A Primer in Corporate Valuation – Part 2

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In the first part of this article series I showed how to value a firm using the market valuation method, where stock prices are used to estimate equity market capitalization.

In this post, I will explain the Free Cash Flow to the Firm (FCFF) method of corporate valuation. The approach is covered in a lot more detail in my textbook, especially Corporate Finance: 2nd Edition, and you can find out much more about the fundamentals of the approach there.

The basis of the FCFF method is Discounted Cash Flow and Time Value of Money. I won’t spend any time discussing this concept here but the interested reader is invited to read any of my textbooks, where I go into this method in depth.

To value a company using the FCFF method, one must first estimate the cash flows that are earned in each year and discount these values to today’s terms.

Step 1: Estimation of Free Cash Flows.

The best way to estimate free cash flows is to work with a company’s management and derive estimates of future cash flows (up to about five years).

However, this isn’t practical in many cases where only the most recent financial accounts are available. In this situation, the easiest way to estimate the cash flows that come into the firm is to use the following formula together with the company’s most recent cash flow statement:

Free Cash Flow to the Firm = Cash Flow from Operations + Cash Flow from Investing Activities

To illustrate, we will continue with our case study of Carillion plc. The cash flow statement of Carillion (taken from the 2013 Annual Accounts) is as follows:


The Free Cash Flow to the Firm in 2013 was thus £107.2 million – £78.4 million = £28.8 million.

At this point, I’d like to state that the massive change in cash flow components between 2013 and 2012 gives me significant concern on the viability of this method in valuing Carillion plc.

This is because we have no way of knowing what is a sustainable cash flow or whether cash flows will settle down in the future.

Keep a look out for cases were the cash flows change significantly from one year to the next. In Carillion’s case, there was a significant disposal of assets (£143.7 million) in 2013 that would unlikely be repeated. However, we don’t know if the cash that was released because of this sale was used to acquire assets in the same year!

Since this post is only to show how to use the FCFF method, we will keep this concern in mind but do nothing to investigate further.

Lets move on to the next steps…

Step 2: Estimate the growth rate in cash flows

A simplifying assumption that I am going to make here is that the FCFF grows at a steady rate forever. Clearly, this is unrealistic. However, it is a good starting point and a Launchpad for more complex analysis later on.

Unfortunately, growth rates are notoriously difficult to estimate as they are based completely on subjective forecasts. My favoured approach is to simply use analyst forecasts as an initial estimate, and iterate further once initial firm values have been calculated.

Looking at the Carillion page on FT.Com (search for the name in the FT.Com website and click on forecasts tab):

280714Fig3Source: FT.Com, July 2014.

Two forecasts are provided for the growth rate: 1.71% and 1.45%.

Looking at earnings figures for the company can also provide some more insight on growth rates (assuming that dividends are paid out as a constant percentage of earnings):


Source: FT.Com, July 2014.

Thus, a third growth rate estimate is 6.53%.

Finally, we can also check Carillion’s annual report to see if they have an estimated growth rate of cash flows. From page 93 of their 2013 annual report:

“The cash flows used to determine the value-in-use calculations are based upon the latest three year forecasts approved by management which are based upon secured and probable orders and the Group’s overall strategic direction. The cash flows are extrapolated from year four, with a terminal value using a growth rate of 2.5 per cent. This growth rate does not exceed the long-term industry average and reflects the synergies from recent acquisitions.”

Step 3: Estimate the discount rate (Weighted Average Cost of Capital or WACC).

The fastest way to find out the Weighted Average Cost of Capital of Carillion is to search Google to see if an analyst has already estimated the figure (sometimes, the company itself will provide the WACC).

From a quick search of the internet, I found this December 2013 report from Saxo Bank (via www.tradingfloor.com) :


The full document can be downloaded here.

The WACC we will go with for Carillion plc is 7.3%

Step 4: Estimate Value of Firm

There are many ways to work with cash flows in discounted cash flow analysis and much of what is calculated comes down to simplifying assumptions. In my analysis here, I am assuming that cash flows will grow at a constant rate forever.

The formula I am using is:

Value of Firm = FCFF(1+g)/(WACC-g) = 28.8(1+g)/(.073-g)

where FCFF = £28.8 million; WACC = 7.3%. We have several growth rates (1.45%, 1.71% 6.53%, 2.5%).

Our estimates of firm value are therefore:

Screen Shot 2014-07-28 at 14.15.23

As you can see, they straddle the market valuation method estimate (from Part 1) of £2.7626 billion.

