9. Example – BHP Government bonds 6% Beta of BHP 1.2 x MRP 6% Calculation for equity discount rate: = Rf + β (MRP) = 6% + 1.2 x 6% = 6% + 7.2% = 13.2% (note, after tax) Discount rate
10. Funding – part debt / part equity BHP’s weighted average cost of capital: 70% equity x 13.2% (from slide 9) Plus 30% debt 7% less 30% tax = 4.9% Equals WACC 10.71% (after tax) (70% x 13.2% + 30% x 4.9%)
11. Calculating value Discount Rate x CFY1 + x CFY2 + x CFY3 etc Discounting is like compound interest in reverse
13. Impairment testing Can’t reverse goodwill write-downs (even if impairment is due to interest rate rise) Unrecognised intangible values “hide” goodwill losses Upgrades and hence future benefits have to be “committed”, or else ignored Many DCF’s are only 5 years Too short a forecast period Most value is in terminal value Terminal value easy to get wrong Lots of silly rules
14. Impairment testing If its (barely) profitable, its not impaired If profit exceeds interest cost of debt, its not impaired You only impair fixed assets. Stock, debtors etc are subject to their own different accounting standards and are excluded from the asset base for impairment testing In reality This isn’t correct What many directors (wrongly) believe
15. Impairment testing – the reality AIFRS impairment test higher of: Market value Value in use (VIU) VIU uses company view of cash flows not market views VIU = L.O.O.C. But most companies use it (guess why?) VIU reduces write-downs
17. Impairment testing – overview Things generally aren’t too bad in Australia Things are very bad overseas in Western World ( large govt debt and deficits in USA, UK, Spain, Portugal, Ireland etc) China has saved us, so far Australian consumers are worried (house values, interest rates, electricity costs, etc) On balance Tread carefully Watch China If China falters significantly – watch out!
18. GFC – what many forget Mean reversion applies in a crisis Note: Forced down by Government. Much lower in USA etc. At least. Or lower, if debt available at all.
19. The GFC hangover Interest costs still higher than pre-GFC (credit spread up 1% or more) Credit availability reflected in debt / equity ratio significantly lower End result – values have generally fallen Index 2007 6,000 (+) 2011 5,000 (-)
20. Valuation trends 2007 – 2011 Lower earnings multiples in 2011 Much less debt Increased cost of debt Significant sectoral differences (e.g. Mining vs Retail)
21. Will it get better? Major government debts due espec to bail outs / stimulus packages USA (e.g.): Large government annual deficit Debt exceeds 100% of GDP Very low interest rates aren’t stimulating demand much Similar, some worse, problems in most of Western world T.G.F.C.
22. Getting better – “best guess” Australia depends on China Rest of world (except e.g. Asia) in poor state Will take a very long time to fix (e.g. USA, UK, Spain, Portugal, Ireland, Greece, etc)
23. Recommended reading Available from leading book stores or Allen & Unwin www.allenandunwin.com Available from leading book stores or Sydney University Press www.sup.usyd.edu.au (Alternatively contact Lonergan Edwards on 02 8235 7500)