Free cash flows are not colourless as they tend to be defined depending on the type of free cash flow valuation being performed.
I once posed this question to students in an equity valuation lecture. The response to this question tentacle to a number of issues:
1. Is there a single valid starting point for performing a free cash flow valuation?
2. What principles govern the estimation of components of the free cash flow valuation such as the maintenance and expansion of fixed assets and the working capital requirement?
3. What principles govern the free cash growth estimation?
4. Are the definitions of free cash flow universally applicable (do they apply to all situations)?
5. Is there a single discount rate that is widely accepted and used for free cash flow valuations?
6. What is the significance of debt and the related interest payment in performing free cash flow valuations?
7. Is net borrowing relevant for free cash flow valuations?
In retrospect, I feel I would have asked the above question in a different or somewhat direct manner. The responses I elicited were intended to show that free cash flows are not colourless as they tend to be defined depending on the type of free cash flow valuation being performed. In this article I will address only issues 4 to 7, for the sake of brevity.
Free cash flow to the firm (FCFF) is cash flow available to the company’s suppliers of capital after all operating expenses including tax, CAPEX and working capital requirement.
Free cash flow to equity (FCFE) is the cash flow available to shareholders only after all operating expenses including tax, interest, net borrowing, CAPEX and working capital requirement.
Notably, the above definitions of free cash flow are different. The striking difference is that free cash flow to the firm deals with gross cash flows available to all stakeholders that provided capital, and consequently it is calculated before the interest and dividend payments.
On the other hand, free cash flow to equity deals with the net cash flow available to the equity participants. As a result, it is calculated after interest and net borrowing (added). This would show the residual cash flows attributable to the equity participants.
There should be a clear distinction in the calculation of free cash flows and free cash flow valuation approach when these two distinct approaches to free cash flow valuation are used:
A. When FCFF is used in a valuation we would value the whole firm. There are two implications of this; one is that we use Weighted Average Cost of Capital (WACC) (as the appropriate discount rate), which represent a minimum return required by the providers of capital. Discounting cash flows at this discount rate give the value of the whole firm. The other implication is that we need to subtract the market value of debt to obtain equity value. This is regarded as an indirect valuation of a firm.
Note for students: Normally when the approach is not specified, we would assume the FCFF. Therefore when examiners ask you to prepare a free cash flow valuation and the approach is not specified, you would assume FCFF valuation). If there is no debt either of the approaches yield the same result.
B. When we value the firm using FCFE, we use the cost of equity(as the appropriate discount rate) which is the required rate of return by equity holders. We will get the equity value directly using this method and thus there is no need to subtract the market value of debt. This approach can also be used when there is no debt in the capital structure. In any case, the WACC equals cost of equity if there is no debt.
Table –Summary of calculation of free cash flows:
FCFF FCFE
Profit before Tax(PBT) 20,000 20,000
Plus Non-cash charges(Depreciation etc) 5,000 5,000
Plus interest expense before tax 2,000 No adjustment
Before Tax
Cash taxes (200) (200)
Working Capital (1,200) (1,200)
CAPEX (3,000) (3,000)
Net Borrowing No adjustment 4,000
Free cash flow 22,600 24,600
Conclusion
Free cash flows are thus not “colourless” as they tend to be defined based on the approach to be used for free cash flow valuation. Therefore the calculation of free cash flows to be used for free cash flow valuation depends on whether we are using the free cash flow to equity or free cash flow to the firm approach. ❐
References:
1. Valuation: Measuring and Managing the Value of Companies, Fourth Edition 2005, Tim Koller et al
2. Equity Asset Valuation, Second Edition,2009, Jerald Pinto
3. Tools for Share Valuation, Financial Management Lecture for undergraduates, 2012, Monash South Africa, Gladman Moyana.
Author: Gladman Moyana CA(SA), RA, is Lecturer at Monash University and Managing Partner at Moyana and Associates.
Mergers & Acquisitions
Mergers and acquisitions (M&A) tend to be dominated by M&A specialists such as lawyers, valuations specialists and investment gurus, leaving the funding function for the Chief Financial Officer (CFO) and the Finance Manager (FM). In today’s changing IFRS landscape CFOs and FMs should play a pivotal role from beginning to end of a transaction rather than merely organising funding. In fact, they should lead the process as their absence may be significantly felt post acquisition through business combination related losses, liabilities, and further cash outflows.
