Financial accounting is the branch of accounting intended for users outside the organization (External

Accountability). IFRS (International Financial Reporting Standards) are required for most of the countries in the
world. It defines also Annual reports and Interim reports (Financial statements). The compulsory documents in the
annual report are Balance sheet, Income statement, Cash flow statement, Statement of Changes and Notes.
Companies listed have to provide additional reports (external auditors, supervisory board, management report).
Financial Accounting provides the numbers about a company used to evaluate it.

Accrual Principle: accounting registers events based on economic activity rather than financial activity. Accrual event
is the moment in which the transaction has its effect  Effects of transactions are recognized when they occur
(transfer of property)  Net Profit [logic for BS and IS]

Cash Principle: Financial event is when cash is received or paid  Cash accounting accounts cash for inflows or
outflows (transfer of cash)  Net cash [logic for Cash Flow statement]

Balance Sheet describes the circumstances of an enterprise in a given point of time (usually midnight 31/12), it
reports assets and related rights (equity and liabilities) expressed in monetary value.

It is divided in two sections: Assets (resources, ‘impieghi’) and Liabilities (rights, present obligations, ‘fonti’)

Assets are clustered in 3 blocks (Non-current assets (long term), Current assets (short term), and assets classified as
held for sale and disposal groups).

NC assets are all the resources used for more than 1 year.

Current assets
Held for sale

How can we evaluate assets? Costs Model or Revaluation Model

Costs Model is based on the historical cost (monetary value paid for its purchase or construction, book value -
depreciation, amortization and impairment). Revaluation Model is based on the Fair Value (value aligned with
market circumstances, you compare it yearly)

Revaluation Model based on Fair Value concept

has strengths and weaknesses.

-High costs and subjectivity

+Reflects more the market conditions

shareholder equity: market value – book value as a

revaluation reserve

With the fair value

model, the change in
the value of an asset
can be balanced either
in the Income
Statement or in the
Equity section of the
Balance Sheet
(reserve)

Benchmark treatment vs allowed treatment:

IAS/IFRS allows to adopt both models, it can indicate preferred accounting criteria (Benchmark Treatment BT), and it
can indicate a possible alternative criteria in accounting (Allowed Treatment AT)

Impairment Test: mandatory, it verifies if the carrying value is fair with reality [recoverable amount of an asset] (to
identify any loss of value due to different causes: market value declines, obsolescence). [carrying value = book value
= asset cost – cumulated depreciation]

The objective is to identify the Recoverable Amount of an asset, which is the highest value btw Fair Value (value
given by market circumstances) and the Value in Use (DCF + TV, discounted present value of estimated future cash
flows DCF expected to arise from its use plus its disposal TV).

If the Recoverable Amount is > expected carrying value (the item is not impaired, the real value is higher than the
one reported. If the Recoverable amount is < expected carrying value: item Impaired  we have to report the
recoverable amount (- new depreciation) and the loss is an Expense in the Income Statement) [Impairment is a non-
cash expense that is reported under the operating expenses section of the income statement)

Case: Carrying amount = asset cost – accumulated depreciation (value/lifecycle x years in use). Recoverable amount
= Fair Value = 4000 < carrying amount 5000  item is Impaired (1000 loss is registered in IS).

From exercises: If the FV is higher than BV the item will be depreciated in the following years, an increase in FV
would be accounted as FV – FV/remaining lifetime  depreciation for the last year.

Property, Plant and Equipment PPE are defined as Tangible assets retained by the company for a long-term use.
Investment property are still tangible and so they need to be depreciated.

Intangible assets are non-monetary assets without physical substance, they need to be identifiable, controlled and
would create future economic benefit. They may be acquired by separate purchased, by internal generation or as
part of business combination. They can be classified in two categories, with Finite life and infinite life.

The main items excluded by IAS/IFRS from BS are start-ups, training cost and advertising costs.

Goodwill is an intangible asset with indefinite life, it arises when a company acquires another company spending
more than the market fair value of net identifiable asset acquired (assets – related liabilities). It is recorder only
when there is an exchange transaction. It may happen because there are some items that create value that you
cannot see in statements (Reputation, Target customers, Strategic positioning, networks; part of Brand Equity)

Case: acquiring at 5000, fair value PPE 9000, liabilities 11k, intangible assets 4k  fair market value net assets = (tot
assets – total liabilities) 2000, goodwill = acquisition cost – fair mkt value of net assets acquired = 5k – 2k = 3000.

Financial Assets could be current and non-current, they are related to financial instruments (contract btw 2 parts
that give rise to a financial asset or liability), financial assets might be cash, equity or contractual rights.
Liabilities are classified as Shareholder equity and Stakeholders rights (banks…), which are classified like assets in
current, non-current and related to assets held for sale.

Shareholders’ equity is based on Direct capital payment or changes in the capital value (off-balance of BS), Net profit
could be distributed as Dividends or kept in Reserves.

Equity = Total assets – third part liabilities.

-Capital is the part of the equity obtained by provisions of shareholders which describes the level of participation
and therefore their rights. It is defined by the shares subscribed at their nominal unit value NV*N – treasury shares
and shareholders receivables. Shares nominal unit value is the initial value offered.

When the Equity capital rising occur for new issued shares, it is priced with reference to mkt prices:

N (new shares occurred), NV (nominal value), MP (mkt price). If MP > NV  N*NV is registered in BS (equity part
under capital), N*(MP-NV) registered in BS (equity part, under reserves), N*MP is registered as a financial cash
inflow (CFS). [doing so we distribute the difference as a reserve, the NV as the capital provided and the MP as a
inflow, and so even if the cash would be higher than the NV we will have a counterbalance in the reserves due to the
additional value of MP]

-Treasury shares are the shares that come from repurchase or buyback, they refer to previously outstanding shares
that are bought back from shareholders by the issuing company. These shares are issued but no longer outstanding
and are not included in the distribution of dividends or the calculation of earnings per share (EPS).

-Reserves are additional shareholders’ rights which have been generated during the normal operations of the
company (share premium reserve, profit brought forward; difference among MP and NV, revaluation model
difference among Fv and book value…)

Income Statement describes the

economic value of physical and financial
transactions undertaken by the
company in a given period, it is drafted
to the accrual basis accounting. It can
be presented by Nature (costs
aggregated on the basis of nature) or By
Function (costs aggregated on the basis
of the activity in period and product
costs, no D&A).
They only differ in the upstream part till Operating profit (which is EBIT if there are no non-recurring expenses)

At the end of the IS entities with securities which are publicly traded are required to report the Earning per share.
This helps to improve performance comparisons btw different enterprises. It shows the Basic Earnings per share and
Diluted earnings per share.

Basic earnings per share are calculated as: Profit or Loss attributable to ordinary equity holders of the parent equity
deducting all expenses including taxes, interests, dividends (Adjusted Profit) / weighted avg of the n° of ordinary
shares outstanding during the period.

Diluted earnings per share are calculated as: Profit or Loss attributable to ordinary equity holders of the parent
equity deducting all expenses including taxes, interests, dividends (Adjusted Profit) / weighted avg n° of ordinary
shares outstanding during the period adjusted with the effects of dilutive options.

Cash Flow Statement summarizes the results of the financial transactions undertaken by the company in a given
period. CF is prepared on Cash logic, it can be presented in two options: Direct method (cash registered by nature),
Indirect method (cash flows derived by adjusting the EBIT for the effects of non-cash transactions like D&A, changes
in Inv and trade payables which are added because already subtracted in the P&L and we decrease it by Interest Paid
and taxes because it was EBIT). [indirect method considers changes in NWC on previous year = + Receivables +
Inventories (i-f) + payables (f-i)]

We can distinguish 3
categories of cash
flows (operating,
investing and
financing)

Between the two

approaches only the
operative changes due
to the different entity
of transactions
Due to different criteria (Accrual and Cash Logics) the Net income from IS and Net Cash Flow from CF might be
significantly different.

The reconciliation btw different logics can be easily seen in the IS indirect method (amortization with different
conditions).

Quality of operating earnings = CFFO / EBIT

Statement of Changes in Equity must show profit or loss for the period, item of income and expense, total income
and expense for the period, the effects of changes in accounting policies.

Marco Tamborini EY

Financial Analysis to deep understand the performance of an entity (one corporation), or group. When we need to
analyze group financial statements we need to focus on all of them. Financial statement responds to legal
requirements, so they don’t define properly the performance of an entity/group, they need to follow accounting
framework, which can be different btw countries. The Analysis is aimed to understand the final position of the
company as well, because it pictures M&A contexts or Benchmark analyses (compare companies within the same
industry), it observes reasons of performances and the lack of improvements.

Financial statements represent the starting point of the whole analysis, a Management Report (technically not part
of the statement) helps the understanding of the statements as it provides additional info and an outlook over the
performances. [In Italy the Civil Code defines purpose and contents of Management Report]

GAAP measure: General Adopted Accounting Principles (like IFRS): There are alternative performance measures like
EBITDA and other indicators

Information included in the management report is important but:

-Sell-side vision bias  management report includes over emphasis towards positive aspects of performances and
optimism for future outlook

-Focus on EBITDA/EBIT/NFP: quickly considered by analysts but difficult to understand their genesis.

-Discretionary measures: subjectivity under some measures like non-recurring items.

Listed Companies have to provide more structured information because they have more restrictions and obligations
towards stakeholders. On the other hand non-listed companies have less requirements and pressure from
stakeholders.

4 steps for Analysis: Critical Analysis of Data Available, Reclassification of Data, Ratio calculation and critical
comparison, Analysis.

Critical Analysis of Data available: Management Report, company’s accounting policy (how the company is applying
standards), BS, IS/PnL, CF, explanatory Notes.

Due to different criteria (Accrual and Cash Logics) the Net income from IS and Net Cash Flow from CF might be
significantly different. The reconciliation btw different logics can be easily seen in the indirect IS method
(amortization with different conditions).

Accounting rules are continuously changing, so it is needed to keep consistent. If a company owns another company
it is needed to draft a Consolidate Report.

Reclassification of data has the purpose to facilitate the accounting analysis. (no mandatory)
  BS can be reclassified as Current/ Non-Current Assets factors with the % of tota l (percentage breakdown), in
Non-Current we might have to divide tangible and non-tangible assets, it gives the possibility to see the
Flexibility of the business (more or less current assets). The more tangible assets I have the more guarantees
I can give to Stakeholders. Financials can be reclassified as equity, current and non-current liabilities.
 IS can be classified as EBITDA, Operating Result, EBIT, EBT.
 Cash flow can be reclassified as Cash at the beginning of the period + net cash flow from operations +
investments + financial activities  NCF at the end of the period.

If you start from IFRS the reclassification process is way easier; it is not used for compliance because it is an internal
tool; PnL can be done in accordance with the different method, it can be reclassified highlighting financial KPIs like
EBIT and EBITDA. Reclassification can be relevant for statements presented in more structured layouts (ex.: ITA
GAAP presentation – OIC)

Ratio Calculation and Critical Comparison

Net Working Capital NWC = Current Assets – Current Liabilities. The higher NWC the better, because we are able to
meet short term obligations by liquidating the operating (current) assets. If it is negative we would need to use one
of the structural assets (sell non-current tangible assets). However, attention shall be placed on the assets included
and therefore you can do a NWC without cash items as well]

How to improve NWC without cash items? Analysis of NWC is the starting point in order to understand if NWC can
be optimized and if there is room for: - reducing the «time-to-bill»- increasing the «time-to-collect»- enhancing
production lead time - improving the outstanding payable days to suppliers as opposed to the average collection lags
from customers.

Net Financial Position NFP: Financial liabilities – cash and cash equivalents – financial receivables, it summarizes the
level of indebt towards borrowers of financial resources to the firm. NFP is typically negative as Groups, companies,
etc. tend to obtain borrowings in order to finance the business. NFP is the quick indicator expressing the amount due
to company creditors. A negative NFP doesn’t mean itself that the situation is bad: as a reminder, company shall take
into consideration the existence of Equity resources (while keeping the relationship balanced with the asset
structure anyway). In the calculation, it’s important to take into consideration «leasing obligations» (accounting
speaking they represent «financial liabilities»).

Net Financial Position / EBITDA (the lower the better, it means how much ‘virtual’ time it is needed to repay financial
debt) [EBITDA in accrual principle], it doesn’t differ due to different Taxes, cost of debt or D&A policies.

Net financial Position / cash flow operations: ability to generate cash from operations (the lower the better) [cash
logic] how much ‘virtual’ time it is needed to repay financial debt with cash logic

Leverage Ratio: Financial Liabilities / Equity Value. If >1 means that company is using more debt to finance its assets
and operations. [level of debtness, financial D/E]

Return on Equity ROE: Net Income / Equity. Return on net assets (tot assets – tot liabilities), how effectively the
management is using company’s assets to create profit (it expresses the investment convenience so it has to be
compared with other investments). It indicates how much an equity-risk investor can get from every € invested in
the company (return of an equity investor)

ROI Return on Investments: Operating Result / (tot assets – non-financial liabilities). The higher the better, it
measures the return on the capital invested (equity and financial liability) without considering taxes, interests and
non-recurring activities.

Days Sales Outstanding (DSO). Account receivables / net sales x 365. It expresses the avg n° of days needed to collect
payment after a sale (the lower the better). [VAT applicable]

Days Payables outstanding (DPO). Account payables / net purchase x 365. The higher the better (Best if DPO > DSO
so then we can finance our activities with commercial debt), avg n° of days to pay suppliers after having received the
goods. (if too high could indicate of bad management) [VAT applicable]
With ratios we need to compare them on a Performance year on year basis. We need to evaluate even the
benchmark intra sectors, industry matters, business models.

Accounting distortion can be many, usually they are:

-Lease accounting (IFRS16, policy change): from operating cost in 2018 to a lease liability of contractual obligation –
annual expense counterbalanced by a Right of Use; interest from leasing and amortization.

-Inventory valuation (change on evaluation of inventories costs: Fifo-Lifo-weighted avg cost), revenue recognition.

Relation btw ROE and ROI

(ROI + D/E) An increase of debt is

good for shareholders only if the (ROI
– r) > 0.

D/E amplifies the ROE

We can distinguish a part for

operating activities, one for
financing…

Analysis case from page 50

Financial analysis 2

We compare financials of two entities: «TOD’S S.p.A.» vs. «GEOX S.p.A.» in order to give the method for analysis.

BS reclassified as Current vs Non-current assets and liabilities. PnL reclassified emphasizing Total Revenue – cost of
production = EBITDA - depreciation and amortization = EBIT - net financial expense = EBT - tax  Net Income. CF
reclassified as CF from operating, investing and financing activities.

Taking into consideration TOD’s we can see through Excel how we reclassified the statements (PPE unified…).
Geox prepares its IS by using a Function criteria (depreciation is not highlighted, so we would need to go through
Explanatory notes to see it (export it from costs), in 2019 Geox had a lost of 33M (net result), while in the CF they
had a cash increase of 9M  The typical operation were positive (63M), but they decided to invest, generating an
outflow of 25M (10M of new building) and they used cash to meet their obligations (28M).

The comparison with previous years is key to understand the genesis of cash and the evolution of statements, Time
Horizon analysis (Variance Analysis). What are the main doubts on a company analysis:
  Are the two companies able to meet short-term obligations?

NWC stands for the excess of assets on liabilities (if we have a positive NWC is fine but we need to understand the
components of the assets, Tod’s has 600M current assets
but we don’t know what does the voice ‘Other’ include (it
could include further expense for accrual basis, and we
could not count on them for NWC, because you will have
further revenue, same as liability. We need to have a look
to notes; furthermore we need to have a look to
receivables which would have to be collected asap (if
customers delay the payment we could not count on those numbers, in addition receivables account risk coefficient
(doubt default provision). Inventories have the same issue due to the fact they are evaluated as LIFO, FIFO or
weighted avg cost (so it is not a real number  Obsolescence reserve). We can calculate the NWC without cash and
if it is close to general NWC it means that company has a lot of liquidity.

Quick Ratio: (Cash + Short term investments + Receivables) (Current assets - inventories – prepaids) / Current
Liabilities; it represents the ability to use «quick» current assets to re-pay the current debt.

By using «quick» current assets, Tod’s is able to re-pay the 26% of current debt (vs. Geox : 11%)

 What is the level of debt? [high debt doesn’t mean is that bad, it has to be seen overall]

Leverage = Financial Liabilities / Equity can be used to study debt. (fin liabilities are current, non-current), we can
calculate it even without the lease impact (it is not the same thing like getting loans from the bank).

NFP net financial position = Financial Liabilities – Cash & Equivalents – Financial Receivables, we can compute it
without lease impact. Tod’s nfp = -234k, nfp without lease = -85. It means that if I have to re-pay all the loans I have
to pay 85k.

To understand if the NFP is sustainable (how the company is able to re-pay the debt), we need to calculate the ratios
NFP / EBITDA or NFP / Cash flow from operations (we need to be aware of the year on year operating CF as well in
order to study the trend and avoid extraordinary events). Responses from the first rate are similar (in the industry
there is the similar debt), while the second is different, so CF is way different (in Tod’s CF is able to repay in 11 yrs,
while in Geox in 2 yrs but we need to understand them better from the CF analysis).

In order to study better CF we need to try to understand what happened to inventories account in order to
reconciliate the loss of cash if there are big gaps btw following years.

Cost of Debt = Interest Expense / Financial Debt, it gives a perspective on the cost of the resources. Geox has a lower
rate and therefore it means it is getting loans with less interests.

 What are the characteristics of the asset composition? [which are the key assets, tangible or not]

Is the asset structure Flexible? (Current Assets > Non-Current Assets)

 Is the company well managing cash flows through Accounts Payables / Receivables?

DPO = A/P / Net Purchases x 365 (in Tod’s we subtract form the operating expenses the change in inventories which
is not a pure transaction). DSO = A/R / Net Sales x 365.

Both have DSO > DPO and therefore they will need to deliver payables before collecting receivables.

