06 JANUARY 2023

Corporate Finance

L'ORÉAL

CAPITAL STRUCTURE
The Wolves of Sorge Street

Barile Antonin
Binetti Flavio
Jacob Lydia
Kudelski Nicolas
Lefuel Noémie
Orde Mirkan
Willi Mathilde

Professor : Theodosios Dimopoulos

Assistant : Evgenii Maiorov

¨
 Table of Contents
1 Introduction ____________________________________________ 1

1.1 L'Oréal Environment & Information _____________________ 1

2 Methodology and Assumptions ___________________________ 2

3 Key Results _____________________________________________ 5

4 Questions ______________________________________________ 6

4.1 Relevering ___________________________________________ 6

4.2 Effect on the shareholders and the stock price ___________ 6

4.3 Bankruptcy risk _______________________________________ 6

5 Conclusion _____________________________________________ 7

6 References _____________________________________________ 8
HEC Lausanne Corporate finance January 2023

1 Introduction

L'Oréal is a French company that focuses mainly on the cosmetics industry. Founded in
1909 by the chemist Eugène Schueller, the company is the world leader in the "beauty"
sector. With more than 35 international brands such as Lancôme or Garnier, L'Oréal has a
turnover of approximately 32.28 billion euros in 2021. The group is present in more than
150 countries and employs more than 85,000 people.
On the financial side of the business, L'Oréal performed well with third quarter sales of
around 28 billion euros. The growth rate that the brand is following is more than 20% com-
pared to 2019. These good results are partly due to the strong growth recorded by L'Oréal
in emerging markets, particularly in the Latin American region. One-off factors such as the
multitude of confinements in China impacted the third quarter performance. However, the
recovery of the division in charge of this sector from these events has been rapid, even
achieving record market share in mainland China.
In December 2021, a strategic share buyback operation was approved by the L'Oréal Board
of Directors. This 22.26 million share buyback transaction, between L'Oréal and Nestlé,
took place as part of the French company's share buyback programme and represented
4.0% of its capital. The total price paid to Nestlé was EUR 8,904 million. These shares were
canceled before 29 August 2022, reducing Nestlé's shareholding in L'Oréal from 23.3% to
20.1%.
During the current decade, the L'Oréal group will implement a business transformation
program called "L'Oréal pour le futur". The brand's ambitions for this programme are for
a period of 10 years. "L'Oréal pour le futur" aims to implement social and environmental
actions in order to respond to various climate and planetary emergencies. The main actions
are, for example, the use of 100% renewable energy in order to achieve carbon neutrality
of the various sites, or the total recycling of water used in industrial processes by 2030.
L'Oréal is a major player and leader in the beauty sector, with a strong presence across the
globe and recognised brands in many market segments. The group faces many competi-
tors, including Procter & Gamble and Unilever. L'Oréal has shown great resilience and an
ability to adapt to market trends, which has enabled it to maintain its leadership position.
One of the French company's differentiation strategies is to build on the beauty of tomor-
row, in other words technology and digital. L'Oréal is acquiring more and more "beauty
tech companies" such as Modiface to merge beauty and technology. This collaboration
offers, for example, the possibility of obtaining a digital diagnosis of the skin thanks to
artificial intelligence.

1.1 L'Oréal Environment & Information

The global beauty and cosmetics market is growing at an impressive rate, from $483 billion
in 2020 to over $510 billion in 2021. With an estimated global growth rate of 4.75%, this
market is expected to exceed $700 billion by 2025. This strong rise of this sector is notably
due to the explosion of digital use in the cosmetics environment. Large amounts of money

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are being spent on research and development of new products, digital innovation, and
artificial intelligence to provide individual and quality service.
Today's beauty market has a particular presence in three main geographical areas. North
Asia ranks first, largely due to China, followed by North America and Europe. This market
average also corresponds to L'Oréal's geographic market breakdown, with North Asia as
its largest market with 35.1% share. The three regions mentioned above represent more
than 80% of the brand's market.
In other news, L'Oréal signed an agreement in September 2022 to acquire the fast-growing
US brand Skinbetter Science, acquiring the latter's extensive knowledge. Ecology is also at
the center of L'Oréal's agenda, with the company achieving an AAA rating for the 7th con-
secutive year, according to the CDP agency. Other measures are in force, such as the
"Ocean Positive" initiative, which plans to positively impact the oceans by 2030. L'Oréal's
Research and Innovation department in North America has strengthened its relationship
with the Massachusetts Institute of Technology (MIT). This strengthening has enabled the
brand to sign an agreement to join the Industrial Liaison Programme, further connecting
L'Oréal to the world of American innovation.

