value of synergies
between target and bidder.
Precedent transactions analysis
10 The Corporate Training Group Ltd - +44 (0)20 7490 4770; trainers@ctguk.com
Drivers of equity return in an LBO
An investor in an LBO deal does not acquire with the target the benefits of synergies as the target
will continue to operate in isolation. Consequently, the LBO team must see different benefits from
paying a premium for the target. These generally arise through the benefits of leverage:
tax savings from interest
downside limited to equity capital injected
potentially very high upside for equity holders
ProbIems with precedent transactions
Relative to public comparables, it is more difficult to conduct a valuation based on precedent
transactions. t 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
nclusion of assumed debt
Acquisition of minority stakes
Volatility of public markets
Calculating premia to pre-bid share price - getting the most appropriate pre-bid price
Had the market already moved on rumours?
Use pre-transaction or post-transaction estimates must compare like with like
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Exercises and case studies
Jude Inc 1
DEF Ltd 2
RegaIia pIc 4
Hey pIc 5
Comps 1 6
Comps 2 7
Comps 3 8
Comps 4 9
Comps 5 10
MyTraveI 11
Pensions 12
MegateI pIc 14
Matthews & Ager 15
BIaine pIc 17
Gatsby pIc 18
Fitz Ltd 19
Grupo Cespa 20
Jefferson Smurfit Group 22
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 1
Jude Inc
Jude nc 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
EBTDA 87
nterest paid 18
Dividends paid 14
ncrease in inventories 1
ncrease in receivables 22
ncrease in payables and operating accruals 9
Tax paid (at rate of 30%) 8
Capital expenditure 412
ssue of shares 232
ssue of debt 143
Requirement
Calculate the relevant free cash flow for the first forecast period.
Valuation exercises
2 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
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 / EBT Multiple
Based on the three comparable companies
a) Latest Balance Sheet (31
st
December 2004):
$m $m
Share Capital 23.3 Fixed Assets 50.5
Retained Earnings 41.7 nvestments 17.6
Borrowings 48.4 nventory 54.3
Other Liabilities 91.4 Receivables 63.3
Cash 13.8
Other Assets 5.3
204.8 204.8
b) Share nformation:
Shares in ssue: 23.3 million, par value $1.00
EBT for 2005F: $12.9m
Net ncome for 2005F: $ 6.0m
Dividend declared (gross): 15.0 cents per share
Expected dividend growth 4%
c) ndependent Valuation of the Assets and Liabilities
Fixed Assets $52.3m
nvestments $12.9m
Provision for Bad Debt $1.0m
Valuation exercises
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d) Dividend Yields, P/E and EV/EBT ratios for three comparable companies:
Dividend Yield P/E Ratio (2005F) EV/EBT (2005F)
Company 1 5.2% 14.2 10.3
Company 2 3.9% 12.3 8.9
Company 3 4.9% 11.1 8.1
e) Cost of Capital
Assume that the company considering acquiring DEF has a cost of equity of 12% and a weighted
average cost of capital of 10% and that DEF is an average risk investment for the acquirer.
Valuation exercises
4 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
RegaIia pIc
The equity share price of Regalia plc, an unlisted company, is to be estimated, as at the
beginning of 2006, based on a discounted cash flow valuation of the enterprise.
The relevant components of free cash flows (in Cm) are as follows:
Year ending in December 2006 2007 2008 2009 2010
EBTDA 2,151 2,390 2,769 3,130 3,474
Working capital (increase) decrease 200 200 (213) (225) (215)
Tax paid 325 375 643 739 810
Tax shield on interest expense 75 78 89 86 79
Capital expenditure 1,780 1,780 1,500 1,500 1,200
Other information
Number of equity shares in issue (m) 6,932
Risk free rate 5.0%
Corporate borrowing margin (over risk free rate) 1.9%
Market risk premium 4.5%
Appropriate Beta 0.83
Debt:Equity value target (market value) 25%
Existing net debt (Cm) 3,033
Minority interest (Cm) 36
JVs and associates (Cm) 340
Corporation tax rate 30%
Nominal growth in FCF post 2010 1.2%
Terminal EBTDA multiple 6.2x
There are no preferred shares in issue.
Requirement
Estimate the price of an equity share in Regalia plc, using a DCF valuation approach, using both
a growth in perpetuity and exit multiple methodology to estimate the terminal value.
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 5
Hey pIc
The equity share price of Hey plc is to be estimated based on a discounted cash flow valuation of
the firm. The discount rate to be used is the company's weighted average cost of capital.
The relevant free cash flows have been calculated as:
2005 2006 2007 2008 2009
m m m m m
1 2 3 4 5
Free cash fIow to firm (FCF) 120.0 129.6 137.4 143.6 147.9
Other information
Number of equity shares in issue (m) 586.4
Risk free rate 3.5%
Credit risk premium (over risk free rate) 1.9%
Market return expected 8.7%
Appropriate Beta 1.15
Debt:firm value target (market value) 38%
Existing net debt 700m
Corporation tax rate 30%
Nominal growth in FCF post 2009 2.2%
There are no preferred shares in issue.
Requirement
Estimate the price of an equity share in Hey plc.
Valuation exercises
6 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Comps 1
A company has the following information:
m C Cm
Stock price 30.00
Shares outstanding 40.0
Cash 125
Book value of equity 1,000
Debt 250
Minority interest 35
Preferred stock 50
LTM EBTDA 100
2005 EPS 1.00
Requirement
CaIcuIate
a. market capitalisation;
b. enterprise value;
c. the 2005 P/E multiple; and
d. the LTM enterprise value/EBTDA multiple.
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 7
Comps 2
A company has the following information:
m C Cm
Stock price 35.00
Shares outstanding 20.0
Cash 400
LTM EBTDA 150
LTM EBT 100
Minority interest 120
Bank debt at book value 500
C250m 6% subordinated debentures trading at 70
Owns a 20% stake in company with C1,000m market capitalisation
Requirement
CaIcuIate
a. equity value
b. enterprise value
c. the LTM EBTDA multiple and
d. the LTM EBT multiple.
Valuation exercises
8 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Comps 3
A company has the following information
m C Cm
Stock price 30.00
Average in-the-money options exercise price 20.00
Shares outstanding 60.0
n-the-money options outstanding 10.0
Cash 500
Preferred stock 500
Minority interests 100
Debt 1,500
Requirement
1. ncluding only common stock, calculate
equity value
enterprise value
2. ncluding all equity-linked claims, calculate
equity value
enterprise value
Valuation exercises
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Comps 4
A company has two operating divisions with different growth and profitability profiles, auto and
technology. The following information is relevant:
x m Cm
Auto EBT 2,000
Technology sales 4,000
Shares outstanding 100.0
Cash 1,250
Debt 5,000
Unfunded pension liability 300
Comparable auto universe EBT multiple 7.0x
Comparable technology universe sales multiple 1.00x
Requirement
Calculate the company's implied:
a. enterprise value;
b. equity value; and
c. equity value per share
Valuation exercises
10 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Comps 5
A company has two operating divisions with different growth and profitability profiles, department
stores and supermarkets. The following information is relevant:
m C Cm
Department store EBT 500
Supermarket EBTDA 300
Shares outstanding 200.0
Cash 1,000
Debt 2,000
Minority interests 100
n-the-money options outstanding 40.0
Average in-the-money options exercise price 10.00
The most common valuation multiple for department stores used in the market is an EBT
multiple. The most comparable department store EBT multiple is 9.0x.
The most common valuation multiple for supermarkets used in the market is an EBTDA
multiple. The most comparable supermarkets EBTDA multiple is 7.0x.
Requirement
1. ncluding only common stock, calculate the implied
enterprise value
equity value
equity value per share
2. Calculate the above including all equity-linked instruments
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 11
MyTraveI
The market capitalisation of MyTravel plc is 1,203m. ts consolidated financial statements show:
Balance sheet (extracts) P&L account
Cm Cm
Lease rentals (222.3)
Cash and cash equivalents 378.6 EBTDA 200.1
D&A (103.9)
Debt 398.6 EBT 96.2
Net interest income/(expense) (2.3)
Minority interests 209.6
Shareholders' equity 312.3 EBT 93.9
Leases
MyTravel plc has significant commitments under non-cancellable operating leases. The average
remaining lease term at the balance sheet date is 10 years. The company's average borrowing
rate is 8%.
The annuity factor for 10 years at 8% is 6.71.
Requirement
a. Calculate EV/EBTDA, without adjusting for off balance sheet operating leases
b. Calculate EV/EBTDA, adjusting for off balance sheet operating leases
Valuation exercises
12 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Pensions
Siemens AG has a defined benefit pension scheme. t prepares its consolidated financial
statements in accordance with US GAAP. The net periodic pension cost for the period of C447m
has been charged to operating expenses during the year.
The market capitalisation of Siemens AG is C42,250m. ts consolidated financial statements
show:
Balance sheet (extracts) P&L account
Cm Cm
Cash and cash equivalents 11,196 EBTDA 6,058
D&A (4,126)
Debt 12,346 EBT 1,932
Accrual for pension plans 3,557 Net interest income/(expense) 318
Minority interests 541 Other financial income 1,225
Shareholders equity 23,521 EBT 3,475
Pension plan disclosures
Change in projected benefit obIigation Cm
Projected benefit obligation at beginning of year 18,544
Service cost 487
nterest cost 1,151
Actuarial losses/(gains) 240
Benefits paid (930)
_________
Projected benefit obligation at end of year 19,492
_________
Change in pIan assets Cm
Fair value of plan assets at beginning of year 14,625
Actual return on plan assets (1,187)
Contributions 2,023
Benefits paid (930)
_________
Fair value of plan assets at end of year 14,531
_________
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 13
Net periodic pension cost Cm
Service cost 487
nterest 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/EBTDA 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/EBTDA for Siemens AG:
using reported data (ignoring pensions disclosures);
3. adjusting for the real pension deficit and service cost.
Corporate tax
Assume a corporate tax rate of 39%.
Valuation exercises
14 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
MegateI pIc
The market capitalisation of Megatel plc is 59,843m. ts financial statements show:
Balance sheet P&L account Peer comparison
m m EV/EBITDA
nvestments in JVs 2,586 Turnover 18,715 Comp co 1 13.5
nvestments in Operating costs (15,117) Comp co 2 9.0
Associates 2,639 Operating profit 3,598 EV/sales
Share of JV (427) Comp co 1 4.5
Net debt 8,700 Share of associate 27 Comp co 2 5.0
Operating profit 3,198
Shareholders Net interest (382)
Funds 15,795
Minority interests 498
[Depreciation 2,752m]
[Amortisation 89m]
An analyst has calculated EV/sales and EV/EBTDA for Megatel plc as follows:
EV/EBTDA =
m 439 , 6
m 543 , 68
= 10.6
EV/sales =
m 715 , 18
m 543 , 68
= 3.7
The analyst has concluded that Megatel plc looks reasonably priced on EV/EBTDA and cheap
on EV/sales against its peers. Megatel plc has far more unconsolidated joint ventures and
associates, and fewer minority interests, than its peers
Requirement
Suggest how Megatel's EV (and resultant EV multiples) could be adjusted or 'cleaned up' to take
minority interests, joint ventures and associates into account.
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 15
Matthews & Ager
The market capitalisation of Matthews plc is to be calculated using comparable company
analysis, with Ager plc as the comparable company.
Ager pIc
The market capitalisation of Ager plc is 14,548m. ts consolidated financial statements show:
Balance sheet (extracts) P&L account
m m
nvestment in JV (50%) 182 Turnover 22,800
nvestment in associate (30%) 33 Operating costs (21,626)
Cash and liquid resources 526 1,174
Share of JV 21
Debt 3,330 Share of associate 3
1,198
Shareholders funds 5,187 Net interest (125)
Minority interests 34
[Depreciation 455m]
[Amortisation 9m]
Joint venture Associate
50% of the equity is owned by Ager plc. 30% of the equity is owned by Ager plc.
Balance sheet (extracts) Balance sheet (extracts)
m m
Cash and liquid resources 302 Cash and liquid resources 11
Debt 662 Debt 31
Shareholders funds (equity) 364 Shareholders funds (equity) 110
The market capitalisation of the joint The market capitalisation of the
venture is 908m. associate is 130m.
Valuation exercises
16 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Matthews pIc
The consolidated financial statements of Matthews plc show:
Balance sheet (extracts) P&L account
m m
nvestment in JV (50%) 22 Turnover 17,244
Cash and liquid resources 487 Operating costs (16,711)
533
Debt 1,356 Share of JV (4)
529
Shareholders funds 4,911 Net interest (76)
Minority interests 53
[Depreciation 409m]
[Amortisation 17m]
Joint venture
50% of the equity is owned by Matthews plc.
Balance sheet (extracts)
m
Cash and liquid resources 42
Debt 80
Shareholders funds (equity) 44
The market capitalisation of the joint
venture is 52m.
Requirements
[The market capitalisation of Matthews plc is to be calculated using comparable company
analysis, with Ager plc as the comparable company.]
a. Calculate suitable EV/sales and EV/EBTDA ratios for Ager plc.
b. State, with reasons, which multiple (EV/sales or EV/EBTDA) appears most appropriate to
value Matthews plc.
c. Applying this multiple, estimate the market capitalisation of Matthews plc.
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 17
BIaine pIc
Blaine plc has an authorised share capital of 10 million 1 ordinary shares, of which 4 million are
currently in issue. The shares have an ex-div. market value of 3.40. This year the dividend was
35p per share and this is expected to grow at a rate of 5% for the foreseeable future.
The company also has 1 million 7% irredeemable debentures in issue which currently stand at
95.
Requirement
Given a corporate tax rate of 30%, what is Blaine plc's WACC?
Valuation exercises
18 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Gatsby pIc
The directors of Gatsby plc are planning a new investment and the following information is
relevant:
the project is in a different industrial sector; Gatsby's normal activities are in Leisure, whilst
the new project is in Retail
the project will cost 2 million and will bring in revenue before tax of 400,000 for 8 years
starting in one years time
tax is payable in the same year as the profits arise at the rate of 30%
the leisure industry has an average Beta factor of 1.4 whilst the retail industry is less risky
having a Beta of 1.1
the current risk free rate of interest is 7.5% with a market premium of 5%
Requirement
Should Gatsby plc invest in the new project?
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 19
Fitz Ltd
Fitz Ltd. currently has in issue 3 million 1 shares and has a cost of equity of 14%.
A dividend of 20p has just been paid and this is expected to grow at a rate of 3% for the
foreseeable future.
The company also has 1million 6% loan stock in issue, with investors requiring a risk free return
of 7.5%.
A new project, to be wholly equity financed, is under investigation (no announcement to the
market has yet been made about this) which would cost 700,000 and would provide net
revenues in perpetuity of 125,000 per annum. The 125,000 is stated in today's terms, although
it would, in fact, start in one year's time.
t is assumed that corporation tax of 30% will be paid as net revenue is received. The outlay
would have no corporation tax effects.
nflation is expected to run at 3% in the future.
The project has a Beta of 1.2.
The risk free rate is 7.5% and the market premium is 5%.
Requirement
What is the market value of the company prior to the project and what is the new market value of
the company after the project?
Valuation exercises
20 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Grupo Cespa
Precedent transactions vaIuation
Grupo Cespa S.A. ("Cespa") is the 2nd largest waste management company in Spain. The total
estimated size of the European waste management sector is circa C20bn, and the Spanish
market represents around 8%. Cespa was created in July 1976 and has since expanded in Spain
and Argentina mainly through acquisitions.
Cespa is a vertically integrated waste management player involved in:
Collection
Transfer
Disposal / ncineration
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 ("&C) segments.
Cespa was jointly owned (50/50) by two major environmental companies: 1) Aguas de Barcelona,
"Agbar (Spanish water company) and 2) STA (waste management company and world wide
leader. Subsidiary of French energy group Suez SA). n May 2003 Agbar and Sita decided to
sell their stakes in Cespa. n August 2003, a Spanish construction company, Grupo Ferrovial,
emerged as the successful bidder after a very competitive process with a wide range of both
industrial players and financial investors involved on the buy side.
Ferrovial made the acquisition based on the following information:
Net Debt
Net debt (Dec 2002) C244m
Financials (year ending 31 December, in Cm)
ActuaI ActuaI
2001 2002
Sales 543 560
EBTDA 94 86
EBT 53 43
Requirement
Based on the above and the attached precedents database and current sector trading multiples,
calculate an appropriate takeover equity value.
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 21
Precedent transaction database
Precedent Waste Transactions - Firm VaIuations
Firm Firm VaIue
Target Acquiror Currency Date VaIue EBIT EBITDA EBITDA EBIT
Leigh Interests GU Holdings Aug-97 170.1 11.3 26.2 6.5x 15.0x
BFI (International ops.) SITA Nov-97 1,450.0 115.0 235.0 6.2 12.6
Caird Group Shanks Group May-99 54.8 3.2 5.3 10.3 16.9
Superior Services Vivendi US$ Jun-99 993.5 55.4 94.5 10.5 17.9
WMI Finland Lassila Tikanoja t Jan-00 100.0 7.5 13.2 7.6 13.3
WMI Netherlands Shanks Group t Mar-00 207.7 18.7 28.8 7.2 11.1
UK Waste Severn Trent Jun-00 380.0 23.0 42.0 9.0 16.5
WMI Denmark Marius Pedersen t Jul-00 120.0 8.8 21.0 5.7 13.7
WMI Sweden Miljoservice SEK Sep-00 2,053.9 NA 285.0 7.2 NA
Hanson Waste WRG Dec-00 185.0 11.5 20.7 8.9 16.1
WRG Terra Firma Jun-03 530.9 NA 96.5 5.5 NA
Severn Trent Hales Waste Jun-03 167.0 13.0 19.6 8.5 12.8
RWE Umwelt Assets Pennon Apr-04 30.5 4.3 7.9 3.9 7.2
High 10.5x 18.4x
Mean 7.5 14.3
Median 7.4 14.3
Low 3.9 7.2
Notes: LTM is Latest Twelve Months period (trailing).
(1) Market Capitalization equals current shares outstanding times current share price.
(2) Net Debt equals total interest-bearing debt plus minority interest and the net eIIect oI dilution Irom
options and convertibles, less cash, marketable securities, and investments in unconsolidated aIIiliates.
