Free Cash Flow Introduction Training

Cash Flow Initiatives - Free Cash Flow Forecasting (Session 1)

Session Objectives

 Put the Cash flow Initiatives and today’s seminar into the context of ABB’s objectives and the overall implementation process  Describe completion of the WACC project  Discuss immediate priorities and longer-term roadmap

“Value management allows ABB to define and deliver strategies that are linked to shareholder return. It integrates value planning and reporting systems and links value-oriented decision making with employee compensation systems that reward value creation. Investment decisions are no longer only based on traditional accounting measures like payback, profitability ratios and returns on capital. Now we also take into account business-specific targets for exceeding the cost of capital, a critical economic benchmark against which to measure expected future cash flow. Many of these ideas are not new. We have touched on all of them through past initiatives. Now we have a process in place for managing value drivers and measuring our performance. We are also instilling more economic responsibility and foresight into our daily thinking. We are confident that, over the long term, this approach will create much more value, not just for shareholders, but for all those who have an interest in ABB’s success.”

Ashraf Hussein, BA FC ABB EGTCH Annual Report 2000 Operational Review

How the Market Values ABB Corporate Value Net Debt

Market Value of Equity 36 BUSD

Free Cash Flow

Now

2000

Free Cash Flow

2001

Free Cash Flow

2002

Free Cash Flow

Future

2003

Discounted by Cost of Capital (WACC)

Weighted Average Cost of Capital (“WACC”)  Calculated as: (% Debt x After-tax Cost of Debt) + (% Equity x Cost of Equity)

 Where: % Debt = Interest-bearing debt as a percentage of total capitalization % Equity = Market capitalization as a percentage of total capitalization

Cost of Capital  The market discounts ABB’s total Free Cash Flow using a cost of capital that reflects ABB’s average cost of debt and cost of equity  But -- the group is made up of different BAs, with widely different risks and therefore different required returns  To increase shareholder value for the group, each BA needs to earn more than its individual cost of capital on a standalone basis

Cost of Capital Application  Each BA needs to know its specific cost of capital, which should be used as a benchmark/discount rate for:  investment evaluation  acquisition/disposal valuation  strategic plan assessment  eventually - historical performance measurement

WACC Calculation Steps 



Established individual “virtual”(standalone) capital structure for each BA using peer group averages Used CAPM to calculate cost of equity for each BA estimated risk-free rates for 50 countries estimated MRP (stock index regression against US index) for 50 countries identified peer group for each BA, calculated levered beta and local currency cost of equity for each peer company, unlevered and relevered cost of equity to BA target capital structure converted relevered peer group company cost of equity to common currency and averaged to BA cost of equity

 

Used multiple regression where “good” peer groups not available Rated each BA as standalone credit to get pre-tax cost of debt

WACC Project Results  Project completed, with WACC computed for 35 BAs in 50 countries

– AFS will use cost of equity, not WACC, because debt is “working capital” for them  WACC used to discount local currency, after tax free cash flows to present value  WACC matrix has now been distributed to all BAs and major countries, and the A&RG investment analysis model updated to apply WACC instead of ROCE

WACC in Practice  WACC is the minimum return required by providers of capital (shareholders, banks)  To increase shareholder value by 15% p.a. (in USD terms), each BA has to earn more:

Target IRR: WACC plus 6%, on average  On average, all projects should earn target IRR -- and every investment should at least earn WACC  Risk analysis will be incorporated in free cash flow projections -Best Case, Base (most likely) Case, Worst Case scenarios -not in discount rate

Risk incorporated in projection scenarios

Present Value

Investment

NPV

Now

Free Cash Flow Free Cash Flow

1999

2000

Free Cash Flow

2001

Free Cash Flow

2002

Discounted by WACC If NPV<0, √ fix, √ sell or √ close If NPV>0, business earns more than WACC (minimum return) If IRR = WACC, PV = invested capital (minimum return) If IRR>WACC by 6%, business earns target return

Future

Consequences: VBM  Change to

– Free Cash Flow culture – Portfolio management discipline – Value Based Management  Discounted free cash flows/IRR will take precedence over other investment approval criteria (IBT, payback, goodwill, etc.)  Must improve accuracy of free cash flow projections -- they are the base to measure value creation. Actual performance will now be compared with original projections, to achieve accountability

Segment Valuation

Portfolio Analysis 5

Portfolio Analysis Group Valuation

Value Driver Targets & Strategic Actions 7

6

BA Valuation 4

Optimal Capital Structure

Strategic Actions & KPIs 1

Cash Flow Forecasts 3 WACC

2

Cash Flow Initiatives - road map  Sequence and timing of Cash Flow Initiatives:  Cash Flow Forecasts: May 2000 • Long-term (5 years + residual value) • Optimistic, pessimistic, most likely scenarios • Influence of external factors

 BA Valuation: June 2000 • What is the business worth today? • Growth, Margins, Investment in Fixed and Net Working Capital, R&D, Marketing - which are most important? • Which businesses are not earning WACC? ∀ √ Sell,√ Fix, √Close

Cash Flow Initiatives - road map....cont’d  Implied Performance Check: • Is the performance implied by the forecasts achievable? • Handshake with Segment, companies

 Value Creation/Driver Targets: • How can cash flow -- and value -- be maximized? • What targets should be set for the most important value drivers?

 KPI’s/Actions: Strategic Plan 2001 • What actions should be taken to achieve the new value driver targets?

