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  1. 033A company pays Rs 20 crore of rent a year. Moving to IFRS 16 puts a Rs 150 crore lease liability on its balance sheet. Before the change its EBITDA was Rs 100 crore and its enterprise value Rs 800 crore. What happens to EBITDA, enterprise value and EV/EBITDA?Accounting riddlesHardCredit SuisseSão Paulo · 2021

    Try it first

    After the change, where does EV/EBITDA land?

    Show the worked solution

    EBITDA rises to Rs 120 crore, enterprise value to Rs 950 crore, and EV/EBITDA eases from 8.0x to about 7.9x. Rent leaves operating costs and comes back as depreciation and interest, which sit below EBITDA, so EBITDA gains the full Rs 20 crore. The lease liability is debt-like, so it joins EV. The multiple barely moves because both sides change together, and it slips only because the lease enters at 7.5x.

    Why does EBITDA rise when nothing about the business changed?

    Think of a family that rents its flat. If you decide to treat the flat as bought with a loan, the monthly rent disappears from the household budget and reappears as loan interest plus wear and tear on the flat. The family pays the same cash; only the labels moved. Under the new standard, rent leaves operating costs and returns as depreciation and interest, both below EBITDA, so EBITDA rises by the whole Rs 20 crore.

    Move EBITDA and EV together and the multiple barely movesBefore: rent is an operating cost100EBITDA800EVEV / EBITDA = 8.0xAfter: lease on the balance sheet+20120EBITDA+150950EVEV / EBITDA = 7.9xMixed bases: wrongLease in EV, old EBITDA950 / 1009.5xNew EBITDA, old EV800 / 1206.7xSame business,three different multiplesThe lease enters at 150 / 20 = 7.5x, below the business's 8.0x,so the blended multiple slips from 8.0x to 7.92x7.9x
    Before the change EBITDA is Rs 100 crore and EV Rs 800 crore, 8.0x; after it EBITDA is Rs 120 crore and EV Rs 950 crore, 7.92x, while mixing the two bases gives a wrong 9.5x or 6.7x for the same business.

    Why must enterprise value move too?

    Enterprise value has to match the earnings line it is divided into. Once EBITDA no longer bears the rent, the claim that rent used to pay for, the lease liabilityThe present value of the rent a company has committed to pay over the lease term, carried on the balance sheet like a loan., must be counted like debt and added to EV, taking it from Rs 800 crore to Rs 950 crore. Move one side without the other and the multiple jumps to 9.5x or collapses to 6.7x, though the business is exactly the same. Those two numbers are what candidates produce when they mix bases.

    The relationship
    800+150100+20=950120≈7.92×15020=7.5×\frac{800 + 150}{100 + 20} = \frac{950}{120} \approx 7.92\times \qquad \frac{150}{20} = 7.5\times
    150the lease liability, added to enterprise value
    20the rent, added back to EBITDA
    7.5xthe multiple at which the lease itself enters
    What it says in wordsThe new multiple is a blend of the old 8.0x and the lease's own 7.5x, weighted by size, so it lands just below 8.0x.

    What does this mean for a comps table?

    Some peers report under standards that capitalise leases and some under rules that leave rent in operating costs. A comps table means something only if every company sits on the same basis, either all before lease capitalisation or all after. For a retailer or an airline with large leases the gap is far bigger than here, so the adjustment can move the valuation more than any view on growth. Indian companies report under an equivalent standard; confirm which rule each peer follows before you build the table.

    Where candidates lose it

    The losing move is adjusting one side. Candidates add the Rs 150 crore liability to EV and stop, report 9.5x, and conclude the company now looks expensive, when the business has not changed at all.

    The second miss is insisting the multiple stays exactly at 8.0x. It moves slightly, and the reason, that the lease is priced at 7.5x, is what separates an answer from a guess.

    What the interviewer asks next

    • What happens to net income in the first year of the lease, and why?
    • Which cash flow statement lines change, and does free cash flow change?
    • A peer reports under rules that keep rent in operating costs. How do you put it on the same basis?

    Asked at Credit Suisse, Investment Banking, São Paulo, 2021 (Wall Street Oasis): can you explain how changes in accounting principles, such as the transition from GAAP to IFRS, might impact the DCF valuation process

  2. 073A company buys a Rs 100 crore asset. It depreciates it over 10 years in its books and over 5 years for tax, at a 25% tax rate. What deferred tax balance exists at the end of year 1 and year 5, and what happens to it afterwards?Accounting riddlesHardBulge bracket IBMiddle market IB

    Try it first

    Before you work it: what sits on the balance sheet at the end of year 5?

