Valuations for tax controversies [(2017 Edition)] 9780995362697, 0995362696

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Disclaimer No person should rely on the contents of this publication without first obtaining advice from a qualified professional person. This publication is sold on the terms and understanding that (1) the authors, consultants and editors are not responsible for the results of any actions taken on the basis of information in this publication, nor for any error in or omission from this publication; and (2) the publisher is not engaged in rendering legal, accounting, professional or other advice or services. The publisher, and the authors, consultants and editors, expressly disclaim all and any liability and responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this publication. Without limiting the generality of the above, no author, consultant or editor shall have any responsibility for any act or omission of any other author, consultant or editor.

About Wolters Kluwer Wolters Kluwer is a leading provider of accurate, authoritative and timely information services for professionals across the globe. We create value by combining information, deep expertise, and technology to provide our customers with solutions that contribute to the quality and effectiveness of their services. Professionals turn to us when they need actionable information to better serve their clients. With the integrity and accuracy of over 45 years’ experience in Australia and New Zealand, and over 175 years internationally, Wolters Kluwer is lifting the standard in software, knowledge, tools and education. Wolters Kluwer — When you have to be right. Enquiries are welcome on 1300 300 224. National Library of Australia Cataloguing-in-Publication entry: Chu, Hung Tuan, author. Lonergan, Wayne, author. Valuations for tax controversies / Dr Hung Chu, Wayne Lonergan. ISBN: 9780995362697 (ebook: epub) Includes bibliographical references and index. Business enterprises--Valuation--Australia. Business enterprises--Taxation--Australia. First published January 2017 ISBN 978-0-9953626-9-7 © 2017 CCH Australia Limited All rights reserved. No part of this work covered by copyright may be reproduced or copied in any form or by any means (graphic, electronic or mechanical, including photocopying, recording, recording taping, or information retrieval systems) without the written permission of the publisher.

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About the Authors Dr Hung Chu is a Director of Lonergan Edwards & Associates Limited. Dr Chu completed his master degree in Finance and Banking (with Merit) from the University of Sydney and his doctoral degree in Finance from the University of Technology, Sydney, where he graduated on the Chancellor’s List for Exceptional Scholarly Achievement in PhD research. Dr Chu is a CFA charter-holder, a Senior Fellow of the Financial Services Institute of Australia and a member of the Extractive Industries Working Group of the International Valuation Standards Council (IVSC). Dr Chu has gained a wide range of practical experience in valuations and valuation-related advisory services. In particular, he has been responsible for numerous assignments and complex litigation and tax dispute matters for both public and private companies as well as various government departments in Australia. In addition to his practical experience, Dr Chu has also been a regular contributor to the professional literature in the area of valuation and its practical implications for various tax and commercial matters. At the time of writing, he is the author/co-author of 35 technical papers in various academic and practitioners’ journals. Dr Chu was also a guest lecturer in property finance and alternative asset classes at the University of New South Wales. Dr Chu is married and has two children. His outside interests include tennis, soccer and travel. Wayne Lonergan’s professional qualifications include Bachelor of Economics, Doctor of Science in Economics (hc), Fellow and Life Member of the Securities Institute of Australia, Fellow of the Australian Property Institute, Fellow of the Company Directors Association of Australia and a member of the Australian Institute of Arbitrators. His career includes being a part-time tutor and Adjunct Professor at Sydney University, an investment advisor, and being a partner at Coopers & Lybrand for 23 years. In 2001 Wayne, together with Craig Edwards, set up the specialist valuation practice Lonergan Edwards & Associates Limited. Wayne’s professional work has concentrated on valuation and related assignments, including consequential loss and quantum assessments, business and due diligence investigations and expert evidence in numerous litigation matters. He has conducted numerous valuations of listed and unlisted shares and businesses, including the preparation of Independent Expert Reports on many hundreds of public company takeover offers. Wayne was National President of the Securities Institute of Australia (SIA) (three years), a member of the Companies and Securities Advisory Committee (CASAC) (nine years), the Australian Accounting Standards Board (seven years), and the International Financial Reporting Interpretations Committee of the International Accounting Standards Board (three years). He has served on numerous subcommittees of the SIA and CASAC and was the Australian representative on the International Accounting Standards Sub-committee on Accounting for Financial Instruments and for Employee Share Options.

Wayne is the author of two other valuation text books, co-author of a loose leaf service on family law valuations, and over 110 published technical papers on valuations and associated accounting matters and is also a regular speaker at conferences. Wayne is married and has five children. His outside interests include sailing and travel.

Author Acknowledgments We would like to thank our fellow directors and staff of Lonergan Edwards & Associates Limited with whom we have worked closely and who have examined and debated numerous valuation issues with us. Special mention should be made of Martin Hall, our fellow director of Lonergan Edwards & Associates Limited, who reviewed and recommended changes to the earlier draft of the book. Many issues discussed in this book have also been influenced by the thought provoking discussions with barristers, solicitors and senior executives of clients of our firm with whom we have had the great pleasure and great privilege of working. Special thanks should go to Selina Lord and Christine Pardy, who have typed and proof read the numerous drafts of the book. In addition, we would also like to thank Alicia Cohen, Jackie White, and other members of the editorial and production teams at Wolters Kluwer for their contributions to the timeliness of the book’s production.

Introduction ¶1-010 Overview At the centre of many tax controversies are valuation issues. These cases typically involve either new valuation issues or require a re-evaluation of conventional (but not necessarily correct) approaches to existing valuation issues. The valuation issues discussed in this book arise, in particular, in the context of stamp duty and income tax cases, and in cases which involve what is colloquially referred to as “land rich” assessments. In terms of stamp duty “land rich” assessments, under the land rich landholder taxing regime, a land rich test is performed to determine whether a relevant landholder is land rich. The land rich test involves assessing whether the unencumbered value of the land holdings of the landholder is equal to, or exceeds a specified proportion of the unencumbered value of its total assets, other than certain excluded assets. Under the regime, stamp duty is levied where the unencumbered value of the relevant landholder’s landholdings in the state exceeds a certain value. Irrespective of whether the land rich landholder taxing regime or the landholder taxing regime is in place, the assessment of whether a liability to stamp duty or tax arises is usually conducted following the occurrence of a commercial transaction where the market value of the total assets of the relevant landholder is either observable or ascertainable by calculation. Thus, from a valuation perspective what is practically (albeit not necessarily legally) required for stamp duty purposes is the assessment of the market value of total assets, land assets and non-land assets to assess whether the percentage threshold (under the land rich landholder taxing regime) or the absolute value threshold is exceeded and, if so, the dutiable value of land holdings (under the landholder taxing regime). In terms of capital gains tax (CGT) implications, under the Income Tax Assessment Act 1997 (Cth) (ITAA 97), a principal asset test (PAT) is required to assess Australian CGT payable by foreign residents. A foreign resident will be liable to Australian CGT arising from a capital gain on a sale of shares in a company if, among other things, the sum of the market values of the company’s assets that are taxable Australian real property (TARP) exceeds the sum of the market values of its assets that are non-TARP. What is legally required for the PAT is the assessment of the market value of TARP and non-TARP assets to establish whether the market value of TARP assets exceeds the market value of non-TARP assets. Clearly, the market value of such assets (as part of a going concern business) is not always readily observable because they may be rarely, if ever, traded on a standalone basis. Thus, for such specialised assets, there is generally no readily identifiable comparable sale transaction to refer to as a guide to value. In such cases, from a valuation perspective, although technically not required under the tax legislation, the market value of total assets, which are often ascertainable, is an important reference point for the underlying asset value assessment in that it can either be used as a direct input to the assessment of the market value of TARP and non-TARP assets, or an important cross-check for reasonableness of the assessed market value of TARP and non-TARP assets by imposing a natural limit on the aggregated values of the underlying individual assets/asset classes and also in terms of value relativities. Thus, for both stamp duty and CGT/PAT “land rich” assessments, the required focus on underlying asset (or asset class) value assessment from a legislative perspective inherently involves a total asset value assessment either because it is required by the relevant legislation, or as a practical cross-check. Although many of the valuation issues raised are in the context of what are generally referred to as “land rich” assessments, what comes out from a discussion of these issues certainly has broader conceptual and practical implications for other valuation driven tax controversies. From a valuation perspective, what is unique about “land rich” cases is that they require a shift of focus from total asset value assessment to underlying asset value assessment/total value apportionment. Although controversial valuation issues arise in both total asset and total equity value assessment, the shift in the focus of the valuation exercise from total equity/asset value assessment to underlying asset

value assessment/total value apportionment involves multiple additional layers of conceptual and practical complexities and hence requires different and often more complex valuation thinking as compared to total asset value and total equity value assessment. In fact, shifting the focus to underlying asset value assessment/total value apportionment opens up new conceptual and practical issues, which may be neither present nor apparent when the focus is on total business value or total equity value assessment. Given that the context in which total asset value apportionment is required typically involves capital intensive businesses which employ specialised fixed and other assets, the issues associated with the underlying asset value assessment/value apportionment exercise are addressed within that context. However, the conceptual framework established in this book can be applied to, or provide guidance for, value assessment and value apportionment in respect of different types of business or in respect of different tax contexts. In addition, while a significant part of the book is dedicated to valuation issues directly arising from “land rich” cases, it also addresses valuation issues pertinent to different tax contexts.

¶1-020 Outline of this book The remainder of this book is organised as follows. Chapter 2: Common errors in applying the market value concept This Chapter addresses the most common conceptual errors in assessing market value, including failure to recognise the asset focus of the Spencer market value concept, failure to recognise the negotiated price focus of the Spencer market value concept, adoption of an incorrect unit of measurement and adoption of an incorrect view of the impact of non-transferability on market value. Chapter 3: Financing risks and the application of the Spencer market value concept This Chapter revisits the concept of market value in cases where financing risk is inherently pronounced and further elevated in times of financial market dislocations like the Global Financial Crisis (GFC) and discusses the appropriate practical way to deal with these unique valuation challenges in assessing the total business value. Chapter 4: The value of total assets This Chapter re-evaluates the relationship between the value of the total assets of a business entity and its enterprise value (EV). In practice, there are several methods commonly used to assess the value of total assets, based on various adjustments to EV. However, this Chapter suggests that these adjustments are generally inappropriate, with the exception of the addition of the value of surplus assets to the discounted cash flow (DCF) based EV. The total assets to which the market value standard is applied for tax and stamp duty purposes should include the net working capital assets. The correctly derived EV reflects the market value of total assets. This Chapter also further clarifies the distinction between EV and equity value. Chapter 5: Re-evaluating the control premium This Chapter re-evaluates the concept of control premium which is important in assessing the market value of both equity and total assets, particularly in cases where the entity which owns the assets is a listed entity. A correct understanding and assessment of control premium has direct implications for the outcome of a PAT required to determine whether or not a foreign resident is liable to Australian CGT arising from a capital gain on a sale of shares in a company and the assessment of EV and goodwill value for tax purposes under the top-down residual method (TDRM). Unfortunately, such understanding has proved elusive in practice. This Chapter also discusses the important distinction between ex-ante control premium and ex-post observed takeover premium, and the incorrect practice of mechanistically assessing the ex-ante control premium for an entity which has not been subjected to a takeover bid as at the valuation date based on average observed ex-post takeover premium. In fact, achieving the correct understanding and assessment of control premium for a given entity requires significantly more complex and lateral valuation thinking. Chapter 6: Re-evaluating the small company risk premium

This Chapter re-evaluates the concept of small company risk premium and highlights the dangers of routinely allowing for a small company risk premium in assessing the market value of an entity and its total assets without properly understanding what is being valued and the nature of the empirical evidence on small company risk premium. Chapter 7: Re-thinking goodwill This Chapter presents a re-think of the concept of goodwill from a valuation perspective and its interaction with other assets of the business, particularly specialised fixed assets. This Chapter examines alternative approaches to goodwill, namely the economic approach, the accounting approach and the legal approach. The limitations of each approach and the differences between them are major contributors to the protracted confusion about the nature and value of goodwill. Having identified and evaluated the inherent limitations and the potential pitfalls associated with the application of each approach and highlighted the differences between the alternative approaches to goodwill, this Chapter proposes a conceptually convergent approach to goodwill under which these differences can be analysed. The application of a conceptually convergent approach indicates that most of the apparent conflicts between the alternative approaches to goodwill turn out to be less divergent than they appear if the evolutionary nature of the value of identifiable assets over time is fully recognised and goodwill is perceived as the attractive force which actively brings in custom (net of custom brought in by identifiable assets) and generates net profit (or net cash flow) for a subject enterprise. This new way of thinking about goodwill has important implications for the land rich assessment for stamp duty, CGT and other tax and stamp duty purposes. Chapter 8: Re-evaluating Murry from a valuation perspective This Chapter re-evaluates the Murry case (FC of T v Murry 98 ATC 4585) from a valuation perspective. Despite its importance in shaping judicial views on goodwill, the focal point of Murry is interestingly not about goodwill value. Thus, there are unsurprisingly residual uncertainties and/or confusion in applying the valuation principles set out in Murry to cases where the focus is on the value of goodwill. This Chapter applies the conceptual framework on goodwill value developed in Chapter 7 to address these uncertainties and/or confusion. Chapter 9: Valuing contract intangibles This Chapter discusses the valuation of contract intangibles, which is a key category of identifiable intangible assets in “land rich” cases. This Chapter highlights the fact that the value of contract intangibles can arise from creating either cash flow benefits or risk-mitigating (discount rate) benefits or both. While the value of contract intangibles creating the former is often straightforward and well understood by market participants, those creating risk-mitigating benefits are not so well understood. This Chapter explains the nature of risk-mitigating contract intangibles and discusses a method to assess their market value as part of a bundle of assets offered for sale. Chapter 10: The value of mining information This Chapter discusses the technical complexity of assessing the market value of mining information and provides a conceptual framework to deal with these challenges. These challenges have not been the subject of discussion in the valuation literature to date. Chapter 11: Valuing cash holdings This Chapter discusses the valuation treatment of corporate cash holdings (apparently the simplest asset), particularly in cases where these cash holdings form a material or significant part of the total assets of a going concern entity and demonstrate that the shift in focus from total business value assessment to underlying asset value assessment (eg land and non-land assets) creates a situation where a valuation treatment which is customarily performed and practically acceptable when the focus is on total business value or total equity value assessment may not be appropriate when the focus is on underlying asset value assessment/total value apportionment. Chapter 12: The deductive valuation method This Chapter discusses the deductive valuation methodology where the market value of specialised fixed assets is assessed by deducting the assessed market values of other assets from the assessed market

value of total assets. The applicability of the deductive method is based on a new conceptual approach to goodwill value assessment discussed in Chapters 7 and 8, and methods of assessing the market values of certain key identifiable intangible assets and monetary assets discussed in Chapters 9, 10 and 11. This Chapter also addresses the conceptual differences in the valuation methods adopted by business valuers and other valuers for tax and stamp duty purposes. Chapter 13: Re-evaluating deprival value This Chapter re-evaluates the use of the deprival value method (particularly its deficiencies and pitfalls) in assessing the market value of specialised fixed assets for tax and stamp duty purposes. This Chapter also compares and contrasts the deprival value method with the deductive method discussed in Chapter 12. Chapter 14: Problems with the restoration method This Chapter explains why the restoration method is a flawed valuation method in assessing the market value of intangible assets (ie non-land assets) in a total asset value apportionment context. This Chapter demonstrates that the application of the restoration method results in the assessed market value of the non-land assets being overstated and the assessed market value of the land assets being understated. Chapter 15: Re-evaluating the marriage value concept This Chapter discusses the controversy surrounding the complexity of the marriage value concept in the context of land rich assessment and develops a conceptual framework that provides guidance when dealing with issues associated with marriage value in a given case. Chapter 16: Value allocation between upstream and downstream segments This Chapter discusses the practical application of the netback method in assessing market value at a notional taxing point between the upstream and downstream segments of an integrated mining or gas-toliquid (GTL) project. Chapter 17: Re-evaluating the application of the comparable uncontrolled price method This Chapter re-evaluates the practical application of the comparable uncontrolled price (CUP) method in assessing the notional market value for a controlled commodity transaction. This Chapter highlights the fact that the availability of observable uncontrolled prices should not be taken for granted as readily representing CUPs. Chapter 18: Re-evaluating the valuation treatment of accommodation bonds in the residential aged care sector This Chapter discusses the valuation treatment of accommodation bonds which has important implications for the taxation treatment of residential aged care facilities (RACFs). There has been much confusion among market participants about this valuation treatment. This Chapter examines the sources of this confusion and provides a systematic conceptual framework to resolve the valuation uncertainty. The conceptual framework developed in this Chapter also provides insights into the valuation treatment of resident loans in retirement villages. Chapter 19: Traps in valuations for land rich assessment This Chapter identifies various fundamental traps in valuations for “land rich” assessment and suggests ways to deal with them. Chapter 20: Re-evaluating the concept of trading stock: the case of vendor finance loans This Chapter provides a conceptual re-evaluation of whether or not a portfolio of vendor finance loans is trading stock. This Chapter exemplifies the conceptual and practical challenges associated with the application of the trading stock definition to financial assets. Chapter 21: Valuing partly completed development projects This Chapter re-evaluates a “sum of the parts” approach to the valuation of partly completed development projects under the goods and services tax (GST) margin scheme, identifies deficiencies in this valuation approach and develops an alternative conceptually sound approach to overcome these deficiencies. The valuation issues discussed in this Chapter are also relevant to the valuation of partly completed

development projects for trading stock valuation and income tax purposes. Chapter 22: Assessing a fair and reasonable royalty rate This Chapter discusses two main interrelated “first principle” approaches, being the royalty cover and net present value (NPV) approaches used to assess a fair and reasonable royalty rate which is an important input in determining the market value of identifiable intangible assets for tax purposes. The “first principle” approaches presented in this Chapter can also be used to assess a fair and reasonable royalty rate in various commercial and litigation contexts, such as assessing a fair and reasonable royalty rate between the owner of an undeveloped mineral resource and the developer of that resource into a productive mining asset, or assessing compensation in patent infringement disputes. Chapter 23: Re-evaluating the discounts/premia to base valuation This Chapter provides a conceptual re-evaluation of the discounts/premia which are commonly applied and commonly subject to dispute. Such conceptual re-evaluation focuses on the nature of the relevant discounts/premia and identifies the conceptual delineation or overlap between these discounts/premia.

¶1-030 On the cutting edge Many of the issues raised in this book are at the cutting edge of valuation thinking. They reflect the evolving nature of the valuation body of knowledge and the need for valuers to continuously re-evaluate the existing body of knowledge, particularly in the face of diverse practical circumstances, and apply the broadened or updated knowledge to re-assess and improve existing valuation practices. It is natural to expect that full market acceptance and court acceptance of some of the issues raised will, in some cases, take some time to emerge.

Common errors in applying the market value concept ¶2-010 The Spencer market value The definition of market value in the well-known and widely-accepted sense recognised in Spencer v Commonwealth (1907) 5 CLR 418 (Spencer market value) is the price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer (WBNAB) and a knowledgeable, willing but not anxious seller (WBNAS) acting at arm’s length within a reasonable timeframe. Despite the fact that the adoption of the Spencer market value definition/concept is generally not in dispute, the application of that concept to assess market value remains susceptible to errors and dispute. There are broadly two types of errors associated with the application of the Spencer market value concept: conceptual errors and measurement errors. These two types of errors are interrelated in that if a valuer makes conceptual errors in applying the market value concept, the resultant measurement of market value is inherently technically incorrect and unreliable (eg assessing the market value of the wrong asset). Conversely, a measurement error (eg adopting an incorrect valuation methodology) is not only wrong as a matter of measurement, it is also conceptually wrong because it is not the “price that would be negotiated” between a knowledgeable, hypothetical WBNAB and a knowledgeable, hypothetical WBNAS despite the fact that assessment of market value is the stated objective of the valuation. Measurement errors are case-specific, depending on the choice of the valuation methodology and associated inputs given the factual circumstances of the case. Although this is not an exhaustive list, the most common conceptual errors in assessing market value are: • failure to recognise the asset focus of the Spencer market value concept • failure to recognise the negotiated price focus of the Spencer market value concept • adopting an incorrect financial unit of measurement, and • adopting an incorrect view of the impact of non-transferability on market value. The difficulty associated with uncovering these errors in practice is that they are usually committed in a subtle way, which is further complicated by the factual complexity of what asset is being valued. In fact, it is the combination of the complexity of the asset being valued, the complexity of the factual circumstances and the subtlety of the valuation errors that underpins many valuation driven tax controversies.

¶2-020 Failure to recognise the asset focus of the Spencer market value concept From a valuation perspective, the concept of market value rests on the premise that market value be established based on negotiations between a hypothetical WBNAB and a hypothetical WBNAS, rather than based on a transaction between a hypothetical WBNAB and an actual or specific seller, or between an actual buyer and actual seller, or between a hypothetical seller and an actual buyer. The application of the market value concept is driven by the nature and inherent attributes of the asset being (market) valued and the negotiated hypothetical price between a hypothetical knowledgeable WBNAB and a hypothetical knowledgeable WBNAS given the characteristics of the asset, rather than being influenced or determined by the identity of either the actual seller and/or the actual buyer. The asset focus is naturally devoid of the incorrect tendency to incorporate the specific characteristics of the actual buyer and/or seller into the market value assessment. In addition, the asset focus and the

assumption of a hypothetical WBNAB and WBNAS are inextricably linked via the assumption that both the WBNAB and WBNAS are knowledgeable. A hypothetical WBNAB and a hypothetical WBNAS should be knowledgeable of all the value-relevant characteristics of the asset being valued and factor them into their reasonable expectations of the economic benefits from and the negotiated price for the asset. Violating the asset focus on an “as is where is” basis inherently results in violating the knowledgeable hypothetical WBNAB and knowledgeable hypothetical WBNAS assumption of the market value concept. The asset focus is also particularly important when the market values of multiple heterogeneous assets need to be assessed separately. Maintaining the focus on the inherent characteristics of each subject asset on an “as is where is” basis ensures the appropriate line of demarcation between the subject assets being maintained and hence their respective market values being correctly established. Not maintaining the focus on an individual subject asset can result in the line of demarcation between the true subject assets being inadvertently or artificially dissolved to create significantly altered assets to achieve a tax or financial optimisation outcome. This is clearly not a market value assessment. Any tax or financial implications should only be consequential from the outcome of the market value assessment. Maintaining the focus on each individual subject asset where the market value of multiple subjects needs to be assessed is also devoid of the incorrect tendency to value the multiple heterogeneous assets on the basis that these assets are bought and/or sold by a single hypothetical WBNAB and/or a single WBNAS who can fundamentally alter the characteristics of the subject assets to achieve some favourable tax and financial outcome. In this regard, focusing on the nature of each individual subject asset being valued on an “as is where is” basis also ensures the line of demarcation between the two substantively different value concepts, being market value and value to the owner (or “special value”) is preserved. This also shows that in cases where multiple heterogeneous assets are valued, focusing purely on a hypothetical WBNAB and a hypothetical WBNAS may still produce a distorted valuation outcome, whereas maintaining the asset focus helps avoid this potential valuation error. The need to maintain the asset focus was highlighted in CCM Holdings Trust Pty Ltd & CCT Motorway Company Nominees Pty Ltd v Chief Commissioner of State Revenue NSW 2013 ATC ¶20-409; [2013] NSWSC 1072. The key valuation issues in the proceedings involved, inter alia, the assessment of the Spencer-type market values of the land holdings of the CCM Property Trust (the trust) and an intercompany loan from the trust to a related entity, CrossCity Motorway Pty Limited (the company), in order to determine whether or not the trust was land rich as at 27 September 2007 (valuation date) for stamp duty purposes. The only land asset of the trust was the land lease being a lease from the Roads and Traffic Authority of New South Wales (the RTA) to the trustee of the trust, which granted to the trustee the right to, and imposed on the trustee the obligation to, operate, maintain and repair the Cross City Tunnel (the tunnel) in Sydney. The trustee subleased the tunnel to the company. As at the valuation date, the company was unable to meet the rent obligations under the sublease (solely from the net tolling revenue of the tunnel) without access to the intercompany loan. Because the company had no other source of income to meet its loan obligations, the company was effectively in default as at the valuation date. Despite the fact that the company was financially insolvent and the intercompany loan was effectively in default, the plaintiff’s valuation expert afforded the intercompany loan its full face value by reducing the cash flows from the tunnel directed towards the payment of the rents to achieve a tax optimisation outcome1 and maximise the potential proceeds from a hypothetical sale of the land lease and the intercompany loan. This approach, which involved fundamentally altering the subject assets and dissolving the line of demarcation between them, was rejected by the court. In summary, failure to recognise the asset focus of the Spencer market value concept results in the following common errors: • valuing the wrong asset • significantly altering the characteristics of the subject asset and valuing the significantly altered asset, rather than the subject asset on an “as is where is” basis, and • incorporating special value into the market value assessment. Footnotes

Footnotes 1

As at the valuation date, the company had significant depreciation tax shelter. The plaintiff’s expert argued that by affording the intercompany loan (which was effectively in default) its full face value, the tax optimisation outcome was achieved because the existing depreciation tax shelter held by the company was fully utilised.

¶2-030 Failure to recognise the negotiated price focus of the Spencer market value concept The focus of the Spencer market value concept is on the hypothetical negotiated price between a hypothetical WBNAB and a hypothetical WBNAS, rather than the monetary settlement of that hypothetical price. The assessment of market value does not require “money actually changing hands”, firstly, because the negotiation is hypothetical, and secondly, due to its inherent price focus, rather than settlement focus of the Spencer market value concept. Failure to recognise the inherent hypothetical price focus of the Spencer market value concept, coupled with the incorrect focus on the identity of the actual seller, distorts the valuation outcome in cases where market value that is determined on the assumption of a hypothetical WBNAB and a hypothetical WBNAS needs to be established in a situation where the actual future cash flows from the asset being valued, partly depends on the actions of the actual owner of the asset (eg executive share options and profit participation units which are redeemed for cash upon the executive’s cessation of employment)2. In this context, an incorrect focus on the settlement of the hypothetical price and the resultant hypothetical payout to the actual owner of the asset, rather than only on the derivation of the hypothetical price by a hypothetical WBNAB and a hypothetical WBNAS unnecessarily and incorrectly results in the behaviour of the actual owner of the asset upon receiving the hypothetical payout being taken into account for market value assessment in a circular manner. Adopting the appropriate hypothetical buyer/seller focus and negotiated price focus means that the asset should be assessed based on reasonable expectations of a hypothetical knowledgeable WBNAB and a hypothetical knowledgeable WBNAS about the likely future behaviour/action of the actual owner of the asset, eg when is the executive reasonably expected to exercise the options or cease employment to cash out the accumulated profit entitlements (as opposed to when the executive would actually do so)? Reliance on reasonable expectations of a hypothetical knowledgeable WBNAB and a hypothetical knowledgeable WBNAS, in turn influences the expected cash flows from the assessed market value of the asset. This is also the appropriate way to maintain the hypothetical buyer/seller focus (rather than the incorrect specific buyer and/or seller focus) in applying the market value concept in cases where actual future cash flows from the asset being valued partly depends on the actions of the actual owner of the asset. Footnotes 2

This is in contrast with the more common situation where the actual cash flows from the asset being valued (eg a small parcel of BHP shares) does not depend on the actions of its holder.

¶2-040 Adopting an incorrect unit of measurement in comparable sales method A unit of measurement was originally a physical concept (eg tonnes) or a magnitude of a physical quantity or quality (eg 22-carat gold), defined and adopted either by convention or required by law that is widely used and accepted as a standard for measurement of the same physical quantity. Any other value of the physical quantity can be expressed as a simple multiple of the unit of measurement.

For example, length is a physical characteristic. The metre is a unit of length that represents a definite pre-determined length. Thus, 100 metres (or 100 m) means 100 times the defined length called a metre. Critical to the usefulness of a unit of measurement is homogeneity because the value of a given physical quantity can only be expressed as a simple multiple of the unit of measurement if all the constituent units are homogenous, or reasonably so. For example, the historic derivation of a foot as a unit of distance was far from homogenous until the need for greater consistency and accuracy resulted in appropriate yardsticks being adopted. The unit of measurement concept is directly relevant when evaluating the implementation of the comparable sales method of valuation, which is popular among property and land valuers. Underpinning the comparable sales method is a common valuation metric (eg $ per square metre), which can be measured from “comparable” properties whose evidence of value is available. That is, the conceptual objective of the comparable sales method is to “impound” market evidence of value into the common valuation metric, also referred to as value per unit, which is subsequently applied to the valuation of the subject property. From a valuation perspective, a value per unit can be regarded as a financial unit of measurement intended to measure a financial quantity (eg the value of a given property). The usefulness of the valuation outcome from the application of the comparable sales method depends on, firstly, whether or not the subject property and the “comparable” properties are truly comparable, and secondly, whether value per unit or the financial unit of measurement being referred to can really capture all the value characteristics of the asset whose value is being assessed. By way of simple example, the market value of 100,000 ounces of gold can be captured in the simple measure of 100,000 times the observable market value per ounce. However, a gold deposit containing 100,000 ounces of gold requires much more complex measurement tools to assess its market value. If the so-called comparable is not truly identical, or if the value characteristics cannot be simply captured in one or very few metrics then the value per unit for the subject property and the value per unit for the reference properties will not be equivalent. As a result, the market value of the subject property cannot be assessed by multiplying the non-homogenous value per unit or the financial unit of measurement implied by the observable value of the reference properties by the number of units (eg physical size) of the subject property. Referring to the original unit of measurement concept in physics, this is conceptually akin to saying the financial quantity (ie market value) of the subject property cannot be expressed as a simple multiple of the financial unit of measurement derived from the reference properties. When the subject property is a single standalone residential or commercial property for which there are plenty of comparable sale transactions, the application of the comparable sales method may not present material technical challenges3. The value per unit derived from the observable market values of truly comparable properties may be an acceptable financial unit of measurement which can be used to determine the “financial quantity” (ie market value) of the subject property. Complications which have unfortunately received little recognition in practice arise in “land rich” cases because the subject land assets are typically specialised land assets (eg a physical airport facility) or a portfolio of specialised properties (eg a portfolio of residential aged care facilities (RACFs)), which are not generally, and sometimes never, sold on a standalone and piecemeal basis, but are sold in one line as part of the acquisition of the going concern entity which owns these specialised land assets. For specialised land assets, there may be virtually no comparable sales evidence. In this case, the approach commonly adopted by property and land valuers is the sum of the parts approach whereby: • in cases where the subject property is a portfolio of land assets (eg a portfolio of RACFs), the conventional comparable sales method is applied to assess the value of the individual land assets within the subject portfolio of land assets. The assessed values of the individual constituent land assets are aggregated to arrive at the assessed value of the subject portfolio of land assets. The application of the comparable sales method to value individual land assets is based on transactions involving standalone single properties, and • in cases where the subject property is a specialised property (eg a physical airport facility), the specialised property is notionally separated into a building improvement component and an

underlying land component. A cost-based method (eg optimised depreciated replacement cost (ODRC)) is used to assess the “value” of the building improvement component, whereas the comparable sales method is used to assess the “value” of the underlying land component. The assessed “values” of the two individual components are then added to arrive at the assessed value of the whole subject property. In both cases, the application of the sum of the parts method subtly triangulates an incorrect financial unit of measurement to value the subject property. This is because what is “impounded” into the common valuation metric (whether it be $ per square metre or $ per bed) from the comparable sales transactions does not capture what is reflected in the market value of the subject property that needs to be assessed for land rich assessments. In simple terms, this is conceptually equivalent to inadvertently equalising, for example, a kilometre with a mile and using 100 kilometres as a measure of 100 miles (whereas this is a clear understatement). The portfolio case In the portfolio case, divergences potentially arise, for example, from the economies of scale associated with owning a large portfolio of relatively homogeneous properties and the clientele effect associated with owning a large portfolio of heterogeneous properties. Economies of scale The economies of scale associated with owning a large portfolio of homogenous physical properties (eg a large portfolio of RACFs in metropolitan areas with high occupancy rates) as opposed to owning a single standalone property (eg a single RACF). The economies of scale stem from the ability to, inter alia, optimise the utilisation of resources and improve purchasing power to generate higher economic benefits and enhance the market value of the portfolio of assets as a whole compared to the aggregated values of the individual assets on a standalone basis. The significant additional economic benefits associated with the economies of scale are inherently not reflected in the common valuation metric or unit of measurement derived from the comparable sales transactions involving single standalone land assets. In this scenario, the portfolio of land assets is traded at a significant premium to the aggregated assessed values of individual land assets on a standalone basis. Thus, using an incorrect financial unit of measurement results in valuing the wrong assets or undertaking the valuation exercise on an incorrect basis because valuing individual single land assets on a standalone basis is substantively different from valuing a large portfolio of land assets as part of a going concern business. In addition, the value of an asset, whether it be an individual (commercial/retail) property or a portfolio of properties, is the present value of the expected (net) cash flows from the asset. The expected net cash flows reflect the costs of exploiting or managing the subject asset. This implies that there needs to be a notional or actual structure in place to exploit/manage the subject asset to generate the expected future cash flows. Under the highest and best use principle, it is reasonable to expect that a WBNAB and a WBNAS of the subject asset would be knowledgeable of the appropriate structure or “financial envelope” within which the subject asset should be exploited to maximise the net cash flows (after-tax) from the subject asset (eg they should be knowledgeable of the tax disadvantages of holding properties in a corporate structure versus a flow through unit trust structure)4. Even when the appropriate ownership structure to exploit an individual property and a portfolio of properties is essentially but not entirely the same (eg a trust ownership structure), owning a large portfolio of properties provides opportunities to achieve economies of scales in terms of cost savings per property exploited/managed compared to owning an individual property. Failure to recognise the need to allow for costs of exploiting/managing (internally or externally) the subject asset and the economies of scale and cost savings associated with managing a large portfolio of properties typically exacerbates the consequences of adopting the incorrect financial unit of measurement by property valuers using transaction evidence involving individual reference properties to assess the market value of a large portfolio of properties. To make the matter worse, this valuation error is perpetuated when the resulting assessed value of the subject portfolio of properties is used in deriving a valuation metric under the comparable sales method to value another portfolio of properties (the subject of another transaction).

