Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
One advantage of the latter is that there is no presumption, if one is thinking in
terms of profits rather than dividends, that there is any particular cash flow
attached to the calculation. Accrued benefits or charges are intuitively fine within
the residual income framework. This is less true for discounted dividend or
discounted cash flow models, since it seems highly counter-intuitive to start with
a stream of cash and then to deduct part of it and add on unrealised gains to get
to a reasonable valuation. But that is what you have to do if the model is to
produce a reasonable valuation. This is why many academics prefer residual
income-type models.
6. Introducing debt
We started with a constant growth company which was only financed by equity,
and discovered that even that could only be properly analysed with reference to
accounting entities such as profits and balance sheets. We then made matters
worse by accepting that whatever the form of our model, it would to have to take
account of accruals. We then generalised it to relax the constant growth
assumption, which made no difference to anything, except that it is not
practicable to forecast individual years to infinity. But however far forward we
project individual years, that represents no methodological problem, just a
practical one.
Now we are going to relax the assumption of no debt (or cash) in the balance
sheet. Intuitively, it should make no difference whether we discount cash flows
to capital at a cost of capital or cash flows to equity at a cost of equity. Again, we
leave the proof to the Appendix, but the point is that:
V E = V F -V D
where the three values stand for equity, the total firm, and debt, respectively. What
we need to know is that it makes no difference whether we value equity directly as:
V E = D*(1+g)/(k-g)
or as:
V E = FCF*(1+g)/(WACC-g)-V D
where FCF is last year’s free cash flow, and WACC is the weighted average cost
of capital.
Free cash flow is calculated as being after a notional taxation rate, which is levied
on operating profit, to derive a so-called Net Operating Profit After Taxation
(NOPAT). Exhibit 1.11 shows the calculation of NOPAT and free cash flow for a
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