ABB’s Cash Flow Initiatives will deliver in Phase I:  Objectives • Initiate the transformation to a culture focused on cash flow generation • Widespread understanding and use of cash flow forecasting and valuation techniques for business analysis and managerial decision making • Introduction of new group software tool for Free Cash Flow Forecasting and Valuation Analysis

 Deliverables • Extraction and mapping of ABACUS/US GAAP into R1 • Free Cash Flow forecasts and valuations for targeted BAUs

Cash Flow Initiatives Training Conceptual (one day) Mapping (one day) MAPPERS (Company Controllers or appointed) Map Consolidation Reconciliation Check

Conceptual (one day) Forecasting (two days) FORECASTERS (BA/BAU Controllers) 1st Forecast

Follow up with Cash Flow Initiatives support network

Conceptual (one day) Country Managers Country CFO Conceptual (one day) BA Managers Implied Performance Check

3 Scenarios

Sign Off

Course Outline  Session 1: Free Cash Flow Forecasting  Where Cash Flow Initiatives fit in with the overall VBM Process  Roadmap of component projects/actions steps  Project responsibilities, objectives, tools and deliverables  Course objectives and post –course reinforcement action steps

 Session 2: Introduction to Valuation  Understanding the principles, not just the formulas  Overview of the valuation process  Valuing components of ABB-consolidation and elimination levels  Separating operating, non-operating, and financing activities  Taking a long term perspective  Decisions require making timing trade-offs between lower Free Cash Flows in one period (Investment) and higher Free Cash Flows in other periods (Returns)

 Session 3: Free Cash Flow  Defining and modeling Free Cash Flow: Direct versus Indirect  How to estimate Free Cash Flow factors  What’s new? – Key similarities with/differences from ABACUS/US GAAP  Cost versus Expense  Sustaining Investment versus Expansion Investment

 Session 4: Value Factors  Linking Free Cash Flow/valuation analysis to decisions and actions designed to change that value  How to compute and interpret ABB’s Value Factors

 Session 5: Residual value  Value realization versus value recognition  Value Growth Duration and sustainability of competitive advantage  Using the ABB 2-stage approach to estimate residual value

 Session 6: Business Valuation  A 5-step process for estimating business value  Estimating and understanding each valuation factor  Selecting the appropriate WACC  Coping with pension fund liabilities, contingent liabilities

 Session 7: How to prioritize value creating activities  Interpreting the R1 Exhibits  How business activities within managerial control affect value – How to conduct disciplined sensitivity and prioritization analysis – Implied performance necessary to justify a range of values – Measuring the value of managerial action, (failure to act) – How to identify under-performers requiring a fix, sell, close response  How business activities outside managerial control affect value  The importance of generating 3 scenarios – What is the size of the opportunity or threat – What can/should be done to take advantage or mitigate these effects – Can we survive what we can’t mitigate? – Revisiting Optimal Capital Structure/WACC on the roadmap

 Session 8: Optimizing a portfolio of businesses  Evaluation criteria  Searching for portfolio interrelationships

 Session 9: Course Synthesis and Next steps  Responsibilities, deliverables and timing  The ABB Cash Flow Initiatives support network

Cash Flow Initiatives - Introduction to Valuation (Session 2)

Session Objectives  Understand the principles, not just the formulas  Overview of the valuation process  Review ABB-consolidation and elimination levels  Separate operating, non-operating, and financing activities  Take a long term perspective  Decisions require making timing trade-offs between lower Free Cash Flows in one period (Investment) and higher Free Cash Flows in other periods (Returns)

The analysis is linked directly to actions designed to increase value  Operating items

Business activities under ABB’s direct control

 Non-operating items

Investment in activities not directly under ABB’s managerial control

 Financing items

Supports strategic activities

Value these three components separately Example Items Value of Operations

+ Value of Non-Operations

+ Value of Financial Assets

Sales, R & D, tangible and intangible investments Shares and Participations in “Cost” and “Equity” accounted companies Deposits

= Corporate Value

_

Value of Financial Liabilities

= Shareholder Value

Short-term & Long-term debt Pension Liabilities

The value of operations is the discounted value of expected future Free Cash Flow Value of Operations

Free Cash Flow

Now

2000

Free Cash Flow

2001

Free Cash Flow

2002

Free Cash Flow

Future

2003

Discounted by Cost of Capital (WACC) •To forecast Free Cash Flows reliably requires a refreshing new way of thinking

BAU forecasts and valuations will be aggregated to higher organizational levels for portfolio analysis ABB Group ABB Group

Industrial Group

Segment 1

BA 1

BAU 1

Segment 2

AFS

BA 2

BAU 2

Note each level requires elimination of inter-business transactions (Sales, Costs, Balance Sheet)

Valuations of business will require taking a much longer term perspective  We need to evaluate both tomorrow’s and today’s consequences of today’s decisions  How long can my business sustain its competitive advantage?  Time is a dimension of value • Nearer term cash flows are worth more

Economic (market) valuations for internal purposes require a very different perspective than accounting and external reporting  Cash flow timing versus matching principle  The need to reexamine what is a Cost Expense Investment

 Economic expectations versus historically completed transactions for accounting

Explicit scenario analysis will also be necessary  Forecast expectations involve uncertainty  Many factors that can impact performance are beyond managerial control  The WACC discount rates reflect primarily systematic risks  Specific risks must be analyzed as cash flow scenarios