Sector trading muItipIes
Country Market Cap
(Eur m) 2003A 2004E 2003A 2004E 2003A 2004E 2003A 2004E
Shanks UK 409 1.03x 0.95x 5.82x 5.77x 10.24x 10.83x 11.38x 12.66x
Severn Trent UK 4,161 2.91 2.70 7.87 7.41 14.02 13.56 19.68 15.22
Sch France 404 1.72 1.56 7.66 6.83 15.19 12.54 144.12 34.20
Lassila & Tikanoja Finland 419 1.59 1.45 8.23 7.14 14.71 13.12 20.97 18.23
VVE France 8,976 0.86 0.82 7.22 6.71 15.81 14.54 27.85 21.89
Suez France 16,499 1.22 1.18 7.53 7.31 14.80 13.90 10.91 13.37
AlliedWaste US 2,435 2.16 2.22 7.11 6.86 10.63 10.02 14.14 10.47
Republic US 3,662 2.20 2.12 7.91 7.45 12.27 11.48 18.45 17.21
WasteMngmnt US 13,569 2.10 1.99 8.22 7.67 15.48 13.47 22.71 19.44
Casella US 238 1.38 1.45 6.71 6.24 15.00 15.35 28.69 23.32
Connections US 1,150 3.47 3.00 9.96 8.58 13.03 11.25 20.37 16.71
High 3.47x 3.00x 9.96x 8.58x 15.81x 15.35x 144.12x 34.20x
Mean 1.88 1.77 7.66 7.09 13.74 12.73 30.84 18.43
Median 1.72 1.56 7.66 7.14 14.71 13.12 20.37 17.21
Low 0.86 0.82 5.82 5.77 10.24 10.02 10.91 10.47
Notes: All companies Year Ending 31-Dec except Shanks (31-March)
PE EV / EBIT EV / EBITDA EV / SaIes
Valuation exercises
22 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Jefferson Smurfit Group
Precedent transactions vaIuation
Jefferson Smurfit Group ("JSG") began as a small rish boxmaker in 1934, becoming a public
company in 1964. JSG has grown from its original rish 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.
n September 2002, JSG was acquired by Madison Dearborn Partners. As one of the largest and
most experienced private equity firms in the USA, MDP have significant expertise in the paper
packaging business. The JSG investment is their 5th in the packaging industry and their most
significant to date in any sector.
MDP made the acquisition based on the following information:
Capital structure
Net debt C1,778m
No of shares 1,126m
Financials (in Cm)
Actual Actual Pro forma
2000 2001 LTM
Sales 4,565 4,512 4,838
EBTDA 576 573 631
MDP expected to dispose of some non-core assets following the acquisition. These were valued
at C223m.
Requirement
Based on the above and the attached precedents database, calculate an appropriate takeover
share price.
Valuation exercises
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 23
Precedent transaction database
Firm VaIue Firm VaIue / LTM
Date Target/Acquiror (a) (US$MM) (b) SaIes EBITDA
Sep-01 Gaylord Container / Temple-nland $859 80% 9.4x
Mar-01 AssiDomn Corrugated & Containerboard/Kappa Holdings 1,070 83 6.2
Dec-00 AssiDomn & Stora Enso / Billerud 618 100 5.9
Jul-00 garas papeis / Klabin 510 228 9.6
Feb-00 St. Laurent / Smurfit-Stone Container 1,333 160 12.0
Jan-99 PCA / Madison Dearborn 2,437 160 7.4
Jan-99 Stone Container / Jefferson Smurfit Corp. 6,500 134 30.6
Oct-97 Cascades nc. / Domtar nc. 698 122 43.9
May-97 Chesapeake (Westpoint) / St. Laurent Paperboard 500 120 10.7
Nov-95 St. Joe Paper / Stone Container 185 80 2.4
Median 121 9.5
Mean 127 13.8
Notes:
(a) Source: Schroder Salomon Smith Barney and the Securities Data Company.
(b) Exchange rate as at period of the transaction.
Valuation solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Exercises and case study soIutions
Jude Inc 1
DEF Ltd 2
RegaIia pIc 4
Hey pIc 5
Comps 1 6
Comps 2 7
Comps 3 9
Comps 4 10
Comps 5 11
MyTraveI 13
Pensions 16
MegateI pIc 18
Matthews & Ager 20
BIaine pIc 22
Gatsby pIc 23
Fitz Ltd 24
Grupo Cespa 25
Jefferson Smurfit Group 26
Valuation solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 1
Jude Inc
Free cash flow for DCF at WACC
$m
EBTDA 87
Working capital adjustments
ncrease in inventories (1)
ncrease in receivables (22)
ncrease in payables and operating accruals 9
(14)
Capex (412)
Tax paid (8)
nterest tax shield (5)
____
Unlevered free cash flow (352)
____
Valuation solutions
2 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
DEF Ltd
1) Net Asset VaIue
Before revaluation $m
Total Value Net Assets 65.0 ($2.79 per share)
After revaluation:
Unadjusted net assets 65.0
Fixed asset revaluation 1.8
nvestment revaluation (4.7)
Provision for bad dept (1.0)
Adjusted Net Asset VaIue $ 61.1m ($2.62 per share)
2) Dividend YieId:
Dividend discount (Gordon Growth Model) assumes value is in dividend stream
= Dividend yr1* / (Cost of equity expected div. growth)
* assumes gross
Est. share value = (0.15 * 1.04) / (0.12 0.04) = $1.95 x 23.3m = $45.4m
Price estimated using average sector dividend yield applied to DEF:
DEF's gross dividend per share = 15
Average comparable gross yield = 4.7%
Est. share value = 0.15/0.047 = $3.19
Est. equity value = $3.19 x 23.3m = $74.4m
3) Price Earnings MuItipIe:
Average comparable P/E = 12.5
DEF's EPS (forecast) = $6.0m/23.3m = $0.258
Est. share value = 12.5 x $0.258 = $3.22
Est. equity value = $3.22 x 23.3m = $75.0m
Valuation solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 3
4) EV / EBIT MuItipIe
Average comparable EV / EBT = 9.1
DEF's EBT (forecast) = $12.9m
Est. EV for DEF = $117.4m
Deduct market value of debt of $53.1m
Add cash (assumed to be excess cash) of $13.8m
Est. equity value = $78.1m
Est. share value = $3.35
5) Summary of ResuIts Equity Value Per Share
Asset Value (before revaluation) $65.0m $2.79
Asset Value (after revaluation) $61.1m $2.62
Dividend discount (Gordon model) $45.4m $1.95
Dividend Yield $74.4m $3.19
PE Multiple $75.0m $3.22
EV / EBIT MULTIPLE $78.1M $3.35
Valuation solutions
4 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
RegaIia pIc
Year ending in December 2006 2007 2008 2009 2010
EBTDA 2,151 2,390 2,769 3,130 3,474
Working capital (increase) decrease 200 200 (213) (225) (215)
Tax (paid) (325) (375) (643) (739) (810)
Tax shield on interest (only forecast periods) (75) (78) (89) (86) (79)
Capital expenditure (1,780) (1,780) (1,500) (1,500) (1,200)
FCF 171 357 324 580 1,170
TV - using growth in perpetuity
17,531
(w)
TV - using EBITDA exit multiple 21,539
Discount factor 0.9263 0.8581 0.7948 0.7363 0.6820
PV - TV - using growth in perpetuity 158 306 258 427 12,755
PV - TV - using EBITDA exit multiple 158 306 258 427 15,488
TV - using
growth in
perpetuity
TV
using
EBITDA exit
multiple
Implied enterprise value 13,904 16,637
Less:
Net debt (3,033) (3,033)
MI (36) (36)
Add
JVs etc 340 340
Implied equity value 11,175 13,908
Implied share price (C) 1.61 2.01
Cost of equity Cost of debt
Risk free rate 5.00%
Risk free rate 5.00% Corporate borrowing margin 1.90%
Equity beta 0.83 Corporate borrowing rate 6.90%
Market risk premium
4.50%
Corporate taxation
rate
30%
Cost of equity 8.74% Post tax cost of debt 4.83%
WACC
Cost of equity 8.74%
Post tax cost of debt 4.83%
target D/EV proportion 20%
target D/Equity value proportion 25%
WACC 7.95%
w TV using perpetuity growth
= 1,170 x (1.012%)/(7.95%-1.2%)
= 17,531
Valuation solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 5
Hey pIc
DCF valuation
Free cash flow 120.0 129.6 137.4 143.6 147.9
Terminal cash
flow
Terminal value
(W) 2,955.7
Cash flows to be
discounted 120.0 129.6 137.4 143.6 3,103.6
Discount factor 0.93 0.87 0.81 0.75 0.70
Present vaIue of cash fIow 111.8 112.5 111.2 108.3 2,180.6
Present vaIue of cash fIow
(Firm/Enterprise VaIue (m))
2,624.4 EV
JVs (m) Current share price (p)
Associates (m) Derived share price (p) 328.2
Minority interests
(m)
Derived premium (discount)
Net debt (m) 700.0 NetDebt
TotaI equity vaIue (m) 1,924.4 EqVal
Equity market risk premium 5.20% EMRP
Cost of equity 9.48%
Cost of debt 3.78%
Discount rate (WACC) 7.314%
Working - Terminal value
FCF
2009
* (1+g)/(WACC g)
= 147.9 * (1.022)/(7.314% - 2.2%)
= 2,955.7
Valuation solutions
6 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Comps 1
A company has the following information:
m C Cm
Stock price 30.00
Shares outstanding 40.0
Cash 125
Book value of equity 1,000
Debt 250
Minority interest 35
Preferred stock 50
LTM EBTDA 100
2005 EPS 1.00
Requirement
CaIcuIate
a. market capitalisation;
b. enterprise value;
c. the 2005 P/E multiple; and
d. the LTM enterprise value/EBTDA multiple.
(in C millions, except per share):
Market capitalisation
Stock price 30.00
Shares outstanding (m) x 40.0
Market capitalisation 1,200
Debt + 250
Cash (125)
Preferred stock + 50
Minority interest + 35
Enterprise value 1,410
2005 P/E Multiple = 30.00/1.00 30.0x
Enterprise Value/LTM EBTDA = 1,410/100 14.1x
Valuation solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 7
Comps 2
A company has the following information:
m C Cm
Stock price 35.00
Shares outstanding 20.0
Cash 400
LTM EBTDA 150
LTM EBT 100
Minority interest 120
Bank debt at book value 500
C250m 6% subordinated debentures trading at 70
Owns a 20% stake in company with C1,000m market capitalisation
Requirement
CaIcuIate
a. equity value
b. enterprise value
c. the LTM EBTDA multiple and
d. the LTM EBT multiple.
Valuation solutions
8 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
(in C millions, except per share):
Equity value
Stock price 35.00
Shares outstanding x 20.0
Equity value 700
Debt
Bank debt + 500
Sub. debt = 250 x 0.7 + 175
Cash (400)
Minority interest + 120
Unconsolidated investment - 20% stake (*) (200)
Enterprise Value 895
Enterprise Value/LTM EBTDA = 895/150 6.0x
Enterprise Value/LTM EBT = 895/100 9.0x
(*) Assuming EBT and EBTDA do not include a profit contribution from the
unconsolidated investment
Valuation solutions
The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com 9
Comps 3
A company has the following information
m C Cm
Stock price 30.00
Average in-the-money options exercise price 20.00
Shares outstanding 60.0
n-the-money options outstanding 10.0
Cash 500
Preferred stock 500
Minority interests 100
Debt 1,500
Requirement
1. ncluding only common stock, calculate
equity value
enterprise value
2. ncluding all equity-linked claims, calculate
equity value
enterprise value
(in C millions, except per share):
Common
stock onIy
IncIude
options
Market capitalisation 1,800 1,800
Option value (10m x C30) 0 300
Equity value / Diluted equity value 1,800 2,100
Debt + 1,500 + 1,500
Cash (500) (500)
Minority interest + 100 + 100
Preferred stock + 500 + 500
Option proceeds (10m x C20) 0 (200)
Enterprise Value 3,400 3,500
Valuation solutions
10 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
Comps 4
A company has two operating divisions with different growth and profitability profiles, auto and
technology. The following information is relevant:
x m Cm
Auto EBT 2,000
Technology sales 4,000
Shares outstanding 100.0
Cash 1,250
Debt 5,000
Unfunded pension liability 300
Comparable auto universe EBT multiple 7.0x
Comparable technology universe sales multiple 1.00x
Requirement
Calculate the company's implied:
a. enterprise value;
b. equity value; and
c. equity value per share
(in C millions, except per share):
mplied divisional values:
Auto = 7.0 x 2,000 14,000
Technology = 1.00 x 4,000 4,000
mplied Enterprise Value 18,000
Debt (5,000)
Cash + 1,250
Unfunded pension liability (300)
mplied Equity Value 13,950
Shares outstanding (m) 100.0
mplied equity value per share 139.50
Valuation solutions
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Comps 5
A company has two operating divisions with different growth and profitability profiles, department
stores and supermarkets. The following information is relevant:
m C Cm
Department store EBT 500
Supermarket EBTDA 300
Shares outstanding 200.0
Cash 1,000
Debt 2,000
Minority interests 100
n-the-money options outstanding 40.0
Average in-the-money options exercise price 10.00
The most common valuation multiple for department stores used in the market is an EBT
multiple. The most comparable department store EBT multiple is 9.0x.
The most common valuation multiple for supermarkets used in the market is an EBTDA
multiple. The most comparable supermarkets EBTDA multiple is 7.0x.
Requirement
1. ncluding only common stock, calculate the implied
enterprise value
equity value
equity value per share
2. Calculate the above including all equity-linked instruments
Valuation solutions
12 The Corporate Training Group Ltd +44 (0)20 7490 4770 trainers@ctguk.com
(in C millions, except per share) Common
stock onIy
IncIude
options
Department stores = 9.0 x 500 4,500 4,500
Supermarket = 7.0 x 300 + 2,100 + 2,100
mplied 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
mplied Equity Value 5,500 5,900
Shares outstanding 200 240
mplied equity value per share 27.50 24.58
Valuation solutions
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MyTraveI
Without adjustment
EV/EBTDA =
m 1 . 200
m 6 . 432 , 1
= 7.2 x
Where:
EV = 1,203.0m + 209.6m + 20.0m = 1,432.6m
Net debt = 398.6m - 378.6m = 20.0m
With adjustment
EV/EBTDA =
m 4 . 422
m 2 . 924 , 2
= 6.9 x
Off baIance sheet debt equivaIent
222.3m x 6.71 = 1,491.6m
EV = 1,432.6m + 1,491.6m = 2,924.2m
Finance element of lease rental
1,491.6m x 8% = 119.3m
Balance of lease rental deemed to be depreciation = 103.0m
Adjusted EBITDA [or EBITDAR]
200.1m + 222.3m = 422.4m
Conclusion
For the impact on EV/EBTDA to be significant, the relevant annuity factor needs to be
significantly different to the current unadjusted EV/EBTDA multiple.
The annuity factor increases as:
- the lease term increases
- the borrowing rate decreases
Valuation solutions
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Cover ratios
3 . 2
2 . 96
= 42. EBT covers net interest 42 times.
3 . 2
1 . 200
= 87. EBTDA covers net interest 87 times.
3 . 2 3 . 222
4 . 422
+
= 1.9. EBTDAR covers net interest and rentals 1.9 times.
P&L account
m
EBITDAR 422.4
Lease rentals (222.3)
EBTDA 200.1
D&A (103.9)
EBT 96.2
Net interest income/(expense) (2.3)
EBT 93.9
Debt repayment
1 . 200
0 . 20
= 0.1. On balance sheet net debt could be repaid out of EBTDA in 36 days.
422.4
1,491.6 0 . 20 +
= 3.6. Net debt could be repaid out of EBTDAR in 3 years and 7 months.
Off baIance sheet debt equivaIent
222.3m x 6.71 = 1,491.6m
Gearing proportion
Treating minority interests as equity:
9 . 541
0 . 20
= 4% on balance sheet.
1,491.6 9 . 541
1,491.6 0 . 20
+
+
= 74% including operating leases.
Valuation solutions
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Balance sheet (extracts)
m
Net operating assets 541.9
Net debt 20.0
Minority interests 209.6
Shareholders equity 312.3
CapitaI empIoyed
20.0 + 209.6 + 312.3 = 541.9m on balance sheet.
541.9 + 1,491.6 = 2,033.50 including operating leased assets.
Valuation solutions
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Pensions
EV/EBITDA
Without adjustment
EV = 42,250m + 541m + 12,346m - 11,196m = C43,941m
EV/EBTDA =
m 6,058 C
m 941 , 43 C
= 7.3
Adjusted, pre tax
EV = 43,941m + [19,492m - 14,531m] = C48,902m
EBTDA = 6,058m + 447m 487m = C6,018m
EV/EBTDA =
m 018 , 6 C
m 902 , 48 C
= 8.1
Adjusted, post tax
EV = 43,941m + [(19,492m - 14,531m) x 61%] = C46,967m
EV/EBTDA =
m 018 , 6 C
m 967 , 46 C
= 7.8
Net debt/EBITDA
Without adjustment
EBTDA
debt Net
=
m 6,058 C
m 150 , 1 C
= 0.2
Net debt
C12,346m - 11,196m = C1,150m
Adjusted, pre tax
EBTDA
debt Net
=
m 6,018 C
m 111 , 6 C
= 1.0
Net debt
C1,150m + [19,492m - 14,531m] = C6,111m
Valuation solutions
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Adjusted, post tax
EBTDA
debt Net
=
m 6,018 C
m 176 , 4 C
= 0.7
Net debt
C1,150m + [(19,492m - 14,531m) x 61%] = C4,176m
Valuation solutions
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MegateI pIc
Dirty muItipIes
EV = 59,843m + 8,700m = 68,543m
EBTDA = 3,598m + 2,752m + 89m = 6,439m
EV/EBTDA =
m 439 , 6
m 543 , 68
= 10.6
EV/sales =
m 715 , 18
m 543 , 68
= 3.7
[The company looks reasonably priced on EV/EBTDA 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 EBTDA); and
adding the value of minorities (as these are not implicit in the investing company's market
capitalisation but included in consolidated sales and EBTDA).
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/EBTDA =
m 439 , 6
m 816 , 63
= 9.9
EV/sales =
m 715 , 18
m 816 , 63
= 3.4
The company starts to look undervalued against its peers.
Valuation solutions
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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
%. t will be more difficult to adjust EBTDA 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
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Matthews & Ager
VaIuation ratios for Ager pIc
EV/EBTDA =

638 , 1
893 , 16
= 10.313 EV/sales =

800 , 22
893 , 16
= 0.74
EV
EV = 14,548m + 34m + 2,804m 454m - 39m = 16,893m
Minority interests
nclude in EV as 100% of subsidiaries' sales and EBTDA 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 EBTDA are included in consolidated
P&L. Market capitalisation reflects MV of equity interests in JV (50%) and associate (30%), so
need to remove.
EBITDA
EBTDA = 1,174m + 455m + 9m = 1,638m
Appropriate muItipIe
EV/EBTDA appears more appropriate as the 2 companies have quite different EBTDA margins
(7.2% for Ager, 5.6% for Matthews).
Market capitaIisation of Matthews
EV
Applying comparable company's EV/EBTDA multiple to Matthew's EBTDA:
EV = 959m x 10.313 = 9,890m.
