ACCOUNTING FINANCE AND CONTROL

Accounting = the measurement, processing and communication of financial information about economic
entities. Accounting measures the results of an organization’s economic activities and conveys this
information to a variety of users including investors, creditors, management, and regulators

(corporate) Finance = the sources of funding and the capital structure of corporations and the actions that
managers take to increase the value of the firm to the shareholders

Control ( in management) = setting standards, measuring actual performance and taking corrective action

This course deals with a set of tools and instruments that are used by an organization for:

- Measuring, controlling and reporting its results,

- In financial and non-financial terms,
- In order to support the achievement of the company’s objectives.

The main final objective of a profit organization is the creation and

maximization of the enterprise value, also called shareholder
value, economic value.

From a mathematical point of view the formula for computing the enterprise value can be represented as
(𝐶𝐹−𝐼)
sum for t from 0 to infinite of cash flows minus investments discounted, ∑∞
𝑡=0 (1+𝑘)^𝑡.

- Investments (I)= assets that a company is going to use for more than 1 year
- Cash flows (CF): refer to cash exchanges related to transactions that have an impact on the short-
term
- Net Cash Flows = CF -I

This is a discounted sum. The idea is that the enterprise will invest in different project and activities
thanks to money took companies and this projects and activities will generate revenues and cost,
financial inflows and outflows. We’ll primarily look at organization that aims to push this final objective.

Still, the world has changed a lot in the last years, so when we deal with economic value’s maximization, we
need to take into account a level of complexity that is huge and is related to the coexistence of many
different stakeholders that are often characterized by different objectives. So the company in order to
create the enterprise value has to deal with a broad range of subjects/stakeholders that also have
conflicting objectives/aims.

A multi-stakeholder perspective

Who is a stakeholder? Someone who interacts with the company.

Building Enterprise value, we encountered two “main” stakeholders, who are also investors:

- Shareholders
- Debtholders

To manage value, a more complete set of actors must be considered:

- External, including individuals and entities who have direct or indirect interests:
o Supplier
o Customers
o Financial analysts

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 o Local communities
o Other societal actors more broadly
- Internal, which refers to managers operating at different levels of the enterprise (i.e. workers,
managers, directors).

Among these stakeholders, what is a financial analyst? Financial analysts are person that typically look
at the financial statement of the company and act as translators, they analyse all the data that are
available from the company (FS, non-financial information, etc.) and then they can deliver, prepare
financial analyst reports that are due either by the clients of for instance a brokerage firm in order to
direct their investments, in this case are called sell side (lato venditore) financial analysts, or we could
have some funds that have some internal financial analyst that are called buy side (lato acquirente)
financial analysts , that typically analyse those companies that are in line with the set of value of the
fund. So in this case the financial analyst looks in particular to those companies that could be
interesting from an investment perspective for the fund he or she works for. So, basically there are two
types of financial analysts:

- The first type, that is called sell side, are basically people that work for brokerage companies,
companies that provide advices to the clients about how to invest their money;
- The second type, that is called buy side financial analysts, are persons that work for funds and
analyse potential investments for that specific fund.

Today they can influence very much the investment that a company is able to achieve.

So we have many stakeholders we have

to deal with that are diversified. We
have those that provide money to the
company (that are the shareholders,
bondholders, banks and investment
companies), the financial analyst that
actually acts as a translator between
those that could provide money to the
company and the company, and other
stakeholders that have more general
interests in our company.

The shareholders could include different types of investor:

Example from Adidas:

The majority of Adidas shareholders is represented by

institutional investors, then we have 8% of private
investors and then treasury shares and employees of
the company itself.

Example of Volkswagen:

We have a 22,5% of foreign institutional investors, 2.3% of German

institutional investors, 18% of private investors, etc.

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( an institutional investor is retention fund, a commercial bank, insurance companies for instance; so
they are those subjects that collect money from single investors and invest in our organization;
a private investor is instead everybody that can buy a share of a company on a trade market for
instance)

then again when we look at institutional investors, we can find an heterogeneity: we could find funds
that are aimed to give client the maximum economic profit , or we could find something different, for
instance social responsible funds/investors.

Example:

This is the biggest fund in world and they are a

social responsible fund because they perform
a negative screening, meaning that they
decide not to invest in those activities that are
considered not social responsible ( for
example they do not invest in weapon
producers) .They decide to cut investments in
companies that have an high CO2
contribution.

So they invest a lot in energy companies but

they select the companies where they want to
invest depending on their environmental performance.

Then there are other funds that are even more advanced in term of screening, that are the impact
investing funds, those funds that balance economic return and social return. Typically, they invest in
activities that guarantee a minimum economic return and a social impact.

This is to say that in the same category we are considering a lot of different players.

Today there is a strong connection between how a company performs not just from an economic point
of view but also an environmental and social point of view and the market performance at list in term
of reputationally effect. Companies engaged in corporate scandals dealing with the environment of the
society ( Volkswagen for example) generally report lower financial performance on the market share.

Market reaction at the announce of Volkswagen scan: they had a huge drop in the share value.

This is an analysis that has been performed

on a large Italian listed energy company in
the last ten years. On the y axis there is the
percentage loss in the share market value of
the shares of this company, on the x axis
there are years. Each of those segments has
a specific meaning: the crosses actually
correspond to the loss in the share market
value after a reputational event dealing with
the environment of the society, such as
pollution events.

The segments are confidence intervals, we use this statistical instrument in order to understand if a loss
is significant from a statistical point of view or not.

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We can notice two things:

- The first one is that there are many crosses that are below the black line ( the black line
corresponds to a loss equal to zero), this means that we have several events in connection to whom
the company reported a negative performance on the market following the communication of an
environmental or social reputational event;
- The second thing regards the timeline and the number of events: the frequency of events actually
grew in the last years. Could this mean that the company has became less sensible to these aspects
because the events are much more? No, probably this company is more exposed to scandals even
for small events. Social media and technologies make distances shorter and shorter and something
that happen in Nigeria is immediately reported here. So even the reaction of the share market is
immediate.

There are some negative events statistically significant with a positive impact. It could be due to an
event and at the same time the company is making another activity so the company is running its
business. This means that in a certain time different events can happen. So, for instance we had a small
negative event dealing with the environment but in the same time the company had its quarterly
report published highlighting very positive results. So, there are confounding events, different events
that overlap and it’s difficult to isolate the contribution of each event to the share market value.

The instruments that we analyse are

applicable also to a type of roganization
that is emerging in the last years, that is
represented by the so called hybrid
organization. Hybrid organizations are
different type of organizatione that aim to
find the balance between the economic and
the environmental and social return, similar
to the fund.

There are some examples, one is

represented by the so called B corporations, or Benefit corporations. They for instance use raw material
that has certain characteristics or look at the performance of the supply chain considering how the
suppliers are selected and considering the environmental impact of a long supply chain. The benefit
corporation movement was born in the US and has been introduced in the last few years in Europe.
Italy has been the first country that has implemented a law for supporting the development of this kind
of organizations.

This is just to say that we are focusing on profit organizations but we are dealing also with a diversified
range of actors that are emerging on the market.

AIMS OF AFC INSTRUMENTS

We have clarified what is the subject of our study. Now we deal with the purpose whereby a company
should employee AFC tools. There are three main tools:

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 - Decision making
- HR Motivation Internal accountability

- External accountability

INTERNAL ACCOUNTABILITY

The internal accountability refers to the use of indicators to guide management, in particular:

- help managers to make decisions coherent with the company’s objectives

- support managers in motivating human resources.

We introduce the concept of Performance Measurement System (PMS), which is a system, a set of
instruments, used by the company for supporting decision making and HR motivation. PMS provides
performance and risk indicators.

A few definitions of PMS:

- A performance measurement system is the process by which managers ensure that resources are
obtained and used effectively and efficiently in the achievement of the organization’s objectives
- A performance measurement system gathers and uses information to evaluate and communicate
the performance of different organizational resources like human, physical, financial resources and
also the organization as a whole
- Performance measurement systems are those systems, rules, practices, values and other activities
management put in place in order to direct employee behaviors towards the achievement of the
company’s objectives.

What are the common elements to the different definitions?

- Our company’s objectives
- Data and information
- Resources

The decision-making cycle and the role of the PMS

The decision making cycle (the process used by managers for making decisions) can be divided in four
phases:

- Planning phase: Definition of goals and actions

- Measurement of results
- Analysis, formalisation and communication of actual results
- Identifying corrective actions

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Planning
This first phase aims at defining an action plan, considering:

- Objectives
- Resources
- Risks

The creation of the action plan is performed using dedicated instruments, typically a master budget
that is supported by tools such as Excel or other software.

A key element is the definition of a model, that allows to estimate, ex ante, the coherence between
resources, objectives and action plans

Example: C= Trip + N * (Hotel + Food + X) (travel)

EBIT = (p - vc) * Q – FC (New product) it is a very simple model l

In the planning phase we have to associate a target to our variables.

What could a PMSs do about the development of the plan? It is not the plan and cannot replace
managers.

The role of the PMS in the planning phase is:

- to provide relevant information based on models in order to set the objectives, so it gives the
managers information about costs, prices, etc. in order to be able to set the objectives, the target
values for the variables;
- to provide managers a tool for verifying the compatibility of objectives, resources and risks. So,
thanks to the PMS we can evaluate if our objectives, resources and risks are actually coherent.

Measurement of Results
We need to verify (after or during actions) if the results the company is achieving are actually coherent
with the objectives stated in the planning phase.

We need to measure results because we are not able to foresee exactly the value of the variables used
for modelling that phenomenon, we don’t know what will happen in the future due to the uncertainty
compared to our estimation. Besides, the models are not able to capture the whole complexity of the
reality.

The PMSs is useful for:

- monitoring the results, measuring them;

- also measuring how the risk profile of the company is evolving, understanding if the main risk
factors a company should deal with are changing ( Is there a new competitor? Are the preferences
of the customers changing? Is the price of my raw material increased due to the shortage of this
material?)

There is a point of attention to highlight: the quality of the model that we are using for planning and
measuring results is fundamental in order to interpret the actual results in the right way.

Let’s compare two different production policies using two models : policy 1 whereby we have a
machine and we produce 100 units of product A and policy 2 in which we produce 50 units of product

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A + 50 units of product B. The variable cost of A and B is the same and is 500€ for unit, fix costs are
20000€.

TC= vc * X + FC
TC = vc * X + FC + nsetup *suc

What happens if we compare these two alternative policies with the first model and the second
model?

In the first case the TC= 500*100 + 20000= 70000€ for policy 1; TC=50 + 50)*100 + 20000 = 70000€

We have the same result but it doesn’t have sense. If we are producing two types of product we’ll have
some setup costs, costs that we have to sustain for switching from product A to product B and for
preparing our machine for the production.

However, with this model we don’t see any difference between the two policies so we could make a
wrong decision.

The second model is more precise because it includes in the cost function the setup cost.

If we use a wrong model we could make wrong decisions but we could also evaluate in the wrong way
our results. For instance, we could select policy 2 and monitoring the results we find that the actual
cost is 71000€. If we are interpreting our result using the first model that doesn’t capture the setup
cost, we could conclude that the production has been inefficient because we spent more than what we
were supposed to spend. However, if for instance setup costs are 2000€ in standard condition, the plan
cost will be 72000€ and since 71000 is lower than 72000 we have been more efficient than the
expectations. I can highlight this difference only if I use the second model. And this is a very critical
point because when we deal with the PMS we need to understand if the model that we are using is
coherent with the reality, if it is able to capture all the elements that are relevant for the decision-
making process.

Variance Analysis
It is the third phase whereby we need to understand what are the factors that determine a
misalignment between objectives and results.

We could have some external factors (not controlled by the company) or we could have some internal
factors (controlled by the company).

Then we have some grey areas, factors that are partly controllable and partly not controllable by the
company.

Feed-back
It is relevant understanding if a certain factor is internal or external because we have the last step that
is the feedback.

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If there is a variance driven by external factors it is difficult that the targets set in the planning phase
will be still achievable.

When we deal with controllable factors we can typically introduce corrective actions in order to keep
the targets and we can modify for instance our action plan.

The role of the PMS is supporting the identification of variances and factors, motivations whereby
these variances were determined and helping us in redefining the action plan and the objectives
providing relevant information.

THE OPERATIONAL SYSTEM

Let’s consider the requirements that PMS should have in order to be able to support our decision-
making process.

- Measurability = refers to the

possibility of measuring and quantifying
the relevant variables and the effects
associated to certain policies in
connection to a specific phenomenon. If
we want to perform decision-making
processes we need to rely on measurable
items as far as possible. Financial
indicators are generally measurable
because there is a formula that allow us to
compute the indicator; instead reputation
is a more complex factor, there are some
measures, however compared to ROI is less measurable;

- Completeness = all the issues that could influence the company’s results should be taken into
consideration. For instance, for computing the enterprise value we need to enlarge our set of
indicators without focusing just on economic performance, but considering different contributions;

- Timeliness = the need of having information available when a manager should make a choice; today
we deal with online real time information because managers have to make decisions more
frequently;

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 - Long term oriented = we need to evaluate the implications on the long term of our decisions. If a
company decides to cut all the environmental investments, this could have a positive income
immediately on the P&L account since there are less costs, however this could damage the
reputation of the company in the long run.

MOTIVATION
So far we dealt with the role of the PMS in connection to decision-making process. The second aim
of PMS is motivating human resources.
The role of the PMS and also the dynamics
that characterize HR motivation can be well
represented taking reference to two main
groups of theories:
- Action theories: explain why an
individual is motivated to work, to put effort
in what he’s doing;
- Choice theories: explain why and
how the objectives of one individual can be
aligned to the corporate objectives.

In the first group of theories we’ll make reference in particular to the equity theory.

Equity theory

Equity theory helps in translating the relation between individual results and the social interactions.

This theory states that each individual gives to the organization some inputs: individual competences, his
background, knowledge, efforts, experience. Then the individual receives some outputs from the
organization: salary, knowledge, personal improvement, experience, a sense of belonging the organization,
autonomy, etc.

According to the equity theory, the situation is balanced when the “ratio” – output/input – is similar among
individuals doing similar activities, in similar positions. In this case we are in a situation of equilibrium. If this
ratio is not the same we are in a disequilibrium situation, meaning that we could deal with underestimation
of the employee or overestimation of the employee and a perception of difference leads individuals to
modify the ratio.

If the output that the employee receives in

relationship with his/her inputs is lower than a person
in the same position, the employee is being
underestimated because in relative terms he/she is
receiving less than he/she is giving. Typically, the
employee’s reaction to a situation like this is to bring
his k to an equal level by reducing the inputs, the
efforts.

On the other hand, we could deal with overestimation, when what the employee receives compared to what
he/she gives is higher than other people in the same position, so the k is higher than that of other colleagues.
In this case the person could think that he/she underestimated his/her contribution, meaning that there is
an increase in the expectations.

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What’s the role for a PMS? The PMS can provide elements for being able of estimating in the right way
contribution of the single individual and providing managers elements for rebalancing. A PMS cannot
determine the rebalance, it is just an instrument that cannot change a situation, managers have to change it
and if they don’t want to change it there is a problem because the PMS will make clear the unbalance. It
could be tricky.

As for the choice theories we’ll make reference to two main theories:

- The expectancy theory

- The goals setting theory

Expectancy theory

This theory moves from the hypothesis that an individual is rational and , in particular, works on this ratio:

Expectation = reward (that a person obtains from a work)/effort ( put by the person in that work)

The objective of a rational person is to maximize this ratio.

We can decompose this ratio into two terms, that are:

Expectation= Reward/ Performance * Performance/ Effort

The performance represents the result obtained in doing something that than leads to a reward. If we look
at these two components of the expectation ratio, we can understand that some key requirements that a
PMS should have in order to be able to support HR motivation.

- PMS needs to be complete. If I want to motivate HR and to align their objectives to the objectives of
the organization, PMS has to ensure that all the factors that are relevant for the company are
somehow included in the evaluation of the individual. Basically, because we have to ensure that the
individual can perform well if he/she is performing well in connection to the objectives that are
relevant for the company;
- PMS needs to consider individuals’ specific responsibilities. There are several cases in which the
performance obtained depends on a group of people. If we think to a complex project, the
performance obtained is actually the results not of the single individual but of the interaction of this
individual with other persons. A PMS should be able to understand the specific responsibilities, if a
person has contributed or not to that result. This is important from a motivation point of view
because if a person knows that his effort will not lead to an improvement of the performance, we’ll
have demotivation that leads to an effort reduction.

Goal Setting Theory

This theory states something that is related to the nature of the objectives that we should set when we
try to motivate people. Individuals decide to which objective addressing their effort on the basis of their
importance for them (as individuals). So it is important to clearly define objectives, we need to think in
term of measurable targets ( the target is the value that we assign to the objective).

Individuals increase their motivation when:

- Well defined goals are set;

- Goals are stimulating and they can hardly be reached…
- … goals can be reached

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The targets should be stimulating (not easy to be reached) but should be reachable. The PMS from this
point of view provide a lot of information about past results, competitors results, standard performances
that could be used as a base for setting the targets.

In complex setting, targets can be complemented with minimum threshold (soglie minime).

So the requirement that a PMS should

have in order to be able to support HR
motivation are:

- Measurability, that can be derived

from the equity theory, we need to rely on
measurable information;
- Specific responsibilities
- Completeness
- Timeliness, a key characteristic that
doesn’t derive from the above theories. If
we receive a feedback immediately after
something that we did, typically it is effective because we have in mind what we did; if the feedback
comes one year later, it will be no effective basically because we don’t remember what happened in
that project. So, this is another characteristic that the PMS should have for motivating HR.

EXTERNAL ACCOUNTABILITY

The third goal of MCS is the external accountability.

Companies need to communicate externally their results to:

- Shareholders
- Banks and other financers
- Central Government and local authorities
- Clients and suppliers
- …

The range of information published has increased after recent financial scandals.

Companies are trying to understand

how to deal with the requirements
of this law basically because with
this law they have to include non-
financial information into the
financial statement with a higher
attention to the reliability of what is
published.

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The number of reports and information we find on companies’ websites is wide:

- Financial reports
- Corporate governance reports
- Environmental reports
- Human resources reports
- Intangibles reports
- Sustainability reports
- …

from this point of view, the requirements that

the tools that we study should have are again
related to the measurability and completeness
of dimension that we report and also stabilty
across time.

Stability across time refers to the need of

keeping the set of non financial indicators that
we report externally stable in order to allow a
comparison. So an external reader should be
able to see the evolution of a company’s
performance of a specific indicator. This is
important because when there is no stability
the broadness of non finncial performance
could lead the company to report those performances on which they have better results. There could
be an opportunistic behaviour if the indicators that are reported change, the set of indicators would be
not stable and this is something negatively evalueted by those that are responsible of veryfing the
reports. This is particularly critical for non financial indicators while it is not for financial indicators
which are in general more stable ( EBIT, EBITDA, ROI, etc.)

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 CONSOLIDATION OF FINANCIAL STATEMENTS
Why should we care about consolidating financial statement?

When a company goes global, enters a new market or a new business it

often does that by creating a new company or by acquiring an existing
company. We have to deal with more complex organizational structure
compared to one single entity. In realty we deal with an arrangement
where we have several legal entities that have relationship among them.

There are different type of relationships, we will talk in particular about subsidiary, associate and joint
arrangement.

The term group can be used only when we have a parent and a subsidiary and in particular the parent
company is basically a company that CONTROLS other entities that are called subsidiaries.

For now we say that we can talk about control if our parent company owns more than the 50% of shares of
a subsidiary. Parent + subsidiaries gives the group.

We could have also a different type of relationship, we could have a company that has no control on
another company but has significance influence; for instance we talk about significant influence when the
investor owns more than the 20% per shares of the investee. In this case we talk about associate. In this
case the investor cannot determine the activities of the associate. In this case the investor is called investor,
not parent.

Then we have joint arrangement ( like joint ventures) where basically we have two or more entities that
have joint control. A big joint venture is for instance Nokia and Siemens. They jointly control the activities,
decide together.

This distinction is relevant because with the introduction of the IAS-IFRS there has been a rationalization of
the way how group accounting can be performed, the way how these different entities report their
performances.

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In particular when we deal with a group, the subsidiary has to
be full consolidated by the parent. If we are Dealing with an
associate, this type of investments are evaluated in the
financial statement of the investor using the equity method.
If we are dealing with a joint arrangement, basically
depending on the type of arrangement ( a joint venture or a
joint operation) we could use the equity method or other
approaches.

focus our attention on a group. Why group accounting is needed?

We have the parent, company A, that owns totally

company B.

Imaging that we are the shareholders of company A, if

we look at the FS of A the equity investment is our
investment in company B ( a simple example). If we look
at the BS of A we can just undesrtand that A has an
investment in another company, that the book value of
this investment is 100 milion and looking at the notes we
can understand that this investment makes reference to
the total value of the shares of company B. but we do not anything about the assets and the liabilities

Is it the same f

as to sell inventories, so as an investement the second

one is better.

If we talk about a group, being able to understand how the assets and liabilities of all those entities is
configured is something that will allow us to better understand the resources on which the group could
count.

There is a second point:

we need a consolidate financial statement for a

second reason, that is we want to achieve a
better understanding of the income of the
group, the profit and loss of the group.

The companies of a group are characterized by

some intra-group transactions, meaning that a
company can sell goods or services to another
company of the group.

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 at the group, it is
not really making a profit basically because the goods sold to company B become inventories, we have just
moved them. B is not selling the goods, it is as if I moved them from a warehouse to another warehouse.

In the FS of A it is a profit, but it is not so from a group perspective. So one key issue will be the adjustment
of these intra-group transactions.

What is a consolidated financial statement

It combines the FS of separate companies that belong to the same group in order to obtain the consolidate
FS. The consolidated financial statement shows the accounts of the group as though the different legal
entities were one single legal entities.

References standard (insert slide 8)

The consolidate FS is ruled by the IFRS 10, which has undergone

several changes through years. We moved from 2001 with another
IAS but then it was modified in order to clarify on the one hand the
circumstances under which we can talk about control and in
particular the IFRS 10 provide a
clear definition of the control
concept. Then it also streamlines
(snellisce) the different methods that were available for consolidating
financial statement, defining the accounting procedures that should be
followed for making the consolidation. IFRS 10 also specified the
exclusion criteria, when the consolidation is not required.

We will focus on the definition of control and on the accounting procedures that should be followe in order
to consolidate a FS.

DEFINITION OF CONTROL

Basically the IFRS 10 introduces three conditions to be verified if we want to talk about control, if we want
to say that we have a parent and a subsidiary. These three conditions are:

- Power
- Exposure or rights to variable returns
- Ability to use power to affect returns

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 vestor controls an investee when it is exposed, or
has rights, to variable returns from its involvement with the investee and has the ability to affect those

POWER

Place greater focus on the In this case we have to

purpose and design of the
investee and other factors
to determine whether
power exists
better understand the
decision making process
of our investee

Focus on rights Focus on rights

that could take that could give it
power away power

Power = decision making, the investor can decide about relevant activities, such as the strategy
adopted by the company, if the company should enter in a specific market, investment in R&D etc.

If the power depends on voting rights, we have to look at the quota, the amount of voting rights that
the investor has.

If the investor has the majority of voting rights, basically we should focus our attention on those
elements that could limit the power associated to the voting rights. What could generate a situation in
which I have the 60% of the shares of the company but I am not able to make choices on its relevant
activities? We could have veto right, and this condition the investor has the majority of the rights but
then if we have a minority shareholder that has veto power they can influence any relevant decision
making process; in the end in this case we cannot talk about control. There is also another situation,
that is when in a company statute we could have a constrain about the necessity of having all the
relevant decisions made unanimously. Meaning that all the shareholders should agree; in this case even
if an investor owns the majority of the shares, he does not have control because there is an
arrangement that actually requires that the decision-making power is not up just to him/her. In all
these situations the majority of rights is not sufficient to conclude that the investor has control over the
investee. And the implication is that if the investor has not control over the investee, it should not
consolidate the investee in its financial statement.

If the investor has the minority of voting rights, is this enough to conclude that the investor has no
control over the investee? No.
In this case we should pay attention to those elements that could increase the power of our investor.

the investee is strongly dependent on the business of the investor, even if the investor does not own all
the shares of the investee it can reasonably influence the activities of the investee.

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 I have just the 30% of the shares. What could
improve my power? If the other shareholders are very fragmented, are characterized by small quota of
shares. So when we deal with the voting rights, for sure we have to pay attention to the number of
voting right held by the investor but then we have to take a look also at the size of the investor vote
holding relative to the other vote holders and the dispersion of the voting rights.

Then we could have also a situation in which the relevant decisions of the investee are not directed
through voting rights, and this could happen due to some contractual arrangement whereby we have
delegated power to another subject, or again when the management of the investee is the same
management of the investor. In this case even if the voting rights are not relevant, the investor controls
the investee.

VARIABILITY OF RETURNS

This condition is related to the exposure of the rights of the investor to variable returns.

What do we mean with variable returns? For instance, if we think to an investor that owns a large
quota of bones of the investee, is the investor exposed to variable returns? What happens if the
investee actually fails? The investor will not receive his money. Bones have a fixed interest, however
the concept of variable returns in this case makes reference to the fact that the benefits/gains/returns
of the investor are influenced by the gain of the investee. If the investee perform well, the investor
gains otherwise the investor loses money. From this point of view the concept of variable returns is
broad and not very well-defined; however typically we look at the type of relationship/ long term
influence that gains or losses of the investee have on the results of the investor to understand if the
investor is actually exposed to variable returns.

Examples of indicators that suggest the relevance of variable

returns are represented by dividends, by bones but they are
also represented by, for instance, the fact that the investor
lends some money to the investee, because in this case,
depending on the results of the investee, there is the risk
that the investor does not have his money back.

In general terms, exposure to variable returns means that

the results of the investor are influenced by the results of the
investee and we have to look at how this influence is
determined.

ABILITY TO USE POWER

This third condition is if the investor has the ability to excert power on the investee. IFRS 10 makes
reference to the concept of principal and agent. What is a principal and what is an agent?

17
The agent is a subject that acts on behalf of someone else. The CEO (Amministratore Delegato) acts on
behalf of the shareholders. The principal is the one that basically decides for its own interest, has its
own benefit as his final objective.

This concept is relevant for the concept of power if we think at a particular kind of investor. Who could
be an investor that act on behalf of someone else?

Typically funds invest in an investee but they do not really control the investee, they are acting in
behalf of the investor that invest in the fund. In this case we are missing the third condition, so there is
no control.

According to IFRS 10 we can conclude that an investor controls the investee only if he is not acting as
an agent but as a principal.

We should eliminate from our sphere of

influence those decision making rights that
have been delegated to the investor by
someone else. In other words if the investor is
acting as an agent on behalf of a third part,
that could be even another company, that
does not count as a decision-making right, from
an accounting point of view of course.

So we have to balance different decision-making rights components.

So the definition of control is quite articulated, the good news is that once we have defined that there
is control thanks to these criteria, then the IFRS 10 has somehow simplified the consolidation process.

We want to assess investor A, B and the

Banks.

Power:

- Investor A has power over the

investee;
- Investor B no. This one has more
share, but in this case decision-making
rights the true indicators of how
decisions are made? Actually in this
case there is an agreement whereby
investor A is responsible for managing
and operating the facility and all the financial decisions. So one investor puts the money (B) and the
other investor makes the decision. This could happen because it knows the sector better. The rules
are set in the statute signed by the two investors. So investor B has not power, because it doesn
make any decisions.
- Tha banks, following the definition of power, have no power.

18
 Variable returns:

- A is highly exposed;
- B also is exposed to variable
returns, it can lose a lot of money;
- The banks are also exposed, they
can also lose money that can maybe be
recovered by the assets of the company.

Ability to use power:

- Is the investor A able of excerting power over the investee? Is it acting as a principal or as an agent?
As a principal, has as objective its own benefits.
- e else;
- The banks are basically investing money of someone else

So if we look at the three conditions, we can say that only investor A meets all the requirements, so it is
the one that will have to consolidate in its financial statement our company, our wind farm.

CONSOLIDATION PROCESS IN EIGHT STEPS

We can distinguish what we call preconsolidation steps/adjustments and real consolidation
adjustments.

PRECONSOLIDATION ADJUSTMENTS

These are preparatory steps, adjustments that we have to perform before we can really combine the FS.

1. ;
All the subsidiaries still have to produce their own FS, then the parent in addition will produce the
consolidated FS;
2. Make all the FS uniform, indeed the FS of the subsidiary may be not in line with the FS of the
parent, for many possible reasons: for instance if we have companies operating in different
geographical area, they will have to respect different regulations and so the documents could
follow different accounting principles, or could be prepared with different currency. Another issue
is quite interesting, that the accounting period FS refer to could be different; in Italy most of the
companies have an accounting period that follows the solar year, meaning that the FS is closed at
31 December. However this was not true in the past.
.

- The accounting period they refer to ( sometimes we can also consolidate two FS that have different
closing time, but according to the accounting principle differences between reporting dates cannot
be longer than 3 months);
- The accounting policies;
- The reporting currency (if necessary, translation must take place);
- The layout.

19
Closing period

When the closing date of the financial statements of one or more subsidiaries is different from that
of the parent company, the subsidiary prepares interim financial statements at the closing date of
the parent company;
When this is not feasible, the closing date of the financial statements of the subsidiary and the parent
company is allowed to be different on condition that:
- the difference between the closing dates does not exceed three months;
- the duration of the financial year and the difference between the closing dates remain constant over
time;
- adjustments are made for significant transactions and events which occur between the closing date
of the subsidiary and the closing date of the parent company.

Accounting policy
If we have companies that compete in different countries they will follow different accounting principles. If
we deal with an US company, US GAAP are quite similar to IFRS because they have tried to align the US
GAAP and the IFRS.

When one or more subsidiaries use different accounting policies than those adopted by the group for
similar transactions, then appropriate pre-consolidation adjustments are made as part of the consolidation
process. Operationally this can be achieved:

- by applying in the su
the extent that these are not in contrast with local law;
- by requiring the subsidiaries to provide individual statements for the consolidation process
appropriately adjusted to be consistent with the accounting policies used for the consolidated
financial statements.

