Contents
Financing (Debt vs Equity) ...................................................................................................................... 2
Brand ....................................................................................................................................................... 6
VALUATION STYLE QUESTIONS ............................................................................................................... 9
Acquisitions ........................................................................................................................................... 19
CSFs and KPIs ........................................................................................................................................ 35
Cyber Security ....................................................................................................................................... 37
Overseas Expansion .............................................................................................................................. 38
Pricing Strategies .................................................................................................................................. 39
Supply chain management and distribution and inventory management. .......................................... 41
Single vs multi supplier ......................................................................................................................... 44
Website views and analysis .................................................................................................................. 45
Research and Development .................................................................................................................. 47
Agreed upon procedures ...................................................................................................................... 50
Sustainability, Corporate Responsibility and Corporate Governance .................................................. 51
,Financing (Debt vs Equity)
Debt vs Equity
Debt:
debt is better for short term financing as it won’t result in a change in control.
+ cheaper to issue
+ no impact on control
+ debt is cheaper than equity’s required rate of return (Kd < Ke)
However, Even if borrowing is available at a lower rate than the required return on equity, this does
not necessarily make it cheaper. Raising more debt will raise gearing. This in turn will increase the
volatility of the residual returns to equity holders making them more risky. This in turn will raise the
required return on equity. In equilibrium, the increase in the return to equity, with the cost of new
debt, will approximately be equal to the weighted average cost of capital.
+ interest payments are not subject to tax
- debt increases gearing, so there is a higher financial risk to equity holders and as such they demand
a higher rate of return (hence, Ke increases). This also increases bankruptcy risk if interest or capital
repayments cannot be met.
- debt isn’t always available – ie. For non listed companies or start ups who cannot provide
securities/collateral. If no security is available, the IR with debt may be higher.
- annual interest is payable which can be difficult for companies with low cash flows.
- can have strict covenants attached, and non-compliance could result in penalties and being unable
to continue operating as a going concern.
Debt choices
- Bank loan (variable or fixed)
- Bond/debentures/loan stock/loan notes
- Overdraft
Bank Loan:
+ Cheap and easy to arrange
+ Interest attracts tax relief
+ Low interest (this is dependent on the levels of security which can be offered).
Best security = land and buildings as they are easy to resell
Worst security = receivables
Low interest rates if the company has a good credit rating and therefore not a high risk
Note that previous IRs offered are not an indication of future IRs as the financial risk may have
changed so IR offered will change to reflect
- Subject to covenants such as interest cover ratio (PBIT/Int) or gearing (D/E or D/(D+E))
- If it is a variable loan, it is impossible to predict the interest payable each year as it moves in line
with LIBOR. This means it is subject to IR risk – as could pay more if interest rates rise.
Could engage in a swap to mitigate this risk, but then won’t benefit if the IR falls.
- Increases gearing which increases financial risk and bankruptcy risk (if capital or interest payments
cannot be met)
- Covenant risk – loans can be subject to covenants which restricts flexibility and can make it difficult
to take out other sources of finance.
- Interest payments need to be met or the bank can recall the loan – this could cause going concern
issues and struggle to continue operating
,- Calculate gearing and interest cover – if this shows risk, may have insufficient debt capacity or
offered high rates
- consider whether there is sufficient PPE to act as security (the carrying amount may only just
exceed existing loans so insufficient, however, there is a chance that fair value exceeds the carrying
amount).
Debentures/loan stock/loan notes/bonds
+ no covenants
+ flexibility with cash flows (irredeemable, redeemable and convertible)
- take longer to issue
Comparing types of finance:
Discuss:
- cost (compare the effective IR)
- maturity date/duration
(i.e, if they are financing a long term investment but the debt is only for a short term, will they have
enough time to generate sufficient cash in the period or will they need to find another source of
finance?)
