Compendium

Question 1

Assume the investment pattern can be repeated for 40 years. From a valuation perspective, why is this almost the same as assuming the pattern will be repeated in eternity?

Answer 1

• due to the present value factor cash flows in 40 years will be of extremely little value today.

Question 2

Which are the two major groups of valuation techniques? Which factors from the companies account are each group built upon?

Answer 2

• The equity value (Dividends/Net Income/Equity) and The enterprise value (Operating earnings/Capital employed)

Question 3

Describe the formula and process for calculating the value of equity in the company, starting with EBIT?

Answer 3

• EV=EBIT/CCE, E=EV-ND-MI

Question 4

Which are the two major components for calculating the required rate of return of equity for the stock market?

Answer 4

• We calculate this by comparing historical returns of the market with the one of 10y government bonds (e.g. risk free rate), the difference is the risk premium

Question 5

What are the three components for calculating the required rate of return for equity in an individual company?

Answer 5

• Risk free interest rate+risk premium (market) + risk premium (company)

Question 6

Describe the beta value and how it is used in company valuation.

Answer 6

Beta value, which measures the share price volatility in a company compared to the market. A high-risk company has a beta above 1,0 and a low-risk company is below 1,0. Most listed companies range between 0,6 and 1,4. To calculate a company specific risk premium the market risk premium is multiplied by the beta. For example, with a beta of 1,2 and a market risk premium of 5 percent, the total risk premium for the company is 6 percent (1,2 x 5 percent).

Question 7

The p/e-ratio is normally used as a market based approach to valuation. Describe how the p/e-ratio is calculated and used this way.

Answer 7

-By using earnings estimates for listed comparable companies in the same industry as well as their current price and multiplying this with the estimated earnings of the company we get the expected price of the company as of today.

Question 8

Describe the different ways investors group PE-ratios?

Answer 8

• Most often into sectors, to compare with companies with similar growth opportunities and risk. Also, common to discuss p/e-ratio for a stock exchange or an equity index.

Question 9

Comparing the market values for S&P 500 companies with net earnings, which was the normal range for the PE-ratio between 1986 and today.

Answer 9

• around 10-15, but sometimes as high as 25 and as low as 7

Question 10

The PE-ratio for the stock market is affected by, not only the cost of capital and the risk premium, but also a third factor, which?

Answer 10

• Inflation, this is the basis for all calculations of required rate of return because it affects the interest rate.

Question 11

Between 1970 and 2010, the long-term PE-ratio in the U.S correlated well with one important macro economic factor – which?

Answer 11

• When the inflation rate is high 1970-1985 the p/e-ratio is low, around 10. When inflation is starting to decline at the end of the eighties (dramatic decline in the oil price) the p/e-ratio is structurally shifted upwards and reach a level of around 20 in the beginning of the nineties. At the peak of the technology bubble the p/e reached 37. Parallel to this, inflation shifted even lower, which created a very favorable stock market environment, consisting of high growth and low interest rates.

Question 12

Between 1989-1994, the Stockholm Exchange had a high PE-ratio, well above what could be considered normal compared to the interest rate level in Sweden. Give one possible explanation to why this was not an example of an overvalued stock market.

Answer 12

• the pe ratio can be rewritten 1/r, and r constitutes of inflation+real rate of return+risk premium, thus this should have to do with either a low real rate of return (e.g. lower results) or lower risk premiums due to some circumstances

Question 13

How does the calculation of the “WACC” differ from the calculation of the cost for capital employed?

Answer 13

• in wacc, market value is used on E/D in percent of CE, and cost of debt is calculated after tax, while CCE is calculated with book values and before tax, but still E/D and CE

Question 14

Describe how the capital is measured in the WACC calculation?

Answer 14

• the capital measure they focus on is Capital Employed, and this is valued at fair value, i.e. market value.

Question 15

How is the interest coverage ratio calculated?

Answer 15

• EBIE/Interest costs

Question 16

Describe how the default risk premium can be calculated using the Damodoran technique.

Answer 16

• He has come up with the conclusion that the S&P rating to a great extent follows the interest coverage ratios. Thus, based on this one can calculate a default spread that is added to the risk-free rate and we can thereby estimate the cost of debt.

Question 17

We estimate the development in the company PMAB for five years, using a constant debt to equity ratio and come up with a value of the equity of 300. As an alternative the development for PMAB is estimated with the capital requirement expected to be financed by debt. In this case the value increases to 400. Describe why the two valuations are not comparable?

Answer 17

• because they are using different levels of debt. This implies that it is easier to get a higher return, but that the company faces a higher risk of default, hence these values are not comparable

Question 18

Describe how the working capital in the DCF model is estimated.

Answer 18

-Working capital is related to revenue. The definition of working capital is current assets, less current liabilities. Excluded from current assets are financial assets, like cash and marketable securities. Excluded from current liabilities is short-term interest bearing debt, like the short-term portion of bonds and bank loans.

Question 19

In the DCF model, how will the relationship between debt and equity effect the valuation?

Answer 19

It will affect the risk-level of the company, i.e. higher gearing implies higher risk but also higher estimated returns. Thus, our WACC should be adjusted depending on this relationship. We henceforth assume a constant debt to equity ratio, so that the company has similar risk over the years, otherwise comparing cash flows is difficult.

Question 20

Describe the difference between the P/e-ratio and the EBIT-multiple.

Answer 20

The EBIT-multiple is based on the enterprise value (EV) and operating earnings (EBIT). The EBIT-multiple is calculated by dividing EV with the estimated EBIT, the same way as the share price is divided by estimated net earnings when calculating the p/e. The interpretation of the EBIT- multiple is equal to the interpretations of the p/e-ratio. High growth and high profitability will result in a high EBIT-multiple. The major advantage with this concept compared to the p/e, is that the EBIT-multiple is not affected by the leverage in the company, since the enterprise value is the value of all external capital the company use, regardless of it is debt or equity.

Question 21

Describe the difference between income statements presented by functions, compared to income statements presented by nature.

Answer 21

• If the income statement is presented by function, it is divided into functions such as production, marketing, administrative and more. If it is presented by natur, one shows raw material, employee costs, depreciation and more. Most companies on the Swedish market present by functions.

Question 22

In which of the two statements is it possible to calculate the EBITDA using information on the face of the income statement?

Answer 22

• If it is presented by nature, since this would imply having a specific line with depreciation. Which the functions do not have.

Question 23

When understanding the structure of the income statement and the balance sheet, it is important to distinguish between two major company groups – which and why it is important?

Answer 23

• One should distinguish between financial and non-financial companies. The reason being that the structure of the financial reports are very different, and it is very difficult to compare the two.

Question 24

When professional users of financial reports use accounting data, they normally distinguish between operating and financial data. Why is this important on a segment level of a business?

Answer 24

• they do this to be able to value different segments of a company, it is difficult to value a business segment merely on net income (tax purposes etc.), and by dividing them and valuing separately one should achieve a more precise valuation, since different segments often present different growth and risks.

