Financial Steering: Valuation, KPI Management and the Interaction with IFRS

By Martin Schwarzbichler, Christian Steiner and Daniel Turnheim

This book is a guide to how financial steering is designed, measured and implemented with a special focus on the energy industry. The authors offer an overview of and practical insights into the links between financial steering and accounting, and the temporary cycles of investment, divestment, return and loss, market highs and lows that form the framework of the entire energy industry across all value chain stages. The faster and the larger the cash cycles of investments and their returns, the greater not only the value created, but also the potential loss if the financial steering is not properly designed and managed. Value and value generation require an understanding of how value is both defined and measured in both and how the business/project economics model of a company works – financial steering provides this. Further, the book also discusses accounting topics such as impairments, new IFRS standards and the impact of accounting on key performance indicators of financial steering, which are associated with these investment decision valuations. The combination of accounting with the cash flow perspective provides a complete understanding of selected practical topics of financial steering which are explained in detail in a large number of examples and case studies. 

The book is intended for a wide range of finance/controlling/treasury/accounting professionals and students. It is written in practical and simple terms to outline the financial steering concept and to bring it to life in daily work and in the decision making process for financial steering. All illustrated concepts are in the same manner relevant and applicable to all other asset-intense industry sectors and their financial steering processes.

• Language: English
• Publisher: Springer
• Release date: Jun 9, 2018
• ISBN: 9783319757629

Book preview

© Springer International Publishing AG, part of Springer Nature 2018

Martin Schwarzbichler, Christian Steiner and Daniel TurnheimFinancial Steering https://doi.org/10.1007/978-3-319-75762-9_1

1. Introduction

Martin Schwarzbichler¹ , Christian Steiner² and Daniel Turnheim¹

(1)

OMV AG, Trabrennstraße, Vienna, Austria

(2)

Austrian Financial Reporting Enforcement Panel (AFREP), Argentinierstrasse, Vienna, Austria

1.1 Design and Aim of the Book

This book aims to provide selected examples for financial steering and to highlight the interaction with IFRS and its potential impact on the consolidated financial statements.

In order to be as practical as possible, the case studies are mostly focused on the energy industry.

All illustrated concepts are relevant and applicable to all other asset-intense industry sectors and their financial steering processes.

The first chapter will introduce the characteristics of the energy industry.

1.2 Introduction to the Energy Industry from a Financial Perspective

1.2.1 Energy Value Chain

Energy is a very broad field of activity. In order to look at the energy industry in a clear and comprehensive manner, it is advisable to structure the energy industry in an energy value chain . In the case of the energy industry, there are various ways to divide the industry into different segments or value chain elements. In the following example, the energy value chain is for natural gas. The energy value chain for each type of energy might be different, and although it is possible to use the general structure of an energy value chain for one type of energy for other types of energy, there are technical, economic and financial boundaries that prevent the entire energy industry from being reasonably depicted through a ‘one-size-fits-all’ approach.

Depicting and understanding the energy value chain are vital to profound and efficient financial steering, financial assessment and reasonable valuation. What you cannot understand, you cannot steer, assess or evaluate. The first thing to consider is where the company, project or activity you are looking at is located in the energy value chain. Only with a proper insight into the interconnections between the company, project or activity under your consideration and the other value chain elements do the business logics become visible. In order to achieve such an understanding, there are a number of questions which must be answered, which might be, for example, what kind of company are we looking at? Is it a vertically integrated company present in various elements of the same or even in different energy value chains? What is the purpose of this vertical integration? Which logic does it follow? It is historically grown or legally required? Is the vertical integration a form of ‘natural hedge’ against commodity price fluctuations or against other forms of risks? Is the company not vertically integrated but specialised in one specific field of activity only? Or is the company horizontally integrated in the sense that it covers all or most of the activities of one field of business activity (e.g. a pure upstream company)?

The depiction of the energy value chain also supports the identification of the contractual framework, the cash flows between the various elements involved and the separation and transparent presentation of risks and returns along the energy value chain. The contractual framework refers to issues including the following: Who is the holder of which contract(s)? What are the specifics of these contract(s)? Can they be amended, terminated or prolonged, if necessary? What is the flexibility arising or shrinking out of these contracts? How can the cash flows between the involved entities and business activities be depicted? Where is the cash flow really generated? Where is value generated or lost along the value chain? Where is the margin generated? Is it kept within the company or activity or shared or even lost to others along the value chain? Why is this? What risks are the company or project considering taking, and what risks are others taking? Is the split of the margins appropriate or disproportional to the undertaken risk allocation? Which entity and player are taking which risk(s) along the value chain? Is the allocation of risks generalised or tailor-made, and what are the reasons for this allocation? The list of checks and considerations has to be extended and prolonged until all eventualities and possibilities have been discussed and taken into account from a reasonable and pragmatic standpoint.