Finance professionals are typically side-lined in very technical companies in which the Chief Executive Officer (CEO) is also the founder and is very technical, for example an IT company in which the CEO still does the software coding. Some big multinationals have M&A teams which report directly to the CEO thus limiting the role of the CFO to financing the transaction. Whether you are in a big multinational or a small highly technical company, as a finance professional, get more involved in M&A deals.
Herewith some of the things to look out for and add value as CFO or FM:
Contingent Considerations
Traditionally the purchase price is paid in total when the deal is concluded. To limit the risk of buying loss-making entities, the purchase price can be paid in stages. A certain amount is paid upfront and the remainder in stages when certain targets are achieved. Targets can be financial or operational.
The seller may also insist on a contingent consideration if s/he expects the fair value of purchase consideration to fall. For example, if part of the purchase consideration is the buyer’s shares, the seller can ask for an additional payment if the share price falls below a certain level within a given period.
The amount paid in stages after acquisition date is the contingent consideration and it forms part of the purchase consideration. So, on day one you have to fair value the contingent consideration and classify the obligation as equity or liability in terms of IAS32 Financial Instruments: Presentation. The fair value is added to the amount paid upfront to get the purchase consideration which will then be used to determine goodwill.
If a finance professional is not involved in structuring the contingent consideration as part of the deal negotiations, there could be undesired consequences.
Contingent considerations are common when acquiring owner-managed businesses. The acquirer will typically retain the previous owner as part of new management. The contingent amount will be dependent on certain targets being achieved. For commercial reasons, the original owner may be required to still be in employment of the company when targets are met for him/her to be entitled to payment. This condition significantly modifies the accounting treatment.
If the whole amount is dependent on the seller remaining in employment otherwise he/she is not paid, even if targets are met, then it becomes an employee benefit rather than a purchase consideration. So, instead of fair valuing the contingent amount and adding it to purchase consideration, one has to expense the contingent amount over the period in which the target is expected to be achieved.
One clause in the contract may result in a huge income statement charge, thus it is imperative for finance professionals to be more involved, in order to achieve commercial arrangements while minimising the impact on the income statement. Armed with the knowledge that requiring the seller to be in employment for the contingent consideration to be paid to the seller significantly modifies the accounting treatment. The CFO can word the terms of the contingent consideration in such a way that there is minimum impact on income statements, if any impact. Simply dropping the clause “requiring the seller to be in employment for them to get any contingent payment’’ may not achieve the commercial reasons of having experienced people, who are in most cases founders of the business; to continue to run the business after acquisition.
Example 1
Entity A acquired entity B for R100 million. R50 million was paid on acquisition date and the remainder will be paid in 5 years when certain financial targets are met. The fair value of the contingent consideration on acquisition date is estimated to be R30 million.
Without the employment clause R30M is added to R50M on day 1 to make the purchase consideration R80M:
Dr Investment in B (SoFP) R50M
CR Cash (SoFP) R50M
Dr Investment in B (SoFP) R30M
Cr Liability (SoFP) R30M
There will also be a journal for unwinding of interest on the contingent consideration.
If the remaining R50M is only paid if the sellers of B are still employees in 5 years and at the end of year 1 the sellers are expected to be in employment after year 5:
Dr Investment in B (SoFP) R50M
CR Cash (SoFP) R50M
End of years 1 to 5
Dr Staff cost (SoCI) R10M
Cr Liability (SoFP) R10M
End of year 5
Liability (SoFP) will be R50M
If the sales agreement states that . . .R50M will be paid in 5 years if the targets are achieved and the sellers are in employment . . . It is the policy of the group to treat 10% of the contingent amount as an employee benefit with the balance as contingent consideration . . .
Staff costs – R5M over 5 years
Contingent consideration – R27 M (R30m x 90%)
Dr Investment in B (SoFP) R50M
CR Cash (SoFP) R50M
Dr Investment in B (SoFP) R27M
Cr Liability (SoFP) R27M
End of years 1 to 5
Dr Staff cost (SoCI) R1M
Cr Liability (SoFP) R1M
End of year 5
Liability (SoFP) will be R5M.