EBITDA
EBTDA = 533m + 409m + 17m = 959m
Valuation solutions
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Market capitalisation
Market cap = 9,890m - 869m - 53m + 26m = 8,994m.
Net debt
1,356m 487m = 869m.
Valuation solutions
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BIaine pIc
Cost of Equity = 5%
340
1.05 x 35
+ = 15.8%
Cost of Debt =
95
0.3) - (1 x 7
= 5.16%
WACC =
1m x 0.95 4m x 40 . 3
5.16% x 1m x 0.95 15.8% x 4m x 40 . 3
+
+
= 15.1%
Valuation solutions
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Gatsby pIc
Discount factor = 7.5% + 1.1 x 5% = 13%
Cash flow & Df Discounted
cash flow
(000's)
nvestment -2,000 x1 -2,000
Cash flow 400 x
(

1.13
1
- 1
13 . 0
1
8
1920
Tax on cash flow -120 x
(

1.13
1
- 1
13 . 0
1
8
-576
Net present vaIue -656
Valuation solutions
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Fitz Ltd
Market value prior to project announcement
Equity =
03 . 0 14 . 0
1.03 x 20

= 1.87; 1.87 x 3m = 5.618m


Debt =
075 . 0
6
= 80; 0.8m 1m x
100
80
=
Therefore market value = 5.61m + 0.8m = 6.418m
After project
Discount factor = 7.5% + 1.2 x 5% = 13.5%
Real (effective) discount factor =
03 . 1
135 . 1
= 1.102; therefore real/effective rate = 10.2%
Present value of future cash flows =
102 . 0
.7 x k 125
= 858.3k
Market value after project = Market value before project + PV of flows of project
= 6.418m + 858.3k
= 7.276m
Valuation solutions
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Grupo Cespa
Precedent transactions vaIuation
Low High Low High
86 86 43 43
5.5x 9.0x 11.1x 16.5x
473 774 477 710
-244 -244 -244 -244
229 530 233 466
475 to 742
231 to 498 ImpIied Equity VaIue range
(in C million)
ImpIied Firm VaIue range
mplied Firm Value
Less: net debt acquired
mplied 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
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Jefferson Smurfit Group
Precedent transactions vaIuation
in Cm (except per share)
EBITDA SaIes
Low High Low High
JSG profit metric (pro-forma LTM) 631 631 4,838 4,838
Appropriate multiple 5.9x 6.4x 0.80x 0.85x
mplied 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
mplied equity value 2,168 2,483 2,315 2,557
Number of shares (m) 1,126 1,126 1,126 1,126
mplied takeover share price C 1.93 C 2.21 C 2.06 C 2.27
ImpIied share price range C 2.05 to C 2.20
Notes:
1. Assuming pro-forma suggests excluding the performance of the non-core assets these will
be acquired by MDP (and subsequently disposed of) and so should form part of the
acquisition price.
Valuation solutions
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2. Precedent multiples:
a. St Joe Paper outlier on low multiple
b. Stone Container and Cascades nc outliers on high ebitda multiples
c. Older transactions removed as less comparable as transactions took place under different
market conditions. Chesapeake
d. garas Papeis - different margins others 2.28 9.6 = 23.75% - whilst average of
remainder is 13% (FV/sales FV/EBTDA = EBTDA margin) and JSG is 13%
e. Weight given to PCA previous private equity transaction
f. Most significant weight given to AssiDomn Corrugated & Containerboard most similar
business and recent
Best practice financial modelling
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Best practice financiaI modeIIing 1
ntroduction 1
Meeting user needs 1
Excel versus modelling 2
Excel set up for efficient modelling 3
Model set up 6
Design 6
Model structure 8
Sheet consistency 15
Using and managing windows in Excel 16
Referencing 18
Relative versus absolute references 18
Naming (cells & ranges) 19
Transpose 24
Formatting 26
Sign convention 26
Colours, size and number formats 27
Styles 30
Conditional formatting 33
Text strings 34
Regional settings 35
F and some other logical functions 36
Common problems with F statements and some simple solutions 38
Nested statements 39
Data retrieval the LOOKUP school 41
CHOOSE 41
MATCH 42
NDEX 43
OFFSET 47
VLOOKUP 49
HLOOKUP 52
Dates 54
Date formats 54
Date functions 54
Consolidating time periods 56
Switches 60
Two-way switch 60
Multiple options 61
Formality 63
Sensitivity 64
Goal Seek 64
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Data Tables 65
Validating data 68
Data Validation - with inputs 68
Data Validation with outputs 70
Conditional formatting 71
Conditional statements 71
The SERROR function 71
Model completion 73
Group outline 73
Protecting the model 73
Report manager 75
Tracking editing changes 76
Historic financials 77
Forecast financials 79
Ensuring balancing balance sheets 79
Setting up the reconciliation 80
Debt modelling 83
The problem 83
A solution 83
Auditing and error detection tools 85
Auditing a formula 85
Finding links 87
The F5 Special 88
Other auditing tips 89
Auditing a model a process 91
Upon opening 91
Coding clarity index 92
Troubleshooting 94
Appendix 95
Excel tricks 95
Excel function keys 100
Best practice financial modelling
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Best practice financiaI
modeIIing
Introduction
Modelling must, by its very nature, be a simplification of the real world. The outputs are
dependent on these simplifying assumptions, and so the most useful models will have the best
assumptions.
A financial model should represent the business accurately whilst using these simplifying
assumptions to make it workable. A good model must be flexible enough to be expanded quickly
to meet changing requirements and to deal with 'what if' sensitivity analysis.
These notes set out ways in which Excel can be controlled and exploited enabling users to:
be faster and more efficient in the use of the Excel tools used in modelling;
understand design principles;
have a clear method for building reliable, robust and flexible models;
be efficient in spotting inconsistencies when auditing other people's financial models;
know how to ensure quality in their models; and
have a set of tools for analysing and sensitising financial models.
The aim is to provide the practical skills to build, modify and audit an integrated and flexible
financial model (or modules there from).
Meeting user needs
The most common complaints about spreadsheet models are:
You can't understand your model in 3 month's time; and
No-one can ever understand your model.
Many of these problems arise because models:
are rarely documented;
include cumbersome formulae (difficult to understand, check and modify);
include wide and/or long spreadsheets;
take a long time to calculate due to iterative calculations (eg interest);
are made up of purely numbers (a graph can quickly highlight results);
have no consistent format; and
mix the assumptions, other inputs, workings and outputs.
Useful models are those that can be picked up and easily and quickly understood by a reviewer.
The more logical, consistent and rigorous the model, the more confidence will be engendered in
the results.
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These notes should help to ensure that your models are not only logical, but can also be
reviewed by others with the minimum of effort.
ExceI versus modeIIing
A Titleist Pro Titanium 905T (9.5 degrees) driver is effectively a long stick with a big lump on the
end. t can be used to push a little white ball along a fairway with varying degrees of success.
Even those with little golf experience can use it to fulfil its role i.e. to prod the ball forward.
However, in the hands of a master it can be harnessed to stroke the Titleist ProV1x 350 yards
with a gentle draw.
Excel is a particularly powerful application which can be used to generate, analyse and present
both simple and complex data. With little experience it can be used as a glorified, and very
useful, calculator. Many users utilise a very small proportion of Excel's enormous functionality,
albeit to very great effect.
Like any sophisticated tool, when used properly, it can be harnessed so creating highly efficient,
interactive and robust financial spreadsheets if only we had a structure and could think of a
practical application for many of the functions.
The skills introduced by financial modelling harness the functionality of Excel within a methodical
and rigorous financial framework which can be applied to a large number of different applications.
Financial modelling, therefore, combines:
1. Financial skills
the strategy of the business or project
the product, project or industry competitive dynamics and their value-drivers and key
sensitivities
accounting, analysis, forecasting, structuring and/or valuation techniques
2. Excel functionality
knowledge of the mechanics of functions and tools
how to practically apply the functions and tools
practical limitations of the functions and tools
3. Robust spreadsheet modelling techniques
design principles
modularity
quality controls and diagnostics
version control
formulae conventions
format conventions
logical thought
data analysis and sensitivity
Best practice financial modelling
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ExceI set up for efficient modeIIing
Even Ernie Els requires his Titleist Pro Titanium 905T (9.5 degrees) driver be tailored to make it
work to his requirements - Right Set Composition: 9.5 Shaft Type: Speeder X (45") Shaft Length:
45" Grip Type: TV58R Grip Size: 2+1 Swing Weight: D6 so that he can use it most efficiently.
n 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-ns 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:
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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. f 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-ns; 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. f 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?. t 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 teration box is not selected
f 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. t 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.
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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
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ModeI set up
Design
Time spent on design is never wasted and you will recoup it many times over while you are
building your model and also when you use it in anger. Clear design objectives at the start
(which don't change) will let you build a simple and straightforward model which should also be
transparent in structure, helping you find mistakes and making it easy to use.
The first step is to scope out the model. The following questionnaire aims to help you uncover
the key issues which will drive the way you structure your model and which will also determine
the user friendliness and flexibility that you will have to build in.
The questionnaire is designed for modellers to sit down with the potential users and consumers of
the results (are they different people?) and get them to give you the answers to all of the
questions.
Scope questionnaire
1. Who is the customer, who wants the outputs and why? What are detailed questions the
model will be used to answer? What are the important outputs? s 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? s 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? s the timing of
events in the model likely to change, e.g. an acquisition, a divestment, the start of operation
of a project? f in doubt assume the worst.
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10. What detailed questions will the model answer?
Valuation
Financing structure optimisation
Liquidity planning
11. Will borrowing or holding assets in foreign currencies need to be modelled?
12. Will there be large changes in the level of debt?
13. Will there be significant seasonality in cash flows or revenues?
14. What will be the inflationary environment of the company being modelled; will real and
nominal forecasts be required?
The questions regarding objectives are useful to have answers to so that you can do your job in
the clear understanding of the levels of usability and professional polish that your model needs.
Questions 7-14 are very important, because these are the typical issues of "detail which won't be
discussed at an early stage, but which will have a fundamental impact on design approach. t 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 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.
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Large, complex models can become unwieldy and, if the users are not trained or don't
regularly use all parts, sections fall into disuse because people don't understand them, don't
trust them or just don't know what they do.
Most modelling groups have one of these "All singing all dancing models and they are often
forsaken, not because of any quality problems but because of lack of confidence on the part
of users and lack of familiarity.
Clear, specific objectives supported by documentation and training is very important for the
success of a standard model. For a standard model of any complexity, documentation and
training are essential.
For any standard model to be accepted the analysis it does and the outputs it produces must be
relevant to the decisions to be made by users. This means consultation and clear design scope.
ModeI structure
The structure of your model will be a function of the results of your earlier work in understanding
the modelling needs. n particular, you will have determined the output desired, the level of detail
required and the degree of flexibility necessary for a successful model.
Good model design has a logical structure in which different modules are separated into separate
sheets in a workbook. A standardised rule-book for the creation of the various sheets will aid
easy construction and review.
The most common structure for financial models is Assumptions; Process; Results: i.e. inputs
followed by workings followed by outputs. However, no matter what kind of model you are
building, it should have a further three elements giving a minimum structure of six key building
blocks:
1. Log sheet;
2. Description sheet;
3. Checks sheet;
4. Assumptions (or input) sheet(s);
5. Workings sheet(s); and
6. Output sheet(s).
By creating separate sheets for each of the building blocks of the model, you allow a reviewer to
build up their knowledge of the model step-by-step: model genesis, model description, checks,
assumptions, process and results. t 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.
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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. t 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.
f you only keep one model, then at best you will one day find yourself praying, perhaps begging
and perhaps even being nice to the T Help-desk as you try desperately to get a copy of last
week's model from the tape back up. t 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:
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Saving procedure
The log sheet is maintained as part of a saving procedure.
1. When commencing a development session where you will be editing the model, on opening
the model, record the name of it in the log sheet on a new line, make some quick notes of
what you are planning to do to it and before you commence work, save the model with a new
name and use sequential (or date) naming, i.e. give each draft a reference number but
otherwise keep the name the same.
2. Switch on Autosave, but leave the prompt checked so that Excel only saves when you want
rather than when it wants to. For users of Excel 2003, Autosave will automatically run in the
background.
3. Regularly save your material when you are happy with the alterations you have made and
keep a record in the log sheet of your work.
4. At a milestone in development, or when you start another session go back to step 1 and start
the saving routine again.
Although the procedure may seem like a chore, it will significantly improve the simplicity of your
job: as well as giving you a clear idea all the time of where you are in development, if you
reconsider design or have to make important changes/throw out part of the structure, the log
sheet will give you another clear option, i.e. to go back to an older version and start again,
instead of "unpicking unwanted code out of your model.
2. Description sheet
How often have you picked up a model which opens up in cell BD4765 on sheet 15 and then had
to try to work out what is happening. A properly documented model will make this task much
easier.
t is useful to have a separate worksheet with instructions on how to run the model. This will
allow other users to understand how to operate the model, especially when additional or non-
conventional procedures are needed to make the model work correctly. Common errors and their
solutions should also form a part of this sheet.
The genesis of the model can be reviewed by looking at the log sheet (see above) and the
checks sheet (see below) should be reviewed in order to verify that there are no red flags.
However, additional assistance can be derived from a description sheet containing the following:
Description of the proposed transaction / analysis
This brief description should:
describe the purposes of the model
identify the key assumptions and where they are to be found
identify the key outputs
give instructions as to how to run the model
When done properly, this will help set the context for the model and so make it easier to use.
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mplicit 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. f 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 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.
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4. Inputs & assumptions
Keeping all of the inputs and assumptions (i.e. the model drivers) in one place is an essential
element to any model. The user needs to be confident that they can control the model from this
single assumptions section. Having inputs dotted throughout the model adds to the complexity of
using and reviewing the model.
Additionally, there are some Excel tools which require like items to be grouped on the same
sheet. The most common of these is the Data Table which is used to check the sensitivities of
key assumptions to key outputs. Data Tables can only be created on the same sheet as the
assumptions.
The exception to this idea of keeping all of the inputs in one place is historic (financial) figures.
Although inputs should go on the inputs page, historic financials are facts rather than
assumptions driving future value, and so it is reasonable to put them on the appropriate sheets
(i.e. P&L historics on P&L sheet).
ControI paneI
Having a separate assumptions sheet (or sheets) is good discipline in any model and a logical
development of it is to integrate a control panel into it.
A control panel is simply an area of the assumptions sheet (or sheets) where all of the switches,
list boxes and other controls which are used to select scenarios and pick particular calculation
bases are placed.
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t 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):
n 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
EBTDA 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 F statements, and for starting row and column counters
100 if using and p, $ and c, C and c etc
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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 F functions
Use flags (e.g. for dates, event triggers) where possible to shorten formulae
Avoid the macho
The shortest formula is often, though not always, the best. '=MAX(0,D16)' and
'=F(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
nsert notes/comments where it may not be obvious what the logic is (for easy review)
Do not create circular references
They slow down calculations and may cause Excel to crash
Results depend on Excel settings (in the Tools; Options; Calculations menu), i.e.,
maximum iterations and maximum change
Once a circular reference has been created, it is very easy to add further circular
references without being aware of it
They can always be avoided with more careful formulation or automated goal seeks.
However, in the interests of time you may be able to tolerate it if you close the circularity
whilst editing the model (for example by having some sort of switch) (see later)
Shade areas in different colours for ease of navigation (some sheets may be large)
Row consistency: where possible, avoid changing formulae across a single row (see F5-
Special later)
Try to keep to one row / one formula
f unavoidable, highlight the non-standard cells
A reviewer needs to be confident that there are no hidden fixes in individual cells
Format consistency: consistent number styles (see Styles later) and sheet set-up (see Sheet
consistency later) enables quick interpretation of the results
Only name those ranges/cells that will be used away from the near vicinity (see Names later)
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6. Outputs
Depending on the size of the model, the outputs may be the same as the workings or, more
often, a summary of the workings (and inputs). Here, format matters.
Outputs should require little calculation other than totals
The most important figures (e.g. debt service coverage, NPV etc) should be formatted to give
them the importance they deserve
Pictures speak a thousand words - diagrams and charts often clarify the results and flows
better than pure numbers
Text strings may be useful to put the output numbers into meaningful sentences
Sheet consistency
The more consistent the format (colours, numbers, columns, titles, headings, footers, views, etc)
between sheets, the easier the construction and review. Hence a lot of the formatting of the
entire model can (and should) be done up front.
There are two methods to arrive at the same result of consistent formatting throughout the model:
group the sheets and format them all together; or
set up one sheet and then copy it the requisite number of times.
The first method could be dangerous as data on other sheets may be overwritten, whilst the
second method is slightly more fiddly when trying to get the correct number of properly named
sheets. When used with the care, the first group edit option is the more straightforward.
The steps
1. Assess how many sheets are needed (and add one it can always be removed)
The easiest way is to name each sheet that you think you will need
Use abbreviated sheet names the shortest name that is understandable
it is very useful to be able to see all of the sheet tabs at once
short sheet names make shorter cell addresses when used across sheets making
formulae shorter and easier to interpret
2. Select all sheets to do consistent formatting (to set up group editing)
Control-Shift-Page Down; or
Right mouse on a sheet tab - Select All Sheets
3. Size the columns
Column A (small); Column B (small); Column C (big)
Natural indents for ease of reading text/headings
To allow sufficient "space should it be needed
Column D (very small)
For check digits
Allows the data to be selected more efficiently if there is a natural break
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Makes naming ranges easier
Enables creation of consistent formulae on corkscrews
Put in all the years (and currency) - i.e. column headings
Column E is the 1st period and then copy the sequence across all relevant columns
Only if a period (eg y/e31/8/07) is in the same column in every sheet throughout the
model can the range name tool be used effectively
Leave a blank column at the end of the final period (make it small)
Allows easy insertion of further periods if they are subsequently needed
Allows the data to be selected more efficiently if there is a natural break
The final column after the blank will be used for recording range names
4. Fit the spreadsheet to the appropriate size
Highlight the next column (after the range names column); and then
Control-Shift-(selects the remaining columns on the sheet);
Format; Column; Hide (or right mouse followed by H) (hides all the highlighted columns)
5. Formatting numbers and text (see Formatting later) if Styles are to be used, then this can
be done following the group edit phase
6. Print set-up (so it is ready to go from the start)
Landscape or portrait?
Default margins are often too large
Headers & footers to include file name (and location if using Excel 2003); sheet name;
date and time; and page of page (page &[Page] of &[Pages])
Print titles (probably the periods) will have to be done outside of the group edit
Remove the gridlines
Using and managing windows in ExceI
Using more than one window
When reviewing a model it is often useful to be able to see two parts of the model simultaneously.