Question 25

Define interest-bearing debt and use the income statement as a starting point.

Answer 25

• Interest-bearing debt is all liabilities that give rise to financial costs. That is, all liabilities on the balance sheet that affects the financial net. The same goes for financial assets.

Question 26

Should the interest bearing debt be valued at book or market value? Why is this normally not such an important distinction?

Answer 26

• They should always be valued at market value. The reason that this might be rather unimportant is that the BV of debt and MV often does not deviate especially much.

Question 27

Cash flow from operations (CFFO) is often used as a substitute to earnings. Discuss the problems with this approach from an equity valuation perspective.

Answer 27

Although CFFO is harder to manipulate than earnings, there are other problems: cash fluctuates to an extent that makes the factor close to impossible to use for spotting trends, CFFO should thus rather be used to spot deviations, over time CFFO should be around the same as the earnings measure over time, a lower CFFO might contest the quality of earnings.

Question 28

What is the difference between the ROE and the ROCE?

Answer 28

-NI/E vs EBIE/CE

Question 29

What is the difference between the ROIC and the ROCE?

Answer 29

EBIE/CE vs NOPLAT/IC

Question 30

What is the difference between the equity to asset ratio and the debt to equity ratio? One major balance sheet group differ.

Answer 30

D/E focuses on the interest-bearing liabilities, which are the ones that increases the risk for a default. A high amount of interest-bearing debt is equal to high amount of fixed interest expenses.

Question 31

How should provisions for restructuring charges be included in the calculation of headline earnings, according to IIMR?

Answer 31

• Provisions for restructuring charges are reversed and charged when the expense occurs. IIMR propagates an all-inclusive view, but also wants non-recurring items to be noted.

Question 32

What presentation technique for the income statement does Richard Baker suggest?

Answer 32

• Baker suggests dividing the IS to two parts, where the second part specifies all of the remeasurements connected to the income statement. This is pretty much what the OCI does as well.

Question 33

Which are the most frequent items effecting comparability?

Answer 33

Restructuring costs/Write downs of intangibles, tangibles and inventory/ gains/losses on shares and other fixed assets/acquisition costs/effects from hedging/Legal claims and settlements/adjustment of the purchase price

Question 34

In which quarter during the year, does the negative items effecting comparability show up most frequent? Over the years 1997-2009, do the items show up randomly or do they follow a certain pattern?

Answer 34

Q4 is the absolutely most common quarter in which these negative items effecting comparability show up. They follow an apparent structure – 80-85% of the items appear in Q3 or Q4 in the majority of the years.

Question 35

One way of analysing risk in a company is by measure the volatility in return on equity over a number of years. When doing this, should earnings include or exclude restructuring charges and write-downs?

Answer 35

hey should include these measures, excluding them would show a much more stable number, but this can’t be an argument sufficient enough, if we expect these to appear over time they should be included, and since this makes it easier to backtrack, might be advantageous for analysts.

Question 36

Which accounting standard from IASB covers pro forma statements?

Answer 36

• There is no general definition or any accounting standard covering pro forma accounting. Companies are allowed to present pro forma information for the comparable and the present reporting period. However, IFRS does not require any particular format.

Question 37

Discuss why the pro forma statements in Nokia might be a problem.

Answer 37

• They only include IS, and does not adjust anything else. Also, difficult to know which adjustments were non-recurring in fact. Hard for media to show the “right” measurement. It was too difficult to understand, and Nokia had to comment on measures of both pro forma and reported, and items that were excluded was problematic since the acceptability was difficult to validate.

Question 38

Why did Telia Sonera present pro forma accounts in 2003? How did it differ from the Nokia case?

Answer 38

• They did it to show Telia and Sonera as a combined unit for the current year and comparable year. Which makes it easier to analyze for the new group. There were issues connected to this as well, the report was extensive and included only IS (4 columns), and and the pro forma measures 2003 became the comparable measures during 2004 (do not know if they are in line with accounting standards). Differ from the Nokia case by following the classical approach and presenting the pro forma figures of the merger for this year as well as the comparable year.

Question 39

i) Discuss what might be the problem with adjusting for “legal provisions” in the definition of “core earnings” in Astra Zeneca?

Answer 39

• Since they are very much recurring, they should not be excluded. The same issue exists with intangible impairments. Also, they netted some recurring figures against other items, and this differed between years and they were not consequent with the conduction.

Question 40

Describe how the income statement and the balance sheet are affected if a company uses accounting for discontinued operations in line with IFRS5.

Answer 40

• In IFRS 5 discontinued operations are shown on a separate line in the income statement. All figures in the income statement that refer to the discontinued businesses are eliminated from the income statement, both for the present year and the previous year. The discontinued operations are shown below net earnings on a separate line, net of taxes. In Sweden approximately 4 percent of the companies presented this line in 2012.

Question 41

What are the criteria’s for using the accounting? (disc)

Answer 41

• The criteria for using the standard is the following: - It must be a separate line of business or geographical area. - It is part of a coordinated single plan. - It can also be a subsidiary acquired exclusively to resale.

Question 42

Assume that company PMAB sells Subsidiary A with sales of SEK 100 million and net earnings of SEK 10 million in 2014 (2013: sales of SEK 80 mn and earnings of 8). The company recognize this transaction as a discontinued operation in the income statement. The cash PMAB receives from the sale in late December 2014 are immediately used for an acquisition of Subsidiary B with sales 2014 of SEK 100 million and earnings of SEK 10 million (2013: sales of SEK 90 mn, earnings of 9). Describe how the two transactions effect the income statement for 2014 and 2013.

Answer 42

• 2013: -80 sales, and 8 under net earnings, 2014: 100 sales and 10 in profit. They get a growth in sales which is not real due to accounting principles. Can be solved with pro forma accounting

Question 43

Discuss the problems in ABB related to discontinued operations.

Answer 43

• ABB recognized a lot of items as discontinued operations. One of the items (oil etc.) was held for sales but they could not find any buyer, and was counted as discontinued for three years. Furthermore, some of the items did not fulfil the requirements for using the accounting method. Also inconsistent in what they show on the IS, show nonrecurring and inconsistent with what is discontinued or not.

Question 44

Discuss the problems with discontinued operations in Svedbergs.

Answer 44

• They accounted the close down of a production facility as discontinued operations, which is not in line with IFRS. Since this would mean their first negative result pretty much ever,

Question 45

Discuss how the use of IFRS5 affects the DCF valuation, both the effect on the calculation of the enterprise value and the net debt.

Answer 45

• From an EV perspective NI from discontinued operations do not affect the calculation, since it is based on FCF and NOPLAT. Thus, the BS effect must be included, A/L should be recognized as separate lines, and these are non-operating from an EV valuation perspective, and thus excluded from the EV, but included, valued to MV in the calculation of the Equity value.

Question 46

Where is other comprehensive income presented in the annual report?

Answer 46

Other comprehensive income (OCI) must be presented immediately below the income statement.

Question 47

The OCi is separated into two parts – which?

Answer 47

• Items that will be recycled to the ordinary income statement and items that will stay in OCI.