- repayment (sufficient cash flows to make repayments)
- liquidity
- IR Risk (i.e, for a variable rate loan)
- Gearing (loans/debt increases gearing which increases financial risk and bankruptcy risk if interest
or capital repayments cannot be met)
- Covenants
- security
- hedging (i.e, if investing overseas, an overseas loan can act as natural hedge against FX risk)
- other
- conclusions
Loan notes example
£10m 2% coupon loan notes issued at par, interest paid annually in arrears and redeemable in 4
years at a 30% premium
1
𝐼 𝑅 𝑛
IRR = 𝑀𝑉
+ (𝑀𝑉) − 1 = 8.8%
Year BF Interest (8.8%) Paid (2%) CF
1 10m 0.88 (0.2) 10.68
2 10.68
3
4 (13.2)
In year 1, the Interest charge of 0.88m goes to the P+L, and the balance of 10.68m goes to the SFP
,Flexing Interest rates
If interest rates are paid half annually, it can be flexed for the full year.
12
(1 + 𝐼𝑅) 6 − 1
Overseas finance:
if investing overseas, then it may be worthwhile to take out a foreign currency loan as this acts as a
natural hedge, however, borrowing in an overseas currency could be more risky
Factors affecting decision to finance overseas
- Is the overseas loan subject to tax relief on the interest? Less attractive if no tax relief
- High overseas taxes increases the benefit of tax relief
- Remittance restrictions makes overseas finance less attractive
- FX risk – overseas finance is risky if the exchange rate is volatile
- A parent company may guarantee the debts of a sub so they can borrow more
Overseas expansion
- Knowledge on overseas market, competition, suppliers and customer demands?
- Transportation costs increased if transporting from UK to overseas? Could get an overseas
supplier but need to carry out due diligence and be confident that quality won’t fall
- Transport increases = greater pollution which isn’t sustainable and could affect their
reputation
- Loan in UK or overseas currency? Natural hedge
- Lack of knowledge on laws and regulations
Dividend Policy
Changes to dividend policy
- If the dividend payout % reduces (i.e, b increases), shareholders may be unhappy and it can
signal financial difficulties for the company. This could cause shareholders to sell their shares
and the share price would fall as a result
- Regular communications should be made with shareholders to explain the reason for the
change
, (i.e, the funds are being invested in a new project which is expected to generate higher
returns)
- The company should hold a meeting with shareholders to answer all questions and avoid a
mass selling of shares
- If shareholders are still very unhappy, the company should pursue another source of finance
Financial Reconstruction
1) Estimate liquidation
Break up value of NCAs and CAs X
Any secured liabilities (X)
Remaining cash X
Remaining liabilities (per the SFP/Question) X
Remaining liabilities/remaining cash = amount issued per £1 of liabilities. This is the minimum.
Restructuring needs to offer higher in order to be worthwhile
2) Refinancing scheme in the question
3) Assess stakeholders position
,Brand
Licensing a brand
A license provides a third party the right to use and exploit the asset (brand) belonging to the
licensor. Licenses over brand rights are common. The licensee pays an agreed amount to the
licensor, relating to sales generated on licensed products (i.e, £5 per item), for the right to exploit
the brand.
The total annual payment would be (number of items expected to be sold x payment to licensor per
product). In perpetuity, discounted at the WACC this would equal (x 1/0.1, or whatever r is).
License agreements vary considerably and could put constraints on the licensee. Some will dictate
branding, pricing and marketing, in order to confirm a high quality and reduce the risk of damaging
the brand, but some will leave these decisions to the licensor.
Licensing can be a method of financing rapid growth without having to make an initial investment, as
the licensor will also bring core competencies which the licensee does not have. Any expenditure
that the licensee makes or developments, will enhance the brand and benefit the licensor (with no
cost or time spent via the licensor).
From a financial perspective, there is low risk to the licensor, as this is a new revenue stream with no
operating costs other than setting up and monitoring the agreement (which are likely to be low).
Hence, the profit and profit margins from this agreement should be high.
