Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
5. Building in tax shelters
The simplest approach to a tax shelter is to see it as an addition to what the firm
would be worth on an unleveraged basis. In other words, we value the company
on the basis of its unleveraged cost of equity, and then add in a value for the cash
that it conserves for its providers of capital, through paying less tax if it is
leveraged than it it is unleveraged. This distortion arises because taxation is
levied on profit after interest payments, so interest is deductible against
corporation tax but dividend payments are not. In effect, what is happening is that
three parties are sharing the operating profits generated: the bondholders, the
government and the shareholders (in that order). If the providers of capital shift
the balance from equity to debt, then their combined take increases at the expense
of that of the government.
The conventional WACC/DCF approach is to handle tax shelters by alteration to
the discount rate. This, it is argued, falls as leverage increases (because of the tax
shelter), until the company becomes over-leveraged, and distress costs boom, at
which point the discount rate starts to rise dramatically.
Our approach will be rather different. Instead of treating tax shelters as changing
the discount rate we shall begin by valuing them as an independent asset in their
own right, and then add the result to the value of the unleveraged assets. This
approach is known as Adjusted Present Value (APV). It will enable us to make
explicit the connections between value and growth that get bundled up in the
conventional WACC calculation. The formula that underpins APV is the
following:
V F = V D + V E = V A + V TS - DR
where V F =value of firm, V D =value of debt, V E =value of equity, V A =value of
unleveraged assets, V TS =value of Tax Shelter and DR is the value of the default
risk.
The traditional WACC/DCF approach picks up the entire value in one calculation
by adjusting the WACC for the impact of the tax shelter. We shall approach the
valuation of the unleveraged assets and the tax shelter separately, and then make
sure that we can reconcile our WACC with the APV valuations. As we shall see
the differences between our recommended formulae and those in general use
relate to the treatment of the tax shelter both in the formula for leveraging and
deleveraging equity Betas and in the formula for adjusting WACC for changing
leverage, for the same reason in both cases. We shall be discounting the tax
shelter at the unleveraged cost of equity, and the standard approach discounts it
at the gross cost of debt.
The discount rate that should be applied to unleveraged cash flows is obvious. It
is the unleveraged cost of equity. The question is what is the discount rate that
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