Clientele effect In cases where a relevant (hypothetical) transaction would result in the transfer of the entire property portfolio, the subject of the valuation exercise is the entire portfolio. If the portfolio of properties is comprised of diverse types of properties, the prospective buyers for the whole portfolio of diverse properties and those for the individual constituent properties may be different. Due to the different clienteles, what is impounded into the financial unit of measurement for the individual properties does not capture what is reflected in the value of the whole portfolio and hence cannot be used as a proxy for the financial unit of measurement in assessing the market value of that subject portfolio. Indeed, depending on the portfolio mix there may, in reality, be no single buyer for the portfolio other than at a discount. By way of simple example, a portfolio of A-grade properties would be saleable to an investor in A-grade properties. However, a portfolio mix of A and C-grade properties, or a portfolio that includes special purpose properties, may only be of interest to a single purchaser at a discount to the sum of the parts value. The componentisation case In the componentisation case, what is impounded into the units of measurement used in assessing the “values” of each notional component does not capture what is reflected into the value of the whole subject property on an “as is where is” basis. In simple terms, an income producing coherent whole property on a going concern basis is different from a mechanistic assemblage of building improvements and underlying land as implied by the sum of the parts method. Thus, the substantively different and unsuitable financial units of measurement embedded in the notionally componentised “values” should not be used through the summation process to assess the market value of the whole portfolio on a going concern basis. In addition, due to the specialised nature of the underlying land component of the subject property as part of a going concern business, comparable sales evidence may be absent. The use of “comparable” sales involving vacant blocks of land whose highest and best uses are different from that of the underlying land (ie its specialised use such as airport land) to assess the “value” of the underlying land component exacerbates the subtle triangulation of an incorrect financial unit of measurement to value the subject property as a whole through the application of the sum of the parts method. Different units of measurement also arise in cases where the reference blocks of land for which a common valuation metric (eg $ per square metre) is derived are substantially smaller or larger than the subject block of land. This is because significant differences in size can result in differences in highest and best use and hence different $ per square metre (ie different unit of measurement). Put another way, the highest and best use impounded into the $ per square metre derived from the transactions involving the significantly smaller (or larger) blocks of land is different from that of the significantly larger (or smaller) subject block of land, making it an unsuitable unit of measurement to assess the market value of the subject block of land. Footnotes 3

However, even in a simple residential scenario there will sometimes be material value differences due to, eg aspect, distance from the railway, main road or quiet residential street, etc.

4

If the subject asset is held in an existing tax disadvantageous ownership structure (eg a corporate ownership structure as opposed to a unit trust structure), the associated tax disadvantages would be reflected in a lower market value of the shares in the company owning the subject asset compared to the market value of units in a trust notionally owning the subject asset, rather than the market value of the subject asset.

¶2-050 Unit of measurement and choice of valuation methodology Recognising the correct financial unit of measurement has important implications for the choice of the

appropriate methodology to value the specialised land assets and the attainment of the appropriate valuation outcome. Failure to recognise and adopt the correct financial unit of measurement usually results in an incorrect triangulation of valuation methodologies which were actually designed for different purposes. This is exemplified by a trap in valuations for stamp duty purposes which involves the incorrect triangulation of a valuation methodology designed for financial reporting purposes. An example of the fundamental flaw of this triangulation is that for stamp duty purposes both land and building improvements are generally treated as land assets, rendering the correct subject of valuation being the market value of the combined land and buildings. In contrast, for financial reporting purposes, the carrying values of land and buildings on the balance sheet are required to be stated separately. Furthermore, these valuations generally reflect the sum of individual land and property values, not the portfolio value. The requirement to determine the carrying amounts of land and improvements separately for financial reporting purposes essentially emanates from required disclosure for each class of property, plant and equipment under the accounting standard for property, plant and equipment and the allowable tax deductions on improvements, but generally not land. The required financial reporting disclosure involves the reporting of three components: gross carrying amount, accumulated depreciation, and net carrying amount at the opening and closing of the reporting period. For financial reporting purposes land is treated as a non-depreciable asset, whereas buildings are treated as depreciable assets for which annual depreciation charges need to be calculated based on estimated useful lives. As a result, separate carrying amounts of land and buildings are required to enable the estimation and reporting of annual and accumulated depreciation charges and net carrying amounts. However, because the income flows to the underlying land and buildings/improvements are not separable, mechanistically adhering to the financial reporting approach creates a gravitation away from an income-based valuation method5 towards a cost-based valuation method in stamp duty and tax-related valuations. From a conceptual perspective, the gravitation away from an income-based approach to a cost-based approach for stamp duty and tax purposes is unwarranted and incorrect because where both land and building assets are treated as land assets, what matters is the income flow to the whole collection of land assets, not the income flow to the individual land asset classes. Put differently, for stamp duty purposes, land assets can be grouped to form a group or groups of land assets to which a separate income or cash flow stream can be attributed, enabling the theoretically correct income approach to be applied. This is consistent with the fundamental valuation principle that the value of an asset is the present value of future cash flows expected to be generated by the asset. In addition, if there is objective verifiable market evidence or data on the income/cash flows generated by the group of land assets, the technically correct cash flow approach can be applied to determine the market value of the whole collection of land assets despite the lack of comparable sale transactions of land and buildings separately due, for example, to the specialised nature of these assets, causing such assets to be rarely, if ever, traded on a standalone basis. Footnotes 5

That is, the discounted cash flow (DCF) or capitalisation of earnings methods of valuation, the latter being a surrogate or variant of the DCF approach.

¶2-060 Unit of measurement in other valuation contexts Adopting the correct financial unit of measurement in valuing land assets for tax and stamp duty purposes should not be controversial in light of the fact that adopting the correct financial unit of measurement is uncontroversial for most other assets. For example, a wholesaler’s stock is valued on a wholesale basis,

not as the sum of the retail values of that stock. Similarly, a portfolio of shares will attract a premium (eg a premium for control) or a blockage discount depending on the circumstances. The market value of the portfolio is not just the total number of shares held times the observed stock market price of the individual shares. The amount as a percentage of face value a rational investor is prepared to pay for a portfolio of credit card receivables would normally be a higher pro-rata than that for an individual credit card receivable. This is because at any given point in time the probability that all the credit card holders in the portfolio default (or alternatively, all choose to pay what is due rather than pay interest) is significantly smaller than the probability that an individual credit card holder defaults (or pays what is due rather than pays interest).

¶2-070 Adopting an incorrect view of the impact of non-transferability on value There are numerous circumstances where there are transfer constraints or prohibitions on transferring ownership of assets. Examples include shares in most family and private companies, employee share options, interests in partnerships, etc. It does not follow that transfer constraints means there “could be no market” and therefore, by inference, no market value. The transfer restrictions cannot reasonably be said to apply to the hypothetical, as per the Spencer market value concept. However, having said this, the price agreed between a hypothetical WBNAB and a hypothetical WBNAS in the hypothetical transaction should reflect the resale restriction and the commercial and financial disadvantages associated with it as an inherent characteristic of the asset which is the subject of the hypothetical negotiations. It also naturally follows that it is sufficient that the application of the Spencer market value concept to assets subject to transfer restrictions be based on a hypothetical market, rather than an actual market. The incorrect treatment of transfer restrictions as equivalent to no market value is also inconsistent with the widely acceptable valuation practice in Australia where the market value of an asset subject to transfer restrictions, more generally referred to as lack of marketability (eg shares in privately-held companies or interests in partnerships), is assessed by firstly assessing the value without resale restrictions and then applying a discount for lack of marketability (DLOM) to the undiscounted value of the asset. The presence of the actual transfer restriction constitutes the reduced transferability characteristic of the subject asset which is hypothetically negotiated in a hypothetical market and requires an allowance for that characteristic in establishing the market value for the asset. The transfer restriction does not impede the occurrence of the hypothetical sale of the subject asset in the hypothetical market on which the correct application of the Spencer market value concept is based. It is important to recognise this subtle but important point. It is incorrect to assert that it is impossible to have a hypothetical buyer and a hypothetical seller and that the situation therefore becomes a “no market” and the asset of no value. Put simply, constrained transferability does not equate with no hypothetical market, and, by inference, no market value. Rather, it means no more than that, the market value of the asset is reduced because of its reduced transferability, not that its market value is non-existent. In fact, it is the long-established and very widespread practice of assessing the market value of non, or limited, negotiability of assets such as private company shares and partnership interests that highlights the asset focus of the application of the Spencer market value concept and indicates the acceptance of the proposition that the application of the Spencer market value concept is based on a hypothetical negotiation between a hypothetical WBNAB and a hypothetical WBNAS in a hypothetical market. It is not accepted valuation practice to conflate lack of transferability with total lack of a market and, by inference, a complete lack of a market value.

¶2-080 In a nutshell Despite the widely accepted definition of market value based on Spencer v Commonwealth (1907) 5 CLR 418, the application of the market value concept in practice has been subject to errors and dispute, with flow-on tax and stamp duty consequences. The recognition and avoidance of the errors discussed in this Chapter are important in achieving a correct

valuation outcome for tax and stamp duty purposes.

Financing risks and the application of the Spencer market value concept ¶3-010 The conceptual and practical challenges The application of the Spencer market value concept in cases where new capital needs to be raised to finance long-term high-risk investments poses significant conceptual and practical challenges. These challenges are directly linked to the significant presence of financing risks for this type of investment which have been brought to the fore again, most recently by the onset of the GFC. In practice, cases where allowance for financing risks is important but often controversial involve the valuation of relatively small companies which require a significant amount of upfront capital outlay to develop an existing asset or a collection of assets1. For example, a significant amount of upfront capital outlay is required by a junior mining company to convert an exploration asset to a producing mine (eg funding the completion of a bankable feasibility study, the construction of mine and transport infrastructure, and purchases of mining equipment, etc), or by a research and development (R&D) company to develop and commercialise a new technology or product (eg funding various rounds of technical trials to gain necessary regulatory approvals, construction of prototypes and commercial plants, product launches, etc). The key commonality between these cases is the need to incur significant capital outlays upfront before any commercial returns in the form of positive cash flows can be realised. Thus, correctly recognising and allowing for financing risk is important when assessing the market value of the subject companies or projects for commercial, capital-raising and tax/stamp duty purposes. Footnotes 1

The subject of valuation or market value assessment in this Chapter is the value of a 100% equity interest in the subject company or the value of the underlying asset owned by the company.

¶3-020 “Highest and best use” principle A fundamental premise underpinning the application of the Spencer market value concept is that the market value of an asset is determined on the basis that the asset is put to its highest and best use. In the case of a mining or an R&D project, the adoption of the “highest and best use” principle implies that the market value of the asset should be determined on the assumption of the availability of funding required to develop or commercialise the project because this is the highest and best use to which the asset should be put. This is corroborated by the simplistic textbook postulation that investment decisions should be separate from financing decisions and firms can maximise value by focusing on identifying projects with positive net present values (NPV) because, in an “efficient” market, these positive NPV projects will be funded. Thus, a mechanistic application of the Spencer market value definition and “the highest and best use” principle in such cases can lead an uncritical valuer to conclude that market value should be assessed on the basis that a hypothetical WBNAB, knowledgeable of the highest and best use of the asset, is cashedup and has the financial capacity to meet the funding requirement. The valuation outcome from such reasoning is that the financing risk which the existing owner of the asset of this type is actually facing is ignored when assessing the market value of the asset, even at the time when the financing risk has not yet been resolved. This valuation outcome is incorrect as it is in stark contrast with the commercial and valuation realities of

relatively small or early stage companies and projects of long-term high-risk, but reasonably attractive prospects. While these companies and projects often have significant “theoretical” NPVs which are derived on the basis that the required funding is available and normal project-specific risks are allowed for by using probability-weighted or “best estimate” cash flows (as opposed to optimistic cash flow forecasts), they face significant difficulties when accessing traditional financing sources (such as bank financing) and securing the required funding for these investments. Such companies are often traded (observably in the case of publicly traded companies) at a substantial discount to these “theoretical” NPVs. The presence of financing risk for these companies is further complicated by three factors: • the significant delays that are common in the development of the underlying asset (whether it be a mine or a new technology) and the resulting deferred realisation of the commercial payoffs from the development of the asset due to, inter alia, technical and regulatory factors • cost blowouts which often materially increase the actual amount of necessary funding compared to the original estimates, creating an additional layer of financing risk for both the provider of the earlier round(s) of funding and the owner of the underlying asset, and • equity dilution, which is discussed further below.

¶3-030 Financing risks and dilution risks Financing risks and dilution risks are inextricably linked. This is because, due to market frictions associated with financing long-term, high-risk investments such as the difficulty in securing debt financing and the inherently limited financial capacity of the founding shareholders of the subject company, the necessary funding often has to be provided by new equity investors. Even if existing equity owners have the financial capacity and willingness to invest more capital, they, being “knowledgeable”, are aware of the higher returns available from other alternative early stage investments and will therefore seek a comparable (market) rate of return. The resultant economic dilution arises from the fact that the price at which the capital is raised from the new equity investor often understates the “theoretical” value or NPV of the underlying asset (ie the value derived assuming away financing risk), thereby disproportionately diluting the owner’s level of ownership in the subject company and the underlying asset. In the case of publicly-listed companies, to make the matter worse, new equity capital is usually raised at a discount to trading prices of minority interests in the company, which may have already been depressed due to “stock overhang” caused by market anticipation of the imminent large capital issue to meet the funding requirement. In commercial reality, given the financing constraints faced by the developers of long-term and high-risk assets of the type described above, equity dilution is often an unavoidable cost that needs to be incurred by the developers/owners of the assets, although the magnitude of that cost is case-specific, depending on, inter alia, market conditions, the stage of development at which the capital is sought, and the amount of capital that needs to be raised. In simple terms, contrary to the “cashed-up” buyer argument and textbook “funding efficiency” postulation, these financing constraints represent an important friction in this market segment which would be elevated in times of financial market dislocations and heightened financing risk.

¶3-040 The correct conceptual framework The value of an asset is the present value of expected cash flows from the asset, which is the essence of the DCF method of valuation. For a development asset which has reached a certain stage of development (eg a mining project which has reached the bankable feasibility study stage or an R&D project which has reached the commercialisation stage), it is generally appropriate to apply the DCF method of valuation. For the subject development asset, this method of valuation is based on a set of cash flow forecasts where negative cash flows (ie capital expenditure (capex)) have to occur before positive cash flows can arise. That is, the development asset is valued at a time prior to the needed injection of new capital to meet the required capex (ie the pre-money value of the underlying asset or, in the obvious absence of interest-bearing debt, the pre-money value of the 100% equity interest).

When assessing this pre-money value, the appropriate way to resolve the apparent disconnect between the outcome of mechanistically applying the Spencer market value concept and the commercial and valuation realities is to recognise and allow for the fact that the provider of the new equity capital acts as a provider of financial liquidity for the business (in the presence of the abovementioned market frictions) and should earn an additional return over and above the return for bearing the normal long-term investment risks associated with the volatility of the future cash flows from the underlying asset. This is practically achieved by explicitly allowing for the discount (to the theoretical or undiluted price) at which the new equity capital is raised2. The theoretical price or undiluted price reflects the theoretical or undiluted pre-money value of the underlying asset which is derived by assuming away the inherent financing constraints faced by the company. The size of the discount to the theoretical or undiluted price at which the new equity capital is raised is, of course, case-specific, depending on, inter alia, the stage of development that the company has reached, the financial position of the company, and the prevailing conditions of the market for funds and the negotiating positions of the company and the provider of the new equity capital at the time of the subject capital-raising. The subtle point that should be noted is that, although the provider of the new equity capital may already have an existing shareholding in the company (as in the case of venture capitalists who have participated in earlier rounds of financing), focusing on their role as the marginal liquidity provider as distinct from the existing holder of equity at the time of the subject capital-raising highlights the need to factor an additional return for the provision of liquidity in establishing the price at which the new capital is raised. This, in turn, forms the basis for establishing the market value of the 100% existing (old) shareholdings and the premoney value of the underlying asset at the time of the subject capital-raising. Explicitly allowing for the fact that the new equity capital is raised at a discounted price concurrently means two things. One is that, for a given amount of capital infusion, the provider of the new equity capital is provided with an additional return in the form of a greater number of new shares to be issued and, as a result, a higher proportional shareholding of the company post-money than if the new equity capital is issued at the (higher) theoretical or undiluted price. The second is that the pre-money shareholdings of the pre-money owners of the company will be economically diluted in the sense that these pre-money shareholdings will represent a lower proportional shareholding of the company postmoney than if the new equity capital is issued at the (higher) theoretical or undiluted price. This results in a reduction in the pre-money value of the existing 100% shareholdings and the pre-money value of the underlying asset for a given theoretical or undiluted value of the underlying asset. Example: Impact of dilution Consider a company which has 10m shares outstanding, no debt finances, and owns an ore deposit. Assume that the required funding to meet the capex is readily available and that the theoretical or undiluted value of the asset (under the DCF method) is $20m. The required amount of capex which is equal to the amount of new equity investment that needs to be raised is $5m. Given the abovementioned value inputs, set out below is a comparison of the existing shareholders between two scenarios. In the first scenario, the new equity capital is raised at the theoretical or undiluted price of $2 per share3. In the second scenario, the new equity capital is raised at a discount of, say, 50% to the theoretical or undiluted price of $2 per share (ie $1 per share).

Table 3.1 New capital raised at New capital raised at theoretical price of $2 per discounted price of $1 per share share Number of new shares issued

2.5m1

5m2

Post-money shareholding of new equity providers

20%3

33.3%4

Post-money shareholding of existing shareholders

80%5

66.7%6

Implied pre-money value of 100% existing shareholding

$20m7

$10m8

Implied post-money value of 100% existing shareholding

$20m9

$16.7m10

Notes 1 $5m/$2. 2 $5m/$1. 3 2.5m shares/(2.5m shares + 10m shares). 4 5m shares/(5m shares + 10m shares). 5 10m shares/(2.5m shares + 10m shares). 6 10m shares/(5m shares + 10m shares). 7 ($5m/20%) × 80%. 8 ($5m/33.3%) × 66.7%. 9 ($20m + $5m) × 80%, assuming away, for simplicity, present value effect. 10 ($20m + $5m) × 66.7%, assuming away, for simplicity, present value effect. The post-money total value if the project is funded is $25m.

In the above example, the theoretical value or undiluted value of $20m overstates the market value of either the 100% shareholding of the company (pre-money), or of the underlying asset (pre-money), simply because that value does not reflect the value-relevant dilution risk and the inverse relationship between risk and value (ie understating risk naturally results in overstating value). To the extent that equity dilution is an unavoidable cost of developing or exploiting an asset (eg a mining project or an R&D project), the market value of the development asset at the time when development costs have not been incurred should reflect the impact of this dilution. Furthermore, there is an equivalence/direct relationship between the value of the 100% shareholding and the value of the underlying asset on a pre-money basis. The impact of financing/dilution risk on the premoney value of the 100% shareholding should have an implicit flow-on impact on the pre-money value of the underlying asset. Another way of looking at it is that, on a pre-money basis, financing constraint is an inherent attribute of the underlying asset and hence should be reflected in the pre-money value of the asset. Putting aside delay risks for the moment, the presence of financing risk would not necessarily change the cash flows or discount rate applicable to the asset conditional on financing risk being resolved/funding being available, but it would affect the probability-weighted cash flows (and their timing) and the discount rate for the asset pre-money and hence its pre-money value. This can be practically allowed for via the application of a notional discount at which the new required equity is raised. Footnotes 2

The actual discount at which the new equity capital is raised may reflect other factors such as lack of control rights that may be associated with the new equity.

3

Being $20m/10m shares.

¶3-050 The “cashed up” buyer argument One may argue that it is implicit in the definition of a WBNAB that the buyer has the required financial capacity. However, a hypothetical WBNAB should be knowledgeable of the liquidity position and the financing/dilution risk borne by the subject asset or business in relation to the required capex and should take this into account when establishing the pre-money offer price for the underlying asset or the 100% shareholding of the subject company. Put differently, even if “cashed-up”, a WBNAB would take into account the opportunity costs of providing capital for the development of the underlying asset or company

which could otherwise be deployed into similar significantly undervalued (“cash strapped”) companies or assets, particularly in times of heightened financial uncertainties. A rational WBNAS would also follow the similar thought process when evaluating a given offer price relative to the outcome of their next best alternative which involves the issue of new equity capital (if it can be raised at all) and the dilution risk associated with it. Even assuming that a WBNAB is “cashed-up”, they would not be expected to pay away to the owner of the subject company the full value benefit (but only a share) from the resolution of financing and dilution risk and set the offer price equal to the theoretical and undiluted value of the underlying asset. Of course, the sharing of such value benefit depends on market conditions and competition for the asset, which can be practically allowed for in the variation of the notional discount at which the new equity capital is raised. Arguments that competing WBNABs will eliminate the discount are refuted by the observable fact that equity/finance providers to such projects do in fact rationally require and obtain this discount despite competition between them, hence, it is reasonable to expect that WBNABs will also obtain the discount. This can be seen from the discounts even large companies listed on the Australian Securities Exchange (ASX) had to incur in raising new equity capital during the GFC, as set out below. Table 3.2: Discounts at which ASX-listed companies raised new capital during the GFC

Announcement date

Amount raised $m

Amount raised/market capitalisation before announcement %

GPT

23 Oct 08

1,350

53

48

Australand

28 Jul 08

461

40

38

Goodman

24 Oct 08

956

36

42

Mirvac

30 Oct 08

500

34

30

Gunns

11 Sep 08

334

32

35

Transfield Services

11 Nov 08

204

29

64

ING Office Fund

3 Dec 08

350

27

22

ConnectEast

24 Nov 08

294

26

19

CSR

14 Nov 08

350

19

22

PaperLinx

29 Sep 08

185

19

29

Alumina

26 Aug 08

910

18

31

Bluescope Steel

9 Dec 08

550

18

23

Incitec Pivot

12 Nov 08

819

16

40

Bradken

29 Jul 08

141

13

9

QBE Insurance

26 Nov 08

2,000

10

11

Orica

22 Jul 08

898

10

18

Sonic Healthcare

12 Nov 08

425

10

11

CSL

13 Aug 08

1,891

9

6

National Australia Bank

10 Nov 08

3,000

8

10

8 Oct 08

329

6

13

Company

CFS Retail Property Trust

Discount %

Leighton

14 Aug 08

703

6

17

Westpac

9 Dec 08

2,500

5

11

AMP

5 Nov 08

450

4

11

Commonwealth Bank

17 Dec 08

1,650

4

11

Commonwealth Bank

8 Oct 08

2,000

3

16

Source: Lonergan Edwards and Associates Limited (LEA) analysis. In practice, the above conceptual framework can be applied to two distinct but interrelated types of cases: • The first type of case involves those companies for which the decision to raise new capital has been made and the fair price at which the new equity capital is raised to meet the funding requirement needs to be assessed at the time of the capital-raising. • The second type of case involves those companies which need to raise new capital (to meet the required capex) in the future but for which the decision to raise new equity capital has not been made.

¶3-060 In a nutshell The application of the Spencer market value concept poses significant valuation challenges in cases where financing risk is significant and further elevated in times of financial market uncertainty. The appropriate way to deal with these challenges is two-fold: • One is to recognise that both a hypothetical WBNAB and a hypothetical WBNAS are knowledgeable of the market frictions and the resultant financing risk present in these cases. • The second is to explicitly allow for equity dilution when assessing the market value of the subject entity and the underlying asset. Mechanistically assuming away financing and dilution risk would result in incorrect valuation outcomes with flow-on consequential incorrect commercial and tax/stamp duty outcomes.

The value of total assets ¶4-010 “Enterprise value” and “business value” The terms “enterprise value” and “business value” are often applied incorrectly and/or inconsistently. In brief: • equity value is the value of owners’ equity • enterprise value (EV) is the value of owners’ equity plus the value of interest-bearing debt, and • business value is used in confusing ways. The term really means total asset value, including those assets funded by trade and other creditors. The reason that the term is used inconsistently is that in most business sales the trade and other creditors are paid out by the vendor. The purchaser then obtains their own trade credit, etc, to (partly) fund the total collection of assets acquired. Further confusion arises if, as is often the case, the vendor collects their own receivables. In turn, the purchaser “reinstates” the debtors by making sales on credit terms. In cases where the entity has multiple distinct businesses, the EV of the entity reflects the sum of the EVs of the individual distinct businesses. However, for an entity which has only one line of business, its EV is the same as the market value of the single business which is determined by the present value of the expected future cash flows from the bundle of total assets employed by that business. This can be practically measured as the sum of the market value of equity (on a 100% controlling interest basis) plus the market value of interest-bearing debt1. As discussed in ¶4-030, if the cash available is operational cash as part of net working capital, it cannot be used to net off interest-bearing debt to obtain “net” interest-bearing debt in calculating EV. The value of total assets often becomes a contentious issue in land rich cases where assessing the value of the total assets of an entity is relevant for tax and/or stamp duty purposes. The source of contention is whether the value of total assets is the same as the EV of the entity. By definition, the value of the total assets of a business entity is the present value of the expected future cash flows from these assets and one might intuitively expect that it would be uncontroversial that valuers, investors, etc, should use EV to assess the value of total assets (the EV method). However, in practice, this is not the case. In many instances, the commonly adopted method is to add the book value of the total liabilities of the entity to the observable or ascertainable implied value of the 100% equity interest in the entity. There are several variants of this alternative method of assessing the value of total assets, where the value of total assets is variously calculated as EV plus: • book value of all non-interest-bearing liabilities and provisions • book value of working capital liabilities • book value of working capital assets • book value of net working capital assets, or • less commonly, other permutations and commutations of the above. These various methods are hereinafter referred to as the EV plus add-on method. Example: Comparing balance sheets In order to illustrate the source of confusion and errors, Table 4.1 below provides a comparison2 between a simplified accounting balance sheet and a simplified economic/valuation balance sheet.

Table 4.1

Simplified accounting balance sheet Assets

$m

Liabilities

$m

Cash

 1

Payables

  1

Receivables

 3

Interest-bearing debt

  7

Producing assets

   14  

Equity

  10  

   18  

  18  

Simplified economic/valuation balance sheet Assets

$m

Liabilities

$m

Cash

 1

Interest-bearing debt

 7

Receivables

 3

Equity

 10

Less payables Net working capital assets Producing assets

   (1)    3    14  

      

   17  

  17  

It can be seen from the above that the economic/valuation perspective (underpinning the EV method) focuses on the forward-looking cash flow generating/maintaining capability of the going concern business and provides delineation between value creation and value distribution. This is because shifting trade payables to the asset side of the valuation balance sheet makes this side of the balance sheet represent the ability of the existing economic resources underpinning the going concern business to create forwardlooking cash flows/value at a given point in time, while leaving the right-hand side or liability side of the balance sheet to represent the distribution of value between the providers of debt and equity capital to the business. This important delineation is blurred in the pure accounting balance sheet (underpinning the EV plus add-on method) due to its inherent focus on the separation of accounting assets from accounting liabilities3. In addition, given that the economic/valuation balance sheet focuses on the forward-looking ability of a business entity to generate cash flows and create value, it also better reflects what the business could be sold for at a given valuation date.

Example: Land rich cases Table 4.2 sets out a sample of land rich cases where we have observed the incidence of the EV plus add-on method adopted by opposing experts4 through our involvement as one of the valuation experts.

Table 4.2: A sample of land rich cases Case

Type of case

Subject of valuation

Nature of add-ons

A

Stamp duty

Mining assets

Non-interest-bearing liabilities1

B

Stamp duty

Mining assets

Non-interest-bearing liabilities1

C

Stamp duty

Aged care facilities

Non-interest-bearing liabilities2

D

Stamp duty

Aged care facilities

Non-interest-bearing liabilities2

E

Stamp duty

Aged care facilities

Non-interest-bearing liabilities2

F

Stamp duty

Aged care facilities and retirement villages

Non-interest-bearing liabilities2

G

Stamp duty

Airport facilities

Non-interest-bearing liabilities3

H

Stamp duty

Mining assets

Non-interest-bearing liabilities3

I

Stamp duty

Mining assets

Gross working capital assets

J

Income tax

Mining assets

Net working capital assets

K

Income tax

Mining assets

Net working capital assets

L

Income tax

Mining assets

Net working capital assets

M

Income tax

Mining assets

Net working capital assets

N

Income tax

Mining assets

Net working capital assets

Notes 1 Including (significant) deferred tax liabilities (DTL) and provision for rehabilitation costs. 2 Including (significant) DTL. 3 Excluding DTL.

The contentious issue arising from land rich cases presents an interesting situation where what is virtually taken for granted in corporate finance theory is challenged by (incorrect) practice, with important flow-on tax and duty implications. The following discussion conducts a conceptual re-evaluation of the relationship between the market value of the total assets of an entity and its EV. To this end, the following conceptual issues are reevaluated5: • what is to be valued • the treatment of working capital assets in assessing EV on a going concern basis, and • the distinction between the treatment of working capital assets on a going concern basis of valuation and a liquidation basis of valuation. The re-evaluation of these issues, in turn, sheds light on the inappropriateness of the EV plus add-on method. Having re-evaluated the conceptual link between EV and the market value of total assets, the distinction between EV and the market value of equity is revisited. Footnotes 1

The interest charge implicit in trade credit is reflected in the cost of purchases and is therefore already allowed for in the calculation of the expected future cash flows.