There are two relevant differences that typically deal with R&D cost and with inventories.

The case of R&D cost is particularly interesting basically because many of the differences that we find
can be explained with this issue.

- According to US GAAP, R&D cost have to be expensed when they are sustained (as incurred). All the
R&D cost will end up in the income statement as a cost. If we pay 200 million in 2017for R6D and
we are a US company, all the 200 million will be included in the IS as a cost item;
- According to IFRS research costs are treated in the same way, they have to be expensed in the IS
when they are incurred; however development cost can be capitalized, they can be brought to the
BS among the assets and then we can depreciate them. So if we are able to capitalize part of the
development cost we will have a benefit, because the reduction of the income will be lower and we
will be able to record that item among the assets.

This is an important step, we have to verify that the items are treated in the same way. If the parent is
a US company and the subsidiary is a UK company, I have to correct the way in which development
costs are treated because the FS of the subsidiary has to be aligned with the FS of the parent. Since we
said that the parent is a US company, we will have to expense the development expenses in the income
statement, we cannot capitalize them anymore.

We need to verify that the same procedures are followed by the parent and the subsidiary.

20
Reporting currency important for the project work

If the scope of consolidation includes companies that keep their accounts in a currency that is different
from the reporting currency of the consolidate financial statements, it is necessary to translate financial
statements denominated in currencies other than the reporting currency of the consolidate financial
statements.

For instance, we have an European company, a Japanese company and an American company. Typically
each financial statement will be prepared with the currency of the area in which the company operates.
But when we have to put these FS together, we have to convert all the FS in the same currency. This
could bring to some differences.

When we look at the Income Statement, IS items (including the profit for the year) are translated
typically using either:
- The average exchange rate of the financial year (or of the month);
- Or we could use for each transaction that is reported in the IS the effective exchange rate at the
day of the transaction, that is obviously very complex and so it is generally not used.
Balance Sheet items, except for the profit for the year, are translated at the exchange rate at the

The implication is that we are using different exchange rate for the items in the IS and the items in the
BS, but the net profit appears both in the IC and in the BS. If we are using different conversion rate the
two numbers will be different, that is the reason why in the FS that we will analyse we will find
something called a that basically includes all the translation differences.

In some cases these translation differences can be high, so we could have huge numbers in connection
with this reserve and we should know that this translation reserve actually accounts for all the
differences related to the currency conversion due to the consolidation process.

3. The last preconsolidation step is the aggregation, the preparation of the aggregate FS: it consists in
combining assets, liabilities, equity, income, expenses and cash flows of the parent with those of its
subsidiaries; each item shall be added according to its accounting category to determine the
aggregate financial statement.
The aggregate FS is just the combination
line by line of the BS of company A and the
BS of company B.
This is the aggregate not the consolidated!!
Then we have to move from the sum of the
FS of the parent and the subsidiaries to
something else that allow to understand
the interconnection/ interrelationship that
exists between the parent and the
subsidiaries.

21
CONSOLIDATION ADJUSTMENTS

The consolidation steps are:

4. Eliminate (offset

What does this mean?

A owns 100% of the shares of B. we have the

BS of both. The first step that we have to
perform is to offset this investment (100)

equity of B.

If we go back to the aggregate, we can see

that in the aggregate we have a sort odf
double counting. We have the value of the investment made by A but hen we also have the assets and
liabilities that explain that investment because we have the palnt of B. so we cannot have both from a
group perspective! So we have to cancel the investment of 100. Then we have to balance basically this
change with another item among the liabilities. How could we balance this change? If we look at the
liabilities, the equity is given by 400 + 100, but 100 was the equity of B. Since we are saying that the
consolidation process assumes that there is no a separate subsidiary, we cannot even have an equity
belonging to the subsidiary and so we have to eliminate it.

In this way basically we have replaced the investment with the corresponding assets and liabilities.

So, repeating, we said that the aggregate is A+ B; however we are not interested in A+B, we are
interested in understanding the performance of the group. In A+B something does not work because
we have an investment in B, but we also have the resource and liabilities that explain this investment.
When we do the consolidation, our aim is to report the FS in a shape as if A had bought the plant on its
own. So this investment should be cancelled because it is a sort of double counting, we are considering
our asset twice.

Then the system is not balanced, we took 100 from the assets, we have to take 100 from the liabilities.
How shall we do that? Well, there is again a double counting because we are still accounting for the
equity of company B. we have replaced our investment with the assets and liabilities that explain the
investment and the equity shoul disappear. So we cancel also the equity of company B.

(We will see also the case of no full control)

In this case we made astrong assumption, that is that the value of the investment actually matches the
value of the equity of B. in reality this is quite rare because several variations arise. So before moving to
cus our attention on what happens when the value of the

22
 , so when these two values are not
the same. For understanding this point, we need to break down the value of the investment, the
components of the price that an investor pais for a quota/ investment in the investee.

Typically the purchase price paid for the investment is constituted by four components:

- : in our first example the book value of the equity was equal to
the price meaning that the other components were zero;
- +/- :
meaning that when an investor buys another company the first thing that typically does is a due

acquire. We want to understand the fair value of the assets and liabilities of the company we want
to buy. We could find some differences, the fair value could be higher or lower than the book
value. If there are these changes we have a tax effect associated;
- +/- tax effects on those changes;
that has a book value of 100. We discover that its fair value is
200, much higher. Actually the company that is making the investment, is realizing a surplus, an
extra-gain and this is a positive income component (plusvalenza in italian). This positive component
will have a tax effect, we could expect in the future to have to pay more taxes related to this
surplus. If the fair value is lower than the book value is the other way round, meaning that we have
a negative difference, a loss in the IS that means a tax saving;
- +/- goodwill,
which refers to an extra-value that the buyer is willing to pay because he expects to be able to
exploit some potential synergies with the activities of the investee. So I am ready to pay a bit more
because I expect that making this investment I will be able to make much more money thanks to
my ability of exploiting its assets and liabilities.
If the goodwill is positive (price paid > fair value of equity attributable to the parent), it must be
included as an asset, the so calle
If it is negative ( price paid < fair value of equity attributable to the parent), estimates of the fair
values of assets/liabilities of the subsidiary should be reviewed; the negative difference- if still
existing- must be allocated to the income statement as a gain.

23
 EXAMPLE: MICKY-MOUSE

Before offsetting the

investment, we have to take
into account the differences in
the fair value of some assets and
liabilities and the related tax
effect. First of all we have to
report the differences in the fair
value of our assets and
liabilities, meaning that we have
to add 1000 for PPE and 200 for
current and non-current
liabilities.
These surpluses are associated
to a tax effect 1000x0.5= deferred tax liabilities of 500.
But we have also deferred tax assets equal to 100 (=200x0.5) (tax saving) in connection to our
increase in the liabilities. Then we have to offset the investment and the equity quota of Mouse.
Now we have to determine the goodwill = difference between the price that we paid 2700 and the
value of what we are buying that is: the book value of the equity 2000 +/- have to add or take out
the extra-value of our assets and liabilities (we know that the value of the plant is 1000 higher but
th 1000 500), +/- we have to adjust this book value
also for considering that the prevision was higher, so we have to reduce by 200 this value because
we have higher liabilities, but higher liabilities mean a tax saving so 200 100.
In the end the value of what we are buying is given by 2000+500-100.
We have paid for all this 2700 so the goodwill is 300, the difference between the two of them.
First we compare the price paid against the value of what we bought. For determining this value we
moved from the book value then, since we know it is not in line with the fair value for all the assets
and liabilities, we have to account for the differences between the fair value and the book value for
some specific assets. These differences imply a tax effect.

24
 5. Recognise and measure the share of equity attributable to other shareholders in non-wholly-owned
subsidiaries (i.e. non-controlling interests)

So far we have assumed that the parent company owns the 100% of shares, but we could have that
it owns just a part of our investee. In this case we have another issue/step that we shoul perform
that is the:

Recognition of non-controlling interests

Non-controlling interests arises when a subsidiary is not wholly controlled.

For example, if a parent owns 85 per cent of a subsidiary, it has to consolidate 100 per cent of the
-controlling interests of 15 per cent.

So we consolidate everything but then we have to recognize a quota (15%) of non-controlling interests.

Measuring the non-controlling interests, the investor may choose to measure a non-controlling interest in
the investee, at the acquisition date, according to two approaches:

- At fair value- the so called full goodwill accounting, or

- At the non- proportionate share e net assets.

What is the difference?

full goodwill accounting

In the first method we are recognizing
the non-controlling interests at the fair
values. We bought the 60% of the
company for 300 million, meaning that
if we make the estimation in a similar
way the remaining 40% is determined
to be 200 million.
On the one hand we have the price
paid by the parent, that is 300 million.
Then we are saying that the fair value
of the remaining 40% is determined to
be 200 million. This is an input data.

If we want to determine the value of

the non-controlling interests and the fair value, the fair value of the non- controlling interests will
be 200 million. So w
Because we paid 300 for the 60%, we are determining the fair value of the remaining 40%:
300+200= 500 million fair value of our investee.
Now we have to determine our goodwill; in order to do this we have to disentangle ( districare,
sciogliere) the different value components as we did before.
So we know that the total value of our company is 500. The book value of our company is 190.
There are surpleses positive or negative? The fair value is higher compared to the book value. If we
make the sum of the fair values minus the book values, the difference is 300, because this sum is
470 and this is 170.

25
 So if we look at the assets of our
investee, they have a fair value that is
300 higher compared to the book
value. It is a surplus but means higher
taxes. The tax rate is on a 40% basis,
so 300*40%= 120.
So the net surplus will be 180.
The overall goodwill, without
distinguing between parent and non-
controlling interests, is equal to 130
[= total value book value of equity
net surpluses (net of tax effects)]

proportionate approach

In this second case we recognize the non-controlling interests based on the proportionate share of the
book value of the equity of the controlled company.

In our example we know that STAR owns the 60% of LIGHT and the book value of the equity of LIGHT is
190. So the book value of the non-controlling interest is 0.4*190 = book value of the proportionate
share that is not owned by the parent.

These are the non-controlling interests. Then we need to undesrtand how we can compute our
goodwill. In this case we are looking our investment distinguishing between the quota owned by the
parent and the quota owned by someone else ( the non-controlling interests). So when we compute
the goodwill, it is determined based only on the fair value of the net asset that is related to the quota
owned by the parent.

know that STAR is paying 300 million for LIGHT.

But when we determine the goodwill under
this second approach, we consider only the
book value of the equity, so 190*0.6 ( 0.6
because STAR bought the 60% of LIGHT). Then
even when we recognize the surplus, that is
associated to the net asset, we do not include
anymore the whole surplus (300) but we
include 180 ( that is the quota that is relevant
for the shares owned by the parent minus the
tax effect). Taxes are 300*0.4 =120, but we
consider just a part of them, so 300*0.4*0.6= 72.

So, in the first case, under the full goodwill accounting, we have that the non-controlling interests are
equal to 200 million and the goodwill is 130. Under the proportionate approach the non-controlling
interests are equal to 76 (190*0.4) and the goodwill will be 78.

So, based on the approach that we decide to follow, the figures of non-controlling interests and
goodwill change. The company can choose what approach it wants to use, this choice depends on the
ability of the company of appropriating most of the benefits.

26
In the full goodwill accounting, the approach estates that we are recognizing in the FS all the benefits
that are pertinent both to the parent and to the non-controlling interests, because we are computing
the goodwill based on the total value of the company ( in the first case we moved from the 500). This
means that this approach is typically used when the percentage of shares that is owned by the parent is
very high, or when the parent has a relevant influence on the non-controlling interests.

In the proportionate approach we are basically keeping the figures about the parent and the non-
controlling interests are separated, basically because we are computing the goodwill moving from the
assumption that we recognize the surpluses associated just to the quota that is owned by the parent.
So this is typically used when the quota that is owned by the parent is lower.

6. Eliminate any intra-group assets, liabilities, equity, income, expenses and cash flows relating to
transactions between consolidated entities
This is the last adjustment and it consists in the elimination of intra-group transactions. This means
that if a parent company sells to a subsidiary goods or services or whatever, this transaction from a
consolidated FS point of view is not material and should be eliminated. Indeed, if we have that
company A sells products or services to company B (or company A lends money to B), from a group
perspective this transaction is exactly equal to shifting material from one warehouse to another one
( or in the case of financing provided b
. So, these intra-group transactions
should never appear in a consolidated FS, meaning that this is the last adjustment to be performed.
From the perspective of the consolidated financial statements, the transactions that occur between
group companies are equivalent to transactions between divisions/ functions within a single
company. Such transactions cannot be presented in the consolidated financial statements, as these
must present only those transactions that group companies have made with third parties, i.e. outside
the group.

We have basically three main types of adjustments:

1. Infra-group revenues and costs, receivables and payables;
If we have a parent that sells a service to the subsidiary, we have some revenues generated by the
provision of the service and if the transaction is not paid by cash immediately, we register an account
payable in the FS of the company that buys the service and an account receivable in the FS of the
company that provides the service. This is an internal flow so we should eliminate revenues and costs
in the two IS and account payable and account receivable in the two BS.

2. Intercompany profits and losses, related to inventories and fixed assets;

The second type of adjustment is related to intercompany profit and losses that could be related to
the selling from one company to the other of a fix asset, for instance a plant, a machine and the
recognition of a surplus or a loss related to this operation.

3. Infra-group dividends;
dividends payed from the subsidiary to parent.

1) Example:

Company A has an 80% stake in Company B. A provided services to B for a total amount of 500 and
company A has recognised the related revenue under operating revenues while compnay B recognised

27
the related costs under operating costs. On 31.12.X the transaction is settled only partially, and
intercompany payables and receivables are recognized for 300.

- Adjustment 1: eliminate the revenues recorder by A (500) and eliminate of the costs recorded by B
(500)
- Adjustment 2: eliminate the receivables recorded by A (300) and eliminate the payables recorded
by B (300)

In general, the adjustments posted to eliminate intercompany payables and receivables, revenues and
expenses follow the steps below:

- Identify which values of credit/debit and costs/revenues arising from intra-group transactions are
recorded in the financial statements of the companies included in consolidate financial statement;
- Make sure there is mutual equivalence between the account, if this equivalence is not present,
reconcile intra-group values;
- Delete the mutual accounts ( receivables and payables, costs and revenues).

2) Example:

Company A has an 80% stake in Company B. on 1.1.X Company A sold to Company B a plant for a total
amount of 1.100 ( book value: 900; yearly depreciation quota: 100). During the year X, Company B
recorded depreciation for 110.

- Adjustment 1: eliminate the surplus gain recorded by A ( 1.100-900=200)

- Adjustment 2: bring back to 900 of the value of the asset recorded by B (purchased and recorded
for 1.100)
- Adjustment 3: eliminate -100=10);
since A sold the plant to B at an higher value compared to the book value of the plant when was
recorded in company A FS, company has adjusted the depreciation quota into 110 ( value of the
asset divided by the useful life). This depreciation is higher compared to the initial depreciation
because the yearly depreciation quota before the internal transaction was 100. This is a
consequence of the internal transaction so we have to eliminate the amount exceeding the original
depreciation quota, that is 10.

In general the adjustments posted to eliminate intercompany profits and losses related to fixed assets
and inventories follow the steps below:

- Adjusting the carrying values of assets that have been the subject of the intra-group transaction
and that are still recognised in the balance sheet of the acquiring company; the value of these
goods must be
- Adjusting the income item by the infra-group
transaction. The result of operations of companies involved in the transaction, in fact, may be
changed as a result of the intra-group transaction, and this change must be eliminated.

3) The last correction is represented by the elimination of intra-group dividends.

We are referring to the case in which company B, a subsidiary of company A, distributes dividends to
the parent company, something that can normally happen. Since we are looking our FS from a group
point of view, we have to eliminate the distribution of dividends since they represent another intra-
group transaction.

28
 In general, what happen when a company pays dividends to another company? What are the items of
the FS that are modified? First of all we have a financial interest that is a financial income for the
company that receives the dividends. For company A, (besides the increase in the cash flows) dividends
are profit that are distributed. So when a company distributes dividends, its reserve of undistributed
profit is reduced.

So, the corrections that we have to perform are referred to these line items.

Indeed, the adjustments posted to eliminate intra-group dividends follow the steps below:

- Eliminating the financial income, recognized by the company that receives the dividends;
- Reintegrating the reserves of the company that distributes the dividends;
- -controlling interests by the amount of
dividends received by them:
Since we said that we could have a company that owns the 60% of the shares of the other
company, when we prepare a consolidated FS, we treat in different way dividends that are paid to
the parent and dividends that are paid to non-controlling/ minority shareholders. Basically, because
the money paid from the subsidiary to the parent is an intra-group transaction, however, the
money paid from the subsidiary to another company that does not consolidate the subsidiary is an
external flow. So that flow will not be corrected and our non-controlling shareholders are receiving
part of their rights, they are being remunerated so their rights toward the company are reduced.

So we have to look at the transaction of the company line by line and eliminate anything that
happens between two companies of the same group.

7. -

8. Prepare the final consolidate financial statements.

EXAMPLE OF STAR AND LIGHT:

Let S, do the aggregate, do the adjustments,

consolidate.

29
When we prepare the consolidate FS, we have to recognize the surplus of asset or labilities in terms of
difference between fair value and book value.

1) the fair value of non current assets of LIGHT was 300 million higher than the book value. We are under
the full goodwill accounting so we report all the surplus.

2) then we have to offset the investment against the equity value, the investment is 300. We have to
eliminate the equity of LIGHT, but we have to recognize the non-controlling interest as computed as the fair
value of the net asset, in our example the fair value of the non-controlling interest was 200. So we have to
add a line called non-controlling interests, we could also find minority interests.

3) then we have to determine the tax effect associated to our surplus (120)

4) and finally we have to determine the goodwill (130).

If we use the proportionate approach, first of all we do not recognize a difference between the fair value of
all the assets, but we recognize just the pro quota component of the difference between the fair value and
the book value, so basically 300*0.6 ( we consider just the quota owned by the parent). Then we offset the
investment against the equity value, so minus 300 minus 190. In this second case the non-controlling
interests are determined as the quota of the book value of the equity, so 0.4*190. We have to recognize
the fiscal effect (72) and then our goodwill is basically the difference between price and book value of the
equity and the net surplus.

Then we have to perform the adjustments for the consolidated FS, for instance the value of the non current
assets will be 290+180= 470. We are moving from the aggregate and applying the adjustments to the
aggregate.

30
Now,
referred to an intra-company transaction, for instance they are related to a service tha STAR provides to
LIGHT. In this case we have just to add a further adjustment, that is the one written in red. So we have to
offset the account receivables and the account payables from the assets of STAR and from the liabilities of
LIGHT. And again we obtain the consolidated FS.

So this is the process that we should follow in order to prepare a consolidate FS.

We said that the consolidated FS is applicable when we deal with a group. If there is no control
relatio
report its investment in a different way, following different rules and typically there are different types of
investment, some of them will be not consolidated and will be represented following different rules.

EQUITY METHOD

This method is frequently used for disclosing the investments in the FS both in case of associates when we
have an entity on which the investor has significant influence but no control, and joint arrangements, and
in particular joint ventures.

The equity method is not a consolidation process, not used when a company has full control over another
company and in this case the investor reports the investment at the cost of acquisition based on basically
the proportionate share in the investee equity. In year 0 the investor reports the investment at the cost of
acquisition. Then, in the following years this value should be corrected year by year in order to consider the
profit and loss that are generated by the investee, meaning that if the investee reports a profit of 100 and I
have a 30% of shares in that investee, I will have to increase by 30 the value of my investment. So I add in
the profit the income that is generated by the investee proportionally to the shares that I own. So the initial
value of the investment is increased of the profit that is realized by the investee ore reduced by the loss
that is realized by the investee. And this increase/reduction is based on the ownership quota of the investor
in the investee.

Then again if I own the 30% of the investee and I receive some dividends, this means that I have been paid
for my investment so the dividends should be deducted by the value of the investment, because I already

31
received a recognition for my rights. So the value of the investment is increased by the profit that is
realized by the investee minus the dividends that have been distributed.

uity as an investment (
at cost of acquisition):

- Profit/ loss from the investee increase/reduce the investment account by an amount proportionate

- Dividends paid out by the investee are deducted from this account.

32
 FINANCIAL ANALYSIS (PART I)

determine for example:

o
o Setting the target price in an M&A (Mergers and Acquisition), this process is done through
something that is called due diligence ( verifica dei dati del bilancio di una società), a specific process
that relies on financial analysis that Then ends acting in determining the target price in an M&A;
o The selling price of shares in an Initial Public Offering (IPO), that is when a company become listed
(quotata)
o The credit stability (rating services)

Financial analysis is a core activity for many different procedures, processes related to the financial and
accounting services.

to be able of
reading and interpreting data/ financial statements in the light of relevant industry trends.

We will give particular relevance to reading these indicators , to linking these indicators to industry
trends, contest evolution.

The final aim of a financial analyst is not to compute (calcolare) indicators, his final aim should be on
being able to understand the meaning of the indicators in connection to a specific industry trend, a
specific contest. So not all the indicators have the same relevance, and it is important to understand
how to select them and how to understand what are the key figures.

Indicators pose questions more than providing answers. process of selecting,

evaluating and interpreting financial data, along with other pertinent information, in order to

In the definition there is nothing about the indicators!

Financial analysis is more than calculating indicators, but it requires the following:

1. Triangulation means
using more than one method to collect data on the same topic. This is a way of assuring the validity
of research cross-validating data but also of capturing different dimensions of the same
phenomenon.
2. Segmental analysis
3. Common size analysis
4. Reclassification and adjustments
5. Benchmarking
6. Accounting based indicators

We will try to understand how to put together all these different instruments in order to achieve an
overall understanding of the performances of a company.

33
1)

What kind of documents should we analyse for our project work? This is part of the sources selection,
meaning that we will have available many different sources:

all the financial disclosures, but they basically include many different documents:
o The financial statement that contains the financial statement schemes, so the Balance Sheet,
Income Statement, Notes
o Shareholder letter That are more descripted documents
o Segmental analysis provided by the company in order to
explain some performances

o Quarterly reports, periodic reports that are issued for instance any four months, any six months to
give

Not financial disclosures, that can contribute in better understanding what a company is doing
in a certain area:
o Sustainability report
o Country report
Market data (we are analysing listed companies, so some trends could be also explained or
better the financial results of a company could influence the marker results)
o Market price of stock
o Volume traded
o Value of bonds

All these issues are relevant for achieving a better understanding of how the company is performing. We
know that the value of the equity that is disc
not the market capitalization, however if we want to achieve a better idea of how the company is
performing we need both the information, so doing the market capitalization is relevant for
understanding what are the expectations of the market for the company that we are analysing

The connection with the industry and economic data, for instance if we are considering an
energy company an interpretation of its results today can not overlook some considerations in
connection to the evolution of the oil price because it has strong influence on all the economic
results of an oil company. So compared to the calculation of the indicators, we need to pose
first of all higher attention to all the possible sources, we have compared with the past much
more sources of information that disclose how a company is behaving and we need to exploit
them.

A couple of examples.

When we deal with a company listed in the US, basically the FS is prepared according to what we call
SEC (US Securities and Exchange Commission) fillings , different forms of financial disclosure for
companies listed in the US. There are different types of formats, some of them are:

o Form 10-K: that is the audited financial statement, the document relevant for our scope. We can
find also some other relevant documents like:

34
o Form 10-Q: unaudited financial statement, meaning that it has not been audited yet but it could
disclose some relevant information
o Form 8-K:current report that companies must file to announce major events, if something happens
after the closure of the fiscal year this document could be used to communicate it for giving more
timing information to the shareholders and the investors and the general public; so it is a way for
providing investors timing information without waiting the subsequent financial statement
o Form 20-F: annual financial statement filled by a non US company that has listed equity shares (is
listed) in the US, ENI produces this format because it is an Italian company listed in the US.

Netflix example

Netflix uses social media to communicate with its subscribers and the public about the company, its
services

information is deemed (ritenuto) to be material? From a financial point of view, a material information
is the material that can significant influence the interest of the shareholders including minority
shareholders.

When an information could influence the value of the shares, for instance, this information is deemed to
be material and companies evolved to communicate openly and transparently to the market material
information. Companies have to be committed to communicate immediately any material information
to the market authorities.

So Netflix is using also social media ( a blog, a YouTube page, Facebook, Twitter and so on) to publish
communications about the company and some of these could be material.

That is to say that the way companies communicate their results is changing totally. The FS is not
enough.

Fincantieri example

Fincantieri became listed in 2014.

An interesting point is the connection between Fincantieri and the state.

Since Fincantieri built ships, a large part of its business portfolio in past was related to the Italian navy.
The Italian navy actually used to buy ships from this company and in particular in the beginning of 2000
we had that Fincantieri was mainly a domestic player with 1 main client per business, and basically its
client was Carnival in the cruise sector and the Italian Navy in the naval sector.

Then we had an evolution of the situation basically because the market environment changed , we had
two main dynamics:

o
all the commodities used to cost a lot, were very expensive; having an high price of the commodities
had a negative impact in term of cost of raw materials;
o State aids (aiuti) ended and we had also reduction in the orders from the Italian Navy.

So they had to change their strategy in order to get new clients and they reorganised themselves into
three business units, including Mega-Yachts, Repair & Conversion, Marine Systems and then they also
tried to get in touch with the Us Market for the military ships.

In 2008 we had the financial crisis, we had global reduction in the orders to this sector and a strong

35
they focused on the oil sector with the acquisition of VARD, a company specialized in production of ships
for providing services to offshore platforms (oil platforms built in sea).

They got VARD, they also made some restructuring and the reorganization in business units.

They became a listed company and basically so far they developed a reorganization process aimed to
improve the order acquisition and optimize the usage capacity in term of cost.

In 2016 we had a new problem, the oil price decreased. A lower oil price means less services to be
provided to offshore platforms and less ships needed for that kind of service. Now the company has
announced a new business plan with good forecasts for the next year thanks to again a reconfiguration
of its own activities, in particular thanks to some agreement that they made for the cruise sector and
the achievement of a larger scale in the oil sector thanks to the optimization in different activities.

This kind of analysis is relevant in order to provide some context about the history of the company we
are analysing: what the company has experienced in the past, what challenges faced. So it is important
to understand the connection between the company and the industry in which it competes, the

performance. Understanding how these sectors could evolve is relevant for a manager for being able to
setting strategies.

2) SEGMENTAL ANALYSIS

Segmental analysis (or reporting) is required for all the public listed entities and consists in disclosing
selected relevant information in connection to the most important operating units of the company,
where the most important operating units are the main divisions/ business segments.

Segment reporting is intended to give information to investors and creditors regarding the financial
results and position of the most important operating units of a company, which they can use as the
basis for decisions related to the company.

Cost of revenues= cost of

sales

Contribution profit= revenue

cost of revenues - marketing

Contribution margin =
contribution profit/ revenue
(to or over)

If we consider that other

companies that compete in
the same industry have a
contribution margin of 15%,
we would say that Netflix is
more profitable.

36
 If we take a look at different
segments, we would discover that
the amount we found is very
different from segment to segment.
We have very good results when
we deal with the domestic market.

However if we look at
international client we
have a completely
different outlook, so the
international segment is
losing money.

The numbers in brackets

(tra parentesi) are negative
numbers .

Our aggregate result is a

combination of the
domestic division that is
performing well and the
international division
where on the contrary we
have a negative
contribution margin.

lkswagen. Our
segments are automative division,
where we have passenger cars and
commercial vehicles and then we have
power engineering and financial
services.

Up we have different brands that are

consolidated below.

If we look at the data by segment, we

can understand what are the most
profitable segments, there are a lot of
minus because this was 2015 in which
it happened the scan Deaselgate
(tricks in the measurement of the level
of emission for Deasel models). The impact was particularly negative in connection with some items.

We can see the segments most affected by the scan and then what are the sectors that in 2016 basically
recovered from the scan ( for example the passenger started to recover).

37
 In the segmental analysis we have to identify what are the most important operating segments and to
understand key financials for these operating segments and this is reklevant in order to make sense of
the overall results.

3) COMMON-SIZE ANALYSIS

The common-size analysis basically consists in the restatement of financial statement information in a
standardized form. We could recalculate/restate our key figures in order to make them more
comparable and easy to be read for understanding what are the key items. We distinguish between a
vertical and an horizontal common- size analysis:

- Vertical common-size analysis uses the aggregate value in a financial statement for a given year as
s amount is restated as a percentage of the aggregate. We look at the
items of our financial statement and we reproportionate each item based on an aggregate value. If
we are looking at the assets, we express each category of asset as a percentage of total asset. So it
consists in looking at the composition of our asset, liabilities, income statement, as a proportion of
the main aggregate value:
o When we analyze the Balance Sheet, the aggregate valued taken as a reference is
represented by total assets or total liabilities, it is the same value;
o As for the Income statement, the measurement used as an aggregate value is revenue.

Example:

Each item of the IS has been restated

as a percentage of net sales ( 67.8%=
957.791/ 1.413.208)

For each year we have expressed each

line item of the assets as a percentage of
total assets.

This is relevant because in this way we

can understand what are the key figures
and in terms of what are the asset or
liabilities or cost or income items that
have a most relevant impact on our
result.

If we think to asset and liabilities, this

information is important in order to understand the composition of the asset and also the rigidity or
flexibility of our assets. So tipically if we consider a company like ENI, Fincantieri these kind of
companies will have higher incidence of non current assets compared to company like Accenture
because they have a strong component in Property, Plant and Equipment.

38
When we look at Income Statement this kind of analysis will allow us to identify the key cost
components, the costs that have major impacts on our margins.

This is a comparison between three

companies: Facebook, ENI and IMA (a
manufacturing company that produces
machines for automatic packaging in
particular for the pharmaceutical and
food industry). We can see the different
structure of the assets of these
companies.

If we compare Facebook and ENI we note that in ENI we have a larger component of non current assets
compared to Facebook, due to an high contribution of Property, Plan and Equipment and so on. But
then if we compare Facebook and IMA we would not expect a situation like this, we would expect a
lower percentage of non current assets for Facebook. In non current assets there are some intangible
assets (brand, patent, goodwill: Facebook bought Whatsapp), so just comparing with the horizontal
analysis could be misleading (ingannevole) because in the end our Facebook figure is influenced by the
composition of non current assets.

