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Accounting and Business Valuation Methods


Discussion Questions
An employee at a hairdressing salon was banking some cheques and casually
mentioned to the bank manager that starting a business one day was an ambi-
tion. The bank manager said that as the employee had been a long-standing
customer it was likely the bank would be willing to help realise such an ambi-
tion. The hairdresser took this to mean that it was possible to go overdrawn,
not realising that formal arrangements had to be entered into.
A friend offered help to get the hairdresser started by setting up a limited
company. The hairdresser used life savings to buy 51% of the company and
the friend subscribed for the remaining 49%. Overall, 25 000 ordinary shares
with a par value of 25 pence were issued for £1 each. The cost of setting up
the company was £1250 (debited to ˜share premium account™).

On 1 April 2007, the new hairdressing company bought a business for £32 060.
For this money, it took over a shop lease covering the period 1 April 2007 to
31 March 2009, valued at £20 000, fixtures and fittings valued at £9000 and
100 bottles of shampoo valued at £60.
The hairdresser felt confident about the future because many of the customers
said that they would transfer their custom to the new business. Wanting to
live the life associated with being a Managing Director, rather than a mere
employee, the new business owner went out and bought a BMW car for £33 000
and managed to dissuade the garage about the necessity of a bankers™ draft,
paid by cheque.

The next step was to arrange a credit account with a supplier of toiletries, and
an order was placed for 300 bottles of shampoo at a cost of £270, payable on
30 days credit. The shampoo was duly delivered. Having placed this order,
the telephone rang; it was the bank manager who was minded to bounce the
£33 000 cheque for the car on the grounds of ˜insufficient funds™ but would
delay such action if the hairdresser came to the bank straight away.
The hairdresser apologised and asked the bank manager to take into considera-
tion of the fact that it was thought that an overdraft had been agreed. The bank
manager agreed to lend £24 000, repayable quarterly over 4 years at an interest
rate of 8% per annum, calculated on the opening balance at the beginning of
each quarter. Interest would be debited to the account at the end of each quar-
ter. On the matter of the £33 000 cheque, it would be cleared provided it was
agreed that an overdraft interest of £536 and a bank charge of £100, being an
unauthorised overdraft charge, was accepted, both amounts being chargeable

62
Telling the story

at the end of the first quarter. The hairdresser realised that this was the only
option and agreed.

Back at the salon, the hairdresser ordered and received toiletries for use in
the salon, costing £1300, on credit. In the first quarter, business was brisk;
customers paid a total of £31 100 for haircuts and in addition bought 330 bottles
of shampoo for £660. In both cases, the hairdresser received cash.

Before the quarter end, the company had paid an electricity bill of £150, cov-
ering the quarter ended 30 June 2007, and had paid wages totalling £10 000.
The company also paid creditors £1215. On 30 June 2007, stock was physically
counted and valued at £200. At the end of her first quarter, the company owed
£400 in wages and £164 for telephone charges.

The owners of the business believed that goodwill should be amortised over
5 years, fixtures and fittings would last 5 years, but the car should be depreci-
ated over 3 years.

The requirement of this question:
(1) Prepare all the journal entries for the ˜Hairdressing company™ for the
first quarter ended 30 June 2007, ensuring that the entries take account
of amortisation, depreciation, accruals and prepayments.
(2) For the ˜Hairdressing Company™, prepare the Profit and Loss Account
for the 3 months ended 30 June 2007 and a Balance Sheet at that date.




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Capital structure and
basic tools of analysis
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Capital structure and basic tools of analysis

In chapter 2, Amanda™s lawyer introduces her to a financial adviser. Together
they produce a 5-year financial plan that is put to a business angel who agrees
to fund Amanda™s business. This chapter illustrates how small companies raise
capital and how their capital structure changes as they grow. The chapter
concludes by going through the basic tools of analysis that calculate ratios to
try to read between the lines of a company™s published accounts.

The topics covered are the following:



• Venture capital (private equity)
• The Enterprise Investment Scheme (EIS)
• Venture Capital Trusts (VCTs)
• The Alternative Investment Market (AIM)
• Capital structures
• Gearing
• The weighted cost of capital
• The financial planning process
• Deal structures
• The Cash Flow Statement
• Exit strategies
• Basic tools of analysis “ ratio analysis
• The importance of cash and key ratios




Case study “ Amanda™s lawyer introduces
her to a ¬nancial adviser
Amanda™s lawyer explained that he was a corporate lawyer specialised in merg-
ers and acquisitions, over the years he had met hundreds of entrepreneurs and
that most problems were surmountable.

Amanda told her lawyer about her family™s secret recipe for salad dressing and
how her first year had been a disaster nearly wiping out her capital. She had
carried out a self-assessment and concluded that not being able to manufacture
her salad dressing had led to unacceptably low margins, but what made matters
worse was her inability to chase debtors or control any of her assets effectively.
She concluded that she needed to invest in a small factory and employ a

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Accounting and Business Valuation Methods

part-time accountant, but could not see how she could do this given her current
financial position. Amanda also admitted that she had a contract that tied her
into buying in her salad dressing for 5 years.

The lawyer assured her that money itself should never a problem; although the
equity gap still existed, really good businesses with a committed management
team could usually get the funding they required. What was needed was an
investor with experience in the food industry whose contacts would enable the
business to go forward. Amanda was concerned that such an investor would
badly dilute her equity, but her lawyer assured her that a capital structure
could be put in place that would give her the incentive to be able to keep a
reasonable slice of the business. He would look for a suitable investor, but in
the meantime she would need to produce a 5-year plan.

This plan would need to have an executive summary, a brief history of the
business and a schedule showing the management team, their strengths and
the gaps in expertise that needed to be plugged. Next the plan should include
details of the products the company would produce, the markets being served,
an analysis of the competition and what strategy the management had to beat
the competition. The plan should also show risks, rewards, objectives and
milestones. In addition, there should be a detailed finance plan.

Amanda™s lawyer told her that he would introduce her to an accountancy firm
whose chosen adviser would show her how to construct a 5-year plan. Fees
would be constructed so that only a nominal charge would be made, reflecting
basic costs, if things did not work out. However, the opposite side of the coin
was that in addition to the standard fee, a ˜success™ fee would be charged on
completion of any deal. In such a case, fees would be paid by the company out
of the proceeds of the share issue.



Capital structures “ venture capital (private equity)
How companies are structured financially is often debated by academics. Some
argue that the capital structure of the company is determined by the ˜pecking
order™, while others argue that there is an optimum structure. Those favouring
the ˜pecking order™ theory suggest that companies will first use profits to grow
their business, then debt and lastly equity. The optimum structure theorists
argue that it is possible to calculate a debt to equity balance that will maximise
shareholder value.

68
Capital structure and basic tools of analysis

However, reality is often different from the theory. Most businesses in the
United Kingdom are small- to medium-sized enterprises (SMEs) often owned
by families. Many of such SMEs are run on the basis that the objective is to
provide their owners with sufficient profit to enable them to maintain their
preferred lifestyle. Growing the business is not on the agenda as the own-
ers will simply not allow their equity holding to be diluted. Expansion is,
therefore, limited to that that can be generated from profits and an acceptable
level of debt. An acceptable level of debt will be dependent on the personal
view of each owner but the maximum amount of debt will be determined
by the level of security each business is willing or capable of offering their
banker.

So for SMEs, the pecking order theory has to apply. Such companies cannot
determine their gearing ratio (the comparison of debt to equity) as how much
capital they have is determined by how much capital they can get their hands
on. Once the owners of a business have found out how much debt they can
have, they have to make a decision “ do I aim to grow the company and settle
for equity dilution, or do I retain total control of the business and accept limited
growth? Many small business owners opt for the latter and this is given as one
of the main reasons why businesses fail to achieve their growth potential in
the United Kingdom.