INCOME STATEMENT:

WHAT ARE THE MAIN THOUGHTS? P/L analysis (comparing lines), main indexes (ROI, ROE). What is the impact of
«accounting» measurements like: amortization, deferrals, estimates?

Positive taxes are not that common, EBIT are different: Tod’s had a positive effect from investment and higher
revenue although the costs are similar.
What is a Group

Group of companies, we will focus on how we can

account and measure the results of the group.
Group formed by a set of companies (separate
legal entities). Parent (holding, controlling entity)
controls Subsidiary companies.

Parent company can have different kind of

relationships, investments can be: Subsidiary (full
control IFRS 10, IFRS 3), Associate (significant
influence, less than 50% ownership, IAS 28), Joint
venture (joint control, creation of a third company
IFRS 11)

In the annual report we can see this kind of investment and the accounting method used to take them into account.
If we have an investment into an associate or joint venture we would comprehend this investment in the BS through
‘Investment accounted for using the equity method’ (to see the details we can see the notes).

Equity method is used when the investor holds significant influence over the investee but does not exercise full
control over it (as in the relationship between parent and subsidiary). Unlike the consolidation method, there is no
consolidation and elimination process [only proportionate share to control and relative investment + net income -
dividends]. If it is Associate I recognize the fact that it is a non-current, intangible asset as a financial investment.

The investor reports a proportionate share of the investee’s equity as an investment (at cost of acquisition):

- Profit / loss from the investee increase / reduce the investment account by an amount proportionate to the
investor’s shares (profit from associate and investment in it)
- Dividends paid out by the investee are deducted from this account [Investment + net income*% – dividends*
%]

Consolidated financial statement: annual reports (BS, IS, CF, Change on Equity, note) for all the companies
Subsidiaries to the Holding company. Doing so we sum up the results of the whole group so we cannot differentiate
btw good or bad performances of each company.

For consolidation we can use IFRS 10. We can find the definition of Control, when we need to consolidate, what are
the exceptions.

Control happens when the Parent has power over subsidiaries (majority of voting rights or substantive power (most
of the BoD), more than 50% shares of the company or relatively high share in comparing with the other
shareholders), when there is exposure to variable returns (both positive or negative returns in base of
performance), ability to affect the return (involvement into decision making).

All the 3 conditions need to be concurrent in order to define Control over a company. Otherwise we need to check if
it could be defined as Associate.

Questions: How do we know when a company is a subsidiary? When parent owns more than 50% or it has power to
affect the returns/decision making and it is affected by them

How to consolidate

Pre-consolidation adjustments, might not be necessary. They are needed to compare values on the same
dimensions.

- Closing Period: fiscal years, subsidiaries need to prepare an interim report with no more than 3 months of
difference (otherwise interim reports)
 - Accounting Policies: subsidiaries apply the same accounting policies of the group (IFRS, GAAP depending on
the nationality of the parent company) [e.g. R&D costs are accounted differently btw GAAP and IFRS, under
them a part of them is capitalized as development expenditures]
- Reporting Currency: IS items are translated the currencies with the exchange rate of each transaction or the
average rate of the financial year; BS items are translated with the rate at the reporting date of the
consolidated financial statement. [different rates for translating IS and BS items lead to Translation reserve
which is a special owner’s equity reserve]

Consolidation Process:

 Combine like items (sum up equal assets, liabilities, equity, debt…)

 Offset (eliminate the fact that the parent has subsidiaries, assuming that the value of equity and investment
are the same  investment counterbalanced with portion of equity), in reality we acquire a company with
Goodwill.
 Eliminate in full intragroup transaction: 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 (if the parent and subsidiaries sell and buy goods within each other we
need to eliminate them from revenues, costs, receivables, payables, profits and losses, dividends under IFRS
10; Transfer Price)

Moving to a more Realistic Scenario… [combination process with fair value and tax effect; impairment for Goodwill;
Non-controlling interests]

 We will have to use Fair value instead of the Book value. Subsidiary's assets and liabilities are recognized at
their fair values at the time control is acquired.

If the fair value differs from the book value we need to consider the Tax Effect: the surplus may create a ‘temporary
difference’ that will give rise to more or less taxes in the future. We want to recognize such future obligation (or
benefit) though the separate recognition of Deferred tax liabilities (or assets).

e.g. company MICKEY buys 100% of shares in company

MOUSE. The cost of the investment is 2.700. The balance
sheet of the two companies at the date of the acquisition is
reported in the following table:

On the acquisition date, the fair value of the assets and

liabilities of MOUSE equals their book value, except for
plant, which fair value is 1.000 higher that the carrying
amount, and provisions, which fair value is 200 higher than
the book value. Consider that the tax rate applied by the two
companies is 50%

Recognition of surplus of Fair

Value, Elimination of
investment and subsidiary’s
equity, recognition of
deferred tax liabilities and
assets (Tax effect on fair
value > book value)

The potential of this

company to generate profit
in future is high and so I have
to defer taxes on a potential
positive result [fair value >
book value]
surplus on assets i have a payment of taxes and so it increases the liabilities, surplus of liabilities increase assets

VARIATION GOODWILL: If the investment value is higher than the book value we need to recognise the goodwill. We
do not depreciate Goodwill but we do the Impairment Test (intangible non-current assets). Goodwill is an asset
representing the future economic benefits arising from other assets acquired in a business combination that are not
individually identified and separately recognized:

The difference between (i) the cost of acquisition and (ii) the parent's interest in the fair value of the subsidiary's net
assets/ liabilities at the acquisition date must be recorded in the following way:

- If positive (price paid > fair value of equity attributable to the parent), it must be included as an asset, the so
called 'goodwill', in the consolidated financial statements;
- If 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.

Goodwill = Fair value of consideration transferred – book value of equity + Fair value of non-controlling interest - Fair
value of net assets at acquisition (ass - liab) – net deferred taxes (ass - liab)

e.g Mickey Mouse

Consideration
transferred –
equity book value
+ fair value of
non-controlling
interests (0 in this
case) - fair value
of net assets at
acquisition (assets
value surplus
minus the
deferred taxes at
fair value –
liabilities surplus +
deferred taxes)

[ass – liab with

related deferred
taxes]

G = Inv – BVE – net surpluses [(surpl ass - defliab) – (liab - defasse)] [liab from assets and assets from liab]

NON-CONTROLLING INTERESTS: if parent acquires less than 100 % of subsidiaries’ shares we have to eliminate the
part which is not under parent control in the consolidation process. We can follow the Full Goodwill Accounting (fair
value) or at the non-controlling interest's Proportionate Share of the investee's identifiable net assets [it depends on
the investor]
e.g. STAR acquires LIGHT by
purchasing 60% of its equity for 300
million in cash. The fair value of the
non-controlling interests is
determined to be 200 million. The
company's tax rate is on a 40% basis.

Surpluses = (140-50+75-30+255-90)

=net, to be taxed.

If the company chooses to apply the Full Goodwill

Method, the non-controlling interests’ value is equal
to their fair value (200 million). In such a case, the
total value of the company is equal to the price paid
by the parent company + fair value of non-
controlling interests.

Goodwill is price paid + fair value of non-controlling

interests – book value of equity – net surpluses (net
tax effect) [difference from paid and book value, -
net surpluses]

The tax effect is determined as surpluses*tax rate =300*0,4 = 120  Net surpluses = 300-120 = 180

If STAR chooses to record the

non-controlling interests at their
Proportionate Share of the
amount of the investee's
identifiable net assets, the
goodwill recognized and
measured in the consolidated
financial statements is only the amount attributable to the portion belonging to the parent company (i.e. STAR).

The value of the non-controlling interests is 76 (i.e. book value of the proportionate share of the investee’s
identifiable net assets) • The portion of net surpluses belonging to the controlling entity is 108 (i.e. 180 x 60%)

[goodwill calculated on book value and with proportionate share of ownership]

To conclude…

So Goodwill is Impaired as an Intangible asset and from the Goodwill section

G = Consideration paid + FV NCI – BV equity– FV Net assets (surplus assets – def taxes liab – (liabilities – def taxes
assets))

For Full goodwill Accounting: [total value]

G = Consideration Paid + FV NCI (total value) – BV equity – Net surpluses (surpluses net of tax rate, 1-t)

For Proportionate Share: (no NCI)

G = Consideration paid – BV equity (% shares owned) – Net surpluses (% owned)

Exercise:

Consideration transferred = 80% * 40000 *

3.5$ = 112’000

Fair Value NCI = 30000 (NCI share value * non

controlled share)

Fair Value net assets acquired = 125000

G = 112 + 30 – 125 = 17k; BVE??

Wrap Up

Operating results include: revenues – costs = routine of company - Non recurring expenses and Income = EBIT – net
financial expenses (interests) = EBT – taxes = net profit

EBT = Net Financial expenses = EBIT - financial expenses

Which are the distinctive characteristics of this real practice approach, compared to a basic/academic approach?

• First you have to read and master financial statements (before calculating indexes)

• The reclassification supports the initial knowledge but it is recalled often in the interpretation of results of the
ratio/indicator analysis

• Ratio and indicators are supporting “tools” in your hands to analyze, to be used to build your narrative and report.
[Ratio and indicators are not the starting point]. Groups need to decide which logic approach have and which
indicators to show.

In particular the richest area is the Operating Return over the investments, where the numerator and the
denominator might have slight variations • Following we introduce: ROI and its variations ROA, ROCE, ROACE.

ROI = Operating result / Tot assets – Non-financial liabilities (capability to generate remuneration on financial assets
(equity and fin liab))

ROA doesn’t care about the source of assets and so ROA = Operating result / Tot assets (no needed to show both ROI
and ROA, it depends on our aim). It measures the ability of managers to generate profit by using company’s assets
for continuing business operations.

ROCE % (return on capital employed) = Operating Result / Equity + Long Term Debt. It is a variation of ROI to
differently characterize the specific components of invested capital (= Equity + Long term debt). It focuses in long
Term financing (equity + total non-current liabilities). (ROI with no current fin liab)
ROACE = Operating Result / avg Equity + avg long term fin debt (over 2 fiscal years).

[Average Equity = (Et+Et-1)/2; Average Long-Term F. Debt = (LTt+LTt-1)/2]. Similar to ROCE but with the use of
average values at the denominators, used to balance fluctuations.

Exercise calculation of indicators of Tod’s BS. Same numerator: Operating Result, we can find it in the IS, if
reclassified we can easily see it. Among these ratios ROA is the lowest (Tot assets on denominator).

Roa Decomposition:

ROS is the margin from operating results

(margin is always the proportion on
revenues).

Turnover is the capability to generate

revenues through total assets (assets
productivity)

If no non-recurring operating result = EBIT

These numbers are useless if they are not

compared in a Cross-Time horizon or
choosing competitors (it is not easy to
choose right ones).

The highest amount in other fixed assets in the example is Investment in subsidiaries, typical when we do not have
consolidation in financial statement. At group level we can see the difference.

In the notes we will see that intangible fixed assets include a lot of trademarks and goodwill. In the project work we
will work on the Group level. Numbers are always relative to industry values.

Dr. Adriana Rosa CFO at EON Italy, we will see the consolidated financial report of all 8 companies within EON group
Annual Report 2019:

Importance of strategy in financial analysis. We will see the corporate profile and business model

E.ON is an investor-owned energy company with approximately 79,000 employees. The Group is led by corporate
headquarters in Essen (Germany). Listed in Frankfurt stock Exchange.

377 companies consolidated. 2 main sectors (Energy Networks: power and gas distribution networks (operating its
power and gas networks safely and reliably, carrying out any necessary maintenance and repairs, and expanding its
power and gas networks); Customer Solutions: platform for the energy transition (supplying customers in Europe
with power, gas, and heat as well as with products and services that enhance their energy efficiency. Customers
across all categories: residential (photovoltaic systems), small and medium sized enterprises (cogeneration,
regeneration plans), large commercial and industrial, and public entities) different kind of target customers

Non-core businesses: Operation and dismantling of nuclear power stations in Germany and the generation business
in Turkey. Renewables: This segment consists of onshore wind, offshore wind, and solar farms. All of the operations
in this segment were classified as discontinued operations effective June 30, 2018, (IFRS 5), and deconsolidated
effective September 18, 2019 [current assets because it will disappear after the selling, it was inside financial analysis
within September, then it went under RWE]

Change in terms of consolidated companies, from 2018 and 2019. (+228, -83)

Major changes on companies consolidated because of the RWE operation

Special Events in the Reporting Period affect numbers.

Acquisition of RWE’s Innogy Stake Closed: (RWEE.ON): At YE2019 E.ON holds 90 percent of all Innogy stock and
thus fulfills the necessary requirement for a merger squeeze-out (100 percent in 2020). Innogy consists of sales and
network business, and corporate functions. (E.ON  RWE): Renewables assets transferred in September 18, 2019
[business deconsolidated].

IFRS 16 Leases (look inside the assets what’s behind leasing contracts, look obligation of the company considering
potential revenue). We apply IFRS 16 Leases for the first time effective the start of 2019. The main impact on our
Consolidated Balance Sheets is an increase in fixed assets (due to the capitalization of right-of use assets), of
financial liabilities (due to the disclosure of the corresponding lease liabilities). Leasing liabilities are recorded under
economic net debt. - Initial application as of 01.01.2019 of €0.8 billion. - Year End balance at 31.12.2019 of €3.3
billion, with an additional depreciation of €0.2billion.

Consolidated Financial Statement and Key

Performance Indicators of YE 2019

Increase of Sales, Operating Cash Flow before

interest and taxes. All positive numbers, the higher
ones are due to RWE deal.

Negative impact on economic net debt is on the

acquisition of RWE (investment)

Variations on 2 FY for most important voices.

Adjusted EBIT is the most suitable KPI for assessing operating performance because it presents a business’s
operating earnings independently of nonoperating factors, interest, and taxes (avoid considering extraordinary
activities, like gaining from divestment of Renewables). Other KPIs are cash-effective investments, adjusted net
income, earnings per share (based on adjusted net income), and Economic Net Debt.

Reconciliation between EBIT and

Adjusted EBIT

Elimination of non-operating
adjustments:

-Net book gains/losses when

Renewable asset is divested;

-restructuring expenses about HR

re-organizing groups,

- effects from market valuation derivates: fair values on commodities Gas and Power (extraordinary because fraud
contracts) -impairments (tangible and intangible to trigger events), -reversal (conditions to reverse the prior
investments), extraordinary operating activities and other (IT and new systems).

EBIT development

From the top we can see how we moved from the two value over a year.

Effects mainly in ordinary business: Energy Regulations, positive for Energy Networks (in Sweden +power tariff),
negative impacts of dynamic competitiveness in UK and regulatory effect in Customer Solutions (price cap).

Effects in non-ordinary operations: -EBIT for divestment in Renewables, +EBIT for Acquisition of Innogy and related
activities.

Non-core activities are a minor factor to the company

(transfer of minority stakes to RWE)

Adjusted net income

Reconciliation from EBITDA

Non-controlling interest are minorities (shareholders minorities), adjusted net income is the answer of the market
about the core business (how is it managing operating businesses).

Cash effective investments

Impact of acquisition of REW in 2019. Boost of Innogy

and corporate function big change, acquisition of
Innogy stock on the market (sept 2019 approval of
100%)

Higher customer solution (new company in Sweden)

Reduction renewables for divestment (although higher

offshore wind business in UK, non-core)

Non-core increase of Innogy corporate function

How the avg shareholder is capable to read these events and impacts? Shareholders have preferred lanes to get
communicated which have a full explanation of the results. Press Release has full communication and shares with all
the details.

Economic net debt

Impact on Fin liabilities for Corporate and green bonds

created to ensure maturity profile. Bonds expire in
different years, it is good to have balance.

Impact on pension provision (increase of 82% of

employee thanks to Innogy)

-asset retirement obligations for renewable business

1. EON issues corporate and green bonds with tenors that give its debt portfolio a balanced maturity profile.

2. Securities and fixed-term deposits, restricted cash, cash and cash equivalents

2020 results and Covid19 impacts (High visibility despite Covid-19, mid-term targets confirmed)

Stable business for EON, they reviewed

the target with the strategy to recover
the small loss within the end of the
year.

Mid-terms targets and dividend

confirmed with recovery plan.
Negative impacts

They would be
covered within
the 2020.

The most
important ones
are Customer Sell
Back for customer
solutions (EON
anticipate the
purchasing years
in advance for the
gas power
generation).

Small reduction on Energy Networks for the reduction of volumes. The situation in the first period was not expected,
sell back were ordinaries. Now they are monitoring better the situation in order to be prepared for any case.

Eon’s strategy to leave renewables and focus on customer solutions, few offshore businesses which are noncore,
strategic decisions to the reduction of CO2 impacts on generation plans through efficiency of grids (cogeneration and
new technologies to reduce emissions)

PW: Competitors need to be identified in terms of businesses or countries (EON has such a wide portfolio, Uniper per
generation…, so it is important to understand similarity on size or by country and sector, on volumes, legal
regulations).

Sole 24ore group Paolo Fietta CFO

Leading multimedia publishing group in Italy in economic, financial, professional, cultural information sector. Listed
in Italian stock exchange.

Complexity of consolidated Financial statements: e.g. Danaher corporation divides its companies in 5 areas although
different strategies and aims. E.g. Big four UK banks: they have different organization and operate differently, so
different numbers are difficult to compare. Comparisons need to be established among companies with

Covid impact: Profit and loss are difficult to analyze with covid pandemic, BS is better to analyze due to the fact it
gives future data. Only Total equities (company independent in the future) and Cash (ensure to respect obligations)

Listed companies vs Non listed companies: MTA vs AIM (smaller markets to let small companies to raise capital,
limited request of information and details). Shareholders PE funds (much more detailed) vs family owners

Quality of information depends on the relevance of management.

2020 and 2021 would see companies to not include amortization in P&L. no impact on cash but temporary impact on
Equity.