The Valuation Process…

Input Mappers enter historical data

Output Forecasters enter forecast data

ABB "R1" Full Analysis Transfer

Managerial Reports

   

Detailed FCF statement Detailed Internal Cash Flow Statement Income Statement Balance sheet, Ratios

 Valuation Analysis  Special Valuation Value Factor Analysis Exhibit

ABB "R1" Basic Version  Quick Sensitivity analysis

Reliable output requires reliable input We must get the details right

We need to step back from the details in order to see the analytical implications -The value factors offer insightful and convenient simplification We test ideas for improvement to confirm our understanding and reinforce business judgment

Cash Flow Initiatives - Free Cash Flow (Session 3)

In this session we want you to . . .  Understand the definition of Free Cash Flow and how it relates to the business  Work through a detailed example of calculating Free Cash Flow and its components

What do we mean by “Free Cash Flow?”  “Free Cash Flow is the level of cash flow generated by a business in excess of the investments necessary to implement its strategy”  Free Cash Flow comes from normal business operations, i.e. it is before non-operational items (e.g. dividends from share participations) and before financing (e.g. interest income and expense, loan and dividend payments, etc)  The term “free” means free of encumbrances, i.e. it is the Cash Flow available to all providers of capital

“Free Cash Flow is the level of cash flow generated by a business in excess of the investments necessary to implement its strategy” Sales Costs Profit Sustaining Investments

Cash Taxes

Direct, NOT Indirect (starting with IBT) Cash costs, NO allocations, provisions or depreciation BEFORE any investments -Capital expenditure (tangible AND intangible) -Net working capital -Research & Development -Sales & Marketing BEFORE taxes ONLY cash NOT future deferred taxes on income from operations NOT including non-operational or financing, e.g. tax deduction on interest expense

”Free Cash Flow is the level of cash flow generated by a business in excess of the investments necessary to implement its strategy” Cash Expansion Investments

BEFORE expansion investments (“CBEI”) -Capital expenditure (tangible AND intangible) -Net working capital -Research & Development -Sales & Marketing

Free Cash Flow

Available to Debt Providers (including Pensioners) Equity Providers

Lets go through a detailed example…

Sales is the first line in the Free Cash Flow Statement  Definition matches US GAAP  Cash IN - but, what about Account Receivables? Cash Advances?

 Can be thought of as: (Market today plus market growth) x market share Volume x price by product, by market segment, by geography Number of hours available x Utilization Ratio x Billing Rates

Costs represent the first cash out  What should be included in cash flow from operations? Operating Non Cash Cost of Goods Sold

Operating Cash

X

Interest Expense

X X

General & Admin. Expense

X

Securitization Charge

X

Amortization of Goodwill

Financing

X

Dividends Received

Gain on Sale of Asset

NonOperating

X

Sales and Marketing Expense

X

Internal Fees

X

Sales less

Cash operating costs equals Profit before sustaining investments

Account Name

2000

2001

Valuation Cashflow Statement Base Scenario 1-day Conceptual Year End: December US Dollar, Millions Account Name

Model ID: 7 Author: cps user Last Calculated: 3/21/00 11:40:41 AM 2000

2001

Total Industrial Sales

1,100.00

1,210.00

Total COGS General and Administration Securitization Charge

(770.00) (55.00) (2.10)

(847.00) (60.00) (2.20)

(25.00) (5.00) 5.00

(25.00) (5.00) 5.00

247.90 (140.00)

275.80 (150.00)

Cash before Taxes (Ind) Cash Taxes (Ind)

107.90 (32.47)

125.80 (31.94)

Cash Flow Before Expansion Inv estment (Ind) Expansion Investment

75.43 (48.00)

93.86 (61.00)

27.43

32.86

Total Internal Fees Other unusual/unspecified cash expense (Ind) Cash disbursments related to Provisions Profit before sustaining inv estments (Ind) Sustaining Investment

Free Cash Flow (Industrial)

Our analysis should answer the following key strategic question: How fast should we grow this business? To answer this question we need to know how much we have to invest to support the expansion.

Total investment is therefore subdivided into 2 categories  Sustaining

 Investment in the business necessary to maintain the existing Cash Before Expansion Investment (CBEI) into the future, i.e. Replace worn out equipment, renewal of obsolete products, maintenance of ABB namebrand recognition

 Expansion

 Investment required to expand or grow the Cash Before Expansion Investment (CBEI) of the business, i.e. Expand capacity, launch new markets/sales campaigns, expand the product/service range.

Total investment includes expenditures for tangible and intangible assets, working capital, sales and marketing and Research and Development

We can see the analysis of sustaining investment by “drilling down” from the exhibit

After subtracting only the sustaining investments we now arrive at Cash Before Taxes  To take taxes into account we must Understand the differences between taxes reported for external purposes and the ‘cash’ taxes we need Continue to differentiate between operating, non-operating and financing items and their tax effects.

