Valuation errors
(header paper)

The average gamma = 0.35. A large proportion (about 35%) of the tax that masquerades as company tax is actually personal tax collected (or withheld) at the company level. Hence the effective company tax in Australia is much closer to 19% than the statutory rate of 30%. There are three milestones in the life of franking credits; they are created when company tax is paid, they are distributed along with dividends and they are redeemed when shareholders claim them against personal tax liabilities.

Two issues arise; how many credits are issued (access) and how many of these distributed credits are redeemed (utilisation)? Over the period July 1987 to June 2002 (the latest ATO data available) about $265 billion of company tax had been paid, creating $265 billion of franking credits of which $77 billion remained within FAB accounts, giving rise to an Australia-wide average access factor of 71% over these 19 years. The distributed credits are valued at about 50% of their face value. Overall, about 35% of company tax is actually pre-payment of personal tax. We can see no variation in the value of credits over time but the changes in the company tax rate have changed the amount of credits available per dividend.

The Australian stock market index has changed many times over the last 130 years (1875-2004) which reflects the changing composition of the Australian economy. We review the changes over time of the major sectors within the ASX (now S&P/ASX) indices. These changes are also very strongly reflected in the volatility of the indices whereby various waves of volatility have passed through the ASX indices. The last major one corresponded with the rise and decline of the resource sector within the ASX market. The decline in that volatility is still happening today in that we are still experiencing the post-boom decline in volatility. We are seeing a similar decline in GDP volatility, both in Australia and the USA. This hints at a declining future market risk premia.

The Australian Market Risk Premiumhas slowly changed over recent decades. We estimate the MRP is now 4.5% per annum. The term "MRP" is a notoriously ambiguous one. We carefully consider the range of MRP estimates, we consider the major changes passing through the Australian stock market. We allow for missing return estimates from the S&P/ASX indices due to credits being ignored (52 bp per annum) and the impact of the PER inflation from 1980-1990. We look for reasons why the MRP might have changed and find that both the total risk of the Australian market has declined and that the price per unit risk has declined (the Australian market-wide Sharpe Ratio has declined).

WACC formulae can be dangerous to use in some cases and they remain a mystery to many people. We introduce a simple logic for describing the various WACC formulae and then we put them to the test for robustness. There are a couple that should always be avoided because they consistently give under-estimates for valuation. They also give the widest spread in valuation outcomes so we strongly suggest that these particular WACC formulae not be used in valuation exercises.

The cost of capital to government is the private sector's pre-tax cost. There is no cheaper capital available to government nor is there any valuation wedge between private and government ownership. Tax equivalent payments, which under government ownership take the form of cash, under private ownership become franking credits, whose market value depends on the pay-out policy of the firm concerned and its ability to distribute franking credits. Government-owned business will make correct investment decisions if they use the private sector post-tax cash flow and the private sector post-tax cost of capital.

In this way, they will get consistency with their pre-tax cost of capital and their pre-tax cash flows. As most returns are observed and measured in the post-tax environment, it is preferable to do all the valuations on a post-tax basis as this will avoid making assumptions about converting observed post-tax data into unobservable pre-tax data.

Errors in valuation calculations are not at all uncommon and some have very large consequences - running into hundreds of millions of dollars! This set of linked papers is a collection of errors we have seen over the years (names of individuals and events withheld). It includes a brief description of each error and example calculations. Contributions (acknowledged or anonymous) are welcome.

Book vs Market errors occur when a valuation Vanilla WACC valuation is conducted with the debt amount determined by the capital expense (the book value) and not the market value of the asset. These will only be the same when the NPV =0. For NPV > 0 projects, it will erroneously understate the debt amount, understate the debt tax shield and overstate the debt cover ratio.

Inflation must be taken out of the nominal WACC after forming the nominal costs of capital and then applying the Fisher equation. Errors are made when forming a “real” WACC from real costs of capital. These errors seem more common in the perpetuity valuation of residual or “tail” cash flows that are often implicitly real.

Tax shields on interest payments must exist before they can have any value. Usually the tax shield on debt interest is readily available and this is consistent with the classical WACC method which values the shield as if it were immediately available. But, if the tax shield on debt is not available for some years due to little or no tax being paid, then the standard WACC approach is in error.

Debt interest tax shields (ITS) should be valued using the cost of equity, not the cost of debt. The tax shield on debt is a cash flow to shareholders , not debt holders. The note on this issue demonstrates that the value of the ITS is the difference of two values, both calculated using the cost of equity but in the special case of a perpetuity the difference reduces to a debt value capitalised at the cost of debt.