There will also be a journal for unwinding of interest on the contingent consideration.
By carefully wording the agreement the staff cost has been dropped from R10M to R1M per annum.
The contingent consideration may be difficult to estimate. Any changes which do not relate to circumstances that existed at acquisition date (even within the measurement period) such as achieving the target, may impact the statement of comprehensive income.
If contingent consideration is classified as a liability, any fair value gains or losses on the liability, will be recognised in the statement of comprehensive income. The impact can be huge and for that reason it is better to have a prudent amount on day one (which is the highest possible amount) thus any subsequent changes will result in a lower amount and will be treated as a gain in the statement of comprehensive income.
If the contingent consideration is classified as equity it is not re-measured. Its subsequent settlement is accounted for within equity and thus there is no impact on the statement of comprehensive income. An equity classification can be achieved by inter alia, settling the contingent amount using a fixed number of own shares (see example below). A contingent consideration which meets the definition of equity in terms of IAS 32 is more desirable as it has no subsequent impact on the statement of comprehensive income. CFOs should strive for such during deal negotiations.
Example 2
Hottie Limited is about to acquire 100% stake in Sexie Limited for R100M plus a contingent consideration if certain financial targets are met. The CEO was wondering what the impact on the statement of comprehensive income would be if:
a) A maximum of R50M is paid in 5 years when targets are met. Today’s fair value of the expected payment based on targets being met is R10M. What will the impact be if the fair value is R25M or R5M at the end of one year due to changes in targets expected to be achieved?
b) 10 000 shares of Hottie are issued at R1 each if the target is met in 5 years. The fair value of the shares is R10M.
Solution
a) The contingent consideration is a financial liability thus its fair value shall be re-measured with gains or losses taken to the statement of comprehensive income.
On day one
Dr Investment (SoFP) 110M
CR Bank (SoFP) 100M
CR Liability (SoFP) 10M
If fair value is R25M at end of year one
Dr Fair value loss (SoCI) 15M
CR Liability (SoFP) 15M
If fair value is R5M at end of year one
Dr Liability (SoFP) 5M
CR Fair value gain (SoCI) 5M
Thus there is volatility in the statement of comprehensive income.
b) Fixed number of shares at a fixed price gives us an equity classification for the contingent consideration. Thus the contingent consideration is not re-measured.
On day one
Dr Investment (SoFP) 110M
CR Bank (SoFP) 100M
CR Equity (SoFP) 10M
No further entries will be made if the fair value of the 10 000 shares is now expected to be R25M or R5M at the end of year 1.
Seller Exit Strategy
When giving up a majority stake, sellers may insist on an exit option if certain events occur. The buyer may give a seller an option to sell his shares to the buyer at a future date if certain agreed upon events occur. This can be done through a put option and the seller in turn agrees to sell the share to the buyer through a call option. The put/call option is a forward purchase agreement which may be a liability on day one with an income statement charge in the form of an interest expense.
By being involved, the CFO can avoid the liability on day one by using trigger events which the buyer controls, such as a percentage of shareholding. For example if the buyer reaches a 75% shareholding he/she will have to buy the 10% remaining shares of shareholder A. So if the buyer’s shareholding increases from 50% to 73% no liability is recognised in the books of the buyer.
A CFO can also propose an Initial Public Offer (IPO) option as an exit strategy for sellers. With an IPO the seller is given the right to request the company to list its shares on a public exchange, such as the JSE. So, instead of forcing the buyer to take his/her shares, the seller will then be given an opportunity to sell his/her shares to the public.
IPO options eliminate the liability associated with a forward purchase agreement provided the sellers cannot force the buyers to buy their shares should an IPO fail. CFOs should carefully consider IPO options as the exit strategy for sellers.
Example 3
Entity A acquired 70% of entity B on 1 January 2012. In terms of the agreement the seller of entity B has a put option exercisable in five years, the option gives the seller of entity B the right to put his remaining shares to A. A in turn has a call option which entitles it to call shares from the seller of entity B on the same day the sellers of B are entitled to put the shares. The agreed selling price in five years is R50 million.