There is, however, reputational risk. A key issue is whether the licensee will enhance, damage or
have a neutral impact on the brand. They could enhance the brand and this would have a positive
impact on the licensors personal sales aswell as the revenue they obtain from the license (as the
licensee’s volume of sales should increase). However, if the quality of the products is not the same,
this could damage the brand and the licensors sales and competitive advantage. Therefore, it may
be beneficial to have some terms in place to control production quality. A break date or exit route
should be established if the agreement fails or the licensee is not meeting the minimum
quality/controls. The licensor should also consider a minimum volume that the licensee must sell
(hence, guaranteeing a minimum revenue which they will receive)
Purchasing/selling a brand
IFRS 13, Fair Value Measurement, defines fair value as ‘the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date’
The fair value recognised is determined from the perspective of a market participant. The issue of
business integration is relevant to financial reporting measurement. If they intend to acquire the
company’s brand, but not use it, this does not mean that the brand has no fair value, as the
assumption is the highest and best use by a market participant (eg, an alternative buyer of the
brand). If however the company’s management intends to continue to use the acq
uired company brand, then it is entitled to assume that its current use is the highest and best use
without searching for alternatives unless market or other factors suggest otherwise.
The fair value is therefore, in part, dependent on the post-acquisition strategy adopted by the
acquiring company(parent) with respect to usage of the subsidiary’s brand.
,In order to quantify the fair value, IFRS13 has the following hierarchy:
Level 1 inputs are quoted prices in an active market for identical assets. This is not normally feasible
for a brand given its unique nature, so this is not applicable.
Level 2 inputs are other observable prices. This might include prices in markets which are not active.
An offer/bid price would classify as a level 2 input, however, if the bid was rejected – it suggests it is
too low a value and is inadequate.
Level 3 inputs are unobservable inputs, including internal company data
Therefore, the three following basis’ could be used to value the brand:
- Market basis: uses market prices and other market transactions
- Income basis: present value of incremental income generated by the brand
- Cost basis: current replacement cost (PV of advertising expenditure)
Minimum price is higher than the level 2 input (market basis) as this was rejected.
Cost basis has no element of added value above cost so over this is likely to be
acceptable/appropriate value (i.e if cost is £3.5m, a price of around £4.5m-£5m is appropriate).
Due Diligence
The acquisition is likely to be material so due diligence should be carried out prior to acquisition to
mitigate some of the risk. Due diligence can
- confirm the accuracy of the information and assumptions in the valuation
- provide an independent assessment and review of the business
- place the bidder in a better position to value the company
Risks and due diligence
- Bid price may be optimistic and hence risk of overpaying for the company
Examine the appropriateness of forecasts and assumptions
Confirm the valuation of assets
Carry out market research to confirm if the brand/goodwill holds any value
Forecast similar companies to act as a benchmark
- Assets may be overvalued
Confirm the valuation made by experts
Due diligence on valuers and confirm their independence
- Compatibility of the companies operating systems needs to be assessed in regards to
operational, HR and IT due diligence. Integrating the two systems could give rise to further
costs.
- Compare valuations/information with industry norms to test reasonableness (and
reasonableness of assumptions).
Agreed upon procedures
In an agreed-upon procedures (AUP) engagement, the auditors would provide a report of factual
findings from the procedures and tests performed, which need to be agreed with both the licensor
and licensee.
The procedures and tests required should be sufficiently detailed in advance so as to be clear and
unambiguous, and discussed and agreed in advance with both the licensor and licensee, so that the
factual findings are useful and appropriate to the licensing contract.
,When performing an AUP engagement on historical financial information, PHM, as practitioners, are
required, as a minimum, to comply with International Standards on Related Services (ISRS) 4400,
Engagements to Perform Agreed-upon Procedures Regarding Financial Information.
Our report for an AUP will not express a conclusion and, therefore, it is not an assurance
engagement. It will not provide recommendations based on the findings. We would request the
licensor and licensee to review the contract and determine their own conclusions.