2

For simplicity, the present value effect is ignored.

3

At a more subtle level, it also double-counts the cost of trade credit: once as cost of purchase and a second time as a liability.

4

For confidentiality reasons, specific details of these cases cannot be disclosed.

5

In order to simplify the analysis and avoid any confusion, it is assumed that the subject entity has no surplus assets. In practice, where there are surplus assets, the value of, or cash flows

associated with, the surplus assets is usually separated from the present value of the expected cash flows from the core businesses of the entity. In such cases, it is common and appropriate to add the market value of the surplus assets to the EV of the core business in assessing the overall EV of the entity. However, this is substantively different from the various “add-ons” that may be applied to EV under the EV plus add-on method, where there are no surplus assets.

¶4-020 What is to be valued? There are three important questions in terms of what is to be valued: • What standard of value applies? • What is the basis upon which the standard of value is applied? • What constitutes the total assets being valued? What standard of value applies? The standard of value most frequently adopted in practice is based on the Spencer market value definition, being the price that would be negotiated in an open and unrestricted market between a knowledgeable WBNAB and a knowledgeable WBNAS acting at arm’s length within a reasonable timeframe. For such participants, the value of any asset or entity is the present value of the expected future cash flows from the asset or entity. The question of what is included in the total assets being valued is closely linked to the purpose of a going concern commercial business or enterprise. A going concern business consists of a collection of assets which are combined with the intention of generating profits or cash flows. Thus, there must be an economic correspondence between the composition of the total assets being valued and the cash flow generating capability of the going concern business. In addition, there must also be a consistency between the standard of value and the subject to which the standard of value is applied. To what is the standard of value applied? Because the standard of value is market value, which is forward-looking in nature and hence technically based on forward-looking cash flows, the total assets to which that standard of value is applied must be those assets which generate or support forward-looking cash flows of the entity (total cash flow relevant assets). In simple terms, the total assets that are to be valued must be those which match, not overstate or understate, the forward-looking cash flow generating capability of the business. Furthermore, since for stamp duty and tax purposes, the total assets being valued are generally a collection of assets owned by a going concern business, the sale of which triggers the assessment of tax and stamp duty liabilities, they should be valued on a going concern basis. What constitutes total assets? Confusion and errors arise in practice partly from the failure to recognise the fact that total assets can be characterised in a valuation sense or in an accounting sense. The total assets whose market value is to be assessed must be the total cash flow relevant assets, rather than the total accounting assets or some mix of the two. This is because: • total cash flow relevant assets include only true assets which, in an economic sense, contribute to the forward-looking cash flow generating capability of the entity. In contrast, total accounting assets, on the one hand, may not include all of the true assets which contribute to the forward-looking cash flow generating capability of the underlying business, due to idiosyncratic accounting conventions. On the other hand, they may include pure accounting entries which have little or no cash flow consequences and, hence, have little or no bearing on the forward-looking cash flow capability of the business6 and little or no market value, and • total cash flow relevant assets include opening net working capital assets which are, as explained

below, consistent with the forward-looking cash flow generating capability of the entity as at that date, whereas total accounting assets include opening gross working capital assets, which inherently overstate the forward-looking cash flow generating capability. Footnotes 6

Examples include unrecognised deferred tax assets, accounting deferred tax liabilities on wasting assets that will never be sold and contingent liabilities.

¶4-030 The treatment of working capital assets in assessing EV on a going concern basis From an economic and valuation perspective, in the case of a capital intensive or land intensive business which has no material goodwill value, the collection of assets employed to support and maintain its cash flow generating capability at a given point in time can be broadly classified into two distinct types: • primary or producing assets, eg mining rights, mining equipment, mining and transport infrastructure for a mining business or land assets and bed licences for a residential aged care facility (RACF), and • “stabilising” assets, eg cash holdings and inventories that act as a buffer for the smooth forwardlooking exploitation of the primary or producing assets. For example, cash holdings are required when revenue will be received after operating expenses (opex) have been paid. Similarly, holdings of raw materials and consumables are required for the uninterrupted exploitation of the primary assets. From an accounting perspective, total accounting assets include gross working capital assets due to the need to separate accounting assets from accounting liabilities for accounting purposes. This reflects how financial statements are required to be presented for accounting purposes. From an economic and valuation perspective, the relevant question is: what level of investors’ funds is invested in stabilising assets? This determines what is available as a buffer for the smooth forwardlooking exploitation of the primary or producing assets to generate forward-looking cash flows. Gross working capital assets for accounting purposes inherently overstate the market value of economic stabilising assets because some of those gross assets are held to settle short-term liabilities arising from past production activities7. At a micro level, the manner in which the expected cash flows from the business and its EV reflect the impact of the stabilising net working capital assets is quite subtle. While being convenient and practical, the discounted cash flow (DCF) modelling based on discrete periods of a reasonable length (say annual) does not show any timing mismatch arising within each annual period from revenue being received after opex are paid, which underpins the necessity of the economic stabilising assets discussed earlier. In simple terms, despite these assets not being apparently visible due to the natural focus and design of an (annual) DCF model, they should be reflected in the present value of the expected cash flows from a business entity because they are economically necessary to the generation of the projected cash flows visible from such a DCF model. The size of the stabilising net working capital assets is not necessarily the optimal or required maximum or minimum size of the economic buffer they constitute. It only reflects what is in place to perform the economic function of the stabilising assets. The amount in place is dependent on time, cycle and sometimes “chance”. The chance dependency is partly attributable to the susceptibility of the available net working capital assets to “noise” caused by delays associated with payments and receipts of cash flows arising from past activities. Any material departure from the necessary amount of net working capital assets caused by the chance dependency factor should be “corrected” by subsequent working capital injections or withdrawals which are readily allowed for within the DCF modelling and reflected in the assessed EV.

However, subsequent working capital injections or withdrawals to move from the existing level of working capital assets to a desirable level of working capital assets in the future are distinct from the existing net working capital assets that are in place to perform the economic function of the stabilising assets, which are reflected in the EV of the business entity8. Footnotes 7

Gross accounting working capital assets also inherently overstate the economic stabilising assets in that they do not reflect present value.

8

The recognition of the distinct existing assets also implies that as long as these are “employed” in the business, they should earn a fair return embedded in the total cash flows from the business.

¶4-040 The treatment of working capital assets on a going concern basis versus a liquidation basis In assessing the EV of a business which is a going concern business, the DCF modelling should naturally and technically pick up the cash flow impacts associated with the ultimate release of working capital on a net present value (NPV) basis in the assessment of terminal value9. However, confusion arises when the terminal value is assessed on a notional liquidation basis where the gross working capital assets as at the terminal date are used. In order to avoid this confusion, it is necessary to recognise that the terminal value assessed as part of the going concern EV assessment is substantively different from terminal value assessed as at the terminal date on a standalone liquidation basis (ie in isolation from the going concern EV assessment). What needs to be assessed for tax and stamp duty purposes is the market value of total assets as at a valuation date, not the market value of total assets as at the terminal date. This is because as at the valuation date, the business entity is still a long-lived going concern business, the going concern basis of valuation applies and the net working capital assets constitute the stabilising assets which are continually being rolled over. The existing necessary net working capital assets are part of the total cash flow relevant assets and reflected in the EV of the going concern business, not separate assets whose market value needs to be added to the EV to determine the market value of total assets. In fact, treating the DCF-based EV of a going concern business (for which expenses are incurred before revenue is received) as being exclusive of the existing necessary net working capital assets implies that the EV of the going concern business can be created with nil working capital. This is not only technically incorrect, but is at odds with commercial reality in that a prospective purchaser of the business with nil working capital would need to re-inject the existing net working capital into the business to generate the projected cash flows underpinning the assessed EV and hence would lower the price paid for the business accordingly. Footnotes 9

Ultimately, net working capital is released when the asset or enterprise terminates, at which time the net working capital flows to equity or debt. Assuming terminal value is correctly calculated in the DCF modelling, the present value of that release will be reflected in the EV. However, in practice, the terminal value is normally calculated by capitalising “steady state” cash flows in perpetuity, where steady state cash flows arise in the year in which there are no expected material changes in net working capital. Inherently, this does not allow for the ultimate release of working capital in the far distant future, although the present value impact of such treatment on the overall EV assessment is generally immaterial.

¶4-050 The distinction between EV and market value of equity EV can be seen from two angles: • it is the present value of the expected future cash flows accruing to the providers of capital to the subject enterprise (ie providers of debt and equity capital)10, and • it is the present value of the total future expected cash flows from the subject enterprise’s bundle of total assets (excluding surplus assets). These angles provide two distinctive ways of how the present value of total future expected cash flows from the bundle of total assets are “sliced”. One is between the providers of (debt and equity) capital to the business and the other is between the constituent (true) assets (correctly valued) underpinning the generation of the total future expected cash flows. Properly understanding the alternative ways in which the present value of the total future expected cash flows from the bundle of total assets is “sliced” indicates that in cases where the capital structure of the subject entity includes interest-bearing debt, the market value of equity cannot be used to represent the EV and, in fact, understates EV and the market value of the subject entity’s bundle of total assets. Misconceptions stem from the failure to distinguish the concept of EV and the practical measurement of EV. EV is conceptually the present value of the expected cash flows from the bundle of total assets employed by the entity. When shares in the entity which employs the bundle of total assets are listed on a stock exchange, the EV can practically be measured as the sum of the market value of the equity on a 100% interest basis, plus the market value of interest-bearing debt (if any). The practical measurement of EV for a listed entity does not alter the fact that EV is the present value of expected future cash flows from the bundle of total assets. The true conceptual nature of EV should not and does not vary with the listing status of the entity at all. Footnotes 10

In cases where the subject enterprise also issues hybrid securities such as convertible notes and options, the true EV includes the value of straight debt, plus the value of equity, plus the value the hybrid securities, plus the economic value (not just intrinsic value (if any)) of the options outstanding.

¶4-060 In a nutshell In assessing the value of the total cash flow relevant assets as at a given valuation date, it is generally incorrect to apply any of the variants of the EV plus add-on method. The correctly derived EV of a going concern business (based on the market values of interest-bearing debt and equity) implicitly makes allowance for the cash flow impacts of working capital assets and liabilities. It therefore represents the market value of total assets relevant for tax and stamp duty purposes, which already includes the market value of net working capital assets. In cases where the subject entity has interest-bearing debt in its capital structure, it is incorrect to use the market value of equity to represent its EV and the market value of its total assets.

Re-evaluating the control premium ¶5-010 The role of a control premium A real and practical complication arises in “land rich” cases, particularly taxable Australian real property (TARP)/non-TARP cases where the market value of the total assets of an entity is not available or cannot be directly observed with a reasonable level of confidence due, for example, to the unavailability of reliable cash flows/earnings forecasts, whereas what is readily available is the aggregated value of minority interests (ie observed market capitalisation in the case of a listed entity) in the relevant going concern entity. The common practice in this case is to add an allowance for a control premium to the aggregated value of minority interests to arrive at an estimate of the market value of a 100% equity interest (or a hypothetical 100% control capitalisation). The sum of the estimated market value of a 100% equity interest plus the assessed market value of interest-bearing debt is used to assess the market value of the entity’s total assets, which comprise TARP and non-TARP assets. A correct understanding of the control premium therefore has direct implications for the valuation of TARP assets, the outcome of the principal asset test (PAT) and the capital gains tax (CGT) liability payable. In addition, in many cases where the value of goodwill also needs to be assessed for tax purposes, a correct understanding of the control premium is important to the appropriate assessment of enterprise value (EV) which, in turn, has direct flow-on impacts on the assessed market value of goodwill under the top-down residual method (TDRM)1. In order to achieve a correct understanding of the control premium and the resulting appropriate taxation outcome, it is necessary to: • define what corporate control is • understand why corporate control is valuable • make a distinction between the observed ex-post takeover premium and the ex-ante control premium, and • understand the drivers of the ex-ante control premium. Footnotes 1

Under this method of valuation, the value of goodwill is assessed as a residual after deducting from the assessed EV the assessed value of tangible and identifiable intangible assets.

¶5-020 What is corporate control? Control of a company is defined as the ownership of a sufficient voting power (eg 50.1% of voting shares) to control decisions on important company matters. Such control typically confers the power to elect and remove directors, appoint and remove officers, fix salaries, determine financial and operating policies, declare dividends, and dissolve or merge the company. There are various levels of ownership where some level of control can be achieved. The degree of control obtained at a given level of ownership is dependent on the legal environment in which the entity operates, the entity’s constitution, and its ownership distribution. In the context of a takeover bid, in addition to the power to influence important company matters, control will enable the bidder to realise potential synergistic benefits.

¶5-030 Why is control valuable? From an acquirer’s perspective, an investment in a controlling equity interest should be a safer and higher return investment than one in a non-controlling equity interest because it enables the controller to access (or at least direct) cash flows as they arise and to implement what they believe to be the best policies in the management of their investment or at least minimise any agency risk2 that would be detrimental to shareholder value. In private companies, controlling shareholders can use their power over corporate management in ways that benefit themselves at the expense of minority shareholders although there are limits on the ability to do so. Footnotes 2

In simple terms, agency risk is the risk that management will make decisions that benefit their self-interest rather than shareholders.

¶5-040 Distinction between observed ex-post takeover premium and ex-ante control premium Like any other asset, the market value of an entity’s total assets is the present value of the expected future cash flows from these assets assessed by a knowledgeable hypothetical WBNAB and a knowledgeable hypothetical WBNAS. Underpinning this is the important premise that a knowledgeable WBNAB and a knowledgeable WBNAS should: • recognise that value is the present value of expected future cash flows, and • apply this correct conceptual framework even when the discounted cash flow (DCF) method of valuation is, for practical reasons, not used and instead its surrogates or other alternative valuation methods are used. The assessment of the market value of total assets requires the determination of the appropriate discount rates at which the expected future cash flows are discounted3. The outcome of a DCF exercise can only be a reasonable estimate of market value if the expected future cash flows and the discount rate(s) are appropriately assessed from the perspective of a knowledgeable WBNAB and a knowledgeable WBNAS. When the subject of valuation is an entity’s bundle of total assets, it is important to differentiate between two types of case. One is where the market value of the bundle of total assets is directly ascertainable from the abovementioned DCF exercise. The other is where the market value of the bundle of total assets is not directly ascertainable and needs to be assessed. This differentiation highlights: • the substantive distinction between the ex-post takeover premium (which is directly observable in the first type of case) and the ex-ante control premium (which is not readily observable in the second type of case) • the common mistake of conceptually equalising the two types of premium, and • the important sequencing which applies to both types of case where the premium (whether it be observed ex-post premium or ex-ante control premium) fundamentally stems from the assessment of the market value of the total assets of the underlying business, not the other way around. Observed ex-post takeover premium The cases where the market value of the bundle of total assets is readily ascertainable typically involve

one of the following: • the direct acquisition of the subject assets where the monetary consideration for the assets is ascertainable or observable, and • the acquisition of the going-concern business which owns the bundle of total assets (or a pro-rata share thereof) where the monetary consideration for the whole business is ascertainable or observable. If the liability to CGT needs to be assessed in these cases, the observable or readily ascertainable market value of the total assets can be used for tax purposes. If the subject business being acquired is a listed entity, the takeover/acquisition premium can be directly observed. The takeover premium is determined by calculating the difference between the final bid price and the share price prior to the announcement of the initial bid price (in cases where the final bid differs from the initial bid). Because empirical and anecdotal evidence shows that investors often anticipate a takeover prior to its public announcement, the share price of the target firm just before the takeover announcement may already capture some portion of the takeover premium. In order to eliminate the effect of the price run-up prior to the takeover announcement (eg the share price three months prior to the bid being announced), the final bid price is normally compared to the target’s share price prior to the commencement of the price run-up (after allowing for the occurrence of other value-relevant events in the intervening period) when measuring the takeover premium. Empirical evidence on takeover premium indicates that the average takeover premium (after allowing for the effect of the pre-bid price run-up) is generally about 30% to 35%, although the actual observed takeover premium varies across entities, industries and over time. It is important to note that the empirical evidence on observed takeover premium is based on a particular subset of firms which were successfully taken over. This takeover premium is observable and is an expost premium in that it is observed after an actual change of control transaction has occurred. It is a premium conditional upon the change of control transaction taking place. Ex-ante control premium In contrast, in cases where the market value of total assets is not directly observable, it needs to be assessed. Typically this occurs when there has been no takeover offer or actual change of control transaction. This is the context in which the ex-ante control premium is added to the entity’s stock market capitalisation. If the entity is a listed entity, what is readily observable as at the valuation date is the market value of equity on a minority interest basis. What is usually not readily observable or ascertainable at that date is the market value of the bundle of total assets employed by the entity. This is particularly so in the absence of a reasonable takeover offer for the whole entity. In such cases, if there is a DCF model which, after appropriate verifications and modifications, reasonably reflects the expected cash flows and discount rate(s) that would be assessed by a knowledgeable WBNAB and a knowledgeable WBNAS for the whole business or the whole bundle of total assets employed by the business, the outcome of this DCF model provides the assessed market value of the bundle of total assets on a “first principle” basis at the relevant valuation date. Once the market value of the bundle of total assets has been assessed, it can be compared against the readily ascertainable market capitalisation of the subject (listed) entity as at a given valuation date. The ex-ante “control” premium is therefore the difference between the DCF-based value of equity on a controlling interest basis and the total market value of equity on a minority interest basis. The market value of equity on a controlling interest basis implied by the assessed market value of the total underlying assets may or may not exceed the ascertainable market capitalisation, resulting in a corresponding ex-ante “control” premium or discount. This is due to, inter alia, the fact that: • the drivers of the DCF-based value assessment of the bundle of total assets by a knowledgeable WBNAB and a knowledgeable WBNAS are not the same as the drivers of the prices at which minority interests in the subject (listed) entity are traded on the stock exchange. There are a number of reasons why this is so. These include the fact that the timing and quantum of net cash flows to

minority shareholders are generally less than, and may be more risky than, those available to a controlling shareholder. Furthermore, the stock exchange value of minority interests can be influenced by short-term market sentiments, trading behaviour, and other factors such as stock overhang • there are differences in the quantum and quality of information available to a knowledgeable WBNAB (and hence reflected in the DCF-based market value of the bundle of total assets) and that available to stock market participants (and hence reflected in the prices of minority interests). While continuous disclosure requirements are designed to reduce this information gap, they do not generally eliminate it. For example, some commercially sensitive information does not have to be disclosed to the market and hence is not reflected in trading prices of minority interests. However, by definition, such information is available to a knowledgeable WBNAB and knowledgeable WBNAS and therefore incorporated in the “market value” of the bundle of total assets. An external valuer having access only to publicly-available information about the subject entity may not be able to ascertain the true extent of the information gap and its impact on the difference between the assessed “market value” of the bundle of total assets (net of the market value of interest-bearing debt) and the “market capitalisation” of the subject entity and the resulting incidence of a hypothetical (ex-ante) control premium or discount at a given valuation date. Any “control” premium over and above, or discount below, the ascertainable minority market capitalisation, implied by comparison with the assessed market value of the subject entity’s bundle of total assets at the valuation date, is an ex-ante premium/discount. It is not directly observable and is assessed at a time when the company has not been subjected to an actual change of control transaction. In this regard, the ex-ante control premium is substantively different from the empirically observed ex-post takeover premium. The ex-ante control premium (if any) is only a mathematical deduction from the DCFbased assessment of the market value of the total assets net of interest-bearing debt and the observation of aggregated minority interest market value. Equalising the observed ex-post takeover premium and ex-ante control premium is incorrect Failure to recognise the distinction between the ex-post takeover premium and the ex-ante control premium may result in the adoption of an incorrect view that the ex-post takeover premium observed from a particular subset of entities (ie those which were successfully taken over) can be routinely applied to the minority interest market value of the entity which is not in this subset at the valuation date when assessing the control value of that entity at the valuation date. In addition, given that the market capitalisation of an entity at a given valuation date can exceed the market value of equity on a 100% controlling interest basis implied by the DCF-based “market value” of the underlying total assets assessed at that date, adopting a significant ex-ante control premium without a correct understanding of the nature of the premium, and a proper evaluation of what could justify the size of such premium and mechanistically adding the significant control premium to the ascertainable minority interest market value of the entity, can result in the assessed “market value” of the underlying total assets being misstated. In fact, the subset of firms being taken over may have unique characteristics which make them takeover targets, eg poor management and synergies. These characteristics may not be present for a firm which has not been taken over at a particular point in time. As a result, the ex-post takeover premium is likely to reflect two factors, which are not always present in ex-ante control premium: • poor target company management, leading to a depressed pre-bid target share price and hence increased observed premium, and • synergy benefits for acquirers, shared in part with target shareholders to encourage completion of the deal. Due to the inherent divergence between the observed takeover premium and the ex-ante control premium, the observed market capitalisation of a listed entity which has not received a takeover offer cannot be routinely or mechanistically increased by simply 30% to 35%, which is the average observed takeover premium, to obtain a proxy for the market value of the entity’s total assets. Each case has to be

assessed on its particular circumstances. The mechanistic application of average ex-post takeover premium to minority interest market value does not take into account: • the different characteristics of entities which have been acquired to those of the entity being valued • empirical evidence on the timing of takeovers which indicates that takeover premiums paid vary with the economic cycle. For example, takeovers tend to occur “in waves” depending upon market conditions. If these market conditions are not present at the valuation date, it is not appropriate to mechanistically apply a control premium based on observed ex-post takeover premium paid in takeovers at different times and under different market conditions, and • empirical evidence on how the size of the takeover premium varies depending on market conditions. For example, during the GFC average takeover premiums increased significantly. Footnotes 3

In practice, the DCF method can be implemented by assessing the DCF value of an asset across a range of scenarios using the appropriate expected cash flows and discount rate(s) for each scenario. The assessed market value of the asset is then obtained by assigning the appropriate probability weighting to each scenario and calculating the probability-weighted DCF value across the scenario.

¶5-050 The determination of ex-ante control premium The ex-ante control premium depends upon: • the value of having direct control over all the entity’s cash flows • the risk reduction from having direct control over the entity’s cash flows, and • the existence and size of private benefits of control. The unlockable value It is a matter of commercial logic that the higher the value (over and above transaction costs) that can be created by moving from a minority interest position to a controlling interest position, the higher the value of control and vice versa. It is not the mere access to all the cash flows of the entity which determines the control premium. It is also the ability to make positive differences to the quantum and risk profile of the total cash flows of the entity. This ability depends on the availability of “room for value improvements” even in the absence of synergy benefits from the combination of the entity with another entity. A company whose incumbent management team is highly competent and well incentivised to optimally exploit the underlying assets should obviously have less “room for value improvements” than a company which is run by a management team that is either not sufficiently competent and/or not properly incentivised to create this value. Consequently (other things being equal), the value of control will be less for the former than the latter. In addition, the size of the ex-ante control premium also depends on the differing levels of synergy benefits to different acquirers. For example, in an industry which is experiencing a consolidation phase, the potential synergies in terms of enhanced economies of scale are available to many prospective acquirers, thereby increasing the bargaining position of the target and the likelihood that a larger share of the expected synergies should be paid away to the owners of the target, resulting in a higher ex-ante control premium. The extent of lower investment risk

When assessing the ex-ante control premium, it is also necessary to assess the difference in risk between holding a minority interest and holding a controlling interest. This risk differential arises from the much greater ability to prevent management actions or inactions which have adverse impacts on value and to cause management actions or inactions which have positive impacts. From the perspective of a minority interest holder, there is a risk that: • the existing management team is not competent but somehow entrenched, perpetuating the adverse impacts of poor management actions/inactions on value, and • while the existing management team is presently competent, they may either leave the business in the future or be replaced with a new, less competent management team or somehow deviate from the appropriate course of actions or fail to make appropriate responses to changing circumstances. This risk is exacerbated for high-risk and high-growth businesses in volatile markets. The size of private benefits of control Private benefits of control available to controlling shareholders may, or may not, come at the expense of minority shareholders. In cases where the private benefits of control are material, the greater the value of the private benefits of control, the larger the appropriate control premium. Example A acquires control of company B. A may then enter into transactions with B on terms which, while stopping short of outright oppression (for which there are potential legal remedies), are nevertheless on more favourable terms to A than would be obtainable on an arm’s length basis.

This is because the larger the value of the private benefits of control, the larger the corresponding element of value discount embedded in the trading prices of minority interests and the larger the component of the ex-ante control premium which represents the elimination of such element of value discount. The complicating factual and judgment issue is to what extent a WBNAB would notionally be prepared to pay away a share of value discount reversal and to what extent a WBNAS would hold out to obtain a larger share. However, when a 100% interest is acquired by a hypothetical WBNAB, the price paid relative to the minority interest price at the time of the acquisition inherently reflects the elimination of any value discount arising from the existence and realisation of private benefits of control embedded in the minority interest price.

¶5-060 In a nutshell Control premium is a complex but important concept in valuations. Observed ex-post takeover premium may differ significantly from ex-ante control premium. Mechanistically applying an average observed ex-post control premium to minority interest values may produce a materially incorrect estimate of the market value of equity on a controlling interest basis and, after allowing for interest-bearing debt, a materially incorrect estimate of the market value of total assets. Incorrect tax and stamp duty outcomes would naturally follow.

Re-evaluating the small company risk premium ¶6-010 The purpose of a small company risk premium The implementation of the discounted cash flow (DCF) valuation method in assessing the market value of the total assets of an entity involves discounting the expected cash flows from the entity at a discount rate (or discount rates) reflecting the timing and riskiness of these expected cash flows. Thus, whether or not a small company risk premium is added to the discount rate has a direct implication for assessing the market value of the entity’s total assets and flow-on tax and stamp duty consequences. From a valuation perspective, discount rates cannot be assessed in isolation of the cash flows to which they are applied. The approach commonly adopted in practice is to assess the weighted average cost of capital (WACC) where the cost of equity is typically determined using the capital asset pricing model (CAPM). The key logic underlying the CAPM is as follows: • An investor will always be willing to make an investment into risk-free securities, such as long-term government bonds. If, however, the investor is prepared to invest in a riskier investment, a premium will be required by the investor in accepting this higher level of risk. Risk represents the extent to which actual returns can deviate from expected returns (which is correlated with the possible deviation of actual cash flows from expected cash flows). Because investors are risk averse, they require an additional return for bearing risk. • The rate of return required will vary depending upon the extent that the specific investment is riskier (or less risky) than an average investment in the market. • The deviation of actual returns from expected returns for an investment can be caused by the occurrence of firm-specific factors (diversifiable risk) and market-wide factors (non-diversifiable risk). An investor should, in theory at least, hold a diversified market portfolio because total risk (ie the deviation of actual return from expected return) can be reduced through diversification (eg the negative deviation of actual return from expected return caused by a technical failure in one investment can be offset by the positive deviation of actual return from expected return caused by a technical success in another investment). Diversifiable risk, therefore, should not be separately rewarded in determining the required rate of return. However, for avoidance of doubt, the firmspecific risk factors (eg the risk of technical failure and, conversely, technical success) should be allowed for in assessing the expected ex-ante/probability-weighted cash flows in the first place. However, under the CAPM framework, the deviation of the actual returns from expected return caused by possible realisation of the risk of, for example, technical failure, would not warrant an additional return because such risk can be diversified away by holding a well diversifiable portfolio. • The risk which is reflected in determining the required rate of return under the CAPM framework is the risk caused by the occurrence of market-wide factors. There are several terms which can be used interchangeably to describe that risk, such as non-diversifiable risk, market risk, systematic risk, or co-variance risk. Put simply, the CAPM-based rate of return reflects the reward for bearing that risk of actual returns deviating from expected returns caused by market-wide factors. • The level of systematic risk associated with the investment depends upon its sensitivity to changes in the value of the market portfolio. It is widely accepted in practice that a reasonable practical surrogate for the market portfolio is a broad share market index1. Such sensitivity or responsiveness is measured by the equity beta factor. In assessing the market value of the total assets of what is considered a “small” company using the DCF valuation method, many practitioners routinely add a small company risk premium2 to the cost of equity derived using the CAPM to arrive at the discount rate adopted under the DCF valuation method3. The often cited (albeit not necessarily correct) reasons for applying the small company risk premium are:

• smaller companies are often in weaker competitive positions, have fewer facilities and product diversification, have higher production costs due to the lack of economies of scale and can be more vulnerable to regulatory risk or labour disruptions • smaller companies do not have the level of access to debt and equity capital that larger companies enjoy • because of the difficulty in obtaining information on small companies (small companies generally have fewer analysts following them than larger companies), it may take longer for the share prices of small companies to react to new information. Accordingly, the beta estimates of small companies may understate the level of systematic risk • various studies in the United States of America (USA)4 have demonstrated a significant “size effect” in that smaller companies have higher equity risk premium over and above that explained by their equity betas in the context of the CAPM. In simple terms, the CAPM-based rate of return is not sufficient to account for the systematic risk of investing in smaller companies, and • it is generally much harder and more expensive to sell an investment in a small company than in a large company. Small companies can have a high level of ownership concentration (ie a few shareholders hold a large percentage of the shares on issue), resulting in a low level of liquidity and larger bid-ask spreads as a percentage of price than for larger companies. Allowing for a small company risk premium on the basis of the abovementioned reasoning in assessing the market value of total assets contains several potential pitfalls which have unfortunately received little recognition in practice, including: • failure to recognise the true subject of valuation • incorrect triangulation of empirical evidence from the USA markets to the Australian market, and • double-counting for risk. Footnotes 1

In theory, the market portfolio should consist of an investment in every asset outstanding in proportion to its total value. The extent to which a broad share market index represents the market portfolio depends on the composition of the index. For example, the broad share market index in Australia is dominated by bank and mining shares and tends to under-represent technology and property shares.

2

Premium refers to the additional required rate of return, which results in a higher discount rate and a lower assessed value (given the inverse relationship between discount rate and value). A value discount such as a discount for lack of marketability refers to a discount applied to the unadjusted value of the equity.

3

The Valuation Practices Survey undertaken by KPMG Corporate Finance Australia suggests that the percentage of practitioners in Australia that adopted the small stock premium was 52% in the 2013 survey, which fell to 34.5% in the 2015 survey.

4

The USA empirical studies often referred to by practitioners in Australia are generally those conducted by Ibbotson & Associates. Ibbotson & Associates published an annual yearbook officially titled Morningstar/Ibbotson SBBI Valuation Yearbook (the Yearbook) that drew from a USA dataset commencing in the year 1926. The Yearbook was discontinued by Ibbotson & Associates after publication of the 2013 edition. However, the Yearbook has been resumed by Wiley & Sons/Duff & Phelps in their publication entitled The Valuation Handbook — Guide to Cost of Capital.

¶6-020 Failure to recognise the nature of what is being valued It is important to distinguish the case where the subject of valuation is a minority equity investment in a small entity from the case where the subject of valuation is the total assets of what is considered a small entity, or a 100% equity investment in that entity which confers to the purchaser the full ownership of the total assets. While the application of a small company risk premium may be warranted in the former case, depending on factual circumstances, the potential pitfall lies in the implicit triangulation of this treatment to the latter case without recognising that the two cases involve two different assets (an equity asset versus the total assets) which are traded in different markets and attract different types of investors or potential buyers. For example, a minority equity investment in a small mining project is often subject to a lack of liquidity (hence, warranting the application of a small company risk premium and the resulting higher discount rate). However, depending on market conditions at the valuation date, the whole (small) mining project having already reached the feasibility stage can be attractive to many participants at the populated junior or mid-tier end of the market that face financing constraints, but wish to prove their producer status or strengthen their production and cash flow profile and be re-rated accordingly. In such cases, using the same (usually large) small company risk premium applied to the minority equity investment when valuing the whole underlying project is clearly inappropriate and results in the small mining project being undervalued. Similarly, it is inappropriate to triangulate a small company risk premium applicable to minority equity interests in relatively small-listed companies to the valuation of a collection of relatively “safe” assets such as a portfolio of residential aged care facilities (RACFs) and bed licences. Such assets had strategic appeal to many participants in a heavily regulated industry at a point in time where the industry was experiencing a consolidating phase and enjoying long-term favourable demographic conditions in Australia5. Footnotes 5

Refer to Chapter 17 for a discussion on the residential aged care industry.