Even where equity dilution is accepted, it can be difficult for small businesses
to attract equity capital. What happens is that as businesses grow they need
capital investment on top of higher levels of working capital and cannot offer
sufficient security to meet their escalating needs. In addition, the SME will
not have grown big enough to attract capital on the equity markets. Also, the
cost of raising money on equity markets, together with the additional costs
of meeting the required compliance requested by those markets, means that
below a certain level, such a course of action would not be viable. This was
first discovered in the United Kingdom by the Committee on Finance and
Industry, set up by MacDonald™s Labour government in 1929 and chaired by
Lord Macmillan. This phenomenon became known as the MacMillan Gap or
the Equity Gap.

Nothing much was done to alleviate the Equity Gap until 1945 when the
incoming Labour government set up the Industrial and Commercial Finance
Corporation (ICFC), a state-owned organisation. The setting up of this organ-
isation that eventually became 3i Group plc is described fully in Coopey and
Clarke (1995).

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Accounting and Business Valuation Methods

In this book, they describe the early problems found by ICFC:

In many cases the central problem was that firms could not provide an estab-
lished profit record, so good judgement on the part of the investor was crucial.
In addition, the kind of expansion involved often entailed a high element of risk,
since it meant investing in new, and often unproven products and markets. The
risk was all the more acute because money would be tied up over a long period.
Yet another drawback was that there was little or no secondary market for any
equity which ICFC might take.

What this meant, of course, was that a new paradigm had to be developed
to assess young and growing companies, operating in entrepreneurial markets
with no financial track record. ICFC was (due its size and capital structure)
effectively the start of what is known today as venture capital, or private equity,
although there had been a few privately owned venture capital houses set up
before Second World War.

Despite the progress made by ICFC and others to provide capital for innovative
small companies, by the late 1960s, it was obvious that many had difficulty in
raising the capital needed. A government enquiry was set up and in 1971 the
Bolton Report concluded that the equity gap still existed. The problems were
the same; the bankers were unwilling to take risks, the cost of raising equity
on the capital markets was prohibitive and financial institutions were wary
of SMEs.

In the early 1970s, the incoming Labour government took the view that as the
concept of free markets was not working, they had to improve the deteriorating
economic position through state intervention. So the National Enterprise Board
(NEB) was set up to provide venture capital to innovative SMEs, especially
those set up in areas of deprivation, and to fund state takeover of larger failing
businesses. Unfortunately, it was the latter that fell under media spotlight,
portraying the Labour government of being akin to the then USSR, thereby
putting it on the back foot. This and the ˜winter of discontent™ in the late
1970s led to the Conservatives winning the 1979 general election with Margaret
Thatcher becoming Prime Minister.

In her first term, Margaret Thatcher set out to do away with state intervention
and encourage enterprise, based on free markets. So the NEB was sold off
piecemeal and what was left was split into two and privatised, with Grosvenor
Venture Managers taking over the business in the south of the United Kingdom
and Northern Venture Managers doing likewise in the north.

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Capital structure and basic tools of analysis

ICFC had undertaken many name changes since its formation and in the
early 1990s the business was known as 3i (three i™s, with iii standing for
investors in industry), but it was still state-owned. Privatising the business had
proved difficult over the years, as investors were unsure about investing in
what was seen as a risky option. However, the government took the plunge
in June 1994, pricing the shares at 272 pence, a price that seemed a fair val-
uation given that the net asset value of the business at 31 March 2004, the
year end, had been 315 pence. The first day of dealings had been fixed for
18 July 1994 and soon the price of 3i plc™s shares moved above 300 pence,
allowing the company to join the FTSE 100 on 19 September 1994 (Coopey
et al.).
As ICFC had originally discovered, the big disadvantage for those offering
venture capital was that there was no secondary market, so the investments
could be realised only through a trade sale or flotation on the main stock
exchange. To alleviate these problems, the Conservative government helped
to set up the Unlisted Securities Market (USM) and the Business Start-up
Scheme (BSS). Under BSS, high-rate tax payers could reduce their income tax
liability, but the restrictions placed upon it to avoid mere tax avoidance made
the scheme virtually unworkable. Accordingly, it was replaced by the Business
Expansion Scheme (BES) where both income tax relief and capital gains tax
relief were available.
This government action spurred on the venture capital industry and it led to the
formation of the British Venture Capital Association in 1983. This organisation
has hundreds of members who over the last 20 years or so have invested
over £60 billion to help start-up, expand and buyout over 25 000 companies
(BVCA directory 2004/5). In addition, there is also an European Venture Capital
Association with members providing equity and other capital in the United
Kingdom and rest of Europe.
Over the last 20 years, the tax incentives available to those investing in venture
capital, or private equity, and the capital markets have changed. The BES
has been replaced by the EIS and VCTs, while the USM closed down to be
replaced by the AIM.


The Enterprise Investment Scheme
The EIS was set up to encourage individuals to invest in small, higher-risk
unquoted trading companies and applies to both start-up and established com-
panies. The scheme offers investors a stream of tax incentives if they subscribe

71
Accounting and Business Valuation Methods

to new ordinary shares in such companies. The shares must not carry any
preferential rights to dividends or to the company™s assets on winding up, and
they must not carry any rights to be redeemed.
Only shares issued by companies carrying out a qualifying trade or carrying
out research and development or oil exploration leading to a qualifying trade
will qualify for relief. Most trades qualify, but the following trades do not:
• Dealing in land, in commodities or futures in shares, securities or other
financial instruments
• Financial activities such as banking, money-lending, insurance, debt-
factoring and hire purchase factoring
• Dealing in goods other than in the ordinary trade of retail or wholesale
distribution
• Leasing or letting assets on hire, except in the case of certain ship-
chartering activities
• Receiving royalties or licence fees, except in the case of the exploitation
of an intangible asset created by the company or its group
• Providing legal or accountancy services
• Property development
• Farming and market gardening
• Holding, managing or occupying woodlands, or other forestry activities
or timber production
• Operating or managing hotels, guest houses or hostels in which the com-
pany carrying on the trade has an interest or which it occupies under
licence or any other form of agreement
• Operating or managing nursing homes or residential care homes in which
the company carrying on the trade has an interest or which it occupies
• Providing services to another company in certain circumstances where
the other company™s trade consists, to a substantial extent, of excluded
activities.
(Source: Revenue and Customs Website (2006/2007).)
Subject to the investment being made in a qualifying company issuing qualify-
ing shares, then income relief at the rate of 20% will be given on investments
from £500 to £400,000 in any tax year. This is the relief for 2006/7, but may
be varied each year.
Investments can be made in single companies and also through managed Enter-
prise Investment Trusts, in which case the minimum investment rule of £500
does not apply. In addition to income tax relief, it may be possible to benefit

72
Capital structure and basic tools of analysis

from ˜capital gains relief™ on the EIS investment, ˜capital gains tax deferral relief™
on other investments, together with other tax benefits.

All these tax relief sound good, so what is the catch? Well, the catch is that
there is no tax relief of any description if the investor is connected with the
company. You are deemed to be connected to such company if you are a
director, partner or employee of the company or are entitled to receive any
money from the company apart from goods or services provided on a genuine
commercial basis. If, as an individual, you supplied secretarial, managerial or
other ˜outsourcing™ services, you would be deemed to be connected. You are
also deemed to be connected if you hold more than 30% of the equity of the
company or can effectively influence the way the company is run by virtue of
voting power, assets held or loans given.

However, there is one exception to the above rules and these are those that
are applied to ˜business angels™. A business angel is defined by Revenue
and Customs (EIS Income tax relief, capital gains tax exemption and loss
relief, chapter 3) as ˜an individual who provides managerial, financial or
entrepreneurial advice to small companies.™

To qualify as a business angel, the individual must not have been connected
to the company prior to the investment made or been involved in carrying
on the trade, and subsequently has become a director who receives or is enti-
tled to receive remuneration. Such a person may make further investments
within 3 years of the original investment. This means that apart from a recog-
nised business angel all investors who are entitled to tax relief are ˜betting
blind™.

One objective of this book is to look at things from the perspective of the
ordinary investor. In this context, an ˜investor™ is defined as a person who has
an interest in a particular company either through buying ordinary shares in
it or by being an employee in the company or by providing goods or services
for the company. For each type of investor, the ultimate risk is the same. The
shareholder risks losing his investment, the employee risks losing his job and
consequently his earnings, while the supplier risks losing money through not
being paid for goods and services provided.

