P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come APPENDIX 17.3 Advanced Definition of Free Cash Flows for Use in the Enterprise Valuation Method n this appendix, we give readers some general guidelines on how to estimate free Icash flows derived from the financial accounting statements of a business. This guidance will be of practical use when navigating real-life accounting statements. Be aware that these suggestions are not a comprehensive treatment of either cash flow determination or accounting measurements. For more in-depth explanations, especially of advanced topics, we suggest you seek professional accounting advice and consult applicable local accounting rules that are pertinent to your particular business situation and valuation objective. The general accounting principle to keep in mind is that (1) every increase in an asset account (or decrease in a liability account) must be subtracted from the cash flow, and (2) every increase in a liability account (or decrease in an asset account) must be added to the cash flow. Table 17A3.1 depicts a general determination of free cash flows and includes a simplified treatment of operating leases and foreign currency translations. We discuss the treatment of purchased goodwill arising from business combinations in the section called “Accounting for Goodwill.” OPERATING LEASES Operating leases are complex because they require an advanced understanding of financial statements, tax implications of the lease, company depreciation policies, and the actual financing terms of the lease. Professional accounting advice is advisable when confronted with an important leasing decision. Long-term leasing is a form of financing property, plant, and equipment. The lessee is the user of the asset or equipment; the lessor is the owner. From the lessee’s viewpoint, long-term leasing is similar to buying an asset or piece of equipment with a loan secured by the asset or equipment. Thus, long- term leasing is a form of financing. Leases often arise, for example, when a com- pany signs a contract to lease its office space, office equipment, major laboratory From Innovation to Cash Flows: Value Creation by Structuring High Technology Alliances Copyright C 2009 by Constance Lutolf-Carroll¨ with the collaboration of Antti Pirnes. All rights reserved. 1 P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come 2 APPENDIX 17.3: ADVANCED DEFINITION OF FREE CASH FLOWS TABLE 17A3.1 Determination of Free Cash Flow Line No. Item 1 Revenues 2 less Cost of goods sold 3 less Selling, general and administrative expenses 4 less Depreciation 5 less Goodwill impairment or amortization of goodwill1 6 plus Implied interest on operating leases 7 equals Earnings before interest and taxes (EBIT) 8 less Taxes on EBIT 9 plus Any increase (or minus any decrease) in accumulated deferred tax liabilities; or 10 plus Any decrease (or minus any increase) in accumulated deferred tax assets. 11 equals Net operating profits less adjusted taxes (NOPLAT) 12 plus Goodwill impairment or amortization of goodwill∗ 13 equals Net operating profits less adjusted taxes plus amortization for goodwill (NOPLATPA) 14 plus Depreciation expense (including any depreciation expense associated with the capitalized operating leases) 15 equals Gross cash flows 16 less Any increase in working capital; or 17 plus Any decrease in working capital 18 less Capital expenditures 19 less Investment in goodwill 20 equals Free cash flow from operations 21 plus Non-operating cash flows 22 plus Any increase in foreign currency translation adjustments 23 minus Any decrease in foreign currency translation adjustments 24 equals Free cash flows to the enterprise ∗Under current U.S. GAAP, only goodwill impairment is allowed for goodwill arising from business combinations accounted for by the purchase method. (Refer to FASB SFAS 142.) In other countries, local accounting standards may permit goodwill amortization. Sources: Financial Accounting Standards Board SFAS 141R (Revised 2007) and SFAS 142; Tom Copeland, Tim Koller, and Jack Murrin,Valuation: Measuring and Managing the Value of Companies (New York: John Wiley & Sons, 2000), pp. 163–165; George Athanassakos, “Note on the Discounted Cash Flow-Based Valuation Methodology as Tested by a Pub- lic Market Transaction” (IVEY 9B05N021), Richard Ivey School of Business, University of Western Ontario, 2005, pp. 1–24. equipment, or other types of industrial machinery. The major economic benefit of leasing is tax reduction; other benefits might be to minimize transaction costs or reduce uncertainty.1 Accounting rules determine whether a lease is an operating lease that is off-balance sheet (meaning it is not recorded