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The enterprise value (EV) arrived at is, effectively, the net present value of the operations of the business. This excludes the value of any fi nancial assets the business may have and, as it is an enterprise value, has not had any fi nancial liabilities deducted from it. By making these adjustments, the equity value is determined.

The key adjustments are as follows:

Add joint ventures and associates Deduct net debt

Deduct un-funded / under-funded pension liabilities Deduct minority interests.

1.

2.

3.

4.

Enterprise

Joint ventures and associates

In EBITA and, therefore, in FCFE, any share of the income and cash fl ows from joint ventures and associates were excluded. Therefore, the enterprise value calculated excludes the business’ share of the value of those investments. This value must be added in separately at time zero.

If these investments are listed, their market value can be used. If they are not listed, and the required information is available, a separate DCF or multiple-based valuation can be performed. Otherwise, the default option is using the book value of investments in joint ventures and associates.

£m 2007

Investment in joint ventures and associates 314

Source: Tesco plc Annual Report 2007, Balance sheet, p. 46

As this is an accounting number, it is the least favoured option. This is illustrated by the following extract:

CHFm 2006

Book value 7,795

Market value 21,784

Source: Consolidated Financial Statements of the Nestlé Group 2006, Note 6, p. 30

1.

Net debt

Net debt is calculated as follows:

Long-term debt X

Short-term debt X

Short-term investments (X)

Cash and cash equivalents (X)

Net debt X

As these numbers are sourced from the balance sheet, they will be book values. For the purposes of valuation, they should be adjusted to fair, or market, values. This information should be disclosed in the notes to the fi nancial statements under IFRS, although it may need to be updated if the balance sheet is not suffi ciently recent.

Fair values

Fair values of fi nancial assets and fi nancial liabilities are disclosed below:

2007

£m Carrying value Fair value

Primary fi nancial instruments held or issued to fi nance the Group’s operations:

Short-term borrowings (1,518) (1,509)

Long-term borrowings (3,999) (3,949)

Finance leases (Group as lessor – note 31) 12 12

Finance leases (Group as lessee – note 31) (183) (183)

Cash and cash equivalents 1,042 1,042

Source: Tesco plc Annual Report 2007, Note 20, p. 77

By deducting net debt from the enterprise value, the effect is to add the value of the liquid fi nancial assets and deduct the value of the standard fi nancial liabilities.

Un-funded /under-funded pension liabilities

The un-funded / under-funded pension liability represents the shortfall between the market value of any pension assets that are held and the present value of the pension obligations. This represents a claim by the company 2.

3.

pension scheme, and / or the retired workers, on the future cash fl ows of the business. This is, therefore, a quasi-debt item and is treated as such.

If the corridor method of pension accounting is being used, which is often the case under IFRS, care must be taken to ensure that the correct economic defi cit is extracted from the fi nancial statements and not the balance sheet defi cit.

31 Dec 2004

Funded status (4,827)

Unrecognised actuarial (gain) loss 2,593

Asset limitation due to uncertainty of obtaining future benefi ts (1,186)

Net recognised liability (3,420)

Source: Bayer Annual Report 2004

Also, in many countries, cash contributions into the company pension scheme, and cash payments to the retired workers, are tax deductible.

This means that the economic pension defi cit attracts a tax shield and should be adjusted for this, assuming the business is suffi ciently profi table

to take advantage of the tax deduction.

:.

Post-tax economic deficit Post-tax economic deficit

Pre-tax economic deficit

= x (1 – t)

t = Tax rate

= €3,379m

= €4,827m x (1 – 30%)

Most IFRS accounts will disclose the related deferred tax asset therefore there is no need to manually estimate the fi gure.

Minority interests

Since the calculation of FCFE began with EBITA, which is before the deduction of the profi t attributable to the minority shareholders in group subsidiaries, the resultant enterprise value includes the minority’s share of the value of those group subsidiaries. As the equity value looks at the business from the perspective of the group shareholders (i.e. the shareholders in the parent company only), the minority interest must be removed.

As with the investments in joint ventures and associates discussed above, if the subsidiaries are listed, their market value can be used. If they are not 4.

the book value of minority interests. Again, as this is an accounting number, it is the least favoured option.

£m 2007

Minority interests 65

Source: Tesco plc Annual Report, 2007, Balance sheet

For completeness, the equity value can be divided by the number of shares outstanding, in order to derive an implied share price. If the business is listed, this can be compared with the actual share price, in order to calculate a control premium.

Enterprise value 41,534

Add: joint ventures and associates 476

Less: net debt (4,415)

Less: pension defi cit (1,211)

Less: minority interests (64)

Equity value 36,320

Number of shares outstanding 7,900

Implied share price 460

Current share price 415

Control premium 10.8%