26 January 2015

Target Canada's interlocking relationships

Going back to the Pre-Filing Report submitted by Target Canada's imminent Monitor, here are some interesting aspects as to how an organization like that is structured.


Four banks were involved:
  • Royal Bank of Canada
  • Toronto-Dominion Bank
  • JPMorgan Chase
  • Bank of America
 Bank of America was the prime banker, into and out of which all funds ultimately flowed:
  • CAD credit, debit and gift card transactions flowed through deposit-taking accounts at TD, which were swept into concentration accounts.
  • Other CAD and USD  receipts flowed through deposit-taking accounts at RBC, which were swept into their respective concentration accounts.
  • Funds from TD and RBC were transferred to the Bank of America on an "as needed" basis, in order to fund Target Canada's operations.
  • There was an account at JPM dedicated to overseas vendor payments, which was funded out of the Bank of America.
  • Bank of America handled all disbursements through several accounts (segregate according to method of payment and currency type), which were swept into concentration accounts. There was also a master account for currency conversion and funding JPM payments, as well as an account dedicated to payments to Starbucks under its licensing agreement for in-store sales.
There is nothing unusual about such arrangements - in fact, I first came across similar structures in the early 1980s, and they were very effective then in managing complex series of transactions. It is interesting, though, that the Canadian banks played an essentially subordinate role here.

Intercompany agreements

There was a master agreement in effect between Target Canada and one of the Target US operating subsidiaries that covered an extremely broad range of support services as well as a license for Target's intellectual property. The support staff were located at Target's head office in Minneapolis, as well as in India. It's interesting to observe that they were only in the process of obtaining approval from the CRA for an advance pricing agreement to assure that fees payable under the APA would be regarded as being at arm's-length. After over two years, one would think that such approval would have already been received.

There were also intercompany agreements in effect for the secondment of employees from Target US operations to Target Canada, where connected expenses were reimbursed, as well as for the management of its leased properties, its buying agency, and its design and development services.

All of these arrangements are quite normal in multinational companies, and they should be used more in Canadian-owned enterprises. That may tie in with the hollowing-out effect I mentioned previously.

25 January 2015

Thoughts on capital investment appraisal

A while back, I posted about the techniques one must use when calculating appraisals in a Canadian context. It was somewhat simplified, as it pertained only to a single alternative. That is unrealistic, as the business world is more complex: 
  • What if there are alternatives?
  • Which one makes more economic sense?
  • Assuming that benefits are equal among the alternatives, which project results in the lowest cost?
  • What if these alternatives have different economic lives?
  • Is leasing or buying the most economical choice?

For the first two questions, the answer is almost always the alternative with the greatest net present value on a discounted cash flow basis. The only plausible exception is where the project represents a major ground-breaking development, and that calls for strategic decision-making at the Board level. That is a discussion for another time.

For the other questions, there is a technique available that has been rarely discussed but is quite powerful, which calls for determining the Equivalent Annual Cost. Put simply, it is the net present value divided by the capital annuity factor, or

$ EAC = \frac{NPV}{A_{t,i}} $

where t = number of years, and i = cost of capital. The capital annuity factor is calculated as:

$ A_{t,i} = \frac{1-\left(\frac{1}{1+i}\right)^t}{i} $

If there is any salvage value at the end of the project, that can be factored in through using a sinking fund factor, calculated as:

 $ SFF_{t,i} = \frac{1}{\left(1+i\right)^t-1} $

This is useful for many scenarios:
  • What if the asset requires periodic overhauls every few years, and in what circumstances is it cheaper to replace rather than overhaul?
  • What commitments must be made for maintaining inventories of parts and maintenance supplies?
  • What if a landlord provides rent-free periods at certain points in the lease?
  • Are there conditional grants or other incentives that are paid subsequent to acquisition or improvement of an asset?
  • Can the asset be sold at the end of its useful economic life, and would that value be different for the various alternatives?
These can be calculated in a rather straightforward manner. Let us take an example of deciding which of two types of storage tanks would represent a more economical investment. A steel tank costing CAD 10,000 with a salvage value of CAD 1,000 and annual operating costs of CAD 1,600 has an estimated useful life of five years. It is being compared to a stainless steel tank costing CAD 25,000 with a salvage value of CAD 2,000 and annual operating costs of CAD 100. Which is the better choice?

In this case, all other things being equal, the stainless steel tank has the lower EAC, and it should be the preferred choice.

For manufacturing and processing operations, assets fall under class 29, which has a different calculation. The result can be modified as follows:

 In this case, the end result would still be the same, but note how different the NPVs are for the capital investment.

This is not a new technique: in fact, it was taught to all CMAs and still represents part of the Body of Knowledge that we are expected to use in our work. It was discussed in much greater detail in A Practical Approach to the Appraisal of Capital Expenditures (C. Geoffrey Edge, V. Bruce Irvine (1981), ISBN 0-920212-29-8), which, having been last issued in 1989, does not seem to be widely available these days. I took one of its examples on this subject, and updated it to take into account the "half-year rule" now in effect for claiming first-year CCA, as well as more realistic rates for corporate tax and cost of capital. Otherwise, the logic is still sound.

I am publishing this because I cannot seem to find anything similar on the web, and this is just too useful not to attract a wider audience in the CPA community. Formulas are embedded, so that its working can be better understood.

23 January 2015

Another sad point about Target Canada

Normally, reviewing bankruptcy and CCAA filings is rather depressing, but there are occasions where some details pop out that really are surprising.

Take the recent news about Target pulling the plug on its Canadian operations:

There's a throw-away observation on p. 16 of the Pre-Filing Report, which disclosed that "[Target Canada] does not have stand-alone accounting and treasury departments." These functions were handled out of Target's head office in Minneapolis, under an intercompany agreement.

Think about it: in establishing its Canadian operation, the US parent decided that it was not appropriate to set up a separate Finance function, whether for reasons of cost or operational efficiency. I have already been familiar with some larger companies setting up shared service centres for consolidating some aspects of their operations world-wide, but deciding to farm out the entire function to another country does not bode well for us CPAs here. This is suggesting a hollowing-out may be coming for many Canadian operations of foreign companies, on a scale we have not yet contemplated:
  • spreadsheet and ERP applications have taken over many tasks that used to be consigned to clerical staff
  • receivables and payables processing can be fully automated, to the point that remittance information can be transmitted to vendors for posting directly against outstanding invoices without human intervention
  • banking transactions can be handled in similar fashion
  • in short, paper-based transactions are essentially obsolete, and any that remain suggest that operations are not being competently managed
  • posting and reconciliation can be handled anywhere, and I am already familiar with such operations being handled out of India, Malaysia and the Philippines by equally competent staff working for significantly less salary that would be the case here
Given these realities, what is left for professional accountants to do on our home turf? Is there still opportunity for developing Finance groups with a critical mass of CPAs that will benefit new Canadian organizations that are not in the public sector? This is definitely worth debating.