This short introduction shall show how intensive this initial evaluation of the energy value chain can be.

To continue with the energy value chain from the example perspective of the energy value chain¹ for natural gas, we must look at the following considerations:

The value chain for the natural gas energy industry can be split—from an economic and financial perspective—into three value chain segments. The first segment is upstream. Upstream comprises the exploration and production of the energy. In the case of natural gas, exploration is needed to gain information on reservoirs and potential future production data. The production element stands for the generation of the energy (in this case, the production of natural gas).

The second segment is midstream . In theory and in practice, there are cases in which midstream is allocated to other segments, most commonly to downstream . In these cases, downstream comprises all the activities that are not covered by upstream. In the following example, midstream is depicted as its own segment for the sake of simplicity and comprises the storage and long-distance transportation of natural gas. The various forms of energy have different characteristics with regard to the economics and feasibility of their storage and transportation. For example, while crude oil and natural gas can easily be stored on a long-term basis from a technical and economic standpoint, electricity cannot be stored at economic terms in the long run. An exception to this statement might be pumped-storage power plants, which store the energy in the form of water in reservoirs until this water is used to generate electricity. Energy can be stored for several reasons. Energy might be stored in order to provide for security of supply (e.g. the national stock obligation for crude oil or filling up storages with natural gas on a voluntary basis in order to have enough commodities for the upcoming winter). Another reason for the storage of energy might be arbitrage business: if there are demand and supply patterns (e.g. seasonal swings; quarterly, weekly, daily or hourly patterns), the storage of energy is part of the physical linkage between supply and demand and opens up the possibility to generate a margin in return for this bridging of supply and demand. For example, if more natural gas will be needed for heating in the cold winter season, but natural gas is stored in equal instalments throughout the year, it is necessary to store the delivered and unused gas during summer in order to withdraw it from the storage in the winter season. The so-called margin or spread is called ‘summer-winter-spread’. Alternatively, it might be also possible to combine two or more different kinds of energy in order to crease a margin. For example, if the natural gas is stored in deposits and withdrawn to be used in a gas-fired power plant for the production of electricity, this is a combination of two energy forms. The natural gas is withdrawn to serve as input for the gas-fired power plant, and the electricity produced during the peak hours of demand during the day is sold at higher prices than that sold during the rest of the day.

Transportation bridges the distance between at least two locations, mainly the location of production and the places of consumption. The interplay between storage and transportation is such that the less energy can be stored from a technical or reasonable economic perspective, the more flexible and close to real time the transportation has to work. For example, in the electricity sector, the energy normally cannot be stored at large scale but has to be produced and transported on demand. Transportation generally also creates a price spread. If the energy is comparatively cheaper at the location of production and more expensive at the location of consumption, the price spread represents the gross profit before deducting the cost of transportation. Transportation of energy plays a key role in the security of supply and the diversification of energy supplies across the markets. There is a wide range of transportation means, and the method of transportation used is determined by the type of energy. Natural gas, for example, might be transported by pipeline, by ship (so-called liquefied natural gas or LNG), by truck (so-called compressed natural gas or CNG), etc.

The third segment is downstream . To continue with the example of natural gas, the downstream segment comprises supply, trading and hub activities. Trading can generally be divided into two broad categories: trading with non-physical delivery (including trading at energy exchanges) and asset-backed trading. A hub is a market place where supply and demand for energy meet. In the case of natural gas, there are two main types of hubs: virtual hubs, which aggregate the supply and demand of a virtually defined marketplace (e.g. a virtual hub comprising the supply and demand of several geographic regions of a country), and the physical hubs, which physically exist at a certain location and which offer their services at these physical locations (e.g. the interconnection of important pipelines containing natural gas, at which the flow of natural gas can be modified). The last element of the downstream segment is containing the distribution of natural gas: this can be the wholesale of natural gas to wholesale counterparties or the selling of natural gas on a retail basis. These activities might also involve a certain delivery profile, which is why the transportation of gas to customers and the storage of natural gas for delivery are depicted in Fig. 1.1.

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Fig. 1.1

Energy value chain and its elements

To give another example, consider a company that is active in the oil and natural gas sector. The oil and natural gas are explored and produced in the upstream segment and then delivered to the two downstream segments. One downstream segment is for the oil, and the other is for the natural gas.