If we look at the IS, we would highlight that purchases, services and other costs for ENI account more
the 80% of total revenues. This is not true for the other companies.

The composition of the

assets is somehow
reflected in the IS
because if we look at the
depreciation for ENI it is
13%, for IMA 3%.

disaggregated data for

Facebook because for
Facebook the IS was
prepared by function.

Typically if we analyse a
European company, or better a company that prepares the FS based on the International Accounting
Standards, if the company prepares the IS by nature in the notes we will find the IS by function; instead
if the company prepares the IS by function, the notes will report the IS by nature. So we could look at
costs articulated both by nature and by function.

If we analyse a US company in many cases the IS is just prepared with the functional perspective,
meaning that the information about cost could be a bit more aggregated, because we have just that
view.

39
 A first consideration is that it becomes a bit more complex to compare Facebook against the other two
companies because of the different articulations: the first perspective is by function, the other two
companies by nature. If we compare IMA and ENI we can report the relevance of raw materials for ENI
and the different incidence of depreciation cost that is coherent with the structure of the assets that we
discussed before.

- Horizontal common-size analysis issues the amounts in accounts in a specified year as the base,
and subsequent are stated as a percentage of the base value. Useful when
comparing growth of different accounts over time.

4) RECLASSIFICATIONS AND ADJUSTMENTS

The understanding of the sources, the segmental analysis and the common-size analysis are preliminary
operations that we need to perform before starting to work on data. Then when we have achieved an
idea of the key numbers we are dealing with, there is a fourth step that consists in reclassification and
adjustments, two different types of corrections that we could use in our Financial statement schemes.

They are aimed to reorganize financial statement in order to :

- improve the readability of Financial Statement data

- isolate the effects that derive from non-current activities
- underline key financial results
- improve the comparability between different enterprises

reclassifying the FS means that we will just provide the key figures using aggregated numbers in a
different way. These aggregates are supposed to have an higher managerial relevance.

What is object of reclassification and adjustments?

- Balance Sheet
- Income Statement

Balance Sheet reclassification

The Balance Sheet, if we look at the assets they are organized into non current assets and current assets¸if
we look at the liabilities we have equity, non current liabilities and current liabilities. When we reclassify
the BS basically the aggregates that we refer to become :

40
- FC: Fixed Capital
- NWC: Net Working Capital
- NFD: Net Financial Debt

We move from an articulation to another.

FC

The FC basically is almost equivalent to the non current assets, because typically in the fixed capital we
include the items that are included in the non current assets. Sometimes this could depend on the type
of measurement we decide to adopt, we could exclude basically equity investments and deferred tax
from the FC. We have a formula that is most frequently used but we could find also some variations;
this is the most common formula but when we move from a FS scheme as produced based on IAS to
reclassifications, adjustments and then to the calculation of the indicators a certain level of subjectivity
can affect the analysis, meaning that different companies could compute even the same indicators
using a formula that is lightly different. So it is important to understand what is the real formula that is
applied.

NWC

It is the second component and it is in the simplest formula it is given by :

account receivable + inventories account payables

This indicator is related to how the company is being paid considering its core business selling goods or
services. In particular, receivable are money that the company is supposed to receive but in this
moment are frozen because the company can not use them, the same of inventories that are money
frozen because the company has some goods in the warehouse and have to sell them for transforming
them into money. The payables are money that the company should pay to its suppliers. So in the end
if we think to these three components together, they give an idea of the quantity of money that the
company has to have frozen, has to invest in operating capital for being able of doing its business, that
is selling products or services to its clients. It is money that the company has to have available to
sustain its own business.

The working capital cycle is defined as the average time it takes to acquire materials, services and
labour, manufacture the product, sell the product and collect the proceeds from customers.

If we look at the NWC, this measurement gives an idea of the operating liquidity of a company and
represent the amount of the liquidity necessary to run the business during the working capital cycle.

Having an high NWC it is negative because it means that for being able of doing its business, the
company has to keep money frozen as inventories and as account receivable. So it is better to have a
low NWC, it is more efficient because money is available to us.

41
The definition for NWC is:

The last three items can be assimilated in the NWC:

- Deferred tax refer to a fiscal/tax credit or a tax debt, could be assimilated to account payables and
receivable
- Provisions for liabilities, when a company expect that in the next future it will have to pay money
for instance for extraordinary maintenance, for discount policy or something like this; so it could be
assimilated to trade and other payables.

Example: the NWC for Fincantieri

If we look at the trend in 2012 the NWC was negative, then we have a progressive increase till 2016.

We focus our attention on the work in progress, we can see that we have a pic in 2015 of the NWC.

A peculiar issue in this sector is that a large amount of revenues are actually recognized when the ship
is delivered, so we have a relevant increase of the work in progress, that is not balanced/reduced by
the recognition of the revenues because most of them are cognised at the end. So for the company
there is a relevant implication, they have to finance basically their operating cycle, so to find the way of
financing their operating cycle.

If we look to ENI this computation is simplified, there are less line items. It is because in practice there
are different labels and formulas that are used with reference to NWC.

42
It is sometimes calculated as Current assets Current liabilities ( in this case we include in the current
assets also the cash and the financial credits).

NFD

It is basically given by: financial debts- cash and cash equivalents

The idea: I could use the cash that I have available in order to repay part of the debt, so the net debt is
the quota that remains. It is the main indicator of the debt of a company.

Sometimes we could find Net Financial Position, generally computed cash debt.

43
Income statement reclassification

As regards the IS, it can be prepared either by function or by nature and in the two cases we could
highlight different aggregates. When we produce it by function we identify the gross margin, that is
revenues cost of good sold and then we get to the EBIT by deducting the preview cost. In the IS by
nature we have revenues operating cost, that is equal to the EBIT. Another aggregate that could be
found is the value added ; so this is a type of reclassification that moves from the IS prepared by nature
where we first highlight the difference between revenues and raw materials/ components that are then
transformed by the company. This allow a better understanding of the contribution of the company to
the increase in the value of the product it produces.

This aggregate allow us to understand how the company is adding value to our product or service, we
move from raw materials or components and we add value to the product by sustaining conversion
costs ( personal class overheads) and transforming the good in the finish product.

So far we are simply aggregating our BS or IS items in a different way compared to what is required by
the accounting standards. We are not correcting them, we are just reaggregating figures.

ADJUSTMENTS

With adjustments we refer to the computation of some corrections that are applied to key figures
typically of the IS , EBIT, EBITDA, Net Profit or total asset for the BS with the idea that we want to
ance. So when we talk about adjusted EBIT
for instance, we are referring to something that is a non gap measurement, so a measurement that is
not performed based on the requirements of the accounting standards but that according to the
company provides a better understanding of the result of the company itself because it is computed by
correcting the effects of some events that could be unusual, non recurrent for that company. So the
idea is to provide a fair representation of the current situation of the company by correcting some

So the first point is that when we deal with reclassification we deal with a different aggregation of IS or
BS figures. Instead adjustments consist in correcting our items in order to provide a better
representation of the results of the company.

We will see two types of adjustments.

44
We have the assets of our company in three different periods, for each period we have the columns

The difference is explained in this case by a change in the accounting principle, at the end of the year
the modification in the accounting principle has been introduced. The value of some items changed due
to the change in the accounting principles. So the value of other assets computed with the standard
that was in place at the beginning of the year was 700 millions, while the value of other assets
computed following the new standard becomes 886. This situation is quite common, there could be
modifications that are ongoing.

We have also a different kind of adjustment that is related to the computation of adjusted EBIT,
adjusted profit, adjusted EBITDA.

For instance we have costs for

recall, sustained for capacity
realignment, for feature recall
activities. These items are
deemed to be unusual because
the company is expecting not to
have this kind of items again in
the future. They are considering
these items occasional.

45
 They are extraordinary not because of the type of business, because they are closely related but
because of the type of event that generated this item.

When I can say that an event is unusual? Basically I conclude that my adjusted EBIT is higher than my
EBIT. When the adjusted EBIT is reliable?

at our figure from the inside we are able to say if a cost has
been increased due to something that is extraordinary; on the other hand, from an external point of
view there is a problem of truthfulness. In the end we have both the numbers and so we can control for
what the number is been adjusted.

We could compare our results with its competitors because they will prepare similar adjusted
measurements.

A case from ENI, we are making

reference to 2014 and 2015. These years
are interesting to compare basically
because in 2015 the price of the oil
decreased a lot and this had huge impact
on companies operating in the oil sector.

We have an industry trend, the drop in

the oil price, that affected all the
companies. So if we look at the
comparison between EBIT and adjusted
EBIT for the oil companies in these years
we will find in all the companies huge
difference related to an industry phenomenon. However we could also have events that are specific of a
company.

5) BENCHMARKING

if we think to ENI, in 2016 it actually reported an ROE ( net profit over shareholder equity) eqaul to
-2.74%. How can we understand if it is very bad or maybe not so bad?

We need to compare ENI results against its competitors to understand if we are in line with them, if we
are overperfoming or underperforming.

This is useful to identify outlier, data that are anomalous, not coherent with the context.

46
The three companies resulted quite in line for 2013, 2014 but in 2015 we had a drop in the results of
Volkswagen and an increase in the results of General Motors. So this is useful for understanding if our
numbers are good or bad and if there are extraordinary results that maybe can explain a contingent
situation like in the case of Volkswagen.

We have to pay attention to how we select the companies.

We have three brewing companies and one of

soft drinks. Two companies are aligned in terms
of sales and trend, other two companies that
again are quite in line however the type of
business in which the two companies are
competing is not the same. CocaCola is not
comparable to AB Inbev.

Looking the ROE, we could notice a pic in

2013 for AB Inbev. This was due to an
acquisition process and this had a huge
impact on the results of AB Inbev for that
specific year due to some revaluation of
the fair value.

We can still compare our three brewers

using an adjustment, so adjusting the
results of AB Inbev in order to clean up
the extraordinary effect due to the fair value recognition.

So first of all benchmarking is useful for being able to understand the figures we are analysing, are they
good, bad, very bad, in terms of comparison with the competitors. However when we make this
comparison we should select the competitors carefully, we have to address companies that operate in
the same field.

Second point, we need to pay attention to the type of events , are they characteristic of the company
and could influence the comparison? So it is important to identify the extraordinary events and to
adjust them.

47
 There are many definitions of benchmarking, some of them focus on the process dimension, some of
them the selection of companies with whom we want to compare. It is typical to refer to sector players,
meaning that in performing benchmarking analysis
secotr and are comparable in terms of strategies, in term of size. Basically because we want to use
benchmarking as a way to understand the quality of the results that we achieved.

continuous process of measuring its own products, services, practices against the toughest competitors
or those companies recognised as industry leaders

kind of performance improvement process by identifying, understanding and adopting outstanding

practices from within the same organization or from other

process of continuously comparing and measuring an organization against business leaders in the world
to gain information which will help to take actions to improve its performance Productivity and
Quality Center, 1999).

The benchmarking process is articulated into five steps that could change depending on the objective of the
benchmarking process.

In particular the five main steps are:

1) Benchmarking objectives
2) Sample selection
3) Involvement modality
4) Selection of performance
dimensions
5) Data correction

1) Benchmarking objectives

What is the objective?

In general terms we can distinguish two types of benchmarking: benchmarking oriented to

performance and benchmarking oriented to processes.
For the financial analysis we make reference to the first one.

48
 A benchmarking oriented to performance aims to focus on the results of an organization in order to
understand what are possible best practices in connection to that specific performance. In this case we
have to select the performance dimensions that are relevant for our purposes. In the financial analysis we
can decide that we want to focus on marginality, on the profitability of the company because maybe I think
that the company had some problems in the past and I want to understand how to improve that specific
performance. So this orientation is focused on the results of the organization, that could be financial or non
financial performance, and the objective of the company is to identify what are some best practices in
connection to that result.

The process benchmarking instead is not relevant from a financial point of view, in this case we do not
focus on the results but we focus on processes that are implemented by the company in connection to the
logistic area for example. We select some processes relevant from a strategic point of view and then we
make an attempt of analysing how different companies configure and carry out those processes meaning
that we do not look at the final results of the company but at how the activities of the company in a specific
field are carried out.

benchmarked are actually coherent with one another. A second issue quite ctitical is the possibility
of a time lag between the result obtained by a company and its processes. Meaning that when we
look at financial results, we are observing a situation in a specific moment in time, for instance the
third quarter 2017. Results achieved in that quarter actually depends on choices made by the
management one year/six months ago. So current results correspond to choices made in the past
and we have no guarantee that choices made now will lead to same good results in the future. So
we could have a time lag between when the decision is made and when the result is reflected in
the financial figures. So when we select our best practices we cannot be sure that these results are
in line with the choices that are made today, there is a time delay in when the effects of our
financial results become evident.
Looking at the processes on the other hand is more informative from a qualitative point of view,
but it is difficult to understand the linkage between processes as they are configured and
contribution to the final result of the company.

2) Sample selection

In this step we have to decide what are the organizations that we want to use as a benchmark, with whom
we want to compare. There are three alternatives:
- Leader Benchmarking: benchmarking on a specific performance or process
o (performance)when Fincantieri became listed, it benchmarked itself against Boeing ( a totally
different sector) on its quality-focused strategy; they did not refer to any company in the
same sector but they looked at a company in a different sector because that company is well
known for its quality process;
o (process) IBM benchmarked itself against Federal Express on its logistics system because it
was considered the leader in that field.
the point is that companies typically could decide to compete, in particular in term of
processes more than performance, with other companies operating in contexts that are
very distant in order to find inspiration, to find new ideas for process improvement.

- Sector Benchmarking: benchmarking with companies that act within the same industry, usual
when we are performing a financial analysis;
- Internal Benchmarking: benchmarking with different units of the same company.

49
3) Involvement modality

We could have two types of benchmarking:

- The unconscious one, indirect involvement of competitors,

usually performed when we deal with the financial analysis, the one that companies typically tend
to put in place. The company selects the competitors that want to analyse and then it uses public
sources or provided by recognized data base for collecting data. In particular information are
gathered through web sites, publications, magazines, employees, customers and vendors,
suppliers, databases, reverse engineering, balance sheets and other institutional public documents;

- The conscious one, direct involvement of the competitors, which provide the needed information.
It is better in terms of the quality of the information collected but in the same time it requires that
companies are available to disclose and shares their own data. These processes are typically carried
out with a third part that acts as a collector and analyst of the data and then a report is produced in
which the main sector dynamics are highlighted without disclosing the specific information of the
specific company.

4) Selection of performance dimensions

It consists in the:
- definition of the scope: identification of the areas of the company that need to be benchmarked. It
refers to the need to clearly highlighting what is the object of our analysis. Upfront we have to
decide if we want the whole company, a specific segment of the company, what dimensions of that
company/segment we want to benchmark;
- definition of the measurement system: definition of indicators for comparison. We have to clarify
for example that we want to compare ROI that is computed EBIT/invested capital and invested
capital is considered with the value at the endo of the year.

5) Data correction
We need to critically read the results of our analysis and we need to understand if the analysis has
been influenced by some exogenous factors.

The best practices may descend from two different reasons:

- Better management: to be individualize through benchmarking
- Difference in the conditions of the context: to be eliminated to make companies comparable.
Factors influencing context include:
o Scale effect, whereby largest organizations can achieve better results thank to their size
o Strategy, focus on different performances ( efficiency vs effectiveness), if the strategical
objectives are different the results could be different;

50
 o Market expectations and perception
o Product itself in Leader Benchmarking

6) ACCOUNTING BASED INDICATORS

In general terms indicators based on annual reports may be classified on the basis of two axis:
- Measurement principle
- Type of indicator.

The measurement principle consists in Accrual or Cash basis.

Accrual indicators are built based on the figure indicators and are reported in the IS and the BS :
ROI, ROE, etc. They follow the accrual principle and are based on economic measurements,
revenues and costs.

Cash indicators are constructed using cash methods, we will refer to inflows and outflows. They
typically are driven by the cash principle, so when money is paid and when money is received by
the company.

If we think to revenues and costs on the one hand and outflows and inflows on the other hand, the
accrual view is more accurate to allocate costs but we have the possibility to change the numbers
still respecting the accounting principles that are not stringent, so the cash principle is the most
objective measurement because we can not play with money, cash flows are objective. So accrual
indicators are used to have a better understanding of the performance of the company in an
accurate way, but this view is particularly useful from an internal point of view when we have no
interest in making our results better than what they are. On the other hand cash indicators are
more objective for an external reader, since there are no items that could be manipulated.

The second dimension of analysis is the type of indicators and here we distinguish between
absolute indicators and ratio indicators.
Ratio indicators, we combine a measurement of the IS with a measurement of the BS.

have ratio but typically a difference.

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We have three hotels. If we look at the EBIT, and if we compute the return on assets ( EBIT/total assets)
these are the data that we have for the three hotels.

At a group level, ROA= sum of the EBIT/ sum of total assets = (240 + 300 + 600)/ (1000+ 2000+ 3000) =
19%.

If we have a target ROA of 20%, how could we achieve it from a group point of view?

- Selling some assets;

- Reducing costs, introducing some efficiency or some reduction cost programs, meaning that the
EBIT would increase;
- A very easy strategy is selling the second hotel in Chicago, my ROA will pass from 19% to 21%.

Is this positive from a company perspective? Cutting investment is typically not positive, we are
improving the results in the short terms (eliminating the hotel with a lower profitability); however this
could have a negative impact on the long run. Cutting investment aims undermining the ability of my
company to be sustainable in the future.

This specific phenomenon whereby the ROA improves when we reduce the total assets, the
denominator, is called denominator management.

The denominator management is the phenomenon whereby a manager could opportunistically

improve its results by cutting the resources. This phenomenon is associated to ratio indicators due to
how they are constructed, being ratio they are relative.

To avoid these problems, absolute indicators have been introduced.

Residual Income is an accounting measure of net operating income minus the amount for required
return on an accounting measure of investment

Residual Income (RI) = Operating Profit (EBIT) K* Invested capital

where K is the cost of capital of the company.

The components are the same of the ROI but in the case of Residual Income we are referring to an
absolute measurement. What is the effect of using Residual income instead of ROI?

The BU has to decide if assessing an investment.

If we use ROI we would decide to not

accept this investment because the ROI
decreases.

If the incentive is not related to ROI but to

RI ( K= 10%) we would accept the
investment because in term of RI it
improves ( 120- 0.1*500 instead of 100-
0.1*400).

Each time an investment is able to repay its cost, (in this case we have return of 20 with a cost equal to
10), our company reports an increase in the indicator. Indeed the RI is an additive indicator.

52
 How we can insure that the two indicators become coherent? If we compare the ROI of our investment
against its cost it become evident that it is profitable from a RI perception. But ROI does not include in
its formulation the cost of capital !

There are further formulations of absolute indicators, the second one is the Economic Value Added
(EVA):

There is an important difference between EVA and RI; this EBIT and this invested capital are supposed
to be adjusted for correcting the economic and capital figures. So the formula is the same for the RI,
however the EBIT used is an adjusted EBIT, where the adjustments are stated by the measurement
protocol that is defined by the consulting company. The problem is that these corrections are not
public. So this indicator in the end is quite useless.

There are different formulations of EVA, whereby we can find instead of EBIT the NOPAT that is the Net
Operating Profit after taxes so EBIT TAXE RATE* EBIT, we use the EBIT but we isolate the tax effect
associate to that item.

If we think about cash indicators, they could be both ratio or absolute indicators.

Now consider these ratios/cash indicators.

The EM is a cash formulation of ROI, the meaning is what is the cash generated by the investment and this
cash is able to cover the cost associated? We compare the cash generated from the investment against the
cost of capital for making the investment.

53
Cash Flow ROI, a cash measurement for operating cash flows, however the ratio is built making reference
not to the book value but to the market value of the invested capital.

There are also some absolute/cash indicators that are:

- Cash Economic Value Added, financial version of the EVA

- Cash EVA= Cash Flow from operating activities K*I

- Cash Value Added (CVA)

- CVA = Cash Flow from operating activities Cash flow required for operating activities the idea is to
compare cash generation and cash absorption.

Our accounting based indicators perform well in terms of completeness and measurability. They are
typically complete because being synthetic indicators they allow to consider the final effect of many
different transactions. In terms of measurability the only point of attention is represented by the issue of
the formulas, how these indicators are calculated could slightly change.

The stability, if the indicator is constant overtime in term of metrics ,is good because we decide the formula
and we can keep computing the indicator with that formula.

We have problems in connection to long term orientation and timeliness. Long term orientation is bad
basically due to the effect that was the denominator management.

Timeliness is low because for computing these indicators we have to prepare the FS first, meaning that we
have to wait that a phenomenon is reflected in financial terms, a long time passes from the moment when I
take a certain choice that determines my result and when the effect of this result is reflected in my financial
indicators. There is a long delay between decisions and effects.

Specific responsib
applicable.

54
 COST OF CAPITAL
The cost of capital depends on the financial structure of the company that is represented by the way how
the company is financing its activities in term of balancing between equity and debt (equity capital debt).

Typically, the cost of capital is estimated using the formula of the Weighted Average Cost of Capital, it
computes the overall cost of capital as the weighted average between two components that are the cost of
equity and the cost of debt:

Ke= cost of equity; Kd= cost of debt; tc= tax rate

The second component is multiplied by a term that is (1-tc) that represents the tax shield effect (scudo
fiscale). We consider the tax shield effect for the cost of debt and not for the cost of equity. Why?

If we think to how the P&L account is structured we have:

Revenues
Operating costs
EBIT
Financial revenues
Financial interests
EBT

Taxes are computed based on the profit before taxes. The interests ( the cost that the company has to pay
to a bank for the debt) are a cost component that means lower income, lower profit before taxes (lower
EBT).since taxes are a percentage of EBT, this means lower taxes. So in the end the financial interests have
a shield effect meaning that they reduce the income of the company, in our case the income before taxes.
In other words, since we have a debt we have an additional cost, an additional cost means lower income.
But lower income means also lower taxes, because they are based on income. And so, from this point of
view, we have a tax saving.

Instead it is not the same for Ke, because the remuneration for the equity investment is represented by
dividends that have no effects on the P&L account.

COST OF DEBT (Kd)

Kd is the cost of debt for a firm and it represents the interest that a company has to pay to remunerate the
debtholders ( banks, financial institutions) for the risk they take by providing debt capital to the company.
So Kd is a return for debtholders and it is articulated into different components:

rf represents the risk free rate; the credit default spread is associated with the company credit rating.

Risk Free Rate (Rf)

rf is first of all a theoretical concept because it represents the remuneration that is expected by an investor
for an investment that is totally risk free; in reality no investment is totally risk free.

So rf is the theoretical return on an investment with no risk.

Can we use a proxy? As a proxy we use the return on government bonds since they are (generally) less risky
than corporate bonds e difficult that a government fails;

55
When we select the interest that we are using for determining our risk free rate, and so when we select
the return that we are using, we have to take into consideration two factors.

- The first factor is the geographical area in which a company is selling its product.

If we are considering an European company we typically use the 10 Y German Bund as a proxy of the
risk free rate; if we are considering an American company we consider the American Government
Treasury bond a s a reference. In developing country, it depends on the level of maturity of the
economy.

- The second factor is the time horizon because if we are considering investments on a five year
o a 5 year government bonds.

We should verify the coherence of the time horizon of our investment and the measurement that Is
used as a reference, that is our government bond.

On Bloomberg we can find the daily values of different types of bonds for different countries.

We can see that in Europe, German bones are those that have attached a lower return. What about the
other countries? The yield on US 10Y treasury bonds is about 2.3%, the yield on India 10Y treasury
bond is around 6.6%, on Brazil is around 9.7% .

We can see that different countries have a return associated to government bones that is variable and
depends on the level of the risk of each country. If we look at Japan we have a very very low return,
however this is a country that has a huge public debt which would lead to an expectation of an high
return. However, most of the debt is hold by Japanese and so it is perceived as a low risk bond.

It is important to identify the right rate to be used in this analysis, the risk of the company is influenced
also by the context in which the company competes. In this way our risk free rate incorporates also the
information about the level of risk of the country where the company works. This could influence
significantly the performance of the company itself. So this is the reason why when we define the risk
free we make reference to the geographical area in which the company or business units of the
company are competing.

Credit Default Spread

The second component of the cost of debt is the credit default spread, an additional premium
represented as a percentage that incorporates the information about the default probability of the
company. So it is an indicator of the default probability of the company. Higher is the default
probability higher is the credit default spread. ( the idea is the higher the risk the higher the
remuneration for debtholders)

56
The credit default spread is estimated through rating systems/ models.

A rating system is a statistical model that allows a bank or a financial institution to assess the default
probability of failure of a company that is asking for a loan based on the financial historical data
(revenues, marginality, etc.) of the company itself. These models are typically regression models and
the historical data of the analysed company refer to revenues, clients, marginality, so generally
financial data.

More recently banks introduced some qualitative factors, such as the type of relationship that a
company has with the stakeholders, but this is a recent evolution.

the rating model development methodology can vary from the expert-judgement-based to the
statistically-developed, depending on factors such as:

- Data availability
- Default history
- Data integrity
- Ease of data storage and retrieval

Rating models have an output like this here we can see

a Finmeccanica company in the sector of helicopter.

So, the output is an evaluation of the default

probability of the company that we are analysing. Then
based on this evaluation, there will be the identification
of an additional cost that is to be applied to that
specific company.

What happens to Leonardo rating from 2013 to 2017? They had a Baa3 rating in 2012 and 2013 that is
not very safe, however it is considered quite safe. If we look at the evolution overtime in 2013 in
February the evaluation was Baa2 in September it was downgraded to Ba1. This means that the
company was evaluated as a speculative investment, so with higher risks.

We can see that between 2012 and 2013 we had two main dynamics:

- The first one is that there is a worsening of the EBIT which decreases and of the debt which
increases;
- at
ended up with a change in the structure because the company involved in the scan became a
division of Finmeccanica and then in 2017 became Leonardo. The reaction of the rating agency was
immediate, we had a downgrade of the rating of the company partly explained by the worsening of
the financial results partly explained by the scandal. This rating is then associated to the credit
default spread that is the cost in percental terms that has to be recognized by the company to the
debtholders depending on the rating of the company.
-

57
 In this picture we can see an analysis that has
been carried out in 2017 on US companies in
which we can see in correspondence to
different level of rating the cost of the credit
default spread.
So based on the rating system, we have an
evaluation of the default probability of the
company that is measured by the rating itself
depending on the scale that each agency uses.

This rating is then associated to a different

credit default spread, that is the cost that has
been recognized by the company to the
debtholders.

COST OF EQUITY (Ke)

Ke is the cost of equity capital of a firm. It represents the interest that the company pays to its
shareholders to remunerate them for the risk they take by providing equity capital to the company and
so for investing in the company and not in alternative investments.

Ke is the minimum expected return for shareholders.

We can estimate Ke using the CAPM (Capital Asset Pricing Model) method, represented by this formula

- rf= risk-free rate

- BL= beta levered (equity beta)
- rm= market return
- (rm-rf)= market premium

What is the meaning of this formula? We already know the risk- free rate (again we use the return on
government bones as a proxy). All together the second term is the equivalent of the credit default
spread for the shareholders, meaning that this term represents the extra-remuneration (exceeding the
risk free rate) that a company should recognize to its shareholders due to the fact that they decided to
invest in that company.

Market Return (Rm)

rm is the return on theoretical market portfolio which contains all the stocks/shares traded in a certain
market.

rm is the average return guaranteed if a player invests in a financial market

Even in this case we can use some proxies because different markets are characterized by different
indexes to whom we can refer.

We use market indexes which are representative of the market in which the company operates

58
Then we have to consider that not all the companies that are listed in a certain market are characterized by
the same level of risk; for instance Leonardo has a different level of risk if compared to ENI, Edison or Fiat.
Instead the rm is the same for the market because it refers to the return of an ideal portfolio that includes
all the companies that are listed in that market. In order to understand the risk exposure related to each
company we have to refer to the other term that is Beta.

Beta

measures how volatile/variable is the firm stock (a share) if compared to the overall market
movements.

It is typically estimated based on historical series.

- > 1 means that the stock is more volatile than the market (i.e. aggressive)
- =1 means that the stock is as volatile as the market
- <1 means that the stock is less volatile than the market (i.e. defensive)

CASE ANDROMEDA

How we can determine the WACC?

We have to consider our levered structure.

The
company has a debt of 700 milion.

Kd= 700/(700+350) (1-0.35)*(0.075)

Ke= 350/(700+350)*0.078 + 1.2*(0.15-

0.078)

The result is 9.2%

0.078 is the risk free rate associated to

German bones

is computed in reference to listed companies because for listed companies we can easily understand
how volatile is the share compared to the market because they are characterized by a share price. This is
not true for not listed companies because there is not an active market that works as for listed companies.

So, for listed companies we can easily identify through an analysis of the historical series, so we look at
past performance and we determine the comparing the return of that specific share to the return of
market where the share is listed.

and we cannot refer to an active market in order to determine our . In this case we use the unlevered
, which is a measure of the volatility of the underline business, meaning that it allows to isolate the
contribution to the risk exposure of a company deriving from its business and the capital structure.

59
To sum up:

o measures how volatile is a stock if compared to the overall market movements

-
- also known as equity beta
o measures how volatile is the underlying business, capital
structure
- It depends on the industry/business of a firm but not on the capital structure of the firm
- Also known as asset beta

- In case of a listed company:

o It can be computed through a regression of the stock returns against the market returns
- In case of an unlisted company:
o We cannot use the regression since the company does not have listed stocks;
o In this case, we have to make reference to the unlevered beta (a measurement of the volatility of
that can be delivered using two
methods:
Comparable companies
Beta industry

HAMADA SIMPLIFIED EQUATION

The relationship between levered and unlevered is given by Hamada equation.

Hamada equation shows the effect of debt or financial leverage on the risk coefficient of the firm.