This can be achieved by opening a second window and viewing both of them at the same time.
n 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
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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 CtrlF6 or CtrlTab. 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.
n this case, the freeze panes command was used in cell C4.
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Referencing
ReIative versus absoIute references
Excel calculates in terms of the relative position of an item i.e. cell C4 is 3 columns and 4 rows
into the sheet. Fortunately, to ease interpretation, the references in Excel use the column letter
and row number address (i.e. C4).
A B C D E
1 147 852 654
2 741 951 357
3 753 258 456
4
5
6
7
f 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.
f 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. f 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.
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A rule of thumb: if you are trying to fix a reference to a cell which is
to the side of your formula the $ is to the side
above or below your formula the $ is in the middle
Naming (ceIIs & ranges)
Cells and ranges can be named that is, they can be referenced in terms of a name rather than
its column and row position within the model.
A name may only be defined once per sheet i.e. the name relates to a unique cell or range on
that sheet. However, the same name can be defined across different sheets, eg 3 different cells
named TaxRate can be created as cell E30 on Sheet 1; as E45 on Sheet 2; and as F10 on
Sheet 5.
F3 is the function key which triggers most of the functionality, i.e. the third function key. This
indicates that Microsoft thinks that the use of names is only behind Help and formula editing (F1
and F2 respectively) as functions which are important to the smooth running of Excel.
Why name?
1. CIarity and speed
Using the F4 dollarising option is quick and widely understood and so has its advantages.
However, where the cell or cell-range is to be used in calculations:
On a number of occasions
At a distance from where it is situated
On different sheets
n different models
As part of a complex formula or function
Within a macro
then naming the cell or cell-range is a better solution. Applying a name to a cell or range can
make model construction and review quicker and easier.
2. Auditing
As we will see, all the auditing tools work in exactly the same way for both cell references and
names. However, if names are used then additional auditing approaches can be introduced.
3. FunctionaIity
Additionally, Excel was created with the intention that names would be used. Consequently,
some functions require the use of names, particularly across sheets (e.g. conditional formatting
and data validation).
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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.
f 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.
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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. f 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:
nsert; 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 "Ratesn
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When a range name relating to a row of data is used in a particular cell, the data, within the range
which is in the same column as the particular cell, will be returned.
For example, if the range named "Sales is defined on Sheet1 as E6:N6 and if the formula in cell
G72 on any sheet is "=Sales, the value returned will be that from column G in the named range
(i.e. cell G6 on Sheet1).
A typical spreadsheet will look like this (Note, only those ranges which will be used extensively
elsewhere on the model have been named):
Pasting the Iist of names
This feature is used to create a checklist of all the names and the number of names used within
the model by listing the names and their location.
Select the place where the first name is to be listed and then
nsert; 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
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When to use a name
Naming rules
Don't name everything
Despite all the advantages of naming cells and ranges, too many names cloud the model (a list of
237 names is not easy to use or review).
Only name those cells or ranges which will be used extensively and at some distance from their
current location be systematic but not out of control.
Range names - aII sheets must be consistent
f 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.
f 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 talic 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 CostsGasn (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.
WkCapncr 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 "n, e.g. CostsGasn, PriceGasn, 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 EBTDA is calculated as
a (named) percentage of sales, it would be over-engineered to calculate the EBTDA
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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 EBTDA has been calculated in a working (as above) and is then used as part
of the income statement the EBTDA 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 MN functions are being used with named ranges, the maximum (or
minimum) number in the range is returned rather than those relative to the column we are
interested in. This is avoided by including a + sign in front of the named range when coding the
formula. For example:
=MAX(+PAT,+RetainedProfits)
Copying to other modeIs
As long as the inputs to the tax sheet, for example, are defined in the destination model (i.e.
using the same names) then the tax workings sheet can be easily inserted into the destination
model.
Click right mouse button on the tax sheet's tab in the source model
Move or Copy
Define the destination model
Check the copy box
This can be useful, but can also cause problems if there is not complete rigour in naming the
more rigour incorporated in naming and model set-up, the easier the copying of modules between
models.
Transpose
Occasionally numbers appear horizontally in a row when it would be useful to have them
vertically in a column or vice versa.
f 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.
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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.
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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). n 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. f 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.
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CoIours, size and number formats
Text & data
Feature Setting Justification
Size Default probably 8 point
Change the view settings if this is too
small on the screen
Anything smaller than 8 point will
default to Times New Roman when
pasted into other applications
f 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)
nputs 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 n the outputs only
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Formatting numbers
To format the numbers:
Format; Cells; Custom; or
Control-1; Custom
The sections, separated by semi-colons, define the formats (in order) for:
1. Positive numbers;
2. Negative numbers;
3. Zero values; and
4. Text.
f 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
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[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,
f 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
t 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 NDEX)
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. t is therefore
recommended that the background be altered to grey: see Excel set-up earlier in the notes.
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StyIes
The use of styles within Excel, as within Word, enables quick and easy changing of all the
formats within the whole model. Headings, dates, subtotals, percentages and others can be
selected (and globally modified) quickly.
At set-up it is worth defining the styles (i.e. the formats) that may be used in the current model
consequently, formatting need only be done once and then quickly and easily applied elsewhere.
For example, it is often worth having the font size as 8 pt for easy transfer to presentations. By
defining styles up front the default can be changed for the whole model.
As within Word, to apply a defined style use the styles drop-down box for the selected cell(s).
Adding styles to the toolbar
n 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
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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. f you wish to create a format, e.g. dates, to be used as a standard to be applied elsewhere:
Format; Style
n the Style name box, type a name for the new style e.g. "Dates (without the quotation
marks)
Modify
On any of the tabs in the dialog box, select the formats you want, and then click OK e.g.
number to custom "dd-mmm-yy (without the quotation marks) etc
To define and apply the style to the selected cells, click OK
To define the style but not apply it to the selected cell, click Add, and then click Close.
3. f you wish to choose the format of a particular, previously formatted, cell, e.g. a multiple, as a
standard to be applied elsewhere:
n the Style drop down box type in the name eg "Multiple and press Enter
Number format
selected
Styles drop-
down box
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Alternatively:
Format; Style
n 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.
nput 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:
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As the number format in the nput style is not defined it will follow the previously selected number
format for all cells. The components of the nput style which are applied are:
Font Underlined, Blue
Patterns Pale yellow background
Protection No protection
As the Date and nput styles do not conflict, cell E8 therefore has both styles applied.
Copy styles from another workbook
Once you have taken the time to define a set of styles in a model, these can be used as the
template for future models.
Open the model that contains the styles you want to copy;
Open the model in which you want to insert the styles, and then click Style on the Format
menu;
Merge;
Double-click the workbook that contains the styles you want to copy.
To replace the styles in the active workbook with the copied styles, click Yes. To keep the styles
in the active workbook, click No. This warning occurs only once, regardless of the number of
conflicting style names.
CoIour
Note, the colour template used on the source document may be different to that in the destination
file so that when styles are merged, the text, borders and background colours are not as
required. To apply the colours from the source document, ensure that both models are open and
in the destination model:
Tools, Options, Color;
n the "Copy colors from box select the workbook that contains the colours you want to copy;
OK.
n this way a template model with all necessary styles and colours can be easily created (and
updated) for quick merging into all future models.
ConditionaI formatting
Conditional formatting applies a defined format to cells which fulfil a condition.
To conditionally format the numbers (for example, where a negative result should not be possible,
or should be flagged, or where a balance sheet doesn't balance)
Format; Conditional Formatting
The more obvious the formatting (size, colour etc) the more useful the result.
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There are two condition (logical argument) options:
Cell Value s the value of the current cell fulfils the criteria
Formula s 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. (t is assumed that there is
appropriate coding to calculate the valuation based on 7 years!).
f 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 F
statement); then choose Format and select white font and no borders from the menus.
Text strings
Text strings allow phrases, sentences, labels and headings within a model to be automatically
updated for changes in assumptions or outputs. For example, it may be useful to have a
standard header in B2 with the company name (Bigco defined in cell E5) and currency (Cm
defined in cell E6) both of which are inputs which may change.
The ampersand [&] is the key to linking different bits of text: The formula in B2
=E5&" in "&E6 results in Bigco in Cm
n 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'.
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For instance, a model may be titled "Year ended 31 December 2006". Assumptions within the
model may change the year-end which has been defined in cell G4. Without a text string,
whenever the date in G4 changes the model will have to be updated cell by cell, a tedious task!
Alternatively, the text can be coded as:
="Year ended "&TEXT(G4,"dd mmmm yyyy").
The TEXT function picks up cell G4 (assumed to contain the year-end information) and then
formats the number contained within this cell into the date format dd mmmm yyyy (which must be
put within quotation marks).
Similar things can be done for multiples [=TEXT(G6,"0.0x;nm ")] and percentages
[=TEXT(G7,"0.0%;(0.0%))] etc. Note that where more than one format is to be chosen in a
TEXT function (for positives and negatives), they must be separated by a semi-colon within the
format text part of the function.
RegionaI settings
To change/view your profile for regional settings:
Start; Settings; Control Panel; Regional and language options; Regional options
This is a profile setting rather than merely an Excel setting it has applicability across all
applications.
Often there are company policies on regional settings all staff in all locations have the same
regional setting, e.g. English (United States). However, it may be useful from time to time to alter
this for local language, currency and formatting idiosyncrasies.
Where a cell is formatted using the number formats and the users regional settings are English
(United Kingdom) then the language (d for day, m for month, etc) and settings (e.g. commas as
thousand dividers, etc) will be used. f 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.
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IF and some other IogicaI functions
A fundamental function to add flexibility to models is the F statement. F 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 F statement is as follows:
=F(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.
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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. n 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
=F((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. f
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.
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Common probIems with IF statements and some simpIe soIutions
Using equals in a test
1. Although Fs are very useful, they can easily break down. f 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.
=F(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.
=F(ABS(cell)>0.001, "Not zero , "Effectively zero)
2. Another potential problem in using equals is where the F statement refers to a user input; for
example where the user has to type "yes or "no into a cell and then using F 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 F statements. The syntax of an AND statement is as follows:
=AND(test
1
,test
2
, test
3
..test
n
)
n 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. f they are all TRUE, then the AND
statement will give TRUE as a result. Otherwise it will give a FALSE.
n the following illustration, C45m of debt is raised (Debtnitialn) on 31 December 2005 and then
is to be repaid following a 2 year grace period (DebtGracen) over the remaining 5 years of its 7
year term (DebtTermn).
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:
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The syntax of an OR statement is the same:
=OR(test
1
,test
2
, test
3
..test
n
)
n 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. f this is the case, no payment is made:
Whether to use AND or OR depends on your thought process.
f you are an inclusive modeller, then your thought process is to define everything that falls
within boundaries AND is your solution.
n the above illustration, the logical argument is to require all the criteria to be met / to fall
within the boundaries.
f you are an exclusive modeller, then your thought process is to define anything that falls
outside boundaries OR is your solution.
n 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:
f 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%.
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This would be written as follows:
Tax charge = F(profit<0,0,F(profit<300,000,profit*19%,profit*30%))
Here the "value if false of the first F statement is another F, and both of the results from the
second F are formulae too.
The main thing to be aware of here is that as the formula gets longer, it becomes harder to work
out what the formula is trying to achieve.
Test
Value if true
Value if false
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Data retrievaI - the LOOKUP schooI
F, although perhaps the most useful function for creating flexibility in models, is limited in its
applications. f we have a problem involving a selection of possible answers, rather than a simple
yes/no, then F rapidly becomes difficult to use.
Excel will allow us to use a maximum of 7 Fs in a statement. This is very hard work to both code
and audit.
The following functions can help resolve this problem.
CHOOSE
MATCH
NDEX
OFFSET
VLOOKUP
HLOOKUP
They can all be found in nsert; 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 F statements and is used widely in
scenario management. t 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,...)
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n 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. n 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. t 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 NDEX,
OFFSET, VLOOKUP and HLOOKUP.
n the above illustration, the MATCH function is used to indicate the period number in which the
semi-annual sales finish. 30 June is the 4
th
monthly period in the sequence and so the MATCH
function is used to calculate this. The function is of the form:
=MATCH(lookup_value,lookup_array,match_type)
lookup_value
The value we want to find the relative position of. This is the semi-annual period end (30
June in cell D15) above.
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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. f 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. f
match_type is 1, MATCH finds the largest value that is less than or equal to lookup_value. f
the value in D15 is 28 June then MATCH returns 3: 31 May is the next lowest value. f
match_type is -1, MATCH finds the smallest value that is greater than or equal to
lookup_value. f 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 NDEX:
1. =NDEX(array,row_num,column_num)
2. =NDEX(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). NDEX is a highly flexible and robust
function as long as the coordinates (row and column position) can be identified.
The array version
=NDEX(array,row_num,column_num)
f a data area is 5 rows deep by 6 columns across and we wish to extract the value in the 3
rd
row
and 6
th
column. The formula becomes:
= NDEX ( 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 NDEX function.
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One dimensionaI data
Often, the trick with such functions is finding a way in which it will help.
The following is an asset schedule for one class of assets which calculates the depreciation
charge (in row 13) based on the cumulative cost at the end of the year (in row 9). The key is to
ensure that assets which have been fully depreciated drop out of the calculation which is where
row 8 comes in. f 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 NDEX, as with many functions, is to know what the answer should be. n 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
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coordinates of this within the data area (row number irrelevant as it is a one row data area; and
second column) we can use NDEX to pick up the required cell.
Analysing the above formula but ignoring the F 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. n 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. n 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.
n summary, the formula is:
= NDEX ( E2:L2, leave blank, 2)
which returns the value in the second column of the range contained in E2:L2.
The reference version
=NDEX(reference,row_num,column_num,area_num)
The reference version comes into its own when we have different versions of the same data. t
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.
n 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.
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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 NDEX
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.
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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. f we are concerned about presentation, these counters could be hidden using white text.
OFFSET
Like the NDEX function, the OFFSET function uses row and column coordinates to identify the
value (or position) of the target cell. n 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 NDEX function, the charge out rate for a director in Hong
Kong can be found using OFFSET.
=OFFSET(reference,rows,cols)
reference $C$2
This is the "starter cell or the reference point from which the OFFSET rows and columns are
counted. To make the row and column counting easier, with two-dimensional data areas it is
usually best to have this cell immediately above and to the left of the data area as the
reference cell.
rows, cols F14, F15
As with the NDEX function, we need to turn the row and column selectors (in E14 and E15
respectively) into numbers so that they can be used within OFFSET. Hong Kong is in the
seventh row of the city names and Director is in the fourth column of job titles MATCH has
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been used to identify these. Likewise, they are 7 rows and 4 columns respectively away from
the reference cell C2.
The row and column numbers can be negative, in which case the target cell will be above
and/or to the left of the reference cell.
Identifying the reference
OFFSET is often used to locate the contents of a target cell. However, it can also be used to
identify the position of a cell from within a range, or a range from within a range for use in other
functions.
n the charge out illustration, OFFSET can be used to identify the charge out rates for all of the
Directors or the Hong Kong office using the extended version:
=OFFSET(reference,rows,cols,height,width)
Using the extended function to find the reference of the Director charge out rates:
= OFFSET($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). t 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
NDEX 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
f 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 NDEX functions can be used to
define the start and end positions of a range. The start and end point can be used to define
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the range for a function if the two NDEX functions are separated by a colon within the
equation. For example,
= SUM (NDEX (DataArea,3,6) : NDEX (DataArea,4,10))
2. Auditing
An NDEX function is easier to audit. f F2, the trace precedents or the Ctrl-[ is pressed, then
the components of the formula are shown. f 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 NDEX. 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 NDEX 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.
f 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.
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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. f 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).
n 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
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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. f 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
n the example above, we have not included a final fourth argument. The final argument is TRUE
or FALSE. f we put TRUE or omit the last argument, then VLOOKUP works as in the above
example.
f we enter FALSE, then VLOOKUP accepts only exact matches. f an exact match cannot be
found, then a #N/A error message will be returned. This form of VLOOKUP must be used when
the selector cell is text (or if column 1 is not in ascending order).
The result of the formula in cell D14 is C89.10 (the value in the 4
th
column of the Casino row).
The selector cell is B14, which this time is text (Casino). Additionally, the data in the first column
of the data area (named Data in cells B2:F10) is not sorted in any particular order. Consequently,
the last argument in the VLOOKUP must be FALSE (or 0).
Strangely, if FALSE was missed off, the VLOOKUP may give
1. the right answer
2. another erroneous value or
3. #N/A
t 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.
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HLOOKUP
VLOOKUP and HLOOKUP work in very similar ways. The difference in their use depends on the
way the data is arranged:
VLOOKUP requires the lookup_value to be represented in the first coIumn of the data area
(or table_array) that is, the lookup is driven by verticaIIy looking down the first coIumn of
the data area to find the correct row (and then finding the appropriate coIumn).
HLOOKUP requires the lookup_value to be represented in the first row of the data area (or
table_array) that is, the lookup is driven by horizontaIIy looking across the first row of the
data area to find the correct column (and then finding the appropriate row).
n the comparable company table below, supposing the company (Ahold in row 7) was a given
and we wanted a formula that would return Netherlands if Country was chosen, C23.95 if Price
was chosen and so on.
=HLOOKUP(lookup_value,table_array,row_index_num,range_lookup)
=HLOOKUP(C12,Data,7,false).
lookup_value C12 (Country in this case)
As with VLOOKUP, this is the output driver (the word Country). This points to which type of
output value we are looking for.
table_arrayB2:F10, named Data
The data area where the required result (Netherlands) is located. The lookup_value, Country,
will be checked against the values in the first row of the table_array i.e. the values to be
checked must be in the first row / header of the data area.
row_index_num 7
The first two arguments have narrowed it down so that the lookup is looking down the
Country column of the range named Data. The 7 indicates that we are looking for the 7th row
in that column that relating to Ahold.
The 7 has been hard-wired into the formula for illustration only. t 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.
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range_lookup false (or 0)
As the first row is not sorted in any particular order and the lookup_value is text, we want an
exact match only (not the closest approximation). As we have seen with VLOOKUP, if the
FALSE argument is not added the HLOOKUP may give:
1. the right answer
2. another erroneous value or
3. #N/A
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Dates
When a date is used in Excel, it is identified as a number. For example, 30 July 1966 is a famous
day. According to Microsoft, that is the 24,318
th
day of the world, i.e. it has been given the unique
number 24,318.
So when did the world begin? The first day of the world (according to Microsoft), i.e. number 1, is
1 January 1900, despite a sizeable body of evidence to suggest otherwise. This is an important
date: if Excel knew that the world started on that date then any other date is merely a number of
days from 1 January 1900. Hence, a unique number can be allocated.
Date formats
1 January 1900 was, of course, a Sunday (which Excel, by default, treats as the first day of the
week). Consequently, not only can Excel count the number of days from 1 January 1900, but
also can very easily work out which day of the week it is.