In respect of the EIS a potential investor may receive a prospectus. Such a
prospectus will be written by experts and will be very cleverly worded. All the
information that are needed to make an informed decision will be there; it will
likely be accurate but not usually in a format that will be easily understandable.

73
Accounting and Business Valuation Methods

For example, the prospectus might say:

The company is forecasted profitable for 2009 and is rated at 11 times estimated
2010 earnings PBIT (profit before interest and tax). We consider the valuation as
attractive based on the forecasted growth.

We now have to read between the lines. The expression ˜forecasted profitable™
means that at the date of the prospectus, the company was not profitable.
The 11 times earnings may seem attractive because in our mind we have
the word ˜earnings™ and the fact that some quoted companies in the sector
are trading at 27 times earnings. But the word ˜earnings™ means profits avail-
able to ordinary shareholders, that is, profits after interest and tax, but before
dividends.

Obviously, the example prospectus does not give a clue as to what the interest
and tax might be, so the only assumption that can be made is that it will
be consistent with the like for like ratio for the quoted company. If you then
examine the accounts of a quoted company (for example), you might find
that the price/earnings (P/E) ratio, if it were based on ˜earnings PBIT™ rather
than on ˜earnings™, falls to 11.5, very similar to our ˜attractive™ valuation. But,
the quoted company is both profitable and quoted whereas the company in
the prospectus is not profitable and its shares will be illiquid. So we must
apply appropriate discounts of 40% for not being profitable and 25% for being
illiquid. These discount percentages are, of course, based on ˜judgement™ and
other percentages might be equally valid. The point, though, is that some
discounting must be applied to take account of the additional risks being
taken on.

Now by applying a discount of 40% and 25% to the 11.5 times valuation of the
quoted company, assuming that the information in the prospectus is accurate,
we can have a rating of 5.2 earnings. We are asked to pay 11 times earnings, but
if we discount this for the 20% tax relief we will be getting, then we are being
asked to subscribe at 8.8 times, for something realistically valued at 5.2 times.
The conclusion is that the proposed investment is not such a good idea when
analysed properly.

Anyone reading an EIS prospectus should trawl it carefully to see how the
shares in the company have been issued. What sometimes happens is that
shares are originally offered to the directors and sponsors at £1 per share, then
is split one thousand times to become shares of 0.1 pence. Outside investors
are invited to subscribe for the shares at 1.5 pence; what looks like a bargain is

74
Capital structure and basic tools of analysis

anything but. It must be remembered that there is nothing illegal or dishonest
in this, as the information will be accurately supplied in the prospectus. It is
simply a case of ˜caveat emptor™, let the buyer beware.

Another ruse that can be used in raising capital for EIS companies is that the
directors are to be paid a ˜success fee™. Again the exact details will be shown
in the prospectus and the effect needs to be calculated. In one prospectus
where the directors paid the same price for their shares as the general public,
their proposed success fee had a dramatic impact. If they were successful,
they would receive a compound return of 153% over 5 years, while ordinary
investors after tax relief would receive a compound return of a staggering 6.8%
over the same period.

The message is that investors considering investing in the EIS need to tread
very carefully. Each prospectus needs to be examined in great detail, for in
addition to the risk of losing the value of the investment, there is another
trap lurking. It is at least arguable that if an investment is made that turns
out to be extremely imprudent, then Revenue and Customs might reject the
concept of tax relief, because one of the conditions of allowing relief is that
˜the subscription is made for bone fide commercial reasons and not for tax
avoidance purposes™. This leads to the first of the investment rules, but before
we do, we need to define ˜rules™ in this context.



Investment rules
When it comes to investments, there is no rule that can guarantee that by
following it the correct decision will be made. It will always be a matter of
judgement. What the rule will indicate is the likely outcome. In other words,
by following the rule, your chance of success should be better than random,
but there are no guarantees. For example, I might have written:

Rule: No reader of this book will win the jackpot on the National Lottery within
twelve months of buying it.

This rule should be on safe ground because if every reader of this book bought
a lottery ticket twice a week, then there would have to be 140 000 copies of
the book sold before it was likely that we had a jackpot winner. But, of course,
it is possible that the first person to buy the book could win the jackpot with
the first lottery ticket bought after such a purchase. Such an outcome would
be extremely unlikely, but possible.

75
Accounting and Business Valuation Methods

Investment rule 1. Never make an investment where the sole reason for
making such an investment is to obtain tax relief.
Investment rule 2. Never invest in Enterprise Investment Scheme companies
or trusts unless you are skilled in reading prospectuses or unless you are
making the investment on the advice of a professional financial adviser
you are convinced you can trust.


Venture capital trusts
Like the EIS scheme, VCTs were set up to encourage investors to supply finance for
small unquoted higher-risk trading companies. VCT™s were introduced on 6 April
1995 and have to be quoted on the London Stock Exchange to qualify for their
tax status. They can invest in companies carrying on the same trades approved
for the EIS scheme, provided they are independent companies with gross assets
of not more than £7 million immediately before the VCT makes the investment.
This £7 million limit took effect from 6 April 2006 (before this the limit was
£15 million) and of course can change from time to time. The maximum invest-
ment a VCT can make in any one company is £1 million, provided that a single
investment does not represent more than 15% (by value) of its investments.

At least 70% (by value) of a VCT™s investments must be in qualifying invest-
ments, as defined above, and at least 30% (by value) of its qualifying holdings
must be in ordinary shares with no preferential rights. Unlike the EIS scheme,
investments do not have to be in new ordinary shares, but investments are lim-
ited to unquoted companies. However, shares that are bought and sold solely
on AIM or on Ofex (owned and operated by PLUS Market Group plc) count as
unquoted companies.

Provided that a VCT qualifies as such as determined by Revenue and Customs,
an investor is given an income tax relief of 30% (from 6 April 2006, and, as
always, subject to change) on investments of up to £200 000 in any one tax
year. However, income tax relief is available only on new issues of VCT™s shares
and is not available for the existing shares that are traded on the London Stock
Exchange. If, however, shares are sold within 5 years of their purchase, then Rev-
enue and Customs can withdraw all or part of the tax relief previously allowed.
The amount withdrawn is calculated as 30% of the amount received for the
shares, provided the amount withdrawn does not exceed the amount allowed
in the first place. Note that this paragraph applies only to VCT shares bought
on or after 6 April 2006; VCT shares bought prior to this are subject to different
rates and/or rules. There is no income tax due on dividends paid by VCTs.

76
Capital structure and basic tools of analysis

In addition to income tax relief, there is no capital gains tax due on gains
made on VCT™s ordinary shares irrespective of whether they were new shares
or second-hand shares bought on a stock exchange.

A big drawback of VCTs was that the trust had to meet the 70% and 30% rule
defined above within 3 years of issuing its shares. This meant that the trust
managers were forced to make investments that they would not have made
out of choice simply to maintain VCT status. Such investments by their very
nature were more likely to fail, so that some investors saw the value of the
VCT investment fall below the amount they paid, even after taking account of
all the tax savings available to them.

However, this will change from 6 April 2007, as cash held by VCTs will count
as an investment for the purpose of meeting the 70% and 30% rules. VCTs have
the advantage that investments are spread over more companies than would
be the case for EIS, but nevertheless investing in them must be considered a
high risk.

Investment rule 3. Invest only in a VCT where your research indicates that
the fund manager operating that VCT is worthy of support. Never select
a VCT at random simply to get tax relief.


The Alternative Investment Market
The AIM was set up in 1995 to enable trading in new, small and growing
companies. Where private equity providers had invested in what turned out
to be a successful company, AIM offered a means whereby they could realise
their investment. Investing on AIM carries far more risk than investing on the
main stock exchange. There are several reasons for this, including:
• AIM is less regulated than the main stock exchange
• Companies quoted on this exchange will be relatively small
• The stock will be relatively illiquid, so that there will be a significantly
wider spread.