¶6-030 Incorrect triangulation of empirical evidence from the USA markets In the empirical study on “size effect” conducted by Ibbotson & Associates and frequently cited by many Australian practitioners, the tradable USA equities market is essentially split into 10 portfolios6 based on market capitalisation, with portfolio 1 representing the largest companies and portfolio 10, the smallest. The 10th portfolio is further broken down in quartiles, the smallest quartile is labelled the 10z decile. Using share price data stretching back to 1926, monthly holding period percentage return is determined for each stock in the sample. The total return on a decile portfolio for a month is calculated as the weighted average of the returns of its composite stocks. The CAPM-based rate of return is then calculated for each decile and subtracted from the total return to arrive at the “excess return” for each decile. The calculated excess return is then compared across the 10 deciles to discern any “size effect” where the excess return increases with size (measured by market capitalisation). Putting aside for the moment the difference between the asset to which the USA empirical evidence is related (ie minority interests) and the subject asset to which the empirical evidence is applied (eg portfolio of total assets in Australia) (discussed above), the main problem with mechanistically applying the USA evidence to value “small” companies in Australia is that the USA stock markets are substantially larger than the Australian share market. A company classified as “small” in the USA markets is not necessarily “small” in terms of market capitalisation in the Australian market. This can be seen by splitting listed companies in the Australian share market into 10 deciles and comparing the weighted average market

capitalisation for each decile across the two markets at a common point in time. To illustrate, set out below is a comparison based on the formation of deciles as at 30 September 2012. The decile statistics for the USA markets were readily available from Ibbotson & Associates, and the decile statistics for the Australian market were available from the Security Industry Research Centre of Asia Pacific (SIRCA). Table 6.1: The disparity in size between USA and Australian markets Decile summary statistics1 Ibbotson & Associates (USA)

No of companies in portfolio

Weighted average market capitalisation US$m

1

173

2

SIRCA (Australia)

No of companies in portfolio

Weighted average market capitalisation A$m

Weighted average market capitalisation US$m2

59,279

205

35,091

36,421

193

11,498

205

452

470

3

187

5,737

205

129

134

4

202

3,445

205

54

56

5

205

2,308

205

28

29

6

234

1,613

205

17

17

7

317

1,039

205

10

10

8

329

651

205

6

6

9

466

358

205

3

4

10

1,068

101

212

2

2

Decile

Notes 1 As at 30 September 2012. 2 Converted using an exchange rate of A$1.00 = US$1.0379 as at 30 September 2012 (source: Oanda).

Source: SIRCA, Lonergan Edwards & Associates Limited (LEA) analysis. The above table shows that: • the weighted average market capitalisation of the first Australian decile (ie representing the largest listed companies in the Australian market) lies between the weighted average market capitalisation of the USA first and second deciles • the weighted average market capitalisation of the second Australian decile which has the equivalent weighted average market capitalisation of US$470m (as at 30 September 2012) lies between the weighted average market capitalisation of the USA eighth and ninth deciles • the third Australian decile which has the equivalent weighted average market capitalisation of US$139m (as at 30 September 2012) lies between the USA ninth and 10th deciles • the fourth Australian decile which has the equivalent weighted average market capitalisation of US$56 (as at 30 September 2012) is significantly smaller than the weighted average market capitalisation of the USA 10th decile (the smallest decile) • the weighted average market capitalisation of the fifth Australian decile is even smaller than the 10z decile which has an average market capitalisation of US$43m as at 30 September 2012,

representing the smallest subset of the USA 10th decile. The above comparison indicates that, except for the first decile, what is considered “small” by USA market capitalisation standards (eighth and ninth deciles) is quite big by Australian market capitalisation standards (second and third deciles). A mechanistic application of the USA evidence on “size effect” would result in a significant small company risk premium in between those applicable to the USA eighth and ninth deciles being applied to an Australian company whose assessed equity value (before a small company risk adjustment) is, say, equivalent to US$500m. This is problematic because such mechanistic application has no regard to whether or not the factors often cited to explain the significant small company risk premium for USA eighth and ninth deciles reported in the Ibbotson & Associates study (eg limited access to financing, lack of trading liquidity, lack of analyst coverage, etc) would apply, to a similar extent, to a US$500m equivalent market cap Australian company. This is also at odds with Australian empirical studies7 on small company risk premium which consistently find that small company risk premium or “size effect” disappears if illiquid stocks with low share prices and market capitalisation (micro cap stocks with market cap being less than A$10m) are excluded. In simple terms, Australian empirical evidence as opposed to USA empirical evidence does not support applying a USA market-based small company risk premium to assess the equity value of a company which is considered “big” by Australian market capitalisation standards, but “small” by USA market capitalisation standards. Thus, it is inappropriate to mechanistically apply a USA market-based small company risk premium to the valuation of an Australian company based on the absolute size of the (unadjusted) equity value of the Australian company. In fact, for those Australian companies which are considered relatively large in the Australian market, but small by USA market capitalisation standards (particularly, those in the second and third deciles in the Australian market), such mechanistic application creates an upward bias on the assessed discount rate8 used to implement the DCF valuation method, and a corresponding downward bias on their assessed equity value and the assessed market value of their total assets while ignoring the available and relevant Australian empirical evidence. These biases are also exacerbated by the fact that the reported small company risk premium is samplespecific, time-specific and country-specific9. Footnotes 6

The portfolios are constructed based on: (a) splitting the stocks traded on the New York Stock Exchange (NYSE) into 10 deciles, and (b) allocating the stocks traded on non-NYSE USA exchanges into the abovementioned 10 deciles. This results in the 10 portfolios not being the 10 equal decile portfolios.

7

Durand RB, Juricev A and Smith GW, 2007 “SMB — arousal, disproportionate reactions and the size-premium”, Pacific-Basin Finance Journal, 15(4), pp 315–328. Gray P and Tutticci I, 2007 “Australian Stock Market Anomalies: A Review and Re-examination of the January and Small Firm Effects”, Journal of Investment Strategy, 2(2), p 27. Clayton L, Dempsey M and Veeraraghavan M, 2008 “Are beta, firm size, liquidity and idiosyncratic volatility related to stock returns? Australian Evidence”, Investment Management and Financial Innovations, 5(4), pp 145–158. Brailsford T, Gaunt C and O’Brien MA, 2012 “Size and book-to-market factors in Australia”, Australian Journal of Management, 37(2), pp 261–281.

8

Micro-Cap Size Premia data (Table A-6 of 2013 Yearbook published by Ibbotson & Associates) commencing 1 January 2004 indicates a size premium of 2.1% per annum for USA stocks in the ninth and 10th decile. If this premium is mechanically applied to similarly-sized Australian companies, the resulting discount rate would be overstated by at least the same amount.

9

There is also empirical evidence which indicates that the size of the reported premium is volatile over time and materially differs between USA and non-USA markets.

¶6-040 Double-counting for risk Double-counting for risk arises when the risk factors used to justify the application of a small company risk premium can be (and are already) allowed for in the assessment of the equity beta within the conventional CAPM framework or the probability adjusted cash flows. For example, there are often less opportunities to realise economies of scale for small mining projects compared to large ones. This results in higher capital costs, higher operating costs and lower margin per unit of production and hence higher operational leverage for this type of project. If the higher operational leverage is already allowed for through the use of higher equity beta and higher cost of equity derived based on the CAPM, it would be double-counting to allow for the same risk factor through the use of an additional small company risk premium. The fact that the equity betas of small companies are generally empirically larger than those of large companies (other things being equal) already accounts for the increased riskiness of the former relative to the latter caused by the presence of the abovementioned factors. Thus, it is double-counting to further allow for the higher total systematic risk of a small company by adding an ad hoc specific risk premium to the CAPM-based cost of equity of that company to account for the same exposure to the systematic risk factors. The small company risk premium (if any) only reflects the portion of total systematic risk, allegedly not captured in the CAPM-based rate of return. In addition, the impact of infrequent trading associated with shares in listed small companies on the measurement of historical equity betas of those companies could and should be dealt with in the measurement of historical equity betas and the assessment of the forward-looking equity betas (based on, inter alia, historical equity betas), rather than purely through an ad hoc addition of a small company risk premium to the CAPM-based cost of equity. Furthermore, for a small private company, it is double-counting to apply a small company risk premium in assessing the discount rate used in deriving the DCF value of the entity and then apply a further value discount (ie a small private company discount) to the resulting DCF value in arriving at the assessed market value of equity, the EV and market value of the total assets of the entity because this technically represents a double allowance for the same risk factors associated with minority interests in small private companies (eg lack of liquidity, lack of access to financing, etc). Lastly, it is technically unsound to “load up” the allowance for firm-specific risks (eg the risk of a new product being unable to overcome technical hurdles or despite being technically proven, being unable to be commercialised due to lack of funding or market acceptance) in the discount rate. These risks are better reflected through probability adjustments in the assessment of probability-weighted cash flows. Allowing for these risks of failure would result in lower expected cash flows from the entity and lower DCF value. For a small company which may have only one single product, compared to a portfolio of products a large company often has, the impact of the risk of technical failure of a single product on firm value is much greater for the former than the latter. In cases where this risk is already reflected in the probabilityweighted cash flows of the “small” company being valued, it is double-counting to also allow for this diversifiable risk in the discount rate10 by adding a small company risk premium to the CAPM-based rate of return. In this regard, it is important to note that not allowing for an additional small company risk premium in assessing the discount rate of a “small” company in question does not imply that the small company would be traded at the same earnings multiple as a large company counterpart. In fact, the small company would generally be traded at a lower earnings multiple, reflecting, inter alia: • lower expected growth (due, for example, to restricted access to funding), and

• higher uncertainty associated with the measure of earnings to which the earnings multiple is applied (due, for example, to lack of information or owner/managers’ optimistic forecasts). In simple terms, the higher forecast errors and specific risks pertinent to the small company being valued are practically allowed for via the use of a lower earnings multiple, rather than “loading up” the discount rate with an ad hoc small company risk premium. The use of a lower earnings multiple under the capitalisation of earnings method is conceptually analogous to allowing for the probability of the owner/manager’s optimistic forecasts not being achieved, resulting in lower expected/probability adjusted cash flows and lower DCF value under the DCF method of valuation. Footnotes 10

Risk of commercialisation failure can also be allowed for in the probability-weighted cash flows. However, to the extent that the deviation of actual return from expected return is caused by the commercialisation failure (as opposed to technical failure) which is driven by the materialisation of financing risk (as was seen during the GFC), such risk has a systematic element and should be reflected in the use of higher equity beta.

¶6-050 In a nutshell It is a technically unsound practice to routinely allow for a small company risk premium in assessing the market value of an entity and its total assets without properly understanding what is being valued and the nature of the empirical evidence on small company risk premium. Allowance for a small company risk premium is case and fact-specific. The recognition and avoidance of this unsound practice is important in achieving an appropriate and credible valuation outcome for tax and stamp duty purposes.

Rethinking goodwill ¶7-010 Why valuing goodwill is a challenge Despite being subject to extensive debate for many years, there is still much confusion and disagreement about the market value of goodwill. A key challenge in achieving a consistent understanding of the nature and value of goodwill is the fact that goodwill is a highly abstract concept. It can be generally defined, but its nature and quantum are difficult to pinpoint for a given business, particularly in the presence of other assets employed by that business. Added to this difficulty are subtle but important differences in the way in which goodwill is understood and assessed by lawyers, accountants and financial analysts. In practical terms, these differences mean that at the very least there will be many cases where the accounting/economic value of goodwill will be nominal or nil (which is simply, but not necessarily correctly, interpreted to mean there is no goodwill) but the legal view will be that goodwill clearly exists. Differences of understanding about what constitutes goodwill have also been noted by the Judiciary; for example, in FC of T v Murry 98 ATC 4585; [1998] HCA 42 at 21, the following was noted: “Such considerations seem to make it impossible to achieve a synthesis of the legal and the accounting and business conceptions of goodwill. Accounting and business conceptions of the term emphasise the necessity for the business to have some value over and above the value of the identifiable assets.” While at first glance this suggests that the legal view and the accounting view of goodwill are significantly different, it is useful to analyse this apparent conflict in a framework within which goodwill is assessed from a wider inter-disciplinary perspective. Assessing goodwill in this framework provides better insights into both the existence and market value of goodwill for a given business and helps market participants (whether they be lawyers, accountants or financial analysts) achieve the same understanding of what is apparently the same concept. From a legal perspective, although what constitutes goodwill in a legal sense for a given case is ultimately a legal question and can be subject to legitimately different legal interpretations, considering a convergent approach to goodwill is useful because this approach provides a wider analytical framework within which some legal interpretations of goodwill can be either assessed or reassessed, resulting in the overall legal understanding of the goodwill concept being reinforced or enriched. Although the nature of goodwill can differ across different types of business, capital intensive businesses provide a useful setting in which the differences in the alternative approaches to goodwill can be highlighted and a conceptually convergent approach identified. There are two main reasons why this is so. Firstly, for this type of business the value of tangible assets should, a priori, be expected to be significant, providing a natural check for reasonableness of the assessed market value of goodwill. Secondly, the sale of a capital intensive business or an interest in such a business can trigger a land rich assessment for stamp duty or CGT purposes under which the market value of the going concern business needs to be apportioned between land assets and non-land assets (including goodwill) either to meet legislative requirements or to perform a valuation cross-check. Such a value apportionment exercise typically focuses on the sources of value creation and, importantly, the relative contribution of each individual asset class to value creation. Given that in this exercise the market value of the whole or totality is typically ascertainable, the assessed or apportioned market values of each individual asset class (tangible assets, identifiable intangible assets and goodwill) are interrelated. In this context, the nature of goodwill, its interaction with other asset classes in a subject enterprise and the measurement of its true worth are naturally brought to the fore and can have important implications for assessing the stamp duty or CGT payable. There are broadly three alternative approaches to goodwill, including the economic approach, the accounting approach and the legal approach, each of which is discussed in detail in the following

sections.

¶7-020 Economic approach Under the economic approach to goodwill, economic goodwill value (as opposed to accounting goodwill value (discussed in ¶7-030)) represents the excess economic earnings power which is conceptually the present value of excess economic income. Excess economic income is the amount of income generated by a business enterprise that is greater than the amount that would be based on a reasonable rate of return on all the tangible assets and identifiable intangible assets currently employed in the subject business. The economic approach to goodwill provides a useful conceptual framework to understand the financial and economic premise underlying the concept of goodwill. This approach explicitly recognises the need to distinguish goodwill from identifiable assets (both tangible and intangible) currently employed by the subject enterprise and the need to allow for a reasonable rate of return on investment in these identifiable assets in assessing the value of goodwill. Under this approach, a subject enterprise has no goodwill (other than of a nominal value) if it does not generate excess economic return (ie a return over and above the reasonable returns on identifiable assets). The subject enterprise can have goodwill, but the goodwill has no material value if the excess economic return is immaterial (ie the properly measured rate of return on currently employed identifiable assets accounts for almost all of the overall returns generated by the subject enterprise). Thus, implicit in the economic approach is the allowance for the ability of the subject enterprise to generate expected future excess economic return from future value-enhancing expansions of the existing identifiable assets or future additions of new identifiable assets through, for example, mergers/acquisitions. A notional securitisation framework Critical to the implementation of the economic approach to goodwill is the need to separate the cash flows that are attributable to tangible and identifiable intangible assets from those that are attributable to (economic) goodwill. While posing significant practical challenges, this exercise invokes a much needed thought process which focuses on: • the nature of the subject enterprise • its asset mix • a “notional securitisation” framework which considers any available market evidence on the required return on a particular asset class (eg property and brand/trade marks, etc). Market evidence on the “fair” return to individual physical asset and identifiable intangible asset classes can be obtained given that: – premises may be leased (allowing “notional” rents to be observed) – debtors may be factored – stock may be obtained on consignment – plant, machinery and furniture may be leased – brands/trade marks may be licensed (allowing a “notional” royalty stream to be observed). A natural outcome of this thought process is that as long as the cash flows expected to be generated by the subject enterprise as a whole can be calculated with reasonable confidence, and the cash flows attributable to individual tangible asset and identifiable intangible asset classes can be ascertained (using, for example, the “notional securitisation” framework mentioned above), the residual cash flows are, by construction, the excess cash flows of the subject enterprise over and above those cash flows attributable to its identifiable assets and can therefore be attributed to goodwill. This is exactly the main thrust underlying the economic approach to goodwill.

However, at a practical level, it is generally simpler to deduct the market value of the other net assets from the properly calculated enterprise value (EV). For example, real estate at its current market value, accounts receivable at their present value, stocks at net realisable value, etc. This is appropriate because market value is the present value of future cash flows. Consequently, if the EV of the entity is either readily ascertainable based, for example, on transaction evidence or can be properly assessed based on the observable total cash flows1 and the market values of tangible assets and identifiable intangible assets are properly measured, the market value of goodwill can be determined as the difference between the properly assessed EV and the market values of its identifiable assets. This method of goodwill value measurement also underpins the accounting approach to goodwill. Ex-post realisation versus ex-ante outcome of management decisions In theory, at a given point in time, expected excess economic return can be attributed to expected future conscious value-adding management decisions, which represent an element of goodwill. However, it is important to make a distinction between the value impacts arising from the expected (ex-ante) outcome of management decisions and those arising from the ex-post realisation of these decisions. While the former may be2 attributed to goodwill, the latter is often not. This is because once a conscious management decision has been made and the outcome turns out to be value-accretive, the corresponding (ex-post) value uplift may become impounded into the value of other asset classes, and is no longer represented by any separate goodwill value. An example of the latter is the case of a port owner considering an expansion, once a decision to build a new terminal has been made and it turns out to be a value-enhancing investment, the value uplift would be largely, if not entirely, reflected in the value of the port’s fixed (tangible) assets, not the goodwill of the port-owning entity. In simple terms, the acquisition of the port’s fixed (tangible) assets to which the new terminal had been added will generally bring with it all the value-accretive benefits of that historical expansion decision. However, the value of the forward-looking value of goodwill may also be enhanced if the outcome of the past managerial decision increases market participants’ confidence in the incumbent management’s superior ability to make future value-adding decisions. This is still conditional upon the superior incumbent management being well incentivised to remain with the business and the availability of opportunities for them to make value-adding decisions, which depends on the characteristics of the industry in which the entity operates and/or its stage of development and pertinent characteristics. In the case of a single purpose operating entity that exists solely for operating/exploiting a single purpose asset (for which a pre-determined expansion plan has been put in place), the scope for exercising future conscious decisions by management with a view to generating expected return over and above the fair rate of return on the identifiable assets currently employed by the subject entity is limited. It is a matter of logic that the element of goodwill which represents expected future excess economic return becomes more and more limited over time and may even cease to exist. Readily assembled management and skilled workforce It is erroneous to believe that simply having skilled staff and assembled workforce and other unidentified factors is sufficient to create material goodwill value. If value contribution from, for example, skill and expertise is largely or fully offset by the market-based compensation paid for acquiring and retaining those skills and expertise in exploiting the collection of identifiable assets, no material economic goodwill value is created for the entity and hence a hypothetical WBNAB of the entity should not reflect a substantial sum for goodwill in their valuation assessment. This is further confirmed by the fact that such skills and expertise are generally replaceable at market rates of remuneration and this would certainly be a lot less, and tax deductible, than paying away a large amount for goodwill. In addition, the availability and functionality of skill and expertise, etc, is necessary to maintain the mere continuity of the entity and hence the existence of goodwill, but is not sufficient for the existence of material goodwill value. It is incorrect to believe that by purely performing the normal duties for which managers and skilled workforces are paid market salaries which are already included in assessing the value of total assets, they can create significant goodwill value for a business (ie significant excess value over and above the value of the identifiable assets they are paid to exploit/manage). The normal utility of

management and workers does not inherently translate into significant excess value creation. This is also consistent with the important distinction between the existence of goodwill in a legal sense and the existence of material goodwill value in an economic sense which is predicated on the existence of material excess returns and uniqueness (which are generally interrelated). Footnotes 1

Refer to Chapter 4 on the market value of total assets measured by the correctly assessed EV.

2

The reason why it is a “may be” is that the mere fact that a conscious decision on, for example, an expansion is expected (ex-ante) to deliver a positive value outcome is not the sole determinant of whether or not the ability to make such a decision constitutes goodwill. The desirability of this expansion might have been so evident that even “blind Freddy” would have made the decision, in which case the ability to make such a decision cannot be attributable to goodwill. Conversely, the expected ability to determine the appropriate timing and scale of the expansion can be attributable to goodwill at least at the ex-ante stage.

¶7-030 Accounting approach Under the accounting approach to goodwill, goodwill is the difference between the costs of acquisition and the fair value of net identifiable assets acquired. Like the economic approach to goodwill, the accounting approach to goodwill recognises the need to distinguish goodwill from identifiable assets employed by the subject enterprise including the value of identifiable intangible assets. The accounting approach focuses on the measurement of the value of the purchase of goodwill3 in the context of either a business combination or for impairment testing purposes. That is, under the accounting approach, goodwill is defined, not in terms of its attributes, but in terms of the way in which its value is measured. Distortions in the “measured” accounting goodwill The measurement of goodwill value (or the supposed “worth” of goodwill) under the accounting approach is inherently subject to the potential combination of wrongly included or wrongly excluded items and to measurement errors. The typical circumstances in which the “measured” value of goodwill can be distorted are: • Transaction costs (advisers’ fees, stamp duty, etc) used to be included in assessing the “measured” value of goodwill.4 • There has been accounting “arbitrage” in allocating purchase price consideration between goodwill and identifiable assets. Historically, this was to minimise annual goodwill amortisation costs and maximise post-acquisition reported profits. Post-Australian International Financial Reporting Standards (AIFRS) goodwill is no longer subject to annual amortisation, and as a result, the arbitrage direction has reversed. • The acquisition costs do not reflect the true market value of the subject enterprise due, for example, to movements in the bidder’s share price (in cases where shares in the bidder are used as purchase consideration). This is because the accounting standards now require that the value of shares issued as takeover consideration be assessed on acquisition date. Previously, value was measured on offer date. As a result of these accounting standard changes, movements in the bidder’s share price flow through to accounting goodwill value because accounting goodwill is calculated as a residual amount. Self-evidently, movements in the bidder’s share price may have little or nothing to do with the market value of the company being bid for. Example

If a gold mining company makes a share offer for (say) an iron ore company and the price of gold rises, or the bidder makes a new gold discovery, the increase in the bidder’s share price will flow through to additional goodwill value, assuming that the exchange ratio as at the acceptance date remains the same as that at the offer date. While there are impairment testing rules, these do not overcome the basic mismeasurement problem.

• The fair values of some identifiable assets are wrongly determined or determined on the wrong basis. For example, instead of being valued as part of the going concern business which was acquired, the identifiable assets (such as property, plant and equipment employed, particularly, in capital intensive businesses) are valued on a piecemeal and standalone basis (ie in isolation of the subject enterprise) • The accounting standards require a deferred tax liability to be recognised for the difference between accounting carrying value (which at the date of acquisition should be market value) and the cost base for taxation purposes. As the market value of the underlying asset is the present value of its after-tax cash flows, then to again deduct tax on the excess of the resulting capital value over the tax cost base double-counts a tax liability, a substantial part of which will never be realised.5 • In the case of business combinations which occur in stages6, the Australian accounting standard AASB 3 Business Combinations (AASB 3) requires the bidder to remeasure its previously held equity interest at its acquisition date fair value and recognise a resulting profit or loss, rather than reflect the change in the assessed accounting goodwill value of the target on the acceptance date7. Due to the very way in which the supposed accounting “value” of goodwill is measured, all the measurement errors, whenever and however they arise, flow directly through to the measured residual “value” of goodwill, potentially making the measured “value” of accounting goodwill in a context of a business combination a distorted indication of both the existence of goodwill and its true worth if goodwill value does indeed exist. At a subtler conceptual level when the identifiable assets, particularly specialised tangible assets, are not determined as part of the profitable going concern business, but, as is generally the case, on a piecemeal and standalone basis, the assessed values of these assets on that basis represent a different type of value, which generally understates the market value of the assets as part of the going concern business. It follows that there is an inherent measurement mismatch between the assessed values of identifiable assets and the usually observable or ascertainable market value of the going concern business, resulting in a distortion in the “measured” value of goodwill. Put more simply, due to this measurement mismatch, what can conventionally be considered as an indication of the existence of material accounting value of goodwill is actually a direct result of the understatement, in some cases, significant understatement, of the market values of the identifiable net assets as part of the going concern business which is acquired. To make matters worse, such understatement directly inflates the “measured” value of accounting goodwill and can create a false impression that goodwill exists and has material value whereas the opposite is true. In addition to the understatement of the “measured” value of goodwill caused by the incorrect (standalone) basis on which identifiable assets (particularly specialised fixed assets) are valued, the “measured” accounting value of goodwill is subject to an additional layer of measurement errors/biases arising from the significant approximation/measurement errors inherent in the application of cost-based approaches such as optimised depreciated replacement cost (ODRC) which are usually adopted to value specialised fixed assets on such an incorrect (standalone) basis. Specific measurement errors/biases associated with the application of the ODRC approach includes, inter alia, failure to: • distinguish between ODRC as measured based on “costs delivered” now or “costs ordered” now for deferred delivery • allow for foreign exchange (FX) fluctuation in the time lapse between order date and delivery date • allow for mean reversion in construction costs • measure the true replacement cost of the asset in question

• appropriately assess the useful life of the asset in question, and • appropriately deal with changes in the assessed useful life of the asset. Dangers of misinterpreting empirical evidence Those advocating the proposition that a normal business without any uniqueness or ability to generate excess returns can have material goodwill value often rely on empirical evidence on broadly: • the proportion of “accounting” goodwill value relative to EV for listed entities, and/or • negative share price reaction to “accounting” goodwill impairment/write-off. There are several problems with such reliance. Firstly, it is inappropriate to extrapolate the reported average proportion of goodwill value relative to EV to assess the market value of goodwill for an individual entity, without assessing the unique characteristics of the subject entity, how goodwill value is measured8 in the relevant empirical studies, and the dispersion/range of the relevant ratio around the reported average ratio. Secondly, following the allowable recognition of purchase goodwill (subject to impairment testing, rather than annual amortisation) with the adoption of International Financial Reporting Standards (IFRS), there has been an accounting incentive to allocate value towards goodwill. This tendency (coupled with the difficulties and incorrectness in valuing real property assets) results in value that would be otherwise allocated to tangible assets being subsumed into reported accounting goodwill value, causing the proportion of “accounting” goodwill value relative to EV being biased upwards. Thirdly, it is inappropriate to interpret the empirical evidence of negative price reaction to goodwill impairment/write-off as confirmation of the existence of the material goodwill value even for an average company. This is because if the value of tangible assets is incorrectly reflected in reported accounting goodwill or reported accounting goodwill is inflated by overpayments for acquisitions, then the subsequent goodwill write-downs only conveys to the market the signal that some reduction in previously expected overall value of the entity had taken place, resulting in adverse share price reaction. The adverse share price reaction is not confirmation of market participants’ recognition of the reported accounting goodwill as representing the true economic goodwill value in a true Spencer market value concept world in which value allocation should be undertaken for tax purposes. Interrelationship between accounting goodwill value and economic goodwill value It is important to recognise that if the market values of tangible assets and identifiable intangible assets are properly measured and readily available (ie in the absence of the abovementioned distortions), it is entirely appropriate to determine the market value of goodwill as the difference between the observable or ascertainable market value of the subject enterprise and the assessed market values of its identifiable assets. Devoid of measurement errors, the accounting approach and the economic approach to goodwill are inextricably linked. This is because a proper assessment of the market values of tangible assets and identifiable intangible assets necessitates that the cash flows attributable to these asset classes be appropriately established. This results in the residual or excess cash flows (if any) properly representing the excess cash flows or economic income generated by the goodwill of the subject enterprises, which is the main thrust of the economic approach to goodwill. Some academic commentators dismiss the need for there to be excess returns for goodwill to have any material market value, while adopting the accounting approach to goodwill under which the “market value” of goodwill is assessed as a residual. This is contradictory because the way in which goodwill is measured under the accounting approach (ie as a residual calculated by deducting the market value of net identifiable assets from the market value of equity) confirms that goodwill value represents the present value of excess cash flows over and above the cash flows to net identifiable assets, given the basic valuation principle is that the market value of an asset is the present value of expected future cash flows from that asset. In simple terms, material residual goodwill value under the accounting approach (which these commentators support) implies material excess cash flows or returns (which they contradictorily dismiss).

In addition, while the accounting approach to goodwill appears to create an impression that the market value of goodwill must always be determined as a residual (ie after the market values of identifiable assets are assessed), this is not necessarily the case. The subject enterprise may exhibit idiosyncratic characteristics which indicate that it has no material goodwill value9. In this case, there is no real need to assess the market values of identifiable assets to arrive at an apparent conclusion about goodwill value. The value of the subject enterprise is simply vested in its identifiable assets. Footnotes 3

Theoretically, the recognition of internally generated goodwill is prohibited by the accounting standards.

4

This was an accounting standard requirement until relatively recent changes. The inclusion of these items in acquisition costs means that the higher the transaction costs, the higher the acquisition costs, the higher the (residual) accounting goodwill value. This is clearly not corroborated with a corresponding change in the underlying economic goodwill value. It also confuses transaction costs with asset value.

5

See also Chapter 18 for further discussions.

6

For example, a 30% initial acquisition and the remaining 70% final acquisition.

7

The bidder may have assessed the total costs of acquiring the target company on the basis of its average cost of acquisition, but the average cost of acquisition is different from the market value of the target on the acceptance date, with a flow-on impact on the accounting value of goodwill measured on the acceptance date as a proxy for the market value of goodwill.

8

For example, if goodwill value is measured as a residual based on the historical costs of the tangible assets, the empirical results may have reflected accounting value of goodwill, rather than the true market value of goodwill.

9

In many land rich cases, this identification issue is straightforward. For example, in the case of a gold mine which produces a commodity product with no “attractive force”, the mining cash flows are valued using the DCF method of valuation. Gold mining and extraction uses longestablished and well-known methods and processes which could generally be replicated by any competent industry experienced management team. If there are no material other (incremental) cash flows, there is no material goodwill value.

¶7-040 Legal approach Under the legal approach to goodwill, goodwill is generally defined as the attractive force which brings in custom. The legal approach to goodwill differs from the economic approach to goodwill and the accounting approach to goodwill in two important aspects. Firstly, the legal approach to goodwill appears to focus on what constitutes the existence of goodwill rather than the way in which the value of goodwill should be measured. Secondly, under the legal approach to goodwill, there is a distinction between goodwill and sources of goodwill, and the sources of goodwill can be represented by identifiable assets employed by the subject enterprise. In addition, the legal approach to goodwill recognises that the sources of goodwill may vary from case to case and tends to refer to goodwill by the source from which it is derived (eg locational/site goodwill, product goodwill, “name” goodwill, personal goodwill, etc).

