Reorganizing the Balance Sheet Instructors: Please do not post raw PowerPoint files on public website. Thank you! Chapter 7 Reorganizing the Balance Sheet

The Problems with Traditional Financial Analysis Why do we need to reorganize the company’s financial statements? Traditional measures of performance, such as return on equity (ROE) and return on assets (ROA), include nonoperating items and financial structure that impair their usefulness. ROE mixes operating performance with capital structure, making peer group analysis and trend analysis less meaningful. ROE rises with leverage if ROIC is greater than the after-tax cost of debt. ROA and ROE commingle operating and nonoperating items. For instance, ROA includes the return on assets for excess cash, which is quite low (near 3 percent). Companies that hold large cash balances can have artificially low ROAs, even when their operating performance is strong. To ground our historical analysis, we need to separate operating performance from nonoperating assets and the financial structure used to finance the business. LAN-ZWB887-20050620-13749-ZWB

Return on Invested Capital (ROIC) Return on invested capital (ROIC) is calculated by dividing the company’s after-tax operating profits by the amount of net capital all investors have contributed to the company. Return on invested capital is independent of the company’s financial structure. The income statement will be reorganized to create net operating profit less adjusted taxes (NOPAT). NOPAT represents the after-tax operating profit available to all financial investors. After-Tax Operating Profit Invested Capital ROIC = The balance sheet will be reorganized to create invested capital. Invested capital equals the total capital required to fund operations, regardless of type (debt or equity).

FCF = NOPAT + Depreciation + Invested Capital Free Cash Flow Free cash flow is the after-tax cash flow available to all investors: debt holders, preferred stock, common equity holders, and so on. Unlike “cash flow from operations” reported in a company’s financial statement, free cash flow is completely independent of financing and nonoperating items. FCF = NOPAT + Depreciation + Invested Capital ROIC and FCF rely on the identical inputs, NOPAT and invested capital. Thus, valuations based on discounted cash flow (DCF) and on economic profit will lead to identical results.

Reorganizing the Balance Sheet: Invested Capital The accountant’s balance sheet mixes operating and financing items. As ROIC measures operating performance, both the numerator (NOPLAT) and the denominator (invested capital) must separate operating items from financing structure in a consistent manner. Let’s first derive invested capital. We start with the primary accounting identity: Assets = Total Liabilities + Equity Next, separate operating assets (like property, plant, and equipment [PP&E]) from nonoperating assets (like equity investments), and separate operating liabilities (like accounts payable) from financial liabilities (like interest-bearing debt). Operating Nonoperating Operating Assets Assets Liabilities + Debt + Equity + = LAN-ZWB887-20050620-13749-ZWB

Reorganizing the Balance Sheet: Invested Capital By separating line items and rearranging the accounting identity, Operating Nonoperating Operating Assets Assets Liabilities + Debt + Equity + = We can create two new terms, invested capital and total funds invested: Operating Operating Nonoperating Assets Liabilities Assets = Debt + Equity + Invested capital equals operating assets less operating liabilities. Total funds invested equals invested capital plus nonoperating assets. Total funds invested can also be measured by summing debt plus equity! LAN-ZWB887-20050620-13749-ZWB

Reorganizing the Balance Sheet: An Example Let’s rearrange the accountant’s balance sheet into invested capital and total funds invested for a simple company (i.e., a company with only few line items). Prior Current Assets year Inventory 200 225 Operating liabilities Net PP&E 300 350 Accounts payable (125) (150) are netted against Equity investments 15 25 Operating working capital 75 operating assets. Total assets 515 600 Liabilities and equity Invested capital 375 425 Accounts payable Interest-bearing debt 125 150 Nonoperating assets are not included in Common stock 50 Total funds invested 390 450 invested capital. Retained earnings 115 Total liabilities and equity Reconciliation of total funds invested Interest-bearing debt Accountant's balance sheet LAN-ZWB887-20050620-13749-ZWB

Invested Capital: Operating Perspective Operating assets include current operating assets (working cash, accounts receivable, inventory, prepaid expenses), along with PP&E and net other long-term operating assets. Include capitalized leases and R&D as operating assets. Operating Assets − Operating liabilities include non-interest-bearing current liabilities; the most common are related to suppliers (accounts payable), employees (accrued salaries), customers (deferred revenue and customer advances), and the government (income taxes payable). Operating Liabilities = Invested Capital + Nonoperating assets include excess cash, marketable securities, notes receivable, prepaid pension assets, nonconsolidated subsidiaries, and other equity investments). Nonoperating Assets = Total Funds Invested Total funds invested from an operating perspective. LAN-ZWB887-20050620-13749-ZWB

Why Separate Nonoperating Items? Evaluation by parts: A good analysis will separate accounts with different performance characteristics. For instance, excess cash will typically have much lower returns than operating businesses. Total Asset Base 14% 3% 0% Core Operations Excess Cash Equity Investments 9% 17% Nonoperating Assets Unit A Unit B

How Much Cash Is Excess Cash? Method 1 Excess of 2% of Revenues Comments Requires only firm-specific information, but doesn’t handle differences in firm characteristics or current market environment. Method 2 Excess of Industry Median or Average Data intensive (requires data for many firms), but handles industry-specific characteristics and differences across time. Be careful—the average can be affected by an asset sale at an industry rival (industry average will rise following sale). Method 3: Regression Regression of Log(Cash/Noncash Assets) on Independent variable Beta T-Stat Intercept −1.921 82.89 Market/book 0.137 27.11 Real size −0.046 15.09 Cash flow/assets 0.171 4.71 Working capital/assets −0.754 29.04 Capital expenditures/assets 0.570 8.77 Total debt/assets −0.301 101.44 Industry cash flow volatility 0.106 1.77 R&D/sales 1.776 21.02 Dividend dummy −0.100 8.94 Regulation dummy −0.010 0.23 Number of observations 87,117 Adjusted R-squared 18.69% Source: T. Opler, L. Pinkowitz, R. Stulz, and R. Williamson, “Corporate Cash Holdings,” Journal of Applied Corporate Finance 14 (2001): 55−67.

Invested Capital: Financing Perspective Debt Equity Equivalents Debt Equivalents + Equity = Total Funds Invested Debt includes all interest-bearing debt from banks and public capital markets. Debt equivalents include off-balance-sheet debt and one-time debts owed to others that are not part of ongoing operations (e.g., severance payments as part of a restructuring, an unfunded pension liability, or expected environmental remediation following a plant closure). Equity includes original investor funds (common stock and additional paid-in capital, net of treasury stock repurchased), investor funds reinvested into the company (retained earnings and accumulated other comprehensive income), and investor funds to be paid out shortly (dividends payable). Equity equivalents include accounts that arise because of noncash adjustments to retained earnings; they are similar to debt equivalents but are not deducted from enterprise value to determine equity value (e.g., most deferred-tax accounts and income-smoothing provisions). Total funds invested from a financing perspective. LAN-ZWB887-20050620-13749-ZWB

Reorganizing the Income Statement: NOPLAT Net operating profit less adjusted taxes (NOPLAT) is the after-tax operating profit available to all investors. NOPLAT equals revenues minus operating costs, less any taxes that would have been paid if the firm held only core assets and was financed only with equity. Unlike net income, NOPLAT includes profits available to both debt holders and equity holders. In order to calculate ROIC and free cash flow properly, NOPLAT should be defined consistently with invested capital. For instance, if a nonoperating asset is excluded from invested capital, any income from that asset should be excluded from NOPLAT. LAN-ZWB887-20050620-13749-ZWB

Reorganizing the Income Statement: NOPLAT NOPLAT includes only operating-based income. Unlike net income, interest expense and nonoperating income are excluded from NOPLAT. Current year Revenues 1,000 Operating costs (700) Depreciation (20) Operating profit 280 Interest Operating taxes 1 (70) Nonoperating income 4 NOPLAT 210 Earnings before taxes (EBT) 264 Do not include income After-tax nonoperating income 3 from any asset excluded Taxes (66) Income available to investors 213 from invested capital as Net income 198 part of NOPLAT. Reconciliation with net income Treat interest as a After-tax interest expense 15 financial payout to investors, not an expense. Accountant's income statement Taxes are calculated on operating profits. LAN-ZWB887-20050620-13749-ZWB

Devil in the Details: Operating Income Hasbro Inc. 10-K Disclosure Management Discussion and Analysis (MD&A) International segment operating profit increased significantly by 54% to $140,784 in 2004 from 2003. International gross profits and operating profits were positively impacted by the cessation of manufacturing at the Company’s Valencia, Spain facility at the end of 2003. [Gross profit] in 2003 included cash charges of approximately $18,400 associated with severance related to this cost reduction initiative. The improvement in operating profit in 2004 over 2003 was also due to lower royalty expense primarily from decreased sales of BEYBLADE, which was partially offset by an increase in advertising expense as a result of the Company’s ongoing initiative to raise awareness of its core brands. Hasbro Inc. After-tax operating profits $ million 2005 2006 2007 2008 2009 Net revenues 3,087.6 3,151.5 3,837.6 4,021.5 4,067.9 Cost of sales (1,286.3) (1,303.9) (1,576.6) (1,692.7) (1,676.3) Gross profit 1,801.4 1,847.6 2,260.9 2,328.8 2,391.6 Royalties (247.3) (169.7) (316.8) (313.0) (330.7) Product development (150.6) (171.4) (167.2) (191.4) (181.2) Advertising (366.4) (369.0) (434.7) (454.6) (412.6) Selling and administrative (624.6) (682.2) (755.1) (797.2) (793.6) Operating profit (EBITA) 412.6 455.3 587.1 572.6 673.6 Include only those expenses that are related to ongoing core operations.