The spread is the difference between the price at which you can buy a share
(the ˜ask™ price) and the price at which you can sell a share (the ˜bid™ price). At
the end of 2006, a random selection of 10 shares quoted on the FTSE 100 gave
a spread range between 0.04% and 0.19%, with an average spread of 0.08%,
whereas a random selection of 10 shares quoted on AIM gave a spread in the
range of 6.67%“40.00%, with an average spread of 16.28%. By and large, the

77
Accounting and Business Valuation Methods

spread is inversely proportional to the price of the share. This means that,
on average, a share quoted on AIM has to gain in excess of 16.5% before the
investor moves into profit. There are tax incentives for investing on AIM, but
given the risks involved, investment rule number 1 has to be remembered.



Capital structures
Companies can raise capital to finance their business from several sources;
equity capital can be provided by institutions, such as pension funds, and
private investors, while debt can be provided by banks, other institutions and
private individuals.

A particular company™s cost of capital will be dependent upon the perceived
risk as judged by the market. Both the investors buying equity and the banks
and others providing debt will require a higher return if they perceive that the
company they are being asked to supply capital for is considered risky.

However, a company™s cost of equity capital is not the same as the investors™
overall expected return buying into that company. Likewise, the company™s cost
of debt capital will not be the same as the expected return of the banks lending
the debt. In both cases, the difference will amount to the cost of ˜risk™. Not
all of the investors™ investments will meet the expected return and banks will
expect that some of their lending will not be recoverable. The only time the cost
of capital is equal to investors™ expected return is when risk-free government
bonds are purchased.

This concept is the same as the principle of insurance. Insurers assess risk and
calculate premiums accordingly. For example, they might charge an eighteen-
year old £2400 to cover a particular car fully comprehensive, but charge a
54-year old only £800 for the same level of cover on the same car in the same
geographical area. The cost of cover for the two individuals is vastly different,
but the insurance company would expect to make the same return on both,
the difference being they would forecast that the 18-year old was more likely
to make a claim.

A company™s cost of equity capital will be equal to investors™ expected return
only where ˜expected return™ is defined as ˜the return required for the investor
to make the investment™. ˜Overall expected return™ can be defined as ˜the net
return the investor expects to make after accounting for the poor investments
in the portfolio.™

78
Capital structure and basic tools of analysis

Equity “ ordinary shares
A private equity provider will expect a compound return ranging from 30%
to invest in management buyouts and established but unquoted businesses to
100% for start-ups. For companies quoted on main stock exchanges, the cost
of capital for an individual company is said to be dependent upon its beta,
as determined by the capital asset pricing model (CAPM). This model was
developed by William F. Sharp and was described in his 1964 paper ˜Capital
asset prices: a theory of market equilibrium under condition of risk™, Journal
of Finance (September 1964). Mr. Sharp won the Nobel Prize in Economics for
his development of the CAPM.

The CAPM states that the expected return from a security is

The risk free rate + (expected return of the market portfolio ’ risk free rate)
— beta.

The beta is a calculation of how a particular share would be expected to move
in line with the market as a whole. If a particular company™s share price was
expected to move in line with the market as a whole, it would have a beta of
1, while if a ±10% movement in the market would result in the share price
moving ±20%, then the beta would be 2.

So, if we assume that the risk free rate is 4.70% and the expected return on the
market portfolio was 14.00%, then the expected return for shares with a beta
of 0.8, 1.0 and 1.5, respectively, would be:

4 70% + 14 00% ’ 4 70% — 0 8 = 12 14%
4 70% + 14 00% ’ 4 70% — 1 0 = 14 00%
4 70% + 14 00% ’ 4 70% — 1 5 = 18 65%

The CAPM is calculated using various economic assumptions, some of which
can be considered dubious from a practical point of view. These assumptions
form the basis of what is known as the ˜efficient market hypothesis™ and include
the following:

• Investors are rational, are risk averse and will assess securities on the
basis of the expected return and standard deviation or variance of return.
• The market is perfect (shares go on a ˜random walk™) and there are no
transaction costs.
• Investors will diversify away unique risk, so only market risk needs to be
considered.

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Accounting and Business Valuation Methods

In his book Where Genius Failed “ The Rise and Fall of Long Term Capital
Management (Harper Collins, 2001), Roger Lowenstein describes how belief in
the efficient market hypothesis led the managers of a fund with the name ˜Long
Term Capital Asset Management™ to lose $3.6 billion. He quotes a senior US
official and a US economist:

Lawrence Summers, at the time a US Treasury Secretary, is quoted as saying,
“the efficient market hypothesis is the most remarkable error in the history of
economic theory” (p. 74).

Robert J. Schiller, an American economist, agreed and dared to suggest that “mar-
kets were too volatile to fit the model of perfect markets” (p. 75).

For some academics, the thought that the efficient market hypothesis is not
valid is simply too much to bear. Lowenstein describes ˜how Eugene Fama,
Scholes™s thesis adviser, devoted the rest of his career to justifying the efficient
market hypothesis™ (p. 74) even though his own research into stock prices
suggested otherwise (p. 71).

Many academics do, however, recognise the importance of human behaviour
with regard to investment decisions and are trying to develop models that take
account of this. However, they are currently outnumbered by the traditionalists,
who argue that mixing finance with human behaviour is effectively mixing
different disciplines. These academics argue, with valid reasoning, that models
developed using invalid assumptions are better than having no model at all.
A model that will give the correct answer 80% of the time must be better than
being in the position where everything is unknown. Otherwise, they question:
how can progress be ever made?

Such reasoning is, of course, perfectly sensible as long as it is appreciated that,
with regard to projecting the future in respect of making investments in stocks
and shares or other forms of gambling in markets buying and selling financial
products, mathematical models are fallible. Occasionally they must give the
wrong answer, and any investor having absolute faith that they will always
give the right answer in the long term, like Long Term Capital Management,
will risk losing everything. However, in perfect or near perfect markets, math-
ematical models will enable the gambler using such models to have a winning
advantage.

In gambling terms, a perfect market is one where human nature cannot have
an impact on the result, such as a spin of a coin, a roll of the dice, the spin
of a wheel or a game of cards. In all these games, the gambler will win in

80
Capital structure and basic tools of analysis

the long term where the odds received on bets are greater than the true odds
(i.e. the true probability) of an event happening and will lose in the long term
where the odds, expressed as a probability, are lower than the true probability
of an event happening. The simplest example is the spin of a coin where the
probability of heads and tails coming up on any spin is 0.5. If a gambler was
offered 6/4 against the chance of a head coming up on the next spin and in
every subsequent spin thereafter, then in the long term he would be guaran-
teed to win. In this case, if the stake was £10, then the expected value (EV)
would be:

EV = (Benefit of winning — probability of winning) ’ (Cost of losing
— probability of losing)
EV = (£15 — 0.5) “ (£10 — 0.5) = £7.50 ’ £5.00 = £2.50

If there were to be 1000 spins of the coin, the expected winnings would be
1000 — £2.50 = £2500. This could be represented as:

500 winning bets, winning £15 = £7500, less 500 losing bets, losing
£5000 = £2500.

Now, the EV simply suggests what is likely to happen, as heads could come
up more than 500 times in 1000 spins and, of course, could come up less than
500 times. What is known is that the more times the coin is spun, the greater
likelihood that the cumulative result will get closer to the probability.

In any game of cards where the full pack is used, the player who can remember
the cards already played and therefore is able to calculate with a fair degree
of accuracy the probability of which cards are about to come up will have a
distinct advantage of playing against a player not having that ability. This is
why some people can make a living playing cards on internet websites, while
the majority of players will lose.

An example of a market that is as near to perfect as it is possible to get is the
horserace betting market. The form of each horse, the rider and the trainer are
known before the start of each race and can be ascertained very quickly by a
click of a mouse at the appropriate website. In addition to this, as the market
progresses, ˜insider™ knowledge, being up to date information known only to
the connections of a particular horse, may become freely available. What can
happen is that as horses are backed, their odds contract, while the odds are
pushed out for those not being backed. In other words, by the off of the race,
the market has reflected what is perceived to be the probability of each horse
winning. Now, bookmakers make a profit by offering odds that are slightly

81
Accounting and Business Valuation Methods

worse than the true probabilities and accordingly, in the long term, they can
expect to win.

