Accounting and finance practices at Henkel AG

Accounting and Finance

Henkel AG is a multinational company focusing its brand and technologies in three business areas that include Beauty Care, Laundry & Home Care and Adhesive Technologies. Established in 1976, the company holds its global market positions in both the consumer and industrial products with well-known brands that include Lactate, Persil, and Schwarzkopf. Henkel's headquarter is in Dusseldorf in German and the company has over 47,000 employees globally. Typically, the company is considered among the most "internationally aligned German-based companies in the global marketplace." (Henkel 2012).

Objective of this paper is to use various financial models to carry out financial analysis and valuation of financial Henkel AG.

Valuation Model

One of the methods to carry out the valuation of a company is to use enterprises discounted cash flow (DCF). The DCF could be carried out using WACC (weighted average cost of capital) that represents the opportunity costs that investors will face when they decides to invest their funds in the capital market. To determine WACC, the three components are used which include after-tax cost of debt, the company target capital structure and the cost of equity. However, none of the variables is observable, various models, approximations and assumptions are used to estimate each of the components.

To carry out the valuation of Henkel AG, the report uses the market data of the company and examines the most appropriate method to carry out the valuation of the company.

Answer to Question 1

a. Generally, the cost of equity is built on three factors, which include the market risk premium, a company specific risk adjustment and the risk. Typically, a commonly used model to estimate the cost of equity is CAPM (capital asset pricing model. To determine the CAPM it is critical to estimate the following:

A Risk-free rate

Market risk premium and,

Market Beta

This report determines the risk free rate by using the U.S. Treasury rates.

Determination of a Risk Free Rate using U.S. Treasury Rates

Theoretically, risk free rate is the rate of returns of an investment that carries no risk of financial loss. The interpretation is that the risk free rate represents the total interests that investors would expect from their investments over a given period. (Damodaran, 2008).

In other word, a risk free rate is an investment where limited rate of return could be obtained with limited credit risks. The U.S. government treasury bill of short-term investment and back by the U.S. government is considered an investment that involves the risk free rates. U.S. Treasury securities are generally considered risk free and considered safest of all investments because the federal government full backs them. (Fleming, 2000). Due to the degree of safety of the treasury bills, the interest's rates are generally low compared to other securities in the capital market.

Thus, this paper uses the three-month U.S. Treasury bill of which maturity is three months to carry out the valuation of Henkel Company. Theoretically, a risk free rate of U.S. Treasury bill is considered short-term investment of approximately three-month U.S. Treasury bill. This paper collects three-month data of the U.S. Treasury bill to determine the risk free rate. This paper chooses the three-month U.S. Treasury bill to value the company because the three-month Treasury bill is carrying the least risks since it is less affected by the fluctuation of the interest rates and the state of the economy such as inflation. However, when the investment on U.S. treasury bills is more than three months, the risks will become high because Treasury bill may be affected by interest rates risks and inflation. Three-month Treasury rate is 0.07% as of April 05, 2013. The three-month Treasury data that determine the risk-free rate of Treasury rate is revealed in Table 1. The company cost of debt is 4.1% and is calculated using the 3-month risk free rate of 8%, where the company beta is 0.7.

Table 1: Three-Month Treasury Risk Free Rate.

BANK DISCOUNT

COUPON EQUIVALENT

BANK DISCOUNT

COUPON

U.S. Treasury (2013).

b). The paper performs regression analysis of 10-year monthly returns of Henkel AG personal product against MSCI World Index. The result of regression analysis is presented in Table 2.

Table 2: SUMMARY OUTPUT of Regression Analysis

Regression Statistics

Multiple R

0,308866

R Square

0,095398

Adjusted R. Square

0,095041

Standard Error

14,47243

Observations

ANOVA

df

SS

MS

F

Significance F

Regression

1

55994,17

55994,17

267,3377

3,3E-57

Residual

530958,5

209,4511

Total

586952,7

Coefficients

Standard Error

t Stat

P-value

Lower 95%

Upper 95%

Lower 95,0%

Upper 95,0%

Intercept

37,42416

0,289694

129,1853

0

36,8561

37,99222

36,8561

37,99222

X Variable 1

0,011502

0,000703

16,35046

3,3E-57

0,010122

0,012881

0,010122

0,012881

Results of regression analysis of Henkel since 2003 against MCI World Index reveal that the company beta is estimated to be 0.70. The cost equity is 8.5%, while the cost of equity is 8.5%, and the company WACC is 8.0%.