A key guide to the procedures that the auditor would carry out would be related to the contractual
terms of the licensing agreement. For example, the number of items sold; the number of customer
complaints about both quality and customer service, the number/% of returns.
The benefit to the licensor of agreed-upon procedures is therefore that it provides evidence for the
board that the licensee is complying with the terms of the licensing contract in identifying,
measuring and attributing all sales. This prevents understating of royalty payments by the licensee
and the monitoring of other contractual terms in a manner that is inconsistent with the licence
contract. Aspects of quality control could also be monitored (eg, customer complaints) to restrict
any reputational damage. This allows the licensor to identify any risk of reputational damage at an
early stage in order to exercise the exit clause and minimise damage early if needed.
,VALUATION STYLE QUESTIONS
Potential company takeover
1) Calculate a price, valuation techniques =
- net asset (minimum price)
- multiple based
- discounted (maximum price)
2) Justify valuation
3) FR impact takeover
- consolidate in group accounts
- use fair value to value net assets and compare to purchase price (GW)
4) Assurance techniques
- market analysis
- comfort over figures in valuation (was this valued by a specialist? Carry out due diligence on
specialist to see if we can rely on these valuations? Confirm the accounting
policies/depreciation police/UEL to ensure that assets are not overstated)
- MV’s verified against a published source (i.e, share price)
- confirm there are no hidden liabilities or arrears contracts
The acquisition is likely to be material, so assurance over a number of aspects of the business would
be beneficial and can mitigate some of the risks. Due diligence can:
- confirm the accuracy of the information and assumptions used in the valuation
- provide the bidder with an independent assessment and review of the business
- identify and quantify areas of business and commercial risk
- give assurance to finance providers
- place the bidder in a better position to value the company
Advantages and disadvantages of acquisition
Advantages Disadvantages
Quicker than organic growth as the company Expensive
comes with goodwill and a customer
base/loyalty
Enables diversification and the ability to spread Can be difficult to find a company to acquire
risk. Quick way to enter new and attractive/fast that is well suited
growing markets
Obtain synergies If entering a new market, may have limited
knowledge on the customer base, competitors
etc which makes it difficult to perform well
Staff members and key personnel could leave
, Need to value the target company to avoid
overpaying and carry out due diligence.
Valuation Methods
Always look at when the company is being acquired. I.e, if mid year (9 months in), only deduct 9
months worth of losses for the year
- Asset Based
Good for: a loss making company, a company that may be liquidated or a company with a lot
of assets
- Net assets (use fair value, not carrying amount, or the book value of equity in the SFP)
for a loss-making company, use fair value of net assets less forecasted losses
for a company entering liquidation, use fair value of assets less any liabilities
- FV adjusted net assets
- Economic Based
- Discounted Earnings. This is not the same as discounted cash flows. For discounted cash
flows, look at free cash flow method
- EVA (this is an alternative way of presenting the FCF valuation approach and gives the same
result)
- MVA
- DCF (discounted cash flow) based
Good for: a company with high future earnings potential (i.e, rapidly growing) or start up
companies.
- FCF
discount rate = WACC, given the MV of debt and the discount rate given = WACC
- FCFE
asked to use the DCF approach and the discount rate = cost of equity
- APV
discount rate given is the unleveraged cost of equity, gearing is going to change over time
(-DVM for MINORITY INTERESTS ONLY)
- Multiple based
Good for: start up companies, or if they provide information about a similar listed company
- P/E
- EBITDA
- Sales
- Operating Profit
Note: the current share price = minimum they are likely to accept, and proposed price (by the
company being sold) is the maximum bid price.
Valuation Pros and Cons
Method +ve’s -ve’s
Multiple/earnings Valuation based on future Profit and loss figure is used and this is
based approach earning potential subject to manipulation as it is affected
(P/E) by accounting policies
Easy to obtain input information
Historic earnings are not always a good
predictor of future earnings
Multiple is based on a similar listed
company, but it can be difficult to find a