The cornerstone of modern financial economic theory is that markets are per-
fect, but it is a simple matter to prove that imperfections in the market make
this supposition unrealistic. For a start, the information available to the mar-
ket place is very complex and is open to different interpretations. The notion
that at any one time the market has priced in the information available to it
about a particular share and that accordingly that share will go on a ˜random
walk™, meaning that it is impossible to tell whether it should go up or down,
is stretching the imagination. Is it really realistic to imagine that as a piece of
information (such as a new set of accounts, or profit warning) hits the mar-
ket, ˜the market™ assimilates it in an instant to arrive at a new ˜correct™ market
price?

What happens is that as a piece of information comes in, the market will react,
but not necessarily in a rational way. Chapter 4 will give actual examples
where advantage could have been taken because ˜the market™ reacted to the
headlines and had not fully studied the detail. The following example illustrates
the point: If interest rates suddenly go up to 2%, the market will panic and
downgrade everything, including companies sitting with millions in the bank
who would likely benefit. Clearly, in this example, the market would correct
the anomaly relatively quickly, nevertheless the quick witted would have had
an opportunity.

In a perfect market, all players have identical information at the same time and
can act upon it accordingly, but to suggest that this can happen in financial
markets is again not realistic. An objective of this book is to show that by
analysing published accounts, private investors can gain an advantage against
the market as a whole. The reason for this is that in the same way that a small
company can be more entrepreneurial than a large conglomerate company,
private investors have the advantage of speed over fund managers who are
often constrained by rules laid down by their employer.

But the real problem is that the financial information is not clear-cut. Even if
it was believed that all investors have the same information available to them
and act upon such information in unison, it will be open to interpretation,
and with investors having different opinions, it all comes down to judgement.
We know that some investors will be rational and risk averse, but we also know
that others will act irrationally and take risks. But there is a further problem;
what will be rational and risk averse to one investor might seem irrational and

82
Capital structure and basic tools of analysis

risky to another. When accounting for human nature, the wisest view to take
with regard to the future is that anything can happen. Even where the market
is in general agreement, it is not possible to forecast which event will force
it into the panic mode with the effect that investors simply follow the crowd
rather than act rationally.

What this means is that neither mathematic models based on economic finan-
cial theory nor an analysis of financial accounts can provide guaranteed results,
but it is argued that the latter by trying to predict the better companies in
the market as a whole has the advantage (if the analysis is correct) of really
eliminating specific risk. Diversification does not, as it is said, ˜diversify away
specific risk™, rather it ensures that bad companies are mixed with good com-
panies to achieve the market mean.

Nevertheless, the CAPM illustrates, correctly, that the expected return will
increase as the perceived risks increases. However the ˜expected return™ should
not be confused with the ˜overall expected return™. It must be remembered that
the return an investor can expect is the ˜overall expected return™ and NOT the
˜expected return™.

The ˜overall expected return™ = ˜Percentage of successful investments —
expected return

The following table illustrates:



Percentage of Expected Overall expected
successful investments return return

Government bonds 100 4.7 4.7
Quoted companies 96 14.0 9.4
Unquoted investments 80 40.0 12.0
(private equity)



Now, even the ˜overall expected return™ will not be accurate in the sense that
actual is very unlikely to equal budget or forecast. Certainly, it is unlikely that
for any given security, the expected return as calculated by the CAPM will
equal the actual.

The CAPM is dependent upon the accuracy of the beta calculation for each
stock, but how accurate this can be is debatable. The beta for each share

83
Accounting and Business Valuation Methods

is calculated by comparing its stock price with the market average over a
significant length of time, but how much a share has moved because of the
market and how much it has moved due to unique events within the company
seem difficult to deduce. If it is assumed that the beta has to be correct and that
any difference in total movement in a share price and that calculated due to the
market is movement due to ˜unique events™, then the CAPM is a self-fulfilling
prophesy.

For example (see Chapter 4 “ The Experiment), Chaucer Holdings plc was
selected as one of the four companies to be backed against a portfolio of 16
companies. On December 2006, this company™s beta was quoted as 0.33, so
(given the expected return of the market portfolio for FTSE Smallcap stocks is
17.5%) the expected return would be: 4 7% + 17 5% ’ 4 7% — 0 33 = 8 92%.

The share started at 60 pence in 2006 and ended the year at 100 pence, and
assuming dividends cover transaction costs, the actual return for the year was
66.67%. Of course, it could have gone the other way, the point being that when
one is trying to predict the future, any formula you use requires a sprinkling
of judgement.

Ordinary shares (new issues) are usually sold by companies at a different
price than that shown on the share certificate. The price shown on the share
certificate will be the ˜par value™ and the difference between this price and the
actual selling price will be credited to the ˜share premium account™. In the EIS
example, with regard to the shares sold to the public, 0.1 pence would go to
˜share capital™ and 1.4 pence would go to ˜share premium™. The cost of a share
issue is usually debited to the share premium account.

Say, for example, a company issues 1 million ordinary shares of 10 pence
for 75 pence and the cost of issuing the shares is £45 000, then the entries
would be:

Debit ˜cash received™ £705 000 (£750 000 less £45 000)
Credit ˜share capital™ £100 000 (1 million shares at 10 pence)
Credit ˜share premium™ £605.000 (1 million shares at 65 pence = £650 000
less £45 000).

The cost of capital for ordinary shares of quoted companies will usually be in
the range of 10%’25%, the actual rate being dependent upon the size of the
company and its credit rating.



84
Capital structure and basic tools of analysis

Preference shares
Preference shares are simply shares that take preference over ordinary shares.
Preference shares are issued with a fixed coupon. For example, a company
issuing 8% £1 preference shares would pay a dividend of 8 pence on every share
each year, provided the company made sufficient profit to do so. If the company
had to pass this dividend (not pay it), then the directors of the company would
not be allowed to pay any dividend on the ordinary shares. No dividend can be
declared on ordinary shares until the preference shareholders have been paid.
Likewise, if the company had to be wound up, ordinary shareholders would
not be entitled to receive a penny until the preference shareholders had been
paid in full.



Cumulative preference shares
A company might have had a bad year and have been unable to pay the div-
idend due on its preference shares, and then follows a brilliant year allowing
it to pay not only the preference dividend but also a bumper dividend on
the ordinary shares. Not surprisingly, under such circumstances, preference
shareholders are likely to feel miffed; so to avoid such a scenario, companies
issue cumulative preference shares. This means that the preference sharehold-
ers must receive ALL the dividends due to them before ordinary shareholders
could be paid. So, if a shareholder holding 6% £1 cumulative preference shares
had not received a dividend for 2 years, in the third year he would have to
receive a dividend of 18 pence per share, before an ordinary dividend could be
declared.

Preference shares can also be varied to carry various entitlements or conditions:

9% Cumulative Redeemable Convertible preference shares:

• Shares are preference shares that carry a 9% fixed dividend.
• If the dividend is not paid in any year, the shareholder is entitled to be
paid a double dividend in the following year, etc.
• Subject to the conditions set down at the time of issue, the company can
redeem (buyback) the shares.
• The company can convert the preference shares into ordinary shares or
debt, as determined by the conditions set at the time of the issue.


85
Accounting and Business Valuation Methods

Debentures
Debentures are loan notes issued by companies that are secured against the
assets of the business, usually in the form of a fixed and floating charge over
all the assets. A debenture will usually be issued for a fixed term, with a
coupon showing the fixed interest rate per annum. The interest rate payable
will usually be a few percentage points over the base rates.


Bonds
Bonds are loan notes that are unsecured. In other words, the bond holder would
be an ordinary creditor, rather than a preferential creditor if the company
were wound up. Where companies have a good credit rating, the bonds are
deemed to be investment-rated bonds, whereas companies have a poor credit
rating, the bonds are known as junk bonds. Investment-rated bonds will pay
interest at an annual percentage rate in single figures, while to attract investors
to take risks, the annual interest rate for junk bonds will often be in double
figures.