It is used to separate the financial risk of a firm from its business risk. This is an indicator of the capital
structure of the company and it states that the relationship between and is given by this formula
where the is multiplied by a coefficient that allows to consider the in order to incorporate the
effects deriving from the capital structure of the company.

This equation is very useful because when we are dealing with an unlisted company for whom we have no
historical series, we can estimate making reference to this unlevered .

60
We have two options:

- We identify some comparable listed companies and we then derive the for our company
based on a comparison with these listed companies;
- We refer to industry .

1) In the first case we select companies that

are comparable with our company but that
are listed because we need to know their
(the volatility of these comparable companies
against the market). Then we unlevered the
of our comparable companies using the
Hamada equation for each of them. Then we
compute the average beta and simply
we can apply using Hamada equation the
capital structure of our company in order to
obtain the beta levered for our company.

2) an alternative is the use of sector

beta. In this case we simply move from the
last step, so we determine the of our
target company as the beta of industry and
we apply to this data the capital structure of
our company.
It is much more better to identify some
comparable companies because the sector
could be very heterogeneous and this
approach is less precise. If it is not possible
we use the industry beta.

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62
 BUDGETING AND FORECASTING

PROSPECTIVE FINANCIAL INFORMATION

In order to assess the enterprise values, we have to rely on prospective financial information (PFI), that is
defined as information that is based upon assumption about future events and the actions that may be
taken by the company. So, when we deal with PFI we deal with estimations based on assumptions, so these
estimations are valid as far as the assumptions on which they rely are valid.

There are three key terms useful when we deal with PFI:

- Planning (Strategic Planning and Medium-range Planning): Top-down plans (processes) that
involves the chief executive or the top management which defines the strategic aims (long term
goals) of the enterprise and high-level activities to achieve the goals of the organization;
- Budgeting: it refers to a yearly plan that enables targets set across the entire organisation and
resource allocation to be aligned to strategic goals. We are moving from a long time horizon to a
shorter time horizon in which we have a different involvement of different organizational units. So
the top management is still involved but the budgeting involves also managers at the operational
level. This process includes not only top-down but also bottom-up phases, meaning that data are
collected from different organizational units;
- Forecasting: it is a process aiming at defining some projections that represent estimations about
how the company will perform in the next future in order to provide managers timely information
that can be made to address shortfalls against targets, or maximise emerging opportunities.

63
BUDGETING

Budgeting is a set of coordinated procedures and activities with two main objectives:

- Formulating a plan of where the organization is expected to be (in terms of accruals and cash flows)
and what it needs to reach its objectives;
- Assigning to organizational units targets i.e. reference values for their
performances- and resources needed to achieve these results.

Then the level of involvement of different organizational units is one key

issue that characterize the budgeting process, the way how different
managers of different organizational units of different functions are involved could be very different.
We could have processes very top-down: at the top level the objectives are defined, they are passed to
the operational functions and there is no negotiation, or very limit, between the operational functions
and the top management. Or we could have processes in which the operational functions make
proposal for the objectives, and then these objectives are consolidated at the top level and made
coherent with the top level. Or in most organizations we have something that is between, we have the
definition of the strategic objectives, then they are deployed at the operational level and then there are
some cycles, meaning that there are negotiations in which the operational unit proposes a target that is
revised by the top management and so on.

It is important that the way how the operational units are involved in this process has to be coherent
with the level of delegation that characterize an organization. If there is an high level of delegation, the
processes should be very interactive.

A key feature in budgeting is the role of people involved in the process:

- Managers responsible for organizational units

- Other employees working within organizational unit affected by target
setting
- Accounting and finance functions supporting the process

When we move from the FS to the budgeting process, we

rules of this process. And also, the level of customization and differentiation of budgeting process is

because the characteristics of this process depend on the managerial style of the management, the

that will lead to the preparation of this document could be very different from company to company.

64
FORECASTING

Forecasts

Rolling forecasts are the same concept but reset expectations for some predefined future period, usually
12 to 18 months.

MASTER BUDGET

The instrument that is used, from an operational point of view, to support the budgeting process and build
a prospective P&L account, CF statement and balance sheet is called master budget. So, the master budget
at the end lead to a prospective scheme of the FS.

Master Budget is an integrated approach used to estimate next year flows and produce prospective
financial statements.

Master Budget encompasses (include) three main categories of budgets:

- Operating budgets, which define the economic flows of raw materials, components, finished
products, services
- Capital expenditure budgets, which define the use of financial and human resources for medium
and long-term period
- Financial budgets, which evaluate the impact of operating and investment plans on cash inflows
and outflows

When we deal with the Master Budget we move from the strategic objectives of the company, that are
then deployed in the operational budgets. The operational budgets lead to a preparation of the
prospective income statement; in particular they allow the estimation of revenues and operational
costs. Then these operational budgets are related to other budgets that are the capital expenditure
budget and the financial budgets. The capital expenditure budgets are budgets that represent the cash
flows associated to investment activities , also called CAPEX budgets: the cash flows that the company
will have to pay to be able to make the investment that has been approved in the current year or in
previous years. There is this linkage because depending on the level of operation we could have an
impact on investments.

The second linkage is between the operational budget and the cash flow budget, because in the
operation budget we are dealing with revenues and costs but we have to verify their effect in terms of
operation. So the cash budget makes an analysis of the cash flow of a company for operating, investing
and financing activities.

65
 These documents are then used to prepare:

- Budgeted Income Statement

- Budgeted Balance Sheet
- Budgeted Cash Flow Statement

ONE SIZE DOES NOT FITS ALL

The major decision variables on which a company can customize the process are:

- Planning horizon: longest period of time for which formal plans are prepared
(in general 1 year);
- Articulation of the plans: if we look at the format of the budget for
a manufacturing company (a lot of emphasis in operating costs) it is very OUTPUT
different from a service company;
- Contents of plans
o Aggregation of the information: for some companies it could change
a lot the level of aggregation;
o Quantitative versus qualitative: no all the companies prepare a budget that is based only
on quantitative figures.

- Articulation and timing of the process: who rules the process, the timing of
- the process can change very much
- Plan updates: one choice could be I prepare budget and

I understand that the forecasts are not in line with the expectations PROCESS
at the beginning of the year and I can update the budget, so this is a rolling budget;
- Planning guidance provided : this is a process that requires the involvement
of different organizational units. Different organizational managers
have to make their estimates. We could provide them some guidelines for the
estimations or not.

66
MANUFACTURING ORGANIZATIONS

RETAIL ORGANIZATIONS

The articulation of the budget is very different because

phases is replaced by the purchases budget. So the format of

the budget changes depending on the core activities of the
company (this is not true for the FS).

SERVICE ORGANIZATIONS

In this case we typically have the

service reserve budget and then the
labour budget, the services overhead
budget and selling and administrative
expense budget. So in this case we
activities but
the core activities are represented in
the service revenue budget and
labour budget.

So the green part of the scheme

could change a lot depending on the
business in which the company
operates.

67
 t framework for the preparation of the budget, because it

move from the operating budgets.

OPERATING BUDGETS

The operating budgets focus on revenues and operating costs and the output of this budget is the
preparation of a prospective income statement till the EBIT (= revenues operating costs).

This is the articulation by function, but we can use also the articulation by nature.

The operating budgets include budgets for:

REVENUES BUDGET

Strong link with objectives and strategies

1) Revenues Budget

It is usually the first budget that is prepared. Depending on the sale budget all the other budget are
prepared, so mistakes are a problem. The revenues budget gives an estimation of the level of sales in
terms of quantities and price.

Revenues budget in then articulated by:

- Product lines
- Geographical area
- Clients
-
depending on the business of the company.

There is a strong linkage between the sale budget and the strategy, because the sale budget
determines the penetration, the market share, the level of revenues. So, it is very critical since it is
related to the strategical objectives of the company and if I make an error with this budget, this error
has a negative impact on all the other budgets.

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For preparing the sale budget we generally make an intensive use of marketing instruments (survey,
.

The level of revenues takes into account many different factors:

- Macroeconomic factors
- New product plans
- Number of units sold in prior periods
- Pricing policies
- Credit policies and collection policies
-

Example: AFC CASE Budgeting year 2018

We see in a very simplified context how the schemes that we analysed in theory are then applied in a
case. We have a company that has just one product and all the data has been voluntarily reduced. In
our case the Revenues Budget is very simple because the company manufactures only one type of
product and the estimations for the sales are reported in a) where we have volume of sales 1000 units
(defined by Sales Manager) and the price/unit

2) Production Budget

Once we have defined the sales budget, we have to determine the amount of products that the
company has to manufacture. This is the only budget that is expressed in physical terms, in unit (all the
other budgets are expressed in monetary terms.).

With this budget we have to make an estimation of the total finished goods to be produced
considering two information:

The first one is represented by the level of sales that is derived from our revenues budget;
The second one is the level of inventories, because on the one hand there could be some units
and on the other hand we need to
consider if the company wants to increase or decrease the level of inventories.

So the budgeted production is given by:

I have to verify if the production capacity that is

available is enough for fulfilling the production
budget. In case of missing production capacity
we need to find a solution. A solution could be:
- outsourcing part of our production buying
from suppliers part of the products that we
need to produce; outsourcing is a short-term
strategy, or it could be also a long-term
strategy if I develop a partnership with the
suppliers;
- we could invest in new machines increasing the capacity; the investments (extension of the
capacity) has a long-term impact, this solution must be double-checked with our strategic
objectives;
- we could reduce sales; reducing sales is a risky option because I am self-limiting my market share,
it could be done in the short-term but has relevant implication from a strategic point of view;

69
- We could modify the inventory policy; modifying inventory policy again is a short-term strategy
because this solution could be implemented for solving a contingent problem;
- An option could be understanding if we can temporary increase our production capacity for
instance postponing some maintenance interventions if they occupy the machines, introducing
some extraordinary work for a short period of time.

So as we can notice, these solutions have an impact on a different time horizon.

AFC CASE

As for the resources, we should consider machine hours, labour, materials. However, we know that
just one resource is critical because the scale of production cannot be increased in the short-term. We
have no constraints in connection with labour or with materials. So our capacity analysis will be focused
on machine hours.

How many units should we manufacture in

2018? 1050 because the target level of sales
is 1000 and we have to consider also the
variation in inventories. Finished good have
to be increased by 50 units compared to the
end of 2017, the level of inventories was 75
at 31/12/2017 and we have to produce
1050 units.

Now we have to compare the capacity in terms of machine hours needed to produce 1050 units against

hours/year but 150 hours/year are

used for maintenance activities. So
the available capacity is 2850
hours/year. The required capacity can
be as 1050 unit * 3 hours= 3150
hours, so the capacity that is needed
is not enough compared to the
available capacity.

In this case adjusting the budget means reducing sales. The capacity is difficult to be adjusted and if we
make all the estimations focusing on this first step that in the end indicates that there is a problem, we

70
 influence on all the costs of the company and all its cash flows.

One of the key point of the budget is that this process is useful for aligning the financials with the
operationals.so the idea of the budgeting process is to ensure that the operations are coherent with
the financial figures.

If we compare the price that is applied by the suppliers, that is a variable cost, against the price applied
by the company, we have the marginality since primary variable cost is higher than 0, it would be
convenient to rely on the suppliers. The other options in this case are not profitable because we cannot
decrease the level of inventories, for decreasing sales we have to reduce the market share, decreasing
maintenance could be dangerous.

So, the remaining 100 units will be purchased by the suppliers.

Now we move from the production budget and translate this production budget into monetary value. We
have to prepare a production cost budget, so we have to determine costs associated to that production plan.

OPERATING COSTS BUDGET

This budget comprises all the resources used in manufacturing a product (or delivering a service):

- Direct material usage budget

- Direct labour budget
- Manufacturing overhead budget
- Direct material purchase budget
- Ending inventories budget

So our production cost budget is the translation in monetary terms of the production plan, considering
different cost items.

Once defined the previous documents we can draft the Budget of the Cost of Sales.

Adding the Budgeted Period Costs, we obtain:

- Operating cost (total product costs + period costs)

- Operating Profit/EBIT

We move from raw materials. In a P&L account we have two components as for raw materials: the raw

the Direct Material Usage Budget and then w

in the P&L account.

- Direct Material Usage Budget

In this budget we find different materials and

components in terms of quantities and prices.

71
 The cost budget is obtained multiplying units per price/cost. To prepare this budget we need
information taken from different data.

AFC CASE

In this case our raw material is reported in the b) table where we have consumption of one component.
For producing one unit of product we need 6 kg/units of raw materials. What is our Direct Material Usage
Budget? We have to consider the number of units to be produced internally. According to the production
ng the

In this case we have that we expect an increase in the level of inventories of raw materials of +5%. So, we
e to buy 50kg during this year (because at the end
we want an increase). If we look at the price of raw materials that is

So, one question in preparing this budget is how the usage of raw materials should be evaluated, what price

t know what value should I

value these raw materials. What I know is that if I buy some raw materials during 2018, I will pay them
do two different things.

1) Of these 5700kg, I could value

an inventory
2) I could decide that the units used during this period for producing my 950 units of final products are
bought during 2017 meaning that all

This choice is a relevant choice and depends on the inventory policy. In particular in this case we say that

already an inventory.

The FIFO a
this case I should use the 1000kg I had as an inventory and then, only when I finish the inventories, I use
the materials bought during 2018 and the inventories that will be left at the end of the period will be
constituted by new raw materials.

This evaluation has an implication on the operating costs, because we are determining the cost of
materials used based on an assumption and this has an enormous impact also on the value of inventory.
In the end my EBIT and the value of inventory will be determined by this choice.

In this case

72
- Direct Manufacturing Labour Budget

This budget identifies the needed manufacturing labour hours. The direct labour is a variable cost.

These costs depend on wage rates.

This representation has to be cross-

checked with the total amount of the
salaries.

AFC CASE

We have a consumption of 2 hours/unit of direct

labour and our employees are paid on an hourly

manufacturing labour is 2 * 8 * 950.

- Manufacturing Overhead Budget

It is necessary distinguishing between:

- Variable overhead: they fluctuate in proportion to the quantity produced

- Fixed overhead: they remain constant over a relevant range of output

For variable overhead: usage per unit

usage budget.

For fixed overhead, analysis of components, a list of all the relevant cost items:

- Depreciation
- Insurance
- Plant supervision
-

AFC CASE

The amount of variable overheads is

the number of machine hours and multiply them

by the cost), fixed overheads include equipment
depreciation, supervisor and other costs.

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- Direct Material Purchase Budget

What is the cost of a unit that is manufactured internally, based on the data we had so far? Raw
materials, labour and overheads (the total cost of good manufactured) over the number of units give us
the cost of one unit produced internally.

Once we have determined the cost of manufactured nits we have to determine the purchase budget.

we want to increase the level of the

inventory.

add target ending inventory and we have

the total requirement, minus the
beginning level of inventory.

AFC CASE

The production usage is 5700kg, but

we want in the end 1050kg, so the
total requirement is 6750kg. at the

purchase 5750kg. So our purchase

budget will be higher compared to
the direct material usage budget
(11500 instead of 11400 because
1000kg of raw materials are stored
as an inventory).

74
 3) Budget Of The Cost Of Sales

One point in the analysis is what should we do in

connection to the units that we buy from the
suppliers, are we considering them as final
inventory at the end of the year or are we using
them and we sell them during 2018? This has an
impact on the cost of good sold and on the level
of invento sell the 100
units that we buy from the suppliers.

We have to consider the cost of direct material

used, of direct manufacturing labour, of
manufacturing overhead. And this gives us the
cost of good manufactured (produced in period). Part of the finished goods have to be purchased by an
external supplier. So first we have to determine the cost of goods available for sale, given by the sum of
what I produce internally and what I purchased from a supplier, plus the beginning level of inventory.

Cost of goods available for sale ending finished goods inventory gives us the cost of sales.

AFC CASE

The cost of sales is given by 900 units

that are manufactured internally at
38

cost of sales is
achieve this number simply
remembering these figures following
the scheme when there are different
types of products.

Now we are ready to prepare our IS in the very first part: budgeted revenues- budgeted cost of sales=gross
margin (margine lordo industriale). To have the EBIT we have to consider period costs.

4) Budget Of Period Costs

Period costs include 3 important categories of costs:

- Selling and marketing expenses (Marketing budget and division between fixed and variable costs)
- Administrative and general expenses
- Research and development expenses

75
The definition of this budget has become crucial:

- High incidence
- Difficult relation with organisation output

There are different ways for calculating the budgeted period costs:

- Incremental Approach
- Zero Based Budget

They differ in terms of:

- Cost
- Time
- Precision

- Incremental Approach

The budgeted period costs (PC) are calculated on the previous year value

is a coefficient which takes into account:

- Inflation dynamics
- The , that is typically represented as level of sales.

The equation implies a linear proportional relatioship between period costs and activity level

- Occasional expenses

An high disadvantage is the amplification of errors, if I made a mistake in the estimation of one year
budget this mistake is repeated in the following years and also amplified by the

The main advantage of the method is the low cost of implementation.

How can we estimate the ing it? For estimating it, the
inflation rate is given by entities like statistical offices in each country , so we have some projections, as
regards the level of activities we use the level of sales of 2018 minus actual sales of 2017.

Zero Based Budget

This is an approach much more precise but also much more expensive. The Budgeted Period Costs are
.

Each organisational unit has to :

- Define the minimum set of resources required for running the unit, necessary for the unit for
surviving;
- and assigning a budget to each project.

This project is expensive in terms of time but there is also a negoziation because each people of
function will try to promote his/her own project. So there is a negotiation between those that decide
the budget and the head of the function that will try to get more resources for implementing their

76
project. This approach is more precise because every cost line has to be justified. The solution that is
often put in place by company is using for one year zero based budget and then using for three/four
years the incremental approach then I use again the zero based budget in order to avoid the
amplification of errors, keeping under control the period costs identifying huge errors.

The main disadvantages are the costs and time of implementation.

Typically at this point we start a further

evaluation, negotiation for
understanding if our target is or not
mandatory, if it is or not feasible. If it is
mandatory but is is not feasible is a
problem because it means that when
we defined that target we used
assumptions that were not valid,
optimistic or whatever.

There is a second checkpoint, based on

which we have to decide if we should go
on with the other budgets or if we
should revise all our operating budgets. This decision is based on the mandatory measure of this target
but also on the implications of the assumptions on which that target has been set.

Then we go on with the other budgets.

77
THE CAPITAL EXPENDITURES BUDGET

It is a budget that provides a representation of the cash flows (no costs) the company is using for
investing activities.

Outilines amount and timing of anticipated capital expenditures

We could invest, for instance in:

- Buying equipment
- Building a new store
- Purchasing and insatlling a materials handling system

Typically we have an investor plan for investments in tangible assets, in intangible assets and in human
resources. In this budget we distinguish the investments based on the approval process, since a capital
expenditure has a long-term impact should be approved by the CEO. In the same year we could have
an investment that has been approved in the past, investments that are undergoing this approval
process and investments planned but that are not yet been formally evaluated, so they are long-term
investments. These investments in connection with their position in the approval process, will be
classified in approved in past years, approved in the year and waiting for approval.

are 100% sure and items that are waiting

for approval or that a manager started to
evaluate and so that could be quite
certain or totally uncertain.

With this budget I want to understand

the effect in term of cash flaws of
different investments.

consider the investments that are waiting

for approval.

FINANCIAL BUDGETS

This is the last type of budget. Financial budgets could be prepared following two different schemes,
perspectives.

The first one is the accounting perspective and reflects the way how cash flows are represented in the
cash flow statement, where we find cash flows divided in operating activities, investing activities and
financing activities.

78
 The second one is the finance perspective. At the end the two perspectives should match. We focus on
the second perspective because it is very often use when a company aims to communicate to
debtholders or shareholders its ability to generate cash.

Profits And Cash

Profit is important and it is the reason businesses exist but:

- Profitable companies go broke because they had all their

- Businesses without cash die.

Cash flows

Cash flows can be retrieved following two perspectives:

- Cash flow can be classified in terms of the activities from which they stem:
o Operating activity Accounting
o Investment activity perspective
o Financing activity

- Cash flows can be classified in terms of the financiers to which they are available:
Finance
o FCFF (Free Cash Flows To Firm) available to both debt holders and shareholders
perspective
o FCFE (Free Cash Flows To Equity) available to shareholders

Accounting perspective

Cash is necessary to:

- Run the day to day business:

o Paying the suppliers (cash outflow) Cash flow from
o Getting paid by clients (cash inflow) operations
- Do investments: Cash flow from
o Purchase new assets (cash outflow) investing activities
o Sell assets (cash inflow)
- Pay back debt, remunerate shareholders:
Cash flow from
o Debt repayment (cash outflow)
financing activities
o Dividends for shareholders (cash outflow)

There are two logics used to assess cash flows

Direct method, where cash inflows and outflows are classified by nature
Indirect method, where cash inflows and outflows are initially derived by adjusting net profit for
the effects of non-cash transactions (e.g. depreciations)

79
 Finance perspective

The company will use some money

for making activities for good,
services and it will generate thanks
to projects and activities some cash
flows. All the flows that happen
between the company and the
clients, suppliers, the State because
of taxes, are included in a first
aggregate that is called Free Cash
Flow to Firm.

FCFF represent the amount of money that a company generates thank to its projects and activities,
thanks to the selling of its products and services, and this amount of money will be available for
repaying those that invest in the company (shareholders and debtholders).
When we move from to FCFF, to understand the financial structure of our organization, we
introduce the Free Cash Flow to Equity (FCFE) considering the amount of cash that is left as
potentially available for the shareholders.
In the FCFF we consider all the cash that is absorbed or generated with the operating activities of
the company. Then we know that shareholders own a residual arrive, meaning that we have first to
remunerate debtholders. Isolating that component we get the money available for paying
shareholders, the FCFE.

- Free cash flow to firm (FCFF):

o The amount of cash that is generated for the firm, after expenses, taxes, investments and
change in networking capital
o Cash available for both shareholders and debtholders
o Asset-side approach: we are looking at resources used for generating value.

- Free cash flow to equity (FCFE):

o The amount of cash that can be paid to the equity shareholders of the company after all
expenses, reinvestment and debt repayment
o Only shareholders are taken as reference (to be remunerated)
o Equity-side approach: we are focusing our attention on what remains at the end for
remunerating our shareholders.

80
How can we determine FCFF and FCFE?

FCFF
We use something that is very similar to indirect approach in the accounting perspective. We move
from an economic value that is the EBIT (or operating profit) and we correct this operating value for
considering the fact that some costs are not cash costs (depreciation) and similarly revenues and
some costs could be characterized by a delay in terms of when the company receive or pay money.

Taxes
We move from determining our interest

correction, different from the accounting

to take out the taxes that the company has

to pay due to operating activities. We are
not used to see this split in connection
with taxes.
We move from the EBIT and we take out
not all the taxes the company has to pay,
but just a quota of those taxes. We
estimate these taxes as: tax rate * EBIT.

Tax rate is computed as: taxes/EBT.

As a second step we have to re-add

depreciation and amortization, since

A third correction is to consider the effect

of the variation of the Net working capital.
An increase in account receivable implies
a reduction of cash available to company,
same also for the inventories. An increase
of accounting payable instead means an
increase in cash available for the
company. If we reduce the NWC we are
making more cash available to the
company.

81
 So if the variation is positive we have a negative effect, if it is negative we have a positive effect.

Account Receivable:

o Money owed by customers to the company in exchange for goods or services that have
been delivered or used, but not yet paid for;
o Therefore, Ars are money that the company will receive in the future but they are not yet
cash inflow.

Account Payable:

o Money owed by the company to the suppliers in exchange for goods or services that have
been delivered or used, but not yet paid for.
o Therefore, Aps are money that the company will have to pay in the future but they are not
yet cash outflows.

The last component of FCFF is

the variation in CAPEX,

with the accounting

perspective.

FCFE

So we move from the FCFF and we add the

cash flows related to financing activities net of
tax effect, since the financial revenue has a
fiscal effect because it has a positive
contribution to the income of the company.
If we consider financial revenues the tax effect
is negative, if we consider interests, that are a
cost, we have lower EBT which means lower
taxes.
Then we consider the variation in debt and
two further items. These two items are still
financing activities but they are different
because we are considering increase in the
share capital (which means that the company is receiving money from the shareholders)
)minus the decrease in the share capital, that is associated to buy-back activities, and we

82
 also consider cash flows related to dividends (money that the company pays to
shareholders). So in the end the FCFE included also these terms even if in the beginning we
said that it is the money available for repaying the shareholders. But we said potentially
available; dividends have been partly remunerated, and they are taken from the
shareholders rights, so the capital is reduced by the dividends since when we distribute
them we cannot see them anymore in equity and liabilities. So FCFE is what remains for
remunerating the shareholders after having repaid any other financial rights. This is a
relevant point about the estimation of the economic value.

THE FINANCIAL BUDGETS

The basic document is the cash budget, which aims at evaluating the budgeted inflows and the outflows of
the organization

A cash budget is a projection over a period of time (typically one year) of:

- Cash receipts
- Cash payments.

There could be a further cash budget, which looks at smaller periods within the budgeting period
(detailed cash budget).

DETAILED CASH BUDGET

The cash flow statement does not highlight the situation of sub-periods across the year:

- E.g.: cash inflows concentrated at the year end

- Problem of liquidity at the beginning of the year

We can define a different cash budget detailing the situation throughout the year:

- E.g.: monthly

The typical framework is constituted by:

- Inflow statement
- Outflow statement
- Synthesis scheme

83
 On the one hand we have all the
inflows (operating, investing and
financing ) and we compare them
with the outflows that are
aggregated in the same way.

Then we add the total inflows to

the opening level of cash and we
obtain the total available cash in
the period. Then we take out the
outflows and we obtain the first
cash balance. Then we consider
the minimum level of cash
required, some company could
have an internal policy that require
them to keep a minimum amount
of cash to avoid the possibility to have a cash unbalance. The cash balance is compared with the
opening debt position that is the usage of these credit lines (fido bancario). Then since I have a
positive cash balance I first repay the interest related to the credit line and then I repay part of the
credit line. In this example the interest related to the credit line is 30, I have a cash balance that is
55 and I will use part of this cash balance for paying the interest of the credit line and I will use the
remaining 25 for repaying part of the usage of the credit line, because when we use money that are
lend by a bank we pay an interest. Credit line and minimum level of cash required are two ways
that a company uses for avoiding liquidity problems (liquidity unbalance) in the short term.

84
AFC CASE

The tax effect associated to the erning for interest

We know the amount of depreciation by the test.

Then we have to determine the variation in

inventories, account payables and account
receivables. We have increase in the level of
invenotries which means a cash reduction that is
equivalent to a cash outflow.

We have to consider the average collection period

for receivable and payable. The level of payable is
available among liabilities and level of payable is
available among the assets of the BS at the end of
2017. This is the start situation.

There is a delay of 3 months related to when the

products are sold to clients and when the company
receives the money, so 17500 corresponds to sales
of the last three months. For the payable is the
other way round. Since we are increasing the level
of payable we are delaying a cash outflow, so from
a cash point of view this is a positive contribution.

85
The final balance is 1770, an increase in the NWC so a cash outflow.

Then we have to consider the investment

strategy which is represented in the
CAPEX variation. As for the investment in
equipment, we are not considering the
whole investment but just the financial
flow that is half of the value of the
investment. We have to consider the
depreciation quota that is not relevant in
connection to CAPEX which focuses on
financial flows.

We have to understand if any strategy could be

put in place in order to reduce this negative
result. Possible strategies could include:

- a revision of the investment plan,

something very critical and strategical that is a
solution assessed only after the compiltation of
all the budgets;
- we could change our NWC strategy,
reducing the collection time for receivalbe or
increasing the payment time for payable;
- we could analyze the second part of our Cash Flow statement that includes the financial strategy in
terms of debt and interest related to debt.

This is a picture of the current situation, these are the

data that will enter the FCFE calculation. We have
financial revenues equal to 600 but also dividends that
we have to pay and also the repayment of debt. As for
financial expenses, we know that on 1st May 2018 bonds
d together with the relative
coupons (the interests of the bonds), me
have to pay the interest rate associated to the first 4

during the year and they amount to the 50% of the bond value.

We take the value of the bonds from the liabilities, and it is 400. Half of the bonds are repaid on the 1st
May 2018 (100) with the related interest/coupon.
rate of 15% that will have to be paid by the end of the year. 15%*2000= 300. So the overall interests
paid on bonds will be 100+300=400.

Then there is another debt whose value is 8000 (from equity and liabilities) and the interest rate of the
bank loan is 10%, 10%*8000=800 that is the interest related to the loan.

86
 For computing the FCFE we must
consider also the tax effect, meaning

however a cost for a P&L account

means also lower earning before taxes
meaning a tax saving. So the net effect
in terms of cash outflows for our
interest will not be 1200 but will be
1200-tax effect that is 0.5*the interest
to be paid. In the end the net financial
interest will be 600.

For financial revenues it is the other

way round, because they imply higher
profits that imply higher taxes. So the
net effect in this case will be 600-
meaning that in the end our financial situation is worsened. We have a financial problem because we
have a negative figure equal to -7850.

We have to consider if any of the options that we defined are feasible. We could understand if we can
modify some of the choices taken in the previous phases of our budget in order to understand if we
are able to limit this situation. But typically, due to the high unbalance, we have to consider what

financial instruments.

We need to identify the tools most suitable for solving this problem. We have two main markets that
we could use for solving our situation that are the equity market and the debt market.

FINANCIAL PLANNING AND FORECASTING

FINANCIAL PLANNING

The resource collection could take place on two principal markets:

- The equity market, that helps companies obtain financing through the issuance of shares (selling of
shares to investors) and in general terms of equity, through a process that is called IPO Initial Public
Offering, that is the listing process;
This is a very strategic option typically chosen in case of deployment of a strategic process, it is not
a solution that could be applied because of a negative balance during the budgeting process. It is a
decision that has long term effect because once a company is listed it is not so easy to delist and
the process generally takes years or several months.
- The debt market, where financers lend money to a company, which is then obliged to remunerate
them and reimburse them according to an established contract. The debt market is very
articulated, since there are many different financial instruments that could be used by the company
for accessing financial resources, some of them are short term, some of them are long term, most
of them could be both (loans).