Let’s first understand the idea behind deferred taxes  Company buys an asset for $80 Depreciation for the books will be straight line for the asset life of 4 years Depreciation for tax purposes allows deduction of 50% in first 2 years

Taxes

3

4

EBITDA Tax Dpn

100 120 140 (40) (40) -

160 -

Taxes @ 30%

60 80 140 160 (18) (24) (42) (48)

Net Income

Books Book Dpn

1

42

Net Income

56

98

100

120

Total

(80) (132)

112

100 120 140 160 (20) (20) (20) (20) 80

Current Deferred Tax Provision @ Effective Tax Rate 30%

2

(80)

140

(18) (24) (42) (48) (6) (6) 6 6

132 -

(24) (30) (36) (42)

132

56

70

84

98

To convert the tax provision to ‘cash’ we have to adjust for deferred taxes (24)

= Tax Provision @ Effective Rate = Balance Sheet Deferred Tax Account

(30)

Bal. B/F “Paid”

(22)

30

4

(4) Provided

32

Bal. C/F

(24)

6

6

32

= Total Taxes Paid or Payable =

(22)

Now we need to separate the taxes paid between operating, non-operating and financing items Cash Before Tax

90

Less: Interest Expense

(20)

Plus: Dividend Income (Non-operating)

10

Profit before Tax

80

Tax Provision Net Income

(24) 56

Cash Taxes @ Marginal Rate 35%

(28) 7

@ Non-operating Rate 10%

(1)

Total Taxes Paid or Payable

(22)

Tax Screen

In practice…

…each BA/BAU will be given three different tax rates:  Effective Tax Rate  Marginal Tax Rate  Non-Operating Tax Rate • Same as marginal rate for Phase 1

Cash Before Taxes minus Cash Taxes equals Cash Before Expansion Investment (CBEI)

Account Name

2000

2001

Valuation Cashflow Statement Base Scenario 1-day Conceptual Year End: December US Dollar, Millions Account Name

Model ID: 7 Author: cps user Last Calculated: 3/21/00 11:40:41 AM 2000

2001

Total Industrial Sales

1,100.00

1,210.00

Total COGS

(770.00)

(847.00)

(55.00)

(60.00)

General and Administration Securitization Charge Total Internal Fees Other unusual/unspecified cash expense (Ind) Cash disbursments related to Provisions Profit before sustaining inv estments (Ind) Sustaining Investment Cash before Taxes (Ind) Cash Taxes (Ind) Cash Flow Before Expansion Inv estment (Ind) Expansion Investment Free Cash Flow (Industrial)

(2.10)

(2.20)

(25.00)

(25.00)

(5.00)

(5.00)

5.00

5.00

247.90 (140.00)

275.80 (150.00)

107.90 (32.47)

125.80 (31.94)

75.43

93.86

(48.00)

(61.00)

27.43

32.86

Now we subtract the expansion investment required to grow the future cash flow of the business Cash Before Expansion Investment (CBEI)

75

Research & Development Expansion Investment

(12)

Sales and Marketing Expansion Investment

(6)

Fixed Capital Expansion Investment

(20)

Working Capital Expansion Investment

(10)

Total Expansion Investment FREE CASH FLOW

(48) 27

Drill Down on Expansion

Note that Expansion Investment implies a reinvestment ratio Expansion Investment = Cash Flow Before Expansion Investment

(48) (75)

=

64%

 i.e. 64% of CBEI is reinvested in the business to support the growth of the business

Free Cash Flow forecasting: Sample Year 1

Year 2

Revenue

USD 1100

USD 1210

Costs

(853)

(935)

247

275

(140)

(150)

Cash before Taxes

107

125

Cash Taxes

(32)

(32)

75

93

(48)

(61)

27

32

Profit before sustaining investments Sustaining Investments*

Cash Before Expansion Investment Expansion Investments* Free Cash Flow

Year 3

* Tangible & Intangible Fixed Assets, Net working capital, Research & Development, Sales & Marketing

… ... ... ...

Cash Flow Initiatives - Value Factors (Session 4)

Session Objectives  Begin the process of linking FCF/ valuation analysis to decisions and actions designed to change value  How to compute and interpret ABB’s Value Factors

Free Cash Flow forecasting: Sample Year 1

Year 2

Revenue

USD 1100

USD 1210

Costs

(853)

(935)

247

275

(140)

(150)

Cash before Taxes

107

125

Cash Taxes

(32)

(32)

75

93

(48)

(61)

27

32

Profit before sustaining investments Sustaining Investments*

Cash Before Expansion Investment Expansion Investments* Free Cash Flow

Year 3

* Tangible & Intangible Fixed Assets, Net working capital, Research & Development, Sales & Marketing

… ... ... ...

Free Cash Flow forecasting: Value Factors Year 1 Year 2 Value Factor

Revenue

USD 1100

USD 1210 G

Costs

(853)

(935)

247

275

(140)

(150)

Cash before Taxes

107

125

Cash Taxes

(32)

(32)

75

93

(48)

(61)

27

32

Profit before sustaining investments Sustaining Investments*

Cash Before Expansion Investment Expansion Investments* Free Cash Flow

10%

P

22%

I

54%

Tc

25%

F, W 65% R, M total

ABB Value Factor Summary Value Factors

Definition

Gt

Sales Growth

Sales t - Sales t-1 Sales t-1

Pt

Cash Operating Profit Margin

Cash Operating Profit Sales t

It

Sustaining Investments

Sustaining Investments Cash Operating Profit

Tc

Cash Tax Rate

Cash Taxes Cash Before Taxes

ABB Value Factor Summary Value Factors Mt

Rt

Ft

Wt

Definition Sales and Marketing Expansion

R&D Expansion Investment

Fixed Capital Expansion Investment Working Capital Expansion Investment

S & M Expansion Investment Change in Sales

R&D Expansion Investment Change in Sales

Fixed Capital Expansion Investment Change in Sales

Working Capital Expansion Investment Change in Sales

Executive Exhibit Account Name

2000

2001

Executive Summary Base Scenario 1-day Conceptual

Model ID: 7

Year End: December US Dollar, Millions

Author: cps user Last Calculated: 3/21/00 11:40:41 AM

VALUE FACTORS Sales Growth (G)