1.2.2 Main Economic and Financial Characteristics of the Energy Industry (e.g. Natural Gas)

To continue with the example of the energy value chain for natural gas, the characteristics of the various value chain segments can be discussed. In general, the upstream segment contains the most risks and involves the highest exposure from an investment perspective. By contrast, the upstream segment provides the highest returns in the entire value chain. These high returns come from the forecasted and planned commodity prices (which in this example are the price of natural gas) that can be yielded at the market. If the commodity prices have changed in the meantime and are not below the originally planned levels, the returns will not be reached. Based on the assumption that the commodity price risk will not be materialising, the payback period should be comparatively short. The maximum exposure, which is the accumulated negative cash flow, represents the point at which the exposure is the greatest. By generating cash inflows, the exposure is stepwise reduced until finally the break-even point is reached. This is the point at which the accumulated (which may be on basis of non-discounted or discounted cash flows) cash flow is zero, meaning that the initial investment has been amortised. In general, the midstream segment does not involve the same capital-intensive investments as upstream, but it might also require large-scale investments. As the returns are not as high as they are in the upstream segment, the payback period is comparatively longer (assuming that upstream yields the commodity selling prices as planned for its activities). Midstream activities might also face return limitations set by external factors such as regulation of product prices and tariffs by regulatory authorities. As the distribution, trading and wholesale of natural gas are less capital intensive than in the upstream and midstream segments, the downstream segment does not normally involve large investments (exceptions might be greenfield investments. For example, investments into a new long-distance pipeline or large-scale refinery). With regard to the involved net working capital along the energy value chain for natural gas, the lowest net working capital requirement is given in the upstream segment. The net working capital might be larger in the midstream segment, but it is definitely highest in the downstream segment. This is because the activities in this segment require inventories (e.g. for trading or wholesale if a certain delivery profile is requested) and trigger receivables or large payables when selling or purchasing the natural gas (Fig. 1.2).

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Fig. 1.2

Value chain segments and its main economic characteristics (example: natural gas)

Footnotes

1

In practice, the value chain might be structured in a different manner. For example, many energy companies structure their value chain in an upstream and a downstream part (midstream is part of downstream).

© Springer International Publishing AG, part of Springer Nature 2018

Martin Schwarzbichler, Christian Steiner and Daniel TurnheimFinancial Steering https://doi.org/10.1007/978-3-319-75762-9_2

2. Value Management for the Energy Industry: Financial KPIs and Ambition Level

Martin Schwarzbichler¹ , Christian Steiner² and Daniel Turnheim¹

(1)

OMV AG, Trabrennstraße, Vienna, Austria

(2)

Austrian Financial Reporting Enforcement Panel (AFREP), Argentinierstrasse, Vienna, Austria

The guiding principle of value creation is activities which earn a return on capital that exceeds their cost of capital. A stable and predictable interaction between the perspectives is a prerequisite for sustainable value creation and steering of a company.

2.1 Value Management

This book shall be a practitioner’s guide to how selected key elements of financial steering can be implemented. This book will focus on Value Management and specifically value creation, thus activities which earn a return on capital that exceeds their cost of capital. This section on Value Management shall also focus on liquidity and cash flow management in the short, mid and long term. It acknowledges that Value Management is embedded in each managerial decision.

In industries which have a focus on capital-intensive investment decisions which are amortised in the long-term, Value Management is especially important. The energy industry is such an example of such an industry and, for companies specifically active in the upstream sector (i.e. exploration and production of hydrocarbons), the economic issue of investing into and replacing of finite resources of hydrocarbons is an additional challenge for Value Management.

To ensure profitability and growth of a company, the following main principles are essential:

A properly operating management (management of revenues & expenses), a value adding and sustainable investment management (management of fixed assets and working capital), sound financing decisions (management of equity and liabilities) and a stable and predictable dividend policy (management of payouts).

The interplay of these main principles drives the profitability and value adding management of the company. The focus on each of the four principles will be adjusted and steered according to the size, orientation, strategy of the company as well as the nature of the general economic conditions experienced by the company.

2.2 Value Management in the Energy Industry

Energy companies might either be set up as vertically integrated companies being present in various elements of the energy value chain or might be set up as horizontally focusing companies which specialise in one or more elements of the energy value chain (e.g. upstream specialists). Both general types of energy companies need to set special emphasis on Value Management focusing both on evaluating long-term investment projects and managing cash flow and cost positions.

As a consequence, Value Management is highly established in the company’s planning and budgeting but especially in its decision-making process. Well-defined metrics, key performance indicators (KPIs) and control functions of energy industry companies’ management information system support the Value Management process in the framework of financial steering (please see Chap. 4 for selected KPIs).

In order to tackle all business relevant risks and uncertainties and ensure proper mitigation measures, Value Management in energy companies is also closely linked to risk management .

The return on average capital employed (‘ROACE’) is one of the most widely used key performance indicators by stakeholders (analysts, etc.). ROACE is a return metric which can be used for measuring the return on the capital employed for either short- or long-term perspectives.

However, there are situations where ROACE might be not the ideal key performance indicator and may even be misleading.

