Convertible accounting: New US GAAP inflates earnings

Changes to convertible bond accounting under US GAAP will mean higher reported debt but, paradoxically, a lower (and sometimes zero) interest expense. In our view, the resulting increase in earnings is artificial, fails to faithfully represent the cost of convertible financing and will not benefit investors.

The recent surge in convertible issuance, and the use of so-called convertible bond hedges, may have more to do with favourable accounting than favourable economics. We use the recent convertible issue by Twitter to illustrate the revised US GAAP and compare this with the more realistic approach under IFRS.

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Zero coupon convertibles do not have a zero cost

Convertible bond issuance is at a record high, with companies ‘benefiting’ from low interest rates and high equity volatility. A recent $1.44bn convertible bond issue by Twitter, with a zero coupon and conversion premium of 67%,­ is a good example.

Convertibles are not the cheap form of financing that is sometimes claimed, nor do we think that so-called ‘hedging’ transactions, which often accompany convertible issues, create value for investors. We present an interactive model to demonstrate how to calculate the cost of capital for a convertible.

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DCF and pensions: Enterprise or equity cash flow?

Defined benefit pension schemes create two leverage effects – financial leverage due to the debt-like nature of pension deficits, and asset allocation leverage if pension assets are not matched with pension liabilities. In DCF valuation these effects must be correctly, and consistently, included in both the discount rate and free cash flow.

We use an interactive model to demonstrate four possible DCF approaches based on enterprise and equity cash flows. Our preferred approach uses enterprise free cash flow with the effects of asset allocation leverage excluded from the discount rate.

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DCF valuation models: Have you updated for IFRS 16?

An accounting change, such as the introduction of IFRS 16, does not in itself alter underlying economics. It follows that equity values derived from DCF models should also be unaffected. However, the IFRS 16 lease accounting changes seem to be creating some confusion.

We explain how to correctly adjust your DCF calculations and provide an interactive pre and post lease capitalisation model to illustrate. IFRS 16 makes DCF analysis easier and less prone to error; leaving your model based on pre-IFRS 16 figures is definitely not the best approach.

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