87
 could be used by a company.

BANK LOANS

A bank loan is a debt provided by a bank to the company. It can be either long or short term, depending on
the maturity of the loan (the length, the contractual term of the loan). The idea of the loan is that a
ay an interest rate that could be of two types: a fixed rate
or a floating rate.

Fixed rate: there is a fixed percentage that

should be paid and this rate is constant for
the whole length of the contract;

Floating rate: it is variable.

The repayment scheme represents how the

debt will be repaid, it could be repaid
following:

- bullet repayment: the capital will be entirely paid at the maturity of the debt;
- amortized repayment: the debt will be repaid pro quota each year, the quota is specified in the
contract.

We have to pay attention to the difference between the interest rate and the effective interest rate.

EXAMPLE: EFFECTIVE INTEREST RATE

there could be some administrative costs/

commissions that in some case could be
also high because they have to cover
transaction costs. If they are high this
means that the interest rate is not really
the one in the contract but is different. So
it is important to determine the effective
interest rate.

In the example there is the representation

of the flows between

88
The nominal interest

flows. So we have 80 in year 1,2,3,4 and 2080 in year 5 (that should be discounted) and we have to
determine the discounting rate that makes these flows equal. This is similar to the IRR.

+ + + + = 1950

Solving this equation we obtain the real cost that the company sustain for accessing to the loan, which is
4.57%.

ll see just two examples: mortgages and construction

loans.

BANK LOANS

Bank loans require warranties.

Mortgage is a type of loan used in the real estate sector where the bank has the guarantee constituted by
real estates (the house or the building that is being built or bought). In cases the borrower fails in
respecting its obligations (is not able to repay the loan), the bank can recoup the potential losses through
the mortgage (it will sell the house to ensure the coverage of its investment).

Nevertheless, the bank does not acquire the property of the mortgage but can sell it on the market.

The issue of a long-term loan implies other costs such as the negotiation costs, evaluation of the mortgage
value, insurance premia.

Subprime mortgages are given to people that in

normal conditions do not reach the criteria that are
necessary for accessing to a mortgage (people that in
the past had some solvency problems, people
without a job). This problem of sub-prime mortages
was put together with another practice that was
similarly quite critical, the way how these sub-prime
mortgages were financed. They were financed with
some financial instruments built on these mortgages
that was also transacted between different financial
institutions. So, the AAA rating was assigned to the
financial instruments that were used by financial
institutions for financing these mortgages and
collecting the money to be lent to individuals and entities. In the US the problem was amplified by a rapid
increase in the price of the houses but then happened a drop in the price of the houses themselves when
people with a sub-prime mortgage was not able to repay the debt, banks acquired the property of the
houses and started to resell them. In the meantime, the value of the houses collapsed because there was a
huge offer and no demand, meaning that the financial institutions were not able to collect the money that
have been used for the guarantee. This process was amplified by the financial instruments that were put in
place in order to rate and finance the sub-prime mortgages and exploit the leverage effect. In the end there
was an amplification effect determined by these three conditions:

- the inability of those that accessed to this type of loan to repay the debt;

89
- the collapse of the house market due to the excess of the offer and the lack of demand;
- the fact that a big amount of these mortgages was made available with a construction of financial
instruments that apparently had a very high rating but in reality, was very bad, because the
underlying instruments were represented by the sub-prime themselves that people were no more
able to pay.

So, several financial institutions failed, and the crisis spread not just in the US but also in Europe.

CONSTRUCTION LOANS

A construction loan is a type of loan where the

proceeds are used to finance construction of
some kind (vessels, aircraft, real estate). It
finances a construction activity for a specific
order and will be repaid to the selling of the
construction to the clients. So, the interest rate
is generally quite low compared to other loans, because the level of risk is very low.

It is designed for financing construction activities and contains specific features, where repayment
ability may be based on something that can only occur when the project is built.

Thus, the defining features of these loans are special monitoring and guidelines above normal loan
guidelines to ensure that the project is completed so that repayment can begin to take place.

EXAMPLE: CONSTRUCTION LOANS (FINCANTIERI)

There are different types of construction

loans. If the company does not pay the
loan, the bank will take the vessels under
construction.

2.5% is a very low interest rate because

the level of risk associated to this kind of
debt is very low. The loan will be fully
repaid from the proceeds received from
the customer upon the delivery of the
completed vessels.

90
SYNDICATED BANK LOANS

A syndicated loan is complex tool in which there are different banks that together finance a strategic
plan. It is characterized by the existence of a group of banks that together finance a strategic initiative
and these banks are called arrangers. The choice of having a group of banks instead of just one entity is
derived by the amount of money and the characteristics of the activities that are financed through this
type of arrangement.

The aim is to lend money to a borrower with a unique contract: this allows the partition of credit that a
stand-alone bank could not disburse.

In this case one single bank could not

take a risk like this and so four different
banks supported SNAM during the
demerging process, the separation from
ENI group.

A syndicated bank loan will be

characterized by higher transaction and
organizational costs. It is not a flexible
instrument, it could be not negotiate.
While other loans could be negotiated.

91
FINANCIAL PLANNING: BACK TO THE CASE ( AFC case)

With the amortized method the only

difference is related to the interest: the
interest rate is fixed (10%), however it is
applied to different values of the debt. The
amount paid in 2019 will be computed
against the initial value of the debt (10000),
however the amount of the interest in 2020
will have to be computed on the value of the
debt that remains in 2019, which is no more
10000 but 8000 (10%*8000= 800) and so on.

how does the cash budget change? We

have to consider a change in financial
expense since we do not pay interest in
2018 but we have to pay a commission,
which is a financial cost that means higher

to consider 1000 as a cost but 1000-

0.5*1000, so in case of bank loan -600 will
be -1100. We also have to modify tha

-
2000+10000=8000.

BONDS

A bond is a security that requires the issuer (i.e company,governement and municipalities) to pay specified
interests (coupons) and make principal payments to the bondholders at maturity or on specified dates. The
bond emission can be targeted to:

- institutional investors
- retail imvestors

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 - both.

From a definitional point of view they can

seem similar to the loans. The financial cost is
the interest for the loan in the case of a bond
is called coupon, the maturity is the
contractual term for the bond as for the loan,
the repayment scheme could be amortized or
bullet and in terms of priority similar to loans,
bondholders have priority on the equity
capital compared to the shareholders.

However bonds are a more complex tool compared to loans. when bonds are issued by a company, they
are called corporate bonds. Within corporate bonds, we have different types of instruments, at a first level
we can distinguish between debt securities (the instruments that we analyse) and hybrid securities.

Hybrid securities are titles that mix

components of debt and equity, for instance
we could have a bond that could be
converted in company shares depending on
the contractual agreement and with a specific
conversion rate.
that could be zero coupon or coupon. Zero
coupon does not have any interest paid
yearly, but all the repayments are at the
maturity. Coupon means that a coupon, an
interest is paid for instance yearly.

Again, as for the loans, we have the

distinction between fixed rate and floating rate coupon, bonds in which the coupon is determined as an
index (that changes daily) plus a further remuneration.

There is the same rating of that found with the cost of capital.

the safer is the bond the lower is the coupon, the

risker is the bond the higher is the coupon. So
when the quality of the bond is low is because it
is considered risky, the coupon amount is high.

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 The complexity of bonds is closely related to
how the bond is issued: a company cannot
issue a bond by itself but it needs to rely on an
intermediary, which generally a consortium, a
group of financial entities. Within these
financial entities there is an agent bank that
acts as main coordinator and the
Underwriting & Selling Group (the agent bank
is typically part of the Underwriting group).

The Underwriting Group is constituted by

financial entities that take on the risk of the
bond emission, meaning that these financial
institutions buy the bonds emitted by our company and sell these bonds to the investors, so they make
profit thanks to the difference between the price at which they are able to sell titles to the investors and
the price at which they buy the titles from the company. If they are not able to sell all the titles, they will
have to sustain the cost. There are different underwriters because in this way banks can lower the risk
associated to the bond emission.

The underwriting group is supported in selling bonds to the investors by some selling banks. We could have
also banks that do not want to take on the risk of the bond emission but can contribute to sell bonds to the
investors. They will have a lower profit but they are not taking on any risks, if they are not able to sell the
bonds they will not lose anything.

which means higher transactions costs because of the several actors between the company and the
investors.

This example refers to a bond emission that

took place in 2011 where investors may
subscribe fixed or floating bonds or a
combination of both.

TF= Tasso Fisso; TV= Tasso Variabile

The issuer rating is the one that gives an evaluation of

the quality of the bond, in this case the issuer rating

The underwriting group are Banca Imi and Unicredit;

and we have a broad selling group.

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The advantage of this kind of instrument is compared to
a financial loan, a company can rise more money (not
compared to syndicated loan which is more peculiar).
Costs are typically higher, first of all for transaction costs
but also because the bond requires a remuneration for
the investor that is generally higher than the
remuneration guaranteed for the Bank.

Bond cannot be renegotiated.

They have the bond emission in 2018 of 10000, a

positive inflow. The maturity date is after 5 years, when
the capital will be repaid. The coupon is fixed rate of
12% to be paid annually starting from 2019. Then we
consider the commission, in particular we have the

group and 5% of the value of the emission to be paid to

the selling group (fees to be paid in 2018). Then the
agent bank will require 2% commission on the value of
bonds managed each year (from 2019).

How will the cash budget change? If we

look at 2018, we will receive money from

have to pay the commission to the

underwriting and selling group. So the two
items that will be differential will be the
net financial expenses ( equal to 1850=
2500 - 2500*0.5 + 600 = 1250 + 600 =
1850) and the variation in debt, the same
of the previous case because the total
amount of the capital is the same.

In the end if we look at the schedule of the

cash flows we have a more complex
articulation related to the fact the bond is
more complex and implies higher

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transaction costs compared to the loan. However, the implication for the cash budget in 2018 are very
similar: higher net financial interests and the variation in debt.

LEASING
This financial instrument can be used by a company to deal with financial constraints. There are two types
of leasing: the operating leasing and the finance leasing.

A lease is a contractual agreement between a lessee (user= company) and a lessor (the owner of the asset).

The leasing is targeted to a specific asset, and it gives the right to the lessee to use an asset for a period,
making periodic payments to the lessor.

The lessor could be the asset manufacturer or an independent leasing company that buys the asset from
the manufacturer and leases it out.

Operating Leasing

An operating or service lease is usually signed for a period much shorter than the actual life of the asset,
that is generally standardized.

The ownership of the asset resides with the lessor, with the lessee bearing little or no risk if the asset
becomes obsolete.

The lessee pays the rent but installation, maintenance and other costs are on the behalf of lessor.

At the end of the life of the lease, the equipment reverts back to the lessor, who will either offer to sell it to
the lessee or lease it to somebody else. The lessee usually has the option to cancel the lease and return
equipment to the lessor.

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Finance Leasing

Finance lease generally lasts for the life of the asset, that is generally less standardized than in the case
of operating lease and is generally instrumental to the lessee business.

A finance lease imposes substantial risk on the shoulders of the lessee.

In many cases, the lessor is not obligated to pay insurance and taxes on the asset, leaving these
obligations up to the lessee.

At the end of the life of the lease, the equipment reverts back to the lessor but it is generally redeemed
by the lesser. A financial lease generally cannot be cancelled.

These different types of arrangement have

a relevant implication on the way how
assets that are operationally or financially
leased are recorded in the financial report.
Operating leasing are recorded in the P&L
account as an operating expense, it is
exactly like a rent.
In case of finance leasing, the company will
have to record the value of the asset
among assets (for instance PPE) and since it

record an equal amount among debt and

liabilities. A lease asset will appear in the
financial statement of the lessee both

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 under the items assets and liabilities (it is very similar to ownership). Then the lessee will have to
pay an yearly rent to the lessor and these payments made by the user will cover:
- partly a contractual cost related to the financial instrument that is the finance leasing,
- but partly these payments will repay the debt that we have recorded at the first year (so the
amount of the debt will be reduced).
So we have an interest quota and a capital quota.
At the end of the life of the asset, the value of the debt will be 0 and the payments will have
covered the value of the debt and the financial costs related to the leasing.

(we do not have to pay any commissions)

What are the items that will change?

EBIT: we have to record a cost in the

reduction equal to the rent; 1200 is

the rent that we have to pay, but the
CAPEX includes a new equipment

overall our EBIT will be 8240 because

we save 1000 related to the lower
depreciation that we have to pay, but
we have to pay 1200 (an operational
cost), and the difference is 200;

Taxes: they will change because EBIT changes;

Depreciation: we have to re-add depreciation, 2000 instead of 3000;

Variation in CAPEX: from 10000 becomes 5000 because we avoid a cash outflow.

The financial items do not change because an operating leasing has not impact on financial items but it
impacts only the operational costs, so only the upper part of the cash budget is affected by the operational
leasing.

FACTORING

Factoring is a credit service that concerns the acquisition of commercial credit by an intermediary (factor)
in order to receive advance payments.

The factor pays a percentage to the counterparty as soon as it receives an assignment or the receivable.

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 There are three main actors:

- creditor: the company that sells something

to clients and the payment is delayed (in this
case it will receive money after 3 months)
- Debtor
-Factor
If the company has some financing needs, or
needs cash for carrying out
projects/activities, or if the amount of receivables is very high, it can any can decide to sell the
credit/receivables to a third party, the factoring company, paying a fee. In this case the creditor
sells the debt to the factoring company and it receives the money immediately, without waiting
until 30 June. This service obviously has a cost, a fee.
- With recourse: if the debtor does not pay
the debt to the factoring company, the
factoring company will ask the money back
from the creditor;
- Without recourse: the factoring company
cannot ask to the creditor the money in case
the debtor does not pay. So if the debtor does
not pay, the factoring company will lose
money. This kind of factoring service will be more expensive than that with recourse.

When the amount of receivables is very

high, it is often used this kind of service.

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 What does change if we assume that the case
company factors its receivables? We have an
ending level of receivables equal to

receivables are sold to a factoring company.

In this case the payable and the inventories
do not change, however the final level of
receivable will be reduced by half. So if we
make the difference between the final and

disinvestment, a reduction of receivable due

to the factoring service: -6250. This is
assimilated to a cash inflow. So the fee that has to be paid for the factoring service is 10% of the

effect.

Compared to the base case we

have a reduction of the NWC, so a
positive contribution in terms of

record a financial cost that is

associated to the fee to be paid to
the factoring company.

Different types of financial instruments do not impact on the same lines and these differences can
drive the selection of the tool that we want to use for solving a cash need.

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LINES OF CREDIT

At the end of the detailed cash budget we introduced a balance with the so called fido bancario or
lines of credit: if the company has a liquidity shortage concentrated in one specific month, we could
solve this issue by exploiting the lines of credit.
A line of credit is a short-term debt that can be used in a very flexible way for financing because it is
an available amount of money that a firm can borrow. This flexibility has a cost, the company will
pay an interest rate depending on the usage that it makes of that amount of money. On average
the interest rate that is paid for the lines of credit is higher compared to short-term loans, long-
term loans and other financial instruments because of the flexibility of this instrument.
It should be used for covering short-term cash imbalances due to the mismatching of operating
cycle inflows and outflows; otherwise, it will become a very onerous obligation.

Even if the company has lines of credit

them because of the costs.

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 BUSINESS VALUATION

So far we have discussed how a company can

forecast economic and financial flows based on
an integrated process.

these information about projections and

forecasting figures in order to access the

EXAMPLE: SNAPCHAT

Snap Inc. is the company that owns Snapchat. What is

the value of this company?

Snap became listed in March 2017, the initial value of

the company was 25 billion.

What happened to Snap? Instagram made stronger

competition compared to the past. The initial value 25
billion 17 dollar per share was the IPO value, value
estimated for the company before that the company
became listed and its shares started to be traded on
the market.

That value was too high. Immediately after the IPO, in the following days, the value of the shares and also
the market capitalization/value of the company increased a lot (the value of the shares moved form 17 to
24 dollar in the first days of the market to 27/28). The market value of the company increased a lot. Then it
dropped, Morgan Stanley revised the business valuation and reduced the target price of Snap from 26 to
16. Besides the higher competition of Instagram, they looked at one of the competitive drivers of Snap so
the users of Snapchat.

So, the type of value is actually quite diversified: the market value and there are two references to how the
value could be assessed:

- compared to comparable companies, on the one hand;

- based on the value drivers, on the other hand.

There is not

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 EXAMPLE: PIRELLI

In the case of Pirelli, one of the big discussion for

the listing of the company was the comparison
with the Finnish peer Nokia. This article was
published before the IPO, September this year.

In this case the evaluation of the company was

initially based in September on the comparison
with competitors.

Value can be assessed based on three main approaches:

-
- Relative valuation
- Value based proxies

Each of these three methods can be used for determining the equity value or the enterprise value, that
are closely related because:

Equity value = enterprise value net debt

o corroborate/verify the figures that we

estimate.

DCF METHODS
DCF (Discounted Cash Flow) methods are the most consolidated among the valuation approaches and
they rely on the direct measure of the company value by estimating the NCF:

The formula can be articulated differently, dividing the planning horizon in two parts: the first one
between time 0 and time T (8/10 years), the second one between T and infinite (it is called the terminal
value and covers the last period, for instance from year 10 to infinite). This leads to:

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A central characteristic of DCF methods is the need to forecast
now (year 0) how a company will perform in the long term.

Three stages:

1. Strategic planning and competitive analysis.

For being able of determining these figures, our NCF, we have to ground the analysis in a strategic
analysis. Before performing the financial analysis, we have to analyse the strategy of the company
in connection to its competitors trying to understand how
competitive positioning will change in the next few years.
2. Financial analysis
3. Value computation

1. Strategic Planning And Competitive Analysis

The goal of this first phase is setting the strategic boundary for then calculating cash flows in the long
run.

The first phase is in turn articulated into two steps:

- Value driver analysis

- Competitive analysis

Value Driver Analysis: The Value Tree

The value driver analysis can be carried out with several methods, but it is generally performed through
a tool that is called value tree.

The value tree analysis is an approach that allows us to directly relate value drivers to cash flow
generation.

The value tree helps us in identifying for

each component of the NCF what are the
non financial determinants.

What are the drivers of all the figures?

The upper part of the tree is absolutely

standard, instead the lower part of the
tree should be specific of the company.

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 When we move from the general
representation (the economic and financial
one) to the operational one we need to take
into consideration the specificities of the
company.

The leaves of the tree are the value drivers,

what should be able to explain why a
company succeeds and the other does not.

If the value drivers are not identified

properly, the estimates will be not accurate.

In the planning phase the tree is built moving from the leaves to the top, so we move from the
operational performances and we estimate how the operational performance is translated into
revenues, costs and so on and how these are translated into cash flows.

Then in due course, so after one year for instance, we have to understand if the estimations were right
or wrong. We could move from the actual value of NCF recorded for year 2017 and we can build the
tree in order to understand if the estimations were right: for instance, we can understand if a variation
in the NCF has been explained by a level of customer satisfaction that was lower compared to the
estimations.

Competitive analysis: The Value Hexagon

The second part of the analysis is based on a competitive analysis since we need to understand not just
the critical success factors of the company but also how the company positions itself against the
competitors.

So, once defined the performance tree, to forecast the value creation we have to analyse the
competitive evolution of the company.

An useful instrument adopted for the purpose is the Value hexagon(also called the corporate strategy
hexagon), which encompasses six phases starting from the market value.

The starting point is the current market value of

the company. The market value could be disaligned
with the current value of the company because we
could have an expectation gap.

Since we are aiming to understand what will

happen to the company, we need to allow changes
and to consider modifications in our model. So we
want to understand how the performances of the
company will change. For doing that we must use a
simply approach which is the value hexagon. It
introduces a source of variation in different blocks
of the value hexagon.

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 Then I compare the value as is with the potential value of the company if I allow internal changes, for
instance linked to efficiency.

it is an example related to cost restructuring.

I could also see what happens when I introduce a new product, like the case of Fonzies. A couple of
years ago the company introduced choco Fonzies, this is an example of internal improvement since the
a slightly modification of the
product.

In the third step we can see what happens if the company disposes some businesses that for example are
no more profitable.

The idea of Enel is to dismiss power plants that

are no more active due to the decrease in the
demand for electric energy. They are trying to
do that by ensuring that new economic
activities are installed there.

Toshiba had a big scan last year

and they are trying to save their
business by focusing on the very
core activities

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 In these examples we are revising the portfolio, we are not just adding one product but we are
dismissing business areas.

We could dismiss some businesses but we could also enter a new business and these are growth
opportunities (fourth step). Growth can happen in different ways.

this is one example where

Perficient has bought Clarity,
a software provider. In this
case the growth was related
to incorporate in the package
of services provided by this
company the services of
another company.

There could be growth

acquisitions to acquire new
competences, but also to
enter a new market, to

market share.

The last step of the value hexagon is represented by financial engineering, which means financial
restructuring, how we balance debt and equity.

In this example, the company has to reduce the

debt and for doing that it has to involve different
stakeholders and to make an agreement with
KLM.

In this way we can understand what is the potential value of our company.

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 in each step of the hexagon we are
modifying a set of variables and we are
supposed to understand at each step
what are the expected net cash flows for
the company in correspondence to that
specific scenario.

The complexity of this analysis has an

implication that is the weakness of this
tool. When we adopt this kind of
competitive analysis we use an heuristic
approach that could lead to a sub-
optimum. Since we move step by step
(first we evaluate the impact of internal
improvement, than that of disposals,
then that of growth and then that of financial restructuring) at each point we select one strategy,
meaning that we ignore many other alternatives. In the end we are performing a bub-optimization due
to this step by step approach (it is impossible to consider all the scenario with all the variables).

2. Financial Analysis
Once the strategic and competitive analysis is carried out, the estimation of financials can start.
to estimate:
- net cash flows (NCF);
- cost of capital (K);
- Terminal value (TV).

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As concerns cash flows we make reference to two different types of flows:

- Free cash flow to firm (FCFF):

o It represents the amount of cash generated for the company from projects and activities,
after expenses, taxes, investments and change in networking capital and that is available
for both shareholders and debtholders. It is an asset- side approach, since we are focusing
on the relationship between the firm and its projects and activities, without entering the
details of how the capital is financed;
- Free cash flow to equity (FCFE):
o It represents the amount of cash generated for the company from projects and activities,
after expenses, taxes, investments and change in networking capital but that is available
for repaying just the shareholders. It is an equity-side approach, since the equity represents
the rights of the shareholders.

With an asset-side approach we

think in term of FCFF, so the
cost of capital should be the
WACC. Indeed, we are not
differentiating between
different sources and the
output will be the enterprise
value. So, in this case we have
an overall perspective.

On the other hand, with an equity-side approach we think in term of FCFE, we are focusing on
the shareholders, the cost of capital will be just the cost of equity and the output will be the
equity value.

These two measurements are complementary.

Terminal Value

We have estimated just one part of the formula, just the components related to the cash flows.

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 The terminal value is a synthetic measure of the ability of the company of generating cash flows
beyond the forecasting horizon (0-T), so after years 8/10/12.
How can we make such estimation? There are three different alternatives:
- Enlargement the forecasting horizon deceptive solution
We try to make a precise estimate not for just 8 years but for 20 years, so we enlarge the window
from 0 to T as much as possible. This solution does not make sense because it is not so easy to be
accurate for estimations for 20 years from now;
- Perpetuity;
- Real options.

The terminal value: Perpetuity

it consists in making a strong assumption, we assume that the cash flows that happen after the last
year of the forecasting period will be equal to the NCF of the last year of the forecasting period. So
the hypothesis is that the NCF of the last year of the forecasting period (T) will stay unchanged for
the subsequent years.
This solution could have sense in a contest which is very stable, however today the contest for sure
will change and we cannot be sure that the cash flows in the last years will be equal to year 8 in our
example. This approach was very common in the past.
This is a geometric series that is
convergent to 1 over the cost of
capital.
So we can see the TV to what is equal
both with an asset-side approach and
with an equity-side approach.

Something more elaborated is perpetuity with growth: we consider a constant growth rate of
NCFs.
We are assuming that cash flows will change but the way how they change is a constant growth
rate. This assumption is quite strong and unrealistic.

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So we accept an unrealistic hypothesis for having a more accurate figure from a mathematical point of
view.

There is also another option that is the

annuity. In this second case the
assumption that is made is that the
cash flows will not be constant for an
infinite period of time but they will be
constant for a limited period of time
that is equal to a certain number of
years. Or we could also have this
option with a certain growth rate.

The terminal value: Real Options

This is an approach that could be used for estimating the terminal value taking into account the
dynamism of the contest. Real options are a method based on the idea that the ability of the company
of creating cash flows after the last year of the time horizon will depend not on the activities that the
company will perform from year 10 to infinite but on the resources that will be available to the
company.

Real options advocates believe that Terminal Value estimation should include the present options
embedded in the investments.

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 If we think in terms of activities we can estimate the
next 5 year cash flows; then if we want to understand
the ability of the company of generating cash flows
afterwards we need to think in term of resources that
will be available to the company and that the
company could exploit in order to answer to the
changing environment.

The real option is defined as the right but not the obligation to undertake some business decision,
that could be the option to make, or abandon, a capital investment in a certain moment in time.

Example:

They just acquired the right/ the concession

time. They started drilling activities only 10

years later when the oil price grew and
when they developed technology needed to
drill in deep water with lower costs.

The first step made by BP was just to buy

the rights to do something, to drill in that
area at this right was actually bought at a
low price because the value of that
concession at that time was very low. In the meantime they went on with R&D activities, the
macroeconomic dynamic lead to a decrease in the oil price. The change of the context made
convenient for the company doing something about that oilfields. The company was able to separate
the acquisition of the right from a managerial decision that was made years afterwards.

The real option consists exactly in splitting these two moments: when I buy the right to do something
and when I decide to exercise the right.

This approach is very similar to a financial instrument that also explains the name of real options that is
call options: a call option is a financial contract between two parties (i.e. the buyer and the seller):

- The buyer of the option has the right, but not the obligation to buy an agreed quantity of a
particular instrument from the seller of the option at a certain time (the expiration date) for a
certain price (the strike price);
- The the commodity or financial instrument should the buyer
so decide. The buyer pays a fee (called a premium) for this right.

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 In the two cases there is a beginning
investment. Then if I want to exercise the
right in the case of financial options I have
to pay the strike price, in the case of real
options I pay for additional investments (in
addition to the concession) for being able
to exercise the right. I will buy these shares
only if the value of the shares will be
higher than the strike price, since we are
buying the right not the obligation.

The share price can be compared to the present value of the cash flows expected from the additional
investment and the expiration date to the pperiod of time before the investment opportunity will
disappear.

In theory the impact of using a real option

approach is that we can eliminate the
possibility of having a negative impact.

In the picture there is the present value of

the investment and the probability of
reporting a certain present value. Typically
for an investment we have distributions like
the first graph. With a real option approach
we are able to postpone a certain decision
by making a small initial investment. This can
help us in reducing the probability of having
a negative figure because the company make
the investment only when it is sure that the
NPV of the investment is higher than the additional investment.

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This point corresponds to the point in which the additional investment equals the NPV of the project.

Since we are not dealing with deterministic choices, it is not totally true that we can eliminate the
possibility of having a negative impact, we can just reduce significantly it.

The terminal value of the company can be conceived as the sum of the present value of all the real
options available to the company, since there are different projects and if we sum the value of all of
them we can obtain the terminal value of the organization.

How can we compute the value of a real

option? There are methods to compute the
value of financial options but they are not
applicable to real options due to the
differences between them.

So, for evaluating real options we can make

reference to a decision-tree analysis. This

real option based on different scenarios.

So the value of the real option is computed as

a sum over the three scenarios and for each
scenario we compare the NPV against 0. The
assumption is that the company will make the
investment only if the return of it is positive,
otherwise it will be 0 since the company will
not make the investment.

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115
 ALTERNATIVE METHODS FOR VALUE ASSESSMENT

RELATIVE VALUATION

We want to estimate the price of this house using

data available that refer to other houses that have
been sold in the surroundings with their size and
the price.

The idea of the relative valuation is to determine

the value of the company looking at the price and
the performance of other comparable companies.

on the observation of the market like in this

example. Then we use this observation to
determine the probable value of the company (in this case of the house). We are introducing a certain
degree of approximation, we cannot control all the different performances that characterize the company.
However we think that we can find some representative items that can be used for estimating the value of
the company based on the market observation.

Relative valuation methods address the issue of business valuation from a different perspective that
traditional DCF approaches.

Relative valuation methods do not

future free cash flows discounted to their present value.
the market observation, by comparing a firm value to that of its competitors.

These methods are also referred to as multiples methods, because the evaluation of the enterprise value
or equity value in this case relies on the computation of some multiples that are used for determining in the
end the value of the enterprise. These approaches provide a probable price for a certain company, based
on the comparison with similar cases.

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For estimating this probable price, there are two main approaches:

- Comparable companies: we select listed companies that have similar characteristics to the target
company for listed companies there is an active
market and we know the daily value of the shares of the company;
- Comparable transactions: reference is made to a sample of similar transactions. This approach
relies on the idea that today we have access to much more information compared to the past,
meaning that even for not listed companies we could have information about selling/acquisition
price in case of transactions. In this case there is an element of complexity that is that a transaction
happens in a specific moment in time so we need to consider the effect of time in the evaluation.

In detail, how a relative valuation can be done?

There are four main steps in relative valuation:

1. defining comparable companies;

2. defining possible multiples, which means converting assets market values into standardized values;
3. analyse and select multiples;
4. apply multiples.

We have to keep in mind that our objective is to determine a multiple (a tool, a ratio) that can be used
for assessing the value of the company looking at some market observations.

1) Comparable companies

This definition focus on three

fundamentals that are cash flows, growth
potential and risk. However, in practice, if

all the comparable companies are basically

selected based on the sector. So typically
the comparable companies will be
companies that belong to the same sector
of the target company, with some
exceptions.

So, there is a huge gap between theory

and practice.

