Ship of Theseus as a Metaphor for Replacement Cost

Looking at the Parthenon being restored, it reminds me of another Greek concept: the ship of Theseus. It is essentially an identity dilemma: If you take care of something, but are forced to replace parts due to decay over time, is that object still the same? This is something I’m sure archeologists wrestle with when they rebuild replica parts to restore murals or structures for which the original parts are long gone. Even if they use the same material, artistry and methods, the original has lost something ineffable.

This concept has been extended several times with several unique spins, my favourite being Plato’s carriage, where Socrates and Plato exchange parts on their carriages until finally “Socrates’” carriage is made entirely of Plato’s original carriage and vice versa. At what point did the identity of the carriage change?

In a vain attempt to bring all my philosophizing back into the MBA realm of finance, it’s sort of interesting when you think about it in the context of the idea in accounting principle of replacement cost or M&A. While accounting will capture the physical quantities contained within a company’s finances, there also exists value beyond the sum of its parts in the same way you would expect an M&A transaction’s synergies to broaden the qualities of the combined entities: that seemingly ineffable quality.

ICP Islamic Finance - "Conventional" Analysis

This morning we had a working session for our ICP - Islamic Finance with some lawyers, a corporate banker and professors. The two teams presented their analysis of the conventional financing structure of the primary security instruments used to finnace our projects. Under this conventional analysis, we looked at the costs of capital and the associated terms related to these types of paper with the intent of understanding the requirements need to make them Sharia compliant.

We also had great explanation from a senior lawyer regarding the structuring and "asset-based" (versus "asset-backed") nature of nominating (rather than selling) assets under a Special Purpose Vehicle (SPV) in order to comply with the necessary requirements of Islamic finance. We had considered the capital gains implications of a sale leaseback transaction, as well as understood how an asset and capital intense infrastucture project would look similar under an adjusted EV to EBITDAR metric regardless of the off-balance sheet financing that may potentially be required.

We have a solid understanding of the work requirements due before our next meeting in early January (before I fly off for London). We also had an opportunity to fire questions back at the professionals in the room in terms to learn what were the appropriate resources for generating comparables for analysis and benchmarking of our theoretical capital structures based on similar Sharia compliant instruments and current market conditions.

Some of the best advice we got:

• Understand the difference between "asset backed" versus "asset based" and how that affects your ability to issue Sharia compliant instruments
• Be aware of tax implications of capital gains/losses in a sale leaseback transaction
• Like any financial security, understand the key characteristics of seniority and expected return for a sukuk issuance and understand market appetite for these structured products

Abnormal Earnings Method – Not Entirely Useless

When we were introduced to the Abnormal Earnings method in Business Analysis and Valuation, I was decomposing the math formula which constructs the value of the equity. As far as I was concerned, it didn’t really tell us anything we didn’t already know through a equity based discounted cash flow (FCFE discounted at re).

However, there was an interesting scenario in which this method actually told us something unique. First the formula:

Market Value = Book Value + (NI1 – re*BV)/re + (NI2 – re*BV)/re^2 + …

Nix is Net Income in year x

BV is book value

While in theory, this formula should return a similar value to an equity based DCF, one unique value is that the valuation is relative to book value, rather than strictly looking at only cash flows. Essentially, what it is saying is, the company is worth it’s book value, PLUS it’s “abnormal earnings” where abnormal earnings are the earnings you get in excess of what you would expect (re).

So in looking at a company that is trading below book value, I used to think that it meant that the market did not believe in the company’s management to perform (the company was burning cash). But it doesn’t just have to be that the company is on a “crash” course. It could also just be that the company is not performing as “expected” that is to say there net income is not necessarily negative, but simply less than what is expected.

Write-Up of Intangible Assets

In M&A, acquiring a company requires you to pay a control premium above the current market price to capture a majority of the shares outstanding needed to own the company. Usually, a company’s equity trades at values above book value (the idea that the sum is greater than the parts) and that there is value creation.

So in an acquisition scenario, there are a few considerations. Firstly, the market price is above the book value. Secondly, the purchase price is above the market value. The cumulative amount by which the purchase price is above the book value is referred to as “excess”. This excess is usually allocated in two ways: Good will and Write-up of Intangible Assets.

Purchase Price > Market Price > Book Value

Purchase Price = Book Value + Excess

Excess = Goodwill + Write-up of Intangible Assets

Intangible assets would normally be amortized, but in this scenario they do not provide a tax shield. This makes sense because if you could amortize them you would essentially be double counting your DA expense (or depending on what type of asset it is, such as Intellectual Property, your R&D expense). Also, if you could count this as an expense, this would provide a tax shield against your acquisition premium and promote higher premiums.