The legal concept of goodwill itself has evolved from “nothing more than the probability that the old customers will resort to the old place” (as described by Lord Chancellor Eldon in Crutwell v Lye (1810) 34 ER 129) to being “the attractive force which brings in custom”, as described by Lord MacNaghten in IRC v Muller & Co’s Margarine Ltd (1901) AC 217 (Muller case) or “whatever adds value to a business” as described by Lord Lindley also in the Muller case. Such a notion of “attractive force” effectively encompasses all the benefits or “value-add” derived from other assets. While this all-encompassing notion of “attractive force” was also recognised by the majority of the Full Federal Court in Murry (96 ATC 4703), it was later rejected by the High Court (98 ATC 4585). The decision by the High Court in Murry marked an important departure from the previous allencompassing notion of “attractive force” and recognised [at 4] that goodwill “may derive from identifiable assets of a business, but it is an indivisible item of property, and it is an asset that is legally distinct from the sources — including other assets of the business — that have created goodwill”. It should, however, be noted that while recognising that goodwill was distinct from identifiable assets, Murry recognised that sources of goodwill could be represented by identifiable assets.

¶7-050 A conceptually convergent approach Developing a conceptually convergent approach to goodwill requires recognition of the evolutionary nature of asset values over time and a distinction between: • the existence and materiality of goodwill (ie existence versus materiality) • the gross attraction of custom and net attraction of custom (ie gross versus net) • cases where customers are drawn or pulled to the business and cases where customers are pushed to the business (ie pull versus push), and • sources of goodwill and sources of profit (or, more technically correct from a valuation perspective, sources of net cash flow). Evolutionary nature of asset values Some assets incorporate new attributes/features over time. Such attributes/features can be brought about by both external and internal factors. Once these new features/attributes have been created, irrespective of whether by internal or external factors, they frequently become part and parcel of the assets in question. Example: Vacant land with DA approval Once a vacant lot of land has been granted a development approval (DA), the DA becomes a new attribute of the subject site. Put another way, the DA has pushed the same asset into a higher stage in its ongoing evolutionary development. The DA itself does not represent a new asset which is added to the existing asset in place.

The temporal addition (but sometimes subtraction) of attributes possessed by an asset causes the value of that asset to evolve over time as well. In the above example, the granting of the DA would result in an uplift in the market value of the land asset because on a forward-looking valuation basis this has meant two things. Firstly, the asset is one step closer to the generation of higher cash flows from which the value of that asset should be derived and, secondly, the costs and risks that would be borne prior to the generation of the cash flows have been reduced. The valuation of an asset at a certain point in time should reflect all the value increments/decrements which have been impounded into the value of that asset up to that point in time. Put differently, the valuation of the asset at that time should reflect the stage of the evolutionary process in which the asset in question contemporaneously resides. It is therefore often inappropriate to value an asset at a given point in time by referring to the original state of that asset in the evolutionary process and measuring either the value of the asset in its original state or the cost of reconstructing the asset in its original state. This is particularly so in cases where there is evidence that the value of the asset in question has evolved over

time. Recognising the evolutionary nature of asset values over time is important in assessing the value of goodwill for capital intensive businesses in the presence of other assets, particularly specialised fixed assets employed by that business. This is because without appropriate recognition of the extent to which the value of other assets has evolved, what is often incorrectly considered as an indication of goodwill is actually a manifestation of the accumulated increments in the value of other critical tangible assets of the business (particularly, specialised fixed assets) over time. The adoption of cost-based valuation methodologies, which is backward-looking in nature, in valuing specialised fixed assets incorrectly assumes away the evolutionary nature of asset values over time. Although some of the accumulated increments in the value of identifiable assets over time can be a direct result of conscious management decisions in the past, it is inappropriate to attribute those value uplifts to goodwill such that goodwill represents the outcome of all historical value-accretive conscious decisions by either previous or incumbent management. This is because both the recognition of an asset and the valuation of that asset all depends on the future economic benefits expected to be generated from that asset. To the extent that at some time in the past goodwill represented the ability of management to make value-accretive decisions, the assessed or apportioned value of goodwill at a given point in time should only represent the ability of management to make future value-accretive decisions, not the outcome of the historical decisions of either the previous management or incumbent management. For example, in the case of capital intensive businesses the decision to assemble individual asset classes (land, plant and equipment, labour, etc) to form a going concern business is a conscious management decision. Before that decision is made, the original state of these assets is obviously one in which they stand alone and in isolation of each other. Once the decision has been made and the going concern business turns out to be a profitable venture, being part of the profitable going concern business has effectively moved the individual assets (particularly, the specialised fixed assets) away from their original individual state and placed them in a higher stage of the evolutionary process, resulting in an uplift in the value of these assets as part of the going concern business. From a risk perspective, the ex-ante uncertainty as to whether these assets would be of more economic utility as part of the going concern business has been resolved as a result of the overall business becoming a successful venture, naturally resulting in an enhancement in their values as part of the going concern business. The consequent enhancement in the value of the assets will automatically accrue to the new owner of the business simply by the purchase of the physical assets as part of the going concern business. In this case, the traditional failure to consider the evolutionary nature of asset values over time or, alternatively, reliance on the value of the individual identifiable assets, particularly specialised fixed assets, in their original (standalone) state inevitably results in the artificial existence of “going concern” goodwill value. The reality is the purchaser of the physical assets reaps the benefit of past “goodwill” decisions already impounded in these physical assets. The distinction between the value of an asset as part of a going concern business and the value of that asset on a standalone basis and in isolation of that business is important in land rich cases where the market value of the going concern business needs to be allocated between different asset classes. In these cases, whether the specialised fixed assets are valued as part of the going concern business which is sold or on a standalone basis and in isolation of the subject business generally has significant implications for stamp duty, CGT and other litigation purposes because the two fundamentally different bases of valuation translate into different types of value, resulting in the two different levels of value for what is generically termed as “market value”. Given that the appropriate basis on which specialised fixed assets should be valued for land rich assessment is market value as part of the going concern business which is sold, any valuation approach which has a tendency to assess these assets on a standalone basis and without proper regard to the extent to which their values have evolved over time is flawed because it basically values the wrong assets (ie standalone assets, not going concern assets) for the relevant statutory purposes. Existence versus materiality The legal concept of goodwill reflected in case law generally focuses on the existence of goodwill, not on the way in which the value of goodwill is measured nor its quantum. If the focus is on the mere existence

of goodwill, goodwill can be said to exist in cases where it has no material value. However, from accounting, economic and tax perspectives, differentiating cases where goodwill does not exist from cases where goodwill technically exists, but has no material value, should be of no economic significance. This is because in both cases the value of goodwill should not impact upon the economic behaviour of rational decision-makers or market participants nor the fiscal consequences of transactions. In this regard, it is important to note that the accounting concept of materiality means that generally a “nil” goodwill value should often really be read as “nominal” goodwill value. Consequently, in commercial reality the proper focus should not be on the question “is there goodwill?”, but on a different question, namely: “can material goodwill value exist?” However, most legal cases focus primarily on the existence of goodwill, not on the materiality of goodwill. If the focus is “is there goodwill?”, it is easier to convince a court that the goodwill is valuable (thus land rich stamp duty or CGT liability is reduced, perhaps to nil). The reality is the mere existence of goodwill does not automatically mean that goodwill is of material value and hence of economic significance to rational decision-makers. Approaching goodwill from the commercially practical perspective of materiality produces a different result. When the focus is materiality, not the mere existence of goodwill, the apparent conflict in many cases between the legal view and accounting/economic view of goodwill becomes less divergent. Under the “materiality” approach to goodwill, cases where goodwill does not exist and cases where goodwill exists but has no material value are treated as substantively the same and the term “nominal value” is substituted for “nil”. As the focus is shifted from existence to materiality, the main cause of the general confusion about goodwill is fundamentally the widespread failure to properly identify and/or properly value all tangible and identifiable intangible assets that results in value which is properly attributable to tangible assets (and some identifiable intangible assets) being wrongly attributed to goodwill. Gross versus net Under the legal approach to goodwill, goodwill is generally defined as the attractive force which brings in custom. Given that the economic and accounting approaches to goodwill make a distinction between goodwill and identifiable assets employed by a subject enterprise, which is also recognised in Murry, a conceptually convergent approach to goodwill should treat goodwill as the attractive force which brings in custom net of the custom brought in by attractive forces created by other identifiable tangible and intangible assets. Under the “net attraction of custom” approach to goodwill, the subject enterprise can have significant gross attraction of custom but no material goodwill if either there is no material net (profit) benefit or the attraction of custom is predominantly derived from other (both tangible and identifiable intangible) assets employed by that enterprise. Defining goodwill in a legal sense as the attractive force which brings in the gross, as opposed to net, custom would make goodwill an all-encompassing item and consist of the benefits derived from all the tangible and identifiable intangible assets of the subject enterprise. This is conceptually inconsistent with both the economic and accounting approaches to goodwill. This is because the value of goodwill is double-counted: once in the value of the tangible and identifiable intangible assets, and again as a goodwill asset. In fact, whether goodwill in a legal sense is defined based on gross attraction of custom or net attraction of custom can have a substantial valuation consequence. If goodwill is defined, in a legal sense, to be the attractive force which brings in the gross custom (or custom generating gross revenue), its valuation will be significantly higher than if it is defined as the attractive force which brings in the net custom (or custom generating incremental cash flows over and above the cash flows attributable to identifiable assets). Put another way, the attribution of gross custom to goodwill effectively means that a significant part of the value derived from gross custom which should be attributed to tangible assets and identifiable intangible assets is diverted to, or double-counted as, goodwill. This creates a flawed justification to value tangible assets (particularly, specialised fixed assets) at their exit value or based on cost measures such as ODRC, which may distort the market value of these specialised assets as part of a going concern business.

Defining goodwill on a gross attraction of custom basis can also create a situation where one can conclude that large loss makers (due, for example, to poor incumbent management) have large goodwill (as long as there is large gross custom). This obviously cannot be so at least from a valuation perspective. The business in its current form has “badwill” (ie the ability to destroy value), not goodwill (ie the ability to create value). Defining goodwill on a net attraction of custom basis eliminates such commercially illogical outcomes. Under the “net attraction of custom” approach to goodwill, the sources of goodwill should be the sources of the net attraction of custom, not sources of the gross attraction of custom. The sources of net attraction of custom, in an accounting sense, are unidentifiable assets that are not capable of being individually identified and specifically recognised as an asset in the statement of financial position. These unidentifiable assets from an accounting perspective would usually include factors such as market penetration, effective advertising, good labour relations and a superior operating team. The High Court in Murry appears to have considered sources of goodwill as sources of gross attraction of custom when it notes [at 4]: “It may derive from identifiable assets of a business, but it is an indivisible item of property and it is an asset that is legally distinct from the sources — including other assets of the business — that have created the goodwill.” From a valuation perspective, whether sources of goodwill should be considered as the sources of net attraction of custom or the sources of gross attraction of custom for a subject enterprise is important to the conclusion on the materiality of the value of goodwill for that business. This is because one can form a conclusion that goodwill has material value as long as the sources of goodwill are proved to exist and if the sources of goodwill are considered as sources of gross attraction of custom, one can conclude that sources of goodwill exist even when the entire gross attraction of custom is generated by identifiable assets (intangible or tangible). Example: Goodwill of a water supply infrastructure business Such a commercially illogical outcome can be highlighted in the case of a business owning a monopoly type asset such as water supply infrastructure, which naturally generates custom due to the basic necessity of the output (ie the inherent attribute of the monopoly asset which generates custom), not due to some “active” attractive force of custom supposedly created by factors such as conscious management decisions, or a well-known brand, etc. In this case, if the sources of goodwill are treated as sources of gross attraction of custom, one can conclude that sources of goodwill and hence goodwill (as an attractive force which brings in custom) has material value, whereas the true attractive force which brings in custom is the physical or monopolistic nature of the specialised fixed assets. Considering sources of goodwill as sources of net attraction of custom does not result in this illogical outcome.

Considering goodwill on a net attraction of custom basis highlights the “active” attractive force which brings in custom as a manifestation of the true goodwill as a separate valuable asset of a subject enterprise. On this basis, however, when the subject enterprise has no goodwill or the goodwill has no material value, it does not mean that conscious management decisions, etc, are not still important to the normal functioning of that business (including a monopoly-type business). The assessment of goodwill should be considered in the context of a value apportionment exercise whereby a WBNAB and a WBNAS, once they have agreed on the purchase price consideration for the whole going concern business, proceed with a (commercially hypothetical) exercise of allocating the agreed purchase price consideration between different asset classes (eg land assets and intangible (ie non-land) assets (including goodwill). In that context, when goodwill does not exist or has no material value, this implies that the WBNAB and WBNAS allocate no material portion of the agreed transaction value to the ability of management (or any other factor) to create an incremental “active” attractive force of custom over and above what can be considered as the “passive” attractive force of custom associated with the other assets (eg land assets) or the inherent attributes thereof. Within this value apportionment framework, if the incumbent management/workforce, etc, is only expected to maintain the attractive force which brings in custom already entrenched in other assets, and alternative management teams can be employed at market rates to perform the same task and achieve the same, if not better, operating outcome, no material part of the observable market value of the whole going concern business would be apportioned (by the WBNAB and WBNAS) to goodwill, thereby

rendering, by construction, the market value of goodwill immaterial. Pull versus push The distinction between gross attraction of custom and net attraction of custom is inextricably linked to the distinction between cases where customers are drawn or pulled to the business and cases where customers are pushed to the business. In cases where customers are pushed to the business due, for example, to the basic necessity of the output of the business or the monopolistic nature of the fixed assets of the business (eg water), the business should not have material goodwill in the sense that there is no material incremental “active” attractive force which brings in custom over and above the “passive” attractive force which brings in custom vested or entrenched in the other assets (eg physical assets) of the business (and which passes in its entirety to the new owner of these assets). In this regard, the High Court in Murry noted [at 24]: “The goodwill of a business is the product of combining and using the tangible, intangible and human assets of a business for such purposes and in such ways that custom is drawn to it.” This indicates that the ability of a going concern business to actively (as opposed to passively) attract custom is a factor underpinning the existence of goodwill as an asset independent of identifiable assets employed by the business. The “custom pull” (as opposed to “custom push”) approach to goodwill is consistent with the “net attraction of custom” approach to goodwill in that both approaches allow for the attraction of custom created by other assets employed by the business, which, in turn, concurs with the economic and accounting approaches to goodwill because it distinguishes goodwill from other assets of the business. The “custom pull” which underpins true goodwill value is present, for example, in cases where new customers are drawn to the business and existing customers choose to remain with the business even when the business has been facing material competition. Sources of profit versus sources of goodwill The distinction between sources of profit and sources of goodwill is closely related to the distinction between gross attraction of custom and net attraction of custom and the distinction between custom push and custom pull. The gross attraction of custom to a business can affect the ability of the business to generate revenue and reduce costs, both of which impact upon its overall profitability. This is particularly true of capital intensive businesses owning monopoly or quasi monopoly assets which possess economies of scale characteristics. The ownership of such assets creates, on the one hand, custom push (as opposed to custom pull) due to their monopolistic power, and, on the other hand, scope for costs savings (ie lower average costs) through economies of scale as the volume of custom rises. This is best illustrated by way of an example. Example: Sources of goodwill for an export coal terminal An export coal terminal is a quasi monopoly asset due to its proximity to certain coal mines and because it is economically inefficient (due to the incidence of significant sunk costs) to duplicate another terminal in the vicinity of the existing terminal. Consequently, custom from the nearby coal mines is effectively pushed to the port. At the same time, given that the costs of operating and maintaining the terminal are relatively fixed, the average cost per tonne of coal shipped will be lower as the volume of shipment rises, resulting in higher cash flows and profits. In addition, changes in the volume of throughput at the port are caused by factors which are independent of how the port is operated, such as changes in demand for seaborne coal imports from China and Japan, opening of new coal mines in the vicinity of the port or a new rail link enabling more distant coal mines to have access to the port. In this circumstance, the gross custom and profitability of the business owning the coal terminal is mostly derived from inherent attributes (ie physical location, capacity, etc) of the coal terminal, not by any unique or superior way in which the port is operated. It follows that while the port-owning entity has significant sources of profit, sources of goodwill in the sense of net (pull) attraction of custom do not really exist for that business simply because users of the terminal have little or no other realistic choice. That is, if goodwill is considered on the basis of net attraction of custom and custom pull, a business can have significant sources of profit but no sources of goodwill if the profitability of the business is mostly derived from identifiable assets or the inherent attributes thereof (and if the ownership of these assets brings all the economic benefits with it).

It is necessary to note that many cases on the legal concept of goodwill appear to focus on the attraction of custom which is inherently likened more to the ability of the business to generate gross revenue than its ability to generate net profit (or at least lower costs), whereas the accounting and economic approaches to goodwill focus on the ability of the business to generate excess (net) returns or super profits which inherently take into account both revenue and costs. If both the attraction of custom and the overall profitability of the business are mostly derived from identifiable assets employed by the business (as in the case of the port-owning business), the economic and accounting approaches to goodwill and the “net attraction of custom” approach to goodwill would produce a substantively similar valuation outcome. In cases where sources of cost savings (and hence excess return or super profits) are created by conscious management decisions, etc, rather than the (higher) volume of custom per se, the legal approach to goodwill (even considered on a net attraction of custom basis) and the economic and accounting approaches to goodwill can lead to different conceptual conclusions as to the materiality of the goodwill value.

¶7-060 Temporal transfer of value from goodwill to specialised fixed assets As discussed earlier, although some of the accumulated increments in the value of the specialised assets over time can be a direct result of conscious management decisions in the past, it is inappropriate to attribute those value uplifts to goodwill such that goodwill represents the outcome of all historical valueaccretive conscious decisions by either previous or incumbent management. The outcome of the historical value-accretive management decisions should be impounded in the enhanced value of the specialised fixed assets as at the valuation date, reflecting the temporal transfer of value from (past) goodwill to these specialised fixed assets. Such temporal transfer of value depends on the industry in which the entity operates, the nature of the subject entity, and the point in the evolutionary life cycle at which the entity resides, as at a given valuation date. In cases where an entity is at an important “juncture” or developmental stage as at a given valuation date (eg mine expansion or transport infrastructure development), there could be a “build up” of goodwill value as at that date. This is because at that point a superior incumbent management team can create material value by making value-adding decisions. The “build up” of goodwill value could be gradually released into higher values of specialised fixed assets of the business or other critical assets of the business as and if the entity successfully passes this juncture. The build up of goodwill value and subsequent temporal transfer of value between goodwill and other critical fixed assets of the entity could emerge again when the entity reaches another important juncture in its life cycle. In this regard, the following statement from Murry noted [at 23]: “From the viewpoint of the proprietors of a business and subsequent purchasers, goodwill is an asset of the business because it is the valuable right or privilege to use the other assets of the business as a business to produce income.” The right or privilege to use other assets of the business as a business to produce income is more important when the business reaches important junctures in its life cycle. At these important junctures, a superior management team could create material goodwill value, whereas an incompetent management team could destroy value, creating “badwill” or negative goodwill. In the latter case, a prospective purchaser could reverse the negative goodwill and unlock value by acquiring control of the business and removing the incompetent management team. In the absence of synergies, the ex-post takeover premium actually paid or an ex-ante control premium expected to be paid to remove the incompetent incumbent management team reflects the market value of the assets of the business being managed by reasonably competent management (ie highest and best use principle discussed further below) and the reversal of the previously existent negative goodwill, rather than the goodwill value of the incompetently managed business prior to the change of control and the resultant removal of the incompetent management team.

¶7-070 Goodwill value and the going concern basis of valuation

From a valuation perspective, the goodwill value of a going concern entity is determined by the ability of the entity to actively generate incremental or excess earnings power over and above the earnings power of the identifiable assets of the entity. The earnings power of the identifiable assets needs to be established on a going concern basis, not on a standalone basis in isolation of the going concern business. On a going concern basis, the appropriate basis upon which the earnings power of the identifiable assets is established separately from the earnings power of the business, with the difference (if any) attributable to goodwill value, is one where the identifiable assets are assumed to be managed/exploited by an average competent management team and skilled workforce. This is because if the identifiable assets are exploited on a going concern basis by a poor management team, a hypothetical knowledgeable WBNAB of the assets can replace the poor incumbent management team with at least an average management team and price the assets accordingly. The assumption of the assets being managed by at least an average competent management team is consistent with the highest and best use principle while enabling the delineation between the value of goodwill and the value of identifiable assets on a going concern basis. If the business being valued has a poor incumbent management team who is mismanaging or poorly exploiting the physical land assets, the business has “badwill” (or negative goodwill representing the ability to destroy value as opposed to create value). In this case, what is paid for the business can be lower than the market value of the underlying physical assets which are priced on the basis of these physical assets being managed by at least a reasonably competent management team (ie highest and best use principle). By replacing the poor management with reasonably competent management, a hypothetical acquirer of the poorly run business can reverse the “badwill” (or negative goodwill) and unlock value from the acquired business, although part of the unlockable value might be shared with the minority shareholders of the poorly run business (in the form of a pure premium for control10) to gain control of the entity to effect the management change. In such cases, the payment of the pure control premium does not signify that acquired business has material goodwill value. The absence of material goodwill value not only arises in cases where the business has a poor management team (in which case negative goodwill value exists), but also in cases where the business has a good management team but lacks the opportunities to add real incremental value. If there are only very limited opportunities for the superior incumbent management team to make uniquely value-accretive decisions or the incumbent management team (no matter how talented and experienced they are) to only make routine or compliant decisions that an average management team is expected/required to make, the going concern business should have no material goodwill value (or vice versa). In addition, given that goodwill is the right to use other assets of the business to produce income, if the opportunities to use/exploit the identifiable assets of the business in a unique way to produce material excess earnings power over and above the earnings power of the identifiable assets are limited, the value of that right or goodwill value is not material (or vice versa). Footnotes 10

The pure premium for control can exist even in the absence of synergies arising from the combination of two businesses.

¶7-080 Goodwill value and value of synergies In cases where there is a tangible offer for a going concern business and the offer price reflects a share of the synergistic benefits accruing to the target, there is debate as to whether or not the value of the target’s share of the synergistic benefits should be reflected in the assessed market value of the target’s total assets at the time of the offer and if so, whether or not they should be part of the assessed market value of the physical assets or goodwill. This is a factual matter. If there are many potential bidders, the value of the target’s equity will be bid up to reflect a share of the synergies expected to be created. This is also consistent with empirical evidence

which shows that one of the key economic motives for mergers and takeovers is to create synergistic benefits and for those synergies driven takeovers/mergers the control premium paid to the target reflects a share of the value of the synergies expected to be created. As the value of the target’s equity is bid up, the implied value of the target’s total assets will be higher given that the market value of total assets is equal to the market value of equity plus the market value of interest-bearing debt. The impounding of a share of expected synergistic benefits into the bidder’s consideration for the target’s equity, hence the equity value and the total asset value of the target occurs during the merger/takeover negotiations (subject, of course, to the probability of an agreement being reached) which are often undertaken over a considerable period of time. The uplift in the target’s equity value and total asset value does not instantaneously occur only on the completion of the takeover/merger transaction. This is also consistent with empirical evidence on market participants’ anticipations underpinning the pre-initial offer target share price run-ups and (where applicable) further target share price movements prior to the final offer being announced. Although the impounding of a share of expected synergies into the value of the target’s equity implies a high value of the target’s bundle of total assets during the bidding process, synergies expected from an already existing (in-play) merger or takeover offer are not technically an asset of the target or the bidder as neither (on a standalone basis) has control over this economic resource11. In the case of such a tangible offer, the debate as to whether the value of the target’s share of synergies should be part of goodwill value or part of an evolutionary uplift in the value of specialised fixed assets is fact-specific and raises the following questions: • In the presence of a tangible offer for the business, should the value of the target’s share of synergies be part of goodwill value or specialised fixed asset value if the target business has no material goodwill value prior to the arrival of the offer? • In the absence of a tangible offer for the business, should a share of the possible future (but yet to be identified) synergistic benefits which is expected (by a hypothetical WBNAB and a WBNAS of the business) to be identified and realised by the incumbent highly competent management team of the business be part of goodwill value of the business? In this regard, the ability of the incumbent management team to make value-accretive decisions in the past is relevant to market participants’ expectations of and confidence in its continued ability to make future value-adding decisions. At a broad conceptual level, in cases where the ex-ante control premium is hypothetically applied when assessing the (hypothetical) 100% control value as at a given valuation date on the basis that it reflects a share of the possible future (but yet to be identified) synergistic benefits, or strategic values which could be realised by a hypothetical WBNAB and hypothetically “brought forward” to the valuation date, this exante control premium should have still “resided” in goodwill value as at the valuation date. This is because, as at the valuation date, the transfer of value between goodwill and the core physical assets (or other assets) of the business has not logically occurred, although it should be stressed that there is no “one-size-fits-all” answer to the characterisation of ex-ante control premium. Footnotes 11

This is particularly relevant in CGT/PAT land rich cases as there may be no tangible takeover offer as at the date of assessment.

¶7-090 In a nutshell Despite being subject to extensive debate for many years, there is still much confusion and disagreement about the existence of goodwill and its market value. Conventional analysis indicates that the reasons for such confusion/disagreement include: • differences between the economic, accounting and legal view as to what constitutes goodwill

• measurement inaccuracies that arise in the assessment of the purchase consideration paid and in the assessment of the value of the underlying assets and liabilities • lack of understanding of the conceptual and valuation characteristics of identifiable intangible assets, and • deliberate gaming of goodwill values for accounting or tax/stamp duty purposes. A deeper analysis of the nature of goodwill and the application of a conceptually convergent approach to goodwill reveals several subtle reasons for the confusion/disagreement about goodwill. These include a failure to recognise: • the evolutionary nature of the values of identifiable assets (particularly, specialised tangible assets) over time • the real drivers of “attractive force” and the distinction between the gross and net financial benefits arising out of that attractive force, and • the distinction between “push” (or passive) attraction of custom and “pull” (or active) attraction of custom. The adoption of the conceptually convergent approach to goodwill has important implications for the assessment of the existence and quantum of goodwill in a value apportionment context in which the observable or ascertainable market value of a whole going concern business is practically required to be apportioned between individual asset classes of that business either as a matter of tax/stamp duty legislative requirement or a cross-check for the reasonableness of the assessed values of the individual assets, particularly land or taxable Australian real property (TARP) assets. The application of such an approach in this context will: • recognise the extent to which the value-relevant attributes of other assets employed by a subject enterprise have changed and the values of these assets have evolved over time in assessing the value of goodwill at a certain point in time, as well as the resulting mismatch arising from comparing the (ascertainable) market value of the whole on a going concern basis against the assessed values of tangible assets on a standalone basis in assessing goodwill value • the temporal transfer of goodwill value to the value of specialised fixed assets (or other critical assets of the business) • focus on the materiality of the value of goodwill rather than its mere existence • treat goodwill as the attractive force which brings in custom net of the custom brought in by the attractive forces created by other assets currently employed by the subject enterprise • assess whether the ownership of identifiable assets (particularly physical assets) would bring with it most or all the economic benefits (ie buy the physical assets and get “the whole lot”) • recognise that goodwill should represent the ability of the subject enterprise to actively draw net custom. In cases where custom is pushed to the business due to attributes entrenched or vested in other assets of the business (eg monopoly or quasi monopoly assets), such passive attractive force should not be attributable to goodwill. Conversely, the active attraction of custom of the business which continues even when existing and new customers have a choice of using competing products or services should be attributable to goodwill • consider goodwill on a forward-looking basis in that it is only the continued ability of the subject enterprise to actively attract future custom over and above the future custom brought in by other assets employed by the business that should be attributable to goodwill, and • not consider the existence of profit as a reliable indicator of the materiality of the value of goodwill

without examining the sources from which the profits are derived. This convergent valuation approach to goodwill value is consistent with Murry in that it recognises the line of demarcation between goodwill and identifiable assets of the business. Furthermore, it not only maintains the important line of demarcation between goodwill and the identifiable assets of an entity recognised in Murry, but also supplements this line of demarcation with conceptual valuation tools to establish the distinct boundary between the value of goodwill and the value of identifiable assets of the entity (particularly the specialised fixed assets). This boundary is relevant to the value allocation exercises required for tax and stamp duty purposes.

Re-evaluating Murry from a valuation perspective ¶8-010 Residual valuation uncertainties FC of T v Murry 98 ATC 4585; [1998] HCA 42 is a landmark case because it sets an important precedent for judicial thinking on goodwill in Australia. In Murry, the taxpayer and her husband had conducted what was described as a “taxi business”. The business was comprised of a single taxi and a licence which had been purchased on the open market. The partners subsequently acquired a second taxi licence from the relevant state authority and shares in a taxi cooperative. The partnership leased the second taxi licence to another person, who owned a taxi vehicle, for a monthly fee. Several years later, the partners sold this second taxi licence and shares in the taxi cooperative to two purchasers acting in partnership. The owner of the taxi vehicle who had leased the second taxi licence from the taxpayer and her husband also agreed to sell his taxi vehicle to the same purchasers. The assets of the two co-vendors were entered on one form issued by the relevant state authority. Among other matters, the form contained a reference to the sale price of $189,000 for the licence, which was described as “Goodwill (Licence Value)”. The question before the court was whether the amount received on the disposal of the second taxi licence, or some part of that amount, constituted a payment for goodwill. The majority of the High Court decided that the taxpayer and her husband did not dispose of a business by their disposition of the second taxi licence and the disposition of that taxi licence did not involve the disposition of goodwill. The natural outcome is that the amount received on the disposal of the second taxi licence (or part thereof) did not constitute the payment for goodwill. The judicial conceptual thinking presented in Murry comprises three aspects: • goodwill as property • the sources of goodwill, and • the value of goodwill. However, the focal point of Murry is neither the value of goodwill per se nor the value of the taxi licence (which was observable and not in dispute). The focal point of Murry is whether or not the disposal of the second taxi licence includes the disposal of a business and its goodwill thereby attracting the CGT concession. In simple terms, important judicial conceptual thinking on the value of goodwill was set out in a case where the focus was not on the value of goodwill itself. Thus, it is not surprising that there are residual uncertainties as to the application of the valuation principles set out in Murry to cases where the focus of the dispute is on the value of goodwill. In fact, in explaining why goodwill can be so difficult to define, Murry [at 12] states: “Another reason is that courts have been called on to define and identify goodwill in greatly differing contexts. In some cases, the nature of goodwill as property may be the focus of the legal inquiry. In other cases, the value of the goodwill of a business may be the focus of the inquiry. And in still other cases, identifying the sources or elements of goodwill may be the focus of the inquiry. It is unsurprising that in these varied situations courts have defined goodwill in ways that, although appropriate enough in one situation, are inadequate in other situations.” The new conceptual framework developed in Chapter 7 provides a framework for the valuation of goodwill in cases where the focal point is the value of goodwill (a non-land asset) relative to the value of land assets. The objective of this Chapter is to apply this conceptual framework to address the residual uncertainties arising from the application of the valuation principles set out in Murry.

The conceptual framework developed in Chapter 7 addresses the residual uncertainties in applying Murry by emphasising the distinction between three different questions: • Does goodwill exist? • Do gross attractive forces which bring in custom exist? • Does material goodwill value exist? This is because one typical source of uncertainty and confusion in assessing goodwill value in practice is that when the term “goodwill” is used in any debate, it is not clear whether it is used in signifying the existence of: • purely a goodwill asset which is legally distinct from other assets of the business • gross attractive forces which bring in custom, or • material goodwill value. Without recognising these important distinctions, any debate on goodwill value can be at cross-purposes and unproductive or, at worst, valuation distortions will arise with flow-on tax and stamp duty consequences. In cases where the focus is on goodwill value (eg land rich cases), what really matters is neither a legal demarcation between goodwill and land nor the existence of gross attractive forces which bring in custom collectively created by all the assets of the business. What matters in these cases is whether or not material goodwill value exists. Confusion typically arises when one attempts to “prove” the existence of a legally distinct goodwill asset or the existence of gross attractive forces which bring in custom and implicitly use this proof to support an unproved and entirely different proposition that material goodwill value must exist.