As dates are numbered, they can be formatted in the same way as other numbers. For example,
to format the date 4 July 2006 (number 38,537):
Control-1, Number and Custom
d dd Ddd dddd
Days
4 04 Mon Monday
m mm Mmm mmmm
Months 7 07 Jul July
y yy Yyy yyy
Years
06 06 2006 2006
Date functions
Appreciating that a date is a number adds a lot of functionality. Some of these functions are not
in the standard set-up of Excel and may need to be added:
Tools, Add-ins
Select Analysis Toolpak
YEAR, MONTH, DAY etc
Where the data is in 3 different cells, being day of the month (28), number of month (2 for
February), and year (2004), this can all be combined into '28 February 2004' by the Date
function:
=DATE(year,month,day)
The result in the cell is now the unique number for 28 February 2004 which can be formatted as
appropriate.
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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 "ds). Note: because 1 January 1900 was a
Sunday, then by default, Sunday is assumed to be the first day of the week, whilst Saturday is the
7
th
. By changing the return type, the start of the week can be altered to, say, Monday.
Defining time periods
f 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. n 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. n 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. n 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.
f monthly or quarterly dates are to be used, method 1 is not suitable but either method 2 or 3 can
be used.
f the relevant date is to be, say, the 5
th
(of each month, quarter or year) then EDATE is the
appropriate function.
f 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.
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Length of periods
As dates are numbers, then by subtracting one date from another generates the number of days
between the dates. Consequently, to count the number of days in a month, quarter or in fact
between any 2 dates is easy.
The YEARFRAC function looks at the proportion of a year between 2 given dates:
=YEARFRAC(start_date,end_date,basis)
The basis should be one of the following, each giving a slightly different outcome
0 or omitted US (NASD) 30/360
1 Actual/actual
2 Actual/360
3 Actual/365
4 European 30/360
Note: the function only gives positive results and so care should be taken in ensuring that the
start date is the earlier date as it will not be apparent from the output.
ConsoIidating time periods
t 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.
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IIIustration
The quarterly and annual dates have both been created using EOMONTH with 3 and 12 being
the number of months respectively.
We are trying to sum the quarterly sales which fall between the year ends - note the first year is
not a full 4 quarters.
SUMIF
=SUMF(range,criteria,sum_range)
The SUMF function requires data (the range) to fulfil a criterion (criteria). f 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. t is only by adding the text string component ("<="&F6)
to the criteria that we can get around this restriction within SUMF.
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 =SUMF(DatesQ,"<="&DatesY,SalesQ)
or =SUMF($E$2:$AA$2,"<="&F6,$E$3:$AA$3)
in F10 =F9-E9
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SUM OFFSET
OFFSET can be used to identify a single cell or a range. t is the latter which we are interested in
here. The address of the range is identified and then the contents summed. The trick is to
identify the starting and finishing point of the range.
PreIiminary step - period counters
n the above illustration, the first year's sales are for the first 3 quarters (i.e. the 1
st
to 3
rd
sales
figures) and the second year is from the 4
th
to 7
th
figures etc. The start and end point in the sales
range can be identified in the following corkscrew:
The end position within the range can be identified using the MATCH function to find the
relevant year end in the range of quarterly dates (using the exact [0] matching criteria):
in F16 =MATCH(DatesY,DatesQ,0), or
=MATCH(F6,$E$2:$AA$2,0)
The start is merely 1 period after the previous ending period
in F15 =E16+1
The OFFSET
The OFFSET function identifies a cell or range which is a specified position away from a starter
cell. The sales data is a 1-dimensional (1 row) range and so only the column and width criteria
are required (together with the required starter cell). t is cleaner to use a cell outside the data
area as the starter cell (in this case D3 - immediately to the left of the data to be summed) as the
address of the target area is always offset a given number of cells from this point.
The OFFSET function then identifies the relevant range as starting so many columns (1, 4, 7 etc)
away from the starter cell (D3) and being 3, 4, 4 etc cells wide (being the difference between the
end position for the relevant year and that of the previous year). As a result, the OFFSET
function has identified E3:G3 for year 1 and H3:K3 for year 2 etc. By placing a SUM around this
range, the relevant consolidated sales is returned:
in F11 =SUM(OFFSET($D$3,,F15,,F16-E16))
SUM INDEX
NDEX can be used to identify, from within a specified data area, a cell value or address. t is the
latter which we are interested in here. The addresses of the start and end of a range are
identified and then the contents summed. As with OFFSET, we need to identify the starting and
finishing point of the range - done using the same preliminary step as for OFFSET.
2 similar NDEX functions are used to identify the addresses of the start and end of a range. As
the sales data area is a 1-dimensional (1 row) range then only the sales data area and the start
(or end) column number within this area need be identified.
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n cell F15, the starter cell address is identified by =NDEX(SalesQ,,F15) where SalesQ is the
sales data area and F15 indicates that the cell we are interested in is in the 4th column of this
data. On its own, the result of this function would be the sales in the 4th quarter. However, when
combined with another function, Excel knows to use the address result instead. Similarly, the end
cell address is identified by =NDEX(SalesQ,,F16).
By combining the results of the 2 NDEX functions a range can be identified and then placed
within a SUM:
in F12 =SUM(NDEX(SalesQ,,F15):(SalesQ,,F16))
or =SUM(NDEX($E$3:$AA$3,,F15):NDEX($E$3:$AA$3,,F16))
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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 F statement based on whether the switch is TRUE or FALSE can be used to alternate the
model assumptions. When using the F 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
=F(Switch=TRUE,"Equity accounting,"Proportional consolidation");
or, more simply
=F(Switch,"Equity accounting,"Proportional consolidation")
would change the cell text from Equity accounting to Proportional consolidation.
Check
box
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The check box can be formatted for colour, using the right mouse button, Format Control; Colours
and Lines.
MuItipIe options
These buttons/boxes are created and amended and then linked to further formulae in the same
way as the Check Box.
Option button
When an option button is created and linked to a cell (B3 below), 1 appears in the linked cell. f 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 F 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. n the above formula, B3 returns a value between 1 and 3. f, 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
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Option button with group box
As more option buttons are created on the same sheet, they are automatically linked to the
original linked cell. f more than one set of option buttons is required on the same sheet, it is
necessary to use the group box.
n the above, two different sets of option buttons are being used to drive different scenarios. f
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). f
November is now selected,
cell link shows 11, being
the 11
th
item in the list.
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Combo box
The combo box works in broadly the same way as the list box, requiring the same inputs as the
list box. The key difference is in the appearance a drop-down box with the options will appear
when the combo box is selected; whilst only the item menu item selected will show when the box
is not selected.
FormaIity
As we have seen, the boxes and buttons sit on top of the model and then are linked to the model
by use of cell links (and extract data from the model, for combo and list boxes, through the input
range). Consequently, they result in the cell link values changing as the different options are
selected. Therefore, despite the user not physically using the keyboard to type in a hard-wired
number (or TRUE/FALSE), the cell link changes.
The consequence of this is that all cell links MUST be situated on the nputs sheet the home of
all other hard-wired inputs.
The switches should, therefore, also appear on the nputs 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.
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Sensitivity
GoaI Seek
Goal Seek is a simple but powerful sensitivity and testing tool. Goal Seek can be used for "break
even analysis and to answer many typical questions that you would ask of a model for example:
'how much growth will 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. n the second (To value) box enter the value you would like the Set cell to equal;
3. n the third (By changing cell) box input the address of the cell containing the input you wish
to vary. n 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.
f 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
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Data TabIes
Data Tables are sensitivity tables by another name and they are brilliant as they are highly
effective tools in assessing which are the most sensitive inputs (ie have the greatest impact on
outputs) of the model. Sadly they use up a lot of memory and so it is essential that the
Tools; Options; Calculation tab
is checked for a manual (F9) calculation (or automatic except tables). Otherwise, after each new
entry anywhere on the model, Excel will try to recalculate the table which will take a particularly
irritating amount of time.
The sensitivity table can look at variations of up to 2 variables. Unfortunately, Excel requires that
the 2 variables are on the same sheet as the sensitivity table. t 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 EBTDA
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. EBTDA exit multiple and equity discount rate) and input
a series of values in the row across the top of the table (e.g. EBTDA exit multiple) and a
series down the left hand column of the table (e.g. equity discount rate). Note: these series of
inputs must NOT be linked to the inputs that you are looking to vary;
3. The ranges in the top row and left column are generally driven from the centre values (7.0
and 13.0% respectively in the following illustration) with equal increments from this centre
value.
4. Highlight all the entries thus made which will, therefore, require a rectangular table to be
highlighted;
5. Using the
Data; Table function
the row input cell reference (being the input varying across the top row of the table) will
be the input for EBTDA exit multiple which drives the rest of the model; and
column input cell (being the input varying in the left column of the table) will be the input
for equity discount rate which drives the rest of the model.
6. Using
F9
a data table will be produced which highlights the sensitivity of the Enterprise Value to the
changing EBTDA exit multiple and varying equity discount rate.
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Enterprise VaIue - m sensitivity
EBITDA exit muItipIe
147.7 5.0 6.0 7.0 8.0 9.0
12.0% 133.0 143.7 154.3 165.0 175.7
Equity 12.5% 130.2 140.6 151.0 161.4 171.7
discount 13.0% 127.5 137.6 147.7 157.8 167.9
rate 13.5% 124.8 134.7 144.5 154.4 164.2
14.0% 122.3 131.8 141.4 151.0 160.6
n the above table, the model output for Enterprise Value is 147.7m when the inputs (assuming
EBTDA 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.
f the EBTDA 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
ncremental
change
EBTDA 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). t 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.
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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.
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VaIidating data
A major problem of financial modelling is controlling the quality of inputs and the results. Data
validation is tremendously useful because it allows you to limit data entry, cell by cell, within your
model.
Data VaIidation - with inputs
Where the cell is an input cell, invalid inputs will not be allowed (and a prompt will indicate why).
This is particularly useful if dates, currencies or text are to be entered in a precise format or to
ensure that an input is within an allowable range.
For example, assume that only a date lying between today and the next year end (which is in cell
E17) can be chosen.
Select Data; Validation
Click on the down arrow by the Allow box and a list of options will be displayed.
Allow Date, between, and then either enter the start and end date or link to dates within the
model.
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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.
f 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. f the source data is on another sheet, then it is necessary to name the source data.
Input message
nput 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 nput
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. f the
source data is on another sheet,
then the source data must be
named.
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Error alert
Data validation is best used to make inputting easy and to ensure robust inputs drive the model.
t is imperative that inappropriate inputs are blocked which is what data validation does.
When entries are blocked the following default message appears:
As this does not indicate how to solve the problem, it is useful to change the message. By
selecting the Error Alert tab, a message can be composed so that the above message is replaced
by "Must enter a forecast date within the next 12 months.
Data VaIidation - with outputs
Additionally, data validation of outputs can be used to "sense check results: f 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 nvalid 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
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ConditionaI formatting
Conditional formats can be used to validate results. We could conditionally format so that those
cells which are not valid / do not fulfil the benchmark criteria appear as a different colour, with
borders, with a coloured background, etc.
The advantage of this is that the problems are highlighted without the use of other functions (i.e.
the auditing toolbar for data validation above).
The disadvantage of this method is that these cells are merely formatted without having any other
functional implication - i.e. the fact that a cell fails a test does not prevent that cell from being
used elsewhere.
ConditionaI statements
The use of flags (0 and 1) through F statements can add functionality if the result of an equation
is not valid / does not meet the benchmark criteria.
f, 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 F statements with 1 or 0 as the values if TRUE or
FALSE respectively. f 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). f the sum comes to 1
or less then the project can get the funding.
The ISERROR function
t can be irritating when #DV/0! appears in a cell, not because a genuine error has been made
but because one of its precedents has not yet been completed. t 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,
f the contents of A1 were 187; A2 were 0; and those of A3 were =A1/A2 the result would
be #DV/0!.
By amending the formula in A3 to
=SERROR(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:
=F(SERROR(A1/A2),0,A1/A2)
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The result being 0 this time rather than TRUE.
Note: the SERROR 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 SERROR
function will cover up any errors and so can undermine the controls put in the model.
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ModeI compIetion
Group outIine
When printing or presenting the model, there may be parts of the model which you do not want to
print e.g. historic periods, detailed calculations for check balances etc. n 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:
t 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). f the bar outline symbol is "+ then the user can click this
to show the hidden area. f 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 EBT. By selecting
the long section (1), then the first number to be visible is EBT. By selecting the shorter section
(2), then the sales information is hidden but the remainder of the P&L is visible.
Protecting the modeI
Once the model is complete and everything works, then it is worth protecting the model to ensure
you don't (or the reviewer doesn't) amend the formulae and corrupt your hard work.
t 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: f report manager is used, at least one sheet must remain unprotected in order to allow
report manager to be activated.
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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.
f you want to protect a sheet, but allow some specific cells to be changed, then cells and ranges
can be "selectively unprotected using the following procedure (note: this will only work if the
sheet is unprotected first):
Highlight the cells which you want to be able to amend;
Format; Cells; Protection, untick the "Locked box. Press OK.
Protect the sheet (as above).
You have created "windows in the locked sheet where you can still manipulate the sheet.
StyIes and protection
Selective protection can be done through the use of Styles. The last of the Style options is
"Protection. All input styles should have this box checked and then modified (protection locked
box is NOT checked) to be "No protection.
As the default setting for cells is to be Locked when the sheet is protected, by leaving the
"Protection style option unticked for all other styles, the result will be that only those cells with the
input style can be changed once the sheet is protected
Hiding
f 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.
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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-ns), 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. f the order needs to be
changed or something deleted, buttons allow this.
t 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: n 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
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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.
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Historic financiaIs
Decide which historics are necessary ie income statement, cash flow statement and balance
sheet.
nputs 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 S 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, EBTDA, EBT 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).
n 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.
t will be necessary to tie some of these numbers into the other financials a profit figure (one of
EBTDA, EBT or net income depending on preference) to start the cash flow and the cumulative
reserves (or equity) for the balance sheet (see below).
The cash flow
Put in the necessary headings (probably operating cash flow and pre-financing cash flow) and
the other figures between these are "noise to make the statements reconcile.
The starting point for the operating cash flow is likely to have been fed from the income statement
sheet (one of EBTDA, EBT 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.
t will be necessary to tie the cumulative cash (or net debt) into the balance sheet (see below)
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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 S 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.
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Forecast financiaIs
To make life easier, the first step must be to get the forecast balance sheet to balance.
Ensuring baIancing baIance sheets
This is done by:
1. Filling in all the totals and subtotals in all the forecast financial statements (including the
retained earnings/equity and cash/net debt reconciliations together with the balance sheet
check calculations).
f the historic financial statements have been set up correctly, then all these formulae can
be copied from the historics.
n order to ensure that the forecast financials continue to integrate, the retained
earnings/equity will be fed from the retained earnings/equity reconciliation in the income
statement workings and the cash/net debt from the cash/net debt reconciliation. As
profits are inserted into the forecast income statement and cash flows into the cash flows
statement then the balance sheet will update. On setting these up in the forecast periods,
there will, initially, be no movement.
2. The balance sheet will not currently balance. By linking each value in the balance sheet
(other than retained earnings/equity and cash/net debt) to the value in the previous year,
the balance sheet should initially balance (at the same value as the last historic year).
3. All movements in other categories within the balance sheet will be updated on a module
by module basis.
For example, if capex is forecast, formulae should be updated to accommodate this -
capex will reduce cash in the cash flow and increase assets in the balance sheet.
When adding the results of the forecast workings, the financial statements should then
automatically update and any errors will immediately be revealed through the checks you
put in earlier if they don't, you shouldn't move on.
Your objective is to create all the individual lines which will make up the income statement, cash
flow and balance sheet. The usual minimum requirements in terms of the number of modules is
three and the components are as follows:
a) Operations and working capitaI
Sales
EBTDA margin
Working capital balances
b) PPE / fixed assets
Net book value
Annual depreciation charge
Aggregate annual capital expenditure
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c) Debt
Closing debt balances
nterest 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:
f the difference is recognisable error of omission the entry has not been entered
in all the appropriate places;
f 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) & EBTDA S
Working capital increase (add to appropriate brought forward figure) BS
EBTDA & working capital increase CFS
Setting up the reconciIiation
P&L BaIance sheet CFS
opening forecast
Sales EBTDA -
Operating costs PPE 600 600 Wking cap incr
EBTDA - other net assets 300 300 Operating CF -
Dep & amort cash 50 50 Capex
EBT - 950 950 Tax
nterest Pre-financing CF -
Tax Debt 625 625 Dividends
Net income - Shares 75 75 nterest
Dividends Retained earnings 250 250 Equity
Retained earnings - 950 950 Net debt flow -
Debt
check - - Cash flow -
Ret earnings Cash
Start 250 (BOLD numbers - inputs this moduIe) Start 50
Retained earnings - Cash flow -
Other Other
End 250 End 50
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Operations and working capital
P&L BaIance sheet CFS
opening forecast
Sales 750 EBTDA 350
Operating costs 400 PPE 600 600 Wking cap incr (40)
EBTDA 350 other net assets 300 340 Operating CF 310
Dep & amort cash 50 360 Capex
EBT 350 950 1,300 Tax
nterest Pre-financing CF 310
Tax Debt 625 625 Dividends
Net income 350 Shares 75 75 nterest
Dividends Retained earnings 250 600 Equity
Retained earnings 350 950 1,300 Net debt flow 310
Debt
check - - Cash flow 310
Ret earnings Cash
Start 250 (BOLD numbers - inputs this moduIe) Start 50
Retained earnings 350 Cash flow 310
Other Other
End 600 End 360
PPE
P&L BaIance sheet CFS
opening forecast
Sales 750 EBTDA 350
Operating costs 400 PPE 600 625 Wking cap incr (40)
EBTDA 350 other net assets 300 340 Operating CF 310
Dep & amort 150 cash 50 185 Capex (175)
EBT 200 950 1,150 Tax
nterest Pre-financing CF 135
Tax Debt 625 625 Dividends
Net income 200 Shares 75 75 nterest
Dividends Retained earnings 250 450 Equity
Retained earnings 200 950 1,150 Net debt flow 135
Debt
check - - Cash flow 135
Ret earnings Cash
Start 250 (BOLD numbers - inputs this moduIe) Start 50
Retained earnings 200 Cash flow 135
Other Other
End 450 End 185
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Debt and interest
P&L BaIance sheet CFS
opening forecast
Sales 750 EBTDA 350
Operating costs 400 PPE 600 625 Wking cap incr (40)
EBTDA 350 other net assets 300 340 Operating CF 310
Dep & amort 150 cash 50 225 Capex (175)
EBT 200 950 1,190 Tax
nterest 60 Pre-financing CF 135
Tax Debt 625 725 Dividends
Net income 140 Shares 75 75 nterest (60)
Dividends Retained earnings 250 390 Equity
Retained earnings 140 950 1,190 Net debt flow 75
Debt 100
check - - Cash flow 175
Ret earnings Cash
Start 250 (BOLD numbers - inputs this moduIe) Start 50
Retained earnings 140 Cash flow 175
Other Other
End 390 End 225
Tax and dividends
P&L BaIance sheet CFS
opening forecast
Sales 750 EBTDA 350
Operating costs 400 PPE 600 625 Wking cap incr (40)
EBTDA 350 other net assets 300 340 Operating CF 310
Dep & amort 150 cash 50 115 Capex (175)
EBT 200 950 1,080 Tax (40)
nterest 60 Pre-financing CF 95
Tax 40 Debt 625 725 Dividends (70)
Net income 100 Shares 75 75 nterest (60)
Dividends 70 Retained earnings 250 280 Equity
Retained earnings 30 950 1,080 Net debt flow (35)
Debt 100
check - - Cash flow 65
Ret earnings Cash
Start 250 (BOLD numbers - inputs this moduIe) Start 50
Retained earnings 30 Cash flow 65
Other Other
End 280 End 115
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Debt modeIIing
The big problem when modelling debt is the ease with which circularities can be created. As a
model is a simplification of the world, then the circularity problem can be circumvented by use of
appropriate simplifying assumptions.