Question 48

Which of the following items must be included in OCI

Answer 48

• currency hedging
• Depends, if hedge accounting is allowed – yes, if not only IS. Financial instruments where hedge accounting is not allowed. Effects normally interest rate and currency derivatives. The value change is recognized in the financial net. Financial instruments where hedge accounting is allowed, which are normally currency and interest rate derivatives. The value change is recognized in the OCI. When the value change is realized, which is when the contract has expired or the hedged transaction has been performed, the value will be recycled to operating earnings (currency, raw material) or the financial net (interest rates).
• hedging of raw materials
• As aboe: Financial instruments where hedge accounting is allowed, which are normally currency and interest rate derivatives. The value change is recognized in the OCI. When the value change is realized, which is when the contract has expired or the hedged transaction has been performed, the value will be recycled to operating earnings (currency, raw material) or the financial net (interest rates).
• revaluation of investment property
• revaluations are presented in operating earnings.
• revaluation of biological assets
• revaluations are presented in operating earnings. There are two effects. The first is the initial value change in the asset. The second is the change in the production cost because the asset has changed value.
• pension adjustments
• It depends whether the pensions are realized in the company or not. If they are: Value changes on net pension liabilities, including the value change on assets in a pension trust, is recognized in OCI. The difference between the calculated return/cost on the net liability and the actual change in the market values of the net liability is recognized in OCI.
• write-downs of goodwill
• This is revalued in the income statement, without any tax effects.
• write-down of inventory
• This is revalued in the income statement, without any tax effects (COGS??)
• available for sale instruments
• Available-for-sale instruments are revalued in the OCI. The value change will be recycled to the financial net.
• value changes on employee stock options
• Employee stock options (warrants) result in new shares being issued. The transaction has, until now, only affected the calculation of earnings per share. From 2005 the company must do a market valuation of the options and include the value as an employee cost in the income statement.
• Stock appreciation rights (synthetic options) result in cash being paid from the company to the employee. The synthetic option must be valued to market price. Costs (normally, when share price increases) or gains (reduced value that previously has accounted for as costs) must be taken to the income statement immediately. The IFRS 2 has not changed the accounting.

Question 49

Discuss how the DCF valuation is affected by the OCI.

Answer 49

• From a cash flow valuation perspective, the items in OCI should not be included in the calculation of the enterprise value. If the items are recycled to EBIT (like currency hedging), they will have an effect on the cash flow in the company when they are recycled. The key issue is, whether the hedge effect is operating or financial. In the income statement the effect will be included in EBIT, but that does not necessarily make it operating. Since the effect will not be repeated and is created using financial instruments, the effect should not be included in the calculations of the enterprise value. The market values of the hedge instruments at the valuations date should be considered a part of net debt.

Question 50

Describe the three levels in the fair value hierarchy.

Answer 50

1. Inputs are quoted prices in active markets for identical assets or liabilities.
2. Inputs are other inputs than quoted prices included in the first level. It can be prices for similar assets or liabilities, but it can also be inputs related to interest rates, credit spreads or volatility.
3. Inputs are unobservable inputs for the asset or the liability. Unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or the liability, including assumptions about risk.

Question 51

Which of the following items have an effect on EBIT?

Answer 51

• Value changes in investment properties – Changes are presented in operating earnings
• Value changes in agriculture assets/biological assets - in operating earnings
• Write-downs of goodwill – above financial net, so yes
• Write-downs of inventory – either cogs or separate line, but affects EBIT
• Financial instruments where hedge accounting is not allowed – no effect on EBIT, in financial net
• Financial instruments where hedge accounting is allowed – first oci then value change realized in operating earnings
• Value changes on pension liabilities – depends if operating or financial according to the company, but most often OCI and thus no effect.
• Available-for-sale instruments – revalued in oci, value change recycled in financial net
• Value changes on employee stock options – should be included in personnel cost,

Question 52

When performing a DCF valuation, how will value changes presented in EBIT affect the valuation?

Answer 52

Fair values are a dimension that runs parallel to the non-recurring items. As mentioned previously, in the valuation process the financial assets and liabilities must be valued to market value. However, it is the fair value at a certain point in time that is important, not the change in the fair value. The change in fair value is a non-cash item in the income statement and must be eliminated from estimated earnings, when doing a cash flow oriented valuation. Since the assets and liabilities that give rise to value changes are very often financial, the value changes will normally not be included in EBIT. Therefore, they will not be a problem when calculating the enterprise value. However, the value change is an indication that the future return from an asset (or the cost for a liability) will be higher or lower than the cost of capital. As such, the value change equals the net present value (NPV) of the asset or liability. If the value change is reliable the estimated earnings in the valuation model should be affected.

Question 53

When performing a DCF valuation, how will changes in forest land affect the valuation?

Answer 53

From a DCF-model perspective, analysts normally exclude large revaluations of forest from the EBIT. For practical purposes small amounts are included. The idea is that small ongoing revaluations and the increase in the production cost will be of equal size, which will end up in a zero-net effect on earnings.

Question 54

If you compare revaluations of investment property (IAS 40) and revaluations of forest (IAS 41), what extra implications does the revaluation of forest add, when performing a DCF valuation?

Answer 54

Compared to revaluing investment property, the change in value on forest is less reliable. There are transactions taking place, but the problem is that the vast amount of forestland the listed forest companies owns, is neither held for sale, nor will be possible to sell in any greater amounts, since there is no buyer willing to buy that much forestland. Therefore, the forest will be included in the production process of the company, which creates valuation problems that are different from the one in the real estate companies.

Question 55

Company A has recognized substantial restructuring charges 2007, 2009 and 2013 in the income statement. Discuss how this might affect the valuation of the company.

Answer 55

It is impossible to somehow estimate when and how large future restructuring costs will be, but if they are recurring (more than twice within a few years), they should be expected in the future as well and thus lower the margin estimates.

Question 56

If Company A recognized a restructuring cost in the first quarter of 2014. Discuss how this probably will affect the analyst estimates for the first quarter of 2015.

Answer 56

this should have no effect unless it is happening the first quarter every year at equal size, in that case we could estimate a cost for this quarter, but if it is a nonrecurring event we should not take height for it. If it happens often we should adjust the estimated margins.

Question 57

Explain how a provision for restructuring costs show up in the accounting, both in the income statement and in the balance sheet? Explain how it effects the accounting the year it is introduced in the accounts and the year/years after.

Answer 57

Often as cost in a quarter, but if substantial, can make a provision which is a cost and liability, and by including it today the future earnings are relieved from some cost. Utilization of the provision does not affect the income statement, cash and the liability is reduced.

Question 58

What misuse does the standard IAS 37 want to prohibit?

Answer 58

The risk of bundling day to day costs and accounting for them as non-recurring (restructuring costs), so that investors believe that the result should be better than it is.

Question 59

IAS 37 defines what is an obligating event. Which five factors are important?

Answer 59

• The part of the business concerned
• The locations affected
• The location, function and number of employees affected.
• The expenditure to be incurred.
• …when the plan will be implemented.