10.00%

10.00%

Cash Operating Profit Margin (P) Sustaining Investments (I)

22.54% 56.47%

22.79% 54.39%

Cash Tax Rate (Tc)

30.09%

25.39%

6.00%

6.36%

R&D Investment - Expansion (R) Working Capital - Expansion (W)

12.00% 10.00%

12.73% 18.18%

Fixed Capital Investment - Expansion (F)

20.00%

18.18%

Sales & Marketing Investment - Expansion (M)

And here’s the Free Cash Flow formula: Sustainable Cash IN: Sales from the prior period X (1 + Sales Growth) X Profit Margin Before Sustaining Investments X (1 - Sustaining Investments/Profit Margin Before Sustaining Investments) X (1 - Cash Tax Rate), or

St-1 X (1 + G) X P X (1 - I) X (1 - Tc) = CBEI Minus Cash OUT: Increase in Sales X (Expansion Investments/Increase in Sales), or

St-1 X G X (F + W + R + M) From our earlier example: 1100 X (1 +.1) X .22 X (1 -.54) X (1 -.25) minus (1100 X .1 X .55) = 32

Special Valuation Exhibit Account Name

2000

2001

Special Valuation Base Scenario 1-day Conceptual Year End: December US Dollar, Millions Account Name

Model ID: 7 Author: cps user Last Calculated: 3/21/00 11:40:41 AM 2000

2001

Cash Flow from Operations Previous Period Sales Sales Growth (G) Total Industrial Sales Cash Operating Profit Margin (P) Profit before sustaining investments (Ind) Sustaining Investments (I) Cash before Taxes (Ind) Cash Tax Rate (Tc)

1,000.00 10.00% 1,100.00 22.54% 247.90 56.47% 107.90 30.09%

1,100.00 10.00% 1,210.00 22.79% 275.80 54.39% 125.80 25.39%

Cash Flow Before Expansion Inv estment (Ind) CBEI Growth Rate

75.43 (60.92%)

93.86 24.43%

Sales & Marketing Investment - Expansion (M) R&D Investment - Expansion (R) Working Capital - Expansion (W) Fixed Capital Investment - Expansion (F) Expansion Investment (%)

6.00% 12.00% 10.00% 20.00% 48.00%

6.36% 12.73% 18.18% 18.18% 55.45%

Expansion Inv estment Expansion Investment / CBEI

48.00 63.64%

61.00 64.99%

27.43

32.86

Free Cash Flow (FCF)

All we have done so far is define value factors  Value Factors allow us to step back from the detail  Later we will use Value Factor analysis to understand which dimension of the business affects value the most  This will allow us to prioritize which component of FCF for focused attention and follow-up later

Cash Flow Initiatives -

Residual Value (Session 5)

Session Objectives  Understand the concept of value growth duration and the sustainability of competitive advantage  Appreciate how the forecast time horizon can affect the business value  Understand and be able to explain the framework selected by ABB

How many years of FCF should we forecast? Corporate Value

Residual Value

Net Debt

Market Value of Equity 36 BUSD

Free Cash Flow

Now

2000

Free Cash Flow

2001

Free Cash Flow

2002

Free Cash Flow

2003

Future

Discounted by Cost of Capital (WACC)

Residual Value is an attempt to cope with a business’ indefinite life  Easiest solution is to separate the value of operations into two time periods PV FCF during explicit forecast period + PV FCF beyond explicit forecast period Total Value of Operations  The idea is to use simplifying assumptions and fewer items to forecast for the residual period value

What would we expect to happen to business value over time? IRR = WACC Business Value

Value Growth Duration (N) = Period of Sustainable Competitive advantage

Time

Forecasting over Time  What goes into the explicit forecast period?  in general, we want to capture the period of competitive advantage (sometimes called Value Growth Duration), e.g. where IRR > WACC  this period will vary by business  in ABB, however, we will make our explicit forecasts all 5 years to allow consolidation from BAU ⇒ BA ⇒ Segment ⇒ Group

 What goes into the residual value period?  we can still distinguish between businesses which are creating value for a period beyond the explicit forecast by using a twostage residual value method 1  the first stage is value-creating; the second stage is IRR = WACC 1. The explicit methodology is described in Copeland, Thomas E., Tim Koller and Jack Murrin, Valuation: Measuring and managing the value of companies. 2nd ed., McKinsey and Co., Inc. 1994

This means we need some additional value factors to value the business: Forecast Period

Value Factors

G, P, I, Tc, F, W, R, M

Residual Period 1st Stage

2nd Stage

IRR>WACC

IRR=WACC

IRR, RR, N

WACC

ABB’s Residual Value requires 3 value factors

Value Description Factor IRR

RR

N

Residual Internal Rate of Return expected on Expansion Investments

Residual Reinvestment Ratio, i.e. estimated percentage of CBEI that will be reinvested to support continuing growth in the residual period Value Growth Duration, Estimated number of remaining periods of sustainable competitive advantage

Formula

CBEI t – CBEI t-1 Expansion Investment t-1

Expansion Investment t-1 CBEI t-1

Suggestions for Forecasting Examine historical and forecast periods. Trend should be decay towards WACC Examine historical and forecast periods. Trend towards a steady state, without big changes Depending on the inputs for other factors this may not be very sensitive