Loans
Debentures and bonds will be issued to individuals, whereas loans usually
refer to money lent by banks. Banks will usually lend money this way if
they are preference creditors by having a fixed and floating charge against the
company™s assets. The interest rate charged will vary from one-quarter of 1%
above the bank base rate for large blue chip companies to four percentage
points above the risk-free rate for smaller, riskier companies; so if the risk-free
rate were 5%, a small company might have to pay 9% per annum for a loan.
The objective for the owners of such businesses is to persuade the bank that
they are not that risky as to be placed in this high-risk category. The loans are
usually repaid over a fixed period in instalments, with instalments due every
quarter, half-year or year, as determined by the agreement.


Bank overdraft
In addition to loans, bank will sometimes allow a firm™s current account to be
overdrawn. Bank overdrafts are not usually secured, so carry a much higher
interest rate than for loans. This rate will be determined by negotiation.

86
Capital structure and basic tools of analysis

Hire purchase
Companies that cannot offer sufficient security to be given a loan, or are deemed
to be too risky for the banks to take on, often have to resort to hire purchase
to acquire new assets. In this case, the lender having paid for the asset will
be its legal owner and will ˜hire™ it to the company. There will be a clause in
the agreement that when the company has repaid the principal in full, together
with the cumulative interest, the company can purchase the asset for a nominal
(very small) amount. The interest rate charged under hire purchase agreements
is usually much higher than that charged for loans.



Debtor discounting/factoring
For companies unable to secure a bank overdraft and therefore unable to fund
working capital, an alternative form of funding is debtor discounting or fac-
toring. This is a very expensive option in that the lender buys the company™s
debtors at a heavily discounted rate. The discount demanded will take into
account a very high interest rate, together with an amount to insure against bad
debts. Companies can negotiate a slightly lower rate of discount if they take
on bad debts themselves. Under such arrangements, the lender will pay the
company for the invoice as it is issued, but will then demand repayment, plus
interest, if they are unable to recover the money from the company™s debtor
after a set period of time.



Gearing
Gearing is simply the relationship between debt and equity, with debt being
every source of capital, apart from ordinary shares, which is equity. The point
about ˜gearing™ is that the higher it is (the percentage of debt compared to
the percentage of equity) the higher is the risk. If a company had no gearing
because all of its capital came from equity, then, provided losses in any one
year did not force it to borrow, such losses would not, in themselves, be a
concern. The company would not pay a dividend on the ordinary shares, but
as there is no compulsion to do so, there is no problem.

On the other hand, if a company™s capital largely came from debt, then the
same losses would mean that the company would be unable to pay the interest
on the debt and the company™s creditors could, at their discretion, wind the

87
Accounting and Business Valuation Methods

company up. Of course, this extreme example is unlikely because a company
in this position would be unable to obtain such a level of debt in the first place.
For large established companies that can acquire debt without a problem, one
key decision that must be made is the level of gearing to be aimed at. In other
words, what percentage of equity and what percentage of debt the company
should aim at.
If a company required £1 million of capital and acquired this through having
£400 000 of equity and £600 000 of debt, then gearing would be calculated as
follows:
The ˜gearing percentage™ (traditionally a UK measure) would be 60%
(£600 000 of debt divided by total capital of £1 million).
˜Debt to equity percentage™ (traditionally a US measure) would be 150%
(£600 000 of debt divided by equity of £400 000).
A company is said to be low geared if its gearing percentage is less than 50%
or its debt to equity percentage is less than 100%, while a company is said
to be high geared if its gearing percentage is greater than 50% or its debt to
equity percentage is greater than 100%. Of course, gearing is all about getting
the balance right between debt and equity and the optimum level will differ
from company to company.


The weighted cost of capital
In theory, a company™s cost of capital will be determined by its gearing or
debt to equity percentage. Suppose, for example, the company (as above) had
calculated that its cost of equity was 15% and its cost of debt was 7%, then its
weighted cost of capital would be 10.2%, calculated:

£400 000 at 15% = £60 000
£600 000 at 7% = £42 000
= £102 000 = 10.2%
£1 000 000


Now, given that debt costs less than equity, it must follow that a high geared
company will have lower cost of capital than a low geared company, and this
fact can impact investors™ decision-making processes.
According to financial theory, a company should take on a project where the
expected return from the project is greater than that of the company™s cost

88
Capital structure and basic tools of analysis

of capital. This means that a high geared company might find a project with
a low return acceptable, while a low geared company would need a higher
return. The implication of this is that when an investor is reviewing a particular
company with a view to making an investment, the investor must consider the
risk relative to:

• that associated with the gearing percentage for the company being
reviewed; and
• that associated with the project itself.

The main issue to be considered here is whether or not an individual company™s
cost of capital is the correct benchmark to be used, given the varying levels of
risk associated with different levels of gearing, or whether the cost of capital to
be used when assessing a project should be based on a fixed gearing percentage.
In the latter case, risk would be assessed on the project itself as it would be
assumed that all companies had the same gearing risk. In other words, the
latter calculation would take away the benefit of having a lower cost of capital
for being high geared on the grounds that being high geared carries a higher
risk overall.



Case Study “ Amanda™s meeting her solicitor
and his recommended ¬nancial adviser
Amanda was sat in her solicitor™s office. Also present was the financial adviser
from the firm of Accountants. The solicitor explained that many individuals
and companies providing private equity had grown in financial stature in the
1980s and 1990s, and this had resulted in many private equity firms chasing
larger deals. Accordingly, there had been fewer firms chasing smaller deals,
but at least some of the slack had been taken up by successful entrepreneurs,
turned business angels. It is to these business angels that he will turn to in
order to get finance for Amanda™s fledgling business.

Amanda was advised that when her business plan was complete, her solicitor
would negotiate on her behalf with a business angel for equity and with a
banker for debt. He would be accompanied by her financial adviser throughout
these negotiations, but it had to be this way as both the business angel and the
banker had to agree with the arrangements before the legal contracts could be
drawn up. The financial adviser assured Amanda that no final decision would
be taken without her approval.

89
Accounting and Business Valuation Methods

Once these negotiations were complete, Amanda™s solicitor would form a com-
pany, the new legal entity for the business, in which Amanda would be a
director. He would arrange for the new legal entity, xxxyz Limited, to buy
the assets from Amanda™s business as a sole trader and would prepare all the
legal documentation to account for these transactions. Finally, with agreement
between her and her business angel, he would draw up her service agreement,
or contract of employment.

The first part of the process for generating capital was to produce a business
plan. The financial adviser explained that the finance section of this plan often
meant that a plan Profit and Loss Account, plan Balance Sheet, and plan Cash
Flow Statement had to be produced showing 5 years forward. The first year was
shown by month or by quarter, thereafter years 2“5 would be shown by year.



The ¬nancial planning process
The first part of the financial planning process is to assess the amount of capital
that is required to meet the objectives of the business. Firstly, the total amount
of capital is computed; secondly, how much debt can be arranged is calculated,
given the security the company can offer. The balance is the amount of equity
that would be required.

The first step is to calculate sales (or turnover) and the costs associated with
this turnover. The second step is to work out how much capital expenditure is
needed and when it would be required.

The plan figures for sales would be broken down into sales by product, sales by
customer, etc. Next, costs would be assessed in detail, listing items such as raw
materials, salaries and wages, electricity, repairs, delivery costs, business rates,
legal and accountancy costs, etc. Then, planned capital expenditure would
be detailed and depreciation rates for each class of asset would be agreed.
Figure 2.1 shows the base workings for Amanda™s 5-year plan.

