Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Two – WACC – Forty years on
What is happening here? We do not get consistent value at all. The sum of the
parts is bigger than the whole, which is not what we want to see. The reason is
that in dividing by ‘k-g’ the impact on values is not linear as we increase ‘g’. It
will have a disproportionately large impact when applied to smaller values of k.
This is very unsatisfactory, and illustrates an equally important truth about the
original Miller and Modigliani analysis to the fact that it was based on a tax-free
and default-free world. It was also premised on a no-growth world. Techniques
for building tax and default risk into the original framework have been known
and used for years. But the significance of the impact of growth on valuation has
not been similarly emphasised, which is very odd since its potential impact on
valuations is far greater, and most valuation models do assume constant growth
after a forecast period.
Our approach to the practical calculation of discount rates is therefore going to
differ from that conventionally followed in text-books, since we shall take pains
to think through the implications of all of our actions on growing, not merely on
static, streams of cash.
The customary practitioners’ approach, unfortunately, is to use a theoretical
structure that works perfectly in a static world, and then to misapply it to a
growing one.
Unfortunately, the result is systematic overvaluation, of the sort illustrated in
Exhibit 2.13.
So as we build tax shelters and default risk into our discount rates we must try to
establish an approach that is robust when applied to growth companies. It must
be said at this point that the authors claim no originality with respect to the
analysis, except, perhaps, to the manner of presentation. The bibliography
provides references in which all of the theory has been presented, but perhaps
because of its complexity it has not yet entered commercial practice. That is what
we aim to change.
4. Leverage and the cost of equity
Let us return to Exhibit 2.12 for a moment. Because we are in a world with no
default risk, the cost of debt does not change, and should be equivalent to a risk
free interest rate. The redemption yield on a long term government bond is often
used as a proxy. As the gearing changes, the cost of equity changes, so that the
value of the company remains unchanged. The formula for the cost of equity
under the standard Capital Asset Pricing Model (CAPM) is as follows:
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