Pro Forma Balance Sheet

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▪ Income from Joint Ventures and Associates.. Historically the income from these sources as a percentage of revenue has been stable at 0,2%. As there are no indications of change, it is assumed to that this ratio remains as a constant 0,2% of revenues.

▪ Net financial expense is estimated as a percentage of NIBD as suggested by Petersen and Plenborg (2012). Since Volvo’s historical measures provides no or little guidance as to how this proportion will look going forward, the estimate will be based on the current depository market rate and the company’s cost of debt. Due to the fact that NIBD is forecasted, the distribution of interest-bearing assets and interest-bearing debt is not disclosed which ultimately leads to uncertainty in the estimate.

However, the market rate on depositions in the company’s legal homestay (Sweden) is zero and the cost of debt is 3,5% (See cost of capital). In order to account for the uncertainty, a 3% mark-up on company cost of debt is applied, thus estimating net financial expense as a percentage of NIBD at 6,5%.

▪ Tax rate. Volvo generates revenue from all different regional parts of the world, which exposes to the company to different national tax laws and different marginal tax rates. Considering this, the average global corporate marginal tax rate of 23,62% will be applied for tax allocations (Damodaran, A, 2017a) . Historically the effective tax rate has been close to this tax rate, with the exception of year 2014 (56%). This tax rate is applied on both operating income and net financial expenses.

For the years 2022 to 2026 a more streamlined model is applied, where only core value drivers such as EBITDA margin and EBIT margin are forecasted. It is assumed that Volvo reaches a steady state, with constant growth and margins, in 2024.

▪ EBITDA margin is expected to somewhat as decrease towards the end as operating expenses is likely to increase. First of all, gross margin will likely decrease as the bargaining power between suppliers and the company (and the industry as a whole) will structurally change. As already discussed, the more advanced inputs from suppliers is expected to put pressure on margins. In addition, heavy investments in R&D and marketing to keep up with government regulation, consumer trends and preferences is projected to be necessary, all of which negatively impacts EBITDA. As a result, EBIT margin is expected to decrease as towards the industry average of 5,3% (Damodaran A. , 2017b)

69 sales to investments in intangible and tangible assets (important note is that this figure might be supressed due to the different accounting standards). Volvo has previously left a period where the company invested more heavily than ever before, with as much as 37% of revenues in 2014. As a result, investments over the coming few years is expected to somewhat slow down. Generally, companies in the industry gradually invest in intangible and tangible assets and therefore investments are forecasted as a percentage of revenue.

In 2016, intangible and tangible assets accounted to for roughly 40% of revenues. Going forward, it is expected that this relationship decrease slightly to 38% over the next coming five years. Beyond this point it is predicted that this ratio increases due to industry changes, stricter government regulation and consumer demands. In technical terms, CAPEX is calculated as the difference between intangible and tangible assets at the end and at the beginning of the period plus D&A during that period. In this case, there is also non-current operating liabilities, to take this into account CAPEX is adjusted by adding the difference between ending and beginning value as it implies a free source of funding. The investments over the entire period corresponds to an average CAPEX as percentage of revenue of 8,3%, coming down from 12% in 2016.

The ratio is somewhat higher than the average of the industry. However, this is considered a necessity for Volvo given their relative size so in order to remain competitive, a higher investment rate is required.

Other Non-Current Assets

▪ Other non-current assets as a percentage of revenue display no trend historically. Therefore, forecast of this ratio is reliant on the most previous year. As such, it is predicted that it remains as a constant 1,5% of revenue.

▪ Deferred taxes. Historically the ratio between deferred tax assets and revenue has been stationary around 2%, looking forward it is assumed that it remains as a constant 2%.

▪ Investments in Joint Ventures & Associates has been fairly stable. Between 2014 and 2015 the ratio between the investments in JV and associates and revenue was 0,4%, whereas in the most recent fiscal year the ratio increased to 1,4%. Given that the auto industry is closely associated to such investments, the ratio is expected to remain at the somewhat higher level (as in 2016).