Another consideration is the effect on asset based leverage ratios depending on where you allocated the write-ups in value. One note was that in companies which depend heavily on leverage (and where asset based ratios can significantly affect ratings and therefore borrowing rates), there is a tendency to try to write up assets rather than allocate the excess to goodwill (also for “optics” reasons).

Aside: Any buyer that is offering an acquisition price below the current market price should seriously reconsider their position. Although we've seen this unique situation with the recent Potash deal, there are some obvious problems with offering a purchase price below the market price.

Financial Management Presentation

Yesterday, my team had our presentation for Financial Management with Asher Drory, a professor notorious for not pulling any punches and generally holding all Rotman students to a very high standard. We didn't want to disappoint.

Our case was on securitization as a form of financing. The company was a collections company which bought bad loans for pennies on the dollar and made a profit by collecting on them. However, they were being squeezed on the margins due to banks beginning to charge more for the bad debts as well as the quality and collectability of the debts shrinking.

The company was also looking to grow, and had been previously financing its growth through the securitization of it's uncollected loans (in this specialized financial industry, loans are a form of inventory, rather than as a liability in a traditional company). However, the conditions of the security were almost exactly the same as debt (monthly interest payments and principal flowthrough).

Therefore, in order to properly understand the risk exposure in the company, rather than have the financing sit off the balance sheet, we made adjustments to show what the balance sheet would look like if they were financed with traditional debt (which is not an unreasonable assumption, given the type of business risk that they are exposed to through this financing is not dissimilar). The end result is that suddenly all their solvency ratios and coverage ratios are totally out of whack. Whereas before their company had reasonable ratios (debt to equity of about 0.8x), their ratios were now about 4 to 5x.

Accounting – The Story Behind the Numbers

It seems like the major topic for this week has been related to working capital. In our financial management course, however, there was a great example case where simply knowing the numbers is not enough.

Simplified Case Info (expressed in thousands):

Revenue = 17805
AR = 6000
Average Day’s Receivable in the industry = 59 days

Analysis:

Company’s Average Day’s Receivable = 123 days

Proposed financing solution: Collect on AR to reduce Day’s Receivable to industry average of 59 days.

If Days Receivable = 59 days, implied new AR is 2878. The change in AR would be 6000 – 2878 or 3122.

So looking at this *mathematical* solution, it seems as if the company can get a free 3 million dollars just by tightening its AR, right? Well as it turns out probably not. The reason?

Most companies define default as non-payment of debts of 90 days or more. Previously, we’ve talked about how debts decay in value as they are outstanding for longer and longer (probability of collection and bad debt expense). If you look at this number, essentially what it is saying that the many of your accounts are in default with an average age of 120 days!

Sometimes you can’t just assume you can make operational changes to reflect a reality that you want. The truth of the matter is that those funds are probably lost. The firm probably won’t collect those accounts and will incur a significant bad debt expense.

In reading more of the case, it also mentioned that the company had a “no returns” policy with its distribution channel partners. Looking at this number not only meant that they probably weren’t going to collect, but that their distributors were telling them that they didn’t want to do business with them any more (affecting their potential future revenue growth). Not only will they not be able to pull 3 million dollars out of working capital, there are some critical red flags appearing about their ability to continue as an ongoing concern.

Excess Cash isn't always just from cash

Putting together the last few posts (House analogy for EV, FCFF and NOWC and N[O]WC as a source of funds), let's look at an example of how they are all interrelated.

Target Company:
Total Assets = $100M
AR = $10M
Inventory = $15M
AP = $10M

Industry Average
Total Assets* = $100M
AR = $5M
Inventory = $10M
AP = $20M

* Total Assets for each company are deliberately the same to make percentage calculations convenient.

Let's also assume that looking only at the company's operations, you are planning on bringing the balance sheet accounts closer in line with industry average. Implicitly, you are improving the company's operations (reducing days receivable, days on hand and increasing days payables).

