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JARAF THE JOURNAL OF APPLIED RESEARCH IN ACCOUNTING AND FINANCE

2010 VOL 5 ISSUE 2

WHY PRE-TAX DISCOUNT RATES SHOULD BE AVOIDED Kevin Davis PRE AND POST-TAX DISCOUNT RATES Martin Hall THE PROBLEM OF PRE-TAX VALUATIONS: A NOTE

Michael Dempsey, Michael McKenzie and Graham Partington

SOME RATES ARE BETTER THAN OTHERS Kaiying Ji

Electronic copy available at: http://ssrn.com/abstract=1755322

JARAF THE JOURNAL OF APPLIED RESEARCH IN ACCOUNTING AND FINANCE

PUBLICATION INFORMATION

EDITORS

JARAF — The Journal of Applied Research in Accounting and Finance is a scholarly peer-reviewed journal hosted by the University of Sydney Business School.

Tyrone M Carlin Acting Dean Professor of Financial Reporting & Regulation The University of Sydney Business School The University of Sydney NSW 2006 Australia

All journal articles published in JARAF have been peerreviewed by independent, qualified experts before publication. JARAF meets the DIISR requirements for classification as a C1 journal. The Australian Research Council (ARC) has included JARAF in the Excellence in Research for Australia (ERA) tiered outlet rankings. JARAF is classified with a B ranking in the ERA 2010 Ranked Journal List. Months of Distribution: July and December Current Edition: Volume 5 Issue 2 (2010) ISSN 1834-2582 (Print) ISSN 1834-2590 (Online)

AUTHOR ENQUIRIES

Nigel Finch Senior Lecturer Academic Program Director, Master of Management The University of Sydney Business School The University of Sydney NSW 2006 Australia

EDITORIAL ADVISORY BOARD Edward I Altman Max L. Heine Professor of Finance Stern School of Business, New York University (USA) John Argenti Chairman, Argenti Systems Limited (UK)

For information relating to the submission of articles, visit the JARAF website at http://sydney.edu.au/business/research/journals/jaraf

Aswath Damodaran Kerschner Family Professor of Finance Education New York University, Stern School of Business (USA)

Please address all enquiries to: Dr Nigel Finch Co-Editor, JARAF The University of Sydney Business School The University of Sydney NSW 2006 Australia

Pablo Fernández PricewaterhouseCoopers Professor of Corporate Finance, University of Navarra, IESE Business School (Spain)

Email: [email protected] Phone: + 61 2 9036 6177 Fax: + 61 2 8080 8381

Stewart Jones Professor of Accounting, The University of Sydney (Australia) Wayne Lonergan Managing Director, Lonergan Edwards & Associates Adjunct Professor, Faculty of Economics and Business, The University of Sydney (Australia) Tom Ravlic Policy Adviser, Financial Reporting and Corporate Governance National Institute of Accountants (Australia) Simon Thackray Director, Equities Research Royal Bank of Scotland (Australia)

Stephen A Zeff Herbert S Autrey Professor of Accounting Jesse H Jones Graduate School of Management, JARAF / VOLUME 5 ISSUE 2 2010 Rice University (USA) Electronic copy available at: http://ssrn.com/abstract=1755322

CONTENTS

EDITORIAL

Tyrone M Carlin and Nigel Finch

WHY PRE-TAX DISCOUNT RATES SHOULD BE AVOIDED Kevin Davis

PRE AND POST-TAX DISCOUNT RATES Martin Hall

THE PROBLEM OF PRE-TAX VALUATIONS: A NOTE Michael Dempsey, Michael McKenzie and Graham Partington

SOME RATES ARE BETTER THAN OTHERS Kaiying Ji

1

2

6 10 14

JARAF / VOLUME 5 ISSUE 2 2010

EDITORIAL

T

hat which at first blush seems simple often reveals deep complexity upon closer, more prolonged investigation. So it is with discount rates. As hammers and nails are to a builder, discount rates are to practitioners in the domain of accounting, finance and financial management. They are, and they are regarded as, fundamental tools — an essential element of any and every repertoire. This raises a paradox. The endemic character of discount rates engenders a sense of ease and familiarity amongst those for whom the application of such tools is an element of the daily stock in trade. Nonetheless, each of the four papers which comprise this edition of the journal revolve around this one phenomenon, and the difficulties which can rapidly emerge when moving from the abstract to the practical dimension. Though each of the papers in this edition is focused on questions relating to discount rates, two distinctive sub-themes are explored. The first, traversed in the contributions by Davis, Hall and Dempsey et al examine in detail the choice between the application of pre-tax and post-tax discount rates. These papers raise a consistent thread of argument that there are enormous dangers associated with the application of pre-tax discount rates. This should be a matter of concern for practitioners, regulators and especially standard setters, who have been enamoured of pre-tax discount rates in a number of financial reporting settings. The second sub-theme examines discount rate choice by Australian listed firms undertaking the process of goodwill impairment testing. There has been a degree of controversy in the financial reporting literature on this point over the past several years, and the contribution by Ji in this edition brings together a heavier weight of evidence in relation to this question than has been previously available. The results suggest that auditors, regulators and company directors should be paying particularly close attention to this matter. As we conclude another year, we extend our thanks, yet again, to our editorial board, to our team of reviewers, our contributors and especially our readers, who now number in excess of 10,000 around the globe. JARAF