ABB’s value factors also relate to the expected growth in Cash Flow Before Expansion Investment (CBEI) IRR

The return opportunities the business can find

times RR

How much expansion reinvestment is made in these opportunities

equals Q

The expected growth rate in CBEI

ABB’s software tool makes these calculations easy  The software also allows for entry of a specified amount for residual value This can be useful in the case of a known exit value

Cash Flow Initiatives -

Business Valuation (Session 6)

Session Objectives  Understand a 5-step process for estimating business and shareholder value  Appreciate how to select an appropriate cost of capital for your analysis

To estimate business value follow this 5step process…  Step 1

Input Data necessary to forecast Free Cash Flow and Residual Value (either detailed Full Version or Basic Version Value Factors)

 Step 2

Select appropriate Weighted Average Cost of Capital (WACC)

 Step 3

Value of operations equals sum of the present values of expected Free Cash Flow and Residual Value

 Step 4

Add the estimated value of non-operating and financial assets to obtain corporate value

 Step 5

Subtract the estimated value of debt and other financial obligations to obtain shareholder value

Step 1: Input Free Cash Flow and Residual Value Forecasts FCF & RV Detail

FCF Residual Value Value Factors G,P,I, Tc, M, R, F, W Residual IRR, RR, N

Step 2: Select Appropriate WACC  Use the tables from the WACC project to identify the Cost of Capital for the Business Area and the relevant country • Note the country selected must match the currency of the cash flows being discounted • For example: use Switzerland WACC to discount CHF cash flows • If local currency cash flows are converted into another currency, specific conversion rates must be used and the WACC country must still match • For example, convert CHF cash flows to USD using forward foreign exchange rates, and discount using US WACC

Step 3: The Value of operations equals the sum of present values of expected Free Cash Flow and Residual Value

How the Market Values ABB Operating Value

Free Cash Flow

Now

2000

Free Cash Flow

2001

Free Cash Flow

2002

Free Cash Flow

Future

2003

Discounted by Cost of Capital (WACC)

Steps 4 & 5: Estimate the other components of value Example Items Value of Operations

+ Value of Non-Operations

+ Value of Financial Assets

Sales, R & D, tangible and intangible investments Shares and Participations in “Cost” and “Equity” accounted companies Deposits

= Corporate Value

_

Value of Financial Liabilities

= Shareholder Value

Short-term & Long-term debt Pension Liabilities

Value is NOT a number  Value is a range, driven by uncertain possibilities  Exploring the richness of these possibilities is what makes the forecasting an valuation effort worthwhile

Cash Flow Initiatives -

How to Prioritize Value Creating Activities (Session 7)

Session Objectives  Familiarize yourself with the exhibits available in ABB’s R1 software tool  Practice application of valuation analysis as a real company  Develop some intuition for the relationship between value factors and shareholder value  Run sensitivity and scenario analysis  Identify the implications of the analysis for management and the prospects for the company

R1 Exhibits are derived from 2 models Full Version Only

Both Full & Basic*

Executive Summary FCF Report Financial Ratios Special Valuation Income Statement DCF Valuation Report Balance Sheet Capital Employed Cash Flow Check Reconciliation Exhibit Internal Cash flow Statement Assumptions Reports

Basic Only* Automatic Sensitivities Value Driver Elasticity

* Note the Basic File uses a simplified Value Factor level of detail and assumes a 100% variable cost structure. A Basic Version can be obtained from a Full Version or by direct input.

Sensitivity analysis allows us to determine which Value Factors (or FCF component) influence value the most

Automatic Sensitivities Report Base Scenario Case Conseptual 1-day Year End: December US Dollar, Millions

Model ID: 4 Author: cps user Last Calculated: 3/21/00 04:31:21 PM

Account Name

1998

1999

2000

2001

2002

2003

2004

0.0%

3.0%

5.0%

5.0%

5.0%

5.0%

5.0%

0 0 0 0 0

9,557 9,557 9,557 9,557 9,557

8,829 9,063 9,219 9,375 9,609

9,381 9,561 9,680 9,797 9,970

9,967 10,087 10,164 10,238 10,343

10,590 10,642 10,672 10,699 10,731

11,252 11,227 11,206 11,180 11,134

0 0 0 0 0

0 0 0 0 0

133,508 133,496 133,487 133,479 133,466

136,033 136,024 136,018 136,013 136,004

138,433 138,447 138,455 138,463 138,473

140,710 140,766 140,800 140,833 140,878

142,868 142,985 143,057 143,125 143,219

22.0%

22.0%

22.0%

22.0%

22.0%

22.0%

22.0%

0 0 0 0 0

12,252 10,635 9,557 8,479 6,862

12,049 10,351 9,219 8,087 6,389

12,651 10,868 9,680 8,491 6,709

13,284 11,412 10,164 8,916 7,044

13,948 11,982 10,672 9,362 7,396

14,645 12,582 11,206 9,830 7,766

0 0 0 0 0

0 0 0 0 0

144,046 137,711 133,487 129,263 122,928

147,630 140,663 136,018 131,374 124,407

151,078 143,504 138,455 133,406 125,832

154,395 146,238 140,800 135,362 127,205

157,587 148,869 143,057 137,246 128,528

SALES GROWTH SENSITIVITY Revenue Growth Free Free Free Free Free

Cash Cash Cash Cash Cash

Value Value Value Value Value

of of of of of

Flow (Revenue Flow (Revenue Flow Flow (Revenue Flow (Revenue

Growth 25% Higher) Growth 10% Higher) Growth 10% Lower) Growth 25% Lower)