¶8-020 Legal demarcation versus value demarcation The discussions on goodwill as property and the sources of goodwill in Murry focus on a legal demarcation between goodwill and other assets of the business (ie establishing the existence of goodwill in a legal sense). Establishing the existence of goodwill in a legal sense is inherently an inquiry of a legal nature and can therefore be addressed using a legalistic approach. In Murry [at 23], goodwill is defined as: “[The] right or privilege to use the other assets of the business as a business to produce income. It is the right or privilege to make use of all that constitutes ‘the attractive force which brings in custom’. Goodwill is correctly identified as property, therefore, because it is the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means that have attracted custom to it. It is a right or privilege that is inseparable from the conduct of the business.” The way in which “legal” goodwill is defined indicates that in order to prove the existence of goodwill in a legal sense for a given business, one needs to show one of the following: • the business generates and is likely to continue to generate earnings from the use of other assets, or • the business has gross attractive force which brings in custom. Even if the business suffers trading losses, attraction of custom (ie the ability to generate revenue, rather than profits) is still sufficient proof of the existence of goodwill in a legal sense for that business. In this regard, Murry states [at 20]: “A business may have goodwill for legal purposes even though its trading losses are such that its sale value would be no greater than its ‘break-up’ value. Once the courts rejected patronage as the touchstone of goodwill in favour of the ‘added value’ concept, it might seem impossible for a business to have goodwill for legal purposes when its value as a going concern does not exceed the value of

the identifiable assets of the business. But the attraction of custom still remains central to the legal concept of goodwill. Courts will protect this source or element of goodwill irrespective of the profitability or value of the business. Thus, a person who has sold the goodwill of a business will be restrained by injunction from soliciting business from a customer of the old firm even though the value of that firm is no greater than the value of its identifiable assets.” However, cases where the gross attractive forces which bring in custom for the business are generated by tangible assets and/or identifiable intangible assets of the business (eg location of the land assets or patent and trade marks) pose a conceptual challenge to the proof of the existence of goodwill for a business under the legalistic approach. In these cases, the question that naturally arises is that if the gross attractive forces which bring in custom are generated by tangible assets and/or identifiable intangible assets, does this mean that goodwill does not exist? Or does this mean that goodwill is subsumed into these identifiable assets or vice versa? In Murry, the response to these conceptual challenges under the legalistic approach is apparently to invoke the “sources of goodwill” concept and recognise that sources of goodwill include identifiable assets. This is evidenced from Murry [at 24]: “It is common to describe goodwill as being composed of elements. However, goodwill is a quality or attribute that derives inter alia from using or applying other assets of the business. Much goodwill, for example, derives from the use of trade marks or a particular site or from selling at competitive prices. But it makes no sense to describe goodwill in such cases as composed of trade marks, land or price, as the case may be. Furthermore, many of the matters that assisted in creating the present goodwill of a business may no longer exist. It is therefore more accurate to refer to goodwill as having sources than it is to refer to it as being composed of elements. In Muller [(1952) 86 CLR 387 at 399], Lord Lindley referred to goodwill as adding value to a business ‘by reason of’ situation, name and reputation, and other matters and not because goodwill was composed of such elements.” Invoking the “sources of goodwill” concept naturally preserves the legal separability of goodwill from identifiable assets regardless of the true identifiable sources of the gross attractive force which brings in custom. The way in which goodwill is defined in a legal sense and the introduction of the “sources of goodwill” concept creates a legal construct, under which the existence of sources of goodwill signifies the existence of gross attractive forces which bring in custom, which, in turn, is sufficient to prove the existence of goodwill in a legal sense. The proof of the existence of goodwill is virtually unaffected by the true sources of the gross attractive forces (ie identifiable assets). This legal construct can be applied to address the question of whether or not goodwill in a legal sense exists or to draw a legal demarcation between goodwill and other assets of the business. Under this legal construct the proof of the existence of goodwill does not require a view on the relative contribution of the identifiable assets (eg land) and the right to use these identifiable assets of the business as a business to produce income (which is goodwill by legal definition). In addition, when the focus of the inquiry is on the mere existence of legal goodwill, the disappearance of a source of goodwill will not result in legal goodwill ceasing to exist if the attraction of custom still exists, regardless of how much such attraction has diminished following the disappearance of the source of goodwill. In contrast, when the focus of the inquiry is on the existence of material goodwill value, the extent to which the quantum of goodwill value has declined following the disappearance of a source of goodwill becomes relevant.

¶8-030 The inadequacy of the legalistic approach for drawing value demarcation Problems or confusion arise when the legalistic construct (without any modification) is used in drawing the demarcation between the value of goodwill and the value of the critical identifiable assets of the business. Given that value is present value of expected future cash flows, drawing the value demarcation (as opposed to only a legal demarcation) between goodwill and these critical identifiable assets requires a view (and a conceptual framework supporting this view) on the relative contribution of these assets to the earning power of the business. The legalistic construct to establish the existence of legal goodwill is inadequate to achieve a consistent

and informed view on the materiality of goodwill value in cases where the focal point is not the mere existence of legal goodwill, but the existence of material goodwill value (eg land rich cases). This is because for these cases, the gross attractive forces which bring in custom may be derived from the critical identifiable assets (eg specialised fixed assets in land rich cases), naturally warranting the drawing of an appropriate value demarcation (as opposed to legal demarcation) between goodwill and these critical identifiable assets. Attributing the gross attractive forces which bring in custom to goodwill value effectively double-counts the same value-generating element: in the value of the critical identifiable assets and again in the value of goodwill. Characterising goodwill as reflecting the net attractive forces which bring in custom is devoid of this double-counting error, while still preserving the independent existence of legal goodwill.

¶8-040 The appropriate approach to drawing value demarcation Although the focus of Murry is not on the value of goodwill, Murry dedicates a separate section to the discussion of goodwill value. Problems arise in practice when the valuation principles set out in Murry are incorrectly applied to cases where the focus is on the value of goodwill. In the following sections, the conceptual framework developed in Chapter 7 is applied to re-evaluate the application of the valuation principles regarding the valuation of goodwill set out in Murry and, in particular, how they should be applied to cases where the focal point is goodwill value relative to the value of other assets of the business.

¶8-050 Goodwill value and the fortune of a business Murry states [at 48]: “Goodwill has value because it can be bought and sold as part of a business and its loss or impairment can be compensated for by an action for damages. An existing business is the sine qua non of goodwill which cannot exist independently of the business which created and maintained it. The value of the goodwill of a business is therefore tied to the fortunes of the business and varies with the earning capacity of the business and the value of the other identifiable assets and liabilities. It is seldom constant for other than short periods.” The conceptual framework developed in Chapter 7 recognises the need to assess changes in the value of other assets in assessing goodwill value. Changes in the enterprise value (EV) of a business over time cannot be automatically attributed to a decrement or an increment (depending on whether the change in EV is negative or positive) in the goodwill value of the business. This is particularly so in cases where the gross attraction of custom is largely derived from the critical identifiable assets of the business and the change in the EV is caused by the occurrence of external factors which are beyond the control of the management of the business. Example An apartment block is purchased by an entity and brought to account at $10m. Consider the following scenarios one-year subsequent to the purchase: • Scenario 1 — a waste treatment facility is (unexpectedly) approved and being built in the vicinity of the apartment block, resulting in the property value declining by 50% to $5m, and reducing the EV by $5m (other things being equal). • Scenario 2 — a large shopping centre is (unexpectedly) approved and being built in the vicinity of the apartment block, resulting in the property value increasing by 30% to $13m, and increasing the EV by $3m (other things being equal). In both scenarios, it is clear that the change in the EV is driven by the change in property value (not goodwill) and should be attributed to property not goodwill. This arises because, by buying the land asset after one of the above exogenous changes has occurred, the value decrement/increment attaches to, and transfers with the land.

When the business is a passive recipient of custom, and the passive attraction of custom is driven by the ownership of monopolistic or oligopolistic specialised physical assets (eg a monopolistic physical airport facility), it is the value of these physical assets (not goodwill) which is largely tied to the fortunes of the business. Put differently, the occurrence of negative exogenous events (eg reduction or increase in

passenger traffic) which results in the reduction or increase in the cash flow generating capacity of the business should be reflected in the reduction or increase in the value of the specialised physical assets), not goodwill value. Conversely, when a business is, for example, at a critical juncture where the value of the business reflects the ability of the management team to actively add value (eg a business on the cusp of a major expansion where the ability to achieve the expansion on time and within budget is critical), changes in business value may be linked to changes in goodwill value.

¶8-060 Goodwill value and the conventional accounting approach Murry states [at 49]: “When a business is profitable and expected to continue to be profitable, its value may be measured by adopting the conventional accounting approach of finding the difference between the present value of the predicted earnings of the business and the fair value of its identifiable net assets. Admittedly this approach can cause problems in valuing goodwill for legal purposes because the identifiable assets need to be valued with precision. Particular assets, as shown in the books of the business, may be under or over valued and may require valuations of a number of assets and liabilities which may be difficult to value. However in a profitable business, the value of goodwill for legal and accounting purposes will often perhaps usually, be identical.” For a profitable business, goodwill value may be assessed as a residual (ie the difference between the market value of the business and the fair value of its identifiable net assets). However, goodwill is not dictated to be valued as a residual in every single case. Example Using the water supply infrastructure example at ¶7-050, customers have no alternative choice but to use the water supplied by the business due to the basic necessity of its product. In this case, if the question is: “does goodwill in a legal sense exist?”, the answer is positive. But if the question is: ”does it have a material value?”, a priori, the answer should be no. This is because there is no active attractive force which brings in custom. If the a priori view is that goodwill has no material value, there is clearly no need to mechanistically value all the identifiable assets to confirm the obvious. In fact, doing so would unnecessarily introduce valuation errors in valuing the tangible assets and/or identifiable intangible assets, which would flow to the assessed goodwill value under the residual approach. This example highlights the fact that the order in which goodwill value should be assessed is ultimately casespecific.

In addition, there is an explicit recognition from Murry above [at 49] that the reliability of the goodwill value assessed as a residual requires the fair value of the identifiable net assets be assessed with precision. This indicates the inter-dependency between assessing goodwill value and assessing the value of net tangible assets, rather than a mere confirmation of the “one-size-fits-all” method of assessing goodwill value as a residual in every single case.

¶8-070 Goodwill value where goodwill is largely derived from an identifiable asset or assets Murry states [at 51]: “Where the goodwill of a business largely derives from using an identifiable asset or assets, the goodwill of the business, as such, when correctly identified, may be of small value. That is because the earning power of the business will be largely commensurate with the earning power of the asset or assets. If the goodwill of a business largely depends on a trade mark, for example, and the trade mark is fully valued, the real value of goodwill can only reflect a value that is similar to the difference between the business as a going concern and the true value of the net assets of the business including the trade mark. A purchaser of the business will not pay twice for the same source of earning power. The purchaser will not pay a sum that represents the earning power of the trade mark and also a sum that represents the earning power of the business. Nevertheless, the earning power of the trade mark is unlikely to equal the earning power of the business.”

The conceptual framework developed in Chapter 7 makes a distinction between gross and net attraction of custom, and recognises net attraction of custom as a true driver of goodwill value. In cases where goodwill is largely derived from using an identifiable asset or assets such as a trade mark, the net attractive forces which bring in custom attributable to goodwill value must be small. It naturally follows that when drawing value demarcation between goodwill and other assets of a profitable business, it is important to recognise that the attractive forces which bring in custom can be created by both goodwill and identifiable assets or identifiable assets of the business. Goodwill should therefore reflect the net attractive forces which bring in custom. Murry further states [at 52]: “When a trade mark is sold it will continue to be a source of goodwill for the business if the business continues. That is because the trade mark will have built up favourable custom which will or may continue after the trade mark is transferred or expired. Similarly, where goodwill is largely the product of the personality of the owner or one or more employees of a business, much of the goodwill of the business will disappear upon the cessation of the connection between that person or persons and the business. Nevertheless, habit may continue to draw custom although the owner or employee has no further connection with the business. These illustrations also show that, although the goodwill of a business may be derived from one or more sources, it can continue to exist notwithstanding that the sources of the goodwill have gone.” The emphasis of this point is on the continued existence of goodwill, not on the continued existence of material goodwill value. The habitual return of even a single customer after the trade mark is sold or key personnel leave the business is sufficient to support the proposition of the continued mere existence of goodwill. When the focus is on whether or not material goodwill value exists, the extract from Murry above does apparently recognise the disappearance of substantial goodwill value after the cessation of the sources. While the existence of gross attractive forces which bring in custom is both necessary and sufficient for the existence of goodwill in a legal sense, it is only necessary but not sufficient for the existence of material goodwill value.

¶8-080 Goodwill value and unprofitable businesses Murry states [at 50]: “In a business trading at a loss or with less than industry average profitability, there may be a marked difference between the value of goodwill for legal purposes and its value for accounting or commercial purposes. That is because goodwill for legal purposes includes everything that adds value to the business — ‘every positive advantage’ as Wood V-C pointed out in Churton v Douglas [[1901] AC 217 at 224]. As a result, a business may have valuable goodwill in the eyes of the law although an accountant would conclude that the business either has no goodwill or that, if it has, it is of nominal value only. The value of such goodwill may be difficult to assess. Having regard to the likely future of the business, often it may have only nominal value. But in some cases, the value of the goodwill may be more than nominal. It may be the difference between the revenues generated by the relevant advantages and the operating expenses (other than a share of the fixed costs) incurred in earning those revenues.” Murry applies two separate approaches to assessing the value of goodwill. The (incremental) “value-add” approach is applied to profitable businesses whereas the “all-encompassing” approach is applied to nonprofitable businesses. The essence of the incremental “value-add” approach is to value goodwill as the excess value over and above the fair value of net identifiable assets. Whereas the essence of the “allencompassing” approach is to attribute every advantage to goodwill regardless of the true source(s) of such advantage and assess goodwill value accordingly. In assessing the value of goodwill for a currently unprofitable business, it is necessary to make a distinction between a temporarily unprofitable business (eg a cyclically unprofitable business) and a permanently unprofitable business (eg a structurally unprofitable business). The former can still have material goodwill value, depending on the overall present value of the predicted (short-term) negative cash flows/losses and the longer term positive cash flows/profits relative to the fair value of net identifiable assets, whereas the latter should be closed and has no economic goodwill value. In simple terms, a

temporarily unprofitable business may have both legal goodwill and economic goodwill value, whereas a permanently unprofitable business may have legal goodwill prior to it being closed, but no economic goodwill value.

¶8-090 Goodwill value and profitable businesses When the focus is on the materiality of goodwill value for a profitable business, it is important to recognise that an incorrect switch from the incremental “value-add” approach to the “all-encompassing” approach, which only applies to unprofitable businesses in Murry, would have a significant impact on the assessed goodwill value. This is because had “every advantage — every positive advantage” or “everything that adds value to the business” been included in goodwill value, goodwill value would have been equal to the entire “predicted earnings of the business” of the profitable business. In reality, however, the incorrect use of the “all-encompassing” thinking on goodwill when assessing goodwill value for a profitable business occurs in a much subtler form whereby all the incremental benefits or value-add of an established business relative to a new business are attributable to goodwill and reflected in goodwill value. In simple terms, the “all-encompassing” thinking on goodwill is subtly invoked within the application of the incremental value-add to assessing goodwill for profitable businesses. This often occurs in land rich cases, as the specialised physical assets are valued on an incorrect basis (typically, on a standalone or piecemeal basis as opposed to a portfolio basis as part of a profitable going concern business). The adopted incorrect basis of valuation results in any temporal increments or decrements in the value of the specialised physical assets being fully and wrongly attributed to goodwill value. The value increments arise, for example, when the land assets evolve from a mere assemblage of assets on a piecemeal basis at the start of the business to a commercially proven collection of physical assets as part of a profitable going concern business. The temporal increments or decrements in the value of the physical assets also arise as these assets, on a going concern basis, incorporate positive value-enhancing or valuedecreasing attributes due to either internal or external factors. This is the evolutionary nature of asset value recognised in the conceptual framework set out in Chapter 7. The adoption of the incorrect “all-encompassing” thinking in applying the incremental value-add approach conceptually creates an inherent bias towards accepting the existence of material goodwill value for any established profitable businesses even in cases where goodwill largely derives from an identifiable asset or assets such as specialised physical assets in land rich cases, trade marks, or licences as demonstrated in Murry. In addition, in establishing an appropriate value demarcation, as opposed to legal demarcation, between goodwill and specialised physical assets particularly for land rich cases, it is important to make a distinction between past goodwill and forward-looking goodwill mentioned in Chapter 7. To the extent that past goodwill (eg arising from past value-enhancing management decisions) had enhanced the value of the specialised physical assets (whose value enhancement can be transferred to a prospective buyer separate from the current operating business), these value enhancements should be reflected in the assessed market value of the specialised physical assets. Forward-looking goodwill reflects whether or not future management decisions continue to create future increments in the value of the specialised physical assets (and other assets) of the business. The distinction between past goodwill and forward-looking goodwill is important in drawing a value demarcation between specialised physical assets (or other critical identifiable assets of the business whichever the case might be) and goodwill because it helps define the boundary of goodwill value relative to the value associated with the other assets of the business at a valuation date. In particular, past goodwill which has already been reflected in the temporal changes in the market value of other assets of the business should not be included in the boundary of goodwill value, which should only reflect forwardlooking goodwill at the given valuation date. This is also consistent with the forward-looking nature of the market value concept. At a future valuation date, forward-looking goodwill at the current valuation date might have materialised as a result of future value-enhancing active management decisions and become past goodwill whose value would be impounded in the value of, for example, specialised physical assets of the business. This

reflects the temporal transfer of value from goodwill to the other assets of the business that should be recognised in applying the valuation principles set out in Murry in cases where the focus is on goodwill value relative to the value of critical identifiable assets of the business.

¶8-100 In a nutshell The residual uncertainties associated with the application of the valuation principles set out in Murry to cases where the focus is on goodwill value can be systematically addressed using the conceptual framework developed in Chapter 7. In particular, the conceptual framework can be applied to address the uncertainties/confusion regarding: • the inadequacy of the legalistic approach which focuses on the mere existence of legal goodwill in establishing the value demarcation between goodwill and critical identifiable assets of the business • the application of Murry in cases where the gross attraction of custom is largely derived from critical identifiable assets of the business, and • the goodwill value of an established profitable business where the value of its critical identifiable assets has also evolved over time as the business matures. Given the importance of Murry, the resolution or mitigation of the residual uncertainties/confusion is selfevidently necessary to achieve an appropriate tax or stamp duty outcome.

Valuing contract intangibles ¶9-010 A component of the bundle of assets offered for sale The value of land assets relative to non-land assets is the focal point of land rich cases. The two major non-land asset classes are goodwill and identifiable intangible assets. The valuation of goodwill has been discussed in Chapters 7 and 8. This Chapter deals with the valuation of contract intangibles which is often a key category of identifiable intangible assets in land rich cases. The basis upon which the market value of contract intangibles is assessed in this Chapter is one where contract intangibles are assessed as part of a bundle of total assets offered for sale on a going concern basis. The other major asset classes making up the bundle of total assets include goodwill and specialised fixed assets. This basis of valuation recognises that: • the need to determine whether or not a liability to pay stamp duty or CGT typically arises following the sale of a 100% interest or a proportional interest in a going concern business, and • while there is an interrelationship between identifiable intangible assets such as contract intangibles and physical assets within the bundle of total assets, this interrelationship does not mean that this asset class has no separate value from the value of the physical assets. It is also consistent with FC of T v Resource Capital Fund III LP 2014 ATC ¶20-451; [2014] FCAFC 37, in which the Full Federal Court stated [at 51]: “In light of the statutory context and purpose, in our opinion, it is implicit that to determine where the underlying value resides in SBM’s bundle of assets, the market values of the individual assets making up that bundle are to be ascertained as if they were offered for sale as a bundle, not as if they were offered for sale on a stand-alone basis.”

¶9-020 Measuring value contribution The market value of each major asset class as part of the bundle of total assets reflects the contribution of that asset class to the often observable or ascertainable overall market value of the bundle of total assets. The market value of the bundle of total assets is technically the present value of the expected future cash flows from that bundle of total assets discounted at an appropriate discount rate. The discount rate reflects the timing and riskiness of the expected future cash flows. Thus, in theory, an asset class, as part of the bundle of total assets, can contribute to the overall market value of that bundle of assets in three ways: • contributing to generating incremental earnings/cash flows • contributing to bringing forward the timing of the expected cash flows given that the closer the cash flows occur, the higher the present value/discounted cash flow (DCF) value of those cash flows and vice versa, and • decreasing the risk of the projected future cash flows (whereby risk represents the extent to which actual future cash flows can deviate from the expected cash flows) and hence increasing the expected (probability-weighted) cash flows and/or reducing the discount rate applied to the expected cash flows. The end result is increasing the present value/DCF value of those cash flows1. The contribution of an asset class to the market value of the bundle of total assets may arise from one type of value contribution or a combination of the abovementioned types of value contributions. The overall value contribution (or otherwise value detriment) of a contract intangible is case-specific, reflecting the specific terms of the contract and may vary over time, depending on market conditions2. Footnotes

Footnotes 1

As discussed in Chapter 6, the total risk (volatility) of the cash flows is theoretically separated into diversifiable risks and non-diversifiable risks. Diversifiable risks are usually allowed for via probability-weighted cash flows, whereas non-diversifiable risks are allowed for in the discount rate (within the CAPM framework). The presence of contract intangibles can insulate the projected cash flows against both diversifiable risks (thereby reducing, for example, the probability of negative cash flows occurring and hence increasing the probability-weighted (expected) cash flows) and non-diversifiable risks (thereby reducing the discount rate applicable to the (already increased) expected cash flows). The risk-mitigating contribution of contract intangibles referred to thereafter reflects the risk-mitigating contribution in respect of both diversifiable risks and non-diversifiable risks.

2

For example, a contract intangible may reduce the absolute quantum of the projected cash flows, but simultaneously reduce the risk of those cash flows. In this case, the value contribution or value detriment of the contract intangible reflects the net value impact.

¶9-030 Common contract intangibles Contract intangibles have value3 if they make one or a combination of the value contributions described in ¶9-020. The first two types of value contribution are straightforward and well understood among market participants. Example: Above-market rate lease A typical example of contract intangibles contributing to generating incremental earnings/cash flows is an above-market rate lease. Assume that there are two identical unit blocks constructed next to each other, with the same outlook, rental appeal, etc. The first building of six units is leased to a number of tenants on six-month leases at a market rental of $250 per week (plus consumer price index (CPI)). The second building is fully leased to the Department of Defence for seven years at a rental of $300 per week (plus CPI) per unit, which will be reset at market rates after the seven-year period. If these two buildings were to be valued or sold, the second building would be attributed a higher value. The second building has an additional (contract intangible) value arising from the above-market rental of $50 per unit (plus CPI) per week discounted over the seven-year lease period. In simple terms, the higher proceeds from the sale of the second building reflects the sum of the market value of the physical unit block plus the market value of a contract intangible (ie an above-market rate lease).

Example: Special payment arrangements An example of a contract intangible in relation to bringing forward the cash flows is a payment arrangement under which the customer is required to settle invoices fortnightly, instead of monthly which is the industry norm.

Footnotes 3

Over and above the market value of the physical assets, absent the contracts.

¶9-040 Risk-mitigating contract intangibles The third type of contribution (in substance, risk-mitigating contribution) is more subtle and not well understood among market participants. In order to properly understand the risk-mitigating contribution of contract intangibles, it is important to recognise that: • the market value of an asset is technically the present value of expected future cash flows from the asset, and

• as a result, within a bundle of assets, there is technically a direct correspondence between the value contribution of a constituent asset/asset class to the market value of the bundle of assets and the contribution of that constituent asset/asset class to the present value of the total expected cash flows from the bundle of total assets. It is important to emphasise the reference to the contribution of an asset/asset class to the “present value of the total expected cash flows”, rather than to “the total expected cash flows”. There are two reasons why this is so. Firstly, referring to the contribution to “the present value of total expected cash flows” indicates that the value contribution of an asset/asset class may come, for example, from the overall risk-mitigating contribution. A hypothetical WBNAB would pay more for a bundle of total assets which has lower likelihood of actual future cash flows deviating adversely from the expected cash flows, than for a bundle of total assets which has the same expected cash flows but a higher likelihood of the actual future cash flows deviating adversely from the expected cash flows. Secondly, referring to contribution to “total expected cash flows” subtly creates a false impression that the value contribution of an asset/asset class only comes from the fact that a portion of the total forecast cash flows can be attributed to that asset/asset class and only the absolute quantum of the forecast cash flows attributable to an asset/asset class determines the market value of that asset/asset class. Contrary to this false impression, value contribution and hence the market value of a constituent asset/asset class may also arise from the risk-mitigating contribution which can be measured in present value terms as shown later. Example: Long-term take-or-pay contracts Under a take-or-pay contract, the upstream buyer is required to pay for a contracted volume/usage, regardless of the actual volume/usage, thereby allowing the downstream operator of the infrastructure-type assets to be shielded from volume and end product price risk. Common examples of take-or-pay contracts include: • long-term carrier contracts between the telecommunications carriers and the owner of the telecommunications towers • long-term rail haulage contracts between coal and iron ore producers and rail operators • long-term gas transportation contracts, and • a customer foundation contract between an upstream gas producer and a pipeline operator.

¶9-050 Valuing risk-mitigating contract intangibles Risk-mitigating contract intangibles provide long-term predictability and growth of expected cash flows from the bundle of total assets, thereby increasing the present value of the expected cash flows relative to those where the contract intangibles are not in place (other things being equal)4. Thus, this risk-mitigating contribution of the contract intangibles can be assessed as the difference between the present value of the expected cash flows from the bundle of total assets on the basis that the subject contract intangibles are in place and the present value of those expected cash flows on the basis that the subject contract intangibles are not in place5. This method recognises the factual position and commercial reality that the contract intangibles are already in place, working in concert with other constituent assets of the bundle of total assets to jointly generate the projected cash flows from that bundle of total assets, and appropriately focus on the contribution of the contract intangibles factually in place to the present value of the projected cash flows. This method is consistent with the Spencer market value concept in that a WBNAB and a WBNAS would be cognisant of: • the need to assess the market value of the contract intangibles as part of the bundle of total assets offered for sale on a going concern basis • the fact that market value of the bundle of total assets on a going concern basis is the present value of

the expected future cash flows from that bundle of total assets, and • the risk-mitigating and value-enhancing contribution of the contract intangibles to the projected cash flows from the bundle of total assets which can be assessed/quantified in present value terms, and hence form the hypothetically negotiated price/market value of the contract intangibles as part of the bundle of total assets. An alternative line of argument is that the market value of the contract intangibles in place reflects the difference between the present value of the expected cash flows from the bundle of total assets (including the contract intangibles) on a going concern basis and the present value of expected cash flows from the bundle of assets in the absence of the contract intangibles, but allowing for the subject enterprise hypothetically recreating the contract intangibles and the time and opportunity costs associated with such hypothetical recreation. Under this alternative line of argument, the market value of the contract intangibles in place reflects only the difference between the present value of the “contracted” cash flows and the present value of the uncontracted cash flows during the hypothetical recreation period. This alternative line of argument is problematic on three counts: • it is counterfactual in that it ignores the fact that the contract intangibles are already in place and do not need to be hypothetically recreated • it effectively measures the notional economic loss from the hypothetical deprivation of the contract intangibles in place and equalises this notional economic loss to the market value of the contract intangibles in place as part of the bundle of total assets. This is conceptually problematic because the notional economic loss is counterfactual and detracts from the question that needs to be addressed, being the contribution of the contract intangibles factually in place to the present value of the projected cash flows from the bundle of total assets offered for sale on a going concern basis, and • it implicitly assumes that the purchaser of the contract intangibles is also the owner of other constituent assets in the bundle of total assets and detracts from the asset focus and hypothetical WBNAB and WBNAS focus of the Spencer market value concept. In simple terms, the Spencer market value of the contract intangibles in place should be determined by its inherent economic attributes (ie risk-mitigating contribution), rather than the identity of the purchaser. In order to determine the present value of the projected “uncontracted” cash flows in the absence of the contract intangibles, it is necessary to assess: • the quantum and timing of the probability-weighted/expected cash flows in the absence of the contract intangible (ie the risk-mitigating contribution in respect of diversifiable risks) • the possible deviation (particularly to the downside) of the actual cash flows from the expected “uncontracted” cash flows in the absence of the contract intangibles (ie the risk-mitigating contribution in respect of the non-diversifiable risks). Quantifying the risk-mitigating contribution in respect of diversifiable risks (eg the extent of increased exposure to the risk of asset stranding due to technological advancements in the absence of the take-orpay contract) is a highly fact-specific exercise. Quantifying the risk-mitigating contribution in respect of non-diversifiable risks (ie the discount rate impact) is technically complex and also highly fact-specific. The discount rate impact is further discussed below. Footnotes 4

In some cases, a contract intangible reduces both the expected cash flows and the risk to these cash flows. Thus, the risk-mitigating impact may be partially offset, fully offset, or more than offset by the impact of the reduced cash flows, depending on the factual circumstances and contracted terms.

5

Depending on contractual terms, the cash flows directly associated with a contract intangible may be available.

¶9-060 Discount rate impact Given the positive relationship between risk and return, one way to reflect the higher risk nature of the “uncontracted” cash flows is to assess the (higher) discount rate applicable to the “uncontracted” cash flows. This discount rate is then used to assess the present value of the “uncontracted” cash flows, which is, in turn, used to compare against the present value of the “contracted” cash flows with the contract intangibles in place. For providers of infrastructure-type services (eg operators of rail, pipeline and telecommunication towers, etc), the discount rate applicable to the “uncontracted” cash flows in the absence of the risk-mitigating contract intangibles is higher generally because in the absence of the risk-mitigating contract intangibles: • the volatility of cash flows would be higher due to a combination of the: – lack of revenue diversification caused by the single product and highly concentrated customer base of the business – greater exposure to downstream demand volatility and asset stranding risk which is the risk that the asset becomes economically obsolete due to diminishing demand – largely fixed cost structure, and – largely single purpose use of the infrastructure assets, and • the infrastructure assets have a significantly lower value due to their limited alternative uses. They would also have minimal liquidation value due to their specialised nature (eg single purpose and location-specific). The lower the liquidation value of a business’ tangible assets, the lower the level of debt financing the business would be able to secure.

