SCENARIO

Introduction
Volkswagen AG (“VW”) is a German multinational automotive1 manufacturing
company and the largest company in Germany.

In the last decade, VW has established itself as the global automotive leader. In terms
of its 2019 revenue, VW was the largest automotive company in the world with a 15%
share of the global automotive market and, in terms of units sold, was the second
largest at 10.22 million vehicles sold, with only Toyota selling more motor vehicles.

VW sells motor vehicles in approximately 150 countries and operates production

facilities in 27 of these countries. It sells motor vehicles under 12 well-known brands
including VW, Audi, Bentley, Lamborghini and Bugatti. VW directly employs over 35%
of all employees in Germany that work for automotive companies, this excludes the
indirect employment through VW suppliers.

VW’s global operations are divided primarily into two divisions, the Automotive
Division and the Financial Services Division.
• The Automotive Division designs, manufactures and distributes passenger and
commercial vehicles, motorcycles, engines, and turbo machinery.
• The Financial Services Division offers financial services that include automotive
financing, leasing and fleet management.

Strategy
VW’s strategy focuses on positioning itself as the global economic and environmental
leader among automotive manufacturers. Its strongly positioned global brands are
key factors allowing it to leverage value and to systematically increase its competitive
advantages. VW’s strategy to expand its customer base is to enter into new markets
around the world, particularly in the global growth markets and markets with low VW
presence.

VW believes it will only successfully meet these objectives if all employees – from
juniors to senior executives – consistently deliver excellence in their roles to ensure
the long-term quality of innovation and products.

From a financial perspective, disciplined cost and investment management play a

major role in ensuring that VW reaches its long-term profitability targets and
maintains strong long-term liquidity.

1
Related to motor vehicles and motor bikes.

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Emissions Scandal2
On 18 March 2020, the United States Environmental Protection Agency (“EPA”) issued
a clean air violation notice to VW. This notice revealed that VW had designed computer
software for its diesel vehicles to detect when they were being tested for emissions
and to deceptively change emissions to improve results. This has become known as
the “defeat device”.

The United States (US) is a key potential growth market for VW, as it only has around
a 3% share of this market. VW has had a major push to sell diesel cars in the United
States using their efficiency as a competitive advantage. This US strategy has been
backed by a huge marketing campaign proudly highlighting its cars' low emissions.
The EPA's findings implicate only 482 000 cars in the US, the discovery has however
led to VW admitting that about 11 million cars worldwide are fitted with the defeat
device.

The consequences of this scandal have been quick with the VW share price losing 41%
of its value since the 20 March public announcement, dropping from a pre-scandal
peak of €172.38 per share to a current, 19 April 2020, price of €100.90. VW’s bonds
have been placed on a negative watch3 by the three main credit rating agencies.
Newspapers claim that VW’s top management have been aware of the use of the
defeat devices from as early as 2012. VW’s long serving CEO, Martin Winterkorn,
resigned on 23 March 2020 following the exposure of the scandal. VW has stopped
any further sales of motor vehicles with the defeat device and has issued an apology
for breaking customers’ trust.

VW’s newly appointed CEO, Mathias Müller, has remained positive, telling VW
managers in a speech that the business can come back from the scandal declaring,
“We have a good chance of shining again in two to three years.” VW has announced
that it plans to recover from the scandal by increasing its focus on electric cars.

2
Note: this scenario is based off an actual scandal that hit VW in 2015
3
A status that the credit-rating agencies give a company while they are deciding whether
to lower that company's credit rating.

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 Costs of scandal

VW has set aside cash of €6.5 billion to cover the expected direct and indirect costs
of the scandal, which is expected to damage VW’s business significantly, primarily in
the following 4 ways:
1. Auto Recall Costs: It is estimated that Volkswagen has 11 million vehicles that it
might have to recall and refit. VW has said that a recall and refit of the affected
vehicles will begin later in 2020 and should be completed within a year. Some of
the vehicles that need to be recalled and refitted can be modified through software
changes, but others will need new parts, such as fuel injectors, to be installed.
The total cost of a recall will depend on whether VW is required by the EPA to
recall and refit all 11 million vehicles, or only those that customers voluntarily
bring in.
2. Legal Costs: VW customers and shareholders are already preparing to file class
action lawsuits against VW for damages. Several countries are also considering
claiming back VW’s tax breaks and other incentives allowed on the basis of tested
emissions.
3. Penalties and fines: The penalties and fines imposed by various governments and
regulators for deception will likely be large, it is however difficult to estimate how
large the fines could be. The maximum total fine that regulators are theoretically
allowed to charge is estimated at €26 billion, most analysts however expect the
reality to be a lot lower.
4. Reputation / brand impact: VW could face considerable losses in future sales,
especially for diesel vehicles, due to the damaged brand image and a loss in
customer trust — all of which could play into the hands of its rivals.
Currently the total estimated scandal costs are subject to significant uncertainty, but
the market has built in a view of the cost through the price drop. The table below
represents your best estimate of expected costs:

Scenario
Worst case Likely case Best case
Probability of 20% 50% 30%
occurrence
1 and 2 above. Car € 6 billion € 2.5 billion € 1.2 billion
recall costs and car
owner lawsuits.
3. above. Government € 26 billion € 14 billion € 2 billion
penalties and fines
(not tax deductible).
4. above. Reputation / 20% loss in EBIT for 20% loss in EBIT for 15% loss in EBIT for
brand impact 5 years before 3 years before 2 years before
recovering to original recovering to original recovering to original
expectation. expectation. expectation.