Indeed, ROACE is not the ideal key performance indicator in a growth phase. The net operating profit less adjusted taxes (‘NOPLAT ’) is not increasing, or there is no NOPLAT generated, while in the same period, the capital employed is increased by adding the investments (the financing of the investments). ROACE is not rewarding growth strategies and growth initiatives in this respect.

Decreases (e.g. impairments) and non-increase of asset basis (e.g. no new investment) improve ROACE in the short term but do not create value.

Off-balance sheet treatments of (core) assets improve the ROACE in the short term but give up NPV in the mid- to long term [under the assumption that off-balance sheet treatment is implementable anyhow].

One-off-net working capital reduction does improve cash and RONA /ROACE but decreases profitability in midterm.

Establishing an ambition level for the targeted ROACE for energy companies, current and historical ROACE levels at the company, as well as the ROACE levels achieved by the peers of the respective energy company, have to be considered.

For the determination of the target ambition level of the respective energy company, various approaches might be applied. Most of them include the calculation of the enterprise value of the company (whereas equity represents the market capitalisation of the energy company). The value added of the energy company is derived in such a way that the return on capital that exceeds the cost of capital and this spread is then multiplied by the capital employed.

In order to monitor when the value added is reached, the resulting target ROACE and ambition level must be calculated.

ROACE and IRR do not result in identical or similar levels: Only in exceptional cases, ROACE and IRR will show the same results. In the vast majority of cases in the energy industry, the ROACE will be higher than the IRR. The following subchapter examines this issue more closely.

2.3 ROACE Versus IRR (Hurdle Rate )

Although companies set the hurdle rates (the minimum IRR requirement a project must achieve) for Value Management (investment decisions, etc.) on the basis of the ROACE ambition level , Internal Rate of Return (IRR) and ROACE are not identical in their results (Coenenberg et al. 2016).

While ROACE depicts a snapshot of the financial reporting-driven return, the IRR provides a return rate based on a ‘full life cycle’, multi-period cash flow view and takes into consideration the time value of money .

The difference in results between ROACE and IRR comprises:

Changing capital employed(CE) basis for ROACE calculation

Timing/discounting effect implicitly reflected in the calculation of the IRR

ROACE and IRR only have identical results in ‘exceptional’ cases.

For this reason, ROACE and IRR only show identical results if:

No repayment/depreciation (i.e.capital employedstays at stable level) of the investment is taking place prior to end of project (see Case #1).

The investment has a useful life of 1 year, and the company is continuously investing, as illustrated in Case #2 below.

The remuneration (e.g. the interest) is linked to the remaining outstanding basis (e.g. the remaining outstanding debt or the remaining asset basis). This situation is illustrated in Case #3. TheNOPLATis represented by the interest component of the annuity, and the CE is simulated by the debt/investment minus the respective repayment for the period.

It has to be noted that Case #1 might exist, e.g. for banks in case of bullet loans which mature at the end of the loan life but is not applicable to investment at an energy company.

Cases #1, #2 and #3 show a capital employed (‘CE’) and NOPLAT remaining at a stable level (Table 2.1). The abbreviation 'mn EUR' represents million Euro.

Table 2.1

Case for identical ROACE and IRR

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In the majority of cases, ROACE and IRR yield different results.

For all other cases than previously noted (e.g. Case #1 and Case #2 example calculations), the average ROACE of a project will exceed the IRR of such project.

The following example simulation demonstrates the gap between ROACE and IRR . It depicts the ‘Equilibrium Status ’ of a company which is continuously investing in the same kind of project (i.e. projects with an identical cash flow profile and stable return but which occur in different years). The simulation depicts three different variants with various return assumptions (i.e. the projects’ IRR stand at 7%, 10% and 15%). Additionally, there is a ‘standard’ project period defined which represents the project period a company might normally see in its project portfolio. This ‘standard’ project period is—for simulation purposes—not limited to one project period (e.g. 15 years) but to a range of periods, ranging from 1 to 40 years. This set of assumptions has been completed by the following considerations:

Any returns generated during the useful life of the asset are assumed to be paid out on a continuous basis to the capital lenders of the project (equity and/or debt sponsors).

The simulation of the difference between ROACE and IRR assumes a portfolio perspective with a steady project pipeline with incoming, existing and out-fading projects. It is assumed that each portfolio (of assets) reaches an ‘Equilibrium Status ’ in terms of a robust and constant capital employed basis.

Investment period is—for the sake of simplicity—1 year. In the eventuality that the investment period exceeds 1 year, the mechanisms and conclusions described will not change.

A flat cash inflow profile is assumed for the entire project period, simulated by annuity (if the cash inflow increases towards the end of the project period (=backloaded cash flow profile), the difference between IRR and ROACE will widen due to the discounting effect and vice versa).

The simulation is looking at the ROACE calculated based on the assets (rather than liabilities and equity).

