Estimating a Discount Rate for Headquarters Costs

You can determine the discount rates of the headquarters by breaking down headquarters cash flows into three categories, each to be discounted at a rate appropriate for its risk: tax shields provided by debt, non-interest tax shields, and headquarters costs.

Tax shields provided by debt have the same risk as corporate debt and are typically discounted at the pretax cost of debt, kb. The present value of these tax shields (assuming they will be available perpetually) is the marginal tax rate, T, times the market value of debt, B.

Non-interest tax shields (from transfer pricing or the fact that losses of one division can shelter gains at another) depend on the probability of realizing them. Thus, cash flows must be defined as expected cash flows from non-interest tax shields. The appropriate discount rate for transfer-pricing tax shields depends on the business risk of the company. Financial leverage is irrelevant because transfer-pricing schemes are expenses before interest. For these reasons, expected transfer-pricing tax shields should be discounted at the unlevered cost of equity for the company as a whole. Tax shields based on the fact that losses in one business unit can shelter gains in another should be discounted at the levered cost of equity, because they can be realized only on income after interest expenses.

Headquarters costs should be discounted at a rate somewhere between the risk-free rate and the unlevered cost of equity, depending on their covariance with general business conditions (as measured by the market portfolio). For most companies headquarters costs tend to rise in good business conditions (as executives and staff receive higher compensation) and fall during recessions. If the changes correlate well with operating profits, then the discount rate could be as high as the unlevered cost of equity. Changes in headquarters costs that are not correlated with business conditions (for example, onetime cutbacks) do not affect the discount rate.

Adding Up the Pieces to Value the Entire Corporation

The final step in multibusiness valuation is to combine headquarters costs and benefits with business unit values. Exhibit 14.5 shows how the values of two hypothetical divisions can be added. From these, you subtract headquarters costs and add headquarters benefits and the value of excess marketable securities. The result is the aggregated value of the company. When the market value of corporate debt has been subtracted, the result should be the value of equity for the company.

A few special situations need to be discussed. How should unconsolidated subsidiaries be handled? How can double counting be avoided? What should be done with excess debt and marketable securities?

Unconsolidated subsidiaries are often an important part of a company. They are clearly separable business units, but how should we think about the cash flows they provide to the parent? Assuming they are not foreign subsidiaries, the best approach is to value them separately, then multiply their equity value by the fraction that the parent owns, and add their result to your estimate of the parent's equity value. An alternative approach is to

Exhibit 14.5 Summary Multi-Business Valuation

Business unit A Business unit B Headquarters benefits Headquarters costs Excess cash and non-operating assets Enterprise value V_._____

discount expected dividends paid from the subsidiary to the parent at a cost of equity appropriate for the riskiness of the dividend stream. This method is difficult to use because dividends are discretionary and, therefore, difficult to forecast.

Double counting can occur when an undervalued asset is carried on the books of a business unit. For example, paper companies sometimes own thousands of acres of timberland that is carried on the books at low value. An almost irresistible temptation is to estimate the market value of the forest and add it to the present value of cash flow. To do so would be double counting because expected cash flow already assumes that harvested trees will be used to produce lumber. They are, in every sense, an inventory. As with inventory, their value is not added, because it is already included in future cash flow as an input to production.

Another common example of double counting is corporate headquarters or other real estate carried at low book value. The rental opportunity cost of the buildings is already reflected in a cash flow that is higher than it might otherwise be if the company were to sell its headquarters, then lease the office space. You cannot have it both ways. Either discount the cash flow as it is, or subtract the expected rental cost from the cash flow and add the market value of the headquarters building.

Excess marketable securities build up in the projected balance sheet of a business unit if it is doing well or, alternately, if debt is increased. This effect is a normal part of the forecasting process and, as discussed in Chapter 11, it has no effect on the present value of a business unit. Excess cash held by the company at the start of the valuation period is a different matter. It should not be allocated to business units. Its value should simply be kept separate and added to the other corporate level values during the aggregation stage.

0 0

Post a comment