Financial Analysis Written test simulation (past years tests)

1

Revenues = 110,500 k€; Gross profit = 30,500 k€

Because the IS is given by Function (administrative expenses,

operating and financial ones…) and therefore we calculate the
Revenues going from the Net Profit above, without considering
the D&A.

Gross Profit = Revenues – Cost of sales (80k)

Non-recurring items are not present, thus Operating Results =

EBIT

Non recurring activities are zero and so EBIT = operating result.

EBIT = net profit + taxes + expenses – income = 15’200

EBIT + operating/distribution expenses -income = Gross Profit = 30’500

Gross Profit + Cost of sales = revenues = 110’500

2.

We firstly find r from the Net Income/Profit from ROI, then we find r with actual values of ROE formula and
subsequently we can find the new ROE

3.

ROS = 15%
EBT = net profit / (1-t); EBIT = EBT + fin exp – fin inc  EBIT = operating result if there are no non-recurring activities

4.

Equity in Bister
= 0.6 * 60 = 36

45 – 36 = 9 which is
the increase of
value of equity
investment
(Goodwill) and it
will be reported as
Non- current asset.

The minority
interests are 60 - 36
= 24 and they
would be added in the Group equity.

Summary: Accounting Finance and Control

Financial accounting is focused on info included in the financial statement, prepared for two groups of people:

• external shareholders and stakeholders - Under IFRS (or other GAAP)

• internal managers (adjusting financial statements)

Financial Accounting indicators (EBIT, ROE, NWC) gives important information to both sets of people, but how good
are in leading companies in pursuing their goal?

The scheme of P&L account is principle, cash flow and BS are secondary. BS and IS are under accrual principle, while
CF on cash logic. This is important in finance accounting. A Mantra: Turnover is vanity, profit is sanity, but cash is
reality.  cash logic

Example: turnover= 4M, operating costs in advance = 3.95M, ROS = operating result / rev.
Revenue are related to the transition of the property and right of the service/good. Although the payment is in 2021
revenues are 4M (accrual). Cash logic tell us that the cash generated is 0 in 2020. Operating result = 50k. ROS = 1.3%
< 10%.

0 inflow, we need to pay in advance the startup, we have a cash which is negative = -3.95M. Without cash you
cannot survive.

Liquidity Indicators: In accounting we use Cash for Short Term indicators. DSO-DPO-NWC-quick ratio.

In normal b2b transaction we have DSO =

60-90 days. NWC is calculated sometimes
only in reference with operational leverage.

Break up rooms Exercise s19 lez 8 on NWC. First of all we need to try to graph a table in the horizontal time. +420, 0,
0, -420 (under the assumption that we do not want to keep the inventories and so there are no payables and
receivables as well (-120, -200, -100).

Liquidity indicator mentioning cash indirectly in the

Long Term

NFP: net financial position (liabilities-cash-

receivables), level of debt.

NFP/EBITDA: number of periods you need to repay

financial liabilities.

Example of NFP/EBITDA: NFP=24,732,300; NFP/EBITDA = 2,58  what can we say? At first the few virtual periods
could make us to say that the company is not so good to repay financial liabilities. Due to the fact that these are data
on soon future you do not know if you can get decision out of it. So you need to have a look to the long run.

Value measurement

Value is the generation of long-term results for its shareholders (cash). When we think of the objective of the
company we will focus on shareholder. From financial analysis (certain and certified data) to forecast value
measurement.

Measuring the value of an enterprise is needed when: Buying a business • Selling a business • Selling a share in a
business • Litigation • Exit strategy planning.

There are different approaches for measuring the value:

-DCF discounted cash flow method; -Relative valuation; -Value base proxies
DCF method rely on the direct measure of
the Enterprise Value:

The formula can be articulated differently, dividing the planning in two parts, the first one between t0 and tT, the
second between tT and infinite (TV)

Value of money across time  actualization of cash flow

From exercises: DCF methods can be used for internal accountability to a limited extent because they can hardly
capture specific responsibilities of internal responsibility centres

A central characteristic of DCF methods is the need to forecast now (year 0) how a company will perform in the long
term. • Three components must be calculated: ✓ Net Cash Flows (NCF) ✓ Cost of capital (K) ✓ Terminal value (TV)

Net cash flows can be retrieved following two perspectives:

Cash flows can be classified in terms of the activities from which they stem (accounting perspective used in the
indirect Cash flow statement):

 Operating activity • Investment activity • Financing activity

Cash flows can be classified in terms of the financiers to which they are available (finance perspective)

 FCFF (Free Cash Flows To Firm) available to both debt holders and shareholders
 FCFE (Free Cash Flows To Equity) available to shareholders

From now we focus on the Finance perspective, which highlights the cash generation for companies’ investors
(Shareholders and Debt holders). To measure NCF for diverse investors there are two approaches:

-Asset Side Approach: Measurement of NCFs generated for both debt holders and shareholders, NCF  Free Cash
Flows To Firm FCFF.

-Equity Side Approach: Measurement of NCFs generated for shareholders, NCF  Free Cash Flows To Equity FCFE

Calculating NCF: FCFF, asset side approach. Assets are seen

as unique, and they are used for both uses.

Free cash flow to firm (FCFF): The amount of cash that is

generated for the firm, after expenses, taxes, investments
and change in Net Working Capital; Cash available for both
shareholders and debtholders Asset-side approach.

Free cash flow to equity (FCFE): The amount of cash

that can be paid to the equity shareholders of the
company after all expenses, reinvestment and debt
repayment; Only shareholders are taken as reference
(to be remunerated)  Equity-side approach.

Equity side approach, we focus on the capital provided

by shareholders and the dividends.

FCFE = FCFF – financial activities.

Our starting point as indicator is EBIT. We need to
adjust it for items that are non-monetary cost or
difference between accrual and cash values and we
need to take away the capital expenditure. We need
to understand which proportion of EBIT goes in
taxes, we use an average tax rate (-tc*EBIT), tc =
Taxes / EBT.

In the blue part we take away all the elements no

related to shareholders, we need to take away
financial expenses and add financial revenues and
capital from shareholders, take away dividends and
take into account the variation of debt.

FCFF

P&L account would give us the EBIT. tc = TAXES / EBT avg tax rate. (EBT – taxes = Net profit)

Depreciation and amortization need to be added, they are included in the cost, but they are non-monetary cost and
so we need to add them again [Fictitious (non-monetary) cost already included in EBIT, here re-added to arrive at
cash]

NWC = account receivables + inventories – account payables = current assets – current liabilities. It is used to
measure the short-term liquidity of a business. Amount of money available to spend on its day-today business
operations. It is a proxy of the cash flows from operations (we subtract the delta of NWC because it is a non cash
transaction)

Capital expenditure is the outflow of the company for investments in new assets (new machines or acquisition,
tangible or intangible) or disposal of assets (sell = disposal)

 delta CAPEX = new investments – disposal = FXt - FXt-1 + D&At (assets of period t – assets previous year (dAssets)
+ current D&A). If we look at the BS we see what’s already discounted, cash flow it is not recorded due to
depreciation. This is why we adjust the formula of CAPEX adding D&A.

FCFE

Financial revenues and expenses are net of taxes (adjusted with the same tax rate tc), financial revenues have a tax
negative effect; financial expenses have a tax positive effect (debt fiscal shield)

We need to take into account variations of debt = Increase of loans/debt – repayment of loan/debt.

dShare capital: Increase in share capital represents the increase of the company equity. Decrease in share capital, is
the amount paid to the shareholders
and it is no more available.

To Wrap up…

Accounting perspective relies on the

indirect Cash Flow statement while
Finance perspective starts from EBIT
and adjusting it.

TAXES found from EBT but then t

applied to EBIT
Ex: Cash flow calculation. FCFF,
FCFE.

For FCFF we would try to use a

framework to simplify the
classification

Taxes are given by tc = taxes/EBT (taxes =

EBT – Net profit). (tc = 6240/16k=39%)

D&A are given. dNWC is negative for Milan

and positive for London, in terms of NWC it
is better for London to have more cash (less
receivables). Capex is for both negative but
Milan do not dispose any asset.

FCFF are the same, although values

where different. Milan has less
investment whether London can
invest more.

FCFE are different due to different

financial expenses, debt and increase
in share capital.

DCF methods: Present Value Calculation

Components are Net Cash Flows (NCFt) for each forecasted year • Cost of Capital (k) • Terminal Value (TV)
Cost of capital differs from the 2 logics:

Asset side approach uses WACC Weighted average

capital cost  Enterprise value EV

Equity side approach uses Ke cost of capital for

shareholders (rate of return)  Equity value E

Financial Analysis: NCF computation

In performing financial analysis, you can adopt

two different approaches: • Invested capital logic
• Shareholders capital logic

Ex s56 lez 8 Company

Valuation Sama

As a consultant, you have been asked to evaluate the Equity Value of the company Sama. This company operates
mainly in Europe in the beverage industry. You have
just estimated the company P&L for next 3 years
(Table 1). Furthermore, you know that the company
will do capital expenditures in 2015 (25 mln euro),
2016 (33 mln euro) and 2017 (36 mln euro).
Moreover, you expect that there will be changes in
the financial structure, as reported in Table 2. Finally,
you have prospects of the net working capital for the next 3 years (Table 3).

Let’s see now the cost of Capital

Different Logics on the cost of capital

Cost of Equity: Ke

Ke is the cost of equity capital of a firm. It is how much a firm has to remunerate its shareholders for the risk they
take by providing equity capital to the firm. On the other hand, Ke is the minimum expected return for shareholders.
It is not contractually defined. How do we estimate it?

We can estimate Ke using the CAPM (Capital Asset Pricing Model) method.

rf = risk-free rate • BL= Beta levered (equity beta) • rm = market return • (rm-rf) = market premium.

Risk free rate: in reality there are no risk-free investments, but we can have several proxies. rf is the theoretical
return on an investment with no risk. Government bonds are generally less risky than corporate bonds. We select
the return on the least risky government bonds of the currency area of evaluation. In Eurozone the 10Y German
Bund is used as a proxy of the risk-free rate [depends on the currency used by the company…]

Returns and risk are strictly correlated, Gov bonds are less risky than Corporate bonds because although change in
economics they try to keep stable.

Current return of a German bond is -0.45%, investor wills to invest in it in order to pay for security instead of risking
losing more money (the historical data of government bonds rates reflects their risk)

Market return: rm is the return on theoretical market portfolio which contains all the stocks in the market. We can
use as proxy Market indexes that are representative of the market in which the company operates. It has to be
decided for companies which operate in different markets. They have to decide in terms of corporate strategy which
rm to take into account, proxy on the stock exchange market (geographical and sectorial).

Company operating in Italy the rf would be German bonds, while Rm would be Italian stock exchange. If the
company plays in EU market it would have the same rf, but the rm would be the euro stock. A company which
operates only in US they would have a rf of US bonds and rm Dow jones.

A company can be listed in more than one exchange, Dualism. This leads to several requirements and therefore is
not a common practice.

Beta levered: it multiplies the market premium (rm – rf)

βL measures how volatile is the firm stock if compared to the overall market movements. It is the risk accepted by
the investor, by investing his capital in a company rather than generally in the market.

Statistically, β is computed as the ratio between the covariance of the asset with the
market portfolio and the variance of the market portfolio

β answers the question: “how much stock returns differ from market returns?”

If the beta is 1 the rm and return of the single company change

together.

If B > 1 the company is more volatile than the market (aggressive

stock), while if 0<B<1 the company is more stable (defensive stock).

If B < -1, r moves in opposite aggressive direction with rm (amazon

during covid)

If -1 < B < 0, r moves in opposite direction but in less amount than the
benchmark

If B = 0 the movement is uncorrelated with the benchmark

βL estimations
In case of an unlisted company we cannot use the statistical procedure since basically the company does not have
listed stocks (cov (asset,rm) / var (rm)). In this case, we have to infer the Unlevered Beta.

We can follow two methods: • Comparable companies • Beta industry (from drafts or official report)

βL and βU

βL measures how volatile is a stock if compared to the overall market movements: – It depends on the capital
structure of the firm – Also known as equity beta

βU measures how volatile is the underlying business, irrespective of the firm’s 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

Bl = Bu * D/E * tax

D/E is the levered ratio linked to the financial risk [capital structure]; Bu is the Risk of the business (connected to the
operational activities); Bl is the Risk of the company

We can derive the Bl and therefore the risk of the company multiplying the risk of the business for our capital
structure.

-Comparable Companies

Since we know Bl and capital structure of each company we can calculate the Bu for each of them, then we can
calculate the avg Bu  needed to get the Bl target (B of the target company not listed) though the capital structure
of the company. [we compute the avg volatility of underlying businesses of comparable to then interfere with our
stock]

1. We take comparable companies for which we have βL

2. We compute the βU of each comparable company (i.e. by stripping

out the capital structure characteristics from βL)

3. We compute the average beta βU,avg of the comparable companies

4. We re-lever βU,avg with the capital structure

characteristics of the target company

-Beta Industry

As second best as beta unlevered it could be

used the one of the industry in which the
company operates

Ex (s34-35 lez 9) Ke = rf + Bl (rm – rf).

Bl: non-listed company, we can estimate it

from comparable companies. t = taxes / EBT;
Debts = loans.
Ex (s45 lez 9)

Given Ke = 9.75% calculate WACC

In an Asset side Approach k = WACC. We

need to calculate the WACC

Ke: cost of equity • Kd: cost of debt • tc: corporate tax • (1-tc): tax shield • E: shareholders equity • D: debt
(including only financial debts)

Tax shield effect: WACC measures how much a company pays for equity capital and debt capital, we use the tax
shield effect in the debt part because the company pays financial interest before paying taxes, tax shield effect
reduce the overall cost of debt because of the interests which do not have taxes (financial advantage of debt)

Cost of debt: Kd

Kd is the cost of debt for a firm. It is the interest that the firm has to pay on financial debts to remunerate the
debtholders for the risk they take by providing debt capital to the firm. On the other hand, Kd is a return for
debtholders. Kd is contractually defined. A theoretical method is to calculate Kd = rf + CDS. CDS
is the credit default spread (it is associated with the company credit rating), how likely is the
company to default.

CDS can be seen from rating scale for the level of risk, where companies are classified through categories.

Kd can be calculated from BS as Kd = Interests (financial expenses) / financial liabilities.

Companies with higher D/E are more risky because they do not have resources to satisfy debts.

Present Value

PV can be formulated differently, dividing the planning horizon in two

parts: the first one between time 0 and time T, the second one between
T and infinite. This leads to:

Terminal Value
Beyond the forecasting horizon (0-T), the precise estimation of cash flows is substituted by a synthetic measure:
Terminal Value (TV). One alternative to measure the TV is calculating a Perpetuity

Perpetuity hypotheses that the NCF of the last year of the forecasting period (T) will stay unchanged for the
subsequent years. Being NCF(T) the last year NCF, the terminal value TV (0) can be calculated as:

From time T up to infinite we can converge

the result to these two solutions.

Perpetuity with Growth rate g

If the company grows with constant growth rate g the TV would be different and we would have:

Summary

Annuity

Annuity approach is useful when the company is not likely to have a regularity or a growth of its net cash flows on an
infinite time horizon, but only on a certain number of years (‘n’ in the formula below).

In this case, the Terminal Value becomes as follows, respectively in case of a constant or growing net cash flow:
Summary:

perpetuity

p + growth

annuity

a + growth

-g < k because
it’s a growth which has to happen for a long time and therefore is usually really small.

Perpetuity makes us think: Can a company live forever?

The lifespan of a company…. – Hundreds of years (e.g. oldest family business) – Few years (e.g. average life of start-
ups).

The long-life business: – Growing at or above the pace of the industry/market (not growing might have severe
drawbacks as, for example, default) – Keeping control over the operations (through M&A the business is acquired by
another corporation thus losing control of operations) – Sustaining performance over time

Exercise on TV

Some reliable estimates for 2020-2023,

FCFE from FCFF (FCFE = FCFF – financial
activities), Ke from capital value formula
because it was constant. TV = FCFE (T)/ ke.
FCFE need to be actualized. After year 4
(2023) we need to consider TV as well and
discount it to the year 4.
Real Options (no written but oral test)

We have seen the business valuation (relative valuation and DCF techniques: asset and equity side approaches). To
analyze the TV we have Perpetuity, Annuity or Real Options.

Future value of a company depends also on the future activities that would be performed, Real Options consider the
value of an investment on the future opportunities and events. TV has to include these future activities that would
generate future cash flows. [more in line with reality…]

Real option is the right - but not the obligation - to undertake some business decision; typically the option to make,
or abandon, a capital investment.

Real Options are a third possibility to assess Terminal Value including strategic considerations about the corporation
business opportunities

Types of Real Options

-Flexibility and mix options (Outsource production or sales  Delay production  Peak generating plants  Assembly
configuration)

-Abandonment or termination options: option to sell or close down a project (fractioning or closing of routes)

-Expansion options (acquisition in emerging markets, investing in interrelated projects)

We evaluate real options from Decision Tree Analysis

Four phases:

1. Definition of the entity of the investments (initial investment and additional investment)

2. Definition of the possible scenarios

3. Calculation of the probability (pi) and the present value for each scenario (PVi)

4. The value of the option is:

The value is the sum of the maximums

of scenarios of the PV of each period
net of investment or zero * the
probability of happening

Example

Suppose a clothing company is considering the introduction of a new line. The project life span is two years. An initial
investment of $50 (cash flows are in thousands) is required to fund the initial development phase. At the end of a
year, a further $50 are required for production. Cash inflows from sales (net of selling expenses) will occur at the end
of the second year. There is some uncertainty about the amount of the cash inflows since it is unclear whether the
market will embrace the new line. The firm estimates that there is a 70% chance that the new line will be a winner.
They also believe that the new line will become more visible after the first year and had estimated of a couple of
possibilities for the subsequent year. The probabilities and the associated cash flows are illustrated on the figure.
The cost of capital is 10%. What is the expected value of the project?
 Every event has its own probability to happen and there are costs and cash flows
estimated. k = 0.1

Expected value of
the project is
calculated as

V (0) = -4.4

(in real options Expected value = TV)

Option of Abandon…

Consider the case where the firm has the option to abandon the project after the first
year. In this case, the second phase of the project would only proceed if the market
direction was favorable over the first year. If the market direction was unfavorable, the
firm would abandon the project, since proceeding would cost a further investment $50
and the expected present value (at time 1) of the cash inflows is what follows in the
tree.

