Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Six – The awkward squad
figure by the rate of inflation. Then, when we retire assets, we retire them at the
current equivalent of their purchase cost, so the 100 that we spent in Year 0 is
retired as 100*1.05 3 = 115.76 when it drops out of the gross assets in Year 3.
The net assets in CCA accounts are derived by looking at the ratio of net to gross
assets in the HCA accounts and applying it to the gross replacement cost assets.
Then since we know the opening value, the closing value and the capital
expenditure, we can derive depreciation as a result. So, at end Year 2, cumulative
depreciation (from the HCA accounts) comprises 32.25 per cent of gross assets,
so in the CCA accounts if gross assets comprise 330.75 then cumulative
depreciation must be 106.67. Closing net assets must be 330.75 - 106.67 =
224.08. Now, if we know that opening net assets were 175.85, closing net assets
were 224.08 and capital expenditure was 110.25, then by deduction the annual
depreciation charge for the year is 72.52.
As with HCA accounts, CCA profit is cash flow minus CCA depreciation and
return on opening capital is CCA profit divided by opening CCA capital. Notice
that the return on capital employed stabilises at exactly 7.5 per cent. That is
where our rather eccentric looking ‘real cash on cash return’ number comes from.
It is the figure for real cash return on cash investment that would provide the
company with a 7.5 per cent CCA return on capital assuming a three year asset
life. In reality, the regulator would not set the cash flow directly, as we have
discussed, but would set a price cap such as to generate expected cash flows that
are consistent with the target return.
The reconciliation between the HCA and the CCA profit numbers is the
difference between the two depreciation charges, the ‘supplementary
depreciation’ in the CCA accounts. But there is an important difference between
the two accounts to which we shall return. For the HCA accounts, clean value
accounting holds. So, for example, in Year 1, capital grows from 100.00 to
171.67, and the net investment of 71.67 equals capital expenditure of 105.00
minus depreciation of 33.33 (net investment), which in turn equals profit of 8.36
plus negative net cash flow (new capital) of 63.31. But these relationships do not
hold in CCA accounts. The reason is the inflation adjustment.
Capital grows each year by more than net investment or the sum of profit
and negative cash flow. Clean value accounting does not hold. This will
have strong implications for how our valuation methodology will have to
work, if we are running off CCA accounts.
1.4.4 Economics HCA-style
The third page of Exhibit 6.1 illustrates the individual cash flows generated by
each of the four years’ of capital expenditure in our forecasts. This exercise has
two purposes. The first is to demonstrate what the economic rate of return is. The
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