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Financial information

The schedules below show selected VW financial information for the last 12 months:

Volkswagen AG - Summarised Management Balance

Sheet as at 31 March 2020

€ million
Liabilities 277 857
Trade Payables 18 338
Finance Division financial liabilities 2 73 817
Long-Term Debt 7 10 220
Other Current Liabilities 47 869
Total Current Liabilities 150 244

Long-Term Debt 7 31 620

Finance Division financial liabilities 2 68 195
Pension & Other Post-Retirement Benefits 27 798
Total Non-current Liabilities 127 613

Equity 96 162
Common Stock 1 218
Additional Paid in Capital 14 616
Retained Earnings 75 704
Other Reserves 4 417
Total Common Equity 6 95 955
Minority Interest 207

Assets 374 019

Cash and cash equivalents 15 479
Short Term Investments 3 12 191
Trade and other Receivables 28 760
Inventory 35 262
Finance Division financial assets 2 51 883
Total Current Assets 143 575

Property, Plant & Equipment 5 48 197

Long-term Investments 4 23 106
Intangible assets 5 60 127
Finance Division financial assets 2 99 014
Total Non-current Assets 230 444

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 Volkswagen AG – Summarised Management
Income Statement for the
last 12 months ending 31 March 2020

€ million
Revenue 1 212 426
Gross Profit 37 391
Operating expenses 5 (24 505)
Operating Income 2 12 886
Net Interest Expense (1 880)
Income from Investments 3 147
Currency Exchange Gains 529
Net profit before tax 14 682
Income Tax Expense (3 665)
Net profit 11 017
Minority Interest’s share (16)
Net profit attributable to parent equity 11 001

Supplemental information
Current number of ordinary shares
outstanding (19 April 2020) 475.7 million

Share price immediately prior to scandal

(15 March 2020) € 172.38 per share

Current share price

(19 April 2020) € 100.90 per share

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Notes

1. The automotive industry in general is cyclical, with ups and downs that reflect
economic cycles. However, even after allowing for economic cycles, the industry
is in a mature phase, reflected in automotive companies’ average growth in
revenues of over the last 10 years of 5.63% per annum. Historically, growth has
been boosted by emerging economy growth, which is not expected to continue
and, as a result, the long-term VW revenue growth forecast is 3% per annum.
2. VW’s financial services division is significant in its size with a total recorded net
asset value of €8 885 million and contributes €1 917 million to the VW EBIT4
above. The net asset value is made up in full of financial instruments all classified
at fair value though profit or loss (with no impact on other comprehensive
income).
3. Short-term investments represent investments in money market deposits, which
have original maturities of between three months and twelve months.
4. Long-term investments relate to non-influential equity interests in various
strategic businesses in the automotive industry.
5. Historically, the automotive industry has always required significant investment in
plant and equipment but, in recent years, the increasing use of technology has
also pushed up research and development (R&D) costs in the industry. A good
measure of the impact of Capital Expenditure (including R&D expenditure) on free
cash flows are to look at Net Capital Expenditure5 as a percentage of EBIT. VW’s
net capital expenditure is 35% of its EBIT.
6. The following table provides information extracted relating to the cost of equity
for VW prior to the scandal.

Global automotive industry German automotive industry

Unlevered beta 0.84 0.80
Equity market risk premium 6.74% 5.58%

7. VW’s long-term debt is made up of various listed bonds and VW had, prior to the
scandal, an average credit spread of 100 basis point (i.e. 1%) more than the risk-
free rate. German government bond information is detailed below.

German government bond yields

Bond name Yield to
maturity
GTDEM2Y:GOV - 2 Year Yield -0.27%
GTDEM5Y:GOV - 5 Year Yield -0.04%
GTDEM10Y:GOV - 10 Year Yield 0.55%
GTDEM30Y:GOV - 30 Year Yield 0.80%

4
EBIT – earnings before interest and tax
5
Capital expenditure (including R&D expenditure) in excess of depreciation and
amortisation charges

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Assumptions
• You should ignore the economic impact of the Coronavirus in your discussion.
• You should assume that the carrying amount of debt is the same as its market
value, and that VW’s current capital structure represents the targeted long run
optimal capital structure.
• Volkswagen’s marginal tax rate is 25%.
• Cash flows should be assumed to occur at the end or the beginning of each year
to which they relate depending on which assumption makes the most sense.
• The Hamada formula to lever and un-lever betas:
(1 − 𝑡)
𝐵𝑢 = 𝐵𝑙 ⁄[1 + ]
𝐷 ⁄𝐸

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REQUIRED - AFTERNOON SESSION

Marks

Sub- Total
total

Communication skills – structure and layout, clarity of

expression and appropriate style. All throughout the question. 5

a. Critically analyse and discuss the appropriateness of VW’s

capital structure before the impact of the emissions scandal
relative to what you feel is optimal. 12

b. Calculate a weighted average cost of capital that would have

been appropriate to use in valuing VW before the emissions
scandal. Justify why you choose to exclude any items from the
capital structure (if any). 12

For the remainder of the question use a weighted average cost of capital of 6.2%.

c. Briefly discuss how the emissions scandal, and the

consequential drop in VW’s share price will impact VW’s
weighted average cost of capital. 4

d. Calculate the estimated value of a VW share before the impact

of the emissions scandal using a discounted cash flow
valuation.
• An explicit period of forecasting is not required
i.e. use 1 year for the forecast period. 14

e. Calculate the current estimated value of a VW share after

including the expected financial impact of the emissions
scandal using discounted cash flows.
• Simply adjust your answer in part d) by the expected
impact of the emissions scandal.
• Hint: Calculate a separate value for each scenario before
probability weighting. 14

f. Assuming your calculations determined that the VW shares are

worth more than their current listed price, identify and briefly
discuss any other relevant issues you would consider before
investing in VW. 9

g. Assuming you have already invested in VW. Briefly discuss how

you could, in this context, use an option financial instrument to
strategically add value to your investment. 5

TOTAL MARKS 75

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