What is the expected value of the project with the option of abandon?

-If the company abandon the project

after the first year they would have
only the possibility to continue
investing if the first year was
favorable.

Expected value of the project takes

into account the possibility to divest
in case of unfavorable situation.

The max between the option and 0 has to be taken and so we remove the unfavorable situation.

We compute the max between {the values not actualized (PV) – Investment; 0}

[even the best case would have been 0 but it will generate inflows in the second year for the 70% of chances and
therefore we keep it]

Relative valuation

It is a possible way to approach Business Valuation. To estimate the enterprise value we need to look at the market
and not at the features of the company. They do not try to determine internal value from future cash flows but
compare it with its comparables and competitors, the companies have to have the same characteristics. This method
is called even Multiple Method.

In relative valuation, the value of an asset is compared to the market value for similar (or “comparable”) assets.
Relative Valuation is widely used to estimate the ‘company value’. It compares the (target) company with other
similar listed ones.

Usually it is less precise but it is Pervasive: Most valuations on Wall Street are relative valuations, Almost 85% of
equity research reports are based upon a multiple and comparables, More than 50% of all acquisition valuations are
based upon multiples.

There are 4 main steps in relative valuation:

 Identifying comparable companies

  Defining possible multiples, which means converting assets market values into standardized values relative
to a key statistic (absolute prices cannot be compared)
 Analyze multiples
 Apply multiples

1.Identify comparable companies: it is not easy, financially speaking they can generate the same CF, have the same
risk (react equivalent), growth potential and same liquidity. [they do not need to be in the same sector]

The identification of comparable companies is one of the most difficult tasks of this approach:

– Identify first the target company value drivers (platform for Netflix)

– Identify those companies with the same value drivers (Spotify platform comparable for Netflix)

– Define companies’ specificities (need to be coherent): • Sector • Geographical Market • Presence of divisional
structure • Size (assets or sales) • Presence or not of comparative advantages • Innovation/development models •
(accounting principles) (In order of relevance: Industry, Risk, Growth, CF)

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.

Parameter is related to the value generation of that company. Cases differ in terms of assets and equity side.

The possible values are Market value of Equity and Market value of the Firm, the parameters can be everything that
give value to the company (revenues, cash flows, book value, n° of customers…)

The most used multiples for asset and equity

sides are 

The market capitalization is the market value of

the equity, which is the share price * n° of
shares. When we talk about the market value of
EV is E + NFP (debt – cash). P is the price of the
shares.

Both historical or future expected values can be

adopted

Asset Side (EV)

EV multiples take as reference (numerator) the Enterprise Value of comparable companies EV = E + NFP (market
capitalization E + net financial position, NFP = financial liab – cash&equivalents – fin receivables.

EV multiples use a performance parameter (denominator) coherent to an enterprise value perspective. (parameter
that is related to the overall assets of the company)

Example

Currently FB’s EV is 9 times the revenues. Before it was 32 times, it is commonly used but we can see how the size
with Twitter is so different although they have similar growth and operate in the same industry (to tell if they are
comparable we need to calculate many factors before). Revenues of FB * multiple of twitter and we can be really
close to estimate the real EV of FB.

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

The main assumption is that if a sample of comparable companies is valued by the

market a certain number (n) of times a given parameter, the target company, can be
valued the same way. In economic terms, the multiple represents the number of
years the parameter should be multiplied by to obtain the company EV.

To define a company with these ratios has different Advantages and Disadvantages.

EV/EBIT – Advantage: focus on operating management – Disadvantage: it does not consider different choices in
Depreciation and Amortization (which is related to cash)

EV/EBITDA – Advantage: good proxy of cash (THE MOST USED!) – Disadvantage: neglect CAPEX for different
industries (for some companies expenditures for example in outsourcing can be crucial, so can be not proper)

EV/FCFF – Advantage: it is a cash flow – Disadvantage: less stable than other indicators (EBITDA may vary less, FCFF
can change completely)

EV/Sales – Advantage: if the above multiples are negative, the multiples are meaningless; in those cases an
alternative is using sales – disadvantage: it does not consider profitability of the company

Case study Kents

We are going to calculate the EV of Kents through multiples. We calculate the multiples per each company and we
calculate the avg of the multiples. EV of Kents is the parameter of Kents (sales, ebitda, ebit) * the avg of multiples 
given these 3 different EV we would see now the approaches to select the multiple.

Equity Side (E)

The Equity multiples let the analyst to directly evaluate the company equity value.

Numerator  market capitalization of the company E (#shares * price per share). The comparable companies must
be all listed to be on the stock exchange with market capitalization. (usually relative valuation is used to give an IPO)

The most common multiples are:

P/E (or PE) = market price / earnings = market price per share / earnings per share (EPS) [MOST USED]

– Advantage: quick – Disadvantage: affected by depreciation, amortization, profit or loss of discontinued operations.

Variables: – price: usually the current price; sometimes, average price over last 6 months or year – EPS: earnings
referred to most recent financial year (current), most recently four quarters (trailing), expected in the next fiscal year
or next four quarters (leading), some future years [both EPS and price change a lot]

Earnings = net profit

PEG: the ratio between the P/E and

the earning growth.

– Advantage: This allows better considering the growth perspectives of the company (CAGR)

-- Disadvantage: the accuracy of the PEG ratio depends on the growth rate used (horizontal time). Using historical
growth rates may provide an inaccurate PEG ratio if future growth rates are expected to deviate from historical
growth rates.

To distinguish between calculation methods using future growth and historical growth, the terms forward PEG and
trailing PEG are sometimes used.

Growth rate = [Eps(t) / Eps (t-1)] – 1. [to use it as number, * 100]

Example

Company A - price per share = 46$ - EPS this year = 2,09$ - EPS last year = 1,74$

Company B - price per share = 80$ - EPS this year = 2,67$ - EPS last year = 1,78$

Only analyzing the PE ratios we can say that B is more expensive (PE = PPS / EPS, you pay 30 times the earning),
earning growth rate is 20% for A and 50% for B (g = EPS dividing EPS last year), PEG of 109 and 60. Even if A is less
expensive than B it won’t give a return like B in the future.

If the PEG ratio is higher than 1 you are paying for a company which is overvalued (no significant growth), if PEG ratio
< 1 it is an opportunity because the growth expected might be an opportunity.

Other two multiples (less important)

P / BV: the ratio between the market capitalization of a company and its book value of Equity (Share Capital +
Reserves + Profit (Loss) of the year)

P / FCFE: the ratio between the market capitalization of a company and its FCFE

Case study #2

Equity value through relative

valuation. EPS = Net profit/
#share. Market capitalization
= Price of share *#shares.

P/E = mkt price per share /

EPS = mkt price / earnings.
We calculate the avg of P/E
and use it for multiplying the Net Profit of the company and find the Equity value (market price / earnings (net
profit))

If we do not have a significant multiple per equity side we can derive it from the EV taking into account that

EV = E + NFP (fin liab – cash - fin rec)

3.Analyze 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... how can we pick one multiple?

- “Cynical approach”: use the multiple that best fits your objective.
- “Statistical approach”: use the multiple that has the highest R-squared in the sector when regressed against
fundamentals parameters (highest correlation)
- “Bludgeon approach”: use all the multiples that you have computed.
- “Value driver approach”: use the multiple that seems to make the most sense for a specific sector, given how
value is measured and created in that context (EV / sales per example can only used when the others are
negative)

Cynical approach: The analyst could use the multiple that best fits his story:

- if he is trying to sell a company, he could use the multiple which gives the highest value for the company;

- if he is buying the same company, he could choose the multiple that yields the lowest value.

While this clearly crosses the line from analysis into manipulation, it is a common practice, calling for some cautions
when reading a report produced by a third party.

Statistical approach: The statistical approach consists into three main steps:

- Identify a subset of multiples that are significant from a theoretical point

- Identify one or more fundamentals?? that could explain the variance among
the multiples of the comparable companies (growth Ebitda)

- Check the relation between fundamentals and multiples (analyzing their

correlation)

Bludgeon Approach: The bludgeon approach consists in using all the multiples computed, however, putting them
together in an overall evaluation:

- Range of values, with the lowest value obtained from a multiple being the lower end of the range and the highest
value being the upper limit (the range could be large)

- Average of the values obtained from the different multiples (the average weight in the same way different
multiples)

- Weighted average, with the weight on each value reflecting the precision of the estimate (if we have revenues
multiple with the impact of different BU on the revenues we can apply the weighted avg)
Value driver approach:

Managers in every sector tend to focus on

specific variables when analyzing strategy and
performance. The multiple used will generally
reflect this focus.

Ebitdax: ebitda +
expenses of exploration

Ebitdar: ebitda + rentals.

4.Apply multiples

The last step is the computation of the EV or E depending on the scope of the analysis. Multiples are easy to use and
easy to misuse, sometimes it is quicker and easier than DCF.

A number of authors have argued that multi-period valuation models based on DCF or residual income are superior
to single-period multiple valuation approaches, which are likely to result in less accurate valuations. However, the
empirical evidence on valuation models used by professional investors and financial analysts stands in contrast to
the theoretical superiority of multi-period valuation models. The strongest and most consistent empirical finding is
the primary importance of the P/E ratio.

We have now finished the Business

Valuation, going through Relative Valuation
(which lays on Comparable analysis) and
Discounted Cash Flow techniques (which
take into account internal data, FCFF, FCFE).
With DCF we studied how to calculate the
TV from historical data (Perpetuity and
Annuity) and from Expectations (Real
options).
Value Measurement

For us Value is the present value. We have 3 ways to study the value of and Enterprise: DCF, Relative Valuation and
now we are going to see the value Proxies.

Value based proxies

They are a simplified way to measure value through indicators, they try to adjust the value of the company and
approximate it in simplified way.

Two categories:

Accounting based: • Residual Income RI • Economic Value Added (EVA) • Cash EVA

Shares’ based: • Market Value Added (MVA) • Total Shareholder Return (TSR)

Accounting Based Proxies:

Proxies in between accounting and finance: they are based of financial statement and make adjustment to align
accounting indicators and present value actualization, including the cost of capital and other adjustments to reduce
the problems of traditional accounting indicators, in particular ratio indicators (we take ROA as exemplary of these)

Example

3 hotels with operating income, tot assets

and ROA. Highest ROA is the one from San
Francisco.

Supposing that the corporate ask to SF to

increase ROA to 30%, how can it achieve
the result?  ROA can be divided as ROS *
AT, we can increase the ROA lowering the
Tot assets or increasing the Op income.

How can we create Value? (in this example

increasing ROA, +revenues, -assets, + income through - costs)
To Increase Operating income we can cut operating costs (C)
and increase sales (B). To decrease assets we can dispose
them. Without doing anything assets lose value due to D&A
and therefore if we stop investing ROA would increase (A)

Between the three options the easiest one for a manager is

A, decreasing assets. It is as well the most dangerous one
because you do not invest in internal activities (only for
short time).

To decrease Cost is not so easy (HR…), for short term it is

better to decrease assets or sell them, but it is not aligned
with creation of Value.

The problems encountered with ROA (and similar ratio) have

led to introduce other financial accounting indicators, that
try to solve three misalignments:

1. Ratio VS Absolute value 2. Absence of the cost of capital 3. Use of Accrual flows VS Cash Flows

Innovative accounting based indicators aims at “solving” these misalignments:

Eliminating the Ratio effects called also “denominator management” and taking into account the cost of capital [1,2]
 Residual income (RI) – Economic Value Added (EVA)

Eliminating both the denominator issue, the k and the misalignment between cash and accrual flows [1,2,3] 
Cash EVA

Residual Income RI

RI is the difference btw Operating income and the

amount for required return on an accounting measure of
investments (investment * cost of capital k). We need to
understand which is the return for investors.

Residual = op income net of return for shareholders/investors

Continuing example

If SF has been upgraded, try to calculate the residual income and see if the investment is cost effective or not using
ROA and RI.

ROA is 24%, and RI is 120k, during upgrade the

ROA is 22% and RI is 140k. ROA decreases and RI
increases. One tool tells us to do the investment
and the other not.

If we think about the present value we take into

account the RI, it is better because it ensures
that we get more money and the increase it is
able to remunerate the cost of capital  if the
ratio btw additional Operating income and
Investment added is > than K the expansion is
attractive with RI. (the ROA doesn’t remunerate
K),
so RI stands for the residual income net of the remuneration of shareholder investment

Economic value-added EVA [Introduced by Stern Stewart consulting]

It is similar to RI but we include an after-

tax Operating Income, and WACC to
tackle both equity and asset side
approaches, using the long term
investment (tot assets – current
liabilities) (ncliab + equity  wacc)

Comparison EVA and RI:

RI is a general formula while EVA takes into account operating income after taxes (useful for international groups to
compare BU on taxation effects). According to stern and steward the k is the WACC, while in RI is the shareholder
cost of capital  RI for shareholder view; EVA for enterprise profile.

Impact on decision making: EVA is lower comparing with the RI (for taxation)

From exercises EVA: Invested Capital = Equity + Long/short financial liabilities??? (only long)

Continuing example

EVA is used if you want to see mainly the tax rate

effect. If we suppose that the 3 hotels are in areas with
different tax rate you make the hotel accountable also
for managing taxes (same operating income got lower
after tax operating income). Companies therefore
decide to use RI or EVA.

If we use the EVA with a tax rate of 30% we see that in

both cases (pre and post upgrade) we get a positive
result for the investment. If we compare Deltas we
have an increase of EVA lower than RI but they are not
comparable, because of different costs of capital and
tax income.

EVA charges managers for the cost of

their investment (like RI but with
WACC) • Value is created only if after
tax operating income > cost of
investing capital (WACC * investments)

• To improve EVA managers must: a)

Earn more after tax income with the same capital b) Use less capital to earn the same after tax operating income c)
Invest capital in high-return project

Cash EVA

Cash EVA is all about cash logic with cash flow from operating activities instead of an accrual logic. It aims at
eliminating both the denominator management, k and the misalignment between cash and accrual flows.
Innovative accounting proxies Are they truly better than ROA?

Advantages: taxes inside a group can be crucial for different geographical SBU [EVA could be better for subsidiaries
when they are independent and so we want to see the net profit], they take into account K, absolute measures do
not led to denominator management [cutting assets on ROA for instrumentally reduce the denominator]

Disadvantages: They are still looking at past events (short term oriented) while value measurement is future
oriented.

Shares’ Based Proxies

They are used as an attempt to simplify value measurement using market capitalization (#shares outstanding *
current share price)

Market Value Added MVA = Market value - Invested capital.

(Mkt value can be final value, avg market capitalization or
others, Capital invested can be equity + fin liabilities).

Total Shareholder Return TSR = Increase in avg Market value

(t – avg market value t-1)+ dividends / initial market value.
(we compare these factors to proxy value creation without
considering cash, assuming market is reference for the
value, as initial market value we can take the avg market value t-1)

Example A2A:

MVA (17) = avg market value

(avg market capitalization is
difficult to compute and
therefore we use a simple
market capitalization, avg price
* #shares) - invested capital
(equity + fin liabilities) = (<0, so
the value is underestimated for
instance for lack of information)

TSR (17) = 0,25; TSR (18) = 0,11

 higher dividends, lower
variance in market value brings
to a -13% of TSR
 If I look at MVA I can get that the company is
not capable to create Value added with the
invested capital.

While for TSR values vary a lot over the two

years. Always ask about these two indicators
because they are ambiguous and therefore we
would need to compute them with the data
we are given (they can be computed with
different inputs)

The key characteristic of these last two indicators is the use of the market value. Although they are quicker to
calculate, the market value is equal to the company present value only if markets are perfect (e.g., perfect
information, perfect factor mobility, zero entry and exit barriers, and zero transaction costs). Yet adopting market
value rather than present value actually means to substitute the company’s own estimations of its future, with the
assessment of the market, which is less informed. As a result, the two indicators are less precise compared to the
direct measurement of the present value, although they are less costly and more measurable. Finally, MVA and TSR
can be used only for listed companies and not for single business units or unlisted companies.

Planning and Control System

It is a qualitative management tool related to indicators and numbers about the company.

We are going to see: • The need for a planning and control system • The definition of a planning and control system
• The structure of a planning and control system • The purposes of a planning and control system • The
requirements of a planning and control system

Need [Outside and inside - Multistakeholder perspective]

In the Damodaran scheme we put together entities and

individuals to control the creation of present value. Enterprise
in the center (made by managers accountable for
organizational unit), Shareholders and DebtHolders
(bondholders and banks). Other stakeholders own some
stakes.

Multi stakeholder perspective (many stakeholders to satisfy),

the control system has to take into account all these members.

Building Enterprise value, we encounter two “main” stakeholders, who are also investors: – Shareholders –
Debtholders (bank and bondholders).

To manage value, a more complete set of actors must be considered: – External, including individuals and entities
who have direct or indirect interests: Supplier, Customers, Financial analysts, Local communities, Other societal
actors more broadly. Internal, which refers to managers operating at different levels of the enterprise

To keep under control and ensure the achievement of enterprise goals under such Turbulent environment and with
Multiple stakeholders with different needs we NEED a Planning and control system.

Definition

Planning and Control System is a structure made by different components to guide and lead managers and
employees to pursue their goals, Maintaining viable patterns of behavior [The definition is more complex because of
the different entity of stakeholders]
Key elements: Strategy coherent; Based on Indicators for internal decisions and code of conduct, It is Forward
Looking (looking also at past performances), and supports both Short and Long terms.

The planning and control system can be called even as: Management control system, Performance management
system.