The paper also determines the Henkel's corporate beta, the paper re-lever the industry average industry beta using Henkel's year debt-to-equity ratio. Debt-equity ratio measures the financial leverage ratio of a company. Typically, financial leverage ratio measures company's ability to settle its short-term and long-term obligations. The formula to calculate debt-to-equity ratio is as follows:

Debt-to-equity-ratio= Total Liabilities/Shareholder Equities

Debt-to-equity-ratio is particularly important is calculating levered beta. For example, with increase in a company debt, there is an increase in the company debt-to-equity-ratio leading to the increase company beta. Typically, a high debt/equity means that a company is aggressively financing its growth with debt, which consequently leads to high beta.

Henkel Debt-to-equity-ratio

Financial Health / Liquidity

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Current Ratio

0.91

1.13

1.34

1.58

1.31

1.31

Quick Ratio

0.41

0.69

0.77

0.93

0.56

0.56

Financial Leverage

2.83

3.07

2.6

2.43

2.31

2.46

2.42

2.2

2.12

2.05

2.05

Debt/Equity

0.56

1.1

0.82

0.72

0.65

0.37

0.52

0.45

0.41

0.26

0.26

Debt/Equity Industry

0.63

0.65

Beta

0.70

Since 2003, the company debt/equity declines considerably. In 2003, the debt/equity was 0.56 and in 2012/2013, the debt-to-equity-ratio declined to 0.26, which is 115% decrease between 2003 and 2013. Henkel risk indicator is presented in the Table below.

Table: Henkel AG Current Risk Indicators

Risk Adjusted Performance

(0.02)

Market Risk Adjusted Performance

(0.19)

Mean Deviation

0.8342

Semi-Deviation

1.46

Downside Deviation

1.45

Coefficient Of Variation

(3,393)

Standard Deviation

1.12

Analysis of Henkel portfolio reveals that the company stock has 1.12 volatility and is 1.35 times volatile than DAX. Moreover, 16% of all portfolio and equities are less risky than Henkel. Comparative analysis of Henkel equities with global equities reveals that volatility of Henkel's historical daily returns is 16% lower than of all global equities. The Beta of Henkel AG is 0.70, and beta refers to the volatility of the stock of Henkel compared to the entire stock market. As being revealed in Fig 1, Henkel perform better than the S & P. 500 since 2003.

However,

"Henkel shares showed a very positive performance overall in 2012. Over the course of the year, the DAX rose by 29.1% to 7,612.39. The index for consumer goods stocks -- the Dow Jones Euro Stoxx Consumer Goods -- increased 26.0%, closing at 423.06. Against this market backdrop, the price of Henkel preferred shares increased to 62.20 Euros, closing the year 39.5% higher on a year-on-year basis. Our ordinary share price likewise posted strong gains, ending the year 38.9% higher at 51.93 Euros. As such, our shares performed clearly better than both the DAX and other shares representing the consumer goods sector." (Henkel, 2012 P. 1).

Fig 1: Henkel Performances Compared to S & P. 500.

Answer to Question 2

A).The most appropriate Treasury rate in valuing the cost of debt of the Henkel AG is ten-year Treasury note. The 10-year Treasury note is a loan that organizations and individuals loans to the U.S. government. The 10-year Treasury note is the rate of return that organization gets from investing in government bond. Typically, the rate is the benchmark of the interest rates. Since, the Henkel debt is driven by risk factors, it would not be appropriate to use Treasury risk free rates to value the cost of debt of the Henkel AG. Analysis of Henkel financial instruments reveals that the company engages in series of long-term debt making the company to enter into series of hedging and derivatives to guide against interest rates risks. As of December 2012, the total amount of company debt was 3.4 Billion Euro. Within the company liabilities, Henkel borrowings with hedging relationship valued 3.5 Billion Euro while the company borrowing with no hedging relationships valued 241 Million Euro. To guide against the interest rates fluctuation associated with long-term debt, the company also enters into the following financial instruments:

Forward exchange contracts, which involves hedging the loans entered by the company,

Interest rate swaps designated for fair value hedge and cash flow hedge,

Other type of interest rate hedging associated designated for hedge accounting,

Commodity futures associated with hedging accounting.

In 2012, the interest rate swap was appropriately 4.7 Billion Euro. The table 3 reveals the total derivative financial instruments that the company enters in 2012.