Strengths and Weaknesses:

The Strengths of the Free Cash Flow Method are:

  1. The method is applicable for all firms (public and private firms) and is useful when the company to be valued has no stock price data.
  2. The method is tied to the financial accounts of the company and is thus based on audited financial figures.
  3. It is good for companies with stable cash flows and constant capital structures.

The weaknesses of the method are:

  1. It doesn’t use stock price information, which is the most timely information.
  2. It is very sensitive to inputs such as Free Cash Flow Estimates, Growth Rates, and Discount Rate.

Admittedly, the method hasn’t been particularly effective in valuing Carillion plc.

To explore this further, I would definitely attempt to come up with a more refined set of cash flow forecasts. I would also look again at the growth rates we used in this example and identify the most appropriate.

Interested readers can find out how to do this in much more detail in any of my textbooks.

In the next instalment of this article series, I will discuss the Asset Valuation method of corporate valuation.

Interested readers can subscribe to my posts by hitting the subscribe button on the left side of the webpage and will receive an e-mail whenever I put up a new article.


A Primer in Corporate Valuation – Part 1

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The last 12 months has seen a resurgence in merger and acquisition activity and a lot of newsprint has related to bid prices that may or may not be at the correct level.

In this multi-part series of posts on corporate valuation, I will describe  general approaches to valuing a firm. It is important to emphasise that the valuation techniques I present pay no attention to industry differences. Each specific industry has its own unique factors to consider and these will be covered in future articles.

Interested readers are invited to check out my textbooks for far more detailed information on corporate valuation.

My advice on corporate valuation is to start off with the methods given in this post, adapt them to the specific industry and corporate conditions, and then come to a consensus view based on all four approaches. Sense checking with other companies is also advisable.

The four methods are:

  1. Market Valuation, where actual market information is gathered on the debt and equity of a firm.
  2. Free Cash Flow to the Firm, where the present value of future cash flows to the firm are calculated.
  3. Asset Approach, where the company’s assets are valued.
  4. Valuation Multiples, where information is used on peer firms in the same industry to arrive at a valuation of the firm.

In this post, I will use the British construction firm, Carillion plc, as an example (the only reason being that it is in the news today for a possible merger with another construction firm, Balfour Beatty plc).

Market Valuation  

The Market Valuation method takes data from the stock market to value a firm.


  1. Equity Value: Visit any financial webpage (such as FT.Com, Yahoo! Finance, etc.) and find the market capitalization of equity. I went to FT.Com and got the information below:


Fig 1Figure 1: Summary data on Carillion plc, July 25 2014 (source: FT.Com)

The Market Capitalisation of equity is £1.46 billion.

  1. Debt Value: In most countries outside of the US, corporate debt is traded irregularly. This means that the prices one gets from financial pages can be out of date by a long way. The fastest way to find the value of a company’s debt is to get the total value of its liabilities from the most recent set of accounts.

Don’t worry about any bond issues or loans taken out since the most recent report because the cash raised would be reflected in the equity market capitalization.

Fig-2Figure 2: Carillion plc 2013 Balance Sheet (Source: Carillion plc 2013 Annual Report)

From Figure 2, the value of the Debt is the total value of short-term and long-term creditors = £722.9 million + £579.7 million = £1.3026 billion.

The total value of Carillion plc according to the market valuation method is thus:

Value of Equity + Value of Debt = £1.46 billion + £1.3026 = £2.7626 billion.

Strengths and Weaknesses:

The strengths of the market valuation method are as follows:

  1. Share prices contain all available information in the stock market including future growth prospects, intangible assets and the quality of a firm’s management, among other factors.
  2. The information you are using is the most up to date out of all the valuation approaches. Other methods use figures that can be many months old.
  3. The method makes no theoretical assumptions and is based entirely on observed market valuations.

Weaknesses are:

  1. Market prices may not reflect value fundamentals. This can occur if a firm is the target of a takeover and the price changed in response to the potential bid.
  2. The company is not publicly traded and so there are no market prices. Most valuations are carried out for private companies with no share price, which makes it impossible to use this method.
  3. The company may be small and traded infrequently leading to stale market prices. Out of date information can cause as many issues as poorly estimated information.

If a company is large and traded on the stock market, the market valuation method can be used quickly and easily to arrive at a firm value.

In my next post, I will explain the Free Cash Flow to the Firm method, which is also known as the income approach to corporate valuation.

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The Best Finance Textbooks 2014-2015

There is a plethora of Finance textbooks available for those wishing to gain a rigorous understanding of the concepts and principles of Finance.