Question 60

Explain in what way, the restructuring reserve in Electrolux 1997 was better handled from an analyst perspective than the one in ABB?

Answer 60

• They were very transparent and showcased exactly what costs that were associated with the restructuring (locations/employees/etc.), while ABB were rather vague about what the restructuring was about, and what areas were expected, and why it was so big. Easier to deduce which one was reasonable.

Question 61

It is easy to criticize the millennium reserve in IBS – why?

Answer 61

they clearly utilized the reserve to smooth earnings and achieve specific targets and look like it was growing, they could thus save 1999 when the demand decreased and postponed the huge decrease by some time.

Question 62

What is the problem with the treatment of the provision for restructuring in Assa Abloy 2003 and years after?

Answer 62

they clearly wanted it to work as a parachute, and secure profits even at bad times, they utilized it in a too slow pace, they had very stable earnings prior to this, but then restructuring got frequent every second or third year. This was similar to the case above, due to bad specification of what happened at Assa, the reserve could be utilized whenever it fitted.

Question 63

Taxes affect the equity valuation and the DCF valuation differently. Describe how it differs.

Answer 63

Taxes affect company valuation either as a deduction of net earnings when calculating the equity value or, as in enterprise valuations, by affecting the calculation of the weighted average cost of capital, WACC.

Question 64

If a company recognize an operating loss one year, but does not account for a positive tax on the loss the same year, how will net earnings the coming years most likely be affected?

Answer 64

the unwillingness to account for positive taxes on losses. This reluctance creates an unjustified tax shield that lowers the tax rate short-term the year earnings are rebounding. From an estimation perspective, it becomes difficult to rely on historical trends when earnings are rebounding.

Question 65

If a company recognize a restructuring provision in the income statement one year, but does not adjust for the tax cost on the provision, how will net earnings the coming years be affected?

Answer 65

• companies are reluctant to account for tax effects on provisions taken place in the consolidated accounts, like provisions for restructurings. The provision is not tax deductible when it is made, but when the cash outflow occurs. However, in the consolidate accounts a positive tax on the restructuring cost must be calculated but companies are unwilling to do this. This unwillingness creates an unjustified tax shield (taxable losses carried forward), which lowers the tax rate the coming years.

Question 66

Two companies are identical and recognize the same tax rate in the income statement. However, Company A has the possibility to do create untaxed reserves each year, but not Company B. Explain why Company A will be valued higher on the stock exchange, everything else equal.

Answer 66

• Becouse it is free financing, which are very favorable since they lower the cost of capital. Hence implying a higher valuation. This retained cash can be invested and yield a higher growth than the other company.

Question 67

Explain why Electrolux ended up with very a high tax rate in 1997 of 72.5 percent and how it impacted future tax costs?

Answer 67

This was the case with the restructuring reserve in 1997. When the company created the cost and the provision, they did not reduce it by the tax effect. This gave rise to a very high accounted tax rate of 73 percent, compared to a more normal 39 percent the previous year.

Question 68

Discuss how a deferred tax liability will affect the DCF valuation?

Answer 68

Lower wacc, higher taxes in the future, higher growth long term. Thus higher valuation, since we can invest what we say be creating a liability at a certain rate.

Question 69

The market value of equity is 100 and has a cost of 10 per cent. The market value of debt is 100 and has a cost after tax of 4 per cent. The deferred tax liability is 20. Calculate the WACC.

Answer 69

• 100/1200,10+20/1200,00=8,333% -> 0,06167

Question 70

Discuss how deferred tax assets will affect the DCF valuation?

Answer 70

Should be treated like financial assets, and thus deducted from EV to get Equity value. Also, in the BS these are undiscounted, but from a valuation perspective, they should be discounted, but due to the short timeframe, usually negligible effect.

Question 71

In general, there are two types of stock options relating to employees. Which one has always had an effect on the income statement?

Answer 71

• Employee stock options (warrants) result in new shares being issued. The transaction has, until now, only affected the calculation of earnings per share. From 2005 the company must do a market valuation of the options and include the value as an employee cost in the income statement.
• Stock appreciation rights (synthetic options) result in cash being paid from the company to the employee. The synthetic option must be valued to market price. Costs (normally, when share price increases) or gains (reduced value that previously has accounted for as costs) must be taken to the income statement immediately. The IFRS 2 has not changed the accounting.

Question 72

Company A issues stock options to employees in the beginning of year 1. The market value of the options is calculated to 100. To receive the options the employees has to work in the company for three years. The management estimate that 10 per cent of the workforce entitled to the options will leave the company within three years. Calculate the estimated cost for the company year 1.

Answer 72

• =(1-0,1)*(100/3)=30, take the charge times 1 minus employee turnover during the time. Then times 1 divided by the time spectra.

Question 73

Company A issues stock options to employees in the beginning of year 1. The market value of the options is calculated to 100. To receive the options the employees has to work in the company for three years. The management estimate that 10 per cent of the workforce entitled to the options will leave the company within three years. From year 2 this rate is lowered to 5 per cent. Calculate the estimated cost for the company year 2.

Answer 73

• (1-0,05)*(100/3)=31,67

Question 74

The market value of employee stock options at grant date in January year 1 is SEK 9 mn. The value will be distributed as a cost in the income statement the coming three years, with SEK 3 mn per year, starting at year 1. In the beginning of year 2 a DCF- valuation is performed. The market value of the employee stock options has now increased to SEK 11 mn. Discuss how the options will effect the DCF valuation.

Answer 74

• should have the cost included, and deduct the difference in MV less the costs already incurred (treat difference as a financial asset).
• Employee stock options are more complicated. Since the market value of the stock options at grant date has been included as a cost in the income statement, the calculation of the enterprise value is affected. However, the basis for the calculation is the market value on the grant date. If the market value of the options at the valuation date deviates from the value at the grant date, which is likely, the difference must be included as a financial asset (if the share price has declined) or a financial liability.
• Another way to handle employee stock options is to eliminate the cost effect from the IFRS2 calculation and instead reduce the valuation by the full market value of the outstanding employee stock options at the valuation date. However, reducing the cost will benefit the calculation, since the cost reduction affects the calculation of the enterprise value on an ongoing basis. This might overstate the enterprise value, because it is difficult to estimate the proper long-term employee cost.

Question 75

What is the major problem for investors with the capitalization of development expenses?

Answer 75

• The major problem with capitalizations of development expenses from a valuation perspective is that companies shift expenses from the income statement to the asset side of the balance sheet. Although the assets are normally amortized within 3-5 years they are difficult to verify because the explanations in the annual report are normally poor.

Question 76

Global pharmaceutical companies are reluctant to capitalize development costs because it happens that products introduced on the market have to be withdrawn because of undesired side effects. There are four factors in IAS 38, which must be fulfilled to be able to capitalize development expenses. Which of them does the Pharmaceutical companies obviously believe they cannot satisfy.