TYRONE M CARLIN & NIGEL FINCH SYDNEY, DECEMBER 2010

JARAF / VOLUME 5 ISSUE 2 2010 / 1

JOURNAL OF APPLIED RESEARCH IN ACCOUNTING AND FINANCE

WHY PRE-TAX DISCOUNT RATES SHOULD BE AVOIDED

Kevin Davis

Lonergan (2009) and Jindra and Voetmann (2010) analyse comparative results from discounting post-tax cash flows at a posttax discount rate versus discounting pre-tax cash flows at a pre-tax discount rate. While their results are correct within the context of their analysed examples, these examples do not include the most common and interesting problems which financial managers will face. This paper demonstrates that there is no simple standard adjustment which can be made to available post-tax discount rates to enable analysis of pre-tax cash flows in the general case. The problem is even more stark when valuation is attempted on a real pre-tax basis, as had been applied in a number regulatory access pricing situations.

2 / JARAF / VOLUME 5 ISSUE 2 2010

Introduction There has been considerable debate over whether it is possible to undertake valuations using pre-company tax cash flows rather than post-tax cash flows. While pre-tax cash flow estimation may be easier than post-tax cash flow estimation, financial markets provide us with estimates of the cost of capital on a post (company) tax basis. While it might be thought that a pre-tax cost of capital can be readily estimated from a post-tax figure by a simple formula using the company tax rate, this is not generally the case. This issue has been of importance in regulatory access pricing where some regulators have used a ‘real pre-tax approach’ and others have used a ‘nominal post-tax approach’. In that context Davis (2006) shows that the real pre-tax approach is not appropriate because no unique rule exists for converting a market determined nominal post-tax rate of return into a real pre-tax rate of return. Lonergan (2009) and Jindra and Voetmann (2010), focusing only on nominal magnitudes, analyse comparative results from discounting post-tax cash flows at a post-tax discount rate versus discounting pre-tax cash flows at a pre-tax discount rate. While

their results are correct within the context of the examples they analyse, those examples do not include the most common and interesting problems which financial managers will face. This paper demonstrates that there is no simple standard adjustment which can be made to available post-tax discount rates to enable analysis of pre-tax cash flows in the general case. Hence, use of a post-tax approach is recommended. The Lonergan and Jindra-Voetmann Analysis These authors use a number of examples to illustrate the relationship between results using pre and post-tax discount rates and cash flows. Jindra and Voetmann demonstrate how consistency of results can be derived for Lonergan’s examples. Their results are most simply demonstrated in tabular form (see Table 1).1 They assume a post-tax discount rate of r = 0.14 and a corporate tax rate of t = 0.30 and show that the two approaches if implemented as per the table notation give equivalent results.2

Table 1: Pre and post-tax formulae for taxable cash flows Example

Post-Tax Approach

Pre-Tax Approach

Perpetuity after-tax cash flow of c(1-t)

V = c(1-t)/r

c/[r(1-t)]

V = c(1+g)(1-t)/(r-g)

V = c(1+g)/(r-g)/(1-t)) = c(1+g)/(r*-g) where

Growing perpetuity after tax cash flow of initially c(1-t)(1+g)

r* = r/(1-t) – gt/(1-t) Single period after tax cash flow of C(1-t) Period N after tax cash flow of C(1t)

V = C(1-t)/(1+r)

V = C/[(1+r)/(1-t)]

V = C(1-t)/(1+r)N

V = C/[(1+r)N/(1-t)]

Several points are apparent from this table. First, it is possible to derive a specific discount factor for each case — but the relationship between the posttax and pre-tax discount factors varies according to the case. Second, this is purely a matter of algebra. Third, and most important, the approach assumes that the relationship between pre and post tax cash flows is exactly proportional to the tax effect of (1-t).



Cash Flows and Return of Capital In practice, cash flows of a project involve a mix of return of capital (depreciation) and return on capital. The former is not subject to company tax (depreciation is deducted from cash flows in deriving taxable income) while the latter is taxable. Consequently, the relationship between pre-tax cash flows and post-tax cash flows will depend upon how the tax system divides those cash flows into capital and income components. That may vary substantially, depending on the nature of the project. In the Table above, the perpetuity examples assume no return of capital, such that all cash flows are taxable at the corporate tax rate of t. Similarly, the single and multi-period cash flow examples treat the cash flow as taxable income — implying that return of capital is taxable.