However, many of these books are either too complex, boring, or simplistic to be a good basis for development of in-depth understanding and application.

When I started my Finance career way back in the very early 1990s, I came at the topic from a Mathematics perspective because that was the basis of my undergraduate degree.  It’s probable, then, that my selection of books will be influenced by this preference.  Apologies if that is the case.

It’s also important to state that I haven’t purposely gone out to review books for this post and so I may have missed a few that should be here.  If that is the case, please get in touch with recommendations and I’ll update the list accordingly.

General Finance:

There are three textbooks that I think are worthwhile for the  Finance specialist. All cover the same topics, with some variation at the edges. The ones below are the best starting point for anyone wishing to start a finance career.

Warning: As you will see, the first book is my own.  I feel like apologising for this, but I really do think it covers the topics very well for an international reader. I hope this doesn’t put you off reading this article as I’ve been unbiased in all of my reviews.

  1. Corporate Finance (Hillier, Ross, Westerfield, Jaffe, Jordan)

The focus is very strongly on European and International Corporate Finance and based on the most up to date academic research. It also covers Corporate Governance (in detail) and Islamic Finance (in passing), which is in demand in many parts of the world.  I use it for most of my Corporate Finance teaching (unless I am using my other books).

2. Principles of Corporate Finance (Brealey and Myers)

A wonderful book and one of those from which I learned Corporate Finance.  It is exceptionally well-written with strengths in capital structure theories and application. The big issue is that this edition is too focussed on the US corporate environment, which isn’t great when trying to understand corporate environments elsewhere.

3.  Corporate Finance (Berk and De Marzo)

The best thing about this book is its central theme of the Law of One Price that permeates the full text.  It’s an excellent way to bring the theory together and the authors do this very well.  My biggest gripe is that the international edition does very little to vary the US text and so I find it of less use in teaching students in the international context.

Specialist Areas:

Once the reader has understood the main theories of finance from the list above, they will be ready to study specialist areas in more detail.  In the list below, I present what I feel is the best in class for each of the areas.

Warning: I haven’t read every book on Finance and so I may have missed a fantastic text.  If you feel that this is the case, please get in touch and I’ll check out any that you feel should be on this list.

Corporate Governance:

1. International Corporate Governance (Goergen)

Corporate Governance is one of my favourite research areas and I feel out of all the books out there, International Corporate Governance has the best breadth of research, theory and practice.  The book isn’t as long as other textbooks in the area but it is the most solid and rigorous.


1. Investments and Portfolio Management (Bodie, Kane and Marcus)

Without doubt, the best in class.  I use this to teach Investments and Portfolio Theory at university and it is by far the most accessible and insightful text in this area.  It is also good for those wanting to study for the Chartered Financial Analyst (CFA) course.

Advanced Finance Books:

These books are for those planning to study at PhD level or above.  I use them not only for doctoral training but also as a basis  for my own academic research.  I do not recommend these for those who have no prior Finance knowledge.

  1. Financial Markets and Corporate Strategy (Hillier, Grinblatt and Titman)

Another of my books.  The main strength of this book is that it combines strategy with finance, which is a major gap in the literature.  It is fairly mathematical but not overly so.  I would also say , though, that the book is getting a bit long in the tooth as it was published in 2011 and so some of the earlier chapters on the financial markets are slightly out of date. The theory hasn’t changed though!

2. Financial Theory and Corporate Policy (Copeland, Weston and Shastri)

I love this book and it was the core of the higher level of textbooks that I read when I was studying Finance as a PhD student.   It explains the main Finance concepts exceptional well and goes into the theory in an accessible way.  My mathematical and theoretical understanding of Finance was helped in so many ways by this book.  The good thing is that it a new edition came out last year, so the material is up to date.

3. The Theory of Corporate Finance (Tirole)

This is a very solid theoretical text on Corporate Finance.  Although it was published in 2010, it hasn’t lost anything of its currency and definitely should be read if you want to understand the mathematical theory of corporate finance.  I promise it isn’t an easy read but well worth it.

4. The Theory of Financial Decision-Making (Ingersoll)

This book nearly killed my career in Finance and it is probably one of the toughest finance books that I have read. During my PhD at Strathclyde, we had to read this cover to cover and I just barely kept up.  However, I did get through the book and I’m so glad I did so.  It’s a shame that it is now out of print but if you can get a copy anywhere, I’d definitely recommend you do so (even if it is just to show off to other finance aficionados!).

4. Foundations for Financial Economics (Huang and Litzenberger)

The second book of my PhD reading and only slightly less difficult than Ingersoll.  It’s a shame that these books are now out of print as they are so important for PhD students to understand how finance really works.

Review: Corporate Finance Exercise Book by Kevin King

I’ve had quite a few students who are preparing for exams in August asking me for additional exercises.  Apart from my own notes and the book-related exercises on the McGraw-Hill Connect system (which I think is truly exceptional), there isn’t actually much out there for students to draw on to revise.

I had a search through Amazon and found the book by Kevin King, ‘Corporate Finance Exercise Book‘.   It is a very small book and focuses on  basic capital budgeting, time value of money, and capital market theory exercises.

It is a good (and exceptionally cheap!) exercise backup for Finance textbooks.

Those students who are wanting to use it in combination with my books should only consider it for the following areas:

  1. Financial Statement Analysis
  2. Time Value of Money
  3. Capital Budgeting
  4. Portfolio Theory and CAPM
  5. Efficient Markets
  6. Long Term Financing
  7. Capital Structure
  8. Dividend Policy
  9. WACC

The book is only 67 pages and is filled mostly with multiple choice questions, but there are decent capital budgeting exercises that may be of use to those studying for this topic.

The best thing about the book is that it if you have Amazon Prime membership, you can borrow it for nothing for a month (which is probably all you will need it for).

I have a large number of Finance textbooks, so if anyone is looking for me to review them please get in touch.


7 key equity characteristics to look out for during economic uncertainty

Although there is evidence of a recovery in certain industry sectors, I am concerned about the possibility of political or economic flare-ups around the world badly impacting on the stock markets.

China seems addicted to credit (like the West before the financial crisis and we know where that ended up), Europe and the US appear on a collision course with Russia over Ukraine, and the Middle East is fomenting instability across the globe.

I’ve been thinking about the different equity characteristics one should consider during this period and have come up with seven pointers.  These will help with the investment decision to buy, sell or hold over the next 12-24 months in any country or region.

Clearly it will be difficult to identify companies that satisfy all 7 of my criteria, but I recommend that all good investments should have, at the very minimum, five of the below:

  1. Low P/E stocks compared to industry medians.  Research has shown that P/E ratios revert to the mean industry P/E ratio over time.  If a company has a low P/E ratio, it may be that the stock is underpriced.
  2. Large Market Capitalisation. When the market is going up, smaller companies do very well and when it is going down, smaller companies tend to be hit worst. Stick to larger companies if you think the market is going to be bearish.
  3. Stick to Industries that have stable continuous demand or do well in downturns.  Again this is a low risk strategy because sectors such as retailers (especially discount companies like Aldi and Lidl) will perform consistently during the bad times.  Strangely enough, firms that sell tobacco or gambling firms do better in downturns and these may be good areas to consider. Finally, Pharmaceuticals and Healthcare companies are solid players irrespective of the state of the economy.
  4. Low leverage firms Companies that have a lot of debt struggle to pay off interest when earnings drop.  A permanent drop in cash flows leads to increased risk when interest payments need to be met.  Stick to companies that have low debt ratios.
  5. High operating efficiency During uncertain periods, only the most efficient companies can respond well to challenging external conditions.  Look for high ROCE (Return on Capital Employed) compared to other firms in the same industry.
  6. Stable recent performance This is a bit controversial, but I like the look of companies that have stable Net Income over the previous 24-36 months.  When the future is uncertain, the drivers of very strong past performance may change dramatically and this could tip the earnings figures down.  Stable performance (irrespective of market conditions) is linked to my point (3) because it suggests that the company has a low risk business model.
  7. Good cash balances More and more companies are hoarding cash (much more than twenty years ago) and as a result there is liquidity in the market.  Ensure that you investment has good cash levels as credit may dry up in poor market conditions.

These 7 characteristics will lead me to invest in relatively low value companies with stable operating performance and lots of liquidity. They won’t provide  stellar returns but would hopefully be safe options if things don’t go well on the geopolitical arena.

Don’t forget that at a portfolio level, diversification is important, so  I invest in several companies rather than only one or two stocks.

Finally, this post is only my opinion and doesn’t represent investment advice to buy or sell financial securities (usual disclaimer!).