Structure

The Planning and Control System is based on existing frameworks (visual schemes) which synthesis the main
components of the system. The three ones we are going to see are Ferreira and Oatley, Simons and Azzone

Despite the leverage on indicators to measure outputs and help the decision making the system takes into account
also the internal context through including into analysis of emotional and social factors, objectives and risks…

Ferreira and Oatley (reference

because it is the most complete
system, 11 components). It is a
complete scheme, although complex
to use operationally (mixing cycle and
components). Around we have the
design elements (contextual factors,
culture, vision/mission, strategy and
organization…) which then interface
with the Operational components and
Cycle to measure effectively the
Performances.

Simons, in a simplified scheme gives us elements of the

overall scheme. Very often people focus on diagnostic
control system (indicators), instead you need to have
other focuses: belief system (for communication of
internal values), boundary system (regulations in order to
avoid risks), interactive part (discussion about
achievement and problems around indicators). It explicitly
introduced uses and the need to balance between
motivational issues and decision making, but underplay
the notion of “planning and control.

Azzone is a simplified analysis of the references

seen before. It is our reference Framework.

Given the risks and objectives we deploy our

resources to make some actions, which are
controlled by our System to control through
Budgeting, Risk analysis and mitigation. Once they
have been applied we measure their performances
of actual results through a Risk and Performance Measurement and Report them through variance analysis to get
feed backs.

Variance analysis with results and expectations to be studied for feed backs.

Purposes

Planning and control systems have two purposes:

Internal accountability, refers to the use of system to

guide management.

 Decision making and Motivation (blue);

External accountability for external entities (red)

Decision-Making

In Internal Accountability we guide management providing plans to support decision making and guide people. The
set of decisions could be Make or buy (operational), managerial (investing in new assets) or Strategic (offshoring).

The Decision-Making cycle can be divided in four phases:

1. Definition of goals and actions (general metrics, productivity, customer service…) [system to control]
2. Measurement of results (monetary metrics, profitability, saving) [performance measurement]
3. Analysis, formalisation and communication of actual results [variance analysis]
4. Identifying corrective actions [feedbacks]

1.Defining a plan of actions considering objectives, resources and risks. Planning and Control Systems provide
information which are based on models and assumptions: Price (Historical, Predicted), Product costs (Material,
Labour, Other costs). Defining the plan needs itself a model (define the drivers). During the planning phase we set a
target.

2.Measurement of Results. After (or during) actions we want to know the results. Measurement would be useless if:
Variables were known exactly since the planning phase or Our models were perfect. Actual results differ from
predicted data: External variables (e.g. sales, material prices); Internal variables (e.g. productivity)

Planning and Control Systems provide information about: – Results – Update on risks

3.Variance Analysis and 4.Feed-back

When results differ from expectations forecasted we need to analyze Variances: – Variances in external variables –
Variances in internal variables. The quality of the models is essential. The final step after the analysis of variances are
corrective actions, where it is important to highlight: – Level of influence – External / internal action

The numbers help us by planning different scenarios with the availability of our resources. Usually the monitoring is
still under monetary metrics.
The decision making is then on other metrics like productivity, customer service and satisfaction, reputation which
have to be transformed in numbers.

Motivation

Motivating employees from social sciences

thoughts, our enterprise objectives would lead
to assign individual tasks which can be
supported and pushed by rewards, which
need to be coherent with performances linked
to the objectives.

Equity Theory

Equity theory helps in translating the relation between individual results and the social interactions • According to
this theory individuals provide input (effort, experience,…) in relation to the output benefits. • The situation is
balanced when the “ratio” - output/input - is similar among individuals doing similar activities • A perception of
difference leads individuals to modify the ratio

The person who receives lower reward is underestimated and so if there is not a higher reward he reduces efforts.
The one who receives higher reward overestimate his work and increase expectations without a solid merit.

We need to maintain an equilibrium and

balance of groups to avoid underestimation
and overestimation of people work. [The
situation is balanced when the “ratio” -
output/input - is similar among individuals
doing similar activities. A perception of
difference leads individuals to modify the
ratio].

Orienting efforts…

The efforts put into activities are not enough for achieving organizational results. Efforts need to be in the right
direction. There are two theories which help in evidencing the role of PMS: – Expectancy theory – Goals setting
theory

Expectancy Theory

Expectancy theory is suggested as the dominant

logic in motivation. According to this theory,
individuals are rational; they act and exert effort
based on the expectation of a reward associated
with their performance. This theory views the
attractiveness of the potential reward as crucial,
but it highlights two relationships that are important for management: (i) performance and rewards and (ii) effort
and performance. Expectations can be computed as Reward / Performance * Performance / Effort.

The relationship between performance and reward emphasizes that individuals’ choices are instrumental to the
achievement of performances associated with rewards. This stresses the need to adopt a complete management
control system in order to prevent individuals focusing only on some behaviors and neglecting others (applying
choices not coherent with overall management but only focused on their outputs)
A second consequence of the expectancy theory is linked to the attitude of individuals in maximizing the expected
outcome. To avoid demotivation, management control systems have to measure only performance that individuals
can influence in line with their specific responsibilities. The higher we go to the hierarchic pyramid of the company
the more difficult it is to understand the boundaries of responsibility.

The Goal setting theory

Setting a reference as an explicit number or a direction (+%), target for reference of actions. It is not easy to set
target numbers and sometimes if the line is already reached the person is not anymore motivated to go beyond it.

Individuals decide to which objective addressing their effort on the basis of their importance for them (as
individuals). Individuals increase their motivation when: Well defined goals are set, Goals are challenging and hard
be reached, Goals can be reached. In complex setting, targets can be complemented with minimum threshold (lower
value)

Summing up…

Equity theory highlights the need to link rewards to individual behaviors and keep a balance of output/input;
expectancy theory points out that this relationship cannot be set for single individuals, but with a broad
organizational vision, making the performances of individuals aligned with the objectives of the company; finally, the
goal-setting theory emphasizes the need to set difficult, achievable and precise goals.

It is useful to summarize the requirements of PMS in relation to motivation:

The system must be complete to avoid opportunistic behaviors (equity/expectancy), timely to give individuals
prompt feedback on their behavior, built around individuals’ specific responsibilities (expectancy), and based on
measurable indicators (goal setting)

External accountability

Planning and control systems are designed mainly for internal accountability but the alignment with the use of
indicators for external accountability is crucial. Providing outside the results of the company to shareholders.

In recent years companies have improved the external accountability with financial reports and corporate
governance reports, sustainability and environmental report (The range of information published has increased)

Planning and control need to manage all the reports to deal with consistency and coherency.

Requirements

 Measurability: is the ability to associate performance and risk with indicators that can be clearly and
univocally measured [MVA can be less measurable than ROA (basing on mkt capitalization options and info
available)]
 Completeness: intended as the capability of PMS to control all the factors relevant for enterprise
 Precision: which is the correlation between the diverse indicators and the present value as the ultimate
reference goal for companies. [ROA is not precise for misalignment with value consideration]
 Long-term orientation: which is the capability to measure and manage long-term implications.
 Timeliness: focusing on the need for indicators to enable prompt managerial action [right timing to let the
decision making]
 Specific responsibility: which is the capability of PMS to give organizational units (and managers)
responsibilities on which they can act (address properly the targets through the right measures) [expectancy
and goal setting theory]
 We can summarize the performances
and the purposes. We see that they are
all important in decision making unless
specific responsibility (motivation). For
motivation precision and stability are
more for managers. External
accountability needs to be clear,
complete and stable (if it is not stable
externals could be suspicious, e.g. if
sustainability reports doesn’t count
certain factors).

Coffee Pot Case

-What are the core values of Coffee Pot? To offer • low costs, • quality coffee • to mall shoppers. Each coffee pot has
the same atmosphere, service and coffee quality

-What are the problems that Coffee Pot was facing?

Problems related to motivational issues: • Jack accepts gifts from suppliers • The Peoria manager decided to sell
pizza and beer without asking • Bonuses are based on last quarter’s numbers • Staff turnover is high (no loyalty)

-How would you structured a planning and control system to face internal motivational issues

Introduce an employee code of conduct • Define a clear way to communicate organizational values • Introduce an
incentive system based on budget rather than beating results of the previous quarter • Link part of the bonuses to
corporate results

Problems related to internal accountability • Financial statements are prepared on a quarterly basis • The company
has never been audited • The company failed to meet quarterly bank loans • The strategy was never revised in
accordance with changing in the environment

-How would you structured a planning and conrol system to face internal accountability issues?

Introduce daily/weekly/monthly reports • Introduce a yearly financial audit • Introduce liquidity indicators/perform
financial analysis to keep under control the financial situation • Introduce a set of KPIs to monitor the environment.

BUDGET

In our framework, the Budgeting is the starting

point but in companies things are messy.
 Budget is a process which is carried out once a
year usually and it is part of a wider planning (to
forecast future years actions). On the two axis we
have the time and the responsibility within the
company.

The strategic planning is quite synthetic and covers

5 years at least (now EU tries to have longer
planning, which means have less detail), the
strategic planning is done by Chief executives and
some BU managers. The programming (lower
years of planning), it is needed a higher
participation by managers (more knowledge of
detail for 2-3 years).

The Budget is the plan in a very detailed way (1 year), the whole company is involved. The output is a document with
Financial flows (accrual and cash forecasting), Targets (for incentives assigned to each organizational units) and
resources and actions.

Distinctive elements of budgeting:

Company-wide activity to quantify future profits, cash, assets. Derived from the strategy. People cover a central role:
– Managers responsible for organizational units – Other employees working within organizational unit affected by
target setting – Accounting and finance functions supporting the process.

Objectives

DECISION MAKING ROLE: To translate long term plans into operative actions (what to do), To identify the needed
resources (how to go), To identify controllable areas (who is in charge to lead the path)

MOTIVATIONAL ROLE: To increase effort of people, to guide behavior of people, to enhance communication
Connected with target and bonuses

e.g. EON: H1 2020 update pag40: budget is more related to internal accountability, instead there are some
companies which are pressured to publish their plans (for being regulated sectors). Forecasting of dividends for
share, delivery plan confirmed. They are exposing themselves on forecast and plans. Investment of energy network…

Master Budget [It is the output document of the

budgeting process that forecasts financial results
of the upcoming period (typically one year)]
Overall structure composed by 3 main areas of
budgets:

-Operating [which originate from the typical

(characteristic) management of a business; they
define the economic flows of raw materials,
components, finished products, services]
-CAPEX [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].

These documents are then used to prepare: – Budgeted Income Statement – Budgeted Balance Sheet – Budgeted
Cash Flow Statement

The general process starts from the strategy, then operating budgets, capex and cash budgets, finally the IS and
Financial statement. Arrows because strategy and objectives are linked to every budget, Retroactive cycle because
the budget and the budgeting process is usually reviewed for constraints, like manufacturing capability constraints,
and therefore we need to iterate our process.

Heterogeneity in practice

Companies tailor both the process and the document, this leads to heterogeneity in term of:

– Content of the document [Quantitative versus qualitative; Aggregation of the information; Format]

- Articulation of the preparation process [Length and timing; Approach: bottom up vs top down]

- Plan updates: rolling vs standard

Standard Budget: the master budget is used

during the year for making Financial Reviews
(usually monthly or quarterly) in which actual
results are compared with budgeting figures
(variance analysis).

Rolling Budget: sometimes budget is updated

across the year by adding a further accounting
period (a month or quarter) when the earliest
accounting period has expired. This approach is
called Rolling Budget. The purpose of the rolling budget is to give management the chance to revise plans and make
more accurate forecasts.

Doing so they can increase the accuracy in forecasting for the following months. The enlargement of a quarter of the
budget will involve the board of executives.

Operating Budget

It forecasts the operating results and EBIT, we start from budgeted revenues - cost of goods sold [Gross margin]
which can be directly related to the usage of equipment and plans for the production (amortization, Product costs) -
Period Costs which are the costs not directly related to manufacturing activity (salaries) [Op. result = EBIT] because
Non-recurring expenses are usually not forecasted, hence Operating result = EBIT.

ROS would be needed to check the

consistency of the results (ROS = Op results
/ revenue)

We need to prepare 7 subdocuments to

deliver an operating budget 
Revenue Budget:

We will use a scheme for doing it. We will plan the revenues at first because they are the most difficult one to define,
we are going to express the amount of sales for each product/service which will affect all the other computations.
We usually start from Historical data and past results, then we try to define if the demand is changing in the
following year. Revenues budget is then re-classified by: • Product lines • Geographical area • Clients

e.g. Ties could face changes in terms of sales because of the remote working. Geographical area is important for B2B
companies, where you have few clients in different areas and therefore you need to classify the revenues for areas.
We need to have engagement with external world (GDP, trends…),

Revenue budget requires a lot of info due to Strong link with objectives and strategies, Intensive use of marketing
instruments (survey, forecasting instrument…). The level of revenues takes into account both external (state of
relevant economies; state of industry; nature of competition) and internal factors (n° of unit sold, credit and pricing
policies, new product plans and manufacturing capacity)

Example: Revenue Budget for Anthea Case. They sell Elderly tools, so during covid they could have had a good
impact.

1) For budgeted revenues the only data we needed were volume of sales and price  70k revenues.

Production Budget: (This is the only budget expressed

in units (not money))

After having defined budgeted sales, we need total

finished goods to be produced taking into account the
inventories of finished goods.

We will assess the production capability of the

company at first.

We can decide whether to produce firstly products with higher weighted contribution margin (price – cost) with its
production requirements (hours…)

IAS/IFRS include, as Inventories, assets held for sale in the ordinary course of business (finished goods), assets in the
production process for sale in the ordinary course of business (work in process), and materials and supplies that are
consumed in production (raw materials). Inventories are required to be stated at the lower of:

 Cost, including -costs of purchase (including taxes, transport, and handling) net of trade discounts received, -
costs of conversion (including fixed and variable manufacturing overheads), -other costs incurred in bringing
the inventories to their present location and condition.
 Net realizable value (NRV), which is the estimated selling price in the ordinary course of business less the
estimated cost of completion and the estimated costs necessary to make the sale.

we need to assess our inventories with the lowest between the cost and the net realizable value because we always
use the lowest value for being prudent.
Policies for using inventories:

 FIFO (the oldest material are the ones to be used firstly)

 Weighted average cost (no differences between time in warehouse but they use a weighted average, Each
unit has a value equal to the ratio between the total costs of goods produced and bought and the quantity
produced or bought over a considered period)
 No LIFO (not allowed anymore by IAS/IFRS because you can’t always use the newest materials).

Production Budget Anthea

We would need to check the constraints. The hours needed aren’t enough and therefore we would need 300h more,
the plan is not feasible  we can change the expectation or we can outsource the additional production.

Outsourcing brings the risk of not having the right quality, know-how. If the sales cannot be re-budgeted we can
manage inventories (less safe stocks). Otherwise we can optimize the efficiency of the system or buy another
machine if it is a constraint. If the additional demand is temporary the investment might not be cost effective (due to
covid for instance). In our case we need to assess the price for outsourcing  100 units will be produced by an
external provider. (MAKE/BUY)

Cost of goods sold budget

It is used to forecast the resources needed in the

production process and comprises the following budgets:

– 2.1 Direct material budget – 2.2 Direct labor budget –

2.3 Manufacturing OVH budget {costs of goods
manufactured (B)}

Also beginning (A) and ending inventories (E) and

outsourcing costs (C) need to be taken into account to
calculate the cost of good sold.

2.1 -Direct material budget: to forecast how many units will be needed to produce our product.

We will need to know as well the inventory level to know the purchase of direct materials. This is why it is important
to know the inventory policy. [Purchases of direct materials = Direct materials used in production - Target ending
inventory of direct materials + Beginning inventory of direct materials] (same structure as production budget but for
the materials, labour and manufacturing ovh)

2.2 -Direct labour budget: identify manufacturing labour hours. They depend on wage rates. We will have the budget
usage per unit and the budgeted hourly rate. (paid and productive labour hours)

2.3 -Manufacturing Overhead (indirect costs) budget: costs that cannot be assigned precisely to one unit of product
(e.g. depreciation). We need to distinguish btw variable and fixed overhead (depreciation, insurance, supervision)

B) The Costs of goods manufactured is the sum of these previous budgets.

C) Cost of outsourcing purchased is made by the forecasted price of purchasing external finished products

D) Costs of Goods available for Sale is no more than: A + B + C

E) We subtract the ending finished goods inventory wanted

F) In order to have the Cost of Goods sold (cost of sales) = Cost of goods available for sale (material + labour + ovh
costs) – ending finished products inventory
Example Anthea Costs of Sales:

We are going to sell 1000 units with 900 from production (900 * unit cost of production = 34560) + cost of
outsourcing 100 * 45 = 4500…

Period Cost Budget

It includes all the costs related to the core activities (operating activities) but not directly to the manufacturing
activity, Selling and marketing expenses (variable and fixed); Administrative and general expenses (wages, rent of
offices); R&D costs.

This budget has become crucial for its incidence and difficult calculation

Example Anthea Costs of Sales:

wages sales department: 4,800 €; - Sales commissions: 2% sales; - Advertising and marketing expenses: 4,300 €; -

Costs for administrative activities: 2,000 €; wages administration/human resources/R&D departments5,000 €;

- Expenses for R&D: 5,000 €

EBIT = budgeted rev – cost of goods sold – period costs = 8440

Ros = op result / rev = 8440 / 70000 = 12% < 15% expected

We can decrease cost of sales but it is easier to cut period costs

From exercises: we can compute EBITDA margin with operating budgets because we have EBIT and D&A can be
found in manufacturing Ovh budget (no related to one unit but affected by manufacturing due to indirect cost
nature)

Capex Budget

It includes all the cash flows related to purchase or disposal of fixed assets (PPE and technologies, patents,
softwares). They refer to new investment while
Opex are operating sales and costs.