2 Methodology and Assumptions

In order to build the analysis, we focused on some assumptions based on methods studied
during class or on our own estimations. (see the table below) The following computations
come from the assumptions.
First, we used the Financial Statement of L’Oréal from 2017 to 2022 from Capital IQ in
order to compute our analysis.
The APV method was used to raise the debt. The method computes the value of a levered
firm from the present value of tax shields added to the unlevered value and subtracting the
bankruptcy costs generated. The formula is as follow:
VL = VU + PV (Tax Shields) – PV (Bankruptcy Costs)
We computed the future Free Cash Flows for 2022 to 2027. After that period, we consid-
ered that the Free Cash Flows would grow as a growing perpetuity to the same rate that
the revenue (Excel & Assumptions). Free Cash Flows were then discounted with the un-
levered cost of capital calculated and summed up to establish the value of the firm.
Unlevered cost of capital’s formula from Modigliani and Miller :
𝐸 (1 − 𝜏)𝐷
𝑟! = 𝑟# + 𝑟
𝐸 + (1 − 𝜏)𝐷 𝐸 + (1 − 𝜏)𝐷 $
In this latter formula, 𝑟! is the cost of equity obtained by the CAPM formula :
𝑟! = 𝑟" + 𝛽(𝑅𝑚 − 𝑟" )
L’Oréal’s beta 𝛽 was obtained by computing a linear regression using total returns of
L’Oréal and the CAC40 returns for the last 5 years. We obtained a 𝛽 = 0,74 and we assumed
the risk premium to remain constant over time.

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The cost of debt 𝑟# was obtained using this formula:

𝑟# = (1 − 𝑃$ + 𝑃$ 𝜌)(1 + 𝑦) − 1
Here, 𝜌 is the percentage of recovery in case of default, 𝑃$ the probability of default. 𝐸 is
the amount of equity, 𝐷 the firm’s debt and 𝜏 the corporate tax.
Afterwards, we had to consider the value of the tax shields. To get this value, we considered
the same method as the study case on capital structure seen during lecture. We first esti-
mated the interest paid in the year 2022 based on the amount of debt outstanding at the
end of the prior year and the firm’s yield on debt.
However, this yield on debt depends on the credit rating of the firm, which we had to
estimate using the trailing interest coverage ratio. The first step was to multiply the debt
with the risk-free rate previously calculated to get the interest paid each year.
With these iterations until convergence, we obtained the new rating of L’Oréal, and we
were able to deduct the yield on debt also based on the trailing interest coverage, and
hence get the interest paid amount. We also get the cost of debt with the same iteration
process for the year 2022 to 2027, to calculate the correct present value of tax shields.
The next step was to obtain the interest tax shields. We calculated this amount using the
previous interest paid amount iterated for each year, and we multiplied it with the effective
tax rate of L’Oréal 24,08% (see table below).
Since we wanted to get the present value of tax shields, we had to calculate the tax shields’
terminal value after 2027 beforehand. We then add this terminal value with the previous
tax shields calculated for 2027.
We finally get the present value of tax shields with the help of our implied cost of debt.
The next step in our valuation process was to consider the present value of the bankruptcy
costs. We based our calculation on the risk neutral pricing model (Almeida and Philippon)
as seen during lectures. We explain the process in the bankruptcy risk part below.
We made these assumptions below and computed our forecasts and regressions on Excel
to get the valuation of L’Oréal before and after restructuration:
We calculated the average annual growth rate of revenues from

the 5 previous years (2017 to 2021) and obtained 5,68%. In addi-

tion to that, we took into consideration the perpetuity growth rate

Growth rate of revenue for future of 3% because the firm is mature. Mature companies usually fol-

years: 4,34% low the historic inflation (which is between 2% and 3%) and the

GDP growth rate (actually between 3% and 4%).

We then computed the average of both growth rate and assumed

it to be constant over time.

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We decided to use the effective tax rate found in the 2022 half-

Effective Tax rate: 24,08% year report of L’Oréal as the best prediction for the following

years.