To see the implications of recognising that cash flows involve both return of capital and income consider a simple three period example of a project which involves outlay of $100 at date 0 and cash inflows of $70 at date 1 and date 2. In Panel A, the tax system allows depreciation (return of capital) at $50 in each year. Using the post-tax cash flows and a discount rate of 14 per cent, the NPV is $5.386. To achieve the same NPV by discounting pre-tax cash flows requires use of a ‘pre-tax’ discount rate of 21.2 per cent.3 Panel B of Table 2 differs from panel A only in so far as having a different depreciation schedule, with first period depreciation of $30 and $70 depreciation in period 2. Using the post-tax approach, it can be seen that the more delayed return of capital and front loading of taxes reduces the NPV. But the critical result is that when the pretax discount rate is calculated which gives the same NPV of $4.740 it is now 21.7 per cent (compared to 21.2 per cent in panel A).

Table 2: Project pre and post-tax cash flows and NPV

PANEL A Date

Cash Flow

Depreciation

Taxable Income

Tax @ 0.3

After-tax Cash Flow

0

- 100

1

70

50

20

6

64

2

70

50

20

6

64

AFTER-TAX NPV @ r=0.14

Present Value

5.386

PANEL B Date

Cash Flow

Depreciation

Taxable Income

Tax @ 0.3

After-tax Cash Flow

0

- 100

1

70

30

40

12

58

2

70

70

0

0

70

AFTER-TAX NPV @ r=0.14


4.740

Conclusion The preceding example illustrates that there is no unique relationship between the post-tax discount rate and the pre-tax discount rate which can be applied in all circumstances. The reason is that cash flows will generally involve a combination of nontaxed return of capital and taxable income. The composition of the cash flow is thus a critical element in determining what pre-tax discount rate corresponds to a given post-tax discount rate. Because tax depreciation arrangements can vary between projects, there is no unique formula available for generating the appropriate pre-tax discount rate for a given post-tax discount rate.

And because financial markets generate returns which are post-tax in nature, our estimates of required rates of return for investors are post-tax rather than pre-tax. Thus, even though the apparent simplicity of using pre-tax cash flows in project evaluation is appealing, it should be avoided because of the problems in deriving a correct estimate of a pre-tax discount rat from the post tax discount rate (which can be estimated (however approximately) from available data). JARAF

AUTHOR PROFILE Professor Kevin Davis, Professor of Finance, Department of Finance, University of Melbourne Research Director, Australian Centre for Financial Studies Email: [email protected]

REFERENCES Davis, K 2006, ‘Access Regime Design and Required Rates of Return: Pitfalls in Adjusting for Inflation and Tax’, Journal of Regulatory Economics, vol. 29, issue 1, pp.103–122. Lonergan, W 2009, ‘Pre and post-tax Discount Rates and Cash Flows — A Technical Note’, The Journal of Applied Research in Accounting and Finance, vol. 4, issue 1, pp. 41–45. Jindra, J & Voetmann, T 2010, ‘Discussion of the Pre and Post-tax Discount Rates and Cash Flows — A Technical Note’, The Journal of Applied Research in Accounting and Finance, vol. 5, issue 1, pp. 16–20.

Notes Their fourth example is a multi-period cash flow. For simplicity of exposition, the table considers as the fourth case a single Nth-period cash flow which can easily be generalised to multiple periods. 1

2

Their paper gives numerical results.

This can be easily computed by using the ‘solver’ function in Excel to find the discount rate which when used to discount pre-tax cash flows gives the same NPV of 5.386.

3



TABLE OF CONTENTS Previous issues of The Journal of Applied Research in Accounting and Finance (JARAF) are available online at sydney.edu.au/business/research/journals/jaraf

Volume 1 (1) December 2006

Volume 2 (2) December 2007

Edward I Altman and Brent Pasternack, (2006), “Defaults and Returns in the High Yield Bond Market: The Year 2005 in Review and Market Outlook”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 1, No. 1, p. 3-29.

Charles W. Mulford and Mark Gram, (2007), “The Effects of Lease Capitalization on Various Financial Measures: An Analysis of the Retail Industry?”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 2, No. 2, pp. 3-13.

Available at SSRN: http://ssrn.com/abstract=943326


Gordon Mackenzie (2006), “Taxation as a Driver for Designing Hybrid Securities”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 1, No. 1, p. 31-42.

Ghassan (Gus) Hossari, Sheikh F. Rahman, and Janek Ratnatunga, (2007), “An Empirical Evaluation of Sampling Controversies in Ratio-Based Modelling of Corporate Collapse”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 2, No. 2, pp. 15-26.