Capex affects BS (classification of non-current

assets); IS (D&A) and cash flow statement (cash
out for acquisition of new assets or cash in for
disposal)

It is simple to calculate because we need to

distinguish cash inflows and outflows (Disposal
and Investments; no accrual). We keep track of
depreciation because then it would be used in
the financial budget

Example anthea capex budget

Assets we already have in BS, depreciation of 1000; 5000 paid in 2021 (5000 in 2022); new acquisition of 5000 (1000
depreciation)

Capex = 5000 investment – related deprec 1000 + 5000 (IT) – related deprec 1000 - deprec of already included assets
1000 = 10000 capex and 3000 depreciation

If we have a disposal we have to consider the cash inflows and adjusting the depreciation without considering the
one related to the disposal.
Financial Budget

It forecasts the cash sustainability for the company, including operational part and investment plans (capex)

There are two types of financial budgets: Budgeted cash Flow statement and Detailed cash budget

-Budgeted cash Flow statement: it can be computed in 2 logics, indirect (from EBIT adjusting the result aligning
accrual and cash principles) or Direct (forecasting future flows by activities like CF direct, more complex)

Indirect (EBIT  FCFF  FCFE)

Example anthea case Financial budget

Negative FCFF. How to manage? – Limiting investments? – Changing the Net Working Capital strategy? – Can the
financial strategy cover the negative FCFF?

Detailed cash budget

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.

Example of detailed method: 3 schemes (inflow statement,

outflows statement and summary)

Inflows scheme: we need to take into account inflows cash from

rev account rec and other item; then we need to compute other
non-operating flows from loans bonds equity increase disposal
of assets and other financing items (tot financing and
investment inflows)  total inflows for each month

Outflows: operating (material, payables, wages, services,

selling expenses) and financing (taxes, liabilities, payables)

Synthesis scheme: opening level of cash + tot inflows = tot

available cash for each month – tot outflows = first cash
balance – min level of cash required = cash balance;

Opening debt position – fin interests = closing debt

position.

With detailed cash budget we are detailed for all the

subperiods of the company.
Final step in the Master Budget is drafting the complete Budgeted Financial Statements: • Completing Income
statement • Defining Balance Sheet • Defining Cash flow statement

Financial Planning

The aim of financial planning is to understand how to manage financial needs of a company • There should be
equilibrium between the financing structure and investments: • Time horizon • Cash management balance • Return
of the investment and cost of capital.

From Anthea case we see the FCFE which is negative, how can we recover from it? Let’s see the possible strategic
actions.

If our financial distress is made of temporary situation we can think on short term solution liability to cover the
financial distress, if the negative impact if for long term horizon issue we need to adopt a strategic action for the long
run.

Additionally we need to take a look at the return of the investment and at the cost of capital. We see the reclassified
BS and study the investments and finance structure. Equity/debt is the main decision we need to take into account.
We can collect additionally cash through two types of market: Equity and Debt market. The first is related on the
shareholders, the second is
composed by all the other
individuals who finance the
company with the expectation to
have the cash back under contracts.

Equity Market

It refers to shareholders. They provide share capital and get back dividends and the ownership, they are paid with
residual rights. They could have ordinary shares (voting rights and participation through shareholders board) or
preferred shares (they do not have voting rights but they have dividends before common shareholders). It is a more
stable source of financing for being a long-term investment (no contracts), no time constraints to repay interests or
dividends to shareholders (there are in the debt market)

We have the Public Equity Market: listed companies in stock exchange, fees paid to be listed.

Private equity market: unlisted companies can sell shares through private investors.

Debt Market

The debt market is characterized by debtholders, who lend money to a company, which is then obligated to
remunerate them according to an established method and schedule.

Two main categories: debtholders and loan holders

Debtholders are outside entities which finance the company in which we settle the timing and what are the interests
that they need to have back. The instruments that we can use on the debt markets are long term instruments when
the timing is over 12 months or shot terms within 1 year. For long term instruments there are bank loans, corporate
bonds and leasing. For short term there are bank loans, lines of credit and factoring (only one related to non-
financial resources).

Bank Loans

They can be long or short term (depending on the maturity). It is a debt that is provided by a financial institution to
the company in return of an interest. The interest
can be fix or it can be variable (floating), defined
according to indexes in the debt market, inter-bank
exchange (like Euribor). The maturity is the n° of
periods of duration of the loan, the end of the loan
is agreed btw the company and the bank.

The repayment scheme for the capital can be Bullet

(give back the capital at the end of the contract) or
it can Amortized (spread across the maturity,
Interest calculated over residual debt). Debtholders
have priority on equity holders.

Bank loans are activated only if they have warranties. Mortgage is a form of guarantee which is constituted by real
estate (“mutuo con immobili”, the bank can then recoup the property…). The type of agreement become longer and
so there could be charged higher fees (upfront commission).

For the financial accounting we need to calculate the effective interest rate EIR to amortize the cash flows and
actualize them. The nominal interest rate needs to be actualized. (EIR is TAEG, NIR is TAN for car sales)

Investment appraisal, IRR is the rate that exactly calculate btw what we get and what we have to give. We want to
know the investment needed to end the contract with present value of 0, this means we have repayed all the loan

Example of EIR

Debt = 2000, maturity 6 years (2024). The nominal interest is fix = 4%, paid annually, upfront commission cost of 50.

If we want to really know the effective interest rate we have to compute the cash exchanges actualized with the
bank. We can find the EIR doing so = 5.52%. the nominal interest was 4%, but given that there is an upfront
commission the rate is higher.

Exercise Anthea case financial distress

1. In 2021, you would like to issue a new bank loan of 10,000 euro to cover capex. The maturity date is after 5
years in 2026. The interest is a fixed rate of 10% to be paid annually, starting from 2022. The commission
fees amount to 1,000 euro to be paid in 2021. Schedule the debt cash flows in cases of bullet repayment.
Consider also an amortized repayment of capital at constant quota of 2,000 euro from 2022 to 2026.

Syndicated Bank Loan

Bank loan in which company ask money but the amount of money asked is so big that we need a group of banks that
provide the required amount. Big M&A for instance. This kind of arrangement is surely more complex. The
differences are in the type of group involved. Transactions are higher because of the arrangers. (bank intermediary)

A syndicated bank loan is a loan provided by a group of lenders, and it is arranged and administrated by one or more
banks
Bonds

A bond is a security that requires the issuer (i.e. company) to pay specified interests (coupons) and make principal
payments to the bondholders at maturity or even on specified dates. Bond is a financial instrument that have 2
parties, a company and an individual or
institution which is ready to buy the bond.
It has a specific duration and can be
related to other organizations or
individuals. It has coupon to be paid
(interest), it has a maturity settled in the
contract, it can be re-payed in bullet or
amortized mode. Bondholders have
priority over shareholders, but not over
debtholders.

There is a division btw debt security and hybrid

(convert the bond in shares). Debt securities are
with coupon (interest) or without, the coupon ones
can be with fix rate or floating rate.

Difference btw bonds and loans: Bonds are on the market and so they can be issued only by listed companies (and
some particular companies), they have a market and the definition of the rate is related to the Rating of the
company.

Bonds can be bought from states or

from company, the intermediation is
made by the issuing company. In other
cases the consortium can handle the
administrative part (they get a % of the
coupon)

Main difference btw loan and bonds are

that we can address higher n° of
financers with bonds, the emission
requires transparency and
intermediaries, the cost of the
transaction is higher and so they are
more costly. [no negotiating on the bond emission, affordable for investment-grade companies with reputation]

Anthea case Bond emission

2. In 2021, you plan a bond emission of 10000 euro, maturity date after 5 years. The coupon is fixed rate of 12% to
be paid annually, starting from 2021. The commission fees amount to 2000 euro to be paid to the underwriting
group and 5% on the value of emission to be paid to the selling group. These fees need to be paid in 2021.
Furthermore, the agent bank will require 2% commission on the value of bonds managed each year, starting from
2022. Schedule the debt cash flows in cases of bullet scheme.

Leasing

Form to get financing related to the rent of a specific asset, it is a special contract by which a user or company
(lessee) rent a particular asset from the lessor (owner). The lessor gives the right to the lessee to use an asset for a
period, making periodic payments to the lessor (e.g. car for managers which can be personalized). The asset creates
a relation btw lessee and lessor. The lessee has all the risks but on the other side the property is still of the lessor.

In the contract you have the possibility to redeem and buy the asset at the end of the leasing. The leasing might be
on most specific assets (e.g. aircrafts for airplane companies).

The contract must be transparent internally btw lessee and lessor, it is not public. There is maturity related to the
duration of the leasing. We have to account for interests. The payment is the leasing charge paid to the lessor
(capital quota + interest).

Leasing is included in asset in BS and it is calculated as PV (in right of use assets)

To sum up:

It is not standardized (no cash). The maturity is generally equal to the life of the asset. The lessor has the legal
ownership but the lessee is in charge of all the other risks and costs (in assets BS right of use). Benefits: it is easier
than a bank loan, lessor doesn’t ask guarantees like banks and so administrative procedures are easier. The debt
amortization is flexible and agreed with the lessor.

IFRS 16 Leasing

It finds the lease as a contract that conveys to the customer (“lessee”) the right to use of an asset for a period of
time in exchange for consideration. Fulfilment of the contract depends on the use of an identified asset and control
of the use of the asset during the lease period.

BS: risks and the use lead to the highlighting of the value of the asset we use (as the sum of cash flows to the lessee
actualized). In the same way we account under debt against our lessee (value is the same PV of future lease
payments, lease liability). Lease assets are recognized on the balance sheet at Present Value of future lease
payments: • Liabilities (debts) are recognized on the balance sheet at Present Value of future lease payments.

In the IS we have to account on depreciation, assets depreciated even if we do not have legal property. Then we
need to account the flows. Depreciation of lease assets (Value of asset divided by useful life) • Interest expenses
(Interest multiplied by the residual debt)

Cash flow statement: • Cash Outflow equal to leasing charge, composed by: • Interest quota (Interest multiplied by
the residual debt) • Capital quota (difference between leasing charge and interests)

Eon financial statement have both financial and operational leasing but now it is not like so. Operating was the one
over which both parts assess the majority of the risk was on the lessee (e.g. car which are used but risk over lessor,
because the asset is customized), the financial one says the risks and benefit are addressed to the lessor (e.g.
machinery, lessor build and construct the tailored asset, risks are over the lessor)  now there is no distinction.

Example:

Company GIR S.p.A. leases at year 0 a machine from a

lessor for a duration of 6 years: • The asset redemption,
at the beginning of year 7, is 53,700€ • The annual
lease is constant and equal to 228,914 • The first quota
of lease will be paid at year 1 • The leasing interest
rate: 5.0015%.
 Leasing interest rate is on residual debt.
Asset value and debt value. We actualize
with the leasing interest rate  the same
actualized value is used for both asset and
debt value.

We account the depreciation for the asset

value yearly. The cumulated depreciation is
only to highlight it.

We have to account in the IS for the leasing

interest that are calculated on the leasing debt
net of capital quota (financial expenses =
financial interests = interest quota)

Debt = 1200k, in the first year we take the initial

value of the debt and multiply it with the
leasing interest to get the interest quota.
Capital quota = leasing rent (cash outflow) –
interest quota. (what we paid – interest). The
new debt is the initial debt – capital quota.

For all the years we need to

calculate interest quota and capital
quota on residual debt in order to
find the new residual debt.

Capital quota is the amount in

which we decrease the previous
debt.

We need therefore to decrease the debt through the capital quota, which is the cash outflow from the leasing rent –
the interests (% on residual debt).

in the Budgeted cash statement: Cash delta debt = net debt + Capital quota of leasing rent

financial expenses = leasing interest

Leasing Anthea case

To check excel

Lines of Credit

A line of credit is an available amount of money that a firm can borrow from banks in short time and with high
interests. It is a very flexible option of financing. It should be used for covering short-term cash imbalances due to
the mismatching of operating cycle inflows and outflows.

Interest rate is very high and fix. No maturity. Interests are repaid monthly. Debtholders are banks and so have
priority on shareholders.
Firms can have access to Several lines of credit at the same time

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 (a financial institution) pays a
percentage to the counterparty as soon as it receives an
assignment or the receivable.

It affects both FCFF and FCFE (dNWC, financial expenses as

commisions). This service of an advance payment is paid with a fee.

Interest is related to the percentage of discount on the face value of the commercial credit. Scheduled repayment is
on the day the debtor is supposed to pay.

It can be with recourse when credit risk remains on the creditor under reserve (i.e. the factor requires the return of
anticipated amounts to the party who sells the credit in case the debtor does not fulfil its duties at maturity)

Without recourse when factor assumes the credit risk. In this case, the factoring cost for the creditor is
comprehensive of this risk analysis, and in the case of insolvency, the factor cannot recoup costs from the client who
gives the credit. This arrangement is a protection against bad debt quality, even if it is not costless.

Factoring allows the company to have liquidity instead of waiting for the natural maturity of receivables. In case of a
factoring without recourse, the company does not suffer the risk of insolvency of the debtor (credit risk)

e.g. FCA reputational effect of factoring; (collecting early cash with less benefits due to commission)

The factor should have information not only on the company but also on the debtor in order to easily value its
insolvency risk.

Example Factoring Anthea case

In 2021 you plan to factor (with recourse) half of the accounts receivable you have. The factor will give you in cash
the 90% of the overall amount of accounts receivable (10% is taken as a commission). For the NWC position of the
firm refer to the first part of the case.

Account receivables halves, dNWC = -6980; commission = 875 net of taxes = 437.5 (financial expense, exercises
operating expense)

Positive effect for better NWC but we still have commission cost.

Comparison of different solutions

For short term cash balancing companies can mix the different financial instruments. In order to assess the best
financial policy it is needed to assess the impacts on more than one year. Through the PV we can assess the best
form along the years.

For Anthea the best option is the Loan, but with broader consideration (long run, overall balance of debt which can
lead to a debt over equity really high and bank do not accept our request)

Accenture

Enterprise performance management, planning & budgeting approaches…

Enterprise performance management EPM [planning and control system]

We want to focus on the Business Strategy. It changed a lot because now it is not anymore on long term horizons (3
years usually) for the volatile market. Target setting will choose the KPIs levels to be reached in finance and not. The
Operate phase is when the company put in practice the targets in operational activities (we can do it through
equipment and teaching…). The monitoring is continuous (monthly) to check the performances.

Information, Decisions and Actions have to be aligned with the targets of the strategy (it is a loop as well).

Planning starts with

targets set on the
Business units, linked to
budgeting phase to
allocate resources
(people, money…) to
satisfy targets 
forecasting and
monitoring

Planning, Budgeting and Forecasting Processes

Timing is key to plan the Strategic planning (LRP, 1 month). After summer they set targets and develop action plans
within each business units (cascade of targets for 1 month). BUs are transforming to satisfy targets requests (1
month) until the Budget Final in mid-November. After it there is the forecasting of FY20 with continuous monitoring.

The processes are multi currencies and with different regulations within different countries, nowadays companies
are working a lot in forecasting because such complexity needs to be defined fast and real time information to be
processed even with the help of external counsellors (like Accenture). The periods taken into account are only ideal
because it usually takes way longer.

The P&C department in the organizations (planning and control)

There is a pyramid used for it. C-Level

is at the top (Chiefs of the company)
which provide long term guidance and
help in PB&F and help with the
dialogue with BUs.

Planning and Control is in between the

C level and BUs to help organize. It
helps to cascade the targets to BUs
(Top-Down) and then BUs respond
with a Bottom Up answer which brings
back to P&C dept which will deliver the
response to C-Level to agree the
targets. (Processes…)

Key Target of the P&C dept: Set objectives with management, Lead the processes and Act with corrective actions to
reach the defined targets.

Budgeting approaches:
Zero based budgeting: when the budget BUs start from scratch the forecasts about the following periods (bottom
up). Costs must be justified for each new period. Managers must justify all expenses and so it is complex to justify
each number with details starting from zero. [general and administrative costs or overhead]

Activity based budgeting: budget is done aligned to processes and internal activities across BUs, this is why it
promoted standardized activities across functions. [production and projects]

Incremental based budgeting: activity but adjusted to account inflation and growth. Previous years budget plus
percentages to obtain current year’s budget, it is difficult to be need to real needs (from old one adjusted). It is
applied to recurring costs. [gov fees]

Driver Based Budgeting: it translates operational drivers to financial ones. It predicts how the firm is linked to
external variables and it allows quick and easy what if analysis. It has focus on expected business outcomes. It needs
alignment on key inter departments cost drivers. [revenues and costs]

Companies are using a

mixture of approaches
according to different parts
of P&L

Best Practices…

Budgeting for 2021 needs to take into account the variability of covid impacts and potential of vaccine. We need to
evaluate scenarios analysis to be ready to adapt.

REAL-LIFE PROJECT IN PRODUCTS INDUSTRY

CFO compartment, company leading product industry with 4 global BUs and 120 markets worldwide (>24 bn eur
sales).

Project overview: they are building a big program with various projects. We will discuss one of finance dept involving
120 countries built with an application to support the process on driver-based budgeting (deployed mode to plan in
a unique way). One of hardest point was to deliver a unique managerial P&L model (decentralized system for all
countries). Define three operational drivers for each P&L line. At the end the one common support technology
(Tagetik, still integrated with excel)

For PW  Define P&L, Define driver three for each line of P&L and then apply technology.

Case of North America: US and Canada, 130 users with a single P&L for product and customers. [actual and planning
& budgeting control]. The focus of NORAM was upon main cities and the main drivers were: Driver based planning
approach (drivers for each line for all regions), Unique integrated application (for all activity depts: logistics,
marketing…) and make it Flexible (Flex Rolling forecasts to perform what if analysis in order to estimate the impact
of potential changes). [goal was to exploit technology to reduce time, data transparency and unique and integrated
process for P&L]

They succeeded with a 6 months approach: Process assessment (they visited all cities to understand how they make
the managerial processes on P&L different for countries), they collected all project requirements and defined how
should be the P&L with the drivers trees.

The application development was then started through programmers and developers with a build phase and real
examples. Then a User test was done to check the expected performance. Now the application is ready and they cut
80% time of budgeting Driver Based planning [post production support].