¶9-070 Allowance for lack of marketability Marketability is valuable to investors because the lack of marketability causes investors to miss opportunities to allocate capital to assets with higher returns or to minimise the loss in the value of their investments. Consequently, the required rate of return on an investment or an asset or bundle of assets which is subject to lack of marketability should be higher than that on liquid, but otherwise identical, investments. It follows that a bundle of assets which is subject to lack of marketability would be worth less than a bundle of assets which is appealing to multiple prospective buyers, but otherwise identical. That excess return is usually called the illiquidity premium, which is the extra return to compensate investors for holding investments which are subject to lack of marketability. The illiquidity premium reflects, inter alia, search costs and time delays associated with finding potential buyers for the investment, given the lack of a ready and active market for the asset. In the absence of the contract intangibles, the bundle of assets (particularly, the physical infrastructure assets) may be subject to reduced marketability due to: • the absence of the long-term growing annuity-like characteristics of the cash flows (which are appealing to long-term yield seeking investors in a low yield environment, subject to their assessment of other factors such as counterparty risk), and • the minimal liquidation value of the physical assets which are not shielded against asset stranding risk. The reduced marketability requires a higher incremental return (over and above the capital asset pricing

model (CAPM) rate of return) to compensate for the additional investment risk. While an additional illiquidity premium is theoretically required to be added to the CAPM cost of equity in assessing the present value of the cash flows from the bundle of assets in the absence of the contract intangibles, there has been no theoretical equivalent of the CAPM to allow for lack of marketability as an additional component of risk. The practical approach to allowing for the reduced marketability in the absence of the contract intangibles is to: • assess the present value of the “uncontracted” cash flows using the CAPM cost of equity and after-tax weighted average cost of capital (WACC) assessed in the absence of the contract intangibles, and • apply a discount for lack of marketability (DLOM) to the DCF value assessed above to arrive at the liquidity-adjusted present value of the cash flows in the absence of the contract intangibles. Assessing the size of the DLOM is case and fact-specific and should have regard to available empirical evidence on discounts for lack of marketability. The application of a DLOM reduces the present value of the expected cash flows in the absence of the contract intangibles (other things being equal) and hence increases the difference between the present value of the expected cash flows with the contract intangibles in place and the present value of those cash flows in the absence of the contract intangibles. However, there may be other offsetting factors such as total cash flow reduction and counterparty risk which limits the value attributable to the contract intangibles as part of the bundle of the total assets offered for sale. The potential impact of applying a DLOM is illustrated by way of a simple example set out below. Example: How a take-or-pay contract is valued

Value of Value of business business without with take-or- take-or-pay pay contract contract Expected (after-tax) cash flow ($m)1

10

10

After-tax discount rate (%)

8

10

1252

1003

—

15

125

85

Present value before allowing for lack of marketability ($m) DLOM (%) (say) Present value after allowing for DLOM ($m)

Value of take-or-pay contract ($m)

40

Notes 1 For the sake of simplicity, the absence of the take-or-pay contract is assumed to increase the possible deviation of the actual cash flows from the expected cash flow, but not the expected cash flow itself, and counterparty risk is assumed to be immaterial. The expected cash flow is assumed to be constant in perpetuity. 2 $10m/8%. 3 $10m/10%.

¶9-080 In a nutshell The value contribution of contract intangibles can arise from creating incremental cash flow benefits (including quantum and timing) and risk-mitigating benefits. The risk-mitigating value contribution of a contract intangible can be assessed by comparing the present

value of the “uncontracted” cash flows in the absence of the contract intangibles and the present value of the “contracted” cash flows with the contract intangibles in place. This is a technically complex and highly fact-specific exercise. Value detriment may also arise when, for example, a contract intangible creates some risk-mitigating benefits but also reduces the projected cash flows and involves counterparty risk.

The value of mining information ¶10-010 Why does mining information need to be valued? The value of mining information has direct stamp duty or capital gains tax (CGT) implications for land rich cases1. This is because, prior to the 2013 Federal Budget announcements, mining information was a nonland asset for both federal and state tax/stamp duty purposes, and the value of mining information affected the overall value of non-land assets relative to the value of land assets, which, in turn, determined whether or not the subject business was “land rich” and the consequential stamp duty or CGT outcome. Following the changes announced in the 2013 Budget, mining information and goodwill are now to be included as part of the value of mining rights for income tax purposes. As a result, the value of mining information and goodwill became part of taxable Australian real property (TARP) for CGT purposes. Whether the states will mirror these changes in stamp duty legislation remains to be seen2. This Chapter therefore focuses on the pre-2013 Federal Budget legislative position and the state stamp duty position. In land rich cases, the direct subject of valuation for tax and stamp duty purposes is the market value of the land assets. As a result, where the value of mining information is used as an input to determine the market value of the land assets where land assets are valued as a residual, the appropriate measure of value for mining information in land rich cases should be the market value to ensure a like-with-like consistency in the measure of value between the inputs and the residual (ie the market value of land assets). In land rich cases which involve mining companies, a practical issue when assessing the market value of mining information is the need to assess that value simultaneously with the market value of other critical assets of the mining business, particularly mining rights, mining plant and equipment and, in some cases, transport infrastructure assets. Consequently, assessing the market value of mining information is technically complex, highly fact-driven, and case-specific. Given this high level of complexity, it is necessary to utilise a conceptual framework which provides some general guidance for the thought process which should be applied to individual cases. Footnotes 1

Recent land rich cases which involve the value of mining information are Resource Capital Fund III LP v FC of T 2013 ATC ¶20-386; [2013] FCA 363 and Nischu Pty Ltd v Commissioner of State Taxation (WA) 90 ATC 4391.

2

In Western Australia, for example, the stampable assets include both the mining rights and chattels (the latter would include mining information).

¶10-020 The conceptual framework The appropriate approach to assess the market value of mining information simultaneously with the market value of other critical assets of the mining business (eg mining rights and plant and equipment) is broadly based on the consideration of: • the next best alternative available to a hypothetical WBNAB and a hypothetical WBNAS of each individual asset in the absence of other existing critical assets (including the cash flow impact of the absence of mining information and the time delay and cost of recreating the information in an optimised way) • the additional value which is created by “doing a deal” where the existing individual assets are

coherently combined and simultaneously sold, and • the way in which the additional value is characterised and, where applicable, apportioned among the different individual assets when establishing the market values of these assets as part of the bundle of total assets offered for sale. Identify the true subject of valuation In this context, the appropriate starting point in valuing mining information is to identify the true subject of valuation. In order to correctly identify the true subject of valuation, it is necessary to recognise the conceptual link between the market value of mining rights (representing the value of the ore in the ground net of the capital and operating costs of its extraction) and the market value of mining information3. This conceptual link arises from the fact that the market value of the ore body is, as per the Spencer market value definition, to be established by a WBNAB who should be “knowledgeable” of the characteristics of the ore body. A knowledgeable WBNAB would, by definition, have up-to-date knowledge of the characteristics of the ore body as at the valuation date. However, this does not mean that the WBNAB has possession of the documents, etc, that record the information. Permanent ownership and access rights Consequently, the subject of the mining information valuation exercise is not the knowledge of the mining information, which is possessed by, or gained by, the WBNAB at the time of the notional acquisition of the ore body. The value of mining information includes the permanent ownership of and access rights to the mining information or the physical medium in which the mining information is recorded (eg the database of drilling results and the drill cores) necessary to continue or re-establish mining operations. The market value of this permanent ownership and access rights is notionally separable from the market value of the ore body as at the valuation date, despite the fact that, in reality, the mining rights and the contemporaneous mining information are usually sold together. From a conceptual perspective, the market value of the permanent access rights to mining information depends on seven related factors: • the nature and complexity of the ore body • the stage of development of the mine • the extent to which the historic information is no longer relevant (eg mined out areas, and areas where it is known there are no recoverable resources) • the complexity of the underlying information • the extent to which permanent access to information can be obtained from other sources • the period of time mining would be interrupted until sufficient information can be recreated, and • the cost and time involved in recreation in an optimised way (eg not total recreation but sufficient to continue operations). Level of complexity of the information The more complex the underlying mining information (which depends, inter alia, on the depth and complexity of the ore body, whether the mine is open cut or underground, etc), the more limited the ability of a hypothetical WBNAB of the mining rights to: • subsequently recall the information (provided to them at the time of the (notional) acquisition of the ore body) in sufficient detail to continue to mine, or to minimise the delay before the mine can be reopened, in the absence of the permanent access to the information and the documents it is recorded on, and • subsequently recall4 the subset of the total information set which is relevant/suitable for the optimal forward-looking exploitation of the ore body.

The more limited the ability of a hypothetical WBNAB of the mining rights to do these things, the more important/valuable the post-acquisition permanent ownership of and access to the information in ensuring that the ore body can be exploited in a manner which underpins what is paid for the ore body in the first place. The reverse is also true. For a simple ore body, eg in an open-cut coal mine, a knowledgeable hypothetical WBNAB of the mining rights is more likely to be able to retain, differentiate and subsequently recall the subset of the total underlying mining information required for the future exploitation of the ore body without the need to have permanent ownership of, and access to, the information recorded at least for long enough to continue operating or minimise the interruption of activities while recreating any essential information in a physical medium for subsequent future reference. In this case, the postacquisition permanent ownership of, and access to, the mining information may have relatively limited separate market value and, in particular, little or no time value from the market value of the mining rights. Example In the case of a big and continuous mineralisation for a relatively abundant commodity like coal or iron ore, the need to exactly retrieve the previously known knowledge of the deposit by having permanent access to the mining information may be relatively unimportant for the future exploitation of the ore body. In contrast, in cases where the mineralisation is in thin seams (eg deep underground gold mining), permanent access to the underlying mining information may be very important or even critical to the safe and optimal future exploitation of the ore body.

Developmental stage of the ore body The complexity of the mining information is closely associated with the developmental stage of the ore body. In the early stage of the life cycle of the mine, mining information and the market value of the ore body are inextricably linked. This is because, at this stage, the existence of the positive mining information establishes the ore body as a promising mineral asset. Put another way, the existence of the mining information distinguishes the ore body from “moor and pasture” which, other than for its mineral content, has nominal value and constitutes a defining inherent characteristic of the ore body as a mineral asset. Another way of looking at this conceptually is that, at this early stage, the ability of a hypothetical WBNAB of the ore body to retain the knowledge of the mining information gained at the time of the (notional) acquisition for future recollection and utilisation is significant due to the relatively modest quantum and simplicity of the mining information which has been accumulated (eg the grades and tonnages might clearly indicate that overburden removal and early pit development can proceed). As a result, the ownership of and permanent access rights to the generally limited set of mining information available in this early stage may have relatively little separate market value and, especially, little time value. However, for more complex deposits, as more and more information is gathered about the ore body over time, the quantum and complexity of the information also increase significantly and knowledge of the detailed characteristics of the ore body may require permanent access to at least the immediately relevant and significantly enlarged information set. Thus, the ability of a hypothetical WBNAB of the ore body to be able to operate the mine based on their knowledge but absent permanent access to the significantly enlarged information set should diminish. As a result, the ownership of and permanent access rights to the subset of the underlying mining information which is useful for the future exploitation of the ore body may become much more valuable5. Nature of the ore body Depending on the nature of the ore body (eg bulk commodity or precious metals such as gold), the permanent access to mining information would facilitate a hypothetical WBNAB/owner of the ore body to more optimally exploit the ore body by, for example: • choosing mining areas within the ore body that will yield higher grade ores, increasing the present value of economic returns, and • avoiding/deferring mining in the areas within the ore body that are less economic or uneconomic. Footnotes

Footnotes 3

This can be further complicated in cases where the business also possesses critical plant equipment/infrastructure assets. In these cases, there is technically also a conceptual link between the market value of the critical in situ infrastructure assets and the market value of the mining information. For simplicity, this Chapter only focuses on the more apparent conceptual link between the market value of the ore body and the market value of the mining information.

4

At least long enough for necessary non-permanently accessible information to be recreated.

5

But, obviously, detailed information about mined-out areas would generally be of limited value.

¶10-030 Assessing the market value of mining information When assessing the market value of ownership of and permanent access rights to mining information, there are several technical and practical issues that need to be considered. First, it is important to recognise that the assessment of value for mining information is highly fact-driven and case-specific. Determining the useful subset Second, the historical costs of collecting the mining information may not necessarily reflect the true market value of that information. This is because a knowledgeable WBNAB of the information is prepared to pay only for the portion of the information which is technically or economically useful for the future exploitation of the ore body as at a given valuation date. For example, the WBNAB would not generally pay for the portion of the information about the areas of the ore body which have been mined out. Similarly, detailed information about areas known to contain no mineralisation would be of little value. That is, what is relevant when assessing the market value of mining information is unlikely to be anything like the mechanistic reproduction costs of the entire set of mining information. Depending on the factual circumstances, this optimal information set might only have to cover the next few months’ mining if, during this time period, other information can be recreated by the WBNAB. In addition, the size of the optimal information and the replacement cost associated with it also depends on market participants’ expectations of relevant commodity prices, movements in foreign exchange (FX) rates, operating costs and capex as at the valuation date. This is because these economic factors, inter alia, determine the size of the economically recoverable reserves/resources which, in turn, determines the portion of the original mining information which is technically and economically useful for the future exploitation of the ore body. This further highlights the fact that in cases where there are material changes in the abovementioned factors in the intervening period, the mechanistic reproduction costs of the entire set of mining information may differ significantly from the costs of notionally recreating the useful subset of mining information that is economically useful in the changed environment prevailing as at the valuation date. In simple terms, the relevant measure of market value is not the recreation cost of the entire information base. The relevant consideration in assessing market value is only the costs of recreating sufficient mining information to get the mine back into production in the shortest period of time and economically rational manner, given the prevailing commodity prices and market conditions as at the valuation date. Replacement cost of the useful subset Third, a hypothetical WBNAB would not pay more for the mining information than the economic (optimised) replacement costs of only the “useful” subset of information. The economic replacement cost is comprised of the current physical replacement cost of the “useful” subset of information, plus the present value of cash flows delayed during the reconstruction of that subset of information (and moved out to the end of the mine life). In simple terms, such an economic replacement cost forms a theoretical upper bound for the market value of the mining information.

Bargaining range Fourth, the true market value of the mining information can be materially below the theoretical upper bound because the only “market” for the information is the arm’s length hypothetical owner of the underlying ore body to which the information relates. While the next best alternative to the arm’s length hypothetical owner of the ore body is to incur the economic replacement costs to recreate the necessary “useful” subset of mining information6, in the absence of a transaction with the arm’s length hypothetical owner of the ore body, the arm’s length hypothetical owner of the mining information has virtually no alternative to extract value from the mining information. All of this indicates that the negotiated price for the mining information will generally gravitate well away from the higher bound of the bargaining zone on a full replacement cost and time value basis. Indeed, a valuer needs to consider the negotiating position of both the WBNAB and WBNAS and their next best alternatives. Sharing of value created Lastly, there is an inherent symbiotic relationship between the immediate possession of the necessary useful mining information and other critical assets of the mining business. The combination of the resource base and the permanent possession of the necessary useful mining information (and, where applicable, the plant and equipment) results in the avoidance of a significant loss of time value of money that would have been incurred if the necessary useful mining information had to be reconstructed. It is therefore a matter of logic that a share of the present value of the cash flows that would otherwise be foregone (and/or be long-deferred) during the period of reconstruction should be attributed to the value of the ownership of and permanent possession of the necessary useful mining information, although the size of this relative share is fact-driven and case-specific. The symbiotic relationship between the permanent possession of the necessary useful mining information and the market value of the ore body also manifests itself in the fact that the value of an ore body usually changes over time as new knowledge of the ore body is released through new drilling results (which is, in substance, the temporal accumulation of the mining information set)7. Footnotes 6

It should be noted that, based on the knowledge of the information temporarily gained by a hypothetical WBNAB of the ore body at the time of the (notional) acquisition, the hypothetical WBNAB can identify the “useful” subset of mining information.

7

Obviously, this is also influenced by commodity price and currency fluctuations.

¶10-040 In a nutshell Valuing mining information poses significant challenges which have not been the subject of adequate public technical analysis and discussion, despite its practical necessity and importance for stamp duty and CGT purposes. This Chapter provides a conceptual framework to deal with these challenges. The key components of this conceptual framework are: • What is of value is the ownership of and permanent access rights to relevant forward-looking valueenhancing mining information. Such value should distinguish between being knowledgeable and possessing the detailed records containing the information. • While being highly fact-driven, the key drivers of the market value of mining information are the complexity of the information and the nature and developmental stage of the ore body at the valuation date. • What matters is not the entire set of mining information but only the subset containing necessary forward-looking8 mining information (given the developmental stage of the ore body and relevant

economic factors at the given valuation date). • Sharing the additional value created by crystallising the inherent symbiotic relationship between the readily available ownership of and permanent access to the “useful” subset of mining information and the ore body (and plant and equipment) should, where applicable, be taken into account when assessing the market value of the permanent access rights to the mining information. • The cost and time value of recreating permanently accessible “essential” information is only the upper bound of the WBNAS’s negotiating range. The lower bound of the WBNAS’s negotiating range is to receive no value for the mining information asset. Footnotes 8

This is not to say that historical information is totally irrelevant, but it is likely that parts of it will be a lot less valuable than its replacement cost.

Valuing cash holdings ¶11-010 Is a dollar of cash worth a dollar? The value of cash holdings can affect the tax/stamp duty outcome in two ways. First, the value of cash holdings affects the value apportioned to the total non-land or non-taxable Australian real property (TARP) assets, which, in turn, affects: • the ratio of the market value of TARP assets to the market value of non-TARP assets for capital gains tax (CGT) principal asset tests (PATs) • the value of the land assets which is the numerator of land rich tests under the land rich landholder taxing regime, given the ascertainable or observable total asset value. Second, under the land rich landholder taxing regime, given that cash is generally treated as an excluded asset for the land rich test, the value of cash holdings affects the value of total excluded assets, which, in turn, affects the value of total non-excluded assets, which forms the denominator of the land rich ratio. Going concern basis of valuation Corporate cash holdings are customarily valued at face value (ie a dollar of cash held in an entity is worth a dollar). This customary way of thinking creates a false sense of simplicity and conceals the conceptual complexity of assessing the actual contribution of corporate cash holdings to the whole going concern entity value when apportioning the total entity value between land and non-land assets. In particular, this traditional way of valuing corporate cash holdings fails to recognise that, for a value apportionment exercise that is practically required to be undertaken for stamp duty and CGT purposes, the value of corporate cash holdings should generally be assessed on a going concern basis, instead of a liquidation basis. In fact, the customary way of valuing corporate cash holdings at their face value appears to be grounded in the implicit adoption of the incorrect (liquidation) basis for value apportionment and valuation of cash holdings. While providing an apparently intuitive and non-controversial valuation outcome for cash holdings, this basis of valuation may differ from the commercial reality of the underlying transaction and be inconsistent with the (going concern) basis of valuation on which the market value of the whole entity is assessed. This, in turn, brings into question the appropriateness of the valuation outcome (ie valuing corporate cash holdings at their face value) because it is both intuitive and non-controversial. Expected uses of cash holdings The value of cash holdings in a going concern entity depends on the use to which the cash holdings are expected to be put and/or the contribution of the cash holdings to the whole going concern entity value. Implicit in this is also the importance of the availability of the alternative uses to which the (material) cash holdings can be put, which is, in turn, influenced by the idiosyncratic characteristics of the going concern entity and the industry in which that entity operates at the relevant point in time. At the most basic conceptual and logical level, as the use (or uses) to which cash holdings in a going concern entity are expected to be put are entity (and circumstance) specific, the value contribution of corporate cash holdings can vary across entities at a given point in time, or over time for a given entity. This brings into question the long-established practice of customarily or routinely valuing corporate cash holdings at their face value. Having a proper understanding of the appropriate basis on which value apportionment should be undertaken and the drivers of the value contribution of corporate cash holdings on a going concern basis is directly relevant to the (hypothetical) apportionment of the whole going concern entity value between cash holdings, intangible assets (eg goodwill) (which are non-land assets) and tangible assets (including land assets/TARP assets) for stamp duty and CGT purposes.

¶11-020 The “cashed up” buyer argument The traditional rationale for valuing cash holdings at their face value is that a hypothetical WBNAB of a going concern entity is “cashed up” and would not attach any premium to existing significant cash holdings of an entity. The validity of this rationale needs to be assessed on a case-by-case basis. In doing so, it is important to recognise that: • valuing cash holdings in a going concern entity, valuing cash holdings in an entity in liquidation and valuing cash holdings outside of an entity (ie on a standalone basis) represent entirely different bases of valuation1. Valuing cash holdings on a going concern basis is generally consistent with the commercial reality of the transaction which triggers the assessment of stamp duty and CGT in the first place. As discussed earlier, when cash is held in a going concern entity, it is a matter of commercial logic and fundamental valuation principle that its value (on a going concern basis) should depend on the use to which it is expected to be put, which is in turn entity and industry-specific, and • a WBNAB is not necessarily “cashed up” with large cash resources well in excess of those necessary to undertake the hypothetical purchase. Being “willing” does not automatically imply “cashed up”. The hypothetical WBNAB is merely a willing buyer of assets of that type. In fact, a WBNAB may even be a “willing” buyer of a going concern entity due, inter alia, to the presence of the material cash holdings in that going concern entity. It is also self-evident that in times of financial market dislocations and heightened financing and liquidity risk globally, valuers should not assume away this market reality. Footnotes 1

Valuing cash holdings on a basis other than a going concern basis (ie liquidation basis and standalone basis) requires allowance for any tax payable on (notional) withdrawal/distribution. Thus, the value of cash holdings on this notional realisable basis can be less than their face value.

¶11-030 The rational and knowledgeable buyer/seller argument Even if a WBNAB is “cashed up”, it is reasonable to assume that the WBNAB is rational and knowledgeable. A knowledgeable and rational WBNAB would be aware of the liquidity position and commercial and financial disadvantages of the subject business without the existing material cash holdings and should take them into account when hypothetically conducting the apportionment exercise. A rational WBNAS would also follow a similar thought process when conducting the hypothetical exercise of allocating value to cash holdings on a going concern basis. For a small high-growth company with limited access to external capital markets (eg a junior mining company with a promising undeveloped deposit/development project), in the absence of material existing cash holdings, a WBNAB would have to inject the same amount of cash into the subject business that could otherwise be deployed into other value-enhancing projects or significantly undervalued (cash strapped) companies due to difficulties in obtaining external financing2. That is, the knowledgeable and rational WBNAB (even if “cashed up”) would not ignore this opportunity cost and would recognise the benefits of the existing material cash holdings when conducting the (hypothetical) apportionment of value to cash holdings and other assets owned by the business being acquired at the relevant time. In the case of such a small and high-growth company, the correct focus on the use to which existing cash holdings are put naturally highlights the fact that the market value ascribed to cash holdings in the underlying going concern entity by a WBNAB and WBNAS of the entity (when conducting the commercially hypothetical exercise of value apportionment) can be more than their face value. The customary way of assessing the value contribution of corporate cash holdings is based on offsetting the cash holdings against the negative cash flows of the development project, resulting in an increase in the net present value (NPV) of the project which is equal to the face value of the cash holdings. This

mathematically driven valuation treatment does not reflect the current small and high-growth nature of the business and the importance of the significant cash holdings to the business at its existing stage of development. In particular, this treatment does not take into account the extent to which the presence of the cash holdings de-risks the financing risk of the underlying development project and alters the systematic risk profile and hence the discount rate applicable to the project. The presence of the significant cash holdings is akin to the presence of an internal capital market when access to external capital markets is either limited or involves significant costs given the long-lived highrisk nature of the project for which capital is required. Thus, the value of the internally held significant cash holdings should reflect at least a share of the costs of accessing external capital markets which could be avoided by not having to raise (often at a deeply discounted price) a significant amount of capital externally to meet the financing requirements. Put differently, in the presence of capital market frictions, the market value of such a small and highgrowth business (with good management) comprising a positive NPV development project and a significant amount of cash holdings which is dedicated to that project should exceed the market value of a business comprising exactly the same project but without the cash holdings by an amount which is greater than the face value of the cash holdings. The excess reflects a share of the costs of raising the same amount of capital externally, including significant dilution costs and other transaction costs that could be avoided by the availability of the dedicated significant cash holdings. When the subject of valuation is the total value of the going concern business, the de-risking benefits can be practically captured in the combination of using a lower discount rate to value the development project (under the discounted cash flow (DCF) method) and valuing the significant cash holdings at their face value3. In this case, there is no real practical need to assess the premium that should be ascribed to the face value of the significant cash holdings and the extent to which the value of the development project would decline in the absence of the significant cash holdings4. However, when the focus of the valuation exercise is value apportionment for stamp duty and CGT purposes involving the acquisition of a 100% or proportional interest in a mining company, where the often delicate value boundaries between different land and non-land assets need to be established, it is no longer appropriate to attribute all the de-risking benefits arising from the presence of the significant cash holdings to the mining development project reflecting, inter alia, the value of the associated mining rights which are treated as land assets. There is a practical need to recognise the de-risking benefits and evaluate the extent to which the value of these benefits should be attributed to the significant cash holdings (ie non-land assets) themselves and constitute the premium at which they should be valued. Without such recognition, there is a natural tendency to value the development project in isolation of the cash holdings and inadvertently attribute the full de-risking value uplift to the project, which flows through to the mining rights, distorting the true value relativity between land assets and non-land assets (to which cash holdings belong) for CGT or stamp duty purposes. Footnotes 2

For example, one such difficulty is the general reluctance of traditional lending institutions to provide financing for junior mining companies despite the fact that they possess undeveloped mining projects with material positive NPVs.

3

However, even when assessing total value, these de-risking benefits are usually not articulated or sometimes overlooked.

4

In simple terms, the cash “premium” is offset because financing risk and equity dilution associated with the financing of the development project are partly eliminated.

¶11-040 A WBNAB for the whole entity versus holders of minority interests

A subtle complication that needs to be recognised when assessing the value of corporate cash holdings in a value apportionment exercise for stamp duty and CGT purposes involves the distinction between the value of cash holdings in a going concern entity reflected in the observable prices at which minority interests in the entity are traded in the market place, and the value of the cash holdings from a hypothetical (knowledgeable) WBNAB who is seeking a 100% interest in the going concern business. The extent to which the value of material corporate cash holdings (relative to their face value) is reflected in the observable prices of minority interests (ie share prices) is ultimately a matter of empirical evidence. Available empirical evidence suggests that the value of corporate cash holdings (relative to the face value) varies across types of business and industry. A (hypothetical) WBNAB seeking to acquire a controlling interest in the entity is, in substance, concerned with the value of the underlying collection of assets owned by the entity, rather than the value of the minority interests in that entity per se. Subject to the acquisition being consummated, a (hypothetical) WBNAB can replace the incumbent poor management (if this is the case) with good management which is expected to put the existing cash holdings in the entity to good use. Thus, the value of the existing cash holdings to a hypothetical WBNAB for the whole going concern entity should be no less than their face value. The reduction in the face value of the cash holdings which would otherwise be expected to occur if the poor incumbent management continued being in place and were expected to commit the existing cash holdings to negative NPV projects is reflected in the economic “badwill”5 of and the reduced purchase price for the poorly run business. By replacing the poor management with reasonably competent management, a hypothetical acquirer of the poorly run business can reverse the “badwill” and unlock value from the acquired business, although part of the unlockable value should be shared with the shareholders of the poorly run business (in the form of a pure premium for control6) to gain control of the entity to effect the management change. The real practical complexity arises in cases where the market value of the underlying whole collection of assets is not available or cannot be ascertained with a reasonable level of confidence (eg due to the unavailability of reliable cash flows/earnings forecasts), whereas what is readily available is the aggregated value of minority interests (ie market capitalisation) in the relevant going concern entity. The common practice in this case is to add an estimate of control premium to the aggregated value of minority interests to arrive at an estimate of the market value of a 100% equity interest. The sum of the estimated market value of a 100% equity interest plus the market value of debt is used as an estimate of the market value of total underlying assets which are to be apportioned between different assets (including cash holdings) on a going concern basis. When dealing with this practical complexity, it is important to: • evaluate the idiosyncratic characteristics of the going concern entity in question and their link to the fundamental drivers of the value of corporate cash holdings (discussed further below) that should be taken into account not only by holders of minority interests in the entity (or their professional advisers), but also by a hypothetical (knowledgeable) WBNAB, and • recognise the link between the extent to which the value of the existing cash holdings is reflected in the observable contemporaneous prices of minority interests (which is entity-specific as discussed further below) and the nature of the control premium payable for the going concern entity in order to avoid any double-counting error. For example, if the observable aggregated value of minority interests already reflects the full face value of the cash holdings, applying a pure control premium of, say, 25%7 to the observable aggregated value of minority interests in assessing the market value of the total assets of the going concern entity, including its cash holdings, is double-counting and would overvalue the cash asset, particularly if the characteristics of the business do not support a premium being attached to the cash holdings8. Conversely, if the observable aggregated value of minority interests already reflects the portion of value of cash holdings relative to their face value that would otherwise be destroyed if poor incumbent management continued being in place (and that would be saved/created when the poor incumbent management is replaced as a result of the change in control), then applying the control premium to the aggregate value of minority interests conceptually (at least) values the cash holdings at their face value, which is consistent with the highest and best

use principle. Footnotes 5

That is, a value-destroying ability rather than a value-creating ability of the business on an “as is” basis.

6

The pure premium for control can exist even in the absence of synergies arising from the combination of two businesses.

7

It should be noted that the (ex-ante) control premium applied when assessing the market value of (100%) equity in a going concern entity at a given valuation date (at which date the entity is not subject to any (tangible) takeover bid) may be different in nature from the takeover premium observed from successful takeovers of listed entities on the stock exchanges (refer to Chapter 5 for a detailed discussion on the distinction between ex-ante control premium and expost observed takeover premium). The observed takeover premium itself also varies across entities, industries and over time.

8

In this case, the face value of the cash holdings should be excluded from the aggregate value of the minority interests and a control premium is only applied to the aggregate value of the minority interests net of the face value of the cash holdings.

¶11-050 What drives the value of corporate cash holdings in reality? The drivers of the value of corporate cash holdings can be seen by comparing and contrasting the role of cash holdings for two types of business: small high-growth businesses and large mature low-growth businesses. For a small high-growth business with good management but having limited access to capital markets, significant cash holdings are highly valuable and can be theoretically worth at least their face value, and sometimes more. This is because the agency risk of the existing cash holdings being frittered away in this case is significantly mitigated due primarily to the fact that the existing cash holdings, which are generally less than the total capex required, are likely to be committed to a specific course of actions which are value-enhancing (ie well-specified positive NPV projects). In addition, the presence of the significant but not excess cash holdings partially de-risks the financing risk of the underlying development/growth projects owned by the relevant business. From the perspective of a hypothetical WBNAB of the business, the presence of the significant cash holdings, which can be the outcome of one or multiple capital raisings in the past, would lessen the future need to raise outside equity and incur the direct and significant indirect costs of raising equity in the form of dilution. Put simply, in such cases, the value contribution of the significant cash holdings not only reflects its face value but also a share of the value-enhancing benefits arising from lower financing risk and dilution risk. In contrast, for a mature and low-growth business, corporate cash holdings can be, in substance, “excess” cash, which is subject to income tax, if withdrawn, and to the agency risk of being unutilised or invested in value-decreasing projects if retained. The agency risk associated with holding excess cash is also present for mature large firms with already well-developed access to capital markets. This is because funding investment projects with existing cash holdings rather than raising external capital can avoid capital market scrutiny and increase the likelihood of the cash holdings being invested in valuedecreasing projects. This is exacerbated in the absence of good management which is prepared to return the excess cash to shareholders through share buy-backs and higher dividend payments, rather than invest in value-decreasing projects. In these cases, the cash holdings can be reflected in the market capitalisation representing the aggregated value of minority interests at no more than their face value (if not at a discount)9. As the value of corporate cash holdings is case-specific, caution should be exercised when assessing

their contribution to the whole going concern entity value when conducting a value apportionment exercise. It is important to identify and analyse the idiosyncratic features of the underlying business whose total value needs to be (practically) apportioned between land and non-land assets and evaluate the conceptual links between these entity-specific characteristics and the fundamental drivers of the contribution of cash holdings to going concern entity value. Conceptually, such value contribution of cash holdings is a positive function of: • the amount and quality of the entity’s investment opportunities • the uncertainty of the capex required to realise these investment opportunities • the volatility of the entity’s cash flows from existing operations (if any) • the lack (or virtual absence) of debt-raising capacity • the costs of raising equity or equity-like capital, and • the quality and durability of the incumbent management. Obviously, as these factors vary across businesses, uncritically valuing cash holdings at their face value may result in incorrect values ascribed to individual non-land assets and land assets, and the overall incorrect apportionment of total value between land and non-land assets. However, this theoretically unsound practice tends to be perpetuated by the customary (seemingly intuitively correct) view of “a dollar of cash is worth a dollar”. The challenge with persuading a move away from this long-established simplistic view is the fact that, in many cases, the adoption of such a view has little bearing on the overall valuation outcome when the focus of the valuation exercise is total value assessment. It is only when the often delicate line of value demarcation between different assets needs to be established (ie the focus of the value apportionment exercise for tax/stamp duty purposes) that the fundamental drivers of the value contribution of cash holdings need to be identified and fully understood and the customary and simplistic way of thinking about cash holdings, which substantively overlooks these fundamental drivers, is brought to the fore and critically reviewed. Footnotes 9

It is not a coincidence that firms with significant excess cash can become takeover targets because value can be unlocked (control premium paid) by changing control, reducing the agency risk, and paying the excess cash out of the business to invest in better investment opportunities.