Three Reasons why Payback Period is Important for Investment Appraisal

I know I am probably going to regret this post as it goes against everything I write in my textbooks. However, over the past 18 months I have become more and more enamoured with this very simple method for making investment decisions. My change in views comes from speaking with large companies on why they choose different approaches to making investment decisions. As you can see below (from Chapter 6 of Corporate Finance), the Payback Period method is frequently used in many large companies across the world. In fact, in the UK it is the most common method used by large firms. Table6_4 The big issue for academics is that, compared to other methods like Net Present Value and Internal Rate of Return, it has so many theoretical weaknesses. In this post, I will first show how to calculate Payback Period, then discuss its weaknesses and finally explain why (despite its failings) I think it is one of the best methods out there for managers to use in their project decision-making. How to calculate Payback Period When you calculate the payback period you are basically saying how long it will take to get your money back. It’s as simple as that. A basic example: You invest £1,000 and receive £400 every year for the next 6 years. The Payback Period will be between 2 and 3 years depending on when the cash flows occur during the third year. Companies will have threshold payback periods beyond which they will refuse to invest in a project. So, for example, if a company had a threshold payback period of 3 years or more in the previous case, they would go ahead with the investment decision. Theoretical Weaknesses in the Payback Period Method There are a number of theoretical and conceptual issues with Payback Period, which make it very unattractive to academics.

  1. It doesn’t differentiate between cash flows that occur early in the project life cycle and those that take place later on.
  2. Because companies have threshold payback periods beyond which they do not consider project adoption, information (which is always valuable) is ignored. So in the example given above, the project may have a very large negative cash flow later in the project (say year 6). This would be deemed irrelevant by Payback Period because it would be ignored.
  3. There is no theory justifying the use of a threshold benchmark Payback Period, and any number used by companies is completely subjective.

Three Important Strengths of Payback Period.

  1. Much of the attraction of Payback Period comes from its simplicity. I sometimes feel that academics forget that many corporate managers are creative entrepreneurs who have skills in other areas like Marketing or Technology. In my experience, many managers do not feel comfortable explaining or understanding concepts like Net Present Value or Time Value of Money. Payback Period simply tells you when you are likely to get your money back – providing insights into future liquidity and project flexibility.
  2. Although the Payback Period does not explicitly consider cash flow risk, by discounting future cash flows beyond a certain threshold period it is effectively reducing the present value of the cash flow to zero, which reflects a very high discount rate. This may be appropriate when firms face considerable uncertainty in its investment environment.
  3. Forecasting cash flows beyond two years can be ridiculously difficult, especially when a new product is being introduced. To arrive at a net cash flow for a specific year, one must predict market size, market share, sale price, variable costs and fixed costs. All of these are predicted with error and that error will become larger the further away the prediction. The best way to visualize this is to think of the prediction error below:

Cash Flow Forecasts When viewed in this way, it is clear that the academic benefits of methods that incorporate all cash flows (NPV, IRR, etc) may actually be weaknesses, since the forecasts of long-term future cash flows will contain so much noise. By ignoring these later cash flows, Payback Period removes this issue. Taken together, I believe that the strengths listed here more than outweigh the academic benefits that are presented in textbooks. How Should You Use Payback Period in Practice From my own discussions with corporate executives about investment decision-making, there is the commonly-held view that even with its weaknesses, Payback Period is best used in combination with another method (IRR and/or NPV). Only if the project is increasing wealth (having a positive NPV) and returns the initial outlay within an acceptable period (satisfies payback), is it worthy of investment. Effective compound analysis using several methods is the optimum approach to investment appraisal and dominates the use of any single method. This explains why the percentages don’t add up to 100% in the table above and why Payback Period continues to be used by companies, even in the face of academic criticism.

The Three Taxation Powers of an Independent Scotland

Scotland Flag

In this post, I will briefly summarise the three main taxation powers an independent Scottish government would have to improve the economy. I will also present some views on the effectiveness of these taxation powers. I am not intending to give a complex analysis of taxation, as this is not the purpose of the blog.  My aim is simply to present difficult issues in the clearest way possible.

1. A Scottish government would have full control over personal taxation.

The Scotland Act 2012 has already introduced partial powers for Scotland to reduce or increase taxation from 2016.  Although the Scotland Act 2012 does not provide complete freedom to manage tax rates, the change is significant and will definitely improve the Scottish government’s ability to increase revenues in the event of a NO vote.

However, Independence would give Scotland full control over taxation, which will allow the government to manage taxation at a more granular level than would be possible under the Scotland Act 2012.

This is clearly the optimal position, but there would be indirect constraints an independent Scottish government would need to consider before making changes in the tax rate.

For example, the integrated UK job market means that individuals could easily move a few hundred miles south or north to take advantage of differential taxation policies.  Because of the fluidity of the labour market in the UK, there could also be unintended (positive and negative) side effects of changing income tax rates that would need to be carefully investigated.