Therefore:
Change in AR = -5M (cash inflow)
Change in Inventory = -5M (cash inflow)
Change in AP = +10M (cash inflow)

Total cash inflow from Operating Working Capital = +5M +5M + 10M = +20M

This change in accounts reflects a type of excess which can be converted into "excess cash". These changes would be manifested in operations through:

• Collecting on debts sooner, reducing credit terms
• Selling out of inventory without replenishment (reducing inventory size and implicit days on hand)
• Taking longer to pay our suppliers, using more supplier credit
• Essentially, running "leaner"

This excess cash would be captured in a financial DCF model as a change in net operating working capital in the first year of operation and built into the company's EV calculation.

Enterprise Value - House Analogy with Excess Cash

Another common question that comes up is related to enterprise value, particularly as it relates to excess cash. Recall that enterprise value is the value of the entire company and should be capital structure neutral.

EV = Equity + Debt - Excess Cash
or
EV = DCF Value + Excess Cash

The initial reaction is: "Wait, how can that be?" How is it that in one formula excess cash detracts from EV whereas in the other it increases? Does that make sense? In explaining, I find that a house analogy is helpful for understanding how to calculate EV.

Scenario 1:
Imagine Steve ownes a house worth $100k. Over the years, Steve has paid down his mortgage to $50k. Therefore, Steve's house's capital structure is $50k debt and $50k equity.

Dave is interested in buying Steve's house. For simplicity, let's say the house hasn't appreciated in value and is still worth $100k. Dave doesn't care what Steve's mortgage is, how much he's paid down etc. After all, that is Steve's capital structure. Dave is a new home buyer and is starting with a $20k downpayment and $80k mortgage.

The main point is that it doesn't matter who is buying the house (over simplified assumption), the house is worth $100k. It is an attempt to understand an unbiased (unlevered) way of looking at value of the company.

Scenario 2:

Let's assume a few changes:

• The $100k price of the house includes $10k in cash which is sitting on the floor of a room
• The house is being rented out as an investment property for $4k per year forever and the appropriate discount rate is 5%

Using the following formula:

EV = Equity + Debt - Cash = $100k - $10k = $90k

Does this make sense? Dave buys the house with $80k of debt, $20k of equity for a total price of $100k. However, immediately upon buying the house, Dave takes the $10k sitting on the floor and pays down his mortgage. Effectively, Dave has only paid $90k for the house.

Using the alternate formula (using a perpetuity formula for DCF):

EV = DCF Value + Excess Cash = $4,000 / 5% + $10k = $80k + $10k = $90k

That is to say, forgetting the cash, the house is worth $80k only from the income it generates. However, because the cash sitting on the floor is not integral to operating the house, it can be taken out of the house without affecting the income stream.

While it isn't an entire conicidence that the end numbers are the same (I've deliberately selected convenient numbers), it should hopefully demonstrate how excess cash in one formula decreases EV whereas in another in increases EV.

Free Cash Flow to Firm and Net Change in [OPERATING] Working Capital

A few of my classmates have been asking me a very common question so I thought I would post the answer. Particularly because I think it is a fantastic question and is something I’ve wrestled with for sometime.

In Corporate Finance, Financial Management and Mergers & Acquisitions, one of the most important metrics of a company’s performance is it’s free cash flow. Or more specifically, it’s free cash flow to firm (aka. Unlevered free cash flow). This is the cash flow metric that is used to value the entire enterprise. It’s defined as:

FCFF = EBIT (1 – tax) + DA – NWC – Capex

Where:
EBIT is Earnings Before Interest and Tax (otherwise known as operating income)
DA is Depreciation and Amortization (which is actually a place holder for all non-cash expenses, but DA is the largest and most common one)
NWC – Change in net working capital (*NOTE* This is the tricky part that people are asking about)
Capex – Capital Expenditures

So while this formula is not new to most, what I want to focus on is NWC. If you have read my post on the difference between OPERATING working capital and working capital will know what I’m getting at.

First, before we even get to that, I want to emphasize a lesson taught in Anita McGahan’s first year strategy course relating to Dupont analysis (one of my favourite frameworks). Dupont analysis looks at Return on Equity and Anita made a fantastic point about how to look at the formula:

ROE = NI / Equity

ROE = (NI / A) * (A / E)

ROE = ROA * FLA

Where:
ROA is return on assets (Operational Strategy)
FLA is financial leverage (Financial Strategy)

In a discounted cash flow, a company’s value is calculated as it’s enterprise cash flows discounted at the appropriate enterprise cost of capital (it’s weighted average cost of capital).

In other words: In the summation formula, the numerator is operating (FCFF) and the denominator is financial (WACC).

This is another good way to think about the difference between OPERATING working capital (OWC) and working capital (WC) as I explained previously.

