Financial Education

Free cash flow to the firm (FCFF) represents the cash flow that a company generates in an accounting period, after paying operating expenses and making necessary expenditures. This cash flow represents the return to all providers of capital, whether debt or equity. It can be used to pay off debt, repurchase shares, pay dividends or be retained for future growth opportunities.

The basic calculation is FCFF = NI + NCC + Int (1-T) – FCInv – WCInv

Were NI is net income, NCC is non-cash charges such as depreciation, Int(1-T) is the after-tax interest payments on debt, FCInv is the investment in fixed capital (capital expenditures) and WCInv is the investment in working capital.

Investors may want to further distinguish between investments in fixed capital that represent required maintenance and those that are intended to generate growth.

When a borrower encounters financial distress, creditors may agree to accept assets as payment for the debt or to restructure (modify the terms) of the original agreement. If the debt is extinguished, the debtor and creditor must recognize gains or losses equal to the difference between the carrying amount of the debt and the amount actually given as repayment. When it is restructured, however, the accounting guidelines frown upon the borrower recognizing a gain due to its own financial distress. Instead, no gain can be recognized as long as the gross cash flows (undiscounted) exceed the original amount borrowed.

Most defined benefit pension plans are based on the employee’s ending salary and years worked. The benefits in many cases will not be paid for many years, but the benefits will then be paid out for a number of years. In order to properly account for the liability, many assumptions need to be made:

• How many more years will the employee work?
• What will be the employee’s ending salary?
• How many years will the employee collect a pension in retirement?
• What type of return can be earned on assets in the fund?
• What is the appropriate rate to discount the liability to present value?

The longer the employee works, the more benefit will be accrued. This increases the potential liability by increasing final salary (more years of raises) and by applying a larger multiple since many plans are based on years of service (for example, the pension equals 1% of ending salary for each year of service). On the other hand, since the retirement is further away it will be discounted back a larger number of years when calculating the present value, which will partially offset the other effects.

The higher the ending salary (or projected annual salary increase) the higher the future (and present) liability.

The longer the employee is expected to live/collect benefits, the higher the liability.

The higher the expected return on assets, the less the company will have to contribute to the fund in order to meet the future obligations.

The higher the discount rate used, the lower the present value of the future liability.

In a clean surplus environment, the change in net pension asset or liability would flow through the income statement as a pension expense. However, both U.S. GAAP and International Accounting Standards allow for a number of smoothing mechanisms when reporting pension expense. Still, the change in liabilities is a good place to start the discussion.

The pension obligation can change for a number of reasons:

1. The employee’s service during the period, which increases the future liability
2. Interest expense on the prior liability
3. Changes in the terms of the plan
4. Changes in actuarial assumptions

Furthermore, the assets in the plan can increase or decrease in value due to contributions, benefits paid and market fluctuations.

Current accounting rules require service and interest costs to be recognized immediately, while the other items can be amortized over a number of years. Furthermore, the rules allow for the return on plan assets to be estimated (the expected return) rather than used directly. All differences between the expected and actual values are also amortized.

Since there are smoothing mechanisms, the reported pension expense will not always reflect the change in the plan’s economic status and investors may wish to use the related disclosures to create a more accurate picture of the financial situation.

Originally stated by Grinold and Kahn (2001), the Fundamental Law of Active Management states that the information ratio (IR) is equal to the information coefficient (IC) multiplied by the square root of breadth (defined as the number of active decisions taken per year.) The information coefficient represents the investor’s knowledge about a given investment.

The law indicates that low-turnover strategies must be more accurate about a given investment in order to produce the same information ratio as a high-turnover strategy.

The Gordon growth model is a type of dividend discount model used to value companies expected to grow at a constant rate forever. However, few stocks exhibit such characteristics. Most valuation models forecast growth for a certain time period before reverting to a Gordon growth model to estimate the ending value.

Practitioners often consider three phases of growth: high growth, transition and maturity. The final stage can be used to estimate the residual value at some future time – often many years away – using the Gordon growth model. The initial stages can be valued using more direct discounted cash flow estimates.

International Accounting Standard 19 (IAS 19) allows certain gains and losses due to changes in the pension plan or market returns to b smoothed over several years rather than recognized at once. As a result, the balance sheet generally does not reflect the full net asset or liability. Prior to the adoption of SFAS 158 US rules were similar. In some cases, such as after the Internet bubble burst, many plans were being shown on balance sheets as having net assets (due to past market returns being smoothed in) when the actual funded status was a net liability.

As an example of the effect smoothing can have, consider note 35 to the consolidated financial statements of Lloyds TSB Group PLC 20-F filing:

The present value of funded obligations is the amount Lloyds would have to pay today in order to satisfy its future pension obligations (assuming the actuarial assumptions involved are correct.) This amount changed relatively little between 2005 and 2006 – an increase of 58 million or less than one third of one percent.

The fair value of scheme assets is the amount Lloyds has in the fund to cover the future obligations. This amount increased by 1.25 billion, or nearly 9%.

Below that is the difference between the two amounts, or the funded status. In each of the two years, Lloyds had less in the fund than would be needed to satisfy the future obligation. In other words, the plan is underfunded. However, the small rise in liabilities compared to assets significantly reduced the funding gap in 2006.

The next line shows how much of the net liability has not yet been recognized due to permissible accounting smoothing. In 2005 there were 485 million of unrecognized losses. In 2006 this shifted to an unrecognized 263 million gain.

So, in 2005 Lloyds had an unfunded position (economic value) of 3.3 billion. Some of this was not recognized on the balance sheet, however, which showed the liability as being just $2.8 billion – 485 million less than the economic liability.

In 2006, the unfunded position had fallen dramatically to just 2.1 billion. However, the smoothing was now ignoring some gains and the balance sheet liability was shown as being 2.4 billion – 263 million more than the economic liability.

Investors might want to replace the balance sheet figures with the economic status in order to get a more current picture of the true assets and liabilities. This would also be useful when comparing the balance sheets of a firm that uses IAS with one that reports under U.S. GAAP. Since passage of SFAS 158, U.S. firms are now recording the full economic liability (net funded status) on the balance sheet.

When measuring the potential liability of a pension fund, there are several relevant measures. The Accumulated Benefit Obligation (ABO) represents the present value of any benefits (whether vested or not) the employee has earned to date. It does not include any benefits employees are expected to earn in the future. It would be the amount due if the plan were terminated.

Mental accounting refers to how investors frame gains and losses. Hedonic editing suggests that investors will be more likely to bundle losses by selling money-losers in groups (feeling the pain one time) and will sell stocks with gains individually (deriving pleasure each time).

Analyzing trading data from a large US discount brokerage house, Sonya Lim published in the September 2006 Journal of Business that investors do seem to integrate losses and segregate gains.

When measuring the potential liability of a pension fund, there are several relevant measures. One of these is the vested benefit obligation, or VBO. The VBO represents the actuarial present value of vested benefits. “Vested” relates to the fact that most plans require a certain number of years of service before earned benefits can actually be collected. For example, many plans will vest at 20% per year for the first five years of service.

When the employee has worked for one year, the benefit earned is the present value of future obligations due for an employee with one year of service. However, the vested benefit (in this example) is only 20% of the benefit earned.