2. A Scottish Government would have full control of VAT.

The SNP has made it clear it wishes to be part of the European Union should the country vote for independence in September. This means that Scotland would need to follow EU regulations on VAT, which states a minimum of 15% with a small number of opt-outs on selected goods like books or children’s clothes.

The big uncertainty with VAT is whether Scotland would need to fully adhere to the new accession rules for EU entrants or whether it would be able to negotiate specific opt-outs as an existing member of the UK.  I believe the second is more likely but that the country would find it difficult to negotiate all the opt-outs that the UK has successful achieved.

3. A Scottish Government would have full control of Corporation Taxes.

The White Paper produced by the Scottish government in November 2013 states that it would reduce Corporation Tax by up to 3 per cent below prevailing UK rates should Scotland become independent.  It is argued that this would attract companies to Scotland and thus result in an increase in jobs and tax revenues.  This is definitely one scenario and I would hope, should the government pursue this path, that it transpires.

However, there are some risks that should be considered.  First, reducing tax rates, reduces income coming into the government.  A tax cut is only beneficial if revenue coming from increased jobs and business taxation more than offsets the drop in tax income from the rate cut.  Because it is yet to happen, neither side of the debate can say with certainty whether the net change in government income would be positive or negative.

Other Tax Powers.

Once one removes revenues from Income Taxes, VAT and Corporation Tax, the remaining tax revenue makes up about 10 per cent of UK government tax income.  An independent Scottish government would be able to set taxes for Air Passenger Duty, Excise, Fuel, and Climate Change.  Although small in absolute value, they would be powerful tools for a Scottish government to encourage specific industries, in particular tourism.


Without doubt, one of the great benefits of Scottish independence would be the ability to manage taxation.  The question the reader must answer then is whether existing taxation policies together with the Scotland Act 2012 (to be introduced in 2016) are so far away from the independence optimum that it merits a vote for independence.

To read into the issue in more detail, I recommend the following texts:

Commission on the Future Governance of Scotland, May 2014, Scottish Conservatives.

Powers for a Purpose, Strengthening Accountability and Empowering People, Scottish Labour Devolution Commission, March 2014.

Scotland Act 2012

Scotland’s Future, Your Guide to an Independent Future, November 2013, Scottish Government.

Scotland’s Tax Future, Taxes Explained, May 2014, ICAS.


Will Scotland be worse off after the Independence Vote?

Scotland 2The sparring between the two sides of the independence debate largely revolves around the question of whether Scots will be worse off if the country votes YES.

The arguments go as follows:

1. For independence: Scotland’s share of oil will increase its GDP by over 20% and this will make it one of the richest countries in the world.
2. For the status quo: An independent Scotland will introduce additional costs in every sphere of life and this will result in Scots becoming significantly poorer.

It is difficult for a normal person to make sense of such conflicting views given that they are so contrasting in nature. In addition, the vitriol and strength of feeling in the debate is such that it is very difficult for a neutral individual to make a balanced argument against this.

So what is the truth?

As I’ve maintained in previous posts, everything is subject to negotiation and the key factor is the allocation of oil to Scotland should the YES vote be successful.

I do not believe that Scotland would receive its existing per capita share of 8.3% but I also do not believe it would receive its geographical share of 84.2%.

In fact the decision on oil allocation will not be taken separately, but be decided together with the share of UK debt that Scotland needs to bear in independence.

So will Scots be worse off?

It is very unlikely that an independent Scottish government and UK government will be able to negotiate these issues without assistance and independent arbitration will be required.

Given that an independent arbiter needs to consider both parties in a dispute and arrive at the fairest outcome for everyone, I believe that the final outcome will be such that the share of oil and UK debt will be apportioned to ensure that neither the remainder UK or an independent Scotland will become significantly worse off after all allocations and costs are considered.

This is not a zero sum game, however, since the additional costs that would arise in the event of independence would be absent in the event of a NO vote.

Consequently, I believe that everyone (UK and Scotland) would be slightly worse off if Scotland is independent once the additional costs are spread across the combined countries.


The reader may now come to the conclusion that I have come out on the side of remaining in the union, on the basis that I expect Scotland (and the rest of UK) will be worse off in the event of an independence vote.

This would be an error. I am still undecided.

If Scotland decides to vote for the status quo, I also believe that there would be pressure in the coming years for a change in the Barnett formula (the model that determines the budget allocation to Scotland within the UK). This would likely result in Scotland having less of a budget allocation overall, resulting in less money.