The probIem
Tax is often calculated using the following:
EBTDA 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.
nterest on cash / revolver balances is calculated using the following:
Opening cash (revolver) balance X
Cash increase /(decrease) in year X
Cash (revolver) at end of year X
Cash increase in the year is a post-tax, post-interest figure and so, therefore, is the cash at the
end of the year. Consequently,
the tax expense is dependent on interest on cash and
interest on cash is dependent on both tax expense and interest on cash.
i.e. a circularity has been created.
A soIution
(Assumption: the debt instruments have a structured repayment profile and any shortfalls or
spare cash goes to the cash/revolver)
1. Build up the individual debt schedules with structured repayments
2. Calculate the interest arising on debt instruments
3. Set up the cash/revolver schedule as:
Opening cash (revolver) balance X
Cash increase /(decrease) in year (leave blank for now)
Cash (revolver) at end of year (opening +/- increase/(decrease)) X
4. Calculate interest on cash/revolver based on OPENNG balance (to avoid circularity).
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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.
n 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,
teration). 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.
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Auditing and error detection tooIs
Auditing a formuIa
F2
The F2 button, when on a cell, edits a formula. Excel will highlight the cells in coloured boxes
which are precedents of the cell that is being edited. Consequently, F2 is the quickest way to
audit a formula when the precedents are located close to the formula, but of limited use when
they are elsewhere.
Control-[
Control-[ Goes to all the precedent cells on the same sheet (goes
to first precedent only if on different sheets)
Control-] Dependent cells (on same sheet only)
F5
When the precedents are elsewhere in the model, highlighting the cell reference or name in the
formula and pressing F5 (the Go To command) will go to the relevant cell (or range).
Unfortunately each component of the equation needs to be done in isolation.
Often the best use of this function is when switching between 2 parts of the model. By going to a
cell (possibly by using the auditing toolbar or Control-[), F5-Enter will return you to the original
cell.
Auditing toolbar
The auditing toolbar is a powerful tool and should form part of the main toolbar for any Excel user.
t 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 #DV/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. f
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.
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Trace errors. Where a cell has an error in it (such as #VALUE! or #NAME!), the use of this
function selects the cell that contains the original formula that has an error and has all that
cell's direct precedents arrowed.
Double clicking on the trace precedents / dependents tool will show both direct and the next
indirect precedent / dependent.
Double clicking on the arrows takes the cursor to the end of the arrow.
Where an arrow points to another sheet, double click on the dotted arrow which then returns the
relevant locations in the Go To dialog box.
Summary
Order Pros Cons
1. F2 Highlights
precedents
Quickest when
precedents are near
Only useful if
precedents are near
2. Control-[ Go to precedents Quick Only goes to first
precedent on other
sheets
3. Auditing toolbar Traces
precedents
Easy visual reference
Double clicking on
precedent line takes
you to other end of line
Requires significant
mouse action
4. F5 Go to precedents Can go to specified
precedents
Better as a way to get
back to original cell
Only goes to one
precedent at a time
Requires significant
mouse action
AdditionaIIy, if names have been used:
5. The name means something to the reviewer
6. Name (drop-down) box - top left of spreadsheet can be used to go to the named cell/range
7. F5 (all names are listed) can be used to go to the named cell/range
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Finding Iinks
When reviewing a model from a third party or when trying to fix your own model, locating and
understanding the links is a very important task. Excel does not have any built in tools to help
you analyse them, but this can be easily done: Firstly, to find the name of any linked files, open
the Edit menu and select Links. A dialog box will be displayed showing the names of linked files
and allowing you to update the links.
The address of the linked cell(s) will appear as ='[Big and Clever.xls]nput'!$P$134
Finding the cells containing links in the workbook requires the following method:
1. Go to the first sheet in the model, go to the Edit menu and select Find
2. As the [ is a bit of a give away in the above address, insert a square bracket, [, into the find
box and press return. Excel will take the cursor to the first linked cell in the sheet and further
linked cells can be found by pressing the find next button in the Find dialog box.
The shortcomings of this method are that it is laborious: if there are a lot of links in a sheet this
process can take a long time and secondly, Excel will only reliably search to find links if we
search sheet by sheet.
Contained in oId names
A source of spurious links is the copying of data between models where the copied cells use a
range name. This can lead to a range name being included in the list of range names in a
workbook, where the cells in that range are in another workbook. These can be found by going
to the nsert 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.
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The F5 SpeciaI
The Go To Special is a very powerful auditing and orientation tool.
t can be activated by
selecting a single cell for most of the options in which case the whole sheet is searched (not possible for Row and Column differences),
selecting an area in which case only the selection is searched; or
highlighting the whole sheet in which case the whole sheet is searched (very useful for Row and Column differences).
When the cell or area is selected:
press F5 and then Special
and then the following box appears:
Finds what Finds what
Both can be specified more
by using the 4 sub-
categories for example,
will go to a constant or
formula result that is a
number or text etc
All cells with comments
Any single inputs
Any result of a formulae
nconsistent formulae across a row
nconsistent formulae down a column
Direct precedents
Direct dependents
(unless All levels
chosen below),
current sheet only
Though not named range
All empty cells (but not " cells)
Same as Ctrl-*
The array containing the cell
Any pictures / objects
Same as Ctrl-End
All non-hidden cells for formatting or chart source
Cells with conditional formatting
Any (or specified) data validation
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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.
(f 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
f a formula contains a function which needs some explanation, by pressing the "= button (edit
formula, immediately to the left of the formula bar [f
x
button in Excel 2003]) when editing the
formula, then Excel will take you to the dialogue box for that function.
n the following, as the CHOOSE function is selected from within the F statement (cursor flashing
on that part of the equation), then the dialogue box for CHOOSE will be shown.
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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+'nputs & Results'!$F$25+AStart))*((SUM(F76:F81)+SUM(F84:F93))*(1-tax)-
(Crate_monthly *Cstart*(F29/F30))))/(1-((PP/(PP+ 'nputs & Results'!$F$25+AStart)*tax)))
By pressing Alt-Return at the appropriate breaks in the formula, the formula will read as:
=-(
(PP/(PP+'nputs & Results'!$F$25+AStart))
*(
(SUM(F76:F81)+SUM(F84:F93))
*(1-tax)-
(Crate_monthly *Cstart*(F29/F30))
)
)
/(1-((PP/(PP+ 'nputs & Results'!$F$25+AStart)*tax)))
The formula will remain in this form for subsequent users.
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Auditing a modeI - a process
Upon opening
Does it contain macros (message when opening re. enable / disable macros)?
Does it have links to other models?
Message on opening states "The workbook you opened contains links to information in
another workbook. Do you want to update .
t 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)
n 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
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Coding cIarity index
The coding clarity index is a scoring system to quickly assess the quality of the code in a model.
The purpose of the index is to give an "objective, or at least independent, basis for assessing
quality in the model and give a guide as to the ease with which the model will be audited. Using
the index is very simple.
1. Choose 50-60 lines of code in total from 3-4 different areas in the forecasts and review the
code.
2. Review the whole model to get a feel for the layout and structure and review any
documentation, help or notes that come with it.
3. Review the questions in the questionnaire and score the model. f the answer to the question
has a score against it, score the relevant marks for that question. t does not matter how
many times or how few times the design problem has occurred.
4. Add up the scores and look up the score in the results table.
Coding clarity results table
Score ConcIusion
0-6 This is a good score, and the model should be straightforward, clear and simple.
As a general rule, this is easy to achieve in simple small models but more
difficult as models grow.
7-10 This score should be readily achievable in most models and is a reasonable
level to set as a minimum quality standard.
t 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. f 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. t 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. t 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. t 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.
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Coding clarity questionnaire
Score
for a
yes
Score
for a
no
ModeI
score
1. Are any numbers hard coded or embedded into
formulae? Even just for the conversion of units?
5
2. Are formulae inconsistent across the rows in the
forecast area?
5
3. Are assumptions spread around the various
schedules of the model and not in a separate
Assumptions sheet or sheets?
3
4. Are inputs colour coded? 1
5. Are complex formulae used where more than 2
formulae are nested inside each other?
1
6. s switching done by multiplying formulae by
statements like (c3=1), instead of using f 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
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TroubIeshooting
The steps for spotting errors in models:
1. Find and correct errors
Find and correct the original source of any of the following (i.e. the location of where the
original problem started), by use of the "Control-[" or the auditing toolbar:
#N/A #VALUE! #REF! #DV/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:
f the difference is recognisable error of omission the entry has not been
entered in all the appropriate places;
f 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.
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Appendix
ExceI tricks
Auditing consistency over columns (highlights rows that are inconsistent)
Select the appropriate columns; F5; Special; Row differences (or Constants if inputs /
hard-wired numbers are to be identified)
F5, Special can also be used to find conditional formatting, data validation, row
differences .
Auditing toolbar
Ensure this forms part of your toolbar to enable inconsistencies to be spotted quickly
Double clicking on the trace precedents / dependents tool will show both direct and
the next indirect precedent / dependent
Double clicking on the arrow takes the cursor to the end of the arrow
Where an arrow points to another sheet, double click on the dotted arrow which gives
the relevant locations in the Go To dialog box
Column selection
Control-space bar; or
Place cursor on column header - Left mouse button
Control-- to then delete selected column; or
Control-+ to then insert a column
Comment insertion (descriptive labels for more complex calculations)
Shift-F2; or right mouse button
Shift-F10; nsert 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
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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
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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.
nsert
Shift-F11 New sheet
Alt-; R or C New row or column
Control-+ New row or column when column or row selected
F3 name into a formula
Listing names
nsert; 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
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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)
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Switch creation
For example
Open the Forms toolbar (View; Toolbars; Forms)
Select the check-box and create its text
Using the right mouse, Format Control; Control; Cell Link (giving cell reference for an
unused cell which will now switch between reading either TRUE or FALSE)
Switching between sheets
Control-Page Up/Down
Switching between split sheets
Shift-F6
Switch to other open workbooks/documents
Control-F6
Spell-check
F7
View multiple workbook/sheets
Open required workbook(s)
Window; New window more than one version of the current model has been created
Window; Arrange; Horizontal (if only want views of current model ensure "Windows of
active workbook is selected)
Control-F6 switch between workbooks/sheets
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ExceI function keys
Key Function Shift CTRL CTRL-Shift ALT ALT-Shift
F1 Get help. Displays
the assistant
balloon
For help on an
option, select the
option, and press
shift F1
Create a chart
that uses the
current range
nsert a new
worksheet
F2 Edit the active cell nsert 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
nsert a new
worksheet
nsert 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
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Debt Capital Markets
Fixed ncome
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2
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Risk and reward
Despite all evidence to the contrary....
....risk and reward will dominate in the end.
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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
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Bonds
7%
100
Company A will pay:
7%
7%
7%
7%
7%
7%
6 Years
Who?
Compensation?
How long?
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Bonds key features
Specified issuer/guarantor
Specified interest payments
Fixed maturity
Final repayment dates
Typically bullet
Early redemption possibilities
ndenture provisions
Covenants
Events of default
Seniority/security
4
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nterest types
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Bonds 2
Risks?
Time
Credit
Liquidity
1 2 3 5 6 4
5
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Borrowers
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Bio-diversity
Variable cashflow structures
Puts and Calls
Premiums and Discounts
Floaters and ndex Linked
Convertibles
Exchangeables
Asset backed
Pass Thru, CMOs and CDOs
Exotics
Credit Linked Notes
6
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Corporate issuance
Limited
Regulation
Rule 144 a SEC
Bearer
Private
Placement
Registered
Gross Yankee
Eurobonds Domestic
$ is the most complicated market
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Medium Term Note (MTN) programmes
Used to save time and costs for a regular issuer
ssuer:
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
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What is an MTN (programme)?
A customer driven private bond transaction
A Medium term note is a private bond issue using
standard "shelf style bond documentation
Although programmes can lead off with a public
issue, most trades are "Reverse enquiry an
investor makes a specific credit and maturity
enquiry
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
(MTN) process
When an issue is required:
nvestor enquires with MLA
MLAs contact issuer with details of requirements and
agree pricing
MLAs send out latest annual documentation
After the deal is closed, MLAs send out a pricing
supplement for each tranche with full details of the
issue
8
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
MTNs Why do they work?
nvestors
Yield enhancement
Credit diversification
Fill duration gaps
Tailored to meet currency
needs
Exposure to alternative
markets/instruments
ssuers
Lower cost
Documentation efficiency
Broaden investor base
Continuous market access
Liability profile management
Discreet market access
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Government bond markets
Large
Liquid
Simple
9
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Government bond markets
Authorities
ssuing Agency Official Statistics Central Bank
Primary Market
Auctions
Timetable
Transparency
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Government bond markets
Authorities
ssuing Agency Official Statistics Central Bank
Primary Market
Secondary Market
Cash Market Repo Market Futures Market
Strips Market
10
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Corporate bonds
Required return?
ssuer quality
Maturity
nterest rates
Coupon frequency
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Pricing process
Name
Maturity
Spread history
Ratings
Comparables
Coupon frequency
11
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The issuance process
ssuer
nvestors
Sales Team
Origination
Co-Iead Co-Iead
Lead Manager/
Book-runner
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The issuance process
Beauty parade
Due diligence
Research
Prospectus
Roadshow
Bookbuilding and allocation
12
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Secondary market in corporate debt
Historically limited
Growing
Coredeal MTS
Other systems
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What is the yield?
Measure of return
Variety of simple measures
The most complete is the Gross Redemption
Yield (GRY) or Yield to Maturity (YTM)
13
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The time value of money
1,000 or 1,000
Now In one year

Why?
Choice
nflation
Credit
= Interest Rate
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The time value of money
1 2 3 4
(1+r)
(1+r)
2
(1+r)
3
(1+r)
4
P
r
e
s
e
n
t

V
a
I
u
e
period
14
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Yield and price
Bond Price $
Bond Yield %
But different bonds exhibit different levels of sensitivity
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Accrued interest
Monday 21
st
Friday 25th
15
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What does yield represent?
+ Credit spread Risk free rate
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Monetary and fiscal policy
Fiscal Policy
Taxation Rates
Government Spending
Monetary Policy
nterest Rates
16
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
ndicators
Gross Domestic
Product
Consumer
nflation
Retail Sales
nternational
Trade
Public
Spending
Private
nvestment
Consumer
Confidence
Consumer
Credit &
Money Supply
Business
Confidence
Asset Prices
Commodity
Prices
Earnings
The Global
Economy
Unemployment
Exchange
Rate
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Conventional Bond Analysis
The Real
Yield
Expected
nflation
NominaI YieId
Historically the source of
much of the volatility
17
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The yield curve
GRY
Maturity
The Coupon Effect
Special Features
Tax Distortion
Curve Fitting Techniques
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Expectations and the yield
nitially flat term structure but economic news
implies an expected rates rise
nvestors?
Speculators?
Borrowers?
What is the impact on the term structure?
18
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
But dominant theory is expectations
Other factors that will affect yield
Maturity
Liquidity premium and uncertainty
Supply and demand
Segmentation Theory
Preferred Habitat Theory
1
The Corporate Training Group
Ratings
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Moody's Standard & Poor's
Smallest degree of risk Aaa AAA Highest rating: capacity to pay
interest and repay principal
extremely strong
High quality Aa AA Strong capacity to service debt
Upper medium grade:
elements suggest
possible future weakness
A A Strong capacity to service debt
but susceptible to adverse
changes in circumstances or
economic conditions
Adequate security at
present but may be
unreliable over time: has
speculative
characteristics
Baa BBB Adequate capacity to service
debt over time but adverse
conditions likely to weaken
capacity to service debt
nvestment grade long term
2
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Moodys Standard & Poors
Speculative: uncertain
future
Ba BB Lowest degree of
speculation
Generally lack
characteristics of
desirable investments
B B Speculative
Poor standing: in default
or in danger of going into
default
Caa CCC Speculative
Highly speculative, often
in default
Ca CC Highly speculative
Lowest rated: poor
prospect of ever attaining
investment grade
C C No interest is being paid
Below investment grade long term
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Ratings hierarchies
S&P Ratings from AA to CCC are often modified
with a + or - to show their relative standing within
a rating category
Moody's modifies its ratings with a:
1 - high end
2 - mid-range
3 - lower end
3
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What are the two basic types of credit
rating?
ssue-specific credit rating
measures the credit risk of a specific debt issue
bonds; notes; commercial paper
preferred stock
municipal notes
measures
the creditworthiness of an entity with respect to the
specific debt issue
the likelihood of default on a specific debt issue
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What are the two basic types of credit
rating?
ssuer credit rating
also called the counterparty, corporate, sovereign
credit rating
measures the credit risk of an entire organisation:
corporation
governments
counterparties
4
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What qualitative factors are evaluated in
the credit rating process?
ndustry risk & market position
Accounting quality
Management
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What quantitative factors are evaluated
in the credit rating process?