While the commonly accepted formula for FCFF is as explained above, anyone who has done a proper financial model is quick to learn that it isn’t change in net working capital which is important, but rather change in OPERATING net working capital (excluding financing items such as cash and short term debt).

FCFF = EBIT (1 – tax) + DA – NOWC - Capex

But the next logical question is what is the difference between something like short term debt (a quantifiable liability) and accounts payable (also a quantifiable liability which is equally a debt of sorts – a debt to a supplier). The answer? Interest.

The reason why something would be considered OPERATING working capital (or particularly an operating current liability) versus a normal working capital (or current liability) is that a financial current liability *bears interest* whereas an operating liability does not.

This raises the next interesting question: How do you treat pension liabilities? As you may recall, I mentioned previously how the CFA treat’s pensions as if they are interest bearing liabilities (or specifically, debts of the company owed to it’s workers which is expected to grow at the company’s cost of debt). This is a perfect example of a judgment call. Some of the top equity research analysts will consider pensions to be part of operating a business (not included in enterprise value as a financial consideration) whereas others will consider pensions to be a type of financing (don’t take my word for it, check out the research reports of companies with sizable pensions and see how different analysts treat different companies). Some will consider current pension obligations as debt (as it has to be financed to be paid out) whereas others will treat the entire long and short term obligation as debt.

Unconventional Sources of Funds

A topic I've noticed has appeared in a corporate finance as well as financial modeling cases. Whereas people often think of raising funds in traditional methods such as raising debt and equity, I don’t think people pay enough attention to potential changes in free cash flow, particularly change in net working capital.

For instance, in corporate finance, we were discussing the acquisition of a private company and what considerations should be taken into consideration when acquiring the company. Besides the obvious item’s we’d learned so far, it was also useful to see what would happen to the company if it’s operations were structure in a manner similar to its public counterparts. That is to say, express AR as a percentage of total assets (as well as all assets and liabilities) and look at the change in cash flow that results from the aggregate change in each account when bringing the private company to the industry average. The result can provide a considerable cash flow in or out of the company. While this principle can be generally applied, this is easy to understand using working capital as an example. This is because that unlike capex, change in net working capital can possibly supply cash flow into the company if it was previously poorly managed financially or if new management can improve the cash conversion cycle.

In our financial management case example, this principle was more pronounced as the history of a company’s operations for four years worth of balance sheet items was produced. Activity / operating ratios were heavily underperforming, particularly in prepaid expenses (compared against revenue as an appropriate base) as well as accounts payable (days payable).

While an “unconventional” method of financing, this was one of the lessons from Bombril on the Latin America study tour, where Gustavo Ramos, the CEO, a former Rotman Commerce undergrad and Columbia MBA, told us about how he turned the company around when it was in financial distress. One of the methods he used to “finance” the company was to stretch the cash conversion cycle: negotiating with suppliers to get more favourable terms, being more aggressive in collecting on accounts receivable, managing inventory (reducing days on hand) etc.

While strategies such as stretching the payables is considered to be a last resort for companies in “survival mode”, it can also be used to trim a type of operational fat and is directly related to the calculation of excess cash (and also excess working capital) as you structure your balance sheet accounts with optimal weightings.

Any non-income generating assets that can be sold for excess cash without affecting the underlying FCF can create additional value for the company. Clearly, this unlocks value in the company not captured in at DCF, but does not make the DCF any less sustainable (valid).

Deloitte Brazil

[LAIST Tour Begins, Fazenda Tozan, Churrascaria – Nova Pampa, Port of Santos, Deloitte, Embraer, Natura, Gol de Letra, Bom Bril, Agencia Click, Nextel Institute, May 6, Rio, Rio Weekend, Petrobras, PREVI]

Deloitte is a well recognized name in the consulting world, operating in 140 countries. In Brazil, Deloitte made its entry in 1911 where they were asked to audit British railroad companies. Today, Deloitte has grown to 4000 professionals working with 132 partners. They have a multifunctional approach (versus a siloed approach) where they provide integrated solutions and command a leading 19% market share of audit services in Brazil followed by KPMG at 17% and PWC at 11%.

They structure their portfolio of advisory services based on industry verticals. In Canada, Deloitte is known to focus on public and financial services whereas in Brazil they focus on manufacturing, retail and the growing financial services sector. Their growth targets are projected to move from 10% to 20% across the board with the highest growth occurring in their consulting services at 25%.