Working Capital

Over the last couple of years, Volvo's has financed its immediate operations due to large increase in its accounts payables as a result of the increased demand and recent growth of the company. Though negative working capital might indicate issues to make ends meet and having to rely raising new capital to finance operations, this is not considered a concern of Volvo as the company have excess cash (not included in the operating working capital) to cover obligations to vendors. Like many companies in the automotive industry, Volvo’s business model when it comes to manufacturing of cars is based on the built to order model (Volvo Cars, 2015). This means that inventories can be held at low levels and the company has relatively few receivables to advance, the company can operate with negative working capital. In other words, collecting

70 cash up-front but paying suppliers later has been a way of expanding the business. Between 2014 and 2016, net working capital decreased (increased in absolute terms) from -11,6% of revenues to -18,7%, maily driven by an increase in trade payables. Investments in working capital is defined as net working capital and is calculated as the ending value of working capital less the beginning value.

Negative operating working capital is not uncommon; Damodaran (2017c) separate working capital ratios by sector and find an industry average in the U.S. of -2,4%. This is likely the result of the power of these large companies’ when demanding longer credit period from their fragmented suppliers. Since the acquisition by Zhejiang Geely Holdings in 2010, the company started searching for ways to manage and optimise its working capital performance. The solution was found in a new supply chain finance (SCF) system implemented by the company (treasurytoday, 2016). Central to this was optimising the liquidity cycle, which has been considerably lower than the average of peers (appendix 13). This demonstrates the company’s strength of employing short-term assets and abilities to generate cash for the company. Since revenues are growing and expected to continue doing so, the positive effects of a negative working capital position is expected to endure.

In the explicit forecasting period, working capital is decomposed into operating current assets (including line items) and operating current liabilities (including line items). Each of the line items under respective heading is forecasted as a percentage of revenue, as suggested by Koller et al, (2005) and Petersen &

Plenborg (2015). Table 14 display each line item as a percentage of revenue. The ratios between working capital items and revenues have been set to reflect historical values and future expectations. For example, it is expected that the company maintain its inventory holding period. Overall, it is assumed that this way of operating, negative working capital balance, will continue going forward reflecting the company’s ability to resist pressure for faster payments from outside suppliers. Over the long run, the working capital is expected to somewhat deteriorate (increase) due to factors identified in the strategic analysis.

NIBD

In 2016 the company held a negative NIBD of €0,942bn which is primarily explained by the company’s cash position where cash and cash equivalents amounted to approximately 24% of total assets and 21% of revenues. Given the 2% assumption of operating cash, this yields a substantial excess cash item amounting to €3,637bn on the analytical balance sheet. This more than covers the company’s €3,195bn in interest-bearing debt, and by adding the remaining financial assets of €0,5bn, the substantially negative NIBD is obtained (appendix 4). The company does not provide any guidance as to how these excess funds will be utilised going forward, but given the target capital structure derived in a later section on cost of capital. However, as Koller et al (2005) highlight, excess cash and newly issued debt does not impact the value of the firm as the effect of capital structure is captured in company cost of capital and not forecasted

71 balance sheet items. Thus, to obtain the target capital structure in 2017, Petersen and Plenborg’s (2012) method of estimating NIBD as a percentage of invested capital in line with target capital structure is used.

Other Balance Sheet Items

▪ Minority interest/Non-controlling interest is forecasted as a percentage of profits after tax, coherent with what Koller et al. (2005) suggests. Historically, the ratio has fluctuated between -6,3% and 30%, going forward it is assumed that minority interest is forecasted as a constant 25% of profit after tax.

▪ Total Non-Current Operating Liabilities is forecasted as a percentage of revenue. The ratio is forecasted based on the average ratio of the corresponding historical values which have been stable at approximately 6%.

Table 14. Pro forma balance sheet assumptions

Source: Constructed by the authors