Chapter 10 Appendix: Illustration of Special Adjustments

Chapter 10 Appendix: Illustration of Special Adjustments

The Chapter 10 Appendix explains some of the special optional adjustments that are available by choosing inputs for rows 158 through 164 of the Comprehensive worksheet of the valuation model. These include adjustments for: (1) LIFO reserve; (2) pension related liabilities; (3) operating leases; (4) incentive stock options; (5) capitalized operating costs; and (6) special goodwill impairment or special charges for accounting changes. The following sections supplement the material in the Chapter 10 Appendix; in particular, they explain how to obtain input data for each of these items and illustrate with data from an actual company. The last section in this document describes a valuation model, Ch 10 Appendix Special Adjustments.xls, that may be used to compare the impact that each of these adjustments has relative to a base case with no adjustments.

LIFO Reserve

Information about LIFO reserves is usually found in the footnotes. For example, on page 31 of Wal-Mart’s 2003 financial statements, a LIFO reserve of $165 million is reported for 2003, and $135 million for 2002. These are the amounts that should be entered in row 158 of the Comprehensive sheet in the valuation model.

Pension Related Liabilities

The only required input for making an adjustment for pension related liabilities is the appropriate implied interest rate. Companies generally use the yield on high-grade corporate bonds (e.g., the yield on AA-rated bonds) as the estimate for this rate.

This is the amount that should be entered in row 159 of the Comprehensive sheet in the valuation model.

Operating Leases

Information about operating leases is usually found in the footnotes. For example, page 40 of Wal-Mart’s 2003 financial statements show:

The Company has agreed to observe certain covenants under the terms of its note agreements, the most restrictive of which relates to amounts of additional secured debt and long-term leases.

The Company has entered into sale/leaseback transactions involving buildings while retaining title to the underlying land. These transactions were accounted for as financings and are included in long-term debt and the annual maturities schedules above. The resulting obligations are amortized over the lease terms. Future minimum lease payments for each of the five succeeding years as of January 31, 2003, are (in millions):

Fiscal Year Ended January 31, Minimum Payments

2004 $ 59

2005 75

2006 60

2007 58

2008 55

Thereafter 230

The objective is to find the present value of the lease payments. Ideally, we would like the actual lease payment in each year, but most companies only report lease obligations for the next five years. Since the actual payments for each year beyond 2008 are not reported, we must estimate them. The payments for the first five years average about $61.4 million per year, and are relatively stable. If we assume that the remaining payments are also in the same range, then dividing the remaining payments of $230 million by the average yearly payment of $61.4 million produces an estimated 3.7 years, which we can round to four years. Dividing $230 million by 4 produces an estimated payment of $57.5 million per year for 2009 through 2012.

Using the approach explained in Chapter 11, Wal-Mart has a cost of debt of about 6%. The present value of the lease payments is:

PV = $408.71 million.

This is the amount that should be entered in row 161 of the Comprehensive sheet in the valuation model. Notice that you must go to previous 10-K statements and make a similar calculation for previous years, since the calculated value of $408.71 million is just for the most recent year.

The company’s interest rate on debt should be entered in row 160.

Incentive Stock Options

Information about incentive stock options is usually found in the footnotes. For example, Microsoft reported the footnotes of its following information in its 2002 10-K report.

Exhibit A-2: Microsoft’s 2002 Option Disclosure
In millions, except per share amounts

Outstanding Options

/

Exercisable Options

Range of Exercise Prices /

Shares

/ Remaining Life(Years) / Weighted AveragePrice / Shares / Weighted AveragePrice
$0.79–$5.97 / 36 / 1.6 / $ 4.83 / 35 / $4.82
5.98– 13.62 / 44 / 0.5 / 11.19 / 42 / 11.18
13.63– 29.80 / 90 / 2 / 15.02 / 84 / 14.97
29.81– 43.62 / 73 / 2.7 / 32.19 / 66 / 32.09
43.63– 60.00 / 191 / 6.9 / 55.81 / 41 / 54.03
60.01– 69.50 / 146 / 6.4 / 66.24 / 35 / 66.53
69.51– 83.28 / 80 / 5.1 / 71.17 / 21 / 71.84
83.29–119.13 / 142 / 4.2 / 89.87 / 47 / 89.29

Although Microsoft has made thousands of different ISO grants, it only reports semi-aggregated data in its footnotes. For example, it has aggregated all of the outstanding options with exercise prices between $0.79 and $5.97. These 36 million shares, shown in the first row above, have an average remaining life of 1.6 years and an average exercise price of $4.83. The value of these options can be estimated using an option pricing model. The file, Ch 10 Appendix ISO valuation.xls, contains a model that can be used to estimate these values. The total value for all of Microsoft’s options is about $18.225 billion.

This is the amount that should be entered in row 162 of the Comprehensive sheet in the valuation model.