Table 3: Derivative financial instruments

Nominal value

Positive fair value2

Negative fair value2

At December 31

2011

2012

2011

2012

2011

2012

in million Euros

Forward exchange contracts

1,445

1,985

7

14

( hedging loans)

(881)

(1,628)

(4)

(12)

( -- 14)

( -- 16)

Interest rate swaps

4,537

4,734

F air value hedge)

(3,300)

(3,300)

(256)

(244)

Cash flow hedge)

(1,237)

(910)

( -- 51)

( -- 19)

Hedge financial instruments

(524)

( -- 16)

Interest rate hedging instruments hedge accounting)

Commodity futures

39

1

1

Hedge accounting)

Total derivative financial instruments

6,407

6,720

Unlike the Treasury free risk rates that carries minimal risks, the 10-years Treasury is being affected with risks, which include the interest rate risks, inflation risks, and the risk associated with the state of the economy. Since Henkel debts are subjected to lot of risks, the company uses several financial instruments to mitigate the risks. Typically, the rise in the rates of the 10-year Treasury note affects the debts of Henkel Company with the fluctuation in the interest rates. Thus, Henkel enters into series of financial instruments to mitigate the risks. Overview of the 10-year U.S. Treasury rate in Table 4 reveals that Treasury notes are also been affected by the interest rates and the states of the economy. In 2003, the Treasury rate was 4.07% while the Treasury rates declined to 1.72% in 2013, which is 136% difference between 2003 and 2013.

Table 4; Ten-Year Historical U.S. Treasury Data

April 5, 2013

1.72%

January 3, 2012

1.97%

January 3, 2011

3.36%

January 4, 2010

3.85%

January 2, 2009

2.46%

January 2, 2008

3.91%

January 2, 2007

4.68%

January 3, 2006

4.37%

January 3, 2005

4.23%

January 2, 2004

4.38%

January 2, 2003

4.07%

Fig 2. 10-YEAR Treasury Rates

b. Henkel credit rating by Standard and Poor is categorized between A and A-1. The company credit rating is presented in the table below:

Table 5. Henkel Credit rating

Standard & Poor's

Moody's

Long-term

A

A2

Outlook

stable stable

Short-term

A-1

P1

Source: (Henkel, 2012)

According to Standard and Poor's rating, the company long-term investment grade is A revealing that the company possess "adequate capacity to meet financial commitments, many positive investment attributes but also elements susceptible to adverse effects of changes in economic conditions." (Henkel, 2012 P. 1). Similarly, the Standard and Poor's rating of Henkel with regard to short-term investment also shows that the company possesses capacity to meet its short-term financial commitment.

Based on historical company yields between 2003 and 2013 in Table 6, it is revealed that the company is able to meet its short-term and long-term investment obligation. In 2003, the company total retuns was 21.06 Euro, however in 2013, the company total returns incraesed to 82.81 Euro revealing 293% increase in the company total return between 2003 and 2013. As being revealed in the Fig 4, the graph below, the company total returns increases sharply over the 10 yaers while the company debt/equity ratio declines over the 10-year period.

Table 6: Henkel Total Returns

Total Returns

Debt/Equity

2013

82,81

0.26

2012

71,74

0.26

2011

51,43

0.41

2010

53,67

0.45

2009

42,02

0.52

2008

25,45

0.37

2007

42,57

0.65

2006

39,71

0.72

2005

29,88

0.82

2004

22,1

1.1

2003

21,06

0.56

Fig 3: 10-Year Henkel Returns

Fig 4: 10-Year Henkel Returns vs. Debt/Equity

Based on the company performances over the last 10 years, the Henkel credit rating should be as follows:

Henkel credit rating

Long-term

AA-

"High probability of timely and completely payment" (Henkel, 2012 P. 1).

Short-term

AA

"High probability of timely and completely payment." ((Henkel, 2012 P. 1).

C. The marginal tax rate is the amount of dollar paid with additional increase income . Typically, the marginal tax rate increases as the income rises. The Henkel marginal rate tax is caculated based on the company income statements. In 2012, the marginal tax rate for Henkel was 24.4%. The braekdown of the Henkel income tax is provided below:

Analysis of Taxes and Income before taxes

Million Euros

2011

restated

2012

Earnings before tax

1,610

2,058

Current taxes

Deferred taxes

35

Taxes on income

Tax rate in %

26.0%

24.4%

Determination of taxes is based on calculation of application of IAS 8 Accounting policies.

Moreover, the company main components of income and taxes are presented in the table below: