Impact Of Having Write Off Assets And Debts

Published Date: 02 Nov 2017

There are different methodologies to valuate a company. To valuate a company in a specific industry, people may use comparable between two or three similar companies to evaluate the abilities of the target company, for example the P/E ratio, and EBITDA margin (Berk and DeMarzo, 2007). Besides that to basis on the comparable, enterprise value would also be appraised in general. Enterprise value means the potential profit opportunities and risk in the existing economics. Based on Megis, Mosich and Megis (1975) "Asset+ Liabilities= Equity" (Pg. 19-20), a company capital structure is mainly formed by assets and debts, which means they are two essential elements for valuating a company’s value (Henning, Lewis and Shaw, 2000 & Rees, 1997).

Impact of Having Write-off Assets and Debts

There are some adjustments would be made for different accounts in a company annual financial report; According to Sorter and Horngren (1962), when there are adjustments for assets, which means the assets are classified as expenses or lost because they are not able to benefit the future operations. However not every firm are willing to make adjustments, they even try to avoid the write-off for their possession of assets because write-downs of the assets represent of operating losses (Strong and Meyer, 1987). People from managerial level would feel panic because of the operating losses cause the equity base availability decline. Though adjustments on assets bring reduction of equity in a company, some company are also willing to have this approach, but also able to add value for the company which describes in next section.

Debts that hold by a company would also affect the valuation of the company. Debt is an interesting indicator because it capable to indicate the firm’s value through determines amount of debt that the firm can obtained (Vasicek, 1984). In other words, through evaluate the debt to equity ratio people can easily to state the company’s ability of solvency and value of company, and this is called as gearing ratio (Arnold, 2012). According to Modigliani and Miller theorem- Proposition 2 (1958), when the company increase their borrowing, the value of the firm would also increase which describes in next section.

How Write-off Assets and Debts Add Value to Company?

Even though the write-off of assets and gearing have different in approaches but also satisfactory resulted in advantages of tax shielded, and this has become the main reason of adjust the value of assets and holding debts in a company as to reduce the tax interest.

Tax shield

While write-downs result in one-time charge against earnings, so it also takes one-time tax shield rather than depreciations (Strong and Meyer, 1987). Based on the theory of Time value, the value of the company would cost less for cash flows, because of the expenses cost in present value instead of future value, which seek as depreciation in value of money (Berk and DeMarzo, 2007). In addition, when a company decided to input debts rather than just equity, the value of the company would be higher and income tax interest payments would be lowered than the ungeared position Based on the Proposition 1 that released by Modigliani and Miller theorem (1958), the value of a company increase because of the tax shield occurrence; while there are more debts are held by the company, the lower tax interest payments for the company could experiences and the value of the company would also upturn. This not only because of the company need specific amounts of money to pay for the debt interest which cause the total profit decline, so there are deduction expenses in taxable income; but also due to the interest on debt is tax-deductible expense which result in savings in cash flow of the company, so the value of the company increase (Kemsley and Nissim, 2002). Since Modigliani and Miller theorem (1958) emphasis no taxes, so the interest payment may not affect by the tax rate under its theorem. However, in realistic tax rate is a matter, so even though Vodaphone has increased its debt ratio during 1998-2001, but because of the growth of tax rate, so they still suffer in the interest payment, which has increase form 28.7% to 33.9%. In this case, Vodafone could not gain advantages from the tax shield.

Cost of Equity

Write-downs assets are seek as signalling and management components which would affect the return of equity (Strong and Meyer, 1987 & Francis, Hanna and Vincent, 1996). While a company decides to make adjustment on the possession of assets (small), they would not only just involve in operating losses, but cause fluctuation in share price. This is because this is the signal to convey the company is willing to change the management strategies for future earnings. Thus, the cost of equity will than increase. Alternatively, while there are large adjustments then the return to earnings will drop (Francis, Hanna and Vincent, 1996).

If debts are relevant in the situation, the cost of equity would increase though. According to Proposition 2 that attempted by Modigliani and Miller theorem (1958), even the cost of debt is lower than the equity, so bring in debts would help to minor the cost of equity. However, this does not exist because it needs high debt in level. Along with Modigliani and Miller theorem (1958) in Proposition 2, financial gearing has a positive correlation with the return on equity. While the debts are brought into the company, the cost of equity rises because the risk would also increase; therefore shareholders expected a higher return form it, which cause increase in cost of equity (Berk and DeMarzo, 2007 & Arnold, 2012).

In annual report of Vodafone in 2000, its profit has resulted in decline from 5.2% to 3.0% after adjustment in 1998, but the majority of interest that pay for the asset has a great decline form £1,267m to £92m only after 2001. As mentioned, since the tax rate has increased, so during year 1999-2000, Vodafone interest cost has increase from £257m to £333m because of the borrowing has also increased for Mannesmann acquisition and merger with AirTouch. Based on the theorem of Modigliani and Miller (1958), as the cost of debt for Vodafone has increased, then its cost of equity should also increase. According to the annual report of Vodafone (2000-2001), the shareholders has invested £122,338m during 1999-2000 and based on the mergers and acquisition actions, the amount have continues to increase. On the other hand, the return to shareholders experienced a great improvement form £9,185m to £22,230 during 1999-2001 (Vodafone’s Annual Report 2000&2011).