Even with the recent global financial distress, like many other consulting and advisory service firms, they have shifted their focus in branches like their Corporate Finance advisory from M&A deals to restructuring distressed companies and managing them in receivership. According to our contacts at Deloitte, Brazilian banks have been exceptionally successful despite (or rather because of) the financial crisis in the US. The top banks in Brazil are local banks (rather than subsidiaries of foreign parents) and their international presence has allowed them to extend their services beyond retail banking into commercial banking and even IPO’s in global capital markets.

Also, with the upcoming convergence of IFRS (Brazil’s current standard) and US GAAP and Brazil’s increasing role in the global market place, they anticipate having a spike in engagements from clients looking for advice on the implications of the changes in accounting standards and their implications on the complicated tax systems in Brazil (greatly differing by state).
Deloitte is also heavily involved in projects like the World Coup 2014 and the Olympics in Rio where they are not only assisting with capacity management of the facilities for the event itself, but also the legacy planning for the facilities in the future after the event itself is finished (ensuring long term sustainability and viability of the project costs).

Deloitte also has a strong focus on social projects, celebrating their “Impact Day” on June 11, the day of the World Cup, where they have a series of planned activities matching their core of applying knowledge with the development of educational programs. All of their professionals will be volunteering throughout the country taking children to play football with star athletes and preparing creative activities throughout the day.

Because of Deloitte’s unique relationship with a variety of top companies (boasting a client list that includes 80% of the Global F500 companies), they have provided us with contacts for our study tour which we will be visiting over the next few days. They also gave us an insider’s view of details into the developments of sectors within the Brazilian economy including the development of the infrastructure (marking the return of their focus on railroads). They gave us an in depth look at why Brazil is such an attractive country with which to have a presence in the global market place and why they have earned their place among the BRIC countries as one of the top emerging markets.

Allowance for Doubtful Collection

In continuing with the thoughts on revenue from last week, I thought it might be worthwhile to look to look at allowance for doubtful collection of funds. Generally, there are two methods which are used: % of receivables and the aging method.

The first method, % of receivables is quite simple and self explanatory. There is a predetermined percentage of receivables (calculated based on historic numbers) which is expected to default.

So assume that this is 1.85%. If the firm's gross revenue is $1M (and all credit sales), then the expected bad debt associated with those revenues is $18.5k. The net value of receivables is $1M - $18.5k or $981.5k.

The aging method is more sophisticated and provides a better picture, however, it requires a great deal more work.

For example: Assume the following definitions:
Normal - Receivables is between 0 and 60 days old (99% chance of collection)
Distressed – Receivables is between 60 to 90 days old (95% chance of collection)
In Default – Receivables over 90 days old (50% chance of collection)

Now assume that of that $1M, there is:
$900k of Normal AR
$90k of Distressed AR
$10k of In Default AR

The expected value of those receivables would be:
Normal – $900k x 99% = $891k
Distressed – $90k x 95% = $85.5k
In Default – $10k x 50% = $5k
Total value = $981.5k

I’ve chosen very particular numbers to get the same result as above, but this also proves a point. If the structure of your debts is predictable enough (or with little variation), a percentage of receivables method is essentially a sort of weighted average of probable defaults.

Understanding Aggressive Revenue Recognition

While we normally look at items higher up on the I/S as being of higher quality (less prone to manipulation), there are still some issues which may cause analysts to take a closer look at some of the top line items. For instance, revenue is not immune to manipulation.

For example, a company that is looking to boost it's top line revenue might be more inclined to aggressively (through a variety of mechanisms) recognize revenue. However, with accrual accounting, there are many potential ways to detect some red flags with regards to changes in current practices by looking at the numbers.

First, let's decompose what revenue is actually composed of. Revenue is composed of two types of sales, cash sales and credit sales. Or expressed as:

Revenue = Cash Sales Collected + Δ A/R

Even if all sales contain some component of credit, the conversion implications as it relates to collecting debts will have a noticable effect on various ratios.

The most obvious among these is the Days Sales Outstanding (DSO) ratio:

DSO = (A/R) / Averages Sales per day = 365 * (A/R) / Sales

This is a familiar activity / operating ratio, because it is used to forcast A/R levels in the OWC schedule in a financial model and is the most obvious place to look to see if the active practices of the company have changed. It also plays a huge role in the Cash Conversion and Operating cycles.

Another interesting note is that with a constant of 365, this ratio tells the EXACT same story as the ratio (A/R) / Sales which offeres some insight into your company's policy with regards to percentage of credit extended per sale.

