Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
Whichever choice we make about how to treat tax shelters, however, there is no
doubt that since we are treating the tax shelter as an item to be adjusted for in the
discount rate (via a net of tax cost of debt), we should not also be taking it into
account in the cash flows that we discount. To do so would clearly be doublecounting.
So when we calculate free cash flow we do so by restating the cash
flows as if the company had no debt in its balance sheet. We discount deleveraged
free cash flow. This is true whether we apply a single WACC, or whether we
value the unleveraged assets and the tax shelter separately, as in an APV analysis.
Turning to the forecasts of economic profit and cash flow, notice a number of
points relating to the calculation.
• The first is that, because we want unleveraged free cash flows, we start not
with pre-tax profits but with EBIT.
• Secondly, the calculation of tax is a notional one. It is what the tax would
have been in the event that we were not in fact going to be creating tax
shelters through the payment of interest. Tax in our forecast profit and loss
account is in fact lower than the tax shown here, and the difference is the tax
shelter that the company will create if it carries the levels of debt that we are
projecting. As with our actual forecast, we add back amortisation of goodwill
into taxable profit, so the notional tax charge is arrived at by multiplying
EBITA by the marginal rate of taxation.
• Thirdly, we would include as part of our NOPAT those provisions for which
we want to pay (deferred taxation, for example), because we do not believe
that they represent a real accrual of liability. The reason for including them
in the NOPAT, rather than putting them alongside depreciation will become
apparent when we move on the discussing the economic profit calculation of
value. Clearly, where we put them in a DCF calculation will make no
difference to the calculation of free cash flow.
• Fourthly, the remaining items (comprising depreciation and amortisation,
capital expenditure and change in non-cash working capital) can
conveniently be netted off against one another to derive a figure for net
investment. This is the extent to which the company grows its balance sheet
size from one period to the next.
So free cash flow can either be thought of as unleveraged cash flow from
operations less investment, or, much more usefully, as NOPAT minus net
investments: profit less the proportion of profit that we have to plough back into
the business to fund future growth. The reason why this is a much better way to
look at the problem is that we have a formula for retentions, which we discussed
in Chapter one. It is that retentions must equal projected growth divided by
projected returns on incremental capital.
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