Real managerial P&L on NORAM.

On left aggregated parts, in the middle the operations resulting aggregated parts. Then the details of each part with
the drivers  it gives a picture of the company in one moment and the drivers will deliver the key indicators that
make the data.

Sales Revenues

Sales revenues is the sum of moltiplications of different products data (volumes affected by covid impacts… and
price impacted by inflaction…).

Material Costs

Detail of single units costs, understand and analyze main drivers (sugar, milk…)

We start from benchmarking P&L across the globe and then associate to the common lines found the drivers. Drivers
will be needed in two directions (revenues and costs), avoid few drivers with same drivers for each line.

To develop a unique tool for everybody from power points and excel files…

CPM: corporate performance management tool to increase efficiency, Tagetik’s potentials.

Main things of the process: structure of budget in multiple phases which reflect a part of P&L (each phase could be
dealt with different budget approaches). The entities involved in the process are many and they all can rely on this
tool now.

Workflow of budget process: each single item is an activity (which could be each action needed to so from the users,
the client defined its own logic to build the process). For a budget process a company like it have 15 million actions.
Now we emulate a controller of the top line: Revenues  run the steps: gross sales through incremental budget, the
excel processed by the system is manipulated by the controller. The goal is to run the budget of gross sales for a
given period. We assume that the quantity are fixed and we are going to change the prices. The controller basing on
inputs and key drivers will decide the figures of the prices for each product (CPM tool let you work in a smarter way,
like adapt previous year prices)  we can adjust these data automatically taking into consideration inflation for
instance. Doing so now the P&L has been updated. Now we will focus on total trade figure. First of all we can
perform what if analysis taking into consideration different inputs on variables.

Net sales usually get along gross sales, we can identify it as a main driver (system calculates the % of it on for each
client, basing on ) with a budget input we can split the trade decided as target to allocate automatically the
amount.

The data inputs are controlled by pre-defined ranges, constraints on fixed assets in balance sheet. Forecasted
volumes sold are given by BUs targets agreed.
Project Work Challenge

Managerial P&L and the Drivers’ choice

Mix and reshape  Company Choice, P&L definition (managerial with all voices necessary), Driver’s Choice (driver
tree to be applied to P&L), Dashboard Creation (dashboard in power BI)

The outcomes of the challenge are 2 deliverables: to create our own managerial P&L and to decide our own drivers
(excel file). In non-mandatory way to create a Power BI dashboard and complement it with a presentation.

Company Ferrero:

Leading market position in food and chocolates snakes. 104 companies worldwide, +6% net sales respect to 2018.
36372 headcounts, distribution over 170 countries.

We need to find on Ferrero website their investor relation and reports to find our own managerial P&L including all
necessary voices. According to the P&L we can identify the main drivers to work on. We can start from the Excel file
sample. Secondly we are supposed to go in detail to identify drivers at least on the sales and cost parts  we are
expected to create a scenario analysis, what if analysis  covid stops in January, covid carries on through years.
Moving numbers on excel we should be able to define different situations. Go deeper on sales and costs.

P&L on 12 months for all products and different drivers (tree with more levels). Costs referred to all sections (period
and production ones). Present results of a couple of scenarios linked to excel (warmer summer…)

Non mandatory option to create a dashboard on power BI linked to excel file. How to link power BI will be showed
on lecture. It is useful for scenarios analysis (worst, best and avg for next years to present to P&C dept, it can be both
for external or internal factors like entering in new markets).

Presentation of 20 mins through what if analysis. We can create a video to present (to look AI presentation) keeping
in head the is for C Levels.

To define P&L and identify P&L among what we want to underline (part of the business).

Finance test simulation

Variance Analysis

Let’s have a look at the framework of our process in the

planning and control system:

Reporting is about communicating the variance results to

managers…

Reporting

Reporting changes depending on corporate level and responsibility centers.

Business units have autonomy in both choosing mix of products/services and can tailor the offer to specific
customers. Responsibility centers or operation center has less autonomy but more responsibility, managers are
responsible for activities within the units, monitoring the KPIs that can be influenced and satisfying the target
objectives agreed with c-level (not responsible for revenues and costs as BUs)

Responsibility centres can be many, we will focus on cost centre, revenue centre and expense centre.

 Cost centre: managers are responsible for costs under their control, costs related with volume production
[production, logistics]
 Expense centre: units which interact with external market, and are not related to volume produced
(marketing, R&D and administrative) [responsible for costs]
 Revenue Center: only revenues under control, if we focus on increasing sales we can’t reduce other
performances like quality or service (commercial units)

Reporting is not equal to variance analysis. Reporting is the act of communication of variance to the managers, while
variance analysis is the methodology to assess the changes.

Measuring the performances of responsibility centers can be done through Variance analysis or ABM.

Variance Analysis

Variance analysis consists of comparing actual values with budget values through the usage of a flexible budget.

Variance could be caused by different factors, managers can use these analysis to understand opportunities or issues
with forecasted values. It allows to make comparison: Favorable variances (more revenues or less costs than
expected) and Unfavorable variances.

Cost centers: responsible for use of resources but not for outputs (sales). The performance is measured through
total cost, variable costs + fixed; VC * Q + FC. Usually the objective is the minimization of total costs under a
threshold. The comparison is usually on budgeted and actual values.

We can follow a hierarchic schema with more levels, at each

level we introduce a device for dividing different
contributions to the total variance, a fictitious budget called
flexible budget which is a combination of actual and
budgeted figures. The first level of Total Cost variance can
be split in 2 components: volume variance and efficiency
variance (it is related to variance of costs in efficiency of
transformation process). On third level we can decompose
the difference of price variance and use variance.

We will assume a one product company (otherwise we would have to compute variance of mixes)

1) First level, calculation of total cost variance.

Subtract budgeted costs to actual period (Actual -
Bdg costs). You cannot state if the performances are
favorable or not, it is true that costs have increased
but also production has increased so we have to
further explore the weight of effects.

2) It implies the introduction of a fictious budget

mixing actual and budgeted values. Budgeted costs
with actual volume of production to make a volume
variance. We can mix the variable Vuc variable
unitary cost (direct labour unitary cost bdg +
 material unitary cost bdg* Qact) + OVH bdg to compare it with actual results to see the Efficiency variance
(actual volume and different costs)
We do not have to consider the non-manufacturing expenses because we are in the cost centre and not
expense one (only production)

3) The third level defines the costs efficiency

variance which is the result of computation
of more parameters, these are partially
controllable by enterprises.
We will use another flexible budget to
monitor 2 variances: the price variance and
use variance. The second flexible budget
has an actual unitary usage as well,
assessing the impact of use variance.
(efficiency in terms of price per unit and
usage of resources comparing with same volume and bdg price/usage) [price rate = cost / resource used;
unitary usage = resource used / units  p * u * Q]
Comparing the second flex budget with actual results we will have the Price/rate variance
Variable unit cost (product i) = unitary use [(h or Kg) / u] * price or hourly rate [€ / (h or Kg)] = [€/u]

[the third level is like comparing Variable costs of budgeted values, flexible bdg and actual values; in the price
variance we need to take into account even the manufacturing overhead actual costs and compare with the
budgeted ones]. Can be performed only for variable costs

Problems with traditional approach on cost centres:

Cost centre are not able to control these variances – Traditional approaches do not consider two important aspects:
• Quality of components; • Feasibility of production  Short term oriented.

Possible solutions: – Adding other information to the traditional measures: • Value drivers • ABM. Using cross-unit
coordination mechanisms.

Revenues Centre: organizational units responsible for

revenues on the market. They usually are commercial units;
Level of sale is a target usually, there could be exception
with total contribution margin, which is the difference btw
revenues and variable costs. First level of total revenues
variance = Actual revenues – Budgeted revenues

We will use a fictitious budget with actual volume and

budgeted price. In this way we can evaluate the impact of
volume variance. Volume variance is negative, it
could be negative but we can act on price variance
and achieve a better result, not always price can be
changed on sales so it is not always controllable (price
takers on commodity and less differentiated
products). On level 3 we detail the volume of sales:
market share (portion of mkt) and market size
(variance on market dimension).

Problems:

Revenues centres not always can control variations in

price and quantity sold; Yearly Revenues are not long-
term oriented indicator.
Possible solutions: Use of a wider set of indicators,
value drivers; Use of cross-unit teams for managing
interdependencies (Usually in reality inter units are
used).

Expense centres: difficult to define performance,

output not easily identifiable with money, lower
incidence on cost structure but now it is increasing. We
can use non-financial indicators to identify activities and
measure their performances. We can use an activity-
based method for budgeting and then evaluating
performances of an expense centre.

These support centers have a high incidence in all types

of organizations. A possible solution for their
measurement is the construction of a balanced
scorecard starting with the identification of activities that
are carried out. According to the characteristics of the
activities of the expense center, different measures can be identified 

Among repetitive activities we can have:

Efficiency-oriented activities: For example enrolled students as driver and we evaluate cost / driver.

We will always have a volume

variance changing actual driver and
a efficiency variance with actual
cost/driver (budget values –
budg*act – actual values. We
therefore define the impact of the
budgeted variable cost with actual
volume on both budgeted values
and actual ones)

[quantitative outputs easy to

assess]

Effectiveness oriented activities where quality is relevant (quality, service level, satisfaction level, overall cost of
activities). We can assess some drivers to evaluate some activities: overall cost of activities, • the quality perceived
by internal or external customers (customer satisfaction survey) • The internal quality indicators • Time

Example overall cost, students satisfaction  Integration of effectiveness and efficiency with student satisfaction per
unitary cost [qualitative measures to be defined to assess the output]

Project activities: usually characterized by a significant amount of resources and long duration. Each project should
be defined, during the planning stage, in terms of: – A set of objectives to achieve (defined both in quantitative and
qualitative terms, according to the activity orientation – efficiency
or effectiveness); – A timetable definition coherent with the
objectives achievement; – The allocation of resources for each
phase of the project

Performance Measurement
It refers to a Set of metrics called KPI which can quantify the actions to reach the company’s objectives. To support
decision making, motivating and report outside the result of the company.

We have already considered KPIs for the financial part (profitability, liquidity, financial structure: D/E, different
market tools) and assess the result through time, now we are going to evaluate the Non-financial Indicators (ability
to leverage on key factors that affect company’s success)  value tree drivers for PW.

Value drivers/KPIs non-financial are classified per Time, Quality, Productivity, Flexibility, Environmental and social
responsibility. It is difficult to succeed in all of them, usually there is a trade-off.

Non-financial indicators measure value drivers. These Value drivers are real competitive factors for the industry as
they provide signals (driver) of value creation. They provide results earlier than financial indicators (financial
indicators requires choices on non-financial. e.g. Revenues are affected by decisions which affect non-financial
indicators like quality affected by n° of defected products by maintenance which impact customer satisfaction).

Connection btw financial, non-financial and value creation

We can expand the value

tree considering not only
IS but also the Assets.
Orange part is the
financial part and it is
standard copy and paste
because every company
considers these
indicators. The blue part
is the essence of the
choice of competitive
factors because it is
necessary to understand
the essential driver which
deliver the competitive
advantage. They became
central of performance
measurement.

The classification of the drivers is done

through the recognition of the
competitive factors (value drivers). The
early signals are important to make
decision firstly in order to grab
opportunities and avoid risks. We
maintain always the function of the KPI
with future revenues or future costs.

Example of indicators:

In the majority of cases few companies do the analysis before variance analysis. They have a lot of KPIs but they do
not link them with financial indicators. In the variance analysis you assess if there is a real correlation of it with
financial indicators.
Time

We can divide time indicator within:

-Time for delivering catalogued products (Revenue driver). Catalogue products are internal products already
produced and here the key element is the delivery time (can be measured as avg delivery time, % delayed deliveries,
avg delay). In order to assess it we need to have a standard ground shipping to compare data for all clients.

-Time for new products (Revenue driver). We can take into

account the Time to Market, considering the product life
cycle. TTM is about the designing and engineering of the
product and it is indeed important for dedicating resources
and investments for compressing it and reaching earlier
profits.

Companies tend to squeeze the TTM because it costs a lot

but some of them have a lot of TTM. E.g. Nutella biscuits
needed 10 years of TTM. The results were amazing…

-Throughput time: it measures the time taken for a product to be manufactured (Cost Driver). If we want we can
divide the factor in some phases (e.g. Zara lean and agile strategies to post pone design; buys material and then
postpone the design, they include it in the Through put time, Zara can squeeze the time to 2-3 weeks instead of 6-18
months of Prada, thanks to the copy of the design of the latest fashion shows with low quality materials for mass
consumption; trade-off Quality-Time). It is a hybrid of TTM and through put time because they already have raw
materials.

Exercise on delivery time

Motivational effect.

If we want to keep a low maximum delay working days first C, avg delay is the same, if we want to minimize % delay
first A.  we need to considerate the type of clients we have, if they are few the max delay is crucial. The logistic
and commercial activity needs to assess the policy to choose the value driver.

A: 6, avg delay 2.7, % delay 66,7.

B: 6, 2.7, 100%

C: 5, 2.7, 100%

Quality

It is the most important effectiveness element as value driver for outsiders. It is articulated on revenues and cost
drivers (internal process quality)

Product quality (revenue driver): Design (feature of products: mobile phones quality on battery duration, GB storage,
bit/s; relation with customers: feedback of maintenance and customer services), customer responsiveness (assess
what is important for clients, customer satisfaction through surveys; even through social media comments or
satisfaction through website appreciation…) and conformance quality (performance of a product relative to its
design and product features: claims and n° of returned products).

Process quality (cost driver): internal failures (scrap rate, waste, n° defeated products)
Productivity

Most traditional KPI, ratio btw Output and Input.

When we have only one product, productivity is easy to assess: Quantity/Volumes (resource used)

With different but homogenous product we can use quantity with physical weights. With diversified products we can
use the actual quantity and the budgeted prices (similar to flexible budgets).

When we compare the Inputs we might have problems while comparing companies with different levels of
integration. E.g. Danone group can have companies which produce milk and other that outsource it. Measuring
productivity one would have more input while the other doesn’t have that input. We need to avoid these issues
using the more general production. To avoid incomparability, products have to be weighted using a value-added
method; this solution is usually more expensive and is suggested only for specific information needs

Partial productivity: Output produced is confronted against a single production factor (labor productivity:
output/#employees; material efficiency with relevant raw material)

The disadvantage is on sensitivity to variations of inputs. If enterprises invest in automation, their productivity per
employee increases significantly, but it does not trace the exchange of input mix

Global Productivity (output produced is compared against a weighted avg of production factors through
production costs), input includes more than one factor and is calculated as their weighted average. Usually, weights
are unit costs of resources; Although standard values can be used, in this way, the indicators become financial. In
particular, when economic weights are used for both output and input, the obtained measure is the ratio between
sales and the cost of production, quite similar to return on sales.

Typical question at Oral exam.

Example: Yogurt as example, provide indicators and metrics for quality and productivity.

Quality of design (% fat, revenue driver, %sugar cost driver), customer responsiveness (usually new product related
to healthy factors, like sugar, cholesterol… The responsiveness could be to check the reaction of the market. Survey
on reaction to variation to bio products, bio preferences, Cost driver; nutritional information), conformance (n° of
claims/returned products, revenue driver), process quality (scrap rate packaging, cost driver), productivity (kg
yoghurt/liters milk, cost driver).

Flexibility

Related to both revenues and cost drivers (flexibility becomes a driver of cost or revenue according to the strategy of
the company). It can be defined as the capability of the company of including changes in the production with limited
cost and time. It can help us in having more clients and reducing costs.

These flexibility categories are described referring to two characterizations of change:

• Type of change, distinguishing between quantitative

changes linked to positive or negative variations of
demand of products/services of enterprises and
qualitative variations related to changes in the type of
product/service produced.

• Entity of change, which can be divided into three

categories: Small changes, which do not require structural variations of enterprise resources. Large changes, which
require structural changes in enterprise resources. Range of allowed changes, referring to the set of environmental
changes that the company is capable of sustaining without structural modification; this capability usually increases
when modular reconfigurable resources are employed. The cost is assessed as forecasted costs on historical basis.
If we mix nature and entity of change we come up of 6 impacts:

Starting from flexibility with small changes, product flexibility is the ability to modify resources for introducing new
products or services (time required for small modifications in activities such as engineering and logistics). Volume
flexibility, which measures the impact on enterprises of small quantitative variations (ratio fixed costs and variable
costs). Operation flexibility is the ability to adapt to large qualitative changes (time required for adapting enterprise
resources to new requirements). Expansion flexibility, indicating the ability to respond to large changes in existing
product demand, depends on the resource modularity (referring to logistics, an example is the maximum increase in
warehouse space, loading capacity). The qualitative range dimension is referred to as production flexibility (range of
products and services manufactured and delivered by companies). Mix flexibility, which is defined as the ability of
companies to withstand changes in the level of demand without additional investments (average number of
products in a period, spare capacity, and setup time)

e.g. Grom. Their strategic competitive advantage is on

quality but they are a good example of flexibility.

Range: It has lower range of products. Low number of

flavors (range on quality), low mix.

Small Flexibility: they change frequently the products

and good Volume flexibility (variable cost and fixed cost
relation to assess small flexibility).

Large flexibility is difficult to assess through Operation

(TTM)

Indicators are made by Managers usually, in the majority of cases the technical unit.

Environmental and social responsibility

This category is the newest and more pressing one. It quantifies the ability of the company to respect society and
environment. This is crucial for external accountability, mostly listed companies reporting, impact on reputation
(revenues), lead on costs reduction (cost driver with fines). We refer to general framework and guidelines for
external accountability:

-GRI global reporting initiative (dimension about environment and sustainability, detailed on protocols): guidelines
divided into: General standard disclosures (strategy, organization, governance and ethics), and specific standard
disclosure articulated in Economic, Environmental and Social (employee turnover, new hiring by age, gender,
religion…). Gri frameworks are useful even for internal accountability to understand some performances.

