Simon Benninga. Financial Modelling 3-rd edition

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168 Chapter 4

straight-line, both for reporting and tax purposes. We then allow the

deferred depreciation line in the liabilities section of the balance sheet

to grow by the rate of sales growth.

We realize that this is a “cheap out” to a complicated problem, but we

think that the advantages of its simplicity outweigh the disadvantages of

the misrepresentation of the actualities.

Taxes Payable versus Deferred Taxes

Taxes payable arise because of a short-term timing difference in the

reporting of taxes and the payment of taxes, whereas the deferred taxes

discussed in the previous section arise because of a long-term timing

difference in the reporting and payment of taxes. Typically taxes payable

occur because the end of the reporting year differs from the date of tax

payments.

Here’s an example: ABC Corporation (whose ﬁ nancial statements

follow) has reported income of $200 for 2003. The company’s tax rate is

40 percent, and therefore its taxes for the year are reported as $80.

However, the company’s actual tax payments for 2003 are only $60—the

remaining $20 will be paid in January 2004, after the ﬁ scal year ends.

The company reports this information as follows:

•

On its proﬁ t and loss statement it reports taxes as $80. This gives it a

PAT of $120, and since it pays no dividends, this PAT is added to the

accumulated retained earnings in the balance sheet.

•

The difference between the taxes reported and the taxes paid ($20) is

put on the balance sheet as taxes payable. This is a current liability,

meaning that the company anticipates that this liability will come due

within a year.

•

The company’s cash ﬂ ow includes an item for increase in taxes payable.

The cash on the balance sheet grows by the cash ﬂ ow.

169 Building a Financial Model: The Case of PPG Corporation

Some companies report taxes payable and deferred taxes together;

Northrop-Grumman is an example; even though deferred taxes are

usually reported as long-term items, Northrop reports them as a current

liability.

Goodwill

Goodwill is an accounting item that is created when assets of one

company are bought by another company for an amount different from

their book value. To understand this mysterious sentence, consider the

balance sheets of Companies A and B:

ABCDEFG

Sales 1000 Actual taxes paid 60

Costs 500

Depreciation 300

PBT 200

Taxes (40%) 80

PAT 120

Cash flow

PAT 120 <-- =E8

Add back depreciation 300 <-- =E5

Increase in taxes payable 20

Cash flow 440 <-- =SUM(E11:E13)

Balance Sheet

2003

Assets

Cash 0 440 <-- =B19+E14

Other current assets 0 0 <-- =B20

FA at cost 500 500

Accumulated depreciation 0 300 <-- =B23+E5

Net fixed assets 500 200

Total assets 500 640

Liabilities and equity

Current liabilities 0 0

Taxes payable 0 20 <-- =E7-H3

Debt 0 0

Equity

Stock 200 200

Accumulated retained 300 420 <-- =B33+E8

Total liabilities and equity 500 640

Assumptions:

1. All COGS in cash

2. All Sales in cash

3. No new assets purchased

4. No debt repaid or taken out

5. No dividends paid or stock sold or repurchased

2003 Profit & Loss

2002

TAXES PAYABLE

Depreciation is reported

from the shareholder P&L

Cash balances grow by

the cash flow

Accumulated retained

earnings grow by the PAT

from the shareholder P&L

(there are no dividends)

Taxes payable are the difference

between taxes reported in the P&L and

taxes actually paid.

170 Chapter 4

Now suppose that Company A buys all of Company B’s stock. We’ll

consider several scenarios.

Scenario 1

Company A buys B’s assets for their book value and assumes the debts

of B. The purchase price is equal to the book value of equity. There is no

revaluation of any assets (you may have to read on to scenario 2 to

understand this sentence). In this case, Company A pays the shareholders

of Company B $1,050 for their shares. In return, Company A acquires

all the assets of B and assumes responsibility for the current liabilities

and debt of B.