Available at SSRN: http://ssrn.com/abstract=943324 Tyrone M. Carlin, Nigel Finch and Guy Ford, (2006), “Hybrid Financial Instruments, Cost of Capital and Regulatory Arbitrage - An Empirical Investigation”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 1, No. 1, p. 43-55. Available at SSRN: http://ssrn.com/abstract=943325

Available at SSRN: http://ssrn.com/abstract=1090482 Suresh Cuganesan, and David Lacey, (2007), “New Challenges for Performance Management: Exploratory Evidence on Organisational Responses to Identity Fraud”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 2, No. 2, pp. 27-33. Available at SSRN: http://ssrn.com/abstract=1094402

Volume 2 (1) July 2007 Sir David Tweedie, (2007), “Can Global Standards be Principle Based? ”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 2, No. 1, pp. 3-8. Available at SSRN: http://ssrn.com/abstract=1012241 Wayne Lonergan, (2007), “AIFRS - A Practitioner’s Viewpoint”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 2, No. 1, pp. 9-19. Available at SSRN: http://ssrn.com/abstract=1012238 Tyrone M Carlin, Nigel Finch and Guy Ford, (2007), “Are All Audits Born Equal?”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 2, No. 1, pp. 21-32. Available at SSRN: http://ssrn.com/abstract=1012237

Volume 3 (1) July 2008 Michael Lim, (2008), “Old Wine in New Bottles: Subprime Mortgage Crisis - Causes and Consequences”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 3, No. 1, pp. 3-13. Available at SSRN: http://ssrn.com/abstract=1263280 Marlene A. Plumlee and David Plumlee, (2008), “Information Lost: A Descriptive Analysis of IFRS Firms’ 20-F Reconciliations”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 3, No. 1, pp. 15-31. Available at SSRN: http://ssrn.com/abstract=1263281 Eugene E. Comiskey and Charles W. Mulford, (2008), “Negative Goodwill: Issues of Financial Reporting and Analysis Under Current and Proposed Guidelines”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 3, No. 1, pp. 33-42. Available at SSRN: http://ssrn.com/abstract=1263302


Volume 3 (2) December 2008 Eugene E. Comiskey and Charles W. Mulford, (2008), “The NonDesignation of Derivatives as Hedges for Accounting Purposes”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 3, No. 2, pp. 3-16. Available at SSRN: http://ssrn.com/abstract=1346112 Vincent O’Connell and Katie Sullivan, (2008), “The Impact of Mandatory Conversion to IFRS on the Net Income of FTSEurofirst 80 Firms”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 3, No. 2, pp. 17-26.

Michael Lim Mah Hui, (2009), “From Servant to Master: The Financial Sector and the Financial Crisis”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 4, No. 2, pp 12–19.


Charles W Mulford and Andrew Parkhurst, (2009), “The Financial Statement Effects of Proposed Changes to the Accounting for Deferred Acquisition Costs in the Insurance Industry”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 4, No. 2, pp 20–27.


Available at SSRN: http://ssrn.com/abstract=1346133 Guy Ford, (2008), “Compensation Structure and Portfolio Selection in a Banking Firm”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 3, No. 2, pp. 27-42. Available at SSRN: http://ssrn.com/abstract=1346139

Volume 4 (1) July 2009 Wayne Lonergan, (2009), “Pre and Post Tax Discount Rates and Cash Flows – a Technical Note”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 4, No. 1, pp. 41-45.


Aswath Damodaran, (2009), “Leases, Debt and Value”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 4, No. 1, pp. 3-29. Available at SSRN: http://ssrn.com/abstract=1435166 Roger Grabowski, (2009), “Cost of Capital Estimation in the Current Distressed Environment”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 4, No. 1, pp. 31-40.

Volume 5 (1) July 2010 Jörg Baetge, Hans-Jürgen Kirsch, Peter Koelen and Roland Schulz (2010), “On the Myth of Size Premiums in Corporate Valuation: Some Empirical Evidence from the German Stock Market”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 5, No. 1, pp. 2-15.


Jan Jindra and Torben Voetmann, “Discussion of the Pre and PostTax Discount Rates and Cash Flows: A Technical Note”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 5, No. 1, pp. 16-20.


Tom Valentine, “Calculation of Damages When Shareholders Sue Their Company”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 5, No. 1, pp. 21-25.

Available at SSRN: http://ssrn.com/abstract= 1655703


Volume 4 (2) December 2009 Greg Gregoriou, Francois-Serge Lhabitant and Fabrice Rouah, (2009), “The Survival of Exchange-listed Hedge Funds”, Journal of Applied Research in Accounting and Finance (JARAF), Vol. 4. No. 2, pp 2–11. Available at SSRN: http://ssrn.com/abstract=1553026