Sustainability practices  SDGs impacts by companies.

Materiality matrix linking factors important to stakeholders and their impact on company success.

Structure of indicator

Defining an indicator is therefore based on an ideal protocol made on these 7 elements:

 Title of the measure, KPI (e.g. customer satisfaction),

 Unit of the analysis (what to measure, single lecture, entire course),
 Value drivers (competitive factors assessed, quality of service and teaching),
 Purpose (why we measure it, effectiveness of teaching),
 Metric (how to compute it, scale 1-10),
  Frequency of measurement (yearly),
 Source of data (online questionnaire).

Characteristics of non-financial indicators:

Timeliness: they have earlier results, Long term oriented (forecast), Measurability can be ambiguous (we must be
fixed on the protocol). Completeness: each indicator refers to a specific factor (completeness must be analyzed
overall), Precision: necessary to distinguish btw internal measures (possible saving/cost reduction) and client
measures (competitors comparison).

Reporting

We started from budgeting, then we moved on performance measurement then reporting. Communication part
about the work is done, it needs to be attractive with specific set of information:

Internal Accountability for C-level, Top-Middle Management and operational level

External Accountability: for external actors (financial statement, governance, environmental and CSR report)

We will focus on the internal reporting, it is quite

difficult to provide information and comment
performances about a specific topic through financial
and non-financial indicators  they are used to
support the decision making and to motivate
employees.

Each company has its own reporting sets, we will look 3

main level to control and support. Corporate level
(BoD), BUs on divisional level with entities responsible
for their activities, operational/responsible centres.

Transfer Pricing [possible oral question]

In the consolidation we have seen that we have many intragroup transactions which generate revenues and costs,
these are problems that affect even internal accountability (if price of BU1 to BU2 is fixed the results are affected).

Wrap up on performance control for organizational units:

What is a BU? It is a division of a company dedicated to a segment of the market and responsible for the
performance of its activities (revenues from products and cost of production). Responsible means that it has to
account for its performance. Difference btw BU and responsibility centers is that the last one is only responsible of
some activities (HR, Marketing office…), while BU is responsible for revenues and costs.

When we have to control the performances of BU there are two problems usually:

-Corporate Cost allocation (among the resources used some

of them are managed at corporate level: HR, legal services)

-Transfer Pricing (BUs can make transactions among them

inside the same corporation)

Transfer Price is the fictitious price for evaluating intra company exchanges between BUs (cost to the receiving and
revenue for the supplying division). It impacts the performances of the divisions. It affects the decisions of BUs to
decide to go for internal or external transactions. Nearly 60% of world trading activity is intracompany.

Transfer pricing system (how to regulate the internal transactions) is required:

 – to provide information that motivates divisional managers to make good economic decisions;
– to communicate data that will lead to goal-congruent decisions, ensuring coherence between divisions
– to provide information for evaluating divisional performances
– to ensuring divisional autonomy
– to plan tax, intentionally moving profits between divisions or locations

To plan Tax

Multinational companies have different BUs spread all over the world. Each country has it own fiscal regulation 
corporations can locate their BUs in lower taxes rate, they can transfer profit (product and services and so revenues)
from one country to another taking advantage of different tax rates (OECD regulates the intra transactions, BUs
should act as separate entities, the Arm stand principle should be used. The price applied should be the same used
on external market as the two BUs were independent).

Example Netflix: they moved revenues from Netherlands to Ireland, even if the revenues were from Italian
subscription. They then stated they would create a division in Italy but for now they exit the attacks from OECD.

For transparency issue the Parent company needs to fill a country by country report to provide an overview of where
profits are made and taxes are paid (problem on digital companies which do not need a physical asset)

OECD is planning to change the rules framework due to its inconsistency with such a globalized and digital world.

Managerial perspective of Transfer pricing

Methods of transfer pricing (how to compute the price for internal transactions) have important managerial
implications: • Market-based transfer prices • Dual transfer prices • Cost-based plus markup transfer prices: – Full
actual cost – Full standard cost – Marginal cost • Negotiated transfer prices

Market based Transfer pricing, price adopted is the same as the external market price. Usually there are lower
transactions costs which make the transfer price lower. It works well when it is easy to define the market price
(homogeneous market). The prices used could be: Listed Prices of similar products; Actual price of products, Price
offered by competitors.

Usually for non-homogeneous markets, high variability of prices and for strategic BUs it would be difficult to define
the market price.

From exercises: Assuming that the price of the final product remains unchanged, if the entity of the transaction costs
saved by one of the two business units is much higher than the amount saved by the other unit, the transfer price
may be slightly adapted to rebalance profitability (i.e. to evenly distribute the higher profitability enabled by the
internal transaction due to the reduction of transaction costs)

Example: oil market, oil price is subjected to high price variability, market based price could be difficult to evaluate.
One solution could be to take the average price, but this means that when the price on the market is lower than the
market-based price the BU could buy from external market (opportunistic behavior because they are independent,
due to misalignment btw Managers and Corporate objectives).

Another disadvantage is for Strategic BUs, they are BU retaining phases of a production process or a specific step of
the value chan. It operates with competitive disadvantage comparing to external suppliers (smaller than
competitors). They are useful for being present on the market anyway and developing products for potential
markets.
Example: A upstream selling products to B, A it has a critical success factor of economy of scale. B has a smaller
market share, A can work as a supplier for both B and C, since the prices are set on volumes the price at which A sells
products to B is 100, while to C is 70 (unitary prices due to different scales). In order to preserve the internal
transactions we should set different transfer price, because if I take the price of the market we would penalize B, if I
stay on the price of B it would penalize A…

Competitive disadvantage in terms of Size and so no competition on scale with C, in order to less penalize both units
we have to apply a dual transfer pricing. (difficult to define the right market price due to the impact of scale on the
prices…)

Dual Transfer Pricing: selling is different than purchase price, the difference is a cost which is compensated by the
corporation for keeping the BUs selling although it is not competitive (it is accounted as a reserve in the liabilities, it
is a strategic decision of the company) [Benefit of Increased integration with transaction among two units, but
disadvantage of Possible sub-optimized decisions and system complicated to manage]

Corporate costs = 100 – 70 = 30 additional cost to make B survive despite the smaller scale, achieving a lower unitary
costs due to the support of the parent company

Cost based plus markup Transfer price

Under this method the transfer price is computed as the cost plus a markup in order to provide a positive
operational margin. Transfer Price = cost + markup

There are 3 different configurations to define costs:

 Full actual cost transfer price: sum of the costs of all resources used to produce a product or deliver a service
 Full standard cost transfer price: budgeted costs of all resources that are going to be used in the long-term
 Marginal cost transfer price: sum of variable costs (both direct and indirect variable costs)

We start from the Full Actual Cost

transfer price (sum of the costs of all
resources used to produce a product or
deliver a service). The TP is the cost
sustained plus the markup, the costs
are the actual costs both variable and
fixed. The formula would be costs of
production plus unitary fixed cost * (1 +
markup). The higher is the cost the
higher is the TP, so BUs have incentives
to have inefficiency increasing
production costs and sell for higher
price to other BUs  There is a
problem of inefficiency and responsibility of BU. [upstream inefficiency to improve performance, lower convenience
for downstream ones]

Full standard Costs: instead of having

current costs of resources we use a
standard cost (budgeted cost of
resources). EBIT of an Upstream BU
would be standard transfer price
revenues – actual costs. In order to
increase EBIT the upstream BU can
increase efficiency (+Q, - costs).

[all data are standard/budgeted cost, in

TP there isn’t a data given by corporate
level and so the inefficiencies of
Upstream level are not impacting the
downstream BU]

[EBIT = TP * Q order of internal transaction – costs BU sustained budgeted; Upstream has no incentives to have
inefficiencies because this would impact the overall EBIT with costs and if they occur they would impact only
upstream BU]

The downstream BU under Full cost transfer price would have an EBIT of revenues of downstream – costs of
downstream (conversion costs for
external market selling, costs sustained
to convert input into output) - costs for
purchasing semi-finished products from
upstream (full standard transfer price)
[at downstream BU, Cv are both variable
and fixed], we are assuming Q sold,
converted and acquired by upstream is
the same…

In order to have positive EBIT the price

of the final product should be higher
than the sum of costs of conversion and
costs of purchasing semi-finished
product from upstream (transfer price).

From the company perspective the price at which the product should be sold has to be higher than the sum of
variable costs of upstream and downstream level. The two thresholds lead to different optimal Q. Downstream BU
would accept lower Q to guarantee positive EBIT (they could accept less order, Problem of underused capacity) [we
don’t consider full costs because fixed are always there anyway beside Q, Cfull(up) is the TP with standard cost]

Example: 2 BU, A-B

What is the minimum price for whom the downstream BU will accept a new order (suppose the case of spare
manufacturing)? What is the minimum price for whom the company will accept a new order?

We see two different prices threshold for company and downstream BU and so there could be an underused
capacity. (downstream has TP with standard costs from Upstream while company has only variable costs for both
BU)  if a customer is not keen to negotiate a price higher than 73 the BU would not sell the product, while the
company has benefits from 60 euros price  different prices will lead to different quantities and therefore
underused capacity

We can change the TP in order to balance the misalignment of price thresholds.

Marginal cost transfer price: Sum of variable costs, both direct and indirect variable costs, plus a mark-up

Problems? Fixed costs of Up BU are not considered but still sustained. Markup is usually set very high to guarantee a
positive operative margin for fixed costs. 
the advantages are abstract: there are still
differences in the level of activity Q (markup
for downstream and not for company).

Negotiated Transfer Price

TP is not fixed at corporate level but it is based on the assumption of negotiation btw BUs. Corporation lets the BU to
find a price for internal transactions. So they are autonomous on deciding internal transactions prices. This could
lead to a increased autonomy and emphasis on adapting capability of BU, the weaknesses are that there is an higher
cost of negotiation, no guarantee that there would be an integration among BUs, more powerful BUs will have more
bargaining power and so BUs could have divergencies.

In order to limit the disadvantages the company could set Constraints of: integration obliged aside of negotiation;
price range fixed by corporate to avoid bias due to contractual power of a BU.

Summing up…
How can we choose the model for transfer price?

The choice depends on integration

and adaptability that the company
wants to achieve. If the company
wants to be integrated to control
variability of market it needs to
adopt a Price based on Market or
Cost. If it wants to be more
adaptable it can use negotiated
prices while with a negotiated within
range it is an intermediate case.

Importance to check Relevant costs (variable costs + opportunity costs which arise if there is no excess capacity and
are the loss of profit from external customers [Q * (external price – variable cost)]); always check relevant cost on
external supplier price to see the convenience for the whole company. (for seller is relevant cost compared to TP)

Exercise on Transfer Price: Goliath case

3 internal transactions are taken into account, we need to compute the TP, then we evaluate the transaction from
buyer and seller perspective (Cv and opportunity cost, relevant costs)

Second transaction, from electronic to plastic BU. Two prices are convenient for both BU, but it is not convenient for
Goliath. The upstream could change culture: Integration (set a dual transfer pricing for letting BU do the internal
transaction but need to pay the differential cost as an investment for integration) or Indipendency (avoid internal
transaction, or set a negotiated TP because it would lead BU to not choose internal transaction)

Convenient of transaction for the company is to be evaluated independently from the TP policy, comparing Relevant
costs of internal transaction (Vc of production + Opportunity costs, which are the benefits BU miss out when
choosing internal transaction (if no excess capacity), price adopted by BU to external customer – Cv of production
(margin) * units to produce internally, no spare capacity, only one order btw internal and external) and Expenses for
external transaction (price buyer downstream is going to pay to outside supplier * Q of order). If relevant costs <
Expenses for external it means it is convenient to produce internally  TP policy to in courage internal transaction
convenient for both BU. Otherwise the corporation define a negotiated TP in order to make BU adaptable to the
market, or corporation avoid the possibility to have that transaction internally.

3rd transaction: metal electronic. Spare capacity, opportunity costs are zero because you aren’t renouncing to an
order because you could fulfill both internal and external order.

Opportunity costs are the potential benefits the division misses out on when choosing internal transaction instead of
external transaction. They are computed only in case of NO SPARE CAPACITY, as the lost incomes from external
transaction due to internal transaction. • They are computed as : (Price the seller sell products to the external
customers – Variable costs of production)* units to produce internally

Exercises on Variance analysis:

1) Use Variance is same volume, same budgeted price rate and the only change is on Unitary usage. (5000
unfavorable)
2) We are dealing with material variance (unfavorable 2000),
 3) Increased waste and price increases
4) 2000 unfavorable

Corporate Costs allocation:

We can allocate certain costs to corporate level. This is because certain costs could be useful to maintain information
of each BU and centralize some important decisions, to motivate managers and measure for reporting to external
parties. [IT department costs, HR & administrative costs, Legal costs, Finance]

How to allocate the costs?

There is the possibility to adopt:

 Complete allocation (avoid proliferation of corporate costs, problem for specific requirements, proportional
complete allocation depending on the entity of costs)
 Partial allocation (direct costs allocated; depending on consumption basis, defined by fees or ABM)
 Splitting costs among all BUs (no allocation could lead to risk of uncontrolled resources)

Partial allocation but even complete allocation benefit from the use of Activity Based Management

Example: Sandy Corporation, CWD and CDD divisions. Corporate costs:

Treasury costs: 600.000 € interest on debt used to finance the construction of new assembly equipment which cost
4.000.000 € in the Paris Division and 2.000.000 € in the Prague Division.

Human resources costs: 1.200.000 € in

recruitment and ongoing employee
training and development

-Complete Allocation

For treasury costs we add a proportional allocation basis depending on entity of a driver of total cost of treasury
divided on overall Assembly equipment = 0,1

Then we split the interests costs on BUs basing

on their assembly equipment costs.

For HR costs are allocated to divisions on the basis of the total direct labour costs incurred in each division

Overall allocated Corporate costs: 880k; 920k

-Partial Allocation

Treasury: We could use a fee to avoid the

problem of consumption driver variable costs
(with a fixed cost to avoid misalignment with
drivers, which are based on ratios)

HR
We can use Activity based management
method:

We therefore allocate partially the total

amount of HR costs keeping the ones related
to corporate level directly.

Overall allocated Corporate costs with

Partial:

630k; 550k

Comparison

Complete allocation: less responsibility at

corporate level, all costs are split among
BUs, they will have more costs which
weren’t managed by them and at the end
they get it at the P&L. Usually the driver to
allocate these costs is revenues, if you are able to have more revenues you will have more costs, the problem of it is
that we could pressure too much BUs, so it has to be consistent to the overall strategy.

Partial allocation: unique consumption driver to split costs, but a portion remains at corporate level. We could use a
fee to avoid variable costs putting a fixed cost.

No allocation: risk of uncontrolled use of resources

Sometimes if the resources have much more capacity than the usage (low saturation) we need to allocate the overall
costs but it would be unfair and therefore we cannot base on a driver but rather on the partial allocation
(consumption trough fee).

Activity Based Management ABM

Cost allocation method for indirect/ovh costs allocation. We can identify the activity included in the ovh and allocate
among them.

Example: we need to identify indirect

costs, then the activities involved.
Now we need to split the indirect
costs among activities. [90k indirect
costs]

We define the allocation coefficient

as overall indirect costs / total time
(eur/min), then we assign the portion
basing on the time spent for each activity.
(activity driver on production time, we can
allocate even for setup time)

Once we defined the cost we can allocate them basing on products:

In ABC we first understand the costs, Cost Understanding (identifying activities, defining use of resources by each
activity = Resource Driver), then we allocate them to each product, Costs Allocation [usually allocation is costly and
not so profitable, so we focus on costs understandings, even cause it is often used by managers for stressing the use
of information for managing rather than calculating costs]

Costs Understanding

Through ABM we need to define value added and non-value-added activities (no benefits for clients, we need to
reduce the impact of these activities and enhance the relevance of value-added activities). The reduction or
elimination of non-value-added activities should allow to save costs without affecting client perception

Process Mapping and Identification of activities:

Taking into account the most relevant activities (>80% consumption of costs), we can identify proper drivers so then
we can merge the ones with similar drivers. [Select two representative products (i.e. a standard and a customized
one) - Calculate product costs under two different hypotheses: (i) merging activities with similar drivers and (ii)
keeping activities separated. - If the costs calculated under the two different hypotheses do not significantly vary,
activities can be merged, otherwise they can remain separated]

ABM is an evolution of ABC and it allows to limit the analysis to cost understanding and have savings. ABM allows to
see the effect of changes in: # Activity volume (e.g. reduction in n° of suppliers) # Cost per driver (e.g. new
information system implementation)

Design of a performance Management System

We will assess the performances of large corporation at all the

levels (BUs, responsibility centers…).

Decentralization (giving more responsibilities to units through

BUs). Giving responsibility to lower level managers it lead them
to job satisfaction and make them exploit their decision
making on deeper information for
gaining experience and be evaluated
better, lowering the commitment of
top management. The disadvantages
could be of lack of coordination and
different objectives/goals of low
managers comparing to the company
bigger picture (e.g. expectancy
theory)

PMS

Timeliness is not relevant for

Corporate level cause their decision
are not so frequent and are more on
the long run. The level of detail of
Corporate decisions is not to high
and therefore measurability is
lacking. Responsibility are increasing for Operational centers which do not see the Big picture but have a short-term
objective.

The number of parameters that can be influenced by a single organizational unit decreases, as well as the set of
information required for management and control. The impact of wrong decisions on the overall results of the
enterprise diminishes. As a result, it is less risky to have less precise indicators.

Value drivers can be divided into performance drivers

Value based indicators are the ones seen with Melisa, their aim is to compute the value of a company (value based
proxies…)

When designing a performance management systems, two dimensions of analysis need to be considered

• System to control • Type of indicator

Many companies still rely on only

accounting indicators. Managers still
agree that financial reports are linked to
accounting indicators because they are
stressed by the market perceived as
relevant.

Q&A Transfer Pricing

Simulation of Exam