Financial characteristics and policy
Profitability
Capital structure
Cash flow protection
Financial flexibility
Ratio analysis is used to help judge the company's
financial strength and ability to repay its debt & to gauge
the company's relative strength within its industry
5
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Ratings are ratio driven (key S&P
industrial ratios)
87.7 74.8 62.6 48.2 42.5 37.7 22.9
TotaI Debt/
CapitaIisation
68.8 69.7 57.2 42.5 33.9 28.2 13.3
Long Term
Debt/CapitaI
87.7 74.8 62.6 48.2 42.5 37.7 22.9
TotaI Debt/CapitaI
6.3 4.9 3.4 2.3 1.6 1.2 0.6 TotaI Debt/EBITDA
15.4
13.6
30.8
8.5
5.8
3.7
BBB
15.9
11.6
18.8
2.6
3.4
2.1
BB
11.8
6.6
7.8
(3.2)
1.8
0.8
B
11.9
1.0
1.6
(12.9)
1.3
0.1
CCC
18.6
19.4
43.2
15.0
9.1
6.1
A
22.1 27.0
Operating
Income/SaIes
21.7 34.9
Return on CapitaI
55.4 128.8
Funds From Ops
/TotaI Debt
25.2 84.2
Free Operating
CF/TotaI Debt
12.9 26.5 EBITDA Interest
Cover
10.1 21.4
EBIT Interest
Cover
AA AAA
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What are ratings used for?
Most ratings requests come from companies that want to
establish a dialogue with their investors
The investors can use the rating to price & compare debt
issues
The investors are therefore asking an independent &
impartial organisation to conduct their credit analysis
The issuer receives financing in line with its credit rating
Both the issuer and investor compensate the ratings
agency
6
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The need for a rating rating agency
evaluation
Request for rating
Assign analytical team and conduct basic
research
Meet issuer
Rating Committee Meeting
Appeals Process
ssue Rating
Surveillance
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Quantitative rating factors
Financial characteristics and policy
Profitability
Capital structure
Cash flow protection
Financial flexibility
Ratio analysis is used to help judge the company's
financial strength and ability to repay its debt & to gauge
the company's relative strength within its industry
7
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Well below average
Below average
Average
Above average
Well above average
business position
Company business risk
profiIe
45 65
25 40 85
20 35 60 105
15 30 50 80 150
10 25 40 60 80
BB BBB A AA AAA
Rating category
Qualitative
analysis
Sainsbury, hmm....
Moderately leveraged.
(FFO/Total debt of 60%)
but how should rate it ?
Rating process
Funds from Operations/TotaI Debt GuideIines
1
The Corporate Training Group
Securitisation
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
A definition
The transfer and pooling of cash flows and assets
to remove operating risks of the originator from
issued securities
2
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
True Sale structure
Special Purpose
Vehicle
Bond holders
Credit
Enhancement
Liquidity
provider
Security
Trustee
Swap
provider
True Sale
Mortgage Loans
Halifax B.Soc
Original
contracts
Grant of
security
Benefit of
security
Principal
and interest
Purchase price
Issue
Proceeds
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Positives
Allows the originator to:
reduce its risk weighted assets
improve return on assets and return on equity
improve asset and liability matching
manage its portfolio
diversify funding sources
get cheaper funding
3
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Negatives
However
can be inflexible
may crystallise VAT , CGT, stamp duty.
assets must be assignable
unsuitable for "whole business securitisation
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
An example of a true sale structure
The Government National Mortgage Association, (Ginnie Mae)
The Federal National Mortgage Association and (Fannie Mae)
The Federal Home Loans Mortgage Corporation (Freddie Mac)
These all issue "Mortgage Passthrough securities - a pool of
mortgages is formed and investors buy participation certificates
which buy them a pro rata share in the pooled assets.
The coupon rate on the securities is lower than the weighted
average interest rate on the mortgages, the difference being paid
to the servicer and any guarantor as a fee.
US Mortgage backed bonds
4
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What can be Securitised?
Corporate Loans
Consumer Loans
Credit Card Receivables
Residential Mortgages
Commercial Mortgages
Auto Leases
Office Equipment Leases
Aircraft Leases
Small Business Loans
Student Loans
Future Export Receivables
nsurance Premium
Receivables
Marine Loans
Oil/Gas Contract Receivables
Property Rental ncome
Railcar Leases
Toll road Receivables
Utility Receivables
Public Houses
Care Homes
Motorway Service Stations
Assets are commercial or consumer related
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
But are they a significant market
segment?
US Bond Market
US Treasuries C 3.3 trillion
US Mortgage backed C 4.5 trillion
US other asset backed C 1.4 trillion
UK Bigger than Gilt Market
Germany - equal to Bunds
EU doubling every 2 years
As important as corporate bond marke
5
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Secured Loan Securitisation Structures
Special Purpose
Vehicle
Bond holders
Credit
Enhancement
Liquidity
provider
Security
Trustee
Swap
provider
Grant of security
Loans
Originator
Original
contracts
Sub charge
of security
Benefit of
security
Principal
and interest
Loan of issue
proceeds
Issue
Proceeds
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
A definition
The pooling of cash flows and/or assets which
may or may not be transferred and may or may
not remove the operating risk of the originator
from issued securities
6
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Beware operator risk
n secured loan type structures we may be exposed to the ongoing business
risk of the underlying business. The focus of risk analysis will be more focused
on the underlying business
Static
CDO
Managed
CDO
Canary
Wharf
Punch Taverns
Tussauds
Leeds
United
Secured Corporate
Debt
Operator Risk
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Credit Enhancement - Subordination
AAA
85%
A 10%
BBB 5%
15% Credit Support
5% Credit Support
7
The Corporate Training Group
CDOs
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
A CDO Structure
PortfoIio
Assets
Cash
Payment
ASSETS
High YieId Bonds
Leveraged Loans
Investment Grade
CDS
High Grade ABS
Mezzanine ABS
CDOs
Private Equity
Hedge Funds
Emerging Markets
Subordinated
Mezzanine
Senior
NOTES
Pays ScheduIed
Cash FIows to
Investors
Cash Payment
Service Providers
(e.g. Management, Liquidity, Hedging)
SPV,
Limited
Partnership
or Fund
ExternaI Trustee
HandIes Reporting and Protects Investors
Assets are purchased
from the market: asset
profile must fit within
certain investment
parameters defined in
the transaction
documents
Cash flows from the
assets are used to pay
down investments
sequentially
8
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Classic CLO Portfolio Ramp-Up and
Amortization
Reinvestment
period
Amortization Period
AccumuIatio
n Period
Reinvestment Period
Transaction
wind-down
PortfoIio ramp-up and amortization
[12] months [7] Years
60%
100%
[5] Years Closing1Q
2005
20% discretionary trading
[9] Years
0%
Ramp up for CDOs of other asset classes (ie ABS, corporates etc) will have varying
degrees of ramp up periods.
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
nterest & Principal Waterfall
CIass A Note Interest
Senior IC/OC Tests
Senior Fees &
Expenses
Redemption to the extent
necessary to satisfy the
IC and OC tests
CIass A Notes
Junior Expenses
ResiduaI to
Subordinated Notes
Reinvestment in new
coIIateraI
To the payment of senior expenses,
interest and curing of coverage tests to
the extent not previousIy paid using
interest Proceeds
During Reinvestment
Period
Senior Fees &
Expenses
CIass A Note PrincipaI
ResiduaI to
Subordinated Notes
During Amortization
Period
Interest WaterfaII
PrincipaI WaterfaII
Junior Expenses
Senior note holders benefit from the credit enhancement created by the subordination of other tranches
Equity holders benefit from any upside resulting in lower than expected default rates or higher recovery
rates, in the portfolio
9
The Corporate Training Group
Derivatives
An overview of derivatives market
10
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What size is the market?
Over the counter (OTC) derivatives
(Approx 80% notional value)
Exchange traded derivatives
(Approx 20% notional value)
Source: BIS and ISDA
www.bis.org or www.isda.org
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The basic concept
Derivatives Package and
Transfer Risk
Two types of contract onIy:
1. Forward / future
2. Option
3. Swaps
11
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Forwards and futures contracts
An obligation between two parties
to buy or sell an asset at a price
agreed today, for delivery on a
future date.
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Options contracts
Buyer has choice i.e. right but not obligation to
perform .
Seller has no choice potential obligation
. at a certain price in the future
Buyer pays premium for this right
Seller receives premium for this obligation
12
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What are swaps?
OTC product
Swap one series of cash flows for another over a
set period
Both parties having an obligation to perform
e.g. interest rate, currency, etc.
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
OTC or exchange traded
Exchange
Standardised
Liquid
Centrally cleared
Heavily regulated
Few products
OTC
Bespoke
Less liquid
No clearing house
Lightly regulated
Product proliferation
13
Forwards and futures
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
An obligation between two parties
to buy or sell an asset at a price
agreed today, for delivery on a
future date.
Forwards and futures contracts
Forwards normally OTC
Futures normally exchange
Forwards normally mark-to-market once
Futures normally mark-to-market daily (and more)
14
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Major forward/future products
nterest rate
Currency
Equity shares
ndices
Commodities
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Money market quotes
15
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Forward rate agreement
The Bloomberg screen is telling us:
2 x 5 3.490 3.496
nvestor Borrower
The swap desk will lend (receive interest)
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Futures
The buyer of a future is obligated to take
delivery/cash settle at the delivery date
The seller of a future is obligated to make
delivery/cash settle at the delivery date
These obligations are commonly offset (closed
out) prior to delivery by undertaking an equal and
opposite trade
16
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Profit
Loss
Price
1000
0
profit
loss
Unlimited
-1000
Long future payoff diagram
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Profit
Loss
0 Price
1000
1000
Unlimited
Profit
Loss
Short future payoff diagram
17
Fair value of futures
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Pricing a future
Cash Price + Cost of Carry
18
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Pricing futures (2)
Futures are more likely to trade at close to fair
value if the following apply
Easy to short sell
Liquid underlying
Non seasonal production
Non seasonal consumption
Ease of storage
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Today
Time
Delivery
Price
Cash
Future
Basis
Basis varies over time
i.e interest rates
change therefore cost
of carry alters
Basis
19
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Counter party risk
Forwards are OTC products therefore suffer
counter party risk
Futures are exchange traded therefore reduced
counter party risk
Clearing house
Margin
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
STR
DeIivery month Price
June 93.13 (6.87%)
September 92.78 (7.22%)
December 92.47 (7.53%)
Buyer of a September future would be fixing an interest
rate receivabIe of 7.22% on a 3-month deposit of 1 million
from delivery day in September
20
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Why use futures?
Synthetic performance
Perform as cash without buying shares
Hedging
Protecting value against adverse movements in prices
Speculation
Leveraged, liquid, standardised
Arbitrage
Simultaneous purchase or sale of underlying to
capture price differences (beyond transactions costs)
Arbitrage with futures
21
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Arbitrage
Future trading above fair value
Cash & carry, i.e. sell future and buy
underlying
Future trading below fair value
Reverse cash & carry, i.e. sell underlying and
buy future
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The arbitrage channel
Fair vaIue
Futures price
22
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Price and trade information
Bid & offer prices
This information will be displayed on screens as well as the
highest and lowest price traded that day and the price of the most
recent trade
Volume
This is the number of contracts traded during the day. t is the
number of longs OR the number of shorts
Open interest
This is the number of open contracts at any time. t is the number
of open longs OR the number of open shorts
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Day 1 Day 2 Day 3
A
B
C
Volume
Open interest
L5
-
S5
-
L5
S5
Volume & open interest
S3
L3
-
5
5
5
3
2
5
23
The Corporate Training Group
Options
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Working definition
An agreement between
Two counterparties that
Gives the holder the right but not the obligation
n return for a premium
To buy (a caII option) or to sell (a put option)
An agreed quantity of
An underlying item
At an agreed price, (strike price or exercise price)
24
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Understanding the terms
Buyer Right not obligation (long/holder)
Seller Obligation not right (short/writer)
Call / put
Strike price
Expiry date
Premium
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Strike price and premium
The price at which the option holder can buy (call
option) or sell (put option) the underlying
instrument is called the strike price
The premium is what the buyer of the option pays
to the seller (writer) of the option
25
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Time and intrinsic values
Strike Premium ntrinsic Time
80 25 20 5
90 17
100 9
110 5
120 3
CaII option premiums, underIying @ 100
Option strategies
26
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Long call
What is the pay-off at maturity for a long call with a strike
price of 100p and a premium of 10p?
-60
-40
-20
0
20
40
60
80
0
5
0
1
0
0
1
5
0
2
0
0
P
r
o
f
i
t
L
o
s
s
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Short call
What is the pay-off at maturity for a short call with a strike
price of 100p and a premium of 10p?
-60
-40
-20
0
20
40
60
80
0
5
0
1
0
0
1
5
0
2
0
0
27
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Long put
What is the pay-off at maturity for a long put with a strike
price of 100p and a premium of 10p?
-60
-40
-20
0
20
40
60
80
0
5
0
1
0
0
1
5
0
2
0
0
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Short put
What is the pay-off at maturity for a short put with a strike
price of 100p and a premium of 10p?
-60
-40
-20
0
20
40
60
80
0
5
0
1
0
0
1
5
0
2
0
0
28
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A recent option price
Wondafone LIFFE equity option
Underlying @ 122
120 strike
Expiry in one month
Call price = 7
Put price = 4.5
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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
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Vanilla option strategies
Long Call Short Call
View
Maximum risk/share
Breakeven
Maximum profit/share
Long Put Short Put
View
Maximum risk/share
Breakeven
Maximum profit/share
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Option types
American
Exercise at any time
European
Exercise at expiry
30
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Option value
Time
value
ntrinsic
value
Premium
value
= +
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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
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n-, 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
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The erosion of time value
0
Profit
Loss
UnIimited
32
The Greeks
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What will happen to the option
price if .?
Moves Call Put
Price Price
Asset Price Rises ? ?
FaIIs ? ?
Volatility Rises ? ?
FaIIs ? ?
Time to Expiry FaIIs ? ?
33
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Sensitivity the Greeks
Each Greek captures and measures a dimension of the risk
in an option position .
The Major Greeks
Delta . underlying asset price
Gamma . change of delta
Vega . volatility
The Minor Greeks
Theta . time
Rho . interest rate
Collars
34
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Collar
Borrowing money over 5 years
Long borrowers option
Downside protected
Short lenders option
Upside capped
Premiums reduced
The Corporate Training Group
Swaps
35
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Types of swap
nterest rate swaps
Asset swaps
Currency swaps
Equity swaps
Credit default swaps
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nterest rate swap
A B
Fixed Rate Payer Fixed Rate Receiver
(Floating Rate Receiver) (Floating Rate Payer)
5%
LBOR
36
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nterest rate swap
One party pays fixed to receive floating from the
counterparty
Principal not exchanged
Fixed rate constant over life of swap
Floating rate LBOR flat
Rates set in advance paid in arrears
Cash flows netted
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nterest rate swaps
?
37
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Money market quotes
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The workings of a swap
Fixed @ 5%
Floating @
Libor + 25bp
Pay Libor
Receive 4.79%
Pay 4.83%
Receive Libor
38
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Uses of swaps?
Comparative advantage?
Re-engineering/hedging
Speculation
Arbitrage
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The pricing logic
39
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Swaps
Swap Desk
Fixed Leg = Floating Leg
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Swap pricing
What is fair fixed rate for a 2 year swap vs. 6 month LBOR?
6 18 12 24
F
s
% F
12
% F
6
% F
18
%
X% X% X% X%
PV
float
PV
fixed
40
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Pricing spreadsheet
today
23-JuI-05 23-Jan-06 23-Jul-06 23-Jan-07 23-Jul-07
Discount factor 1 0.9665 0.9345 0.9025 0.8712
Days 184 181 184 181
Year basis 365 365 365 365
Year proportion 50.4% 49.6% 50.4% 49.6%
Forward 6 month Libor 6.87% 6.90% 7.05% 7.25%
Cash fIows
Nominal 10,000,000
FIoating
Cash (346,323) (342,164) (355,397) (359,521)
Present Value (334,731) (319,770) (320,738) (313,199)
PV Floating (1,288,437)
Fixed 6.00%
Cash 300,000 300,000 300,000 300,000
Present Value 289,958 280,365 270,743 261,347
PV Fixed 1,102,413
NPV (186,023.8)
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Swap pricing
What is fair fixed rate for a 2 year swap vs. 6 month LBOR?
6 18 12 24
6.87% 7.05 % 6.90% 7.25%
X% X% X% X%
(1,288,437)
1,288,437
41
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Pricing spreadsheet
today
23-JuI-05 23-Jan-06 23-Jul-06 23-Jan-07 23-Jul-07
Discount factor 1 0.9665 0.9345 0.9025 0.8712
Days 184 181 184 181
Year basis 365 365 365 365
Year proportion 50.4% 49.6% 50.4% 49.6%
Forward 6 month Libor 6.87% 6.90% 7.05% 7.25%
Cash fIows
Nominal 10,000,000
FIoating
Cash (346,323) (342,164) (355,397) (359,521)
Present Value (334,731) (319,770) (320,738) (313,199)
PV Floating (1,288,437)
Fixed 7.01%
Cash 350,623 350,623 350,623 350,623
Present Value 338,886 327,674 316,429 305,447
PV Fixed 1,288,437
NPV -
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Swap pricing
What is fair fixed rate for a 2 year swap vs. 6 month LBOR?
6 18 12 24
6.87% 7.05 % 6.90% 7.25%
7.01% 7.01% 7.01% 7.01%
(1,288,437)
1,288,437
42
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Subsequent valuation
Present value of remaining streams
Cancellation?
Offsetting swaps
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Present value of remaining streams
today
23-Jan-06 23-Jul-06 23-Jan-07 23-Jul-07
Discount factor 1 0.9711 0.9431 0.9167
Days 181 184 181
Year basis 365 365 365
Year proportion 49.6% 50.4% 49.6%
Forward 6 month Libor 6.00% 5.90% 5.80%
Cash fIows
Nominal 10,000,000
FIoating
Cash (297,534) (297,425) (287,616)
Present Value (288,937) (280,489) (263,656)
PV Floating (833,082)
Fixed 7.01%
Cash 350,623 350,623 350,623
Present Value 340,492 330,657 321,413
PV Fixed 992,562
NPV 159,480.8
43
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The swap curve
Maturity
GRY
Gov
Swap
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Special types of interest rate swaps
Amortising
Accreting
Rollercoaster
Forward start
Basis swap
44
Currency swaps
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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
nterest is paid by swap parties on the currency
received
45
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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
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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
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CRCUS
'Combined nterest Rate and Currency Swap'
Example:
A UK company wishes to raise variable rate funds
by accessing the Japanese bond market
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Outline
1 ssue a fixed rate bond in Japan. Receives Yen fixed
2 Yen/ cross currency swap
3 RS
UK Co
Yen fixed coupon
Yen principal
fixed interest
principal
UK Co
Libor interest
Net: Receive principal paying floating rate
fixed interest
UK Co
Yen principal
Yen fixed interest
47
Equity swaps
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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 LBOR
Pay performance
Receive Interest LIBOR + Spread
Credit
Suisse
Client
48
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What are the risks?
n order to eliminate the market risk CS will hold
the underlying instrument as a hedge
CS has NO MARKET RISK as the performance
on the cash hedge will offset the performance
payable on the swap
CS has INTEREST RATE RISK nternal funding
rates are reset daily, interest rates on the swaps
can be reset monthly
CREDIT RISK The movement in the underlying
instrument between reset dates
Credit swaps
49
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Protection buyer
Protection seller
Basically
like an
insurance
policy
Premium
Payment (if default)
Single name credit default swap
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Credit default swaps
Premium payments
Quotation
What constitutes default?