Cost of Goods Sold/Revenue:

26,12%
We computed these ratios regarding the revenue in 2021. We
SGA/Revenue: 51,65%
then considered these ratios to be constant for the following
R&D/Revenue: 3,18%
years.
Depreciation & Amortization/Reve-

nue: 2,217%

We computed the net increase in PPE, and we added the Depre-

Capex/Revenue: 2,29% ciation expense for 2021 and then computed the ratio Capex/rev-

enue. We assumed this ratio to be constant over time.

ΔNet working Capital/Revenue : We calculated the average in ΔNet working Capital for 2020 and

13,23% 2021 and then computed the ratio NWC/Revenue for the follow-

ing years.

We computed the average daily rate of the US-5year Treasury

Risk-Free Rate: 1,601%
Bond for the last 5 years.

Market risk Premium: 9,04% We calculated the market expected rate of return (Rm) minus the

risk-free rate that we obtained (excel).

Recovery in case of default: 40% As assumed during lectures.

Bankruptcy cost: 0,532 Considered as Perfume industry bankruptcy costs in the given ta-

ble.

Risk-Free rate + the credit spread corresponding to AA rating

Yield on debt: 2,75%
firm.

Unlevered cost of capital: 8,23% Assumed to remain constant over time.

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3 Key Results

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4 Questions

4.1 Relevering

4.2 Effect on the shareholders and the stock price

The transaction will not create value for existing shareholders; indeed, we can see that the
operation of issuing debt so that the leverage rate switches from 1.95% in 2021 to 40%
permanently, has a very negative effect on the value of the shares.
Since this money is not used in a share buyback, the increase in the debt ratio increases the
present value of the tax shield, but this is much lower than the increase in the present value
of the distress costs.
According to our estimates, without the increase of leverage, the value of the share, which
is equal to the market capitalization1 divided by the number of shares2, is EUR 343.00 (cur-
rently EUR 356.153 in reality).
After increasing the leverage from 1.95% to 40%, the share value would be EUR 183.904.
We can therefore see that an increase in the leverage rate without carrying out a share
buyback would have the effect of almost halving the value of the share.
The effect on shareholders would therefore be a loss in value of EUR 159.10 per share,
which would lead to general dissatisfaction on their part with the company's strategy. In-
deed, the company has no interest in carrying out this modification of the structure of its
capital, because the effects that this action would have would be negative, both from the
point of view of the shareholders and the company. (eg: rising interest rates, loss of share-
holder confidence, increased risk of bankruptcy, etc.)

4.3 Bankruptcy risk

We know that more leverage increases the value of the firm by the tax shield, however,
levering too much can increase the risk of default on debt and the firm may then face bank-
ruptcy costs.
Since we are using the APV method, the value of our levered firm is given by:
𝑉% = 𝑉& + 𝑃𝑉 (𝑇𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑𝑠)
If levering too much induces bankruptcy costs, the value of the firm given by the APV
method is now:
𝑉% = 𝑉& + 𝑃𝑉 (𝑇𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑𝑠) − 𝑃𝑉 (𝐵𝑎𝑛𝑘𝑟𝑢𝑝𝑡𝑐𝑦 𝑐𝑜𝑠𝑡𝑠)

1
Annex: excel sheet “valuation before leverage”, cell: E43
2
Annex: excel sheet “Balance Sheet”, cell: G75
3
Source: Yahoo finance, 04/01/2023
4
calculate: excel sheet “valuation after leverage”, cell: E43 / excel sheet “Balance Sheet”, cell: G75

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To maximize the value of the firm, we use this formula to tradeoff the tax benefit of debt
relative to bankruptcy costs.
To estimate how levering can negatively impact the firm’s value, we need to estimate the
present value of bankruptcy costs that is calculated by the probability of bankruptcy times
the bankruptcy costs with risk neutral valuation.
It is given by this formula:
𝑞$ 𝜙𝑉&
𝑃𝑉(𝐵𝐶) =
𝜙 + 𝑟"
()* !
Where q0 is the risk neutral probability defined by 𝑞$ = (,-() (,)/)