Here’s the resulting balance sheet of Company A after the

acquisition:

BACD

Company

A Company B

Assets Assets

Cash 10,000 Cash 500

Current assets 12,000 Current assets 1,000

Plant property and equipment Plant property and equipment

At cost 10,000 At cost 1,600

Accumulated depreciation -3,000 Accumulated depreciation -250

Net PP&E 7,000 Net PP&E 1,350

Total Assets

29,000

Total Assets

2,850

Liabilities and equity Liabilities and equit

Current liabilities 10,000 Current liabilities 800

Debt 3,000 Debt 1,000

Equity Equity

Common stock 2,000 Common stock 1,000

Accumulated retained earnings 14,000 Accumulated retained earnings 50

Total liabilities

29,000

Total liabilities

2,850

GOODWILL ACCOUNTING

171 Building a Financial Model: The Case of PPG Corporation

Here are some points to note:

•

Cash of A after purchase = Cash of A + Cash of B − Purchase price.

Before the acquisition, A had $10,000 of cash and B had $500. In acquir-

ing B, Company A gets all of B’s cash, but pays $1,050. The total cash

left after the acquistion is $10,000 + $500 − $1,050 = $9,450.

•

Current liabilities, Current assets, Debt of A after purchase = sum of

A + B debt before purchase. The acquiring company takes over the debts

and assets of the acquired company. In this scenario there is no revalua-

tion of the assets—meaning that A values B’s current assets at their book

value of $1,000 and values B’s ﬁ xed assets at their book value of

$1,350.

•

At-cost value of ﬁ xed assets = prepurchase of A + Net ﬁ xed assets of

B. The book value, $1,350, of B’s ﬁ xed assets is their fair market value.

However, in the acquisition this whole amount is booked as a “ﬁ xed asset

at cost.” This means that after their purchase the depreciation of B’s

assets is based on their prepurchase net value (and not on their pre-

purchase at-cost value).

BACD

Purchase price 1,050

Assets

Cash 9,450 <-- =B4+E4-B23

Current assets 13,000 <-- =B5+E5

Plant property and equipment

At cost 11,350 <-- =B8+E10

Accumulated depreciation -3,000 <-- =B9

Net PP&E 8,350 <-- =B30+B31

Total Assets

30,800 <-- =B32+B27+B26

Liabilities and equity

Current liabilities 10,800 <-- =B14+E14

Debt 4,000 <-- =B15+E15

Equity

Common stock 2,000 <-- =B17

Accumulated retained earnings 14,000 <-- =B18

Total liabilities

30,800 <-- =SUM(B36:B40)

Company A buys assets of Company B and assumes B's debt.

Price = Book value of equity

9. This is like a revaluation at the current book value.

172 Chapter 4

•

There is no change in equity accounts of A after purchase from A

before purchase. A’s equity before the purchase was $16,000; this number

doesn’t change in the purchase.

Scenario 2

Company A buys B’s assets for more than their book value and assumes

the debts of B. None of the assets is revalued—Company A considers

that the current assets of B are worth $1,000 and that the fair market

value of B’s plant, property, and equipment is $1,350 (their preacquisi-

tion book value).

Suppose that Company A pays the shareholders of Company B $2,000

for their shares and in return acquires all the assets of B and assumes

responsibility for the current liabilities and debt of B. In this case, the

postacquisition balance sheet will show

•

Cash balances of $10,000 + $500 − $2,000 = $8,500

•

An item called Goodwill of $950. The goodwill is the excess of the price

paid by A over the book value of B’s equity.

BACD

Purchase price 2,000

Assets

Cash 8,500 <-- =B4+E4-B23

Current assets 13,000 <-- =B5+E5

Plant property and equipment

At cost 11,350 <-- =B8+E10

Accumulated depreciation -3,000 <-- =B9

Net PP&E 8,350 <-- =B30+B31

Goodwill 950 <-- =B23-SUM(E17:E18)

Total Assets

30,800 <-- =B32+B27+B26+B33

Liabilities and equity

Current liabilities 10,800 <-- =B14+E14

Debt 4,000 <-- =B15+E15

Equity

Common stock 2,000 <-- =B17

Accumulated retained earnings 14,000 <-- =B18

Total liabilities

30,800 <-- =SUM(B38:B42)

Company A buys assets of Company B and assumes B's debt. Price >

Book value of equity

Assumption: The book

value of B's assets is an

accurate reflection of

their market value.