An alternative method is the portion of aggregated accrual attributed to revenue recognition method which is calculated as (A/R) / Δ in Net Operating Assets (or NOA).

However, note that the major components of NOA are Inventory and A/R (related to OWC which is similar but also includes A/P, prepaid expenses and other current / operating liabilities). Notice that when financial modeling, these items are modeled against ratios which incorporate I/S items such as Revenue, COGS, Operating expenses etc. Note that in turn, these items (COGS, Operating Expenses etc.) are usually modeled as a constant percentage of Revenue.

The end result? It doesn't matter which of the two ratios you use, they should both tell you the same story. If a company starts taking more aggressive revenue recognition through extending credit (and possibly risking having customers default on purchases), both of these ratios will increase as A/R as a % of sales increases faster than sales.

Defined Pension / Benefit Obligations

One of the interesting topics in the CFA Level II material is the mechanics for Defined Pension / Benefit Obligations. Previously, in the Rotman Finance I exam / CFA Level I material, I posted an example of the basic mechanics of how a pension plan would be valued (how much would be the PV of future benefit cash flows based on life expectancy and % of salary expectations and what rate of saving would be required to save the required FV to generate those future CF's).

However, if you notice, the "mechanics" of a pension plan are suspiciously similar to that of a bond. And that should come as no surprise. In the retirement or payout phase of retirement, it is as if the retiree is cashing out a fixed income investment (getting regular payments over time) or similar to amortizing a bond liability for the pension plan. However, when they are still "young and saving money" the pension plan is receiving regular payments overtime. The because the payments are regular and defined, they have all the characteristics of a bond.

This metaphor extends even further when you think about what the worker is doing. First a few contrasting scenarios:

Scenario 1: The worker makes a salary of $100k per year.

Scenario 2: The worker makes a salary of $70k per year, but has a defined benefit plan where the company contributes $30k per year into it.

In both of these scenarios the worker (assuming fair treatment) is being given the same value through salary (note also, the I/S in both scenarios reflects a $100k expense with regards to this worker... the only difference is that the $30k would be recognized as deferred wages or change in pension benefit non-cash expense on the CF/S).

However, let's take a closer look at that $30k. What is another way of looking at this? Well, another perspective is to say that the worker is deferring $30k of salary in the hope of future gain as realized through the defined pension benefit. In essence, the worker is loaning money to the company. Assuming that the DPO/DBO is as risk free as the company can guarantee (it is a contractual obligation) in terms of seniority of capital, this money actually ranks as quite senior (priority claim). This is a topic of particular interest with the recent financial crisis, especially as it related to Chrysler and it's recent financial trouble and relationship with the UAW / CAW.

This answers the next question: What is the appropriate discount rate for these funds? Well if you assume this obligation to be one of the most senior forms of claims against the company, it should have the most risk free rate the company can afford which is usually the same rating as it's highest quality bond.

This also raises an interesting point, if you were a lender or potential acquirer (through M&A or LBO) and you were analyzing a company with a defined benefit plan, would you consider the liability similar to debt? While it is not strictly a form of debt in the same way as a revolving credit facility, debenture, high yield bond, PIK or other, it noticably has many of the same characteristics (and is often modeled as a bond liability).

Non-Cash Expenses

A friend was asking me some questions about financial statements and modeling companies and it brought up an interesting question. What exactly are non-cash expenses? For example, when we calculate FCFF we normally just focus on depreciation, although technically depreciation is just a component of the broader category of non-cash expenses. The next most obvious non-cash related expense is deferred taxes.

This got me thinking about what else is included:

• employee stock compensation (appearing on the I/S as operating expenses in SG&A)
• deferred wages (possibly relating to a pension plan obligation or company matching scheme, also appearing in SG&A)
• restructuring charges
• impairment of good will
• amortization of intangible assets
• non-controlling interest

These are normally the cash flow items that appear right in the "adjustment for non-cash expenses" (or similarly named category in CFO) with depreciation and deferred taxs after NI but before operating working capital.

When we were doing financial modeling in NYC, this was the most common question people where people were confused and were asking each other as it related to what exactly was going on in the statement. Other items, like OWC, CFI or CFF were normally pretty straight forward.

With the CFA level II material, at least it is going over some of the more common items in detail which really helps when reviewing and reading F/S. It provides a bit of clarity as to exactly what is happening in the income statement and the real cash effects it is having on the operation of the company.

