Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
1.4.7 Valuing the CCA accounts
Now suppose that you are valuing a company for which the published accounts
are the consolidated CCA figures from page two of Exhibit 6.1. There are a
couple of seductive but horribly wrong things that you could do, and we look first
at the wrong and then at the right approaches below.
1. An obvious mistake would be to take the net cash flows, grow them in the
terminus at 5 per cent annually, and then discount them at a real discount
rate. If we use the 7.5 per cent target CCA return on capital we get a value
for the enterprise of 687.77, which has the merit of being very obviously
wrong!
2. Since how the company accounts cannot alter its cash flows, it follows that
if we are going to value the company by discounting its net cash flows the
discount rate that we should use is the nominal rate of 14.75 per cent, even
if we are applying it to cash flows derived from a CCA model in which the
forecasts have been obtained by assuming a real rate of return on
replacement cost assets.
3. Another superficially attractive way to value the company would be to use
an economic profits model and to use a real discount rate. Unfortunately, as
we have seen in page two, the projected returns on capital are in all years
lower than the real discount rate of 9.29 per cent. In fact, running an
economic profit valuation on this basis gives a negative intrinsic value for
the enterprise of -41.11, which again has the sole merit of being obviously
wrong! The culprit is the breakdown in clean value accounting.
Clean value accounting implies that balance sheet growth must equal net
investment, which must equal profit plus negative net cash flow (new capital). So
we have to add back the inflation adjustment, which of course means that the
returns on capital that we derive are again now nominal. Look at page eight. We
are correctly deriving a value of 100 by applying a nominal discount rate of 14.75
per cent to returns that include the inflation adjustment. The pattern of economic
profit is, however, different from that calculated in page five, because the inflation
adjustments are providing a better picture of value creation than the HCA accounts
did, with their straight line depreciation. However, it is still not perfect. We still
have a small negative value creation in the first four years perfectly offset by a
positive terminal value of 1.87. To apply economic profit to CCA accounts you
must include the inflation adjustment in the calculation of NOPAT, and then
discount the resulting economic profit at the nominal cost of capital.
1.5 Conclusions for modelling utilities
To explain the accounting and modelling points that relate to CCA accounts,
which are not intuitively obvious, we have had to take recourse to a rather simple
company. It has no working capital and is entirely funded by equity. Its asset life
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