The identification of comparable companies becomes more difficult to apply when there are relatively few
firms in a sector. Defining an industry more broadly increases the number of comparable firms, but it also
results in a more diverse group of companies. Furthermore, it is difficult to define firms in the same sector
as comparable firms if differences in risk, growth and cash flow profiles across firms within a sector are
large. So there is a trade-off.

The identification of comparable companies should be based on the analysis of the value drivers (i.e.
comparable companies should have the same value drivers of the target company).

Factors that should be considered in selecting comparable companies:

- sector(s), the basic assumption made by many analysts is that same sector means same growth,
same cash flow and same risk but this assumption is not true;
- size, this gives us an idea of the target market of the company and also its potential growth;

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- financial risk, for listed companies is quite simple to find information about risk of the beta or their
solvability;
- geographical market, where companies operate because this has a relevant influence in terms of
potential growth (for instance, is it a saturated market?);
- market share;
- growth perspective;
- customer segments addressed, different customer segments have different profitability associated;
- innovation/development models that the company is putting in place.

In this example they use an approach whereby

they select two companies and they use these
two observations (advertising revenue and
user growth) for determining the multiples
and the value of the company.

This example is taken from the oil sector

and all these companies compete in the
provision of services for oil companies, in
particular for the drilling cases.

Key Energy Services is a medium-small

company operating in this field. All the
data are in millions of dollars.

The first four companies are characterized

by a large capitalization; instead in the
second half of the table there are
companies with a small capitalization that
are characterized by lower level of
revenues.

Looking at the description, we notice that the selection of the companies was driven by the type of
service that is offered. So, all these companies operate in the field of support services for oil
companies, without caring too much of the size of the companies because of the specificity of the
sector.

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 A third approach for the selection of
comparable companies is based on the
segmentation of the business areas.
When Fincantieri made IPO, it was
actually in these sectors: shipbuilding
(cruise, naval and others), offshore and
equipment, systems and services.

For each of this segment Fincantieri had a

different positioning and different
competitive factors. From this point of
view, it was not possible to find a
company (or more than one company)
that had the same portfolio. So, in this
case the complexity of selecting comparable companies was related to the fact that the portfolio of
Fincantieri is wide and peculiar.

So, Fincantieri selected for each segment different comparable

companies. Some of them were players in the same segment; other
companies operate in totally different sectors (in System Integrators
we find for example Airbus and Boeing) because they share a similar
competitive advantage. In particular Airbus and Boeing are well
known for their reliability and their quality.

2) Define possible multiples

Once comparable companies are identified, market values need to be converted into standardized
values, since the absolute prices cannot be compared.

We cannot compare directly the

enterprise value and the equity value of
the comparable companies for
determining the value of the target
company because absolute prices
should be standardized.

First formula: the enterprise value of the target company can be computed considering the multiple in
which we standardize the enterprise value of the comparable company to a performance that is
considered representative for the comparable company. Based on this parameter we then determine
the enterprise value by multiplying the multiple for the performance parameter of the target company.

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Asset side (EV)

- EV multiples take as reference (numerator) the Enterprise Value of comparable companies

E= EV Net Financial Position

E=market capitalization
NFP= (long-term + short-term debts) available cash

EV = E + NFP

- EV multiples use a performance parameter (denominator) coherent to an enterprise value

perspective.

These four multiples are very common.

The most used is the second one for two

reasons:

- It is a proxy of cash generation;

- It is not affected by different
depreciation policies, so it allows a
homogeneous comparison. This is
important especially in the energy sector.
Companies that have higher vertical
integration, they have also higher
depreciations because they have higher investments. If we compare companies with different
levels of vertical integration, we need to refer to EBITDA. Depreciations are also variable and can be
manipulated and if we think in term of EBITDA we could eliminate potential manipulations.

The last one is used in some specific contexts, when we have negative figures in term of EBITDA,
operating profit even if it is not so precise because it is not so stable.

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 The four companies are comparable so we could
determine for each of them the three multiples
and then we could build a table in which we
determine EV/sales, EV/EBITDA and EV/EBIT.

As a second step we should move from four values

to one value. If we look at EV/sales we have four
different multiples that range from 9 to 12, with an
average of 11. Then we determine the enterprise
value of our company, that will be equal to:

(sales of the target company) *(multiple)= 200*11

= 2200.

Two considerations:

- We can rely on different parameters and relying on

different performance parameters we end up with
different evaluations; it is important to understand that
we are selecting different potential multiples that mean
different evaluations.
- So far, we focused on the enterprise value, however
multiples can be used both for computing the enterprise
value and for computing the equity value.
Equity value = enterprise value net financial debt.
We should be aware that when we select the performance parameters, we need to be consistent
with the specific perspective that we are using. If we are computing the enterprise value, we are
using an asset-side approach. If we think to EBIT and net earnings, the measure that is coherent
with an asset-side approach is EBIT.
Instead when we use an equity-side approach, we are focusing our attention to the shareholders
or FCFE ...

Equity side (E)

- Equity-side multiplies take as reference (numerator) the Equity Value of comparable companies
(i.e. market capitalization).
- Market capitalization of the company or equally its stock price (P). the market capitalization of the
company is given by the price of the stock on the official exchange multiplied by the number of
outstanding shares.
- Equity-side multiplies use a performance parameter (denominator) coherent to an equity value
perspective.

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 The P/E ratio is the most used. It is
immediate since for its computation are
used data that are immediately available;
however, we are using the very last line of
P&L account that are affected by
depreciation, amortization, etc. it is very
difficult to isolate what is ordinary from
what is extraordinary.
We have to understand how this ratio has
been computed both for the price and for
the earnings per share since the time
horizon can vary.

PEG is more useful than P/E in start-ups and

in I-tech sector. Because in a start-up and in
an I-
have lower earnings. With this indicator we
make explicit the effect of the growth and the
value of the company will be assessed in a
more precise way, we able to highlight the
dynamic of growth year by year.

Company A has P/E = 22

The earning growth rate is a percentage and is
represented by (the earning per share in the year
previous value)/ previous value.
So: (2.09-1.74)/1.74 = 20.
PEG = 22/20 = 1.1

In case of company B, P/E=30

Earning growth rate is: (2.67-1.78)/1.78 = 50
PEG = 30/50 = 0.6

If we compare the two companies, company A has a growth

rate of 20% and our multiple is less affected by the growth
dynamic; instead, as for company B, we notice a higher impact
on the PEG ratio. The PEG ratio gives us a more complete
perspective because it incorporates the information about the
growth dynamic, even if it is not valid in absolute terms.

These are other two multiples typically

used. P/BV gives information about
the extent to what the market value is
aligned or disaligned to the book
value.

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 here we find the multiple trailing
price/sales. In this case the analyst
had to refer to the sales because all
the profits were negative (EBIT,
EBITDA, ...) So, this choice was
somehow forced. Since the company
became recently listed, we have the
trailing price.
We can see the comparison with
Twitter and Facebook.
28x is used for indicating a multiple
(28 times), it is exactly the ratio
trailing price/sales.

P/E for Still is 16.7, for Sparkling is

17.84. the average between these two
figures is 17.28. Then the performance
parameter that we should use for
computing the value of Water is net
earning 17.28* net profit of Water =
equity value equal to 2384.

3) Analyse and select multiples

When using multiples to evaluate a business, the values obtained are likely to be different using
different multiples, and deciding which multiple to use can make a big difference to the value
estimate

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 EXAMPLE: INPUT DATA

EXAMPLE: MULTIPLES

Hence, how can we pick one multiple?

- use the multiple that best fits your objective. The analyst selects the multiple

- S : use the multiple that has the highest R-squared in the sector when
regressed against fundamentals.
- use all the multiples that you have computed.
- use the multiples that seems to make the most sense for a specific
sector, given how value is measured and created in that context.

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 analysis in order to understand the
correlation between the multiple that
we have selected and the
fundamentals.

At the end we run a regression, the R-

squared is a measurement of
correlation, the higher the better.
Higher R-squared means that the model
is able to explain a large part of the
variance.

This approah is apperently more solid,

in practice we have a limited number of
observations and it is rare to find very high R-squared with this analysis.

Weidentify some multiples that we think that

could be relevant for our company and we use
all of them. So we end up with different
valuations. We could use a range of value
instead of one value; sometimes we are forced
to give a number. In this case we could use an
average of the different values, however the
cast that all the items have the same weight
could be a strenght or a limitation depending
on the characteristics of the numbers that we
are using. It could be a problem in the case of
having multiples that are very unstable, since I
could be more interested in having a more precise estimation. Finally we could have a weighted
average, where the weighting system could be qualitative or quantitative.

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 We make a qualitative analysis trying to
identify what are the drivers that explain how
the company creates value in a specific
segment and we select the multiples that are
able to reflect these drivers.

For some sectors this approach is easier

because there are already papers that have
identified some multiples that are the most
suitable for that specific sector. For other
sectors this is more difficult and from this
point of view the budgeon approach would
be preferred.

- Retailing sector: EV/sale is the multiple used more frequently because this sector focuses on sales;
- Infrastructure sector: EV/EBITDA because in this sector the impact od depreciation is huge;
- Real estate: Price/Cash Flows. This is because on the one hand in this sector there is a problem of

problems in receiving cash, financing the construction projects. On the other hand their results
could be strongly affected by depreciation approaches, so considering depreciation could lead to
data that are not transparent because are affected by different policies;
- If we think to the telecommunication service or to all the subscriber based businesses, have as a
multiple EV/Subscriber where subscribers are a
proxy of sales because they are a driver of sales;
- In the oil & gas we have:
o EV/EBITDAX, where EBITDAX is EBITDA net
of exploration expenses. Indeed in an oil & gas
company there are huge costs sustained by the
company for exploring and identifying some sites
where there is oil and where they can perform
drilling activities;
o EV/Reserves: high reserves are a key issue
for an oil company.
- In the airlines sector, if we want to compare
airlines we have EV/EBITDAR where EBITDAR is
Earning Before Interest Taxes Depreciation
Amortization and Rent. This is because many
airline companies pay a lot of money for
aircraft that are leased. In this way we are
neutralizing differences in choices made by the
operator about having their own fleet or
renting the fleet to financial leasing or
operational leasing.

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 In this table there are some relevant figures
for some European companies.

4) Applying multiples

The last step is the computation of the EV or E depending on the scope of the analysis.

These are the three ingredients you find in almost every equity research report-comparables, a multiple
(or standardized price) and a story (which represents the attempt to control for differences).

It is important to combine discounted cash

flow analysis
able to make projections, to understand the
impact of the strategy of the company on
the long run, translate that strategy in
numbers, with an evaluation based on
multiples.

VALUE BASED PROXIES

Value based proxies are indicators which try to approximate the shareholder value in simplified way;
The number of indicators proposed is very high; focus on three diffused metrics:
o Total Business Return (TBR);
o Market Value Added (MVA);
o Total shareholder return (TSR).

These value based proxies are not evaluation methods but are indicators used sometimes to determine the
value of a company in a quick way.

The TBR is a different formulation of the discounted cash flow techniques.

It is computed as:

TBR = V(1) + NCF (1)

Where:

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V(1) = value at the end of year 1
NCF(1) = net cash flow of year 1

Basically, this indicator is just a different formulation of the shareholder value equation. This indicator is
not often used.

The idea that characterize the following two indicators is that they aim to estimate the shareholders
based on the market value (they use market value as a proxy for shareholder value).

Market Value Added (MVA) is computed as:

MVA = Market value Invested capital

(invested capital is debt + equity)

This difference gives us an idea of the ability of the company of increasing its value moving from initial
funds provided by both debtholders and shareholders. So, we are measuring the value created for the
shareholders with a proxy that is a market proxy. We are replacing the estimation of future cash flows
made by the company through a discounted cash flow technique with the evaluations made by the market,
represented by the market capitalization. This is a much simpler approach because these data are

characterized by perfect information and not all the information are published, so the market is less
informed.

Total shareholder return (TSR) is computed as:

TSR =

Variance in market value is given by the difference between the selling value of shares the initial value of
the shares (the value at we bought the shares). This difference is generally called capital gain. So, the
numerator gives an information about what we get thanks to the appreciation of the shares and what we
get when the company distributes dividends: this is the total gain of the shareholders.

At the denominator there is the expense for the shareholders, so the investment that he made when he
bought the shares.

We are considering again the market as a relevant way of determining the value of the company, we are
basing the valuation on the market value.

We can find these two indicators quite frequently because they are intuitive; in particular if we are
interested in a quick gain they give an idea of the value that shareholders can make from an investment in a
company.

There are also some cases in which we can put

together the short-term orientation with the long-
term orientation.

The idea is to lo
over a long timeframe.

In this representation it is important to highlight the

long- term orientation and the comparison with the
industry. All the oil companies have been affected by
the oil dynamics in the last years and they are

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recovering now. This is an industry dynamic. So even if we had a negative result, this is explained by the
industry dynamic.

measurement system. We have seen different approaches, in this table they have been grouped
distinguishing between DCF methods and other methods (relative valuation and value based proxies).
Indeed these two approaches have different characteristics.

o Completeness:
- DCF methods ensure high completeness, instead when we use relative valuation or even more
when we use value based proxies in the end we are using synthetic measurements (for instance a
multiple look at one specific performance measurement);
o Measurability:
- it is poor if we consider DCF methods and average if we consider relative valuation;
o Precision:
- they aim to
perform a direct measurement of the shareholder value; for the other methods it depends because
they use the market value as a proxy for shareholder value so if the market is well informed there
could be a strict connection between shareholder value and market value, otherwise we could have
a problem;
o Long term orientation:
- It is good for DCF methods by definition and it is average for relative valuation and value based
proxies because they look at the market value;
o Timeliness:
- The computation of DCF requires a lot of time, instead when we deal with relative valuation or
value based proxies, since data are immediately available, the timeliness is good;
o Specific responsibilities:
- It is good for top managers provided that there is a problem of opportunistic behaviour;
o Stability
enough in term of frequency.

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THE ISSUE OF MEASURABILITY

On the one hand, as for DCF methods, at the end of the year, the only measurable data is the NCF of the
year, as for accounting based indicators;

In order to ensure the orientation to the long term, this method relies on estimations; hence there is the
risk of opportunistic behaviour of management because the organizational units involved in the calculation
could overestimate future performance in order to highlight a positive contribution to economic value
creation. So we need to trust the estimations that have been done.

To limit this problem there are two possible approaches:

o
o Dialectic Inquiry

On the other hand, this is not true if we think to relative valuation and value based proxies because they
are based on market observations. However, measurability is still not good because we could select
multiples in an opportunistic way, we could make average between different multiples that could affect the
estimations. For sure, relative valuation and value based proxies are more measurable but there is still a
certain space for manipulation.

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 VALUE DRIVERS (or key performance indicators)
Now we want to move from measuring to managing and from this point of view the instruments that could
be employeed are different.

DEFINITION

The Value Drivers refer to indicators which provide earlier signals (driver) of the shareholder value
creation:

We distinguish three types of drivers:

- Non financial indicators of the present performances, that allow us to understand revenues and
costs. They could be revenues drivers or cost drivers;
- Non financial indicators of the resource state, that aim to monitor future performances in terms of
terminal value, to explain how the company is ensuring its sustainability in the long term;
- Drivers of risks that allow to monitor risk probability and impact, that aim to understand if the
company will be able or not to achieve its objectives. This category is partly overlapped with the
first two categories.
Today if we think to the report that is made for top managers, but in particular the board of
directors, companies are used to report both performance indicators and risk indicators in order to
demonstrate that all the main sources of risk are under control.

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 net cash flow generation

TIME INDICATORS

Company B: 20 orders have been

delivered on time, 40 orders have been
delivered with one weak of delay, 30
orders with 2 weeks of delay, 10 orders
with 3 weeks of delay and 0 orders with
more than 3 weeks of delay.

These two companies measure their

delivery time with two different indicators: number of delayed orders and average delay. If we observe
the trend in the delay, the company A will use the number of delayed orders and on the contrary
company B will use the average delay. In the first case we try to minimize the number of disapppointed
customers because of the delay, but the company is not interested in reducing the delay meaning that
this strategy could result in huge delays even if for a small number of customers. In the second case we

with no much complain but we cannot have long delays.

The selection of the indicators depends on the relevance of the time performance for the company, we

to mix time indicators in order to ensure that no opportunistic behaviour is put in place.

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To sum up, we have many different indicators that can measure the same performance, time from
either a cost or a revenue perspective. We have to carefully select the indicator, because each indicator
measures a slightly different performance, meaning that we have to select the indicator in a coherent

Quality indicators could be distinguished

between cost and revenues drivers; as for
cost drivers we focus on internal quality, so
typically indicators in this field are scraps
percentage, re-manufacturing percentage,
re-working cost, re-working time, number of
re-
quality from a cost perspective.

On the other hand we have the revenue

prespective that is how quality is used for
increasing sales. From this point of view we
could distinguish at least three different
dimensions that are : design quality, customer responiveness and conformance.

Design quality: is represented by the design

characteristics of the product. For instance for a
smartphone it could be how many hours the battery
is supposed to last;

Customer responsiveness: is the relevance of the

performance for the customer and the expectations
of the customers. We could consider 8 hours for the
duration of the battery to be a good performance or
we could expect 20 hours as a good target. How

expectations?

Conformance: is the coherence between the performance that is declared by the manufacturer and the
actual performance.

All these three dimensions look at different quality performances and we need to understand what is
the most relevant for the customer.

There is a further element of complexity when we deal with quality that is represented by a distinction
between objective parameters and expectations. There is a difference that has been analysed and
explored in different studies between the objective performance, the quality as measured in objective
terms, and the perception of the customer, how he perceives that objective measurement.

This perception is highly influenced by the expectations. For exploring this dynamic there is an analysis
that is called IPA, that stands for Importance Performance Analysis.

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 This is an example of IPA, taken from a project
that is carried out early on Italian universities.
Students are asked to fill some student
satisfaction survey both for the teaching and for
the services that are provided by the secretary,
but also the Logistic, the IT and so on.

With those data they generally do an analysis

like this. The survey is based upon a scale of 4/5
points, in this case it is a scale of 4 points.

In this case the analysis is related to the central

secretary and we can find the results of a
couple of years ago. The higher is the score the higher is the satisfaction. If we look at the Y axis, we can
find the importance that in case was measured with a correlation coefficient. The higher the score the
higher the correlation, meaning that that specific parameter has an high weight on the overall
satisfaction of the student toward the service. For example, the simplicity of forms and documents has
ity when dealing with evaluating the service
received.

This analysis allow to identify what are the areas that are on the one hand more important for the
client, on the other hand the areas where the university is performing well or performing not so well

So, looking at the graph we can find:

- keep up the good work: a quarter in which we have performance dimensions relevant for the
student and where the university is performing well;
- concentrate here: where there are performance dimensions in which we have to invest since they
are relevant for the student and in which the university is not performing well;
-
- low priority: area in which the universities are not so good, but the performances are not relevant.

We cannot distinguish between cost and

productivity.

These indicators can be classified based on

how we measure outputs and inputs.

We can distinguish different productivity

indicators, depending on the characteristics of
the output.

In particular, if the output is homogeneous, it

could be measured in physical terms. A
second type of industry is that one where the
output is not totally homogeneous but it is
easy to express the output made by the
company with a sort of conversion rate. If we
think to the textile sector, we could transform

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the output into equivalent unit thinking in terms of consumption of raw materials (for example product
A is equivalent to 2 units of product B because it consumes more textile).

Finally, for diversified products it is difficult to use the equivalent units so the output should be
translated into monetary terms for being able of adding different products. We use units of each
product * price, that is very similar to the sales.

There is one critical situation in which also standardized sales are not
applicable as a measurement, that is when we want to compare companies
with different levels of vertical integration.

We measure the outputs as price*number of units= sales.

If we are comparing companies that have different level of vertical

integration we could experience some problems.

If level of sales of company A and of company B is equal to 1000. We consider one relevant input factor
that is the number of employees and this number is 10 for company A and 50 for company B.

-
-

Looking at the figures we conclude that company B is less productive than company A because the ratio
is much lower. However, this difference could be explained by a different level of the integration of the
two companies. If company B covers just the last phases of the value chain, for instance energy
distribution, and instead A is a vertical integrated company that moves from the purchasing of raw
materials, these figure are totally correct and this second company has a lower productivity just
because it covers more phases of the value chain.

In this case, if we are using productivity indicators for comparing companies that have different levels
of vertical integration, sales is not a reliable measurement because it will penalize those companies
that are more vertical integrated. In these cases it is important to use value added as a performance
parameter, value added is computed as sales cost of raw materials and components.

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 We can distinguish productivity indicators based
on inputs.

Partial productivity: All these indicators aim to

understand the contribution of a specific input
factor to the final output.

Global productivity: we consider all the inputs that

the company uses, cost of raw materials + cost of
labour + cost of technology.

We can classify these indicators on two axes

depending on the nature of the change,
qualitative or quantitative, and the entity of

representation. We can find different types of

flexibility. If we look at the x-axis, we have the
entity of change and at the y-axis we have the
cost of change.

The line represents the costs that a company has

to sustain.

The entity of change could be either small or large: it is small when we are referring to changes that do
not require any stuctural modifications; it is large if we are referring to a change that requires a
structural modifications.

We can observe that if the entity of the change is small, the costs associated are limited. Instead if the
entity of change is large, costs are higher because we have structural modifications.

In the graph are highlighted the segments that give us an idea of the ranges of change that a company
is able to face with limited costs, ranges of permitted variations.

If we think to the entity of change we could classify

flexibility indicators distinguishing between small
changes, large changes and range where range refers
to the set of environmental changes that the company
can face with limited costs.

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 Quantitative changes are changes related to the number of units produced, while qualitative changes
are related to the type of products produced.

Examples:

For small changes, I will use the operating leverage (ratio between fixed and variable costs), in case of
large changes the fixed costs change (there are investments) and so we will not use the operating
leverage. Time required to implement modifications measures qualitative and large changes; maximum
warehouse space measures quantitative changes and it is a range indicator, gives information about
what happen if I increase the production level in terms of warehouse costs. Till a certain number of
units, there is enough space that means that no structural modifications are required and I could
consider the change as a small change since there is enough space to store the products; afterwards if
the level of production increase further, I will have for example to rent a new space, that is a structural
modification.

Number of products produced in a period measures quantitative and range changes: looking at the
number of products that I am able to produce in a period and combining this information with the
capacity that I have, I can understand to what extent I can increase the production level without
sustaining further costs.

Range of products produced in a period is qualitative and we can derive information about how many
types of products I produce in a period, it is range change when combined with the capacity.

We could look at these indicators as cost drivers and

revenues drivers. In particular, when we think in terms
of cost drivers we are referring to costs that the
company has to sustain in connection with the
consumption of energy and environmental resources
or related to fines that the company has to pay due to
negative impact on the environment of the society.

When we think in terms of revenues drivers instead,

the customer is interested, for instance, in the CO2
emission, green consumers quota, reputational effect.

How the company is exploiting social and environmental performances as a leverage for attracting
customers has been one of the main driver for the diffusion of sustainability reports, that have become as
formalized as financial reports.

137
 This picture represents the growth in the diffusion
of sustainability reporting since 1993.

The 93% of companies in the world produce

sustainability reports.

These data are by country and we can see that

sustainability reporting is a very common
practice in America, is quite common in Asia
Pacific area and in Europe, is a bit less common
in the Middle East and Africa even because

size and the propensity of this company to

produce sustainability reports.

This analysis is made by sector and we

can see that those sectors that have
highest environmental impacts are also
those sectors that report more. The first
reporting sector is Oil & Gas, since oil
companies they typically use resources in
countries that are not their original
countries so they have to demonstrate
that they generate positive impact and
that they delimit as much as possible the
negative impact.

What are the instruments that can be used by a company for reporting their sustainability
performance?

The main instrument is represented by the GRI (Global Reporting Initiative) standards. In 2016 the GRI
issued new reporting standards that are these ones that will become compulsory from 2018.

138
 The framework is constituted by different
standards, in particular we have GRI 101, 102
and 103 that represent the current tools that
should be used by a company for producing its
sustainability report.

They explain how the company should prepare

the report, the reporting principles that are
related to both the content and the quality of
the report.

The idea of the reporting principles related to the

content is that the sustainability report should
identify all the stakeholders that are relevant for
the specific company. The idea of the materiality
analysis is to match items that could influence
stakeholder
the items that the company could influence or
modify.

This instrument allow a materiality analysis.

Materiality is not linear because we have to
consider two axes, different dimensions that
correspond not to one specific item but to
different items that could be relevant for the
company and the stakeholders.

139
 This is an example of GRI protocol where
we can see how according to the GRI the
indicators should be reported.

the relevance of the indicators, why that

topic could be relevant.

Then there is the compilation, the formula

which includes different steps. Here there
is an explanation about how the company
should collect data about that specific
performance dimension.

Then we have some definitions, the

documentation that could be used for
determining the indicator and the
references.

We could find also something more, that is

the sector guidance for a list of specific
sectors, where more detailed information
about the specificity that should be
addressed at each step is reported.

For example for the Oil and Gas we could find

that is not enough to disclose market share but
that we have to explain market presence and
provide information about certain policies, the
volume and characteristics of estimated proved
reserves and production, and so on.

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However, there are some problems related to this protocol. If we want to apply it we still have to select
what materials are important or not, for a Bank raw material are an item that is not so impacting in
terms of environment. Any companies use millions of different types of raw materials, however most of
them are not relevant. When I prepare the report, I should decide which raw material is relevant or not
and this could be tricky. First of all, I have to know very well the company for being able of

behaviour because if I know that my performance is not so good in connection with a material that
maybe is not so evident for a specific sector, I tent not to report it.

In order to overcome the problem of

credibility of sustainability reporting,
there are some third parties certifications,
auditors that provide insurance on the
disclosure.

The trend in the last years has been

growing, if we look at the blue bar we can
see that over the 60% of the companies
have its report ensured, the 45% have its
reports ensured by third parties.

For a financial report the insurance is a

certification made by external auditors
and it deals with both the process and the
credibility of the numbers. Instead, when
we deal with sustainability reports, the
insurance is about the process put in
place and not the figures, so it is weaker
than the financial insurance.

There are other two types of instruments

that could be used by the company for
reporting performances that are on the
one hand synthetic indicators and on the
other hand P&LA.

this is an example of synthetic indicator

that is represeted by the carbon footprint,
a way used for transalting all the relevant
emissions and environmental impacts into
equivalent tonns of CO2for being able to
add them, and this is done through a

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conversion rate that is the global warming potential.

The last type of reporting is represented by

the Integrated or Environmental P&LA. This
instrument is being increasingly used. The
first point is that the aim of the P&LA is to
translate the environmental and social
impact into monetary terms in order to be
able to add this environmental and social
impact to the profit that is generated yearly
by the company in order to determine the
overall impact.

The tools used for traditional reporting are

being modified in order to be able of
including the information about
sustainability, that 30 years ago was not a
key feature for a company.

RESOURCE INDICATORS
Indicators of Resource State aims at capturing potentialities for enterprises to innovate and grow. So,
this second class of indicators is specifically focused on analysing and providing a picture of those
resources that are critical for the company and that can explain the ability of the company to be
sustainable in the long run.

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They cover both tangible and intangible assets.

We refer to four types of resources (even though this classification is not mandatory):

- Financial;
- Technological;
- Human and organizational;
- Image and reputation.

When we deal with indicators of Resource State, first of all we have to identify the critical resources
three types of
measures:

- Quality
- Quantity
- Accessibility, how much resources that are critical resources are available to that company.

This is an example that aims just to provide

some examples of indicators that could be
found in connection with different types of
resources.so, these are not indicators that
we could apply in connection with any
company. For instance, we could monitor
technological resources from a qualitative
point of view analysing the number of
patents that have been awarded or better
the value of patents awarded; in terms of
quantity we could analyse the incidence of
new product sales that gives us an idea of the amount of sales that a company is able to realize
leveraging on its innovation capability; in terms of accessibility we could look at the research centres
relationships.

Looking at these three dimensions is critical since in this way we can really understand the possibility of
the company to sustain and further develop the resources, that we said are critical for the business
sustainability.

Intellectual Capital

One aspect that is increasingly common when dealing with indicators of the state of resources is the
measurement of the Intellectual capital asset.

Often companies refer to Intellectual capital as resource, which join different type of assets and it is
referred to a model including three dimensions:

- Human capital: skill, training, education, experience, quantity and quality of an organisations
employees.
- Relational capital: relationships with customers and suppliers, brand names, trademarks and
reputation.
- Internal structural capital: intangible assets and knowledge embedded in organisational structures
and processes (includes patents, research and development, technology). It aims to understand the
ability of the company to formalize knowledge that has been internally developed.

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 Key performance indicators

on key performances (mostly non financial) are introduced in

order to provide within management reporting weak signals on the changing environment;

The scope of KPIs is to anticipate possible problematic variances between actual variances and targets.

KEY RISK INDICATORS

The concept of KRI is partially overlapped with the concept of KPI but in theory it aims to be something
different even if the difference between them is not always clear.

o KPI also detect a problem after an event already happened, KPI do not provide timeliness, time
information
-
o A KPI does not allow to measure an increase in the probability that a negative event will happen
- For instance: the probability that defects ratio would increase
o Risk indicators are complementary to KPI
- They provide even more weak signals from the changing environment. So, the idea of a KRI is to
identify a selected set of measurement that could act in a way that is even more anticipatory
compared to KPI.

indicators that measure factors or parameters that could lead to a variation in the defect rate.

Typically a KRI is an indicator that is already known and typically it is also a KPI for another function.

EXAMPLE OF KEY RISK INDICATOR (KRI) [utilities]

This example is related to an

energy utility. This company had 5
years ago huge problems of
liquidity: on the one hand they
had problems in the renegotiation
of a debt, on the other hand they
had problems in collecting money
from the customers. Since then,
they started to report to the risk
committee (a committee within
the board of directors) these
indicators as KRI.

We can find an analysis of different receivables divided by the business units of the company that are:
mercato, acqua e gas, ambiente and energia.