Termination payment
Deliverable obligations
Physical or cash settled
CTD
Transaction size
Choosing a protection seller
50
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Basket CDS
Basket CDS
Four names 5m each
Notional 20m
Corp X
40bps
5m
Corp y
25bps
5mn
Corp Z
15bps
5mn
Corp a
24bps
5mn
Basket CDS
21bps
20m
Premium for 4 individual
CDS = 104bps
Average = 26bps
Premium = 20m x 21bps
42,000 pa
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Basket CDS after default
Basket CDS
Corp X defaults
Pay 5m recovery value
Corp X
40bps
5m
Corp y
25bps
5mn
Corp Z
15bps
5mn
Corp a
24bps
5mn
Basket CDS
21bps
15m
Premium = 15m x 21bps
31,500 pa
51
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First to default CDS
FtD CDS
Four names 5m each
Notional 20m
Corp X
40bps
5m
Corp y
25bps
5mn
Corp Z
15bps
5mn
Corp a
24bps
5mn
Ftd CDS
60bps
5m Premium for 4 individual CDS =
104bps
Premium = 5m x 60bps
30,000 pa
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FtD CDS after default
Corp X
40bps
5m
Corp y
25bps
5mn
Corp Z
15bps
5mn
Corp a
24bps
5mn
FtD CDS
60bps
5m
FtD CDS
Corp X defaults
Pay 5m recovery value
CDS terminates
52
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CDS summary
Buy a CDS
Buy protection
Pay premium
Receive on default
Short credit
Sell a CDS
Sell protection
Receive premium
Pay on default
Long credit
1
The Corporate Training Group
Syndicated Loans
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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
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What is a Syndication?
dentical documentation
Pro rata drawings
All banks are on an equal footing
Larger amounts involved
Administration achieved through an Agent
Borrower
Agent
Bank A Bank B Bank C Bank D
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Syndicate vs Bilaterals
Syndication
One (big) agreement
Agent & fees
Many banks, but
Few relationships
Formality
Procedure
Group decisions
Bilateral
Simple documents
Few fees(?)
One bank
One relationship
nformal
3
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Key Players in a Deal
Borrower
Mandated Lead Arranger (MLA)
Financial commitment
Participating Bank
Book Runner (usually one or more of the MLA's)
Co-ordinate the MLA group
Agent
Administration/nformation distribution
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Role of the Book Runner
(Arranger & Underwriter)
Determining the Syndication strategy
Which banks
How many banks
Size/price considerations
Joint book running
Strategy must be agreed
But division of labour is useful if there are a large
number of banks to contact
Managing the investor base
4
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Role of the Agent
Post signing management
nformation distribution
Monitoring of covenants and collateral
Dealing with amendments, waivers and payments
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Syndicated Lending
Borrower
Lead Arranger
Co-Arranger
Lead Manager
Agent
Manager
5
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300
89
89
80
42
AIIocation
(Cm)
Total
Manager
Lead
Manager
Co-arranger
Lead
arranger
TitIe
19
10
5
3
1
No.
335
100
100
90
45
Bid/PIanned
finaI take (Cm)

100
40
50
60
Fee Rate
(bps)
3.00
0.36
0.45
0.48
Fees (m)

Allocation a Typical Outturn
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Abertis Loan for Purchase of SANEF
C750m 364 day tranche (364 day extension)
Euribor + 40bps
C2.66bn 364 day tranche (3 year extension)
Euribor + 75bps
C150m 364 day revolver (3 year term out)
Euribor + 75 bps
Margins ratchet upwards over time to encourage a capital
markets take-out
6
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C3.5 bn Syndication
RBS
C200m
MLA
La Caixa
C200m
MLA
Barclays
C200m
MLA
HSBC
C200m
MLA
JPMorgan
C130m
MLA
Ahorro Corporacion Financiera
C102m
. .
C81m
28 Banks
. .
C40m
5 Banks
. .
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Eiffage & Macquarie Loan for 70%
SAPPR
C5.85bn 7 year term loan
Euribor + 90bps
C1.8bn 7 year revolver
Libor + 30 bps
Commitment fee of 30% of margin
C1bn one year cash bridge with leads will not be
syndicating
7
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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
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Key Phases of a Syndication
- nformation Flow - Credit Event e.g. acquisition - nformation package
- Exchange of ideas - Credit approval - Finalise syndication strategy
- Structure/Price - Loan Documentation - Approach Banks/Presentation
- Agree ndicative term Sheet - Underwritten Offer - Credit Approvals
- nitial Syndication Strategy - Closing - Documentation
- Signing in Banks
Pre-Mandate Underwriting Syndication
MANDATED SYNDICATION SYNDICATION
COMPLETE
8
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Underwriting
Commitment to provide funds
Certainty to the borrower
Strong message to the market
Alternatives are 'Best Efforts' and Club deals
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Syndicated Loan Structures
Term loan
Revolving
Standby loan
Multi currency loan
Evergreen loan
9
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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
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Term Loan
Time
maturity
Commitment
millions
Outstandings
End of
availability
10
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Uses of Term Loans
Permanent capital
Just because debt is a good thing
Long term financing of acquisitions
Long term financing of capital assets- property, equipment
Refinancing risk management is a big issue for
companies-
Short term debt is cheap, but it can evaporate if a company gets
into operating difficulties
f debt is generally expensive today, your debt cost will be high
today.
Long term committed financing together with tools like swaps can
remove these big risks- fixing rates.
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Revolving Credit Facility
The key difference between a term loan and a
revolving credit is that:
n 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
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Revolving Commitment
Time
End of availability - maturity
Outstandings
Commitment
millions
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Uses of Revolving Credits
Working capital finance seasonal or intra-month
Standby facilities
Backstop facilities
Acquisition "war-chest
12
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Standby Facility
Backstop to a commercial paper programme
Short term
Small commitment fee if undrawn
High interest rate if utilised
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Price
FaciIity Size Sector
Bank
ReIationships
FinanciaI
Covenants
Term
Current State of
Bank Market
QuaIity of the
Credit
Purpose of Ioan
Pricing Factors
13
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Pricing
Before any indicative pricing is given to the client, the
Syndications Originator must present the transaction to
'Pricing Committee'
Pricing Committee consists of the Originator & the
Distribution team
Distribution team sets the pricing level
Pricing is often linked/ratcheted with the Credit Rating of
the client
150-250 50-100 25-50 20-35 Margin (bp)
BB BBB A AA Rating
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Syndicated Loan Fees
Front-end fee
Arrangement fee
Participation fee
Underwriting fee
Commitment fee
Utilisation fee
Agency fee
14
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Syndicated Loan Fees
Front-end fee
A one-off amount payable up front to the arranging
banks and to be shared between them and the
syndicate banks (according to roles and level of
commitment)
Quoted as a flat % or b.p based on final facility amount
Normally paid on signing date, date of first drawing or
within 30 days of signing
Arrangement fee/ Participation fee/ Underwriting fee
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Syndicated Loan Fees
Arrangement Fee
Arranging bank normally keeps a portion of the front-
end fee as an arrangement fee
Considered to be the arranging banks 'reward' for
winning and arranging the deal
15
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Syndicated Loan Fees
Participation Fee
s the portion paid out of the front-end fee to
participating banks in a primary syndication
t is a credit-related fee calculated on each bank's
allocated commitment, which is normally paid within 30
days of signing
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Syndicated Loan Fees
Underwriting Fee
f the deal is underwritten, this will be included in the
front-end fee
t 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
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Syndicated Loan Fees
Commitment Fee
Refers to the payment to the banks for making a credit facility
available to a borrower over a specified period
Exist in 2 forms:
Facility fee
calculated as an annual % or bp of the full amount of the committed
facility & payable to all banks committed to the facility based on their
level of participation
Payable in arrears, at fixed intervals for the duration of the facility
Size of the fee is related to the financial strength of the borrower
Non-Utilisation fee
An annual % fee based on the undrawn portion of the committed
facility for the duration of the facility
Payable quarterly in arrears
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Syndicated Loan Fees
Utilisation Fee
Payment to the lender based on the average level of utilisation
during a specified period
Designed as a margin enhancement
Agency Fee
An annual fee
Calculated as a fixed lump sufficient to cover at least the
administrative and money transfer costs of the bank
t is not shared with any of the other banks
17
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Documentation Requirements
To potential Participating Banks
nformation memoranda
nvitations for banks to participate
To the Client
Term sheets and Offer letters
Loan agreements
Key legal clauses & agreements
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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
t should contain all the material requirements of
the arranging banks(s)
18
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What makes an Effective Term Sheet?
Borrower name, Description of facility, Amount & Purpose
Maturity, conditions of availability and repayment
Arrangers, lenders, agent
Fees and interest rates (& definition of cost of funds rate) and when
they are payable
Representations & warranties, Covenants & undertakings and
Conditions precedent
Cancellation and Events of default
llegality, Taxes, ncreased costs and Expenses
Transferability, documentation and governing law
Clear market and Market flex
1
Equity
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What is equity?
Part ownership
Permanent capital
Risk capital
No guarantees
2
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Equity
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Types of equity
Ordinary
Preference shares
Depository receipt (ADR/GDR)
Convertible/Exchangeable
3
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Share rights
Voting rights
Pre-emptive rights
Cash dividends
Stock dividends
Stock splits
Key Participants n The Global
Equity Markets
4
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Twelve 'players'
1
2
3
4
5
6
7
8
9
10
11
12
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Key Participants
Corporates
Investment
Banks
New
Shares
Pension
Fund
Insurance
Group
Money
Manager
"Secondary
nvestment Banks
ntermediate nstitutions
"Primary Distribution Process
5
Key roles in the equity division
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
nteraction in Equity Division
Research
ECMG
GeneraI
SaIes
Trader
SaIes
Trading
Proprietary
Trading
SpeciaIist
SaIes
6
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Key Roles in 'Cash'
Trader - firm's capital for client liquidity
Sales traders - execute client business
Prop traders trade with firm's capital
Sales - account manages clients
Research product ideas
ECMG originates and processes primary
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The Typical Client
Management
CEO/CIO etc
Equity
Investment Committees / Asset AIIocation
PM PM PM
PM PM PM
Other Assets Debt
Sector AnaIysts
DeaIers
7
The secondary market
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Market choices
Physical
Quote
Driven
Electronic
Order
Matching
8
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LSE UK trading services
Domestic securities with less
than two Market Makers
Quotes with
exposure orders
SEATS plus
All other domestic securities
with at least two Market
Makers
Competing quotes SEAQ
FTSE 250 not on SETS,
midcaps, some small caps,
AM 50 & leading rish
Order book with
Market Makers
SETSmm
Most liquid securities incl.
FTSE 100, liquid FTSE 250
Order book SETS
Securities traded Trading structure System
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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
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The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
A SETS screen
BUY SELL
Time

Volume Price Price Volume Time
11:03 14,000 254 255 3,100 11:15
12:08 7,000 254 256 3,400 11:12
11:31 13,000 253 256 15,530 11:45
11:32 6,500 253 256 5,721 11:52
11:20 10,350 252 257 15,000 12:00
11:24 14,050 252 257 7,290 12:02
11:40 6,933 252
Highest
buy price
Then time
of entry
Lowest
sell price
10
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Key features of SETS
Normally standard settlement T + 3
Whole market views entire order book
Tick sizes:
Below 500p = p
500p to 1000p (incl) = p
Above 1000p = 1 p
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
SETS order types
Limit
At best
Fill or kill
Execute and eliminate
ceberg
Market
11
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
"Dealing away
Order book accounts for about 70% of London
liquidity
Can deal away and report to LSE
Mainly at or close to SETS price
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Key features of SEAQ
Mandatory two-way quotes
'All weather' prices
Prices firm to brokers up to quoted size
Minimum size
Trades reported within 3 minutes
Protection available on largest blocks
12
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
SETSmm
A hybrid system
Market makers must submit two way prices as in
SEAQ, these prices are submitted as orders as
opposed to quotes
n addition brokers can submit orders to the order
book as in SETS
13
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
SEATS plus
Another hybrid system
Allows a maximum of one Market Maker to offer
a firm quote, trading is completed in the same
method as on SEAQ
Brokers can submit orders onto the system which
other brokers can then see and select to 'hit'
Trade reporting is automatic for 'hit orders
14
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The US market
15
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The US markets
AMEX
Small Caps. ETFs & Options
NASDAQ shares on auction
basis
Exchanges NYSE, American, Regional
OTC NASDAQ ("merged with
AMEX in 1998)
OTCBB (penny stocks)
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
NYSE versus NASDAQ
Auction Market
Order driven
75% trades with other
investors
Priority for public over
specialists
Centralised order flow
DeaIer Market
Quote driven MM
Market makers trade
against public orders
No priority for public
Dispersed order flow
among MMs and ECNs
16
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
NYSE versus NASDAQ
Auction Market
Specialists must provide
liquidity / dampen volatility
Specialists evaluated
Single opening price
no trade ahead of opening
DeaIer Market
MMs minimal size
obligation, no obligation on
volatility
No evaluation of MMs
No single opening price
MMs can trade ahead of
opening
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
ECN Electronic Communications Networks
Electronic trading access levels
SOES - Small Order Execution System
NASDAQ more information
17
The primary market
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Focus on PO distribution
Book build
Modern structure US origins
No underwriting syndicate maximise fees
Generate demand then price
Client "at risk price set at end
Underwriting
Traditional structure UK origins
Underwritten by syndicate split fees
Generate price then demand
Broker at risk demand finalised at end
18
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Key phases in an PO
Winning and understanding the deal
Establish the selling proposition
Distribution position deal, generate demand
Distribution generate
momentum, fill orders
Trading and completing
the deal
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Parties involved in PO
ssuer
Selling shareholders
Bankers
Legal advisors
Accountants
Public relations
Stock exchange
Printers
19
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Syndicate structure
70-90% of the gross fees
Leads process - allocates stock at pricing
The Key Role
Status for relationship banks not playing
bookrunner role
Use research and sales penetration
Bulge only if C1m+ fees available / key strategic
client
Underwriting fees only - little chance of
receiving stock
Bookrunner
Joint Lead
Co-Iead
Co-manager
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Sample new issue timetable
CompIetion of
offer
Commence
preparation of
Offering CircuIar
T-3 months
AnaIyst briefing
T-7 weeks
PubIication of
research, start pre-
marketing
T-4 weeks
Offer Iaunched
T-2 weeks
Pricing &
aIIocation
T
6 weeks
Appointment of
advisors
Financial due
diligence
Legal due diligence
Drafting of offering
circular and Listing
Particulars
Preparation of Research
3 weeks
Syndicate analysts
briefed on PO
All syndicate
participants publish
research
Research reports
form the main
marketing
documents
Pre-marketing
2 weeks
Research
analysts
approach key
institutions
Pre-marketing
feedback critical
to finalise
management
roadshow
programme
Roadshow & BookbuiIding
2 weeks
Price range
announced
Management
meets
institutions in
key financial
centres
Syndicate
members build a
book of demand
Due DiIigence and preparation of Offering CircuIar / Listing ParticuIars
StabiIisation
4 weeks
Bookrunner
stabilises price in
immediate
aftermarket
On-going research
coverage and
investor relations
programme
Start of Process
T-3/4 months
20
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Follow on offerings
Sale on open market
Full book build
AEO
Block trade
Rights issue
Rights issue
21
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Rights ssue Fundamentals
Lead managers will sell the shares on their behalf at the end of the offer period
Shareholders normally receive cash equivalent to the difference between the
price received for the unsubscribed shares sold and the rights issue price
(which goes to the issuer)
SharehoIder Options
Take up rights
SeII niI paid rights
Do nothing
Shareholders exercise their rights by paying subscription price
Normally an active trading market for nil paid rights
Theoretical value = the difference between the theoretical ex rights price
('TERP') and the rights issue price
Listed and traded independently for up to 3 weeks
AEO and block trade
22
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Provide a "Quick-to-Market solution to vendors or issuers of
substantial equity stakes wishing to monetise their positions through
access to the Equity Capital Markets
Typically, these transactions are launched, executed and priced on
a fast track basis, usually within a 24 hour period
Block Trades and AEO
Disposal of :
i. Cross/Non-Strategic
Shareholdings
(Secondary)
ii. Own Shares
(follow on)
Monetisation
through :
a. Block Trade
b. Accelerated Bookbuild
The equity-linked market
convertible bonds
23
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
Convertible bonds
What are they
Mandatories
Exchangeables
Hybrids
ssuer perspective - impact on equity and senior debt
nvestor Perspective
Different investors
Arbitrage
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What is a Convertible?
THE DEBT PERSPECTIVE ON A CONVERTIBLE BOND
Has par vaIue
Pays coupon
Maturity date
Senior to equity in
event of
Iiquidation
Exchange for
NEW shares
(conversion ratio)
Option of hoIder
ConvertibIe
Bond
CaII
Option
Straight
Bond
24
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
The jargon
A "balanced
convertible
"Equity like, high
parity
"Low parity, bond
like
Bond floor
Parity
Share price
Convertible
value

Recovery
vaIue
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
What is a Convertible Bond?
Unsecured lending with (fixed) coupon
Can be subordinated to existing bonds (or in form of
a preference share)
Embedded option - right (but not obligation) to
convert to shares
Flexible, specified terms and conditions
f not converted then redeemable at maturity
25
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Additional Features
On top of conversion option .
Many CBs have call and put features
Callable = issuer announces call and holder has right to
convert
Call feature mainly used to force early conversion
Putable = holder sells back for put price
Put feature usually used where interest rates rise and if convertible
falls deeply out of the money. Puts are potentially very dangerous
for issuers
The Corporate Training Group Ltd +44 (0)20 7490 4770 www.ctguk.com
A Case study
Issuer: Versatel Telecom nt'l N.V.
Security Type: Unsubordinated ConvertibIe
Bond Rating: Unrated
TotaI Proceeds: C125mm
Greenshoe yes
Issue Price: 100%
CIosing Date: 28 Oct 2004
Coupon: 3.875%
YieId To Maturity: 4.63%
Conversion Premium: 28%
Conversion Price: C2.033
Share Price at issue: C1.588
Maturity: 7 years
CaII Option: After 5 years subject to a 130% hurdIe
Redemption Price at Maturity: 100%
Use of Proceeds: Refinancing bank faciIity / Iengthening debt maturity
Listing: Euronext (Amsterdam)