𝑦 − 𝑟" is the yield spread of the firm estimated with the credit rating AA of L’Oréal and ⍴ is
the historical estimates of recovery in case of default.
Ø is the percentage loss of the unlevered firm value.
We use the risk neutral probability of default q to make a risk-adjusted valuation of the
financial distress costs.
To make the valuation of the firm for the years after increasing leverage, we have iterated
the costs of bankruptcy for these years with the formula given below.
The bankruptcy costs at date t is defined by
𝑞0 𝜙𝑉&,0 + (1 − 𝑞0 )𝜙0-,
𝜙0 =
1 + 𝑟"
The formula that we used allowed us to estimate the present value of the bankruptcy costs
in period t knowing the value of the bankruptcy costs in t+1.
As we can see in the excel for the year 2022, increasing leverage to 40% induces much
bigger financial distress costs than the benefit of the tax shield.
Higher leverage for l’Oreal is not beneficial as there is not a trade-off between the expected
costs of bankruptcy and the tax benefit of debt.
In case of bankruptcy due to too much leverage, l’Oreal will lose more value than it could
gain from the interest tax shield.

5 Conclusion

To conclude, we could notice that increasing the leverage ratio to 40% of L’Oréal has an
overall negative impact on the company.
Indeed, the total value of the company with the current debt situation is always greater
than that with a leverage of 40% and this from 2022 to 2027. This can be explained by the
fact that the present value of their bankruptcy costs will always be much higher than the
present value of their tax shield. The total value of the company according to the APV
formula will therefore decrease significantly.

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The people who would be most affected by this increase in leverage would be the compa-
ny's shareholders. Indeed, L’Oréal would strongly demote the value of their capital and
thus of their market capitalization, the shareholders would thus see the value of their shares
fall strongly (-159,36 EUR), moreover the risk of bankruptcy of L’Oréal would increase and
that would be negative for its shareholders.
This scenario would therefore be negative for all the stakeholders of the company, the
shareholders, the debt holders, and the company itself.
The difficulty of this work was to set the right hypotheses and to work with the right formu-
las. It was difficult at times to find certain values for our assumptions to obtain good results.
Some of the results of our valuation therefore differ from what we can see from the market
values. The difficulties we encountered may have had an impact on the valuation of the
company and our results. Moreover, the future is uncertain and difficult to anticipate, espe-
cially with the current economic situation, which made it even more difficult to perform our
work.

6 References

Clavell, A. (2022, 1 décembre). L’Oréal annonce un partenariat avec la biotech française

Microphyt. journalduluxe. Consulté le 27 décembre 2022, à l’adresse

https://journalduluxe.fr/fr/beaute/loreal-partenariat-biotech-francaise-microphyt

Fontaine, J. (2021, 19 octobre). Une opportunité pour les cosmétiques sur le marché chi-

nois. Openstring.

https://www.openstring.io/opportunite-chine-marques-cosmetiques/

Groupe L’Oréal : Stratégie Et Organisation. (2020, 23 janvier). L’Oréal.

https://www.loreal.com/fr/groupe/decouvrir-loreal/strategie-et-organisation/

La beauté : un secteur en pleine révolution digitale. (2022, 31 mars). Eminence.ch.

https://eminence.ch/marketing-digital-business-de-beaute/

L’Oréal Paris. (s. d.). Amazon.it.

https://www.amazon.it/stores/LOr%C3%A9alParis/Paginaprinci-

pale/page/B0F67EAE-65EC-4FFF-9F6E-AFF8352D8E9B

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Monchau, C.-H. (2021, août 17). La transformation digitale de L’Oréal. Allnews.

https://www.allnews.ch/content/points-de-vue/la-transformation-digitale-de-

lor%C3%A9al

OPÉRATION STRATÉGIQUE APPROUVÉE PAR LE CONSEIL D’ADMINISTRATION DE

L’ORÉAL. (2021, 7 décembre). loreal-finance.

https://www.loreal-finance.com/system/files/2021-12/CP_OPÉRATION%20STRA-

TÉGIQUE%20APPROUVÉE%20PAR%20LE%20CONSEIL%20D%27ADMINISTRA-

TION%20DE%20L%27ORÉAL_0.pdf

Opérations sur titres. (2023, janvier). loreal-finance.

https://www.loreal-finance.com/fr/operation-titres

Résultats semestriels 2022. (2022, 28 juillet). loreal-finance.

https://www.loreal-finance.com/system/files/2022-09/Commu-

nique%20du%2028%20juillet%202022.pdf

Roberts, R. (2022, 25 juin). 2022 Beauty Industry Trends & Cosmetics Marketing : Statistics

and Strategies for Your Ecommerce Growth. Common Thread Collective.

https://commonthreadco.com/blogs/coachs-corner/beauty-industry-cosmetics-mar-

keting-ecommerce

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