The difference between ROACE and IRR , which is depicted in the next table, does not only determine the difference when looking at portfolio level but is also equal to the result of single investments when looking at the average NOPLAT and capital employed over the project period (Table 2.2).

Table 2.2

Simplified simulation of IRR /ROACE delta I

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As can be seen in the previous illustration, the gap between IRR and ROACE widens with increasing return assumption and with an increasing useful life of the project. In relation to the energy industry, this could be understood as follows: the higher the project return (as the risk may be higher compared to other industries) and the longer the project period (capital-intensive projects with longer amortisation periods), the larger the gap between ROACE and IRR.

The following overview illustrates graphically the calculation methodology of the previous simulation. It assumes that a company is yearly investing 100 mn EUR in similar projects with a useful life of 5 years and a return of 15%. It can be seen that the investments are steadily depreciated and that the ‘Equilibrium Status ’ of CE and NOPLAT is reached from year 5 onwards, when there are projects in all life cycles starting from construction to full depreciation of the asset (Table 2.3).

Table 2.3

Portfolio view to simulate IRR /ROACE delta

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Looking at the ROACE development in the above-simulated portfolio, as well as the ROACE development of a single project, it is noted that the ROACE is zero or even negative during the construction period due to increasing capital employed , while zero or even a negative NOPLAT (e.g. due to non-capitalised operating expenses) is generated.

As progress advances, in the project timeline, the ROACE increases as on the one hand cash inflow is occurring, and therefore a positive NOPLAT is generated, and on the other hand the CE decreases due to depreciation. If a company continuously invests in similar projects with identical returns and cash flow profiles, the ‘Equilibrium Status ’ will be reached, which means that both CE and NOPLAT will remain stable and therefore will lead to a constant ROACE.

Once the ‘Equilibrium Status ’ is surpassed, the ROACE then steadily increases as there are no new investments and the remaining assets in the portfolio are continuously written off.

To calculate the ROACE of a portfolio in ‘Equilibrium Status ’ as shown above, the following formula¹ was applied:

$$ {\displaystyle \begin{array}{ll}\mathrm{avg}.\mathrm{ROACE}& =\frac{\mathrm{avg}.\mathrm{NOPLAT}}{\mathrm{avg}.\mathrm{CE}}\\ {}& =\frac{\left(\mathrm{Annuity}\ \mathrm{factor}\times \mathrm{Annual}\ \mathrm{investment}-\frac{\mathrm{Annual}\ \mathrm{investment}}{\mathrm{Useful}\ \mathrm{life}\ }\right)\times \mathrm{Useful}\ \mathrm{life}}{\left(\frac{\mathrm{Annual}\ \mathrm{investment}\times \left(\mathrm{Useful}\ \mathrm{life}+1\right)}{2}\right)}\end{array}} $$$$ \mathrm{Annuity}\ \mathrm{factor}=\frac{\left({\left(1+i\right)}^n\times i\right)}{{\left(1+i\right)}^n-1} $$

where ‘i’ represents the interest rate/IRR and ‘n’ stands for the number of period of the useful life.

Translation from Project’s IRR to an Average Portfolio ROACE

Components of the ROACE translation formula:

NOPLAT

In order to derive at the NOPLAT of the portfolio, the annual NOPLAT of a single project is calculated by multiplying the annuity factor by the annual investment and deducting the annual depreciation.

The NOPLAT of a single project is then multiplied by its useful life, which is defined by the number of projects in operation necessary to reach the steady state. For example, if the useful life is 5 years, then there is one project in construction phase not generating any NOPLAT and five projects in various projects stages of the operation phase which are generating cash.

Capital employed (CE)

The annual NOPLAT of the portfolio is then divided by the CE in the ‘Equilibrium Status ’, which is the annual investment multiplied by the project period, consisting of 1 year construction and the useful life, divided by two.

The total project period is divided by two in order to reflect that the projects in the portfolio are at various stages. We thus take an average from the middle of the project period.

Translation from an Average Portfolio ROACE to a Project’s IRR

When calculating the required IRR in order to ensure the achievement of a certain target ROACE for a portfolio, the previously stated formula cannot be directly translated to a similar (‘inverse’) formula, due to the fact that the IRR/interest rate cannot be encapsulated from the annuity factor -part of the quotation entirely.

The annuity factor -part of the quotation² is as follows:

$$ \mathrm{Annuity}\ \mathrm{factor}=\frac{\left({\left(1+i\right)}^n\times i\right)}{{\left(1+i\right)}^n-1} $$

where

‘i’ represents the interest rate/IRR .

‘n’ stands for number of periods of the useful life.