Operations (Revenue Operations (Revenue Operations Operations (Revenue Operations (Revenue

Growth 25% Higher) Growth 10% Higher) Growth 10% Lower) Growth 25% Lower)

OPERATING PROFIT MARGIN SENSITIVITY Cash Operating Profit Margin (P) Free Free Free Free Free

Cash Cash Cash Cash Cash

Value Value Value Value Value

of of of of of

Flow (Profit Margin Flow (Profit Margin Flow Flow (Profit Margin Flow (Profit Margin

25% Higher) 10% Higher) 10% Lower) 25% Lower)

Operations (Profit Margin Operations (Profit Margin Operations Operations (Profit Margin Operations (Profit Margin

25% Higher) 10% Higher) 10% Lower) 25% Lower)

In this case, improving the profit margin is 80 times more important than sales growth!

Threshold Margin is another very useful concept  The remaining Value Drivers being given, the Threshold Margin is the minimum operating profit margin that must be achieved if the company is to break even economically  The Threshold Spread is the difference between the actual profit margin and the threshold margin  The greater the Threshold Spread, the greater the opportunity to create value through sales growth

If the spread is zero then the company is earning exactly its cost of capital  Computer goal-seeking software can compute the Threshold Margin

The size of the Threshold Spread will dictate the value creation associated with growth

Higher Sales Growth leads to: Generous Threshold Spread Actual Profit Margin 20% Threshold Margin 8% Threshold Spread 12%

Large value creation IRR > WACC

Narrow Threshold Spread (positive) Actual Profit Margin 9.1% Threshold Margin 8% Threshold Spread 1.4%

Small to modest value creation: Higher % Fixed Costs enhances value creation effect of growth; Higher value creation could be achieved by improving the threshold spread

Zero Threshold Spread Actual Profit Margin 8% Threshold Margin 8% Threshold Spread 0%

Neither growth nor shrinkage affect value if cost structure is 100% variable. Growth with a proportion of fixed costs leads to modest value creation. Business IRR = WACC Better to improve Threshold spread

Negative Threshold Spread Actual Profit Margin 6% Threshold Margin 8% Threshold Spread (2%)

Growth leads to higher value destruction. Disinvestment from business with IRR<WACC is implied unless a positive threshold spread can be restored

We have an enhanced understanding of the trade-off between Sales Growth and Profit Margins

Case 1: Generous Threshold Spread Sales Growth Very Important

Curves are Horizontal Strategic Focus On Growth Higher Fixed Costs

£600 £548

Profit Margin Unimportant  A strategic focus on growing the business is optimal since the generous threshold spread applies to any extra sales  If the cost structure includes some fixed costs then sales growth will also improve the profit margin

Sensitivity to Profit Margins suggests an entirely different strategic agenda Curves are More Vertical Sales Growth Unimportant Higher Fixed Costs Strategic Focus On Threshold Spread

Profit Margin Very Important

 A strategic focus on improving the Threshold Spread suggests exploring: Raising sales prices even if this results in modest volume reductions. Lowering the level of fixed and/or variable costs Leveraging the investment efficiency of F, W, M and R through technology, working capital management improvement, focused marketing, or superior early detection and exploitation of research advantages. Elimination of assets not central to the competitive advantage, e.g. Marriott Hotels and Sara Lee Corp.

Value driver profiling provides other advantages…  Other value driver trade-offs can be examined, e.g. P versus F  As part of the benchmarking process, superimpose competitor value driver combinations on the graph  Value driver profiling explicitly links acquisition prices and the minimum post-merger operating performance necessary to create value  Value driver profiling can be applied consistently:

• Across different decisions e.g. projects, strategies, acquisitions • Across different businesses e.g. SBU’s, Divisions, the Holding company

A Value Factor sensitivity gives an indication of its importance, but...  What action step/level of effort is necessary to achieve the change? Is this realistic?  An action which affects one Value Factor may also affect other Value Factors, e.g. sales growth may only be possible at a lower margin  Deciding which action to take requires making tradeoffs between multiple Value Factors and multiple time periods higher investment/lower FCF today vs. higher revenues/higher FCF tomorrow

We also need to understand how different business conditions affect value, investment and financing requirements  WACC estimates reflect primarily systematic risk Specific risks must be analyzed as part of the cash flow

 Scenario analysis will improve the reliability of the cash flow forecasts In the future actual performance will be compared to original projections to achieve accountability

ABB will require 3 scenarios to be developed  Base (most likely) case, Best case, and Worst case scenarios  Excellent scenario analysis reflects Identification of factors with greatest impact on business results Establishment of factor cut-off levels that imply a change in business activities is desirable Development of contingency plans to take advantage of new upside potential or to mitigate downside difficulties

Valuation of Alternative Strategies  Today’s strategy: 5% growth.  Growth strategy : 10% growth. Same products, same markets, lower profit margin

 Hockey stick strategy: Reduce sales in the first 3 years and increase margins from Year 2002

 Focus strategy: Reduce sales by 15% within 2 years. This will increase profit margin by 3%

 Investment strategy: Invest MUSD 26 over 2 years. Investment

followed by 3 years of 15% annual growth, 3 years of profit margin at 22% and 3 years of incremental fixed and working capital falling to 5% and 10%, respectively

Make a guess...