Answer 76

(•The company has the technical feasibility to complete the intangible asset so it will be available for use or sale. )
•The company demonstrates its intention to complete the asset.
(•The company shows its ability to use or sell the asset. )
(•The company can show how the asset will generate probable future economic benefits. )
•The company can measure the expenditure attributable to the intangible.

Question 77

Discuss how DCF valuations are affected by capitalized development expenses. Elaborate on the effect on the FCF, as well as on the effect on the continuing value.

Answer 77

Should in theory have no effect as we only look at cash flows (and not accrued numbers), thus they have the same impact on FCF, but when looking at the continuing value it is more difficult. Using NOPLAT assumes constant earnings in eternity – which means that amortization/depreciation must equal the investment pace, or rather capitalization pace. This might be difficult in reality but we experience the same issue with depreciation on other goods.

Question 78

The software company IBS recognized capitalized development costs in the balance sheet 1998-2000. Why was the capitalization in the first quarter year 2000 questionable and how did it affect earnings during the quarter?

Answer 78

In 1998 the capitalized R&D was reduced, which had a negative impact on earnings in the second and the third quarter. In 1999 capitalized R&D increased, which increased earnings all four quarters. During the first quarter 2000 the capitalized R&D increased dramatically, which increased earnings dramatically. The company gave no explanation.

Question 79

Earnings before tax in the software developer ENEA increased from SEK 60.8 mn in 2005 to SEK 81.0 in 2008. In 2009 the company changed CEO. How did the new CEO value the intangible asset related to the development activity?

Answer 79

• In 2009 the company changed management and in the report for the first quarter 2009 the new management made a write-down of R&D-costs of SEK 24.5mn. This lowered the future amortizations and increased the future earnings

Question 80

In a purchase price allocation, what will be the effect on future earnings in the consolidated group, whether the surplus value from the acquisition is recognized as “goodwill” or as “other intangibles”?

Answer 80

• One problem with the separation of goodwill from other intangibles is that it has different earnings effects. Goodwill is not amortized but other intangibles are. This creates different earnings effects depending on the proportion of other intangibles. Obviously, companies have an incentive to recognize as little amortizable “other intangibles” as possible.

Question 81

In a research conducted by Ernst & Young, how much of the enterprise value was in average for all the companies allocated to identifiable intangible assets?

Answer 81

• On average, for both preliminary and final purchase price allocations, 23 percent of the enterprise value (acquisition price plus net financial debt) was allocated to identified intangible assets and 47 percent was goodwill, with the allocation varying considerably from industry to industry. The remaining 30 percent were allocated to tangible or financial assets.

Question 82

In the same research by Ernst & Young, which was the most frequent “other intangible”?

Answer 82

1. Customer-related assets (disclosed in 44 percent of the transactions where at least one intangible asset was recognized)
2. Brands/trademarks (disclosed in 31 percent of the transactions where at least one intangible asset was recognized)
3. Technology (disclosed in 20%of the transactions where at least one intangible asset was recognized)

Question 83

In cash flow valuations, acquisitions of subsidiaries are very seldom included in the estimated development. Instead analysts try to estimate the organic growth for the group. Discuss the concept of “organic growth” and the problems relating to DCF valuation model.

Answer 83

Organic, in this sense means excluding acquisitions. - history of the company will include acquisitions, which means that we cannot use historical data for sales growth, for estimating organic growth. - The second is that, although many companies voluntarily present the organic growth as complementary information in the text to the report, there is no way for an outsider to test the validity of the figure. - Thirdly, the estimated growth will not be comparable to the growth most companies achieve, because the actual growth will include acquisitions. From a quarterly perspective, trying to keep track of a company, the investors still need to have an opinion about the total growth in the company. - Although it is very seldom discussed, the growth estimates could as easily include acquisitions. Most companies acquire others fairly frequently, which implies that acquisitions should not be more difficult to estimate, than investments in property, plant and equipment.

Question 84

Meda started up as a company acquiring product rights without any patent protection from other pharmaceutical companies. The product rights was amortized over 15 years. How did Meda managed to escape a large part of

Answer 84

• In the income statement 2005 the company showed amortizations on intangibles of SEK 199mn on profit before tax of SEK 142 mn. The acquisition strategy before 2005 had been focused on acquiring product rights. The product rights were amortized over 15 years, equal to 6.7 percent per year. Using the same amortization rate on the newly acquired goodwill would have increased the amortizations by SEK 340 mn. This would have transformed the profit in 2005 to a substantial loss. The separation of the acquired intangibles in Viatris in product rights and goodwill, obviously had a marked effect on the earnings development.

Question 85

What was the amazing effect on earnings in Nordnet Bank from the acquisition of EQ Bank in Finland? How was the effect created and accounted for?

Answer 85

The internet bank Nordnet Bank acquired the Finnish bank EQ Corp in the third quarter of 2009. The purchase price allocation (PPA) ended with a negative goodwill of SEK 53.8mn due to a revaluation of “customers” to SEK 161.2mn. With a SEK 53.8mn lower value on customers, no gain would have been recognized. The effect on the third quarter earnings can be compared to the 12 month rolling earnings at the end of the third quarter of SEK 254.7mn. What does this gain implies?

Question 86

Company A has goodwill in the balance sheet, which equals 100 per cent of equity while Company B has goodwill equal to 200 per cent of equity. Discuss how the amount of goodwill might affect the future share price in a down turn in the business cycle. What other factor than goodwill is important to include in the analysis?

Answer 86

Both could erase full equity if bad enough, but more dangerous for 200%, thus perhaps larger effect on shareprice due to lower possible future equity available to shareholders. But, this is hard to comment on in general, and very much dependent on the specific company. What is important is to include them in the historical trends. It is a signal that the management has paid too much for another company in the past. Either the management was not skillful enough to negotiate a reasonable acquisition price, or the timing was poor. It can also be an indicator that the prices on companies in the sector actually are very high, too high to perform a successful acquisition strategy.

Question 87

What is an impairment test and how is it conducted on consolidated goodwill?

Answer 87

The required technique for write-downs in the standard is the impairment test. The company has to estimate future cash flows coming from an asset and via a cash flow valuation try to appreciate the value.

Question 88

Which factors relating to an impairment test do the company need to inform investors of?

Answer 88

IAS has stressed that companies have to inform investors of estimated cash flows, cost of capital and the risk premium inherent in each valuation. It is also important that companies comment on the on-going situation, for example whether the earnings (cash flows) that originate from an acquired company are in line with the plan at the time of the acquisition.

Question 89

Give some examples of indicators of value decline that may give rise to an impairment test.

Answer 89

• decline in market value;
• significant changes in technology, market or legal environment;
• the rate of return has increased during the period;
• book value of the net assets is more than the market capitalization;
• evidence of physical damage;
• significant changes take place, like restructurings;
• the economic performance of an asset is worse than expected.

Question 90

What is the maximum number of years a company can estimate/budget cash flows for?

Answer 90

The basis for estimating future cash flows is: -Reasonable assumptions that represent management’s best estimate. -Cash flow should be based on the most recent budget/forecast for a maximum period of five years. -Cash flow after five years should be used by extrapolating at a steady or declining growth rate. - If inflation is included it must be included both in the cost of capital and in the estimated cash flow.