Non-Leveraged Accretive Mezzanine Financing

I was looking over my CFA Level II materials for corporate finance this weekend when I looked at the CFA's definition of different types of risk. For instance:

Sales (Business / Industry risk)
- Operating Expenses (Operating Leverage)
- Interest Expense (Financial Leverage)
_____________
Cash flow

The definition of any type of leverage (operational or financial) is increasing your fixed cost component but reducing your variable component.

It got me thinking, is it possible to have an instrument which doesn't increase leverage and solvency ratios, but also provides accretion for common equity holders? For instance, if you want to deleverage, the general strategy is to purchase debt with equity (which results in dilution because cost of equity is higher than cost of debt due to risk concerns etc). I don't know if this is possible, but I asked myself about a preferred share with very particular characteristics.

Fixed income instruments (coupon paying bonds, dividend paying preferred shares) increase the fixed payments required which technically increase leverage.

Accretive
Is it possible to have a preferred share that, rather than paying a fixed predetermined dividend (similar to dividend yield based on price), that pays a percentage of net income (similar to a stated dividend payout ratio). Because it is more senior than common equity, the cost of this capital would be less than the cost of equity (accretive if used in a refinancing / capital restructuring).

No Leverage
But the payout would also be variable based on NI meaning that it isn't technically leverage according to the CFA definition (plus it would be classed as equity rather than debt on the books). If earnings are low, the payout is low. If the earnings are high, payout is high. It rises and falls as a variable component rather than a stated fixed component.

The problem with this model of an instrument is that I don't think you could get a "senior" level instrument to payout variable to net income with a cost of capital less than common equity because they technically face the same level of risk (percent of NI).

Also, because earnings can be manipulated, perhaps the payout would work if it was stated as a percentage of EBT or some other higher quality form of earnings? At first I thought EBITDA, but then I realized that doesn't make sense. It would have to be paidout after EBIT (because interest should be a more senior form of financing and paid first). However, EBT is often modeled with a fixed tax rate to go to NI (so a % of EBT is really a % of NI since tax rate is usually constant).

Perhaps it could be payed out as a % of EBITDA which is paid out after interest?

This would justify the instrument being more senior and paying a lower cost of capital.

Why isn't my deal accretive?

I'm building an M&A model for two firms in the same industry and I noticed that the deal I was modeling wasn't accretive. However, the PE for the target was lower (marginally) than the PE of the acquirer and I was using a capitalization structure that was similar for both (both had about the same debt to equity ratios implying similar capital structures). Both also paid about the same interest rate on their debt.

According to simplification and a common interview question, as I mentioned before: buying a high return equity with a low return equity means you should get to "keep the difference". So in this case, when I modeled an acquirer with implied cost of equity lower than the target, I couldn't figure out why my model was telling me the deal was dilutive!

Turns out, I had forgotten about my asset write ups. What I had done was allocated 25% (not sure if this is a reasonable number - I don't have practical experience yet and I also don't have intimate / insider knowledge of the company being modeled) of my good will to writing up intangible assets. What does that mean?

Often a company develops intangible assets (brand value, patents). Companies are generally not allowed to record the value of their own internally developed intangible items on the books (because this would be a very subjective exercise). However, when companies are purchased, the value above book value is recorded as goodwill. Companies can further allocate portions of this good will (not sure the legal or accounting regulations, although I'm sure there are plenty) on the books as intangible assets and amortize them over time.

So what happened in my model? I merged two companies that had similar capital structures and costs of capital (with the target returning *slightly* more), but these synergies were being offset (at least temporarily in the short run) by the increase in D&A expense due to the write up of intangible assets resulting in an apparently dilutive deal.

Note, however, that for an owner with "foresight" (that is to say, not earnings focused), having a higher write up value increases the D&A expense which results in an increase in cash flow (from the tax shield of a non-cash expense) and also reduces debt and interest payments in the long term (model assumes a sweep with a portion of debt financed in a revolver). That is if you can stomach the low to negative earnings results in the short run. The deal would look more dilutive in the short run, but actually be much more accretive in the long run.

Managerial Accounting / Operations - Capacity Management

One interesting topic which has surfaced in our introductory classes of Managerial Accounting (this morning) and Operations (yesterday) is the idea of capacity management. This is a topic I've been very interested in for a variety of reasons, particularly focusing on the idea of stock-outs and capacity planning.

For example, the ideal scenario is to create *just enough* inventory to satisfy's the period's needs. Creating any more (assuming a perishable good) results in inflated costs related to waste and/or inventory carrying costs. Creating any less results in lost revenue related to stock-outs.