144
We can find the amount of the receivables and their incidence over the overall quota. We see the
amount of receivables that are not due yet, then we find receivables that are due but they are quite
recent (delay in payment is up to 90 days), then we find delay higher than 90 days, than a year, than 2
years. The company had problems of liquidity in the past and we know that receivables are current
assets and that high receivables mean for the company high quantity of money that the company
cannot use. Being able of reducing these figures, I improve the liquidity of the company. So, the same
figure is a KPI for one function and a KRI for the company as a whole. We derive two different types of
information:

- the first type of information is if our collecting function is working well, is collecting well the
receivables;

- the other information is related to the potential exposure of the company.

EXAMPLE OF KEY RISK INDICATOR (KRI) [retail company]

This is a second example which is totally

different and it deals with a retail company,
a company that operates in the food and
beverage industry, and has different shops.
This kind of companies has a problem
related to misbehaviour or theft from
customers but in particular in this case from
the employees.

So we find a selection of indicators that have

been grouped into two categories. One is the sales receipts:

- Write-off sales receipts per operator/ per shop: how many receipts are cancelled by the operator in
order to understand if the average is significantly different from other operators or other shops;
- Average time for producing a sales receipt compared to other operators/shops;
- Timing of emission of sales receipts (closing hours, opening hours): if there is an increase of the
emission of sales receipts in the closing hours or opening hours this is considered a risk factor.

In the previous example we looked at an overall figure in order to understand something about the
company as a whole, its solvability. Here, we are looking at something very specific with very detailed
indicators, that are automatically collected by the information system, in order to identify some
anomalies that could be related to the sales receipts and to the opening cash register (n. of times the
cash register is opened per operator/per shop; average time between two manual opening of the cash
register per operator/per shop).

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EXAMPLE OF KEY RISK INDICATOR (KRI)

The last example is an example of

possible risk indicators that are used by
companies that work in developing
countries. This is an example from
Angola and if we look to the GDP there
was a huge decrease in the last years.
What happened in the last three years
that affected some specific countries?
Angola is one of the main exporters of
oil.

Having a clear idea of the

macroeconomic performance of a
country is very relevant for a company
that wants to operate in that area
because it provides information about
the level of maturity of the economy
that has a relevant impact on the possibility of finding business partners there.

Last example of KRI is the so-called Value at Risk.

Value At Risk (VAR)

Value at Risk measures the maximum potential loss in value of a risky asset or portfolio over a defined
period for a given confidence interval.

for one year at 95% confidence level, there is a only

This indicator is typically computed looking at past performances.

Key Risk Indicators

KRI can be related to:

1. Internal processes attention to possible overlap with KPI

2. Internal resources attention to possible overlap with KPI
3. External context
4. Potential loss

The idea of these different measuerements is to provide us information about the probability and also
the impact, if we think to the value at risk, that future negative events will happen. The difference
between a KRI and A KPI is not so clear and KRI today are very fashionable and are a part of the
reporting to the board od directors that is gaining more and more relevance.

146
 KRI Typology

KRIs vary in term of metrics adopted; they can be:

- Objective or Subjective, referring to measurement:

o Objectiv
o Subjective: refers to metrics derived by perception (managers, clients, employees, etc.);
- Single or composite, referring to the number of events the indicators monitor:
o Single: monitor a single event (e.g. oil price);
o Composite: synthetize the control over more than one factor (for example synthetic country
risk indicators collects different factors).

Measurability is good, provided that we have a

clear protocol. Long term orientation is generally
good since we selected indicators that are value
drivers, they are relevant for explaining how
revenues and costs change. So they should be by
definition long-term oriented.

Timeliness is good because we are looking at non-

financial performances and we are eliminating all
those extra-times required for transforming an
operational performance into a financial one.

About specific responsibilities, it is good at operational levels when an operator can master a selected
set of indicators. If we think to the CEO, it is quite difficult for him to master all the indicators since they
are too much.

The issue of completeness

Completeness depends on the number of chosen indicators.

If the number of indicators is high, a synthetic measure is needed. This can be done using:
- An implicit weighting system

147
- An explicit weighting system

If we improve the delivery time we experience an

improvement in the value creation that at the
beginning will be proportional, the more we improve
deliver time the more we improve value creation.
However, after a while this relationship will become
not linear, probably being able of improving the
delivery time of 1 more hour will bring to a benefit in
terms of value creation that is lower compared to the
past. This is because the customer will give a lower
relevance to this improvement. For instance, if we
have reduced delivery time to 1 day, probably for the

certain point the relationship between the improvement and the benefit becomes no linear.

This is important because when we try to put together different non-financial indicators, we typically
have to introduce a weighting system if we want to define a synthetic indicator. However, the
assumption when we introduce this system is that there is linear relationship and since we do not have
a linear relationship, but we have a saturation effect, we have to be careful. We must pay attention to
when the saturation effect starts in order to be able to change that balance.

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 DASHBOARDS AND SCORECARDS

SCORECARDS

All the three types have advantages and disadvantages: it is impossible to build good PMS without a mix of
indicators. In order to
different types of indicators, indicators that belong to different families in order to complement the
strengths and weaknesses of different types of measurement. This is the idea of dashboards and
scorecards, they are set of indicators that are selected in order to reflect the key performances of a
company and that together can answer to all the managerial needs. When we design this set of indicators
we typically have to define two main issues:

- the format of the set of indicators,

- the process that we use for selecting the indicators.

ented by the Balance Scorecard.

The term Balance Scorecard is used as a synonymous of dashboards and scorecards because this specific
model is the one more diffuse and popular. However, it is important to highlight that the balance scorecard
is a specific type of dashboard.

These are data from an Italian survey and we can see that
the Balance Scorecard is quite spread. About the 40% of the
companies that were interviewed used the Balance
Scorecard at that time.

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BALANCE SCORECARDS

The format of a Balance Scorecard is how a dashboard is articulated and we can see that it is articulated
into four scorecards, four perspectives that are connected by the vision and the strategy of the
company. The four scorecards are:

- Financial perspective
- Customer
- Internal processes
- Learning and growth

o The financial perspective is a group of indicators where we can find key figures about the financial
performance of the company which analyse the company trend towards shareholders with
reference in particular to:
- Profitability (ROE, ROI, net operating income)
- Size (market share, sales)
- Cash generation (cash flow)
-
o The customer perspective collects indicators that highlights performances linked to the
organisation relation with the market:
- Product range; frequency of new product introduction;
- Delivery time;
- Customer satisfaction survey
-
o The internal process perspective includes measures oriented to the control of internal efficiency
- Average cost of production
- Throughput time
- Defect rate

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- Cost of raw materials
-
o The learning and growth perspective is instead oriented at highlighting the innovative capability of
the company; they are generally the indicators of the state of resources, that allow us to
understand the ability of the company to be sustainable in the future, there are measures such as:
- Time to market
- Learning curve
- Indicators about image and reputation, about the investment, about the trading and composition
of human resources.

These four perspectives reflect the ability of the company of creating value. If we look at the

explain why the four dimensions are connected by vision and strategy.

There is an ongoing debate that actually

confronts two different points of view
that aim to tell something about how we
should select indicators that should be
reported in the Balance Scorecard.

So far we assumed that the selection of

indicators should be guided by vision
and strategy. Then there are two
streams of literature: the first stream
stresses in the selection of the indicators
the concept of balance, meaning that it
claims that the key point in selecting the
indicators is to ensure that we give equal relevance to the four perspectives. We have just to populate
the four perspectives tryng to answer to the questions above. We should ensure that each perspective
contains more or less the same number of indicators, for instance 5/4 indicators for each. In this case
the format guides the selection, we have to populate the four blocks in a balanced way.

The second stream states that causality is key: the format is a guidance but in the end we have to stress
in the selection process cause, effect and linkages between objectives. We have to move from a
synthetic
record in the four scorecards understanding the cause-effect relationship. We are cascading the
objective from the final objective and identifying the actions that in our company will lead to that
result. First I decide the objective
them in the four scorecards, the cause-effect relationship is stressed.

In practice the balance scorecard gives a fo

thinking in terms of strategic goal, how it is deployed into synthetic objectives and how these synthetic
objectives can be achieved by implementing some strategic actions.

When dealing with the Balance Scorecard we deal with three main term: objective, indicator and
target. When we deploy a strategy we move from a strategic objective that could be to improve
profitability; this objective should be measured by an indicator for instance we could measure
profitability in terms of EBIT margin. The Balance Scorecard separates the process of definition of the
objective from the identification of the indicator.

151
 When we try to balance between balance and
causality we build the so-called strategy map
connecting the objectives to different
perspectives of the Balance Scorecard. Looking
at this picture, we have articulated our
objective into the four perspectives of the
Balance Scorecard. We could have more than
one objective associated to the same
scorecard.

Once we have defined the objectives, we

should associate to the objectives the
indicators. For each objective we should
define how that objective could be measured.
Then each objective should correspond to
different indicators. For instance, operating
efficiency could be measured looking at the
contribution of key cost items to our sales: i.e.
raw materials/sales.

Finally, we have a third component which is

represented by the target, a quantitative goal
that a function or the company is supposed to achieve (for instance when we deal with margin we
should quantify that margin).

To sum up, we first decide the objective, then the indicators and finally the target. There is a clear
separation.

Since we said that at the centre of the Balance

Scorecard there is the vision and the strategy and
the process of selection of the indicators should
be guided by the vision and the strategy, the
indicators that are included in the Balance
Scorecard are by definition variable. They should
be changed depending on the strategy.

This is contrary to what we said about stability for

external reporting. When we deal with the
Balance Scorecard the indicators that are
included in this type of dashboards should be

152
updated, meaning that if the company changes strategy also the indicators that are included in the
dashboard should be modified.

Each indicator of the Balance Scorecard is

described using an information protocol.
We can find the definition, the formula
used for computing the indicator, the
motivation why that indicator is relevant
at a company level, the frequency
whereby the indicator should be updated
and the detail needed for the data
representation, the responsibilities for
achieving the target and for reporting
data.

So in the protocol there are a lot of information, this is a protocol of a big company. It is important for
big companies to ensure that numbers are computed in the same way standardizing the measurement.

These examples are taken by a research about

the format and the processes used by companies
in creating the Balance Scorecard.

The balance scorecard of Alpha is quite

disappointing: we can see that the company has
some financial figures (ROI, EVA, CAPEX, OPEX)
and then many technical parameters and they
monitor production costs. However, they do not
look at all at market indicators and at resource
state perspective, the only indicator related to investment is CAPEX. Their set of indicators has nothing
to do with a Balance Scorecard.

153
 This is another example. In this Balance
Scorecard we notice that it is unbalanced:
there are a lot of indicators for the internal
process and a few for the other three
perspectives. Besides, many of the indicators
in the internal process are production focused
and also overlapping. If we look at time
indicators, we have cycle time, set up time,
throughput time, set up time/ throughput
time. There is a huge stress on production
time.

OTHER TYPES OF SCORECARDS

Further to the approaches illustrated, several other types of scorecards have been proposed. The more
interesting are:

- Tableau du Bord (TdB);

- Third generation Balanced Scorecard
- Risk scorecards
- Sustainability scorecards

It was introduced in France before the

formalization of the Balance Scorecard.
The idea in this case is that the company
should be able to define its strategic
objectives, translate them into critical
success factors as we did with the value
tree. Then I associate to the critical success
factors the indicators. These indicators
then constitute the Tableau de Bord. This
process is repeated at each business unit
level.

On the one hand the format is more

general than that of the Balance Scorecard
which is more stringent. In practice
companies that use this model tend to have
a prevalence of financial indicators over
non-financial compared to the Balance
Scorecard.

The two models have a big point in

common represented by how the strategy
should drive the selection of the indicators.

154
 Northern countries typically refer to this model.
It is very similar to the Balance Scorecard since
there are four perspectives that do correspond
to the four dimensions of the Balance
Scorecard. The idea of this model is to connect
the four perspectives to a timeline and they put
the human element at the centre.

This last format moves two objections

against the second generation Balance
Scorecard:

- It is not so easy to have a clear

distinction between definition of objectives,
indicators and targets. Somehow this
distinction could appear theoretical. The
solution proposed by the third generation
BSC is to remove the distinction by defining
Destination Statements where we can find

- The BSC required resources for following the formalized process, instead this is more immediate
and less time consuming.

155
The Balance Scorecard became very fashionable and some modifies versions were proposed. Today it is
used as an instrument for measuring some function performances, for instance we can find the IT
balance scorecard, the BS for the sustainability strategy, the BS for different business units. So, the
process has been applied to different parts of the organization.

There are an example of the sustainability

scorecard and of the risk scorecard.

156
157
 CHANGING UNIT OF ANALYSIS: MEASURING BUSINESS UNITS PERFORMANCE

instruments discussed so far (value based

techniques, accounting based indicators,
KPIs, dashboards and balance scorecards)
could be applied to different types of
organizational units but also how these
methods should be modified.

First of all, we introduce a distinction between business units and responsibility centres that allow to
understand if the model that we introduced in the first part of the course could be applied.

By definition, Business Units are organizational units with autonomy in choosing both the mix of
product/services produced and resource used, so they are responsible of both revenues and costs. A BU
masters all the leverages that are needed for improving revenues and improving managing costs.

Responsibility (or Operational) centres are organizational units that are not responsible for both revenues
and costs (contrary to BU). A responsibility centre is responsible either for costs or for revenues. The key
feature that characterize a responsibility centre is that it does not master all the leverages that are needed
for making profits. Of course, this has some implications in terms of the model that we can use in order to
measure performances when we deal with a responsibility centre.

If we think to a BU, typically it is evaluated based on measurement such as EBIT, EBITDA, profit, margins,
that are measurements in which there are all the components, revenues and costs.

This is an example in which we can see that

the business units are actually evaluated in
term of the key account indicators (EBIT,
revenues, costs, investments, R&D
expenditure). In the end we look at the BU
from a P&L account perspective and this is
a very common situation.

158
When we go in deep in the organizational structure and we move from business units to other
organizational units, the lower organizational units have not the possibility of mastering all the parameters
that in the end contribute to the EBIT.

To design performance control for organizational units, we need to:

- Identify organizational units to be measured:

business performances, I could be interested in the company as a whole. Or I could be

interested in having a segmental analysis for different BUs or in having a detailed analysis about
any organizational units within the company. This is a design choice whereby we are defining what
is the most disaggregated unit of analysis that we want to measure.
The number of organizational levels for whom performances are measured is the PMS depth. The
selection of the unit of analysis for the reporting system should be coherent with the delegation
style of the company. When the PMS depth increases, both its capability of capturing specific
responsibility and its costs do increase. The choice of the depth of a PMS should be coherent with
the management style and the level of autonomy in decision-making processes; in this way a PMS:
o Provides the information that is relevant to decide to the organizational units;
o Ensures accountability of each organizational unit.
If any decision is made centrally, it makes no sense to have a very detailed control system that
allows to disaggregate data at the BU, at the responsibility centre because in the end there is one
centralized decision maker. Instead we have a more disaggregated system (more perspectives that
correspond to different units of analysis) when there is high delegation, if the decision-making
process involve people at different organizational levels I tend to configure the system in a way that
empowers these people to make decisions.

- Define performance indicators for:

o Business Units
o Responsibility/ Operational Centres

If we think to the requirements, we can see that some of them are more relevant at the top
levels and less relevant at the operational level and vice versa. We consider this evaluation in
is low compared to the other categories.

159
 For instance, for top managers we need
to ensure completeness, long-term
orientation and precision in term of
connection with shareholder value
creation. Instead for top managers
timeliness is low compared to the
operational managers that have to make
day by day decisions, while at top levels
we could allow information that is less
frequent (not yearly for sure).

At the operational level, measurability,

ability of capturing specific responsibilites
and timeliness will be crucial.

If we analyse different models that we have

introduced so far, we can identify some
polarizations in the models that are used at
top levels, models that are used at BU level
and models that are used for operational
centres and teams within an operational
centre. So, when we deal with the company
perspective, we need a mix of the different
instruments that we have discussed so far.

o Typically value based indicators (DCF, value based and so on) represent the core measurements
from a company point of view. Then we have typically selected financial information focused
maybe on profitability, liquidity and solidity and few selected value drivers. We have some key non-
financial figures that are well representative of the main parameters. In general, six parameters are
considered as well representative of the performance of the company because the human mind is
supposed not to be able of mastering more than 6 parameters at time. So, when we look at the
performance of a company we have value based indicators, selected financial indicators and few
selected value drivers.
o Then we move from the company to the BU, at a BU level typically the accounting based indicators
are the core, then we have selected measurements at BU level for value drivers non-financial
parameters that will be different compared to the corporate figures, and then we could apply even
if with some limitations, value based assessment. We can apply instruments that are based on
value based models, both DCF and relative valuation or value proxies, but typically these models
are used at BU level less frequently than where they are used at a corporate level. They are
generally applied at BU level once a year.
o Finally, we cannot use value based techniques for operational centres because value based rely on
the idea that we can estimate inflows and outflows, but operational centres are not responsible for
both revenues and costs. Then we could have an economic analysis of cost and revenues that are
specific of the organizational unit and then value drivers represent the key parameters.

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 BUSINESS UNITS
Us within the company two problems have to be considered:

- Existing transactions with other Bus within the company (intra-company exchanges) transfer
pricing problem. In most of the cases, when we deal with a group, there are some exchanges of
goods and services that happen between BUs of the same group. The problem is how should we
price these transactions. The issue of defining the price of transactions that happen between two
different BUs of the company has relevant implications from a managerial and a tax perspective.
This problem is addressed by a transfer pricing system.
- Resources used by BUs but managed at the corporate level corporate cost allocation problem

CORPORATE COSTS ALLOCATION

Corporate costs include the cost of those resources that are available at a corporate level and that are
shared by different business units. How can I determine the cost of a central service that has been
exploited by different BUs?

In practice there are three approaches that could be used for managing the problem of cost allocation:

- Complete allocation: all the corporate costs are allocated between BUs, any costs sustained
centrally is allocated to the BU
o Need of precision high cost in maintaining the system
o Risk of not using needed services
- Partial allocation: we select some specific costs that are allocated to the BUs based on some criteria
o Allocation on the basis of consumption drivers
o Definition of fees
- No allocation: we have shared resources but we decide that we do not want to allocate any costs to
our BUs
o Risk of uncontrolled use of resources

161
 When we deal with costs, we typically
distinguish between direct costs, indirect
production costs that are also called
manufacturing overhead (depreciation of
production and equipment, rents of
warehouse used for production and so
on) that need to be allocated to products
that are produced, period costs that are
not related to production activity
(typically selling and administrative
expenses) that are by definition indirect
and that we need to allocate.

Corporate costs are a particular type of period costs, so we are dealing with indirect costs.

There is a method called Activity Based

Costing that could be used for allocating both
manufacturing overheads and period costs.

An allocation is based on the computation of

an allocation coefficient in which we have a
ratio between the cost that we want to
allocate, the numerator (this cost could be the
cost of the R&D function) and the allocation
basis, the criteria used for performing the
allocation.

Complete allocation

It is based on a proportional allocation, generally using as allocation basis the amount of sales. In this way,
potential inefficiencies of corporate functions are transmitted to the business units.

In this case the company considers the sum of all the corporate costs and then this total is typically divided
among different business units using a proportional allocation, meaning that they select one allocation
basis that should be applicable to any BU and any costs. Then, this allocation coefficient is computed with
total corporate costs as numerator and sales/number of employees/ number of full-time equivalents or

162
whatever at the denominator. In the end we have an allocation that is very rough since it is very aggregate.
This approach is typically very simple, it has an organizational advantage which is that if the company
performs a complete allocation, it induces business units, whom costs are allocated cover the role of a

fact that the criteria used for making the allocation are rough (i.e. sales).

This could be a problem in the decision-making process, but most of the companies make the allocation in
this way.

Example

This example represents a case very frequent in reality that causes high tension between business unit and
corporate when this allocation is used in connection to the incentive system.

BU A and BU B are commercial units, without dedicated fix costs (this means that shared resources are
managed centrally);

BU A and BU B have sales equal to 100 millions each, and return on sales of 10% for BU A and 50% for BU B;
EBIT will be 10 for A and 50 for B.

Corporate costs are 50 millions, and are allocated on the basis of the level of sales. So, the allocation
coefficient will be 50/ allocated to BU A and 25 million allocated to BU B.
Hence, operating profit is 15 millions for BU A and 25 millions for BU B. We have divided between the two
business units our corporate costs based on the level of sales.

The head of BU A has to decide about the production of an additional order of 40 millions that does not
require any additional corporate cost. What the effect is? The allocation criteria will increase the quota of
corporate costs that are charged to BU A, meaning that if we do the alloca
sales will become 140 and 100. The margin will not change, and the EBIT will be 14 for A and 50 for B. the
allocation coefficient becomes 50/240 and in particular the quota allocated to BU A will be (50/240) * 140 =
29.2. For BU B (50/240) * 100 = 20.83.

In the end the result of the acceptance of the new order is that the net profit for BU A decreases, because it
is charged a higher quota of corporate costs. Instead, BU B does not change anything, but its final result
improves. So, if we want to perform a complete allocation using such allocation basis like sales we need to
accept this kind of distortions.
large corporations, to make clear that activities that are carried out at corporate level should be sustained
by the business units. This has an organizational benefit that is that business units challenge the
proliferation of corporate costs because in the end are charged to their P&L account. However, we need to
be very cautious in situation like this.

Partial allocation

A second approach consist in partial allocation. The idea is that I select some shared resources that I decide
to allocate, I do not allocate any corporate costs but just a set t
find in this case allocations based on sales for example. The idea is that we allocate less costs but we
allocate them better. Then, we have two different options:

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 - Allocation proportional to a driver, for each
corporate cost we select a different driver and we
allocate the cost of that resource with dedicated
allocation basis assuming again a proportional
relationship with the consumption of the driver;
- Fee allocation

Partial allocation: allocation proportional to a driver

This cost should be divided between BU A and BU B.

In the reference period, the BU A has used 20 hours of the legal office and B has used 60 hours of the legal
office.

We have selected the corporate resource of whom we want to allocate costs, the resource in this case is
the legal office. We are using an allocation proportional to a driver and in this case the driver is the number
of hours used by the

What happens to the allocation coefficient if unit B uses 30 hours only?

The cost is largely absorbed by A, the allocation coefficient become 10000/ (20+30) = 200
that is allocated to A is 20
reduces the use of the shared resource but the effect is paid also by A. This is because in the allocation
proportional to a driver, we are selecting the resources, the drivers but we are doing still something not
very precise. We are thinking in actual terms, we are not considering if the capacity that is available is used
or not. So, there are periods of the year in which the resources will be more expensive and periods in which
they will be less expensive. So business units try to manage these resources when they are less expensive,
and so, in those periods we have also a problem of capacity. We are encouraging to ask for that resource in
a period in which it is largely used, one of the possible solutions is to use a fee allocation.

Partial allocation: fee

The fee allocation allows to think in terms of available capacity. We estimate when we do the budgeting
process an hourly cost in our example that is given by the cost of the legal office and its available capacity,
for instance 100 hours. We have a fee

ave two main benefits:

- We avoid distortions depending on the level of usage of resources, depending on difference

between actual and available capacity;
- Estimation of the cost of unused capacity

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There is a situation in which also partial allocation based on standard fees could be risky. What happens if
we have a corporate resource that is characterized by high variability in the usage?

and has very few requests in the rest of

the year.
clear, a manager looking at the figures of unused capacity could decide to reduce capacity. However, this is
risky if we think to resources that have seasonality, that have variability in the consumption, but then are
not easily replaceable. An excess of capacity of capacity when we deal with shares resources should not
immediately lead to a different allocation of resources.

No allocation

In the case of no allocation, we decide not to allocate any corporate resources. This is typically done when
the overall weight of shared resources is not high, so this is not the case of large companies.

TRANSFER PRICES

Transfer price is a for evaluating intra-company exchanges: it is the price a division

charges for a product or service supplied to another unit.

The transfer price is:

- A cost to the receiving division

- A revenue to the supplying division

Once defined, transfer prices affect:

- Division performances
- Divisions decisions
- Company result

Transfer prices are a relevant problem: nearly 60% of world trading activity is intra-company.

A transfer pricing system is required for several purposes:

- To provide information that motivates divisional managers to make good economic decisions;
- To communicate data that will lead to goal-congruent decision;

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- To provide information for evaluating divisional performances;
- To ensuring divisional autonomy;
- To plan tax, intentionally moving profits between divisions or locations.

A SIMPLE CASE

Profit

6000 1200 1500 1000 = 2300

The profit for BU1 will be:
TPX 1000(purchasing cost) 1500
(conversion costs)

BU2 sells the good to the market so gains

6000 and has conversion costs for 1200
minus the transfer price related to
component X: 6000 1200 TPX
In the end, the profit of the two business units depends on TPX. What happens if we define TPX =
4800? The profit for BU1 would be 2300 and for BU2 0.
Instead if we define TPX = 2500, the profit for BU1 would be 0 and for BU2 2300.
What if one BU is located in Italy and the other one in Panama? Looking at this example, we have
shifted profits very easily from one BU to the other. So, by defining the value of this transfer price
we ended up with a totally different result. So, by defining the transfer prices which are fictitious
prices, we affect enormously the result of the business units and of the company, because based on
the business profit, that a business unit will pay more or less taxes, meaning that in the end we
have an impact on a company level. So, it would be convenient for the company to shift profits in
those countries where business units pay less taxes. It is not fair and also not very legal.

In the last years we have assisted to debate like

this. A large corporation that is Amazon, has
been requested by the European Community to

the centre of this debate is connected to how

corporations evaluate their internal transactions.

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 The same issue was discussed also for Google,
Facebook and so on.

In the last years we had a lot of debats about web

companies, internet companies basically because
the connection of their business activities with a
geographical location is weaker. But this problem is
not relevant just for these players, it is relevant for
any multinetional corporation in which we have
more legal entities in which the business units are
constituted by different legal companies, because
different legal companies have different financial
reports and pay taxes.

This is a survey that has been carried out few

years ago among Italian listed companies about
why companies have developed a transfer
pricing system. If we look at the results, the 74%
said that the objective of their transfer pricing
system is associated to their tax planning. Then
there is a small difference between tax planning
and unfair practices. Another 65% of the
respondents claimed that the motivation of
their transfer pricing system was related to
evaluating performances in a fair way in order
to better understand what business units were
improving their results.

So, the divisional exchanges for multinational companies can be used for transferring profit from one
Policy makers at world
level have tried to develop instruments in order to define in a better way how the transfer prices should be
fixed, what are the procedures that a company should use in order to set the value of the transaction.

In particular, in 1995 OECD (Organisation for Economic Co-operation and Development) published a
guidance reflecting an international consensus reached by OECD member countries.

The core principle of the guidance is that company, when fixing their transfer price, should follow the so

comparable transactions that could happen in comparable companies between different independent
entities. So, the idea is that the internal transaction should be evaluated as if it has occurred between

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independent parties. Then the guidance provides different methodologies that can be used for doing this

The first element that consitutes the guidance is represented by methodologies for setting the transfer
price, that are specifically thought for the objective of ensuring fair tax behaviour, in order to avoid an
opportunistic behaviour. A second element is represented by reporting, in the last two years we assisted to
the introduction of dedicated reporting in order to allow different tax agency to be able of collecting
reliable information about how different companies carried out their business activities, at what extent
they generated revenues and costs in different countries. This means that in the end a tax agency should be
able to understand if the company is paying the right amount of taxes where it is carrying out its business
or not.

The key component of the country by country reporting is to allow information to be provided to different
tax agencies which will be able to triangulate what happens in different countries and hopefully this could
help different tax agencies to understand if a shifting of profit from one country to another is happening
and in case of opportunistic behaviour they can fine the company.

models available to set the transfer price and als what are the strength and
weakness of the different approaches.

TRANSFER PRICING METHODS

o Market-based transfer prices
o Cost-based plus mark up transfer prices:
- Full actual cost
- Full standard cost
- Marginal cost
o Negotiated transfer prices
o Dual transfer prices

MARKET-BASED TP

A market-based TP is defined based on comparable transactions and the idea is that the price that is
applied to an internal transaction should be the same price of a transaction between two independent
parties. Prices applied to internal transactions are the same that would be applied to the same product and
service when it is sold/bought on the external market.

Sometimes, this price is corrected to take into consideration lower transaction and administrative costs
that are typical of internal transactions; in this case, the advantages are divided between the two
organizational units between whom the transaction takes place. In particular, if we think to transaction
internal to a company, w
control when the goods are received, supply management, etc.) than in the case of a transaction between
two companies that do not belong to the same group. The problem is that sometimes the business units
involved in the transaction have different benefits in term of transaction costs.

EXAMPLE: BU A sells to BU B; savings in terms of transaction costs are often not equally distributed
between the business units. For instance, we could have lower transaction costs for supplying function and
higher transaction costs for the buying business unit. BU A has savings in terms of transaction costs equal to
10 and BU B instead saves 20. Even if we are considering the market as a reference for setting the transfer
price, in this situation we have to pay attention to the unfair distribution of benefits in terms of transaction
costs because this distribution could create tensions between the two BUs because one has a higher
benefit deriving from the internal transaction than the other. If the market price in this example is 100, we

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have two options. We could fix the TF equal to the market price, however this option could be perceived by
the BU as unfair because BU B has an higher saving. What we can do is modifying our TF in order to ensure
that the same benefit is distributed between the two business units, so in this situation we could fix the TF
a bit higher or a bit lower than 100 and we could modify the figure to ensure that BU A and BU B derive
from the transaction the same benefit.

equal to 5 from BU B to BU A. We could do that rising the TF to 105 because in this way BU A will have a
benefit equal to 10 than it will have an extra-profit equal to 5 and the overall benefit is 15. BU B has savings
for 20 but it has to pay 5 more, meaning that it has savings for 20 and an extra-cost of 5, still it has an
overall benefit of 15.

In this way we are ensuring that from an internal point of view, the transaction is fair. We move from the
market as a reference, but then, if the market reference introduces a distortion, a different treatment of
the business units, we need to correct that price.

There are three cases in which these market-based TP are not applicable

- Non-homogeneous markets
- High variability of prices Cost + mark up
- Strategic divisions

A first problem is when the object that we are buying is very peculiar and we
homogeneous market to whom we can refer as a benchmark, so the transactions that happen between
business units have no comparable transactions. In that case we could make reference to an alternative
method, based on cost + mark-up.