Question 91

In 2006 Atlas Copco sold a business segment recognising a gain of SEK 9113mn. However, the true gain was substantially lower – why?

Answer 91

They had made an incorrect write down of GW before, included in a big bath to get higher future results. Thus this gain was overstated, and was second-to-none in reality

Question 92

Stora Enso sold a U.S subsidiary in 2007 that was acquired in 2002. In the annual report for 2007 the management stated that the transaction did not recognize any gain or loss. Explain why this statement was false.

Answer 92

The management stated that the divestment did not resulted in any gain or loss. It looked like the acquisition in 2002 had at least shown a break-even for the period 2002-2007. This was of course false. The total loss on the acquisition was at least the write-down of EUR 1167mn and EUR 1300mn.

Question 93

In 2003/2004 the medical technical company Sectra acquired the R&D company Mamea. Most of the assets in Mamea were activated development expenses. Immediately Sectra took a write-down of goodwill of SEK 71mn in the income statement. Discuss the effect of the write-down on future earnings in the group.

Answer 93

The write-down of SEK 71mn decreased earnings in the Sectra group. They called the write-down “non-recurring” and stated that it was an adjustment to the group accounting policy. However, this reason for the write-down does not comply with IFRS/IAS. Only if Sectra can show a true value decline, the write-down is acceptable. If we assume the acquired intangible asset in Mamea instead was capitalized development costs (Mamea was a development project within mammography), Sectra would have been hit by an amortization of development costs of approximately SEK 14mn per year with an assumed amortization rate of 20 percent. That compares to earnings of SEK 89mn in Sectra before the write-down.

Question 94

Why can Swedbank be criticized for not writing down goodwill of SEK 12.6bn in 2009?

Answer 94

Swedbank’s impairment test of goodwill in the full year report 2009 came up with the conclusion that no write-down of Baltic goodwill was necessary. One part of the valuation was based on historical earnings, but the “history” started in 2004 and stopped 2008, the year before the meltdown. Earnings before taxes in average for this period was SEK 2981mn, but choosing the average for 2005-2009 would have lowered the earnings base to SEK 420mn. Why did they choose the first average?

Question 95

Discuss how the key-ratio return on total assets (ROA) can be used to spot overvalued goodwill in the balance sheet?

Answer 95

For the Stockholm Exchange the average ROA is 9.1 percent, a level that 27 of the companies achieve. From the graph it is quite clear that a lot of the companies do not deliver a marketable return the last years. Very few of the companies in the group have impaired intangible assets.

Question 96

A purchase of shares can be accounted for either as equity accounting, proportionate consolidation or full consolidation with a minority interest. Which key-ratio is not affected by the use of accounting method?

Answer 96

From a cash flow valuation perspective, this is both an earnings and a balance sheet problem. The three consolidation techniques have very different effects on operating earnings and on the balance sheet, but have similar effects on net earnings.

Question 97

) If a 50/50 join venture has a balance sheet with a high portion of debt, which of the three consolidation techniques would you prefer to use (if you could choose) to end up with as little debt in the group account as possible?

Answer 97

Equity accounting. The accounting is based on a presumption that the owner has an ability to “exercise a significant influence” if it holds 20 to 50 percent of the voting rights in another company. The accounting technique does not include any other balance sheet effect than the effect the ownership of shares in the associated company gives rise to

Question 98

If a profitable 50/50 joint venture could be accounted for using either proportionate consolidation or full consolidation with a minority interest, which would present the best return on total assets (defined as operating earnings in per cent of total assets)?

Answer 98

Proportionate, since that would imply that we do not have to account for all assets but only the part we actually own. This would of course imply a higher ROA.

Question 99

Discuss whether a minority interest (non-controlling interest) is a part of the liabilities or equity?

Answer 99

Minority interests are part of equity, according to IFRS. This is correct from a debt- holder perspective, but from an equity holders perspective minority interests are always a liability. IFRS states that “net income” should be recognised without reduction of minority interests. Instead minority is shown as a reduction of net income, below the income statement.

Question 100

According to IFRS 3, where in the income statement and the balance sheet is non- controlling interest presented?

Answer 100

Below net income and between equity and debt.

Question 101

Assume PMAB has shares in a 50/50 joint venture accounted for in line with the equity method. This results in earnings in associated companies are presented in the income statement. Discuss how the accounting affects a DCF valuation.

Answer 101

From a company valuation perspective, equity accounting presents problem. The major problem is that valuations based on EBIT/NOPLAT, normally should not include earnings in the associated company in the calculation of the enterprise value. Instead the shares in the associated company should be valued separately and added to the value of equity as a financial asset.

Question 102

Assume PMAB owns 51 per cent of the shares (and voting rights) in a subsidiary. The subsidiary is consolidated with a 49 per cent non-controlling interest. Discuss how the consolidation of the subsidiary and the non-controlling interest affects the DCF valuation.

Answer 102

• Full consolidation recognise the highest income of the three methods because the minority part is not excluded in earnings. The minority interest (non-controlling interest) is shown below net earnings as complementary information but in operating earnings the minority interest is very seldom revealed. When valuing a company using net earnings, it is important to deduct the minority interest from the income figure. When doing an enterprise valuation, minority interest must be deducted from the enterprise value as debt, calculated to market value, which requires extra information from the subsidiary.

Question 103

How are non-core non-operating businesses in general included in the DCF valuation?

Answer 103

Non-core businesses should be valued separately and be added as a financial asset to the enterprise value, when calculating the equity value. One example is discontinued operations. As was presented in one of the previous chapters, net earnings in the discontinued business is included below EBIT (does not affect the enterprise value) and the assets and liabilities was included in the calculation of net debt (and consequently deducted from the enterprise value, when calculating the equity value).

Question 104

Describe the two methods for including a fully owned finance subsidiary in the DCF valuation model.

Answer 104

Either the method above or: Another example is shares in associated companies. In the cash flow valuation model we exclude the earnings effect in the associated company from EBIT in the group. Many companies disclose the share of earnings in associated companies in the financial net, than no adjustment is needed. However, some include earnings from associated companies in the group EBIT. If that is the case, the earnings must be excluded. Instead a market valuation of the shares in the associated company must be performed. The market value will be included in the net debt as a financial asset.

Question 105

Discuss how the DCF valuation model is affected by a finance subsidiary, if it is treated as a financial asset.

Answer 105

The other method is to exclude the earnings in the finance subsidiary from consolidated EBIT, but include assets less liabilities as a net financial asset in the net debt calculation. The financial asset must be valued to market value. In this approach the WACC will not be affected, since financial assets are generally not included in the calculation. The finance subsidiary is treated equal as an associated company.

Question 106

What is the problem with currency hedges, from a general valuation perspective?