The following lines are where numbers have been inserted following delibera-
tions as discussed in the above two paragraphs:

Line 10: Turnover “ zero rated
Line 11: Turnover “ standard rated
Line 16: Wages
Line 22: Cost of sales “ existing products
Line 23: Cost of sales “ new products

90
Capital structure and basic tools of analysis

E G H I J L M M O P



Amanda Five Year Plan Base estimates for Earnings Statement and Balance Sheet

Prior Year Qu 1 Qu 2 Qu 3 Qu 4 Year 1 Year 2 Year 3 Year 4 Year 5
Line
Number £ £ £ £ £ £ £ £ £ £
Calculation of VAT
770,000
10 480,000 Turnover “ zero rate 150,000 924,000 1,200,000 1,200,000 1,200,000
180,000 200,000 240,000
11 0 “ standard rated 60,000 170,000 230,000 826,000 1,250,000 2,500,000 4,000,000
12 480,000 Total turnover 150,000 180,000 260,000 410,000 1,000,000 1,750,000 2,450,000 3,700,000 5,200,000

14 416,800 Purchases “ zero rate 122,000 146,000 122,000 146,000 536,000 592,120 766,000 766,000 766,000
15 47,300 “ standard rated 10,600 21,200 92,800 134,880 259,480 591,660 942,760 1,862,760 2,812,760
16 12,000 Wages 6,900 6,900 12,000 14,980 40,780 134,980 170,000 250,000 450,000
17 21,489 Depreciation and other non-VAT 1,145 1,146 17,396 17,397 37,084 68,472 67,731 165,988 165,658
18 497,589 Total costs 140,645 175,246 244,196 313,257 873,344 1,387,232 1,946,491 3,044,748 4,194,418

20 (17,589) Profit/(loss) before interest 9,355 4,754 15,804 96,743 126,656 362,768 503,509 655,252 1,005,582

22 384,000 Cost of sales “ existing 120,000 144,000 120,000 144,000 528,000 582,120 756,000 756,000 756,000
23 0 “ new products 27,000 76,500 103,500 413,000 600,000 1,250,000 2,000,000
24 384,000 120,000 144,000 147,000 220,500 631,500 995,120 1,356,000 2,006,000 2,756,000

26 12,000 Cost of sales “ wages 3,000 3,000 8,000 8,000 22,000 75,000 100,000 170,000 250,000
27 6,000 Cost of sales “ rent 1,500 1,500 9,000 9,000 21,000 36,000 36,000 60,000 60,000
28 239 Cost of sales “ other 0 4,000 4,000 4,000 12,000 0 0 0 0
29 18,239 4,500 8,500 21,000 21,000 55,000 111,000 136,000 230,000 310,000

31 402,239 Total ˜cost of sales™ 124,500 152,500 168,000 241,500 686,500 1,106,120 1,492,000 2,236,000 3,066,000

33 18,500 Distribution costs 5,000 7,200 13,000 20,500 45,700 87,500 200,000 364,000 532,000
34 43,600 Administration costs 10,000 14,400 20,800 33,860 79,060 125,140 186,760 278,760 430,760
35 6,250 Depreciation 1,145 1,146 17,396 17,397 37,084 68,472 67,731 165,988 165,658

37 68,350 Total distrbution & administration 16,145 22,746 51,196 71,757 161,844 281,112 454,491 808,748 1,128,418



40 9,411 Operating profit/(loss) 9,355 4,754 40,804 96,743 151,656 362,768 503,509 655,252 1,005,582

42 27,000 Exceptional items 0 0 25,000 0 25,000 0 0 0 0

44 (17,589) Profit/(loss) before interes 9,355 4,754 15,804 96,743 126,656 362,768 503,509 655,252 1,005,582

46 Capital expenditure 650,000 650,000 1,000,000

48 5,000 Van “ depreciation 833 833 834 834 3,334 2,222 1,481 988 658
(3 yr reducing balance)
49 1,250 Fix. & Fittings “ depr. 312 313 312 313 1,250 1,250 1,250 0 0
(4 year straight line)
50 0 New assets “ depr. 16,250 16,250 32,500 65,000 65,000 165,000 165,000
(10 year straight line)

52 Output VAT 0 0 10,500 29,750 40,250 144,550 218,750 437,500 700,000
Input VAT “ purchases (exenses) 1,855 3,710 16,240 23,604 45,409 103,541 164,983 325,983 492,233
53
54 Input VAT (Capital expenditure) 0 0 113,750 0 113,750 0 0 175,000 0

56 Due to (from) Customs & Revenue (1,855) (3,710) (119,490) 6,146 (118,909) 41,009 53,767 (63,483) 207,767



Figure 2.1 Case study “ Amanda “ 5-year plan “ base estimates


Line 26: Cost of sales “ wages
Line 27: Cost of sales “ rent
Line 28: Cost of sales “ other
Line 33: Distribution costs
Line 34: Administration costs
Line 42: Exceptional items “ the figure of £25 000 is the estimated cost for
buying out the 5-year purchasing contract with Zehin Foods plc.
Line 46: Capital expenditure
Line 48: Depreciation on the van, calculated as 33.33% per annum on a
reducing balance basis

91
Accounting and Business Valuation Methods

Line 49: Depreciation on fixtures and fittings, calculated as 25% per annum
on a straight line basis
Line 50: Depreciation on the new assets, calculated as 10% per annum on a
straight line basis
Other rows in Figure 2.1, are calculated using a formula, as below:
With regard to all the formula shown, the following applies:
An ˜asterisk™ means ˜multiply™, so — = — = multiply.
A ˜forward slash™ means ˜divide™, so / = · = divide.
A ˜dot™ means ˜add together™ the full range, i.e. sum(J11.J13) would mean
J11 + J12 + J13.
Where a cell has to be equal to another, the = symbol is used. For example,
Line 131 in column G must equal line 142 in column G, the script would say:
Line 131:
Column G = G142.
In this case, the formula that would go into cell G131 would be: = G142.
With regard to the above line numbers, an amount has been inserted in every
column, except column L. In every case, column L can be calculated as the
sum of columns G through J. So, for example:
L10 = sum(G10.J10)
L11 = sum(G11.J11)
With regard to lines that are computed by formulae, rather than by inserting a
number, column L can be calculated by using either the formula above or any
of the formulae below.
Line 12: On each column it is the sum of line 10 and line 11, so:
Column G = G10 + G11 and column H = H10 + h11, etc.
Line 14: For each of the four quarters, = column on line 22 + £2000 (estimat-
ing quarterly zero-rated supplies other than food to be £2000) and from
year 2 = column on line 22 + £10 000, so:
Column G = G22 + £2000.
Column H = H22 + £2000
Column I = I22 + £2000
Column J = J22 + £2000
Column L = sum(G14.J14)
Column M = M22 + £10 000
Column N = N22 + £10 000, etc.

92
Capital structure and basic tools of analysis

Line 15: Each column is calculated by using the same formula, so:
Column G = G18 ’ sum(G14 + G16 + G17)
Column H = H18 ’ sum(H14 + H16 + H17), etc.
Line 17: Each column is calculated by taking the sum of lines 48“50, so:
Column G = sum(G48.G50)
Column H = sum(H48.H50), etc.
Line 18: Each column is calculated by using the same formula, so:
Column G = G12 ’ G44
Column H = H12 ’ H44, etc.
Line 20: Each column is calculated by using the same formula, so:
Column G = G12 ’ G18
Column H = H12 ’ H18, etc.
Line 24: Each column is calculated using the same formula, so:
Column G = G22 + G23
Column H = H22 + H23, etc.
Line 29: Each column is calculated using the same formula, so:
Column G = sum(G26.G28)
Column H = sum(H26.H28), etc.
Line 31: Each column is calculated using the same formula, so:
Column G = G24 + G29
Column H = H24 + H29, etc.
Line 35: Each column is calculated using the same formula, so:
Column G = G17
Column H = H17, etc.
Line 37: Each column is calculated using the same formula, so:
Column G = sum(G33.G35)
Column H = sum(H33.H35)
Line 40: Each column is calculated using the same formula, so:
Column G = G12 ’ sum(G31 + G37)
Column H = H12 ’ sum(H31 + H37)
Line 44: Each column is calculated using the same formula, so:
Column G = G40 ’ G42
Column H = H40 ’ H42, etc.
Line 52: Each column is calculated using the same formula, so:
Column G = + round((G11 — 0.175),0)
Column H = + round((H11 — 0.175),0)
Column I = + round((I11 — 0.175),0)
etc.


