Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Five – Valuing a company
in which varying discount rates are required. This is where the company is
already mature and stable. Nothing is going to happen to the riskiness of the
existing business. But the company may have indicated that it was its intention
to substitute debt for equity simply in an attempt to reduce its cost of capital.
As we saw in Chapter two, increasing the proportion of debt in a balance sheet
does two things. It increases the size of the tax shelter, and it increases the risk to
both the debt and the equity. There is dispute about both the appropriate treatment
of the tax shelter and the treatment of the risk premium on the debt. We shall take
the simplest (and, we believe, probably the best, approach) here. We shall
discount the tax shelter at the unleveraged cost of equity, and we shall assume
that 100 per cent of the risk premium on debt is default risk, and that debt has a
zero beta. We explored the implications of these conclusions in chapter two and
will merely assume them here.
Whatever the stand that we take on theoretical questions, there is also a practical
issue as to which of the two methodologies to adopt: adjusted present value
(APV), which we discussed in Chapter two, or time-varying WACC (TVW). The
former works by valuing the assets and the tax shelter as separate components.
The latter works by iterating a different annual solution for WACC each year. We
shall use TVW as our methodology for this exercise, for two reasons. The first is
that whereas APV is intuitively easy to understand, TVW requires some
explanation if it is to be replicated. The second is that TVW is in many ways more
flexible, because it is possible to build default risk into the cost of debt. As we
saw in Chapter two, APV cannot handle default risk, which has to be derived by
running a WACC calculation to derive a value that can be compared with an APV,
with the difference attributable to default risk.
We shall continue to use Metro as our example. It is a perfectly reasonable
candidate for a share buy-back, and using it will have the additional benefit that
we can illustrate to readers the mechanism modelled on the equity tab, and the
impact of the buy-back on a valuation that has already been established using a
constant discount rate.
Before we do this exercise, look again at Metro’s ratios of debt to capital in the
model reproduced above. Debt is falling steadily. In the event that this really
happened, the company’s cost of capital would rise steadily, making our
valuation above over-optimistic. So there are two possibilities: either that the
forecast above is right, and that the valuation above is too high, or that the
company will maintain a more leveraged balance sheet, perhaps through buybacks,
in which case the valuation above could be more or less correct. Let us test
these hypotheses.
In Exhibit 5.3 overleaf, we reproduce the three main financial statements, the equity
tab, and two new valuation tabs for Metro (pages 13 and 14). It is the same model,
with a €1 billion share buy-back built into it in 2007, and a somewhat different
valuation routine to cope with TVW. The other parts of the model are not reproduced
since all the operating figures are assumed to be the same as in Exhibit 5.1 above.
213