Capitalized Operating Costs

Information about capitalized operating cost is usually found in the Investing section of the Statement of Cash Flows. For example, the Statement of Cash Flows of Xerox for 2002 show:

Year ended December 31,
2002 / 2001 / 2000
(in millions)
Cash Flows from Investing Activities:
Cost of additions to land, buildings and equipment / (146) / (219) / (452)
Proceeds from sales of land, buildings and equipment / 19 / 69 / 44
Cost of additions to internal use software / (50) / (124) / (211)
Proceeds from divestitures / 340 / 1,768 / 640
Acquisitions, net of cash acquired / (4) / 18 / (856)
Funds released from (placed in) escrow / 41 / (628) / --
Other, net / (3) / (11) / (20)
Net cash provided by (used in) investing activities / 197 / 873 / (855)

The item labeled “Cost of additions to internal use software” is actually an expense incurred by Xerox in the development of software that it uses. In other words, Xerox “capitalized” these costs (which were primarily personnel costs) instead of showing them as an expense.

These are the amounts that should be entered in row 163 of the Comprehensive sheet in the valuation model.

Special Goodwill Impairment or Special Charges for Accounting Changes

The Statement of Cash Flows for AOL Time Warner for 2002 are shown below (note: the company changed its name and is now known as Time Warner):

AOL TIME WARNER INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
Years Ended December31,
(millions) / 2002 / 2001 / 2000
OPERATIONS
Net income (loss)(a) / $(98,696) / $(4,934) / $1,121
Adjustments for noncash items:
Cumulative effect of accounting change / 54,235 / — / —
Impairment of goodwill / 45,538 / — / —
Depr.& amort. / 3,059 / 8,936 / 443
Amort. of film costs / 2,536 / 2,380 / —
Writedown of investments / 2,227 / 2,537 / 465
Gain on sale of investments / (136) / (34) / (358)
Equity in losses of investee companies / 399 / 975 / $36
Changes in operating assets and liabilities,:
Receivables / 200 / (469) / (84)
Inventories / (2,489) / (2,801) / —
Accounts payable and other / 70 / (1,973) / $996
Other balance sheet changes / (176) / 68 / (668)
Discontinued operations / $265 / 596 / —
Cash provided by operating activities / $7,032 / $5,281 / $1,951

Notice that the statements show a non-cash charge of $54.235 billion for “Cumulative effect of accounting change” and $45.538 billion for “Impairment of goodwill and other intangible assets.” Both of these charges are special write-downs associated with the previous merger of AOL. The merger of the companies led to about $127 billion on the balance sheet account called Goodwill. In essence, this was the amount paid for the acquisition that was above the acquisition’s book value. Since then, the value of AOL deteriorated sharply, and Time Warner wrote down the Goodwill in 2002. In fact, the reported Goodwill for 2002 was only about $37 billion.

If you believe that Time Warner will not repeat mistakes like its merger with AOL, then future projections of capital expenditures should not be unduly influenced by the high level of Goodwill that would result if you did not make this adjustment (recall that the default for the valuation spreadsheet is to ignore amortization and other reductions in Goodwill). To make the adjustment, you should enter the total of the impairment and accounting change (since it was due to the write-down of Goodwill), which is $99.773 billion, in row 164 of the Comprehensive sheet in the valuation model.

Comparing the Impact of the Adjustments

The file Ch 10 Appendix Base Model.xls contains the financial statements of a hypothetical company, because there are few actual companies that would require all of the possible adjustments. By using a hypothetical company that does need the adjustments, it is possible identify the impact of each adjustment.

The Comprehensive sheet shows that all entries for the special adjustments are initially zero. To see the impact of an adjustment, use the Scenario Manager and then look at the results in the sheets for Hist Analys and Proj & Val. For example, to see the impact of an adjustment for LIFO reserves, go to the Excel menu and select Tools, Scenarios. Then select LIFO Adjustment. Then click Show, and then Close. This will insert values for the LIFO Adjustment in row 158 of the Comprehensive sheet. After looking at the resulting changes, you can restore the original values by selecting Tool, Scenarios, Base, Show, Close.

You can create a new worksheet showing a summary of all scenarios by selecting Tools, Scenarios, Summary. We have already done this, so the file Ch 10 Appendix Special Adjustments.xls already has a summary sheet, reproduced below. The first column shows the inputs that are changed for the various scenarios and the resulting outputs, including estimated stock price, NOPAT, Capital, ROIC, and FCF. The second column shows the base case, while subsequent columns show the possible adjustments.