Answer 106

The problem from a valuation perspective with currency hedges is that it creates a timing problem in the analysis of earnings. By hedging currency flows the company creates a delay in the currency effect on earnings. The delay can be short, if the hedged amounts are small or if the hedging period is short but is can also be long, if the hedged amounts are substantial and/or the hedge period is long. When the hedge period is long and fluctuating, the most severe income effects occur.

Question 107

If an instrument is used for hedging activities but is NOT considered to qualify for hedge accounting according to IAS39, how will value changes on the instrument be recognized in the accounts?

Answer 107

Financial instruments where hedge accounting is not allowed. Effects normally interest rate and currency derivatives. The value change is recognized in the financial net.

Question 108

If an instrument is used for hedging activities and is considered to qualify for hedge accounting according to IAS39, how will value changes on the instrument be recognized in the accounts?

Answer 108

Financial instruments where hedge accounting is allowed, which are normally currency and interest rate derivatives. The value change is recognized in the OCI. When the value change is realized, which is when the contract has expired or the hedged transaction has been performed, the value will be recycled to operating earnings (currency, raw material) or the financial net (interest rates).

Question 109

Hedging of currencies create a short-term loss or a gain for the company. Which are the three major business actions a company can perform, to create a long-term business hedge?

Answer 109

1) Increase prices on the foreign market to compensate for the decline in the foreign currency. 2) Switch from local suppliers to suppliers with production in the same currency as the company has sales. 3) Shift production to the same currency area as the company has sales. This is the true long-term hedge. This is what a car company like Toyota, Honda, BMW and Mercedes have done the last twenty years in the US.

Question 110

From a valuation perspective, what was the problem in Modo/Holmen 1996, with the hedging effect and the presentation of it?

Answer 110

In the fourth quarter report the company just mentioned that they had been involved in successful currency hedging. In the annual report two months later, it was possible to see how successful. The currency hedging had all the signs of a financial speculation. One factor was the amount of hedging. It expanded dramatically in 1994-95, in expectations of an increase in the Swedish krona. The hedging was not renewed in 1996. Was it luck or successful analysis? – Thus, difficult to analyze since the gain from this was a large part of the earnings, and could not have been expected by analysts prior to this. Looks a bit like speculating which makes it even harder to estimate.

Question 111

How does the accounting for hedges in Aarhuskarlshamns 2006-2009, differ from the accounting in Modo/Holmen?

Answer 111

They have very stable earnings over the years, and the hedging has made the earnings rather volatile, so instead for stabilizing earnings they have had the opposing effect. The effect from revaluation of hedging instruments has created tremendous swings in earnings, although the total effect 2006-2009 on earnings can be neglected. Without the effects from hedging the company has a very stable earnings trend, which can be seen in the graphs on the next page. One interesting question is – why are they involved in these hedging activities?

Question 112

Discuss how hedging and hedge accounting must be adjusted for in a DCF valuation model.

Answer 112

In general the DCF model separates operating transactions from financials. The operating transactions must be long-term and will have an impact on EBIT/NOPLAT and consequently on the calculation of the enterprise value. The financial items will not have an impact on the enterprise value, but will be added or deducted to the enterprise value, to come up with the equity value.
From this perspective it is quite obvious that gains and losses from hedging cannot be included in the enterprise valuation. Consequently, effects from financial instruments included in operating earnings must be eliminated. On the other hand, the market value of the assets or the liabilities arising from the financial instruments must be added to the enterprise value (assets) or deducted from (liabilities), when the equity value is calculated.

Question 113

What is the problem with changes in accounting principles from a valuation perspective?

Answer 113

The problem from a valuation perspective is that a change in accounting principles normally changes, not only the financial statements for the present year, but also the financial statements for the comparable year. Normally the change shifts costs or income from the previous year into equity the present year. The current year and the previous year will be calculated using the same principle, but the previous year will not be comparable to the data in the previous years report. The valid accounting standard is IAS 8, Accounting principles.

Question 114

When the standard for activating development costs was introduced, how was the comparable year affected?

Answer 114

When companies adopted Swedish GAAP No. 15 (activating R&D as an asset) they were not allowed by IASB to change the comparable year. The reason was that the principle did not exist a year earlier and the companies were assumed not have sufficient information about the amount that could have been activated the previous year. The prohibition to restate the previous year created an earnings increase the year when the new standard was introduced.

Question 115

How did the standard for goodwill amortizations change in 2005 and how was the comparable year 2004 affected?

Answer 115

in 2005 goodwill amortizations were excluded from the income statement because of the new standard from IASB. All companies changed, both the present year and the comparable year. Before the change, companies were only allowed to change the estimated amortization period of goodwill, not eliminate the amortization. The change in the estimated amortization is a change in estimate, while eliminate the amortizations completely is a change in principle. This created an earnings increase between year 2003 and 2004. However, this is always the case because even if the companies are allowed to change the previous year account there will always be another “previous year” compared to the one we just have restated. For instance, when companies present 5- and 10-year trends, there will always be problems with changes in accounting principles.

Question 116

Elekta changed accounting principles in the fiscal year 1998/99, from recognizing a sale in line with percentage of completion, to recognizing the sale when the contract was completed. Therefore, the beginning balance of equity in 1998/99 was reduced by SEK 224mn. Discuss how this affected earnings in 1998/99, compared to if the accounting principle would not have been changed?

Answer 116

As an effect of this change, equity in the company was reduced by SEK 224mn, “which corresponds to projects that were recognized as income but which had not been delivered on April 30, 1999”. All figures preceding years were recalculated. The effect on earnings after tax was that SEK 224mn, included in the income statement 1998/99 had now been excluded from earnings. The amount showed up in the income statements the preceding year when the products were delivered. Consequently the company accounted for the same delivery twice, but using different accounting methods. The problem is that this is not a change of principle, but a change of accounting method because of change in the business model. Elekta should not have changed the accounting for the transactions that already had taken place. What they should have done is change only the future transactions. If the company believes that the percentage of completion method is no longer valid to use because the business have changed, they are free to change accounting method, but only for future transactions.

Question 117

Explain how the enterprise value, the equity value and the interest bearing debt are connected.

Answer 117

The interest bearing debt is important in valuation when the equity value of the company is to be calculated. Interest bearing debt is a reduction from the enterprise value in order to obtain the value of equity. In this calculation interest bearing is measured at the valuation date, valued at market price and must be “stable” (free from temporary factors). In practice “the valuation date” in a stock market company is the last quarterly report.

Question 118

Which accounting standard covers the accounting and presentation of interest bearing debt?

Answer 118

The phrase “interest bearing” is not defined in any accounting standard or law. Still, approximately 80 percent of the non-financial companies on the Stockholm Exchange recognise the amount, also in the quarterly reports.

Question 119

What is the definition of interest bearing debt from a valuation perspective?

Answer 119

The Swedish Sociaety of Financial Analysts (SFF) has issued a standard that defines interest bearing. The definition is the following: All liabilities that give rise to interest costs in the income statement. The definition originates from the way value of operations is calculated, where the starting point is “earnings before interest costs and taxes”.

Question 120

Are pension liabilities a part of interest bearing debt? Why or why not?