93
Accounting and Business Valuation Methods

Line 53: Each column is calculated using the same formula, so:
Column G = +round((G15 — 0.175),0)
Column H = +round((H15 — 0.175),0)
Column I = +round((I15 — 0.175),0)
etc.
Line 54: Each column is calculated using the same formula, so:
Column G = +round((G46 — 0.175),0)
Column H = +round((H46 — 0.175),0)
Column I = +round((I46 — 0.175),0)
etc.
Line 56: Each column is calculated using the same formula, so:
Column G = G52 ’ sum(G53+G54)
Column H = H52 ’ sum(H53+H54)
Column I = I52 ’ sum(I53+I54)
etc.


Having completed the above workings, with the exception of inserting the figure
for ˜intangible assets™ into the Balance Sheet and inserting stock, debtor and
creditor days into the spreadsheet, the 5-year plan for the Earnings Statement
and Balance Sheet can be completed totally by using formulae.

Figure 2.2 shows the 5-year plan Earnings Statement. The formulae for
Figure 2.2 are shown below. Throughout the 5-year plan Earnings Statement,
each column is calculated using the same formula:


=
Line 68: G12, H12, etc.
=
Line 70: G31, H31, etc.
= G68 ’ G70, H68 ’ H70, etc.
Line 72:
=
Line 74: G33, H33, etc.
= G34 + G35, H34 + H35, etc.
Line 75:
= G72 ’ sum(G74+G75), H72 ’ sum(H74+H75)
Line 77:
=
Line 79: G42, H42, etc.
= G77 ’ G79, H77 ’ H79, etc.
Line 81:
=
Line 83: G161, H161, etc.
= G81 ’ G83, H81 ’ H83, etc.
Line 85:
= G85 — 0.25, H85 — 0.25, etc.
Line 87:




94
E G H I J L M N O P

Amanda Five Year Plan Earnings Statement (Prior to equity investment)

Qu 1 Qu 2 Qu 3 Qu 4 Year 1 Year 2 Year 3 Year 4 Year 5
Line
Number £ £ £ £ £ £ £ £ £

68 Turnover 150,000 180,000 260,000 410,000 1,000,000 1,750,000 2,450,000 3,700,000 5,200,000

70 Cost of sales 124,500 152,500 168,000 241,500 686,500 1,106,120 1,492,000 2,236,000 3,066,000

72 Gross profit 25,500 27,500 92,000 168,500 313,500 643,880 958,000 1,464,000 2,134,000

74 Distribution 5,000 7,200 13,000 20,500 45,700 87,500 200,000 364,000 532,000
75 Administration 11,145 15,546 38,196 51,257 116,144 193,612 254,491 444,748 596,418

77 Operating profit before Exceptional item 9,355 4,754 40,804 96,743 151,656 362,768 503,509 655,252 1,005,582

79 Exceptional items 0 0 25,000 0 25,000 0 0 0 0

81 Operating profit after Exceptional item 9,355 4,754 15,804 96,743 126,656 362,768 503,509 655,252 1,005,582




Capital structure and basic tools of analysis
83 Interest 2,330 1,782 2,075 11,924 18,111 53,508 51,311 55,748 117,830

85 Profit/(loss) before tax 7,025 2,972 13,729 84,819 108,545 309,260 452,198 599,504 887,752

87 Corporation tax 1,756 743 3,432 21,205 27,136 77,315 113,050 149,876 221,938

89 Earnings 5,269 2,229 10,297 63,614 81,409 231,945 339,149 449,628 665,814

91 Preference dividend

93 Earnings available to equity holders 5,269 2,229 10,297 63,614 81,409 231,945 339,149 449,628 665,814


Figure 2.2 Case study “ Amanda “ 5-year plan “ Earnings Statement (prior to equity investment)
95
Accounting and Business Valuation Methods

Corporation tax has been calculated by charging the small company with the
rate of 25% against net profit, or profit before tax. This will be inaccurate for a
number of reasons, including the following:

(1) In later years, the full tax rate of 30% (note that this rate can change
from one year to the next) would apply.
(2) Depreciation is not allowed for corporation tax purposes. Instead cap-
ital allowances at the rate of 25% per annum on a reducing balance
basis are usually allowed, although this rate can be higher in certain
circumstances.
(3) Certain expenditure, such as entertainment, is not allowed for corpora-
tion tax purposes.

The point is that to compute corporation tax accurately, it is necessary to carry
out what can be complex computations. All we are doing here is preparing a
5-year plan with the idea of providing potential lenders with an overview of the
business so that they can make a decision whether or not to become involved
with the company.

Any potential lender reading this plan would realise that if profitability were
better than forecast, then the actual cash available to the company would be
different from that shown.

Line 89: = G85 ’ G87, H85 ’ H87, etc.
Line 91: Will be zero in all columns, but this will change later when the
investment structure has been worked out (see Figure 2.5).
Line 93: = G89 ’ G91, H89 ’ H91, etc.

Figure 2.3 shows the 5-year plan Balance Sheet. The formulae for Figure 2.3
are shown below:

Column E is taken from Amanda™s actual result as shown in Chapter 1.
Where totals appear between two lines, the formula for column E is the
same as that for every other column.
Line 106: The figure in each column is £25 000 and this is the valuation of
the salad dressing recipe. In practice, the value of this intangible asset
would be assessed every year.
Line 108:
Column G = E108 + G46
Column H = G108 + H46
Column I = H108 + I46
Column J = I108 + J46

96
E G H I J L M N O P

Amanda Five Year Plan Balance Sheet (prior to equity investment)

Prior Year Qu 1 Qu 2 Qu 3 Qu 4 Year 1 Year 2 Year 3 Year 4 Year 5
Line
Number Days £ £ £ £ £ £ £ £ £ £

106 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000
Intangible Assets
108 20,000 Tangible assets 20,000 20,000 670,000 670,000 670,000 670,000 670,000 1,670,000 1,670,000
109 6,250 Depreciation to date 7,395 8,541 25,937 43,334 43,334 111,806 179,537 345,525 511,183
110 13,750 12,605 11,459 644,063 626,666 626,666 558,194 490,463 1,324,475 1,158,817
Net tangible assets
515,463 1,349,475 1,183,817
112 38,750 37,605 36,459 669,063 651,666 651,666 583,194
Total net fixed assets
114 20 193,200
95,761 Stock 33,425 36,822 52,932 60,609 60,609 81,753 122,521 168,000
60 969,863
115 118,500 Debtors 98,630 118,356 177,863 289,151 289,151 311,433 438,699 680,137
30,851 1,563,023
116 220 Cash at bank (33,610) (71,706) (846,610) (188,296) (188,296) 206,201 502,870
117 214,481 98,445 83,472 (615,815) 161,464 161,464 599,387 1,064,090 878,988 2,726,086
Total current assets
334,602
119 30 43,200 Creditors 44,204 56,190 75,958 100,104 100,104 105,807 154,006 242,856
51,942
120 (2,380) VAT (1,855) (3,710) (119,490) 6,146 6,146 10,252 13,442 27,879
221,938
121 0 Corporation tax 1,756 2,499 5,932 27,136 27,136 77,315 113,050 149,876
0 0 0 0 0 0
0 Dividends 0 0 0
123 40,820 44,105 54,979 (37,601) 133,386 133,386 193,374 280,498 420,611 608,482
Total current liabilities
125 173,661 Net current assets/(liabilities) 54,339 28,493 (578,214) 28,078 28,078 406,013 783,593 458,377 2,117,604




Capital structure and basic tools of analysis
989,207 1,299,056 1,807,852 3,301,421
128 212,411 Total assets less current liabilities 91,944 64,952 90,849 679,744 679,744

130 743,311 1,571,066
200,000 Less: long term loans 124,265 95,043 110,643 635,924 635,924 713,442 684,143
614,913 1,064,541 1,730,355

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