To ascertain what IRR has to be achieved in order to ensure the achievement of a certain ROACE for a portfolio, we can use the process of interpolation (e.g. by using goal seek in Microsoft © Excel). Using interpolation for the following formula leads to the requested result of the projects’ IRR needed to support a certain portfolio ROACE—result under the set of assumptions previously outlined in this chapter.

The next figure illustrates the development of the single ROACE components as depicted in the earlier simulation. Looking at the following figure, it can be noted that the CE gradually moves closer to half of the invested CAPEX with the increase of useful life of the asset as the share of construction phase among the total project period decreases. The NOPLAT decreases comparatively less than the capital employed and even begins to increase between a useful life of 7–12 years, as indicated by the red line in the next illustration. This leads to a widening of the gap between ROACE and IRR . As IRR takes the time value of money into consideration, the NOPLAT gradually increases with useful life due to the compensation of the discounting effect . In the following figure, the thin red line represents the intersection line between the area where the NOPLAT decreases less than the CE and where the NOPLAT increases due to the discounting effect (Fig. 2.1).

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Fig. 2.1

Development of ROACE components

Application of the ROACE vs IRR Logic in an Example

Applying this simplified logic to an example company, assuming:

An annual investment of 3 bn EUR

An average useful life of 20 years

That all projects reach exactly 15% hurdle rate

As can be seen in the next table, the company would reach a ROACE of 20.9% in the ‘Equilibrium Status ’. Turning it around and searching the hurdle rate for a 15% ROACE, results in a hurdle rate of 11.4% as shown in the second figure). However, this simulation neglects—for the sake of simplicity—the additional WACC spread on top of the ROACE target to cover overhead and non-profit improvement CAPEX and assumes that all projects are performing as planned and that the portfolio is at ‘Equilibrium Status’ (Table 2.4).

Table 2.4

Simulation of target hurdle rate /ROACE

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In the previous simulations, it is assumed that a company invests annually a stable amount of cash into new projects, that funds are provided on a yearly basis (‘ramp up’ phase) until the ‘Equilibrium Status ’ is reached, and that future investments can be entirely financed from operating cash flow .

Another way to look at it would be to assume that a certain amount of funding is provided in the first year only and that afterwards the amount earned and equivalent to the yearly depreciation is reinvested (Table 2.5). The additional return is assumed to be paid out to equity and debt providers in the respective year. Also, as is the case in the following figure, the ROACE will stabilise at 16.4% and will lead to the same result as already indicated in the earlier analysis (see Table 2.3).

Table 2.5

Simplified simulation of IRR /ROACE delta II

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Conclusion

Summing up the analysis of this chapter, ROACE does not equal IRR in the majority of cases. The average ROACE of a project respectively a portfolio usually exceeds the IRR mainly as a result of the discounting effect , implicitly reflected in IRR, leading to an increasing gap between IRR and ROACE, the longer the project period. Considering that energy companies are typically investing in long-term projects, setting the IRR hurdle rate based on the ROACE ambition level should make sure that the ROACE target is achieved or even exceeded as soon as ‘equilibrium state’ is reached. The difference between IRR and ROACE can therefore be seen as an additional markup on top of the defined WACC spread in order to ensure the achievement of the ROACE on a portfolio level. Reference is also made to the critical reflection on ROACE as metric, which was mentioned at the beginning of this subchapter.

2.4 Alternative Approaches to Calculate the Value Added and Capital Employed

There are two ways to calculate value added : the absolute method and the spread method .

In the first method, value added is calculated by subtracting the capital charge (capital employed × WACC ) from the NOPLAT .

In the second method, value added is the result of the value spread (ROCE³ – WACC ) multiplied by the capital employed .

Both approaches result in a value added in absolute terms (e.g. in mn EUR) and lead to the same result (Fig. 2.2).

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Fig. 2.2

Calculation path: Two ways to calculate value added

There are generally two approaches to calculate capital employed : asset-side and liability-side calculation.

On the asset-side, capital employed is the result of noncurrent assets plus the net working capital .

On the liability-side, it can be calculated by two methods: capital employed is the result of the total balance minus noninterest bearing liabilities or of the equity plus interest bearing liabilities reduced by cash.

Bibliography

Literature

Coenenberg, A. G., Fischer, T. M., & Günther, T. (2016). Kostenrechnung und Kostenanalyse (pp. 789–854). Stuttgart: Schäffer Poeschel.

Footnotes

1

Quotation for annuity factor with payment in arrears.

2

Quotation for annuity with payment in arrears.

3

ROCE or ROACE .