    Show the worked solution

    A deferred tax liability of Rs 2.5 crore at year 1, Rs 12.5 crore at year 5, and it unwinds to zero by year 10. Book depreciation is Rs 10 crore a year; tax depreciation is Rs 20 crore for five years then nothing. In years 1 to 5 taxable profit is Rs 10 crore below book profit, so the company pays Rs 2.5 crore less tax than it charges, and the difference accrues as a liability. From year 6 the position reverses and the liability drains at Rs 2.5 crore a year.

    Why is there a liability when the company has paid less tax?

    Think of a shopkeeper allowed to pay this year's electricity bill next year. Cash looks better today, but the bill has not vanished; it sits as something owed. Faster tax depreciation lets the company deduct the asset's cost sooner, so it pays less tax now and more later, and the accounts record the later tax as a liability the moment the saving is taken. The income statement charges tax on book profit, Rs 2.5 crore a year more than the cash actually paid in years 1 to 5, and that extra charge is what builds the balance.

    Faster tax depreciation opens a gap, then closes it: tax deferred, not cancelledYr 0Yr 1Yr 5Yr 1050100book value, 10 a yeartax value, 20 a yeargap 50 at year 5x 25% = DTL 12.5Deferred tax liability, Rs croreYr 12.5Yr 25.0Yr 37.5Yr 410.0Yr 512.5Yr 610.0Yr 77.5Yr 85.0Yr 92.5Yr 100.0red: builds, green: unwindsYears 1 to 5: pay Rs 2.5 crore less tax each year. Years 6 to 10: pay Rs 2.5 crore more. Net over ten years: zero.
    The asset's book value falls by Rs 10 crore a year while its tax value falls by Rs 20 crore, so the gap between them reaches Rs 50 crore at year 5 and 25% of that, Rs 12.5 crore, is the deferred tax liability, which then unwinds by Rs 2.5 crore a year as book depreciation continues with no tax deduction left.

    How do you get the balance without a schedule?

    Compare the two values of the asset. The deferred tax liability is the tax rate times the gap between the asset's book value and its tax value, because that gap is profit the tax authority has not yet taxed. At year 1 the book value is Rs 90 crore and the tax value Rs 80 crore, a gap of 10, and 25% of 10 is Rs 2.5 crore. At year 5 the book value is Rs 50 crore and the tax value is zero, a gap of 50, so the liability is Rs 12.5 crore. At year 10 both are zero and so is the liability.

    Year endBook valueTax valueGapDeferred tax liability at 25%
    19080102.5
    37040307.5
    55005012.5
    7300307.5
    100000.0
    Rs crore. The liability is always a quarter of the gap between the book value and the tax value of the asset, which is why it peaks at Rs 12.5 crore when the tax value hits zero at year 5 and disappears when the book value catches up at year 10.
    The relationship
    DTL=t×(book value−tax value)0.25×(50−0)=12.5DTL = t \times (\text{book value} - \text{tax value}) \qquad 0.25 \times (50 - 0) = 12.5
    DTLthe deferred tax liability, Rs crore
    tthe tax rate, 25%
    book valuecost less book depreciation, Rs 50 crore at year 5
    tax valuecost less tax depreciation, zero at year 5
    What it says in wordsThe liability is the tax rate applied to the profit the tax authority has not yet taxed.

    Why does a banker care about a timing difference?

    Because it is cash. In years 1 to 5 the company keeps Rs 2.5 crore a year more cash than its income statement suggests, which shows up as an increase in deferred tax liabilities in operating cash flow, and in years 6 to 10 the same amount drains out. A model that uses book tax on EBIT misses both legs, and a buyer of a company with a large and growing deferred tax liability should ask whether it is still growing because the company keeps buying assets, or about to reverse. Say the limitation: the balance reverses only if the company stops adding new assets, and tax rules on depreciation differ by country and change, so confirm the current rates before building this into a model.

    Where candidates lose it

    The common loss is calling the balance a deferred tax asset, because the company has paid less tax and that feels like a benefit. Paying less now means paying more later, which is a liability.

    The second loss is saying the two methods cancel out and so nothing appears. They cancel only over the full ten years; at every year end in between, the gap is real and sits on the balance sheet.

    What the interviewer asks next

    • Now the asset is sold at the end of year 5 for Rs 60 crore. What happens to the deferred tax liability?
    • What would create a deferred tax asset instead of a liability?
    • The tax rate rises to 30% at the start of year 3. What happens to the balance, and where does the change hit?