173 Building a Financial Model: The Case of PPG Corporation

Scenario 3

Company A buys B’s assets for more than their book value and assumes

the debts of B. Some of the assets are revalued. In the following example

Company A considers that the current assets of B are worth $1,200 in

comparison to their preacquisition book value of $1,000 and that the fair

market value of B’s plant, property, and equipment is $1,500 (as opposed

to their preacquisition value of $1,350).

Suppose that Company A pays the shareholders of Company B $2,000

for their shares and in return acquires all the assets of B and assumes

responsibility for the current liabilities and debt of B. In this case, the

postacquisition balance sheet will show

•

Cash balances of $10,000 + $500 − $2,000 = $8,500

•

Current assets of

$$12 1,000 ,

A’s preacquisition

book value of current

assets

↑



2200

A’s valuation

of the fair-market

value of B’s current

assets

↑



= $13,200

•

Fixed assets at cost of $11,500 and accumulated depreciation of

$3,000:

DCBA

Preacquistion

Postacquistion

fair-market value

Total on postacquisition

balance

sheet

Fixed assets at cost

A 10,000 10,000

B (revalued) 1,600 1,500 11,500 <-- =C5+C4

Accumulated depreciation

A -3,000 -3,000

B (set to zero) -250 0 -3,000 <-- =C8+C7

Net fixed assets

A 7,000 7,000

B 1,350 1,500 8,500 <-- =C11+C10

COMPUTING THE FIXED-ASSET ACCOUNTS

174 Chapter 4

ABC

Acquisition price 2,000

Book value of B's equity 1,050

B's current assets

Fair-market value 1,200

Book value 1,000

Excess 200 <-- =B19-B20

B's fixed assets

Fair-market value 1,500

Book value 1,350

Excess 150 <-- =B24-B25

Goodwill 600 <-- =B15-B16-B21-B26

COMPUTING THE GOODWILL

Here’s the whole balance sheet:

•

An item called Goodwill of $600. The goodwill is the excess of the price

paid by A over the book value of B’s equity, minus the undervaluation

of B’s assets. In the case we’re discussing:

175 Building a Financial Model: The Case of PPG Corporation

BADC

Company

A Company B

Assets Assets

Cash 10,000 Cash 500

Current assets 12,000 Current assets 1,000

Plant property and equipment Plant property and equipment

At cost 10,000 At cost 1,600

Accumulated depreciation -3,000 Accumulated depreciation -250

Net PP&E 7,000 Net PP&E 1,350

Total Assets 29,000 Total Assets 2,850

Liabilities and equity Liabilities and equity

Current liabilities 10,000 Current liabilities 800

Debt 3,000 Debt 1,000

Equity Equity

Common stock 2,000 Common stock 1,000

Accumulated retained earnings 14,000 Accumulated retained earnings 50

Total liabilities

29,000

Total liabilities

2,850

B's assets are revalued

Purchase price 2,000

Revaluation of B's assets

Current assets worth 1,200

Fixed assets worth 1,500

Assets

Cash 8,500 <-- =B4+E4-B24

Current assets 13,200 <-- =B5+B27

Plant property and equipment

At cost 11,500 <-- =B8+B28

Accumulated depreciation -3,000 <-- =B9

Net PP&E 8,500 <-- =B35+B36

Goodwill 600 <-- =B24-SUM(E17:E18)-(B27-E5)-(B28-E10)

Total Assets 30,800 <-- =B37+B32+B31+B38

Liabilities and equity

Current liabilities 10,800 <-- =B14+E14

Debt 4,000 <-- =B15+E15

Equity

Common stock 2,000 <-- =B17

Accumulated retained earnings 14,000 <-- =B18

Total liabilities

30,800 <-- =SUM(B43:B47)

GOODWILL ACCOUNTING

Company A buys assets of Company B and assumes B's debt

Price > Book value of equity

Goodwill =

+ Excess of purchase price over

B's BV of equity

- Excess of revaluation of B's

assets over their BV

Under new United States accounting rules adopted in 2002, Goodwill

is not depreciated. It may, however, be decreased. A decrease would

occur if the value of the acquired assets is subsequently “impaired.” For

example, suppose that subsequent to the acquisition, Company A decided

176 Chapter 4

that B’s current assets are really worth $1,100. This asset impairment will

cause a decrease in goodwill by $100.