© Springer International Publishing AG, part of Springer Nature 2018

Martin Schwarzbichler, Christian Steiner and Daniel TurnheimFinancial Steering https://doi.org/10.1007/978-3-319-75762-9_3

3. WACCs and Hurdle Rate

Martin Schwarzbichler¹ , Christian Steiner² and Daniel Turnheim¹

(1)

OMV AG, Trabrennstraße, Vienna, Austria

(2)

Austrian Financial Reporting Enforcement Panel (AFREP), Argentinierstrasse, Vienna, Austria

The WACC (weighted average cost of capital) and the hurdle rate determine key input parameters for investment decisions in energy companies. The WACC is necessary to calculate the required key financial KPIs— NPV , DPI and DPP—while the hurdle rate sets the minimum return requirement a project needs to achieve in order to reach approval and to subsequently contribute to achieving management’s ROACE target.

The WACC and hurdle rates should acknowledge the difference in business risk between various business segments and imply the different country specifics.

If energy companies act as international players in the industry, there is a wide range of country-specific risks involved. It is thus important that country-specific risks are priced in for investment decisions, and for this reason therefore, the risk-return requirement of projects needs to be properly reflected in, for example, country-specific WACCs and country-specific hurdle rates.

This chapter provides an overview of the WACC and also provides a description of the identification and allocation of risks in either the WACC or the cash flow of the business case.

3.1 WACC Formula

The weighted average cost of capital (WACC),¹ commonly referred to as the cost of capital, is the expected rate a company has to pay on average to its equity and debt providers. It also determines the minimum acceptable rate of return for long-term investments.

If an investment earns more than its cost of capital, it will create value. If the return of an investment is below the cost of capital, shareholders’ value is destroyed.

The following formula is used to calculate the WACC (Fig. 3.1):

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Fig. 3.1

Composition of the WACC formula

3.1.1 Explanation of Formula Elements

3.1.1.1 Percentage of Equity (%E)/Debt (%D)

The sum of equity and debt makes up the total market value of a company’s financing. So the percentage of equity (debt) is simply calculated by dividing the market value of the equity (debt) by the total market value of the company.

3.1.1.2 Cost of Equity (r e)

The cost of equity is the rate of return required by shareholders and can be broken down into two components: the risk-free rate and the risk premium. The risk premium generally covers two forms of risk, the business risk and financial risk. If a company is purely equity financed, the WACC is equal to the cost of equity, and the involved risk is limited to business risk. If a company is increasingly financed with debt, the cost of equity increases due to the financing risk involved.

3.1.1.3 Cost of Debt (r d)

The cost of debt represents the market rate that a company is paying on its debt. As interest paid on debt is in general tax deductible, only the net cost of a company’s debt is reflected in the WACC formula (t = corporate tax rate).

3.2 WACC Parameters

The WACC for an energy company can² be structured in several ways and can follow several approaches. The approach has to be selected on a case-by-case basis. The WACC can be calculated on different levels: e.g. on group level, on business segment level, on country or even on asset level.

There might be input parameters which are applied uniformly throughout the levels, for example, risk-free rate, corporate spread and market risk premium and specific inputs, respectively, which are the beta factor, the country risk premium, the applied capital structure and the tax rate. In practice, it might be most common to take an investment decision on the level nearest to the investment (i.e. on country or even on asset level) (Fig. 3.2).

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Fig. 3.2

WACC calculation approach

The following sections give an overview of the single parameters used in order to work out the WACC and explain in detail where the basis for assumptions is applied. As the WACC serves as basis for long-term investment decisions, the input data should be based on a multiple years’ period in order to firstly ensure that current market developments are included and, secondly, to avoid high fluctuations and distortions due to short-term effects.

From this point onwards, we will use an example company in this Chapter and Chap. 5, internationally active and headquartered in Austria called the energy company.³ The WACC for this company will be calculated in this chapter. This WACC will then be used for the valuation of this energy company in Chap. 5.

3.2.1 Risk-Free Rate

The risk-free rate represents the theoretical rate of return of an investment with zero risk. It determines the interest an investor would expect from a risk-free investment over a specified period of time.

In practice, government bond yields are often used as a proxy for risk-free rates as they are preserved by the market as risk free due to the fact that they are backed by the full financial standing and rating of the government.

There are different ways of deriving the risk-free rate from a government bond such as the often used approach of taking the average structured yield curve according to Svensson (1994) for a time horizon of, for example, 30 years for a valuation period of 30 years.

3.2.2 Levered Beta

The beta (β) determines a measure of volatility or systematic risk of a security or an industry against the market as a whole. It is calculated using regression analysis by dividing the covariance of the security’s returns and the market’s returns by the variance of the market’s returns over a specified period (market is defined as the respective peer group for our energy company).

A commonly used expression of beta is

$$ \beta =\frac{\mathrm{Cov}\left({r}_{\mathrm{a}},{r}_{\mathrm{b}}\right)}{\mathrm{Var}\left({r}_{\mathrm{b}}\right)} $$

ra Return of the security

rb Return of the market

Cov Covariance

Var Variance

If the beta of a company is less than 1, this indicates that the company is less volatile than the overall reference market, while a beta above 1 indicates that the company is more volatile than the overall reference market.