on the balance sheet), or a financial (capital) lease (meaning the financial lease is capitalized). When a finan- cial or capital lease is capitalized, the present value of the lease payments must be calculated and shown alongside debt on the right-hand side of the balance sheet. The same amount must be shown as an asset on the left-hand side of the balance P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come Appendix 17.3: Advanced Definition of Free Cash Flows 3 sheet. This “asset” is then depreciation over the life of the lease. The depreciation is deducted from income, just as depreciation is deducted for any purchased asset. The corresponding balance sheet effect is that both the capitalized asset and debt are reduced by the amount of the depreciation.2 Actually, there are many types of leases, but it is beyond the scope of this appendix to discuss them all in detail. In Table 17A3.1, we treat operating leases from the point of view of the lessee. We are assuming that the company is paying a monthly or annual leasing fee in exchange for the right to use the leased equipment over the life of the contract but does not own the asset. The lessor retains ownership of the equipment. To carry out an enterprise valuation of a company with operating leases, we need to adjust the company’s financial statements and also the free cash flows to treat operating leases as if they were capitalized. The rationale is that operating leases, being a form of debt financing, should be treated the same as capital leases. Recall that in an enterprise valuation, we focus on unleveraged free cash flows (i.e., excluding the effects of financing). For simple operating leases, these six steps are the basic adjustments:3 Step 1. We reclassify the implied interest expense portion of the lease payments from an operating expense (usually found in cost of goods sold, or in selling, general, and administrative expense) to an interest expense. This reclassifi- cation increases earnings before interest, taxes, and amortization (EBITA) by the amount of implied interest. (Refer to line 6 of Table 17A3.1.) Step 2. At the same time, we need to remember to adjust EBITA taxes for the effects of the reclassification done in Step 1. Step 3. Next, we add the implied principal amount of operating leases to the amount of invested capital and to debt. In effect, we are increasing the asset side of the balance sheet at the same time we are increasing the liabilities side of the balance sheet for the capitalized portion of the principal amount of the operating lease. However, these balance sheet adjustments have no net effect on the free cash flows shown in Table 17A3.1, so we do not need to do any adjustments for Step 3 in the table. Step 4. We now add back the depreciation expense associated with capitalizing the operating leases to line 14 in Table 17A3.1. Step 5. Then we treat the principal amount of the lease as additional debt in the weighted average cost of capital (WACC) calculation. (Refer to Chapter 17.) We need to be sure that the WACC incorporates the impact of the leases. Step 6. We add back any surplus cash and then subtract the amount of capitalized operating leases and debt in order to calculate the final equity value of the firm. With operating leases, sometimes it is difficult to estimate accurately their total value. For our example, we wish to estimate the value of an operating lease by capitalizing the stream of lease payments by an appropriate cost of debt. Capitalizing the stream of payments can be done several ways. One approach is to take the current year or next year’s lease payment and divide by the cost of debt (as if it were a perpetual bond or a terminal value with no growth). Another approach is to discount the future minimum lease payments at the company’s marginal borrowing rate. In the United States, accounting rules require the amount of lease payments to P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come 4 APPENDIX 17.3: ADVANCED DEFINITION OF FREE CASH FLOWS be disclosed in the footnotes to the financial accounting statements. Be aware that the present value of the future minimum lease payments may underestimate the value of any leases that management intends to renew. Finally, to estimate the implied interest expense on the operating lease, simply multiply the implied principal amount (the capitalized amount) by the marginal borrowing rate. We show the result on line 6 in Table 17A3.1. Once we have finished making all the adjustments, we then follow the normal procedure described in Chapter 17 to discount the operating free cash flows of the firm by the adjusted WACC to compute the value of the whole firm (entity value).