Minority Interest

When a company owns more than a 50 percent stake in a subsidiary but

does not fully own the subsidiary, the equity not owned is reported as

minority interest. In the following example we compare the consequences

of Company A buying all of Company B and Company A buying 90%

of Company B. Neither company pays dividends.

ABC DEFGH

Profit and loss Profit and loss

Sales 1000 Sales 100

COGS 500 COGS 55

Depreciation 100 Depreciation 8

Interest 50 Interest 2

PBT 350 PBT 35

Taxes 140 Taxes 14

PAT 210 PAT 21

Retained 210 Retained 21

Assets Liabilities

Cash 100 CL 300 Cash 10 CL 30

CA 500 Debt 500 CA 50 Debt 20

NFA 1000 Equity 800 NFA 100 Equity 110

Total assets 1600 Total liabilities 1600 Total assets 160 Total liabilities 160

Profit and loss Assets Liabilities

Sales 1100 Cash 110 CL 330 <-- =D14+I14

COGS 555 CA 550 Debt 520 <-- =D15+I15

Depreciation 108 NFA 1100 Equity 910 <-- =D16+I16

Interest 52

Total assets 1760 Total liabilities 1760

<-- =D17+I17

PBT 385

Taxes 154

PAT 231

Retained 231 <-- =B11+G11

Profit and loss

Assets Liabilities

Sales 1100 Cash 110 CL 330

COGS 555 CA 550 Debt 520

Depreciation 108 NFA 1100 Minority interest 11 <-- =10%*I16

Interest 52 Equity 899 <-- =D16+I16-G35

PBT 385

Total assets 1760 Total liabilities 1760

Taxes 154

PAT 231 <-- =B10+G10

Minority interest 2.1 <-- =10%*G10

Retained 228.9 <-- =B39-B40

Consolidation--90% ownership

MINORITY INTEREST

Company A Company B

Consolidation--100% ownership

Bank Valuation

5.1 Overview

This chapter applies pro forma techniques to the valuation of a

bank. Many of the topics are similar to those in Chapters 3 and 4,

which showed how to build a pro forma model of a ﬁ rm and how to use

this model for the valuation. As in our previous discussion, to do the

valuation we will want to derive the bank’s free cash ﬂ ows (FCF) and

discount them at an appropriate weighted average cost of capital

(WACC).

However, banks have some peculiarities that warrant a separate dis-

cussion. The primary distinction has to do with the deﬁ nition of the FCFs

for a bank. Whereas the FCF for a nonﬁ nancial company excludes all

ﬁ nancial items, the FCF for a bank has to take explicit account of the

ﬁ nancing of the bank’s lending activities. To the extent that a bank

borrows to ﬁ nance its lending, this lending should be part of the bank’s

net working capital. The FCF for a bank therefore includes many of the

ﬁ nancial items that we have excluded in the case of a nonﬁ nancial

company such as PPG (Chapter 4).

This chapter starts with a discussion of the ﬁ nancial statements of a

bank and proceeds to show how to deﬁ ne a bank’s free cash ﬂ ows. We

then illustrate several bank valuation techniques: using the FCFs, using

the residual equity cash ﬂ ows, and using P/E ratios.

5.2 Analyzing Bank Balance Sheets

In this section we analyze the balance sheets of banks using the enter-

prise valuation model of Chapters 3 and 4. Our main point is that many

of the ﬁ nancial items on a bank’s balance sheet should be included in

the bank’s working capital. This practice contrasts with our analysis of

nonﬁ nancial corporations, where we stressed the importance of exclud-

ing the ﬁ nancing items from the enterprise valuation.

5.2.1 The Enterprise Valuation Model for a Nonﬁ nancial Company

We start by reviewing enterprise valuation for a nonﬁ nancial company.

As pointed out in the previous chapters, a good way of thinking about

valuation is through the use of the accounting paradigm, but using market

values. When we create a valuation model for a nonﬁ nancial company,