The direct beta (also known as raw beta or levered beta) is based on the analysis of one single company, e.g. the regression of the energy company’s share price against a stock index. As the direct methodology already reflects the capital structure and tax rate of the respective company, no unlevering and re-levering of beta are required.

In the case of levered betas of the peers of the energy company, the derived betas need to be unlevered, meaning the peer-specific financing effects from leverage need to be removed and afterwards re-levered (replaced) by the company-specific capital structure. The unlevered beta (also known as asset beta ⁴) determines the beta of a company without any debt and is often used when comparing the risk involved in specific companies or industries.

The following formula shows the conversion of the direct beta (levered beta) to the unlevered beta (asset beta):

$$ {\beta}_{\mathrm{unlevered}}=\frac{\beta_{\mathrm{levered}}}{1+\left(1-\mathrm{tax}\right)\times \frac{D}{E}} $$

In order to aggregate the unlevered betas of the comparable peers into one single beta, the betas can be either weighted based on the mean or median or alternatively based on the r ² (coefficient of determination). After determining the company- or industry-specific unlevered beta, this is then re-levered with the company-specific capital structure by applying the following formula:

$$ {\beta}_{\mathrm{levered}}={\beta}_{\mathrm{unlevered}}\times \left[1+\left(1-\mathrm{tax}\right)\times \frac{D}{E}\right] $$

The levered beta (also known as equity beta) changes in positive correlation with the amount of debt a company has in its capital structure. This means the more financial leverage and therefore the higher the levered beta, the more earnings are committed to paying back that debt, which increases the associated risk for the equity stakeholders as well.

The simplified example below should illustrate schematically the levered beta based on different capital structures (Table 3.1):

Table 3.1

Example simulation of levered beta

The stock index for the determination of the beta can be selected on a case-by-case basis. The decisive point when selecting an index is what this index shall represent. There are indices which represent the leading share worldwide and capture large and mid-cap representations across several markets and industries. There are commonly used indices which represent a wide range of companies and industries, but there are also specialised indices which represent the industry or the country (e.g. Austrian Traded Index (ATX) or the German DAX index) in which the company with which they are being compared to is active. Upon the selection of the index, the beta result will be influenced.

The following steps need to be undertaken to derive the unlevered/levered beta:

Step 1: The share price of each peer is regressed against the selected index based on the weekly or monthly data over a certain time period. This leads to the direct beta (raw beta) of each peer.

Step 2: In order to derive the unlevered beta (often also known as asset beta), the levered betas of the peers are unlevered by applying a (e.g. multiple years’ average) capital structure and tax rate of each peer (βunlevered = βlevered/[1 + (1 − tax) × (D/E)]).

Step 3: The unlevered betas of the peers are then comprised into the unlevered beta for the energy company’s view by weighting based on, for example, (a) median or (b) average or (c)r². Steps 1 and 2 use the data only on a separate peer basis. Step 3 is aggregating the separate peer data into one peer group number by the weighting based on, e.g. (a) median or (b) average or (c) r². Steps 1 and 2 use the data only on a separate peer basis. Step 3 is aggregating the separate peer data into one peer group number by the weighting based on, e.g. (a) median or (b) average or (c) r², etc.

Step 4: The levered beta is then re-levered with the capital structure and tax rate of the energy company’s group view, its respective segments and countries. The levered beta also differs from country to country as different tax rates are applicable. Steps 1 to 3 did not use any data of the energy company so far; only with re-leveraging the data (group, segments, countries) of the energy company is used for the first time.

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3.2.3 Market Risk Premium

The market risk premium (MRP) describes the risk premium for an investment in a market portfolio instead of a risk-free bond and determines the difference between the expected return on a market portfolio and the risk-free rate. The MRP represents the systematic risk that cannot be eliminated by diversification.

A variety of recommendations on MRP can be found on the market. Example for a MRP can be taken from calculations of investment banks, from other financial institutions or from financial advisors. For the energy company , reference is made to the KPMG study which shows a MRP of 6.3% (KPMG 2016).⁵

This is also within the range of the recommendation of auditors’ recommendation, looking, e.g. on the Austrian (capital) market. The recommended range for the MRP is 5.5%–7.0% of the Expert Group on Business Valuation of the Austrian Chamber of the Tax. Advising, Auditing and Accounting Profession (Kammer der Wirtschaftstreuhänder 2012).

3.2.4 Country Risk Premium

The country risk premium (CRP) refers to the additional risk associated with investing in an international company rather than the domestic market. It refers to risks in connection with macroeconomic factors such as political instability, volatile exchange rates and economic turmoil. The countries’ comparative risk exposure is, inter alia, assessed and rated by credit rating agencies