Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Two – WACC – Forty years on
The deduction from the value of the enterprise, which falls to the debt, is the area
of the quadrilateral A to E to F to G. So the value of our enterprise can be
represented as the sum of the value of the two options prior to the cost of the
specific default risk, minus the cost of the specific default risk.
It is as if we took our second case from Exhibit 2.21, in which all of the
risk premium on the debt was ascribed to its Beta, and then decided that
we were going to cut the value of the debt again, to reflect default risk,
and that this time the loss of value would not be recycled via the Beta of
the equity.
7.3 Implications for arbitragers
What this analysis implies is that just as ignoring the option relationship between
debt and equity holders may result in a massive undervaluation of the equity in a
company if that option is valuable, so might naïve application of the standard
option model result in considerable overvaluation of the entire enterprise. If we
start with an estimated enterprise value and then allocated it using option models
between debt and equity we may ignore default risk. Starting with the market
value of the enterprise value, rather than an estimated enterprise value, should
avoid this, but is clearly very limiting. We may not always believe that the market
is right about the enterprise value.
Readers may be interested to refer back to the Vivendi example. There, the
analyst’s estimates of fair value were significantly below, not above, the market
enterprise value. It is reasonable to suppose that the analyst’s sum-of-the-parts
valuation represented a fairly cautious approach to the market values of the
business in the event of forced liquidation.
The market value of the enterprise may or may not include a deduction for
specific risk. As we have seen, whether the capital market demands
compensation only for market risk or for specific risk as well remains an open
question. One sample is not enough to support the contention that the analyst’s
value includes default costs while the market value does not.
The question of whether or not specific risk is priced will not merely
affect the resulting estimate of enterprise value. It will also change the
allocation of that enterprise value between debt and equity, because the
loss of value resulting from the specific risk of default represents a
deduction from the payoffs that attach to the debt, but does not alter the
payoffs to the equity.
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