 Which one of the alternative strategies creates the most value?  Rank the alternative strategies

Free Cash Flow: Today’s Strategy 160'000 140'000 120'000 100'000 80'000 60'000 40'000 20'000 0 Value of Ops.

PV fcst FCF2000 FCF2001 FCF2002 FCF2003 FCF2004

PV RV

Free Cash Flow: Growth Strategy Today

Growth

160'000 140'000 120'000 100'000 80'000 60'000 40'000 20'000 0 Value of Ops.

PV fcst FCF2000 FCF2001 FCF2002 FCF2003 FCF2004

PV RV

Free Cash Flow: Hockey stick Strategy Today

Hockey Stick

160'000 140'000 120'000 100'000 80'000 60'000 40'000 20'000 0 Value of Ops.

PV fcst FCF2000 FCF2001 FCF2002 FCF2003 FCF2004

PV RV

Free Cash Flow: Focus Strategy Today

Focus

160'000 140'000 120'000 100'000 80'000 60'000 40'000 20'000 0 Value of Ops.

PV fcst FCF2000 FCF2001 FCF2002 FCF2003 FCF2004

PV RV

Free Cash Flow: Investment Strategy Today

Invest

160'000 140'000 120'000 100'000 80'000 60'000 40'000 20'000 0 -20'000

Value of Ops.

PV fcst FCF2000 FCF2001 FCF2002 FCF2003 FCF2004

PV RV

Conclusion: Investment Strategy creates the most value relative to today’s value 10000 5000 0 -5000 -10000 -15000

Growth

Hockey Stick

Focus

Investment

Change from Today's Strategy

Are we satisfied with the results?  We have identified the most value-creating Strategy (Investment)  We have also learned that Sales Growth is only value-creating for this business when there is an increase in Profit Margin  We have seen that early negative cash flows may still lead to an increase in value (Investment Strategy)  We have seen that that the highest early cash flows do not necessarily generate the highest value (Focus Strategy)  We can rank the Value Factors in terms of their impact on FCF and Corporate Value

What Strategy should this business choose?

What might we have missed?  Would a different strategy require or allow a different long-term financing policy -- and therefore change WACC, and Corporate Value?  Would a different strategy lengthen the competitive advantage period -- and therefore change Corporate Value?  Is the business earning enough? How can we tell?  Does the Strategy fit in with the overall Group Strategy?  What about the risk inherent in each Strategy -- how would we measure it?

There is no one-size-fits-all “right” answer for all businesses; the analytical process is the same, but each business will have its own unique best Strategy, most important Value Factor(s), and action plan

Cash Flow Initiatives -

Optimizing a Portfolio of Businesses (Session 8)

Session Objectives  Appreciate the difference between business strategy and portfolio strategy  Understand the role of portfolio interrelationships in enhancing portfolio value

The scope and value of the portfolio review and strategic capital allocation process  Traditional analysis compares a proposed plan to competitor and historical performance. • Are we doing better than our competitors? • Are we doing better than last year?  Modern analysis additionally considers whether the strategy: • Maximizes value • Is this business worth more to someone else? • Optimizes use of scarce corporate resources • Do we have better investment opportunities? • Is consistent with overall corporate strategy • Is financially feasible • Does the strategy generate or use cash?

Corporate strategy determination is changing from portfolio management to interrelationships  The portfolio approach attempts to create value by buying and selling businesses Is the risk return relationship appropriate? Can outside investors reproduce the portfolio for themselves? Note that the definition of SBU implies that each of the businesses in the portfolio is wholly independent

 Corporate strategies have moved from this diversification and opportunism to selection of a core strategy and a portfolio of businesses with complementary interrelationships

Portfolio Interrelationships Technology or Logistics Support

Joint Advertising to Achieve Scale Shared Warehousing

Shared Service Operations

Core Strategy

Portfolio Strategy is not just passive review  Portfolio strategy must ensure that the group performance is value maximizing  Significant emphasis must be placed on an enlightened realignment of the core strategy and portfolio to keep pace with the changing business environment and competitive conditions

• Buying businesses that are most valuable to your firm • Divesting businesses that are more valuable to other firms • Developing Fix, Sell or Close strategies for businesses that are underperforming • Other transactional ways to enhance the value creation effort • Joint ventures • Strategic partnerships

Cash Flow Initiatives -

Course Synthesis and Next Steps (Session 9)

Have we met our objectives?  Course represents only the first step of the learning process  Post-course reinforcement is necessary to assimilate learning into an individual skill an an organizational capability Practice, trial and improvement

Readings can be a helpful part of the learning process Free Cash Flow/Valuation  Rappaport, Alfred. Creating Shareholder Value. New York: Free Press, 1986.  Copeland, Thomas E., Tim Koller and Jack Murrin, Valuation: Measuring and managing the value of companies. McKinsey and Company, Inc. New York: John Wiley & Sons Inc. 1990.

Underlying Finance Principles  Brealey, Richard and Stewart Myers. Principles of Corporate Finance. 4th ed. New York: McGraw-Hill, 1991.  Shapiro, Alan C. Multinational Financial Management, 2nd ed. Newton, Massachusetts: Allyn and Bacon, 1986.

In addition, form internal and external support relationships to answer questions  Fellow course participants  Co-workers and associates  CS – TFF

GOOD LUCK!