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 A second problem is when we deal with products
with variable prices.

If we think to the oil price, the oil is a commodity

whose price changes daily. In this case it is quite
difficult to find a market reference.

We could use an average but then what

average? A yearly average, daily average,

If we use a price on a daily basis, there is a

problem since we have to change the TP daily.
So, from a computational point of view we
should trace when the transaction happened
and how we evaluated the transaction, that
could be more complicated unless we have a
good information system.

The alternative could be to enlarge the time

window, using a weekly average or a monthly
average or a yearly average. We exclude this
option upfront because if we have high
variability of prices, there will be days in which the average price will be higher or lower than the actual
price. When the average price is lower than the market price, the supplying function will find higher
convenience in selling to the market. When the average price is higher than the market price, the buying
function will have no convenience in internal transactions. So, in the case of high variability of prices, if

in which internal transactions are not convenient either for the buying or for the selling unit.

As we said we could change the price daily, so if

the price is constantly aligned with the market
price the problem is solved. It is true from a
computational point of view but it has some
behavioural implications. If the TP changes daily,
our internal buying function will try to
understand when it is more convenient to buy in
order to optimize its raw materials costs. The
problem is that in reality if we think to what is
happening between two business units, this is
just an internal transaction. This is a fictitious
price but the oil in our case has been already
bought by someone else; so if the transaction is happening internally we have downstream business unit

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that is try to optimise the purchasing price of the oil but this raw material has been bough by the
upstream function in a different moment of the day/month/week. In the end the downstream unit is
putting a lot of effort in optimizing a fictitious price and the benefit that the business unit will realize will
not be a benefit for the company as a whole because the raw material has been bought by the upstream
function following probably different logics. In the end the downstream BU is realizing a saving which is not
a real saving from a company perspective and on the other hand it is putting effort in trying to optimize the

We typically choose a TP that changes daily, that is also more expensive.

If production costs include raw material costs, the refinery could be induced to improve its results by

Is this right from a company perspective?

- Oil is actually purchased by the purchasing function and not by the refinery, hence a possible cost
reduction achieved the refinery is not real
- In the attempt to optimize its purchasing costs, the refinery could finish its stock with a negative
impact on the production process

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 There is a third problem which is very
peculiar, not so frequent related to cases
in which we have strategic divisions. In
this situation we could use market based
transfer prices but their usage could lead
to a negative result.

A strategic division is a division held by the

company mainly for strategic purposes
but without being part of the core team of
the company.

integrated company that has two

divisions, A and B. A is a company that competes in the base chemicals sector that is characterized by
large scale economies, if the volume that are produced by this division are higher A is able to obtain
savings and to lower the unitary cost. We have on the one hand the division A which is the core division
and on the other hand we have the strategic division B that operates in the fine chemicals sector, which
works on specific types of elements that are derived from the base chemicals company. This is a
strategic division because it is characterized by a very small scale, it is maintained by the company in
order to be able to catch information about the downstream market. The role of this division is not to
be competitive in the fine chemicals sector, but its role is to help the company as a whole to
understand the dynamics of the downstream market.

In a case like this, it happens that when division A supplies components to external players, prices that
are applied by A are strongly influenced by the volumes of the orders because the key characteristic of
that industry is the existence of large scale economies. If the order is larger the company is able to
achieve lower unitary costs. If we compare the orders that come from external players with the orders
that come from the strategic division, it is quite natural that the orders that come from the external
players are much larger (since division B does not aim to be competitive in that market). The problem is
that if we use market based transfer prices, the transfer prices should follow market rules but we said
that when A deals with external clients the size of the orders is typically larger and A is able to exploit
economies of scale. This means that on average the price that is applied to an order made by external
clients could be lower compared to the price that division A applies to a smaller order made by division
B (in this case 100 instead of 70). In this case it is not convenient for A to apply the market price (70)
when we deal with an order made by company B because it is more expensive for A to produce
compounds for B because the size of the order is small; on the other hand if division A applies to
company B the fair price (100, determined by the actual size of the order made by division B), division B
will not be able to sustain this cost because division B is selling to the same clients of company C. Even
if B does not aim to compete in that market, it has to at least stay in the market and to be able of sell its
products to the final customer and so it can not sustain such an high price.

We can solve this situation using a system of dual transfer prices.

Dual Prices

evaluate the internal transactions in a different way. Dual prices system is called so because it is based
on the application of different prices to upstream and downstream units.

In the previous case, we would apply a price of 100 to the upstream BU and a price of 70 (the market
price) to the downstream BU. The difference (30) will be considered as a corporate cost that is

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accounted centrally, that allows to make evident the cost that the company decided to sustain to
maintain in house this strategic BU. This approach is quite expensive because we have to keep a double
system updated but it has two benefits: it allows to evaluate and understand how much the company is
investing in the strategic division; it allows to treat our divisions as two independent profit centres
responsible of revenues and costs.

COST-BASED PLUS MARK UP TRANSFER PRICES

They are applied typically when market based transfer prices are not applicable.

Transfer Price = cost + mark up

The cost component is the cost that the selling unit has to sustain for producing the products or
services that are sold to the downstream unit. Then there is the mark up, an extra- gain applied to the
cost.

If we assume that our cost structure is total cost= variable cots* quantity + fixed costs, the unitary cost
will be variable costs + (fixed costs)/ quantity. The transfer price could be determined as the unitary
cost* mark-up. This mark-up is an addition that could be applied to the base cost, it is typically
expressed in percentage terms and the transfer price will be: cost * (1+ ). The idea is to incorporate a
margin moving from the cost.

When defining the transfer price, we have to understand how to evaluate the cost, that is the base
component of the transfer price.

There are different configurations:

- Full actual cost transfer prices: sum of the cost of all resources that are used in producing a good or
delivering a service.
- Full standard cost transfer prices: budgeted costs of all resources that are going to be used in the
long term.
- Marginal cost transfer prices: sum of variable costs (direct costs + variable indirect costs)

TP based on full actual cost

Cost- based transfer prices are defined on the basis of the cost of a product/service increased by a mark
up.

When we deal with full actual cost, we refer to actual data.

However, the usage of actual data could lead to a huge
distortion because: we said the transfer price is (variable
cost + (fixed costs/quantity)) * (1 + ), if we determine the
EBIT of the upstream selling unit, it will be

operating profit= TP*Q -VC*Q -FC , if we replace TP in this

equatio .

So, if the selling unit increases costs, its EBIT increases.

Actually EBIT increases either with an increase of costs or with an increase in quantity. This is a
distortion that leads to the second category of transfer price, represented by:

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TP based on full standard cost

If we use full standard cost the TP will be (budgeted VC + (budgeted FC/ budgeted Q)) * (1+ ). These
values are standard values.

So in the operating profit we find standard/

budgeting values and actual values, meaning
that we cannot simplify the cost anymore. If
the selling division is sustaining higher costs
than what is budgeted, it will report a
negative EBIT. There is no more incentive for
the upstream division for raising costs,
because the TP is based on budgeted values.

What is a contribution margin? It is defined

as: price VC.

downstream; if we look at the cost structure,

we know that the TP will be

(20 + (10000/1000)) * (1+0.1) = 33 = TP

If we think in terms of VC, the VC for the

downstream unit will be 40 + 33 = 73. The
criteria used for evaluating short-term
decisions is contribution margin higher than
0: price VC >0. If we consider the TF and the VC of the downstream, the contribution margin will be
higher than 0 when the price is higher than 73.

The downstream will accept the order if the price is higher than 73. From a company perspective 73 is
not the right price because we are including a piece of fixed costs of the upstream because of how the
TP in constructed, that is represented by 10 which is also amplified by the mark-up. From a company
perspective the right price is 20+40=60, which is the minimum price that will be accepted. We could
have some sub-optimizations that derive from the way the TP is constructed; the optimum from a
company perspective is different from the optimum from the BU perspective. We have a tension
between a push towards integration, we could make decisions from a global perspective, and the fact
that we cannot centralize any decisions and so we need to give autonomy to the BUs, accepting that
they are evaluated based on profits, that means that we need to introduce these kinds of mechanism.

If we have unused capacity the division will give up orders that better saturate the resources that are
available.

Even without applying any mark up the minimum acceptable price for the downstream BU is:

P Variable Cost downstream unit Full Cost upstream unit > 0

Instead the minimum acceptable price for the company is:

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 P-Variable Cost downstream unit Variable Cost upstream unit > 0

Hence, the downstream BU will not accept orders that are actually profitable for the company as a
whole, leading to a lower saturation of production capacity.

There is not a real solution to this problem, one proposal made by literature is to replace TP based on
full standard costs with TP based on marginal costs. This means that instead of building the TP as (VC +
FC/Q)*(1+ ), in the case of marginal cost the TP is VC* (1+ ). This is a solution just apparently, I am
eliminating from the TP the component related to FC. But we defined the mark-up in order to ensure a
profit to the selling unit; when we define the TP in this way, it happens that the mark-up is much higher
compared to the old . So, in the end FC are remunerated through the and do not appear in the
formula but the result is exactly the same, in order to ensure a profit to the selling unit I have to fix a
higher . So, this is not a real solution that helps the company solving the dynamics seen before.

Negotiated prices

When we deal with transfer price we typically have a policy that is defined centrally by the company that
states how internal transactions should be valued. The reason why this policy is centrally defined is that it
should consider the specificities of the company, the balance of power between the divisions and it should
ensure that one division do not prevaricate on the other and it should be coherent with the managerial
style. The existence of a central policy is something that limits the flexibility of the business units because it
states the value for the transactions. This leads to higher rigidity of the system and it limits the ability of the
company to compete in turbulent contexts.

Another possibility for defining the TP is the negotiated TP in which the BUs agree that the TP is based on
the negotiation between the upstream and the downstream BU. In this way we are replicating what
ice,
but it is not sure. However, in most of the cases, negotiated transfer prices are not totally free since this
mechanism allows a partial negotiation within certain thresholds, between an upper and a lower bound, it
is not totally free. This system was introduced because of the attempt of limiting the influence of a central
policy. On the one hand, having a centralized policy ensures standardization in choices, that different BUs
are treated in the same way, on the other hand it can make the system more rigid.

In the case of unused capacity, if the two Bus were two different companies, the downstream BU would try
to negotiate a price reduction with its supplier, in order to be able to accept the order. To simulate the
same situation, negotiated transfer prices can be introduced: the BUs are free to negotiate the TP and
decide whether to buy and sell internally or deal with outside parties.

Information related to market prices or marginal and full costs can inform the negotiation process.

The balance of power between different organizational units plays a relevant role, as in any market
transaction. Internal transaction costs increase.

With negotiated prices, there is no guarantee of integration between the choices of different Bus.

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 We have to balance the tension between
integration and adaptability. This tension is
at the bases of the choice of the transfer
pricing system. If I want to stress the
relevance of adaptability I will go towards a
negotiated system (pure or partial), on the
other hand if I want to stress integration I
will go towards a central policy, if I want to
stress integration a little more because I
want to have a global optimization, I will
not use transfer prices, but I will look at my
business units as responsibility centres
(responsible just for either revenues or costs).

Depending on what is more efficient and effective in a given context, pressure towards adaptability or

want to use.

These are some data about the diffusion of the

different configurations. We can see that the
configurations most used in practice are full
standard cost and the market price.

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 CHANGING UNIT OF ANALYSIS: MEASURING RESPONSIBILITY CENTRES

Now we move to our last unit of analysis,

represented by responsibility centres.

Responsibility centres

Responsibility (or Operational) centres are organizational units that are not responsible for both revenues
and costs (contrary to BUs).

There are three types of responsibility centres:

o Cost Centres, that are organizational units for which a relation between output and required resources
can be traced, but they have not a direct link to the external market;
o Revenues Centres, that are organizational units directly interacting with the external market;
o Expense Centres, that are organizational units that provide services that are relevant for supporting
the production of goods or services but they do not interacte directly with the external market and for
which it is not possible to set a standard relation between input and output.

Recap how variance analysis can be performed on a cost centre or a revenue centre.

Cost centres

Cost centres are:

o Responsible of the use of resources

o Not responsible of determining the output level

The economic indicator traditionally used to evaluate cost centres is cost:

Total Cost = Variable Cost * Q + Fixed Costs

Performance of these centres is traditionally

measured using variance analysis. Variance analysis
is typically articulated into three levels.

At a first level of analysis we have the Total Cost

Variance. Then, it is analysed at a second level of
analysis and divided into Volume Variance and
Efficiency Variance. The third level of analysis goes
in depth with the Efficiency Variance and
disaggregates it in the Price Variance and the Use

build.

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 At a first level we have Total Variance in which
we compare Actual Cost and Budgeted Cost.

values:

- variable costs of ;
- fixed costs of 20000
- quantity of 1000u,

and actual values:

-
- fixed costs of 20000
- quantity of 1200 u.

So, we compare budgeted and actual values: we have budgeted cost = 10*1000 + 20000= 30000 and actual
cost = 8.5*1200 + 20000 = 30200. Actual cost budgeted cost is +200, this is an extra cost: we are
spending more than the budget. Looking at this total variance we are not able to understand where we are
not performing as expected.

At a second level, we analyse the volume

variance and the efficiency variance. This level
is based on the flexible budget, which is a
hybrid of budgeted and actual figures. It is
computed based on budgeted variable and
actual volumes. For computing this flexible
budget, we are using budgeted figures as for
the cost and actual figure for the volume. This
intermediate player allows us to compare the
budget and the flexible budget and so to
understand if we have a volume variance (if
we are spending more due to an increase in the demand); then, we have the actual results against the
flexible budget in order to understand if we have an efficiency variance (if we are spending more because
we are less efficient than expected).

If we go back to the example, at budget we have: 10*1000 + 20000=30000; the flexible budget is: 10*1200
+ 20000=32000 and the actual is 8.5*1200 + 20000=30200. We have higher costs due to higher quantity
produced. The efficiency variance tells us we are behaving well because we have a negative variance of
1800 that tells us we are spending less than expected considering the actual volume.

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 At a third level of analysis, we can go more in
depth with the efficiency variance, meaning
that we can try and understand why we are
being less or more efficient than expected.
The third level of analysis has a second flexible
budget between flexible budget 1 and actual
results in order to disaggregate the efficiency
variance. In the flexible budget 1 the variable
cost is budgeted, in the flexible budget 2 we
have budgeted hourly rate (or budgeted
unitary cost if we are dealing with raw
materials) and actual labour usage or material
consumption. Looking at the difference
between flexible budget 1 and flexible budget 2 we can identify if there is a use variance, if we are
employing more material than we are supposed to do. Looking at the difference between actual and
flexible budget 2, we can identify if there is a price or rate variance (we are paying the labour more than
what we budgeted).

Example: we move from flexible budget 1 where we have:

ion
0.15h/u * actual quantity = 1800. The use variance is +600, we are using more direct labour than expected,
at the same time we have a difference in the rate because we are paying the employee more than the
budget, we are spending more because we are using more labour but we are also spending more because
we are paying labour than the budget.

Problems of the traditional approach:

o Cost centre cannot be able to control all these variances because volume variances are not under the
real control of the head of the manufacturing function because the quantity/volume is generally
determined by someone else, the selling function. For sure the manufacturing unit can influence that
parameter in fact, depending on the quality of the products to be produced, the sales will increase or
decrease. However, the manufacturing unit is not totally responsible of the volume variance; in a
similar way if we think to the efficiency variance we have price variance and use variance. The use
variance is the unitary usage, a real matter of efficiency, and it is under the control of the
manufacturing function. However, if we think to the price variance it depends because if the
manufacturing unit is autonomous in selecting the suppliers and negotiating, the price variance is under
its influence. In practice it is quite rare, because there is a purchasing function that will be responsible
of selecting the suppliers based on a vendor rating process, negotiating the contract with the supplier
and in the end the selection of the supplier could explain the quality of the material of the components
that enter the production process. In the end this parameter is not under control of the manufacturing
function. So, if we rely on flexible budgets for evaluating the performance of a production function, we
have to be careful because we have to isolate the cost components that are truly determined by the
production function, otherwise we do not respect the principle introduced at the beginning of the
course that was the ability of a performance measurement system of monitoring, capturing and
understanding the specific responsibilities.

o Traditional approaches do not consider two important aspects:

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 - Quality of components: if our production unit in the attempt of reducing the total cost and being
more efficient determines a lower quality of the products, this lower quality could be reflected in
lower customer satisfaction that could lead in the long-term in a reduction of the quantity sold.
We are forgetting of some parameters that this production function can influence, so in the end
this instrument should be complemented with something else and the output of this kind of
analysis should be read in the light of what an organizational unit can influence or not.

- Feasibility of production.
o Short term oriented

Revenues centres

The mechanism is the same if we move from a cost

centre to a revenues centre, revenues centres are
organisational units whose responsibility is limited
to the output. They usually are commercial units.

The performance indicator traditionally used is

revenues:

Revenues = price (p) * Volume (V)

At a first level the Total Variance will be:

actual revenues budgeted revenues.

At a second level of analysis we are able to

disaggregate into volume variance and
price variance. In particular volume
variance will be different between budget
and flexible budget.

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 At a third level of analysis we further divide the
volume variance in market share variance and
market size variance. The volume, what is sold
by the company, can be seen as the market
share of the company * the market size. Changes
in the volume can depend on an increase or a
reduction in the market or an increase or a
reduction in the market share. Even in this case
we introduce a further flexible budget to
highlight the effect of the volume. In the flexible
budget 1 the size of the market is actual and the
market share, the quota of the market, is a budget. Meaning that the difference between the flexible
budget and the budget gives us the market size variance that could be somehow exogenus, the difference
between the flexible budget 2 and the flexible budget 1 is driven by the change in the market share.

Problems of the traditional approach:

o Revenues centres not always can control variations in price and quantity sold:
for revenue centre is the same of cost centres: some parameters are influenced by other functions (the
quantity sold can be influenced also by the production function), on the other hand we could have
some external dynamics that could explain for instance the market size variance meaning that if we are
assessing the performance of our revenue centre/commercial unit, we can isolate the contribution of
the market size but it does
Even in this case, the flexible budget is an useful instrument in order to identify where there are
problems or opportunities; however, in order to use it for measuring performance of responsibility
centre, we need to be careful because we have to identify the pieces of this framework that make
sense in connection with how decisions are made in our organization.

o Yearly Revenues are a not long-term oriented indicators.

Expense centres

Expense centres are characterized by:

o Output not easily identifiable with money;

o Difficulties in defining an input/output relation using standard coefficients.

Traditionally for this type of functions, there used to be a threshold, a predetermined budget that could
not be exceeded. There has been a limited attention to these centres, for their historical low incidence
on total costs; now the cost structure has significantly changed and in the last twenty years the
relevance of these support functions and these expense centres increased a lot requiring for the
introduction of a more precise way for monitoring the performance of these centres. Control on
performance is not possible.

If we put together all these considerations about cost centre, revenue centre and expense centre we
could see that traditional approaches to the performance evaluation of these responsibility centres

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 need to be modified. The way how they can be modified is based on some technical instruments and
organizational re- focus on the first two elements, that are accounting techniques used for
monitoring the results of this organizational unit, however it is useful to highlight that when we deal
with the need of evaluating performance within the company considering more disaggregated units of
analysis, also the organizational design of that function plays a relevant role. One of the key issue from
the organizational point of view, is the introduction of coordination mechanism that ensures that
different functions are somehow aligned. We do not focus on the organizational redesign.

Possible solutions:

o Adding other information to the traditional measures through the two accounting instruments:
o Activity based analysis (ABM)
o Value drivers
o Using cross-unit coordination mechanisms:
o Inter-functional teams
o Task force

Accounting instruments

Activity Based Management

ABM stems from Activity Based Costing (ABC). The ABM is a process that can be used for evaluating
performance for any organizational function, can be used at different levels of analysis and it is
frequently used in particular for responsibility centre. The reason is that the ABM uses a main
reference the activities performed by the organizational units, the cost centre, the revenue centre
and the expense centre.

Why considering activities? For two main reasons.

- The activity as a unit of analysis is more stable than other organizational units (e.g. an office or a
function):
Typically, companies perform periodically some reorganizations and when these
reorganizations are carried out some activities can move from one organizational unit to
another one. The activity is stable meaning that it used to be performed in the past and it is
performed now; the organizational unit will change following different reorganizations while
the activity would remain.
- The activity as a unit of analysis is more homogeneous than other organizational units:
if we think to an expense centre, it performs many different types of activity; in the human
research function we find different activities that are performed, for instance selection and
forming new employees, evaluation of the employees, cost analysis for the employees. This
group of activities is heterogeneous and if we put the activities all together we could have
activities that are very diversified and if we focus on the activities as a unit of analysis we can
capture this difference.

ABM system relies on the idea of using activities as unit of analysis for defining KPIs and then we
evaluate organizational units based on the activities that they perform and based on the
parameters that are relevant in connection with those activities. Identifying KPIs is easier when
thinking in terms of activities than when thinking in terms of offices and functions.

ABM derives from the Activity Based Costing.

In ABC we can identify 2 main phases:

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o Phase 1- costs understanding:
o Identifying activities;
o Defining the use of resources by each activity (resource driver)
o Determining a measure that drives the consume of activities (activity driver)

o Phase 2 costs allocation:

o Apportioning the activity costs to each product

ABM is a simplified version of ABC because it

focuses on the first part of the ABC. We are
not interested in understanding the single
quota of the cost that should be allocated to
the product; we are interested in
understanding resources that are consumed
by different activities and what can explain
why we are registering higher costs
compared to the last year, for instance.

The focus on Phase 1 is often used by managers for stressing the use of information for managing
rather than calculating costs (accounting exercise)

The steps of ABM are:

o Process mapping and identification of activities;

o Representation of activities as a micro-enterprise:
o Resources (personnel, services, technolog
o Client (external or internal)
o Supplier (external or internal)

1) The process mapping can be carried out either using a

bottom up process or a top down process. In the top down case, we
have a consultant or the controlling function that do the mapping
and this imply that this person should be very knowledgeable about
the company because he/she has to be able to understand what are
the processes and the activities that should be associated to each
function.

In the second approach, instead, there is the involvement of the

employees of the function itself. Each function builds its own
process list, there is typically someone that acts as a moderator/
collector for all the activities. This approach leads to results that are
much more precise, people that work in functions are those that know the processes better even if in this
case we end up having a long list of activities.

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A possible solution is the top down approach with more inter-confrontation with the units, interviewing
different people from the organizational units.

2) With the ABC curve we need to identify the primary and the secondary activities. We need to
understand the activities, that is a first step, and associate to these activities a unitary cost.
3) Then, we need to identify a driver for the primary activities, meaning that we have to associate to
each activity a measurement of the output produced.

For determining the ABC curve we typically

rely on a table like this, where on the rows
we have different resources and on the
columns we have the percentage of
absorption of that resource by different
activities. For instance resource 1 has been
consumed for the 20% by act. 1, for the 60%
by act. 2, for the 20% by act.4. then, by
multiplying these percentages by the cost of
the resource, we can identify the cost of
resource 1 that is consumed by 1, 2 and 4.

Based on this process, we can determine the overall cost of the activity.

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 example:

we have internal personnel

or external personnel. The
internal personnel has the
level, a category, and the
gross cost, the salary, and
the part-time percentage.

These are the activities performed by the

accounting function; the cost of each
activity is estimated considering the
salary times the percentage: the expense
management consumes the 60% of the
time of the employee number 1 and the
20% of the time of the employee number
2. In this way we can estimate the cost of
the activities.

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 Once we have determined the cost of the activities,
we can build the ABC curve meaning that we can
order the activities from the most expensive to the
less expensive and the activities are represented on
the axis and on the y axis there is the cost
absorption, the percentage of total cost that is
consumed by each activity. This is a cumulative
curve and we can identify in this way the primary
activities as those activities that are responsible for
at least the 80% of the cost of the function and
secondary activities that are responsible of the
remaining cost. This is useful for reducing the
number of activities in order to select a limited set of activities that are however highly responsible of
the overall cost of the function.

When selecting the drivers, we need to consider these three criteria that are:

o Correlation between the driver and : we need to identify drivers that are
representative of resources that are consumed by the activity. Typically, we should pay attention to
measurements that are already carried out within a company or an organization for other scope in
order to understand if we are able to select some measurement that is already monitored for different
reasons.
o Measurement cost: the measurement is an extra-cost for the company. We need to balance the
precision of the measurement with the measurement cost. If we need to introduce an extra-indicator
tant
to balance the correlation of the metric with the consumption of the resources with the cost of the

within the unit and try and understand if they can be used as a driver
o Behavioural impact

. The trade-off between cost and precision is

represented by this picture where we see that
the more a measurement is precise the more it
is expensive but if we have a very precise
measurement the cost of the error that we can
perform is reduced.

What ABM is useful for?

This representation can be used for 2 analysis:

- Identification of value added and non-value added activities:

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 As we said, expense centres in the past used to be evaluated based on maximum thresholds that could
not be exceeded. This kind of analysis is useful to understand if some activities that are carried out by
these expense centres are really not valuable maybe because the organizational function has changes,
processes have changes and so on.

- Identification of costs components/causes:

o Activity level;
o Cost per driver

Second, we have a quantitative analysis that is more related to cost and activities, meaning that for
each of our activity we can perform an analysis of cost components and we can understand how an
eventual variation, differences in the cost, could be explained by variation in the activity level, or
variation in the level of output and so on.

The first analysis is aimed at identifying non value added activities. In particular we consider non value
added activities:

o Activities without a client

o Activities for which clients attribute no benefits

The elimination of non-value added activities should allows to save costs without affecting client
perception.

The second analysis looks instead at the activity cost composition, see the example below:

in this case we have two activities carried out

by the purchasing function: supplier
management and order emission. The total
cost is the sum of the resources that are
consumed by the two activities. Then we have
the drivers, which are n. suppliers for supplier management and n. orders for order emission. The cost per

the order emission. This is the output of the ABM analysis.

How can we use this set of information? We can use them in two different ways.

ABM allows to see the effect of changes in:

o Activity volume
First, we can simulate what happens if we record a change in the activity volume (if we have to
manage 300 suppliers instead of 320 or 400 instead of 320). How does the cost of the function

we have flexibility in acquiring resources, we can assume that an increase of 80 suppliers will lead

if the volume that the function should manage change because it increases or it decreases? In the
first case, how many resources we need to employ for ensuring a new level of activity, or if it
decreases, what is the amount of resources that is made free and that could be somehow used for
different purposes. We need to be careful because we are dealing with expense centres and
probably not all the resources are totally flexible, maybe we have resources dedicated to one

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 function that cannot be moved from the function to another one. However, at a first level of
analysis these figures can help us in quantifying what are the resources that we need to commit or
that we can save due to a change in the activity level, in the value of the driver.
This type of usage means that thanks to this analysis, we can understand the sizing of the resources
in prospect or past terms.

o Cost per driver

There is also a second type of usage that, instead, is related to the value of the cost per driver. We could
try and understand if there is a learning effect whereby the company is able from year to year to reduce
unitary costs. This analysis is useful to understand hoe the function is being able of managing efficiently
resources.

Variation in the driver volume (E.g.: 10% reduction in the n. of supplier)

Variation in the cost per driver (E.g.: new information )

To sum up, we said that traditional approaches rely on the flexible budget and the flexible budget has
some shortcomings that are related to the parameters considered and to the ability of our
responsibility centre of mastering the parameters that are included in the analysis. As regards expense
centres, traditional approaches just define a threshold that should not be exceeded. The shortcomings
of this method can be solved using and ABM approach and using value drivers. Moving from the ABM, a
simplified version of the ABC that relies on its technicalities, we discussed the process that we need to
follow in order to implement an ABM in order to highlight that the benefits that could be related to an
ABM are at two levels: at a first level we can gain a better comprehension of how the activities and the
processes are carried out by our function. This is valuable because it allows us in identifying what are
the value added and the non-value added activities. The second benefit of an ABM analysis is more
quantitative and it is related to the possibility of using the set of information that derive form an ABM
analysis in order to simulate or understand the effect of variation in the activity level or in order to
understand or to simulate the effect of improvement actions in terms of unitary cost (cost per driver).

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 The instruments that we can use for
complementing the flexible budget are the
ABM and the value drivers.

Thanks to the ABM, as we said, the first

result that we can obtain is a better
understanding of processes and activities.
Thanks to this better understanding, we
can guide the selection of the value
drivers that we can use for measuring the
performance of the organizational units.
By mapping processes, selecting activities
and selecting drivers we could try and
classify our activities depending on their
characteristics. This is an example in which activities have been classified based on two dimensions:

- the first one is the orientation to efficiency and effectiveness: we could have activities very
repetitive but in which we want to minimize the cost, on the other hand we could have activities
more focused on effectiveness ensuring the customer satisfaction;
- the second one distinguishes between repetitive processes and projects. At a company level we
can find many repetitive processes but also some projects (development of a new system, of a
new tool).

Based on this classification we can guide the selection of the value drivers. For instance when we move
from efficiency to effectiveness, the cost per dirver remains a relevant parameter but we want to know
something more about the quality of the supplier meaning that the output of the ABM system is not
enough. I have to complement my cost per driver indicator with something more that could be a piece of
information about the raking of the supplier, or about customer satisfaction; the ley issue is that we have to
integrate the unitary cost with further value drivers that are able to capture the qualitative dimension of
our process that has an impact on the customer satisfaction, where the customer can be either internal or
external.

The ABC gives us in output a better understanding of the processes and our cost per driver indicators. This
information could be enough if we are looking at efficiency oriented and repetitive processes but are not
enough if we are dealing with processes that are oriented to efficacy or if we are dealing with projects. In
this case we have to complement the ABM with something else, some KPIs that have to capture a section
of internal or external customers and the project dimension if we are dealing with projects.

Repetitive activities

- Repetitive and efficiency oriented activities

o Performance analysis is focused on comparing budgeted costs and drivers with actual results
o A traditional approach can be followed in this case highlighting volume and efficiency variances
- Repetitive effectiveness oriented activities:
o Performances can be measured using indicators like these:
Overall cost of activities
Quality perceived by internal or external customers (e.g. CS survey)
Internal quality indicators
Time

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