Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Six – The awkward squad
of 100, and by implication it has correctly put a value of zero on the stream of
future economic profit. All that is happening is that returns are underestimated in
the first two years and overestimated after that. The two effects cancel out.
But the crucial point here was that we knew that the appropriate discount rate was
14.75 per cent. Suppose instead that we were valuing a US utility where the
regulator was using accounting returns as a proxy for economic returns (which it
probably would) so that we were all using the assumption that the company was
generating returns of 15.37 per cent on its assets.
Substituting this discount rate results in a valuation of 88.50 (again, for both
methodologies). The valuation is being understated if the valuer follows the
regulator in taking the ROCE to be a proxy for the IRR. The valuation shows the
company to be worth less than its regulatory asset base (the 100 of sunk
investment at end Year 0), which would be perverse, if it were being permitted to
earn its cost of capital.
1.4.6 Economics CCA-style
The easiest way to model real projected cash flows is to convert them all into
Year 0 money, so that the Year 1 numbers are discounted for one year’s worth of
inflation, Year 2 for two years’ worth, and so on.
Page six of the model does this and allows us to make the same calculations as
we did in page three for the nominal figures. Firstly, the calculations show us that
the real IRR on our investments is 9.29 per cent, which compares with the 7.5 per
cent real ROCE that we see in the CCA accounts. Thus in this case the accounts
are seriously understating the actual profitability that we are achieving, rather
than overstating it as in the HCA calculations.
Secondly, if we are prepared to stay in Year 0 money then we can produce
adjusted profits and balance sheets CCA, as we did on page four for the HCA
accounts. These are shown on page seven of Exhibit 6.1, and they illustrate the
following points. Firstly, as with the HCA equivalents, the calculated CCA
ROCE each year is 9.29 per cent, which we know to be the correct IRR.
Secondly, an economic profit model would therefore value the company at 100
as at start Year 1. Thirdly, as clean value accounting applies, a DCF model would
necessarily do the same.
Incidentally, to understand the reconciliation between the real and the nominal
returns, you need to remember that returns compound, so that 1.0929 (real IRR)
times 1.05 (inflation) equals 1.1475 (nominal IRR).
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