Determining Operating Taxes Find and convert the tax reconciliation table. Search the footnotes for the tax reconciliation table. For tables presented in dollars, build a second reconciliation table in percentages, and vice versa. Data from both tables are necessary to complete the remaining steps. Determine taxes for “all-equity” company. Using the percent-based tax reconciliation table, determine the marginal tax rate. Multiply the marginal tax rate by adjusted EBITA to determine marginal taxes on EBITA. Adjust “all-equity taxes” for operating tax credits. Using the dollar- based tax reconciliation table, adjust operating taxes by other operating items not included in the marginal tax rate. The most common adjustment is related to differences in foreign tax rates.

Operating Taxes: Step 1 Start by converting the reported tax reconciliation table to percentages. To convert a line item from dollars to percent, divide the line item by earnings before taxes ($3,590 million in 2008). Earnings before taxes are reported on the income statement. $ million 2004 2005 2006 2007 2008 Income taxes at statutory rate 2,769 3,249 3,258 2,317 1,257 State income taxes, net of federal 215 279 261 196 92 Foreign rate differences (17) (10) 5 − Other, net (25) (51) 23 (103) (71) Reported taxes 2,911 3,444 3,547 2,410 1,278 Earnings before taxes 7,912 9,282 9,308 6,620 3,590 percent 35.0 2.7 3.0 2.8 2.6 (0.2) (0.1) 0.1 (0.3) (0.5) 0.2 (1.6) (2.0) 36.8 37.1 38.1 36.4 35.6 Source: Home Depot 2008 10-K, note 6. Tax reconciliation Step 1: Reformat tax reconciliation table

Operating Taxes: Step 2 Next, use the percentage-based tax reconciliation table to determine the marginal tax rate. You can use the company’s statutory rate plus state or local taxes to calculate a proxy for the marginal rate. In 2008, Home Depot paid 37.6 percent in federal (35.0 percent) and state (2.6 percent) taxes. Use this marginal rate to compute taxes on adjusted EBITA. In 2008, taxes on adjusted EBITA equaled $1,820 million (37.6 percent times $4,845 million in EBITA).

Operating Taxes: Step 3 After computing taxes on adjusted EBITA, search the dollar-based reconciliation table for other operating taxes. For Home Depot, the only operating taxes paid beyond marginal taxes were foreign rate differences. In 2006, foreign rate differences resulted in $5 million of additional operating taxes. Therefore, increase taxes on adjusted EBITA by $5 million to determine operating taxes in 2006. Operating taxes 2004 2005 2006 2007 2008 Step 2 Marginal tax rate 37.7% 38.0% 37.8% 37.6% × Adjusted EBITA 8,214 9,731 10,231 7,787 4,845 = Marginal taxes on EBITA 3,098 3,698 3,868 2,956 1,820 Step 3 Other operating taxes (17) (10) 5 − 3,081 3,688 3,873

Free Cash Flow Free cash flow is the after-tax cash flow available to all investors: debt holders and equity holders. Unlike “cash flow from operations” reported in a company’s annual report, free cash flow is independent of financing and nonoperating items. Current year Net income 198 NOPLAT 210 Depreciation 20 Decrease (increase) in inventory (25) Gross cash flow 230 Increase (decrease) in accounts payable 25 Cash flow from operations 218 Subtract investments in operating items from gross cash flow. Capital expenditures (70) Decrease (increase) in equity investments (10) Free cash flow 160 Cash flow from investing (80) After-tax nonoperating Income 3 Evaluate cash flow from Increase (decrease) in interest-bearing debt nonoperating assets Increase (decrease) in common stock − Cash flow available to investors 153 separately from core operations. Dividends (113) Cash flow from financing (138) Reconciliation of cash flow available to investors After-tax interest 15 Treat interest as a financial payout to investors, not an expense. 113 Accountant's cash flow statement

Advanced Issues Capitalizing Research and Development (R&D) If a company has significant long-term R&D, do not subtract the annual R&D expense. Instead, capitalize R&D on the balance sheet and subtract an annualized amortization of this capitalized R&D. Capitalizing Operating Leases If a company has significant operating leases, capitalized the operating leases on the balance sheet and add back lease-based interest to operating profit. Convert the remaining rental expense to depreciation. Excluding Recognized Pension Gains and Losses Pension gains and losses booked on the income statement are usually hidden within cost of goods sold. Remove any recognized gains or losses from NOPLAT. Unrecognized gains do not flow through the income statement, so no change is required for unrecognized gains. LAN-ZWB887-20050620-13749-ZWB