However, in real life, it is unrealistic to assume perfect inventory planning all the time, so chances are there will be some days with over stock and some days with stock-outs.

The basic formula for profit is: Profit = Revenue - Costs

and

Profit Margin = Marginal Revenue - Marginal Cost or Marginal Revenue - Variable Cost

We know that we will incur some sort of inefficiency or uncertainty cost in the form of over / under stocking as mentioned above. However, the idea is to minimize this "capacity cost" we have to understand how operations affect these costs. For example:

A bakery sells donuts for $1.00. Donuts cost 10c to make. Therefore, over-stocking results in a cost of 10c per donut due to wastage. However, stock-outs cost $1.00 per donut due to lost sales. Therefore there is a 10 to 1 cost per unit on either side of the ideal capacity target. Let's say on any given day, the average sales is approximately 1000 donuts.

To minimize the cost side of the profit equation, we have to look at the probability of capacity distributions above and below the target.

Let's make a HUGE assumption (for simplicity) and say that there is a uniform distribution about the target (not normal, but uniform). Let's say there is a 10% chance of the actual daily sales being:

1. 950
2. 960
3. 970
4. 980
5. 990
6. 1000
7. 1010
8. 1020
9. 1030
10. 1040

How many donuts should the bakery produce?

I would propose that you should overlay the capacity with the associated cost of capacity management. What do I mean? If you produced 1000 donuts and you only sold 950, you're capacity related costs would be amount of capacity variance x cost per unit of variance. Generally this would be expressed as:

Capacity Related Cost = Capacity Variance x Cost per unit of Variance

So in this case:

Capacity Related Cost = 1000-950 x (10c)

=$5.00

What about baking 1000 donuts and then selling all 1000, but having an additional 20 donut customers who go unserved? Then:

Capacity Related Cost = 1000-1020 x ($0.90)

= $20.00

Notice that for a smaller number of donuts not sold, there is a much larger effect on Capacity Related Costs. This is a reflection on the profit margin (profit from one lost sale = marginal revenue - variable cost). That is to say, it is much worse to not sell 1 donut rather than have 10 donuts go stale.

To optimize planning (create a capacity level which will optimize profits) it would make sense to minimize the Capacity Related Costs. Since we have the probabilities of the capacity distribution and the associated costs with under production, what target capacity creates the minimal expected capacity related cost? Below is a chart outlining the capacity related costs for given target and actual production levels.

You'll notice that the optimal production level is actually 1040 or 1030. This sort of makes sense as the costs for missed sales are so high. Generally, because of the structure of the model, there are two major factors affecting the end result for capacity planning:

• Volatility and variablity of demand
• Profit margin (difference between cost of wastage and cost of lost sales)

The 4 C's of Credit

I have some friends who are looking at trying to gain positions in Fixed Income so I thought I would have a quick review of the 4 C's of Credit. They are:

1. Character - The management team's record, strategy and internal controls
2. Capacity - Ability to meet debt obligations
3. Collateral - Assets pledged to back the loan
4. Covenants - Restrictions on activities as well as maintenance

Recall that in bankruptcy, there is a hierarchy to how remaining capital, collateral and other assets are distributed relative to tranches. However, in restructuring "everyone gets a haircut".

Also, when building credit ratings, there are various ratios that are looked at, particularly:

• Profitiability Ratios
• Liquidity Ratios (Short Term Solvency)
• Capitalization (Leverage) Ratios (Solvency)

[Operating] Working Capital - What's the Difference?

I was working with a buddy on a financial model recently and this came up as an issue. It's very confusing because Working Capital is defined by operating assets and liabilities (short term or current assets and liabilities) and it *seems* synonymous with Operating Working Capital, which it is not. First, the definitions:

Working Capital is defined as:
WC = CA - CL
CA - Current Assets
CL - Current Liabilities

However, when doing M&A or LBO's we aren't concerned with Working Capital as much as we are with Operating Working Capital. Why?

Cash and Short Term debt instruments are actually financing components and aren't actually included in Operating Working Capital (OWC). In an acquisition, the target firms capital structure is usually zeroed out (unless there is a debt roll over clause) and the capital structure used to purchase the company is plugged in (including good will, recognisable intangible assets etc).

So Operating Working capital has some adjustments:
OWC = CA - CL - Cash + Short Term Debt

It's the same idea as excess cash rather than cash in Enterprise Value.