Base / LIFO Adjustment / Pension Adjustment / Lease Adjustment / Stock Option Adjustment / Capitalized Cost Adjustment / Impairment Adjustment
LIFO2004 / 0 / 40,000 / 0 / 0 / 0 / 0 / 0
LIFO2003 / 0 / 30,000 / 0 / 0 / 0 / 0 / 0
LIFO2002 / 0 / 20,000 / 0 / 0 / 0 / 0 / 0
LIFO2001 / 0 / 10,000 / 0 / 0 / 0 / 0 / 0
PensionInt2004 / 0% / 0% / 6% / 0% / 0% / 0% / 0%
PensionInt2003 / 0% / 0% / 6% / 0% / 0% / 0% / 0%
Lease2004 / 0 / 0 / 0 / 90,000 / 0 / 0 / 0
Lease2003 / 0 / 0 / 0 / 100,000 / 0 / 0 / 0
Option2004 / 0 / 0 / 0 / 0 / 110,000 / 0 / 0
CapitalizedCost2004 / 0 / 0 / 0 / 0 / 0 / (30,000) / 0
CapitalizedCost2003 / 0 / 0 / 0 / 0 / 0 / (20,000) / 0
Impairment2004 / 0 / 0 / 0 / 0 / 0 / 0 / 20,000
Impairment2003 / 0 / 0 / 0 / 0 / 0 / 0 / 21,000
NOPAT2004 / 183,664 / 193,664 / 185,104 / 186,904 / 183,664 / 153,664 / 183,664
NOPATAdj2004 / 183,664 / 193,664 / 185,104 / 186,904 / 183,664 / 153,664 / 163,664
Capital2004 / 1,565,281 / 1,605,281 / 1,565,281 / 1,655,281 / 1,565,281 / 1,515,281 / 1,524,281
Capital2003 / 1,435,164 / 1,465,164 / 1,435,164 / 1,535,164 / 1,435,164 / 1,415,164 / 1,414,164
ROIC2004 / 12.8% / 13.2% / 12.9% / 12.2% / 12.8% / 10.9% / 13.0%
FCF2004 / 53,547 / 53,547 / 54,987 / 66,787 / 53,547 / 53,547 / 53,547

The LIFO adjustment increases capital, since inventories are now being recorded at prices closer to their current values. But this reduces the cost of goods sold, resulting in a higher NOPAT. Although these changes cancel out one another in the calculation of FCF, they do improve the reported ROIC, and they change other ratios, namely, COGS/Sales, Inventory/Sales, and the average tax rate. Therefore, making the LIFO adjustment will alter the historical values of these ratios, and has implications for projections of these ratios in the Inputs worksheet, as well as for comparisons of financial ratios between companies that use different inventory accounting methods. Therefore, the adjustment should be made before estimating the key inputs in the Inputs worksheet.

The adjustment for pension related liabilities improves NOPAT, since some pension related expenses are moved out of SGA and into interest expense. This has no impact on capital, but it does improve the ROIC and FCF, resulting in a slightly higher estimated stock price. Note that we were already including the pension-related liability in the long-term debt calculation, but had not included any interest cost for it in the interest calculation. This adjustment corrects the omission. Thus, ignoring adjustments for pension related liabilities would tend to result in an estimated stock price that is biased downwards.

The adjustment for operating leases increases capital, since the leases are now being capitalized. There is a simultaneous increase in debt obligations. Capitalization increases NOPAT, since part of the lease expense is being shifted to an interest expense, but there is also an increase in annual depreciation charges, which partially offsets the reduction in lease expense. The annual depreciation will result in annual reductions in operating capital. The major advantage of making the adjustment is that it reveals more truthfully the relationship between investment levels and sales, between SGA and sales, and gives a more accurate measure of ROIC. This may be very helpful when comparing firms that have significantly different policies with respect to their use of operating leases as an alternative to outright ownership of assets. As when making the LIFO adjustment, adjusting for operating leases will alter the historical values of several ratios, and has implications for projections of these ratios in the Inputs worksheet, as well as for comparisons of financial ratios between companies that have differing leasing policies, so the adjustment should be made before estimating the key inputs in the Inputs worksheet.

The adjustment for incentive stock options doesn’t affect the firm’s operations (i.e., its NOPAT, capital, ROIC, or FCF), but it does increase the claims on the value of operations held by others than the current stockholders, resulting in a lower estimated stock price. Thus, ignoring adjustments for incentive stock options will tend to result in an estimated stock price that is biased upwards. This is a potentially important adjustment for companies that make heavy use of incentive stock options.

The adjustment for capitalized costs increases the reported costs, which reduces NOPAT. However, it also reduces the amount of capital (since the cost is no longer being capitalized). These effects cancel out one another with respect to FCF, but result in a lower ROIC.

The impairment adjustment does not affect FCF, but it does increase extraordinary expenses. The impairment reduces the amount of other operating assets, so it reduces the ratio of other operating assets to sales. Thus, ignoring adjustments for impairment will tend to result in an estimated stock price that is biased downwards, because it is based on an unrealistically high ratio of operating assets/sales. Since ROIC doesn’t include the impact of extraordinary expenses, the impairment adjustment improves ROIC. Of course, this assumes that in the future the company won’t make the same kinds of bone-headed acquisitions that eventually resulted in an impairment charge.