So, either way (YES or NO), public spending will need to fall in the coming years and this will make the Scots poorer.

I will probably be accused of being overly simplistic, and I accept that criticism.  I’ve approached the issue from a completely objective viewpoint and have stripped out the details to arrive at a bigger picture.

This will clearly lose information.  However, I believe that by focussing on the bigger issues, one can see an outcome from a broader perspective.


The impact of an Independent Scotland on North Sea Oil Revenues

North Sea Oil Rig

In a previous post, I argued that the key factor for success of an independent Scotland is the proportion of North Sea revenues that would be allocated to the country.  I gave extreme upper and lower bounds on what that allocation may be and argued that the final distribution of revenues would be subject to negotiation between the UK and Scottish Governments.

Putting the allocation percentage aside, the second key factor in the Oil debate is the actual cash flows coming from combined North Sea operations. In this post, I will propose a basic revenue model to help understand the oil issue for an independent Scotland.

Obviously I cannot explore the full complexity of the oil debate in under 1,000 words, but I do hope this brief post can provide some clarity to allow the reader to make their own decision on this matter.

Revenue Model

The total North Sea revenues that would come to an independent Scotland are:

Scotland Energy Revenues = Proportion of North Sea Revenues allocated to Scotland x Total Net Income generated from North Sea operations

So, for example, if, after negotiation, Scotland receives 50% of all North Sea Revenues and total revenues generated from the North Sea are £15 billion, Scotland’s energy revenues will be 50% of £15 billion = £7.5 billion.

The central questions are therefore:

  1. What impact will an independent Scotland have on the corporate revenues generated in the North Sea?
  2. What impact will an independent Scotland have on the costs of doing business in the North Sea?
  3. What are the inherent risks of the doing business in the North Sea in an independent Scotland?

Clearly, the optimal outcome is that income will be increased, costs will be reduced and that the risk of doing business will be lower.  This would increase corporate profitability and lead to higher tax revenue for Scotland.

We now deal with each question in turn.


The principal source of revenues from the North Sea comes from income generated via taxation of those corporations extracting oil and gas.  So when we think of Scottish revenues, we are effectively considering the profitability of multinational firms like BP, BHP, Centrica, Conoco Philips, Chevron and Shell in their North Sea extraction activities.

Although important, the effect of Scottish Independence will be only one of a number of factors impacting upon the revenue streams from doing business in the North Sea.  Other factors that will have equal or more importance are:

  • Oil and gas prices are generated in the international marketplace and they are volatile;
  • International demand for energy is growing but the geographical demand for oil and gas is changing with the evolution of fracking in the US and elsewhere;
  • Energy is traded in US dollars and the $/£ exchange rate fluctuates on a continuous basis.

Costs and Operational Efficiency

  • Oil and gas production is a function of the efficiency of the extraction methods employed by energy firms and the amount of oil left in the ground.  There is evidence that existing business models are not optimal and significant efficiencies could be achieved in the future (PWC, April 2014).


The possibility of independence has clearly created uncertainty in the sector.  It is difficult to predict the future, but we do know the following:

  • A future independent Scottish government would have the power to implement differential tax rates and tax incentives for energy firms to encourage further investment in the North Sea;
  • The loss of an integrated UK energy policy would significantly raise costs of oil firms doing business in an independent Scotland;
  • £44 billion of capital was invested in projects in 2013 and this will realize significant revenues in the future irrespective of the independence result.
  • Costs of decommissioning the existing oil fields for new ones will need to be borne by someone (Scotland, UK, or both).  This amounts to a potential £35 billion liability.
  • A future Scottish government would have the freedom to develop a renewables energy policy specific to Scotland.


In this post, I have set out the factors that contribute to the revenues generated by North Sea operations. I have argued that considerations, unrelated to Scottish independence, will dominate the revenues generated in the North Sea.

To predict future Scotland energy revenues requires the forecasting of a large number of variables and outcomes.  The reader is warned, therefore, against putting too much weight on forecasts from independent reports.  It is simply too difficult to come up with anything of real statistical power or reliability given the inputs required.

Final Thoughts

Although independence will have an impact on North Sea oil (and I definitely believe independence will increase the costs of doing business in the North Sea and Scotland), I am of the opinion it is of secondary importance to industry factors affecting the energy sector.

This is an important point as it brings the reader back to my earlier post.  The key issue for Scotland is not how businesses will engage with an independent Scottish government, but how much of the total UK oil revenue can be negotiated by Scotland, post-referendum.