On day one, entity A will recognise a liability which is the fair value of the value of R50 million to be received in five years. If the fair value is R30 million, entity A will have the following journals: Dr Equity R30M
Cr Liability R30M
There will also be a journal for unwinding of interest on the contingent consideration
The liability is then subsequently measured at either fair value or amortised cost in accordance with IAS 39, Financial Instruments: Recognition and Measurement.
Example 4
Entity A acquired 70% of entity B on 1 January 2012. In terms of the agreement the sellers of entity B have an IPO option which entitles them to request a public listing for entity B in five years. Should the IPO fail, they are entitled to request another public listing after three years and should it fail again, their rights fall away. 30% of B’s shares are expected to be worth R50m in five years.
No liability will be recognised in the books of entity A on day one as entity A has no obligation to buy the shares.
What if Entity A is obliged to buy the shares when the second IPO fails?
In that case entity A will recognise a liability on day one. In doing so, it will take into account the probability of successful IPOs.
A properly structured IPO option will avoid potential liability and cash outflows, hence it is more desirable than put/call options.
Transaction costs
The current IFRS 3 requires all acquisition related costs to be treated as expenses. In the previous version of IFRS 3 acquisition related costs were capitalised, so from a group perspective, there was a benefit in having the acquirer pay for all such costs.
So, in light of the change, CFOs can minimise cash outflows by pushing some of the payments to the acquiree. Though there is no difference on the consolidated income statement, there is an impact in terms of cash flow management, especially if the acquirer and acquiree are in different jurisdictions with different, if not stringent, exchange control regulations. As an example, a CFO will avoid paying out money for transaction costs into a jurisdiction in which it may be difficult to get money out through dividends or management fees, but will rather have an inter-company payable and receivable, which eliminates on consolidation.
There are plenty of ways in which finance personnel can add value in business combinations, but that value can only be realised if they are involved.
Other complicated issues
There are other complicated issues associated with mergers and acquisitions, such as share- based payments, pre-existing relationships, re-acquisition of rights, contingent liabilities, intangible assets to mention a few. These were not covered as there is little a finance person can do to influence the accounting impact of these issues.
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Author: Rodgers Mavhiki CA(SA), Cert FMM, is a consolidation and technical accounting expert who has worked closely with M&A teams. He served on SAICA’s Accounting Practices Committee (APC). He is the Head of Financials Sorted at W Consulting.
Rising to the challenge of 2013
Small tweaks to your practice can yield big returns.
Accountants primarily engage in four management activities: productivity, pricing, cost management and client management. From these we can derive five keys that enable us to focus on improving profitability: Leverage, Utilisation, Billing rate, Realisation and Margin. This is known as the LUBRM model.
Let’s look at an example:
1 Partners 4
2 Total personnel 28
3 Leverage 2/3 L 7
4 Chargeable hours x 29,400
5 Utilisation 4/2 U 1,050
6 Standard fees x 14,700,000
7 Billing rate per hour 6/4 B 500
8 Net fees x 13,083,000
9 Realisation 8/%6 R 89%
10 Net income x 4,709,880
11 Margin 10/%8 M 36%
12 Net income per owner R 1,177,470
If we eliminate the specific firm values we can see the model more clearly:
1 Partners
2 Total personnel
3 Leverage 2/3 L 7
4 Chargeable hours x X
5 Utilisation 4/2 U 1050
6 Standard fees x X
7 Billing rate per hour 6/4 B 500
8 Net fees x X
9 Realisation 8/%6 R 89%
10 Net income x X
11 Margin 10/%8 M 36%
12 Net income per owner 1,177,470
This model helps us understand how a professional service firm’s management can change the bottom line.
Of the five keys, three in particular – utilisation, billing rate and realisation – lend themselves to short-term change. The others – leverage and margin – do not so readily respond to change. It takes time to change the ratio of staff to owners, and a cost cutting programme is not easy to implement without making sacrifices. If – and I make no assumptions here- we can increase any or all of our utilisation, billing rate or realisation, the improvement will be reflected in the net profit of the business.