Answer 120

One problem relates to interest costs on pension liabilities. According to IAS 19 the interest cost can either be included in operating earnings or in the financial net. This makes it difficult to know if pension liabilities should be a part of interest bearing. It all depends on how the company has recognised the interest expense.

Question 121

What is “net interest bearing debt” compared to “interest bearing debt”?

Answer 121

Investors also use the term “net debt”, which is the interest bearing debt, less cash and cash-like securities. In some cases companies define “net debt” as the interest bearing debt, less all assets in the balance sheet that give rise to interest income in the financial net. However, it is difficult to understand if the interest income from the assets is included in the financial net, which is the definition from an valuation perspective.

Question 122

Give an example of a temporary factor that can lower the interest bearing debt at a certain point in time (for example December 31).

Answer 122

Another problem relates to the sustainability in the net interest bearing debt. Like all figures, also this can be manipulated. For example, if the company do not pay the suppliers the month before the balance sheet date. Trade creditors will increase as well as the cash account. When calculating “net debt” cash will reduce the sum. However, sooner or later the company has to pay the lagging creditors. At that point the net debt will increase again.

Question 123

Company A has long-term bonds that are traded on the bond market. Because of poor profitability, Company A is downgraded by Standard & Poors. The market price of the bonds decline and investors recognize a loss. How will this decline affect the book value of the bonds in Company A’s accounts? How will it affect the income statement?

Answer 123

In the company accounts the liability will normally be recognized at cost, but the accounting standard allows companies to revalue the debt, through OCI. Previously the accounting standards did not allow companies to revalue the liability because the company still had to pay back the face value of the liability. The company are, however free to repurchase the bonds at the market. In this case a gain will occur and the gain will be included in the income statement.

Question 124

Company A has long-term bonds that are traded on the bond market. Because of poor profitability, Company A is downgraded by Standard & Poors. The market price of the bonds decline and investors recognize a loss. From a DCF valuation perspective, how should the bonds in Company A be included in the valuation of Company A – to book or market value?

Answer 124

From a valuation perspective, however, the market value of the liability must be used. The reason is that a downgrade of liabilities undoubtedly increases the acquirers risk premium. Therefore it will lower the calculated enterprise value. If we only recognize the negative effect in the enterprise value and not the positive effect from having outstanding bonds at a low market value, it would be inconsistent.

Question 125

The construction company B has substantial advances from customers. Discuss the implications on the calculation of “net debt” from this.

Answer 125

In the receiving company the advance is a liability included in working capital. The cash that the company receives ends up on the cash account and is normally not possible for analysts to separate from other cash. The problem is that the cash from the advances is not cash from a valuation perspective, but “work in progress”. Since it cannot be distributed to the shareholders, we must not include it as “financial” in the calculation of net debt in the DCF model. Therefore, it is not to be recommended to calculate “net debt” in companies involved in long-term contracts, but rather stick to a gross “interest bearing debt”.

Question 126

Which are the major problems with pensions from a valuation perspective?

Answer 126

• The pension liability is complicated to calculate because of the long time frame and the non-monetary nature (no specific maturity date).
• The accounting standard includes value fluctuations on the liability, included in other comprehensive income (OCI), which can be difficult to interpret.
• When a company is valued in two sections; operating and financial - interest costs on pension liabilities should be deducted from operating earnings while pension liabilities should be considered an interest bearing liability.
• When a company is valued in two sections; funded assets should also be considered a part of the net debt and the expected return on the asset must be excluded from operating earnings.

Question 127

If a company is valued using a DCF-model, discuss how the NOPLAT and the net debt will be affected by the volatility in the pension liability in the above example?

Answer 127

It is vital to understand if the financial net includes the interest cost from the pension liability or not. If it is included, the liability is a part of interest bearing debt. That is the preferred solution. EBIT/NOPLAT will in this case be affected by the operating costs and are therefore suitable as a base for the calculation of the enterprise value. However, companies are not obliged to recognize the net pension obligation as a financial item, neither in the balance sheet nor in the income statement. The information can be found in the footnotes to the annual report, which makes it fairly easy to adjust for.

Question 128

Between 2005 and 2011 Astra Zeneca recognized deficits from pensions in OCI each of the seven years. Discuss the implications on the DCF valuation model from the deficits and whether it impacts the enterprise valuation or the calculation of debt.

Answer 128

It is also very important to analyze the OCI account to make sure the accumulated pension adjustments over time are approximately zero. If this is not the case, either the operating cost must be adjusted or the risk premium in the WACC calculation. When deducting the interest bearing debt from the enterprise value, the market value of the pension obligation, net of pension assets, must be included as a part of the interest bearing debt.

Question 129

Define what is a “net pension obligation”?

Answer 129

A pension liability can be covered, in full or to some part, of assets that the company has included in a trust. The assets in the trust must be separated from the company and should only benefit the pensioners. The pension obligation will then be: Present value of pension obligations - Pension fund assets = Net pension obligation

Question 130

What characterizes renting versus ownership of an asset?

Answer 130

Rents are characterized of short-term periods and high expense compared to owing an asset, paying interest and amortizations on the loan. The user can normally cancel the contract on short notice, but cannot keep the asset when the renting period expires. The owner of the asset must be compensated in the rent for the risk of not being able to renting out the asset if the user chose to cancel the contract.
Owing an asset includes bearing the risk for value decreases. The transaction is long-term and the owner has several fixed expenses as interest costs, depreciations, insurance and services costs. The fixed costs are normally small in the beginning when the asset is new, but increases with age and use. On the other hand, the sum of interest costs and depreciations decline over the lifetime of the asset, if the normal straight-line depreciation is applied.

Question 131

Which are the four sectors in the economy, where leasing and long-term rents has the greatest impact?

Answer 131

1. Airlines 2. Shipping 3. Ground transportation 4. Retail

Question 132

Which are the two ways to handle accounting for leasing?

Answer 132

• Operating leases, which have the same characteristics as a rent. The lease is short-term (shorter than the lifetime of the asset) and there is no option for the user to purchase the asset when the lease-term expires.
• Financial leases (capital leases) have the same characteristics as ownership. The lease payment normally equals the economic lifetime of the asset and the user has a purchase option at the end of the lease term. There are small lease payments in the beginning of the lease term compared to an operational lease.

Question 133

How is the footnote related to leasing structured?

Answer 133

the information required in the accounting standard IAS 17 is:
• The lease payment for the coming year
• The sum of the lease payments for year two to five
• The sum of the remaining payments after five years

Question 134

What is the effect of leasing on the dcf valuation?

Answer 134

The FCF is affected by either:

• The investment of 1840 (PV of all future lease payments), while depreciations and interest costs are added back. The treatment becomes equal to an investment. The yearly lease payments must be eliminated. In this case the lease liability is an interest bearing debt of 1490.
• Or the yearly lease payments reduce the FCF. In this case the liability is included in working capital.

The calculation of the continuing value is either:

• Affected by depreciations on the asset, which are included in NOPLAT.
• Or affected by the yearly lease payments