Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
Exhibit 2.17: APV for varying growth (1)
APV for varying Growth
APV valuation
Annual CF k Value at different growth rates
0% 2% 4%
Assets 100 10% 1,000 1,250 1,667
Tax shelter 10 5% 200 333 1,000
Firm 110 1,200 1,583 2,667
The second problem is a theoretical one. Are tax shelters really equally risky (or,
more properly, as riskless) as the company’s outstanding debt? To generate a tax
shelter a company has to generate a profit. The tax shelter is a function of a
difference between two levels of pre-tax profit: that which the company would
have generated on an unleveraged basis and that which it would generate after
paying interest on a given level of debt. It is not the risk attaching to the interest
payment itself that is relevant. It is the risk attaching to the marginal amounts of
profit generated in the two examples.
Let us illustrate the point with a real example. In 1996, the Kuwait Petroleum
Corporation put up for sale its UK North Sea assets (held through a company
called Santa Fe Petroleum). The assets were eventually bought by the Norwegian
exploration and production company, Saga Petroleum, at a price that implied the
use of a relatively low discount rate. This was partially justified by the fact that
Saga borrowed the consideration, and that it had a marginal rate of taxation on its
Norwegian operations of 78 per cent. If you can pay interest at a net rate of 22
cents in the dollar then money seems cheap.
The two years that followed the acquisition, 1997 and 1998, were characterised
by the Asian economic crisis. Oil prices collapsed. By the end of 1998 Saga was
not making the profits that were required to shelter its interest payments. In its
year end accounts it was required to write down the acquired assets. This put a
severe strain on its balance sheet, and the company responded with an attempted
rights issue, which was not supported by its shareholders. During 1999, while oil
prices were recovering, it lost its independence. At no point was Saga unable to
pay the interest on its debts. So did it make sense to value the tax shelter by
discounting it at the cost of debt? Clearly not. But that is exactly what happens
when you say that the net cost of debt is the gross cost of debt times one minus
the marginal rate of tax (the basis of almost all company valuation models)!
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