Small improvements in performance yield big results
Let’s suppose we can increase the average chargeable hours from 1050 to 1100 and at the same time increase the billing rate achieved per hour to R525. This will result in an increase in net profit as follows:
1 Partners 4
2 Total personnel 28
3 Leverage 2/3 77
4 Chargeable hours 30,800
5 Utilisation 4/2 1,100
6 Standard fees 16,170,000
7 Billing rate per hour 6/4 525
8 Net fees 14,391,300
9 Realisation 8/%6 89%
10 Net income 5,180,868
11 Margin 10/%8 36%
12 Net income per owner R 1,295,217
Increase in net income per owner R 117,801
In addition to the ideas I outlined last month, in my series of articles next year I will be looking at a wide range of strategies for nudging up your utilisation, billing rate and realisation.
Increasing your commitment to your clients, the quality of your client service and investing in your own expertise are all key components of enjoying greater rewards from your business. I cannot recall working with any firm where a strong work ethic did not exist, but within some of those firms there were owners who were underperforming and not contributing as significantly as others. Granted, we are all different and performance will vary from one firm to another and from one owner to another, but where there is room for improvement it is important to acknowledge it.
What will you do differently in 2013?
Where do you need to improve your performance in 2013? How can you improve your firm contribution? How can you increase your value to clients?
Although focusing on some of these numbers is important for monitoring and managing your business, the fact is that clients do not buy hours. No one buys time! If you were to survey clients who leave one firm for another they will never say: “I left because I didn’t like their hours.” So, if clients are not buying hours what are they buying? My answer is that they are buying solutions to problems.
Initially this might simply be a need to comply; or there might be other business or personal reasons for their availing themselves of your expertise. How we perform and deliver that service will, to a large extent, determine the client’s perception of our service and value – and their willingness to return for service next time around. In considering how best to deliver a service it is helpful to note the advice of Peter Drucker, regarded by many as the father of management, who stressed the importance of knowledge workers striving to “do the right things” rather than “do things right”.
Drucker goes on to say: “Nothing else, perhaps, distinguishes effective executives as much as their tender loving care of time.” Time is a resource that once expired can never be recovered. Yesterday is gone, but we still have tomorrow and next year. What would it mean to you to plan for 2013 to be your best ever year? Imagine what it would feel like at the end of 2013 to look back on a successful year in which you actually achieved your goals and fulfilled your ambitions!
So take up those inner challenges and record what you wish to do differently this year. Then set out a plan for accomplishing this. You might, for example, enlist the support of a trusted accountability partner who can encourage you and keep you focused on your plans and your execution of them.
Enhancing your skill base
Earlier I expressed my belief that our role as professionals is to provide solutions to problems. Your professional qualifications entitle you to deliver your compliance services, but it is your appetite and capability for developing your own knowledge that determines your ability to occupy a larger space in your clients’ lives.
Last month I suggested embarking on a programme of self-development. This month I would like to recommend a couple of books from my current studies. A friend recently recommended ‘The 100 Best Business Books of All Time’ by Jack Covert and Todd Sattersten, which provides brief overviews of books by authors such as David Packard, Richard Branson, Peter Drucker, W. Edwards Deming, Taiichi Ohno and many others. It’s a great place to start if increasing your understanding of management is on your agenda.
Another book well worth reading is The Reinventors by Jason Jennings. He takes the view that:
“Every business must be constantly and quickly changing…or they’ll eventually find themselves in a downward spiral that will ultimately result in their demise. If a business isn’t growing, the people who want to have more responsibility won’t get what they want when they want it, and they’ll find a reason to leave and pursue better opportunities elsewhere.
Unless a business is constantly undergoing radical change, it will never be able to stay ahead of its customers’ constantly changing wants and needs, and its growth will first falter and then completely stop.”
Responding to change arising from technology or regulation is simply reacting to external drivers, but taking charge of your own firm’s success and destiny is more than staying on top of these drivers – it is also advancing your position by reengineering, or ‘imagineering’ as Walt Disney called it, and planning a future that is exciting and meaningful to you, your team and the community you serve.
To conclude, I would like to extend an invitation that you should also be offering to your own clients – which is for you to provide me with feedback. Send an email to journal@saica.co.za and I will do my best either to respond personally or to incorporate my responses in future articles.
Author: Mark Lloydbottom is an author and consultant to accounting firms.