This is an imperative and the outcome of these negotiations is unknown at this point in time.

Assuming that an appropriate allocation of oil reserves is achieved, an independent Scottish government would need to ensure it is able to manage the international risks of the oil sector and optimise its engagement with energy firms.


  1. Government Expenditure & Revenue Scotland 2012-13. The Scottish Government, March 2014.
  2. Scotland Analysis: Energy. HM Government, April 2014.
  3. Northern Lights: One Vision One Strategy. PWC, April 2014.

Would an Independent Scotland have Border Controls with the Rest of the UK?

UK Border Controls

This week, Labour leader, Ed Miliband, raised the prospect of border controls in the event that Scotland gained independence and pursued different immigration policies.

In this short post, I will put forward the regulatory environment around the issue of border controls and then explore the different possible scenarios that may occur.

Again, I will not argue for the possibility of one outcome over another, but will leave it to the reader to decide what is most likely.

Regulatory Background

One of the goals of the EU is to harmonise working conditions for workers of all member states.  The scheme for this is called the Schengen Agreement, whereby all member countries abolished border controls with each other but imposed increased border checks for individuals arriving from non-member states.

The only countries within the EU where Schengen does not apply is the United Kingdom and Republic of Ireland.  As an island state, the UK has successfully argued that border controls are important to ensure immigration is controlled effectively.  Consequently, it has opted out from the agreement.  (As a side note, this is why British travellers must go through passport checks at airports like Amsterdam Schipol when travelling to other EU countries).

Ireland is not in Schengen because it wishes to maintain its own Common Travel Area agreement with the UK, which would not be possible if it had open borders with the rest of the EU.

Figure: Schengen within the EU

Screen Shot 2014-06-28 at 13.43.25

Source: European Commission Home Affairs Web Site

Border Controls: Three Scenarios

There are three scenarios that may occur in the event of Scottish independence.

  1.  Scotland maintains a Common Travel Area agreement with UK and achieves an opt-out from Schengen.  It is very much in Scotland’s interests to maintain free movement of workers between all of the existing UK and Ireland. As part of the UK, businesses have operations across the whole country and workers move freely from one part of the UK to the other, often on a daily basis. This is much more common than Scots commuting to the   European Union for employment and so a Common Trade Area similar to that of Ireland would be optimal to any Scottish government.  In this scenario, there would be no border controls between England and Scotland.
  2. Scotland applies to EU and Schengen is enforced as condition of entry.  The Scottish Government has already stated that it wants to be part of the European Union.  Given that Scotland would be negotiating in every area of EU membership, it is possible that Schengen could be one of several necessary criteria for membership.  If Schengen membership was applied in Scotland, then border controls would definitely be imposed at the Scottish border with England. This would significantly increase costs to employing workers across borders and have a detrimental impact on Scottish business and the Scottish economy. The benefits from Schengen, however, would be an improvement with doing business in Europe, which would have a positive effect in the much longer term to the Scottish economy.
  3. Scotland opts out of Schengen but increases skilled-worker immigration to improve the Scottish economy. The Scottish Government has gone on record saying that immigration policies would be a decision for any future independent Scottish government.  However, it is likely that Scotland would lower skilled-worker immigration controls relative to the rest of the UK to promote its own economy. If future Scottish policies lead to immigration issues in the rest of the UK, which undermine the British government immigration policies, it is possible that some form of heightened border checks may occur.  I would not expect this to be imposed unilaterally, however, and it would only occur if negotiation between the two governments fail.

It is worth noting that the increase in illegal immigration from Africa via Italy and Greece has been exerting substantial pressures on the Schengen Agreement in continental Europe, and political parties in several EU countries are now pushing for heightened border checks of the type discussed this week by Ed Miliband.


I have laid out three Border Control scenarios that may occur in the future if Scotland votes for independence.  It is important to emphasise that not all three are equally likely, and they are simply scenarios.

A common theme of my posts will be that no party can say with certainty what the future will hold if Scotland becomes independent.  I am not diverging from the path with this post.

Whether there will be border posts at the England-Scotland border is fully dependent on negotiations post-independence.

My personal view, for what it is worth, is that scenario (1) is most likely, scenario (2) is least likely, and scenario (3) would only occur after a number of years and under specific conditions.  However, this is only my opinion.


1. http://ec.europa.eu/dgs/home-affairs/what-we-do/policies/borders-and-visas/schengen/index_en.htm

2. http://www.yesscotland.net/answers/what-about-immigration