¶11-060 Interaction between cash holdings and goodwill While necessary for value apportionment between land and non-land assets for tax purposes, assessing the value of the de-risking benefits and the extent to which this value can be allocated to cash holdings is a complex and intellectually challenging exercise which is highly case and fact-specific. The difficulty and complexity associated with the task of establishing the delicate value boundary for corporate cash holdings is elevated due to the intricate interaction between the presence of significant cash holdings and economic goodwill for a small and high-growth business. Economic goodwill10 can exist in a situation where at least the following conditions are met: • management is talented and has a proven track record • there is a systematic mechanism in place to retain talented managers (eg direct managerial ownership of shares) and motivate them to identify new opportunities and make profit-maximising decisions for the business, and

• the nature of the business and the structure/nature of the industry in which the business operates entails a sustainable fertile ground for talented mangers to create excess return and value or, in simple terms, “make a difference”. In this regard, if the presence of significant cash holdings enables a competent management to “make a difference”, whether the premium is attributed to cash holdings or goodwill makes little difference to the overall relativity between land and non-land assets, if both cash holdings and goodwill are non-land assets for stamp duty and CGT purposes. It should be noted that, like total value assessment, value apportionment is also time-specific (and circumstance-specific). Example For a gold mining business, after the significant cash holdings have been deployed over time to the optimal use by the good management, the value relativities between cash, goodwill, mining rights and mining infrastructure assets would change in such a way that the value of cash holdings and part of the “past” goodwill value would be impounded into the value of tangible assets such as mining rights (representing ore in the ground) and mining infrastructure assets. That is, there is a transfer of value between these different assets over time.

Footnotes 10

Refer to Chapters 7 and 8 for a detailed discussion on the nature of goodwill and goodwill value.

¶11-070 In a nutshell A value apportionment exercise conducted for stamp duty and CGT purposes warrants more complex and lateral valuation thinking than a total value assessment exercise. Richer and broader valuation thinking inevitably brings into question valuation practices that are virtually taken for granted when the focus of the valuation exercise is total value assessment. The valuation of even the simplest asset, ie corporate cash holdings, is a clear example. When delicate value boundaries need to be established for different land/or TARP assets and non-land or non-TARP assets (including corporate cash holdings) for stamp duty and CGT purposes, it is important to recognise the going concern basis on which value apportionment should be undertaken and cash holdings (in a going concern entity) being valued accordingly. This naturally results in a move away from the fixated valuation thinking of “a dollar of cash in an entity is worth a dollar” to a dynamic valuation thinking which is grounded in the recognition of the fundamental drivers of the role of corporate cash holdings and the variation in the value contribution of corporate cash holdings across different types of business, or across different stages of development for the same type of business. Unfortunately, the necessary shift in valuation thinking when the focus of valuation changes from total value assessment to total value apportionment and, in particular, the need to assess the value of corporate cash holdings on a going concern basis taking into account its fundamental drivers has received almost no attention in practice (although valuation best practices would normally take some time to evolve and be accepted).

The deductive valuation method ¶12-010 The challenges of valuing specialised fixed assets Specialised fixed assets are those assets which do not typically sell on the open market except by way of a sale of the going concern business to which they belong. Specialised fixed assets include, for example, an airport landing facility which is comprised of land and specialised building improvements or a portfolio of specialised fixed assets such as a portfolio of residential aged care facilities (RACFs). Due to their very nature, the market value of many such specialised fixed assets is not directly observable1 and has to be assessed in cases where this is required for tax and stamp duty purposes. It is difficult to apply the direct comparison method in assessing the market value of specialised fixed assets due to the virtual absence of appropriate comparable sales/rental evidence. In the absence of such evidence, two common valuation methods applied in practice are the summation method and hypothetical rent capitalisation method (collectively referred to as the bottom-up valuation method). Summation method Under the summation method, the inherently coherent specialised fixed asset is notionally separated into (specialised) building improvements and (specialised) underlying land and the market value of the whole specialised fixed asset is assessed as the sum of the assessed market value of the building improvements, based on some cost measure such as optimised depreciated replacement cost (ODRC), plus the assessed market value of the underlying land, based on the direct comparison method. Hypothetical rent capitalisation method Under the hypothetical rent capitalisation method, the market value of the whole portfolio of specialised properties is assessed by aggregating the assessed values of the individual properties, whereby the assessed value of each individual property is assessed using the hypothetical rent capitalisation method based on rental evidence in respect of “comparable” individual properties. Key problems The key problem with the application of the bottom-up valuation method in assessing the market value of specialised fixed assets is that they are based on incorrect units of measurement. This is because what is “impounded” into the common valuation metric (eg $ per square metre or $ per bed) used in the bottomup valuation method often does not properly capture what should be reflected in the assessed market value of the specialised fixed assets that needs to be assessed (eg readily income producing nature, economies of scale associated with a portfolio of homogenous assets or clientele effect associated with a portfolio of heterogeneous properties)2. This Chapter discusses an alternative valuation method (the deductive valuation method) that can be used by practitioners in assessing the market value of specialised fixed assets. Footnotes 1

An example of an exception would be hotels, which sometimes trade as land and buildings separately from the hotel business operated on that site.

2

Refer to Chapter 2 for a detailed discussion on units of measurement and property valuations.

¶12-020 What is often overlooked

What is overlooked in dealing with the difficulties in assessing the market value of specialised fixed assets is that in many cases the market value of the entity which employs the specialised fixed assets being valued is observable or ascertainable by calculation. The ascertainable market value of the entity provides an important market-based reference point against which the unobservable market value of the specialised fixed assets can be assessed. Obviously, the observable or ascertainable market value of the entity reflects the total value of all the assets employed by the business. However, except for the value of the goodwill and specialised fixed assets and in some cases, identifiable intangible assets such as long-term take-or-pay contracts, the values of other assets employed by the business such as net working capital assets, readily replaceable/moveable small items of plant and equipment and financial assets are generally readily ascertainable. Thus, whether or not the market value of goodwill (and, where applicable, identifiable intangible assets) is ascertainable given the factual circumstances of the case is relevant to whether or not it is possible to arrive at the assessed market value of the specialised fixed assets from the ascertainable market value of the entity and other assets employed by the entity. This line of conceptual reasoning has understandably received little attention among property practitioners in assessing the market value of specialised fixed assets. There are broadly three main reasons why this is so. Firstly, a view typically adopted by property valuers is that goodwill value (and identifiable intangible value) are within the realm of business valuation, not within the realm of property valuation. Secondly, there is a misconception that the going concern business which employs the specialised fixed assets always has material goodwill value. This misconception stems partly from the confusion as to the difference between the existence of goodwill in a legal sense and the existence of material goodwill value. Thirdly, there is a misconception that goodwill value is dictated to be measured purely as the mathematical residual calculated by subtracting the assessed market value of specialised fixed assets and the assessed market value of other identifiable assets from the ascertainable market value of the total assets. The corollary of these contrasting views is that the market value of specialised fixed assets cannot be assessed as a residual by property practitioners. A wider perspective from which property practitioners can re-assess these contrasting views and explore an alternative approach to valuing specialised fixed assets is based on the recognition that the valuation of specialised fixed assets is a unique area of valuation where business valuation and property valuation are intertwined. This is due to, on the one hand, the availability of market-based business value evidence and, on the other hand, the unavailability of market-based specialised property value evidence. Such an asymmetric availability of market evidence requires an investigation of the link between business value and property value, which, in turn, requires a close examination of business goodwill, if the market value of the specialised fixed assets is to be correctly assessed3. In particular, a correct conceptual understanding of goodwill is important to the questions of whether or not the observable or ascertainable market value of the entity can be used in assessing the market value of specialised fixed assets for a given case. External expertise on business value (including the value of goodwill and other assets of the business) can be sought, when required, to explore the alternative approach to assessing the market value of specialised fixed assets. In addition, the question of which asset could and should be valued first is ultimately case-specific. Examples The value of a (non-specialised) building from which an information technology (IT) company is operating can be directly assessed using comparable sales evidence (which is plenty). In this case, the goodwill of the going concern IT business (if any) can be assessed as a residual as is conventionally the case after correctly valuing the identifiable intangible assets, and subject to crosschecks for commercial reasonableness. In contrast, in the case of a monopoly water utility where customers have no alternative but to use the water supplied by the business due to the basic necessity of its product, a priori, the monopoly utility should have no material goodwill value, because there is no active attractive force which brings in custom.

If a commercial common sense evaluation shows that the a priori view is that goodwill has no material value, there is clearly no need to mechanistically value all the tangible and intangible identifiable assets to confirm the obvious. In fact, doing so would unnecessarily introduce valuation errors in valuing the other

assets, particularly the specialised fixed assets and the identifiable intangible assets, which would flow to an incorrectly assessed goodwill value under the top-down residual approach to goodwill valuation. These examples highlight the fact that the order in which goodwill value should be assessed is ultimately case-specific, depending on, inter alia, the extent to which property value gravitates towards business value and the level of property “intensity” of the business. Example A law firm (LawCo) experiences an increase in property “intensity” over time. The following schematic diagram shows that as the property “intensity” of a business increases, the income from “exploiting” the property assets would naturally gravitate towards the business income4. It naturally follows that property value would gravitate towards business value: Figure 12.1: Property value and property “intensity”

Footnotes 3

Refer to Chapters 7 and 8 for detailed discussions on a comprehensive framework in understanding the nature of goodwill and assessing goodwill value.

4

It should be noted that the income from “exploiting” property assets in the scenario where LawCo acquires and operates from its own property is the notional market rent that LawCo would have had to pay to a third party had it not owned the property.

¶12-030 The deductive valuation methodology In cases where a business has no material goodwill value (or the market values of its goodwill and other assets are separately ascertainable), it is possible to determine the market value of specialised fixed assets using what is referred to as the deductive valuation method. Under the deductive valuation method, the market value of specialised fixed assets is determined from the ascertainable market value of the whole business less the ascertainable market value of other assets (eg contract intangibles, licences, net working capital assets, financial assets, small items of movable plant and equipment, etc), and less ascertained goodwill value.

Obviously, the deductive valuation method may not be applied in all circumstances. The applicability of the deductive valuation method to value specialised fixed assets depends on the ascertainability of goodwill value, which, in turn, depends on the level of property/fixed asset “intensity” of the business. The higher the level of property/fixed asset “intensity”, the more likely the deductive valuation method is applicable to value a specialised fixed asset and vice versa5. In this regard, specialised fixed assets such as airport facilities, mining infrastructure assets and RACFs are typically employed by inherently property/fixed asset intensive businesses which have no material goodwill value, providing support for the application of the deductive valuation method to value these assets for tax and stamp duty purposes. In these cases, specialised fixed assets can be valued on a going concern basis virtually in the same way as a fully leased conventional city building, which is based on the net cash flows expected from the asset, not based on the summation of the separately assessed values of land and buildings under the summation method. This is entirely to be expected in the case of the city building because in the absence of material goodwill value, there is a virtually complete convergence between the market value of the specialised fixed assets on a going concern basis and the market value of the going concern single purpose business which owns these assets (after allowing for the ascertainable values of any other minor assets of the business). In order to correctly understand the link between the business value and property value in such cases, it is necessary to recognise the relevant “business” to which the business value is attached. The relevant business is a going concern business owning and exploiting the specialised fixed assets (eg a conventional central business district (CBD) commercial building or a physical airport facility). This is different from a specific business conducted from an individual physical facility or upon an individual site (eg an accounting practice occupying the CBD building or the retail businesses and duty free shops operating at the airport). In substance, the deductive valuation method is conceptually reconcilable with the DCF valuation method. This is because: • the market value of the total assets including the specialised fixed assets is the present value of the expected cash flows from the collection of assets • the market value of the assets other than the specialised fixed assets (including where applicable, the ascertained value of goodwill) is the present value of expected cash flows from those assets, and • since present values are additive, the difference between the market value of the total assets and the market value of the assets other than the specialised fixed assets must be the present value of the cash flows attributable to the specialised fixed assets, which is by definition the market value of the specialised fixed assets. In fact, given that the market value of the going concern business which employs the specialised assets and the value of assets other than the specialised fixed assets are ascertainable, the deductive valuation method represents the objective thought or mental process a hypothetical knowledgeable WBNAB and a hypothetical knowledgeable WBNAS would adopt in establishing the negotiated price for the specialised assets in their hypothetical negotiations, which is the market value of these assets. In the Spencer case, Griffith CJ said: “In my judgment the test of value of land is to be determined, not by inquiring what price a man desiring to sell could actually have obtained for it on a given day, ie whether there was in fact on that day a willing buyer, but by inquiring ‘What would a man desiring to buy the land have had to pay for it on that day to a vendor willing to sell it for a fair price but not desirous to sell?’ It is, no doubt, very difficult to answer such a question, and any answer must be to some extent conjectural. The necessary mental process is to put yourself as far as possible in the position of persons conversant with the subject at the relevant time, and from that point of view to ascertain what, according to the then current opinion of land values, a purchaser would have had to offer for the land to induce such a willing vendor to sell it, or, in other words, to inquire at what point a desirous purchaser and a not unwilling vendor would come together.”6 The key technical advantages of the deductive valuation method in cases where goodwill value and the

value of other assets of the business are ascertainable arise from the fact that: • it is based on an objectively derived and contemporaneous starting point, being the observable or ascertainable market value of the total assets including the specialised fixed assets • it is based on a conceptual framework which takes into account the nature and market value of goodwill for the going concern business which employs the specialised fixed assets and the interrelationship between goodwill value and specialised fixed asset value, rather than the unsound practice of treating goodwill value as a pure mathematical residual without any proper framework to assess the commercial reasonableness, or lack thereof of that value • it utilises the ready ascertainability of the market values of other assets7 of the business • it is based on the appropriate unit of measurement (being either the market value of the whole specialised fixed asset or the market value of the portfolio of specialised fixed assets on a going concern basis), given that its starting point is the market value of the whole collection of assets on a going concern basis, and • it is based on value inputs from constituent assets, which are consistently measured in market value terms. Footnotes 5

For businesses which are not property and fixed asset intensive, the property assets are usually non-specialised assets, which can be valued using the traditional property valuation methods. It is inappropriate to reject the applicability of the deductive valuation method in valuing the specialised fixed assets of property/fixed asset intensive businesses on the basis of its unsuitability in valuing non-specialised assets of non-property/fixed asset intensive businesses.

6

Spencer v Commonwealth [1907] HCA 82 at 432.

7

In assessing the market value of the other assets of the business, it is necessary to make a distinction between true property (in an economic sense) and pure accounting assets. The former are identifiable, capable of ownership and able to be transferred, whereas the latter are merely accounting entries which may have very different, and sometimes no, future cash flow consequences (with obvious significant value implications). In simple terms, in implementing the deductive valuation method it is the market value of the other assets that is deducted from the market value of total assets.

¶12-040 In a nutshell In cases where the value of goodwill (and other assets) is ascertainable, the deductive valuation method can deal with the problems associated with applying the bottom-up method to value specialised fixed assets, particularly the application of incorrect units of measurement. Specialised fixed assets are usually employed by property/fixed asset intensive businesses, many of which have no material goodwill value. The key advantage of the deductive valuation method is that it employs consistent market value-based inputs and is reconcilable with the theoretically correct DCF valuation method. There is, however, no “one-size-fits-all” answer. The application of the deductive valuation method to assess the market value of specialised fixed assets is ultimately fact-driven and case-specific. If well understood and properly applied, the deductive valuation method can and should be added to the valuation tools of property practitioners.

Re-evaluating deprival value ¶13-010 The basic questions A valuation approach sometimes adopted in practice to assess the market value of specialised fixed assets is based on the concept of deprival value. There are three basic questions that naturally arise from the application of deprival value for tax purposes: • How is deprival value measured? • Does the measured deprival value represent the market value of the subject specialised fixed assets? • If the measured deprival value does not represent the market value of the subject specialised fixed assets, what is the appropriate valuation framework? The objective of this Chapter is to address these questions. The answers have direct implications for the assessment of stamp duty under the landholder taxing regime and the assessment of CGT subject to a principal asset test (PAT). There are, of course, ramifications for other tax and commercial purposes.

¶13-020 How is deprival value measured? Deprival value1 is generally calculated as the lower of replacement cost and recoverable amount, where the recoverable amount is the higher of value in use and net realisable value. Thus, the measurement of deprival value requires three inputs: • replacement costs • value in use • net realisable value, which is market value less costs to sell. At the most basic conceptual level, the way in which deprival value is measured indicates that one of the inputs to the calculation of deprival value involves market value. Consequently, the assessment of market value based on deprival value contains an inherent circularity where deprival value is to be calculated and used to represent market value, whereas market value needs to be assessed to calculate deprival value in the first place. Notwithstanding the inherent circularity in the use of deprival value to represent market value, the measurement of replacement costs and value in use, which are the other two inputs to the calculation of deprival value, poses several conceptual and practical problems. Optimised replacement cost (ORC) The ORC of an asset is the cost of replacing the subject asset’s economic output or service potential, rather than the cost of constructing or acquiring an identical asset (ie the cost of creating a replica of the subject asset). Example If a subject asset has production capacity of 200 units per annum, but production has only ever reached 100 units per annum and is reasonably expected to remain at that level, the replacement cost of that asset should involve the cost of replacing production capacity of 100 units per annum, and not the cost of replacing production capacity of 200 units per annum. That is, the economic service potential of the subject asset is only 100 units per annum despite its physical capacity of 200 units per annum.

The difference between the physical capacity and the contemporaneous economic potential may reflect structural changes and the resulting reduction in the demand for the output in the intervening period

between when the subject asset was constructed and the current date. The contemporaneous theoretical ORC of the asset should reflect the contemporaneous economic service potential and exclude the element of historical over design or over engineering. In addition, even in cases where the economic service potential is still 200 units per annum, as a result of technological advances, there may be more efficient and cheaper ways of constructing an asset which can deliver the same level of economic service potential. The theoretical replacement should reflect these technologic advances, rather than the original method of constructing the asset. ORC is the cost of constructing or acquiring a modern equivalent asset2. The extent to which the replacement cost of an asset can be optimised and hence differ from the pure reproduction cost of the asset varies from case to case, depending on, inter alia, industry-specific technological and other improvements and capital redundancy such as over engineering or excess capacity. In cases where the subject asset is not a brand new asset, measuring the replacement cost of the asset involves allowing for the partly worn out nature of the asset, resulting in the introduction of the optimised depreciated replacement cost concept. Optimised depreciated replacement cost (ODRC) As discussed in Chapter 7, the measurement of ODRC is a conceptually and practically complex exercise, which requires the consideration of a multitude of factors, including: • the identification of the modern equivalent asset. For example, a modern equivalent asset of a subject airport facility, which is in close proximity to the CBD and has well-established transport infrastructure connectivity, cannot be located at a remote site far from the city with virtually no existing transport infrastructure connectivity • allowance for the time delay associated with the physical replacement of the asset, the costs involved and the cash flows foregone during the replacement period and the adverse changes in market dynamics upon the entry of the replacement asset when a hypothetical potential purchaser of the asset chooses to construct a replacement asset, instead of acquiring the asset. An error frequently made in practice is not to allow for the time delay and associated opportunity costs • the (incorrect) tendency to use other conveniently obtained cost measures such as historic costs or indexed historic costs as a proxy for current replacement cost • mean reversion in construction costs • different bases of price quotations used in estimating replacement cost including fluctuations in foreign exchange (FX) rates • allowance for the partly worn state of the subject asset. An error frequently made in practice arises from mechanistically using straight line depreciation which does not recognise the difference between depreciation for accounting purposes and economic depreciation which reflects the decline in the economic utility of the asset • allowance for the useful life of the asset in question and/or changes in the useful life of the asset over time due to internal or external factors. For example, reserve and resource upgrades due to either exploration success or increases in commodity prices would extend the economic lives of the integrated mining and transport infrastructure assets (other things being equal), and • the interplay between optimisation and optionality. Spare capacity created at the time of construction is not necessarily economically redundant capacity, but provides optionality when demand increases over time, particularly when it is significantly more costly to augment capacity at a later stage or when such spare capacity provides a back-up option in emergency situations. Common traps in applying ODRC A common justification for the use of ODRC either as a standalone approach to assessing market value or a cross-check against a measure of market value derived using other approaches is based on the proposition that a hypothetical WBNAB of an asset would pay no more for the asset than the cost of

replacing the subject asset with a modern equivalent asset. Despite sounding intuitive, there are several traps in the practical application of this proposition. First, replacement cost is often incorrectly measured (eg by virtue of excluding the time delay and opportunity costs associated with the replacement of the asset) but the incorrectly measured and significantly understated replacement cost is used as a theoretical upper bound for the assessment of market value. This inherently creates a tendency to reject a correctly assessed estimate of market value if it is greater than the significantly understated theoretical upper bound, resulting in a downward bias on the assessment of market value for the subject asset. The reverse is also true if replacement cost is overstated by not properly allowing for over engineering or over design. Using incorrect depreciation rates which are not reflective of the true physical and economic obsolescence of the specialised asset is also another source of distortion in the measurement of ODRC. Secondly, even when replacement cost is correctly measured, it merely reflects the cost of constructing a modern equivalent asset on a standalone basis and in a different, competitive market dynamic, rather than the value of a monopolistic or quasi-monopolistic asset as part of a mature going concern business. For example, the cost of constructing a new (empty) airport facility may be unconnected with the value of a monopolistic airport facility which is part of a mature profitable going concern airport business3. In simple terms, replacement cost does not reflect the evolutionary nature of asset value and the changing market dynamic arising from the hypothetical replacement exercise. Thirdly, while the correctly measured ODRC (instead of ORC) may provide a theoretical upper bound for the assessed market value of a subject second-hand specialised asset, the next best alternative for a hypothetical WBNAB of the specialised asset is to construct a new asset and hence incur ORC, instead of ODRC, given the absence of the market for second-hand specialised assets and the inability to recreate a second-hand asset. Value in use4 In the context of deprival value as defined, the concept of “value in use” can be interpreted as either: • the market value for existing use which is the value of an asset based on the continuation of its existing use assuming that the asset could be sold as part of a continuing business operation and regardless of whether that use represents the highest and best use, or • the value of the asset to the current owner, which may include some element of special value (or at least the owners’ assessed cash flows and discount rate). Irrespective of how value in use is specifically defined, this concept rests on the common assumption that value is determined by a particular investor or a particular owner (ie existing owner) or a particular class of owners (those who continue the existing use regardless of whether it represents highest and best use or not). In contrast, the market value of an asset is theoretically the present value of the expected cash flows from the asset on the basis of its highest and best use (after allowing for the costs of switching from the existing use to the highest and best use in cases where the two are different). When reliable cash flow forecasts are available, the calculation of present value is based on capital market inputs (eg government bond yield, equity market risk premium, equity beta, etc) used to derive the discount rate. These inputs, which are usually derived from prices at which listed securities are traded in the market place, reflect, in substance, how market prices for securities are established by an average or marginal market participant, not by a particular participant. In addition, the expected cash flows used in assessing the market value of the asset reflect a knowledgeable hypothetical WBNAB’s “best estimate” unbiased forecasts of the future cash flows from the asset, rather than those of a particular buyer or investor or groups of investors who are either overly optimistic, overly pessimistic, or can extract unique synergies from the ownership of the asset, which are unavailable to a representative hypothetical WBNAB. In simple terms, value in use and market value are conceptually different in that: • market value is based on highest and best use, whereas value in use is based on the use confined to

the owner, and • value in use is based on “entity-specific” or “investor-specific” assumptions about discount rate and future cash flows, whereas market value is based on discount rate and future cash flow assessments made by average or marginal (price setting) investors5. Conceptually, if the existing use of an asset is different from (and, by definition, inferior to) the highest and best use of the asset6, the class of market participants who value the asset on the basis of its highest and best use would simply outbid the class of market participants who value the asset on the basis of its (inferior) existing use. In a normal market setting, competition within the former class of market participants would ensure that the price paid for the asset truly reflects its highest and best use. This is in fact consistent with commercial reality. From the buyer’s perspective, the adoption of the market value for existing use concept effectively and unrealistically assumes away the competition among knowledgeable market participants which underpins the properly assessed market value for an asset. The commercial irrationality of the market value for existing use concept where there is a divergence between the existing use and the highest and best use of the asset can also be seen from the seller’s perspective. The adoption of the market value for existing use concept means that a knowledgeable hypothetical seller would have to accept a lower price (reflecting the inferior existing use) even in the knowledge that someone else is prepared to offer a higher price (reflecting the highest and best use of the asset) for the asset. In economic terms, the price which underpins the market value for existing use concept does not practically exist because the market in which the asset is assumed (for valuation purposes) to be traded is conceptually not in equilibrium. Even when the existing use of the asset is the same as its highest and best use, the measurement of value in use is highly problematic given that “entity-specific” or “investor-specific” discount rate and cash flows are not objectively assessed. This is in contrast with market value which is assessed using objectively verifiable market data. Footnotes 1

The deprival value concept has its foundations in an insurance context dating back close to a century ago. Its use became more widespread in the context of tariff determination and asset valuations in (originally public sector owned) infrastructure assets. The concept was contained in Practice Standard 9 (Financial Reporting of Real Property and Related Assets) published in the third edition of the Australian Property Institute (API) Valuation and Property Standards (November 2001). However, it is not included in the subsequent editions of the standards, although the concepts of replacement cost, depreciated replacement cost (including optimisation) and value in use are still contained in API guidance notes on valuations of real property for use in financial reports.

2

There may be, for example, more and/or stricter environmental requirements to recreate the same level of economic service potential. If so, the cost of constructing or acquiring a modern equivalent asset should also reflect the contemporaneous environmental requirements, rather than the environmental requirements at the time the original asset was constructed.

3

Of course, the going concern business is comprised of multiple assets including the monopolistic physical assets, government licences, chattels, net working capital assets, etc. The value of the monopolistic physical assets as part of the going concern business reflects the relative contribution of these assets to the cash flow generating capacity of, and the present value of, the total expected cash flows from the going concern business. In certain cases, the monopolistic characteristics of the physical assets are created by economic factors (barriers to entry, economies of scale and scope, etc) and/or geographic factors (eg being the only airport servicing a particular catchment). In these cases, while the existing government licences are necessary for the normal functioning of the business, their relative contribution to the value of the going concern business would be nominal if the ownership of the monopolistic physical assets allows the owner of the business, in the absence of the existing licences, to simply

apply for and obtain new licences at nominal cost. Put differently, the cash flow generating capacity of the going concern business is predominantly driven by the ownership of the monopolistic physical assets. In other cases (such as bed licences for residential aged care facilities (RACFs)), the licences are tradable in the market place, allowing their contribution to the market value of the whole going concern business to be readily ascertainable. 4

The term “value in use” has different meanings in different contexts.

5

Obviously, market value and value in use would converge if the existing use is considered the highest and best use and the assumptions about discount rate and cash flows adopted by a specific owner or specific group of investors are the market-based assumptions that would be adopted by a representative market participant.

6

Highest and best use in relation to market value is commonly defined as that use from among reasonably probable and legal alternative uses, found to be physically possible, appropriately justified and financially feasible which results in the highest value for the subject asset. In certain cases, determining whether the existing use is the highest and best use is a challenging exercise itself, particularly when the highest and best use can vary over time due to the occurrence of exogenous factors such as technological advances, demographic changes, regulatory changes, industry consolidation, etc. In these cases, highest and best use and market value may need to be concurrently determined.

¶13-030 Does deprival value represent market value? In order to examine whether deprival value represents market value for specialised assets, it is necessary to distinguish these assets from readily replaceable assets such as non-specialised small movable items of plant and equipment and financial assets. For a readily replaceable asset, the replacement cost of the asset should be equal to the (observable) market value of an identical or equivalent asset. Example If a business loses a used Toyota Land Cruiser and that vehicle/asset can be replaced with a similar vehicle/asset traded on the second-hand car market for $40,000, the replacement cost of the asset is $40,000, which is also the observable market value of the same asset.

However, it is conceptually inappropriate to infer from such an outcome that the application of the deprival value approach will always produce the market value of specialised assets for which comparable sales evidence is absent. This is because for those assets, the application of the deprival value approach to assess market value is subject to considerable calculation difficulties as noted above (including implicit use of market value within the deprival value definition). Furthermore, both of the possible (calculable) outcomes from the application of the deprival value approach, being replacement cost and value in use, are subject to significant measurement errors and are conceptually different from market value. In practice, given the difficulties in assessing value in use, the application of the deprival value approach to assess the market value of a specialised asset tends to gravitate towards an ODRC-based approach, which may not in practice be a true ODRC approach, but rather can become an indexed historic costbased approach. In addition, the incorrect conceptual equalisation of deprival value and market value creates an incorrect tendency to equalise the mechanistic calculation of deprival value with the assessment of market value, resulting in a departure from the fundamental valuation tenet that market value of an asset is the present value of the expected future cash flows from the asset. This is particularly evidenced in cases where the present value of the expected cash flows from the asset can be ascertained and is greater than the calculated replacement cost.

In this case, the deprival value is mathematically equal to the calculated replacement cost and proponents of deprival value would assess market value at the calculated replacement cost and typically attribute the excess of the present value of expected future cash flows over the calculated replacement cost to goodwill. Such a valuation treatment is clearly problematic and produces an inherently downward biased estimate of market value because it ignores the present value of the expected cash flow from the assets which is the theoretically correct measure of market value. It is also based on the uncritical adoption of the assumption that the business owning the subject specialised asset has material goodwill value, which does not necessarily hold. The downward bias on the assessed market value is further exacerbated if the replacement cost is significantly understated due, for example, to not taking into account the time delay and opportunity costs associated with the replacement of the asset. Having said that, it is necessary to note that despite its theoretical and technical correctness, the proper implementation of the DCF method depends on the availability of reliable cash flow forecasts7 and the appropriate assessment of the discount rate, including maintaining the consistency between the discount rate and the cash flows to which it is applied8. Adopting biased cash flow forecasts or incorrect value inputs in assessing the discount rate produces a distorted DCF value which should not be used to represent market value9. In addition, in the absence of reliable cash flow forecasts or other contemporaneous evidence of value, alternative methodologies (including the replacement/ODRC method) obviously need to be considered to provide a proxy for market value. The focal point in this case is the correct measurement of replacement cost and ODRC which needs to be supplemented by a correct understanding of the conceptual interplay between true market value, physical replacement cost, economic replacement cost (being physical replacement costs plus time and opportunity costs) and ODRC. Footnotes 7

It is necessary to emphasise that market value is the present value of future cash flows. Thus, what matters is not necessarily the availability of reliable cash flow forecasts for the specialised physical assets per se. The availability of reliable forecasts of total cash flows from the going concern business and the ascertainable market value of other assets of the business may be sufficient to allow the implied present value of the cash flows attributable to (and hence the market value of) the physical assets to be assessed by deduction.

8

For example, after-tax cash flows should be discounted at an after-tax discount rate.

9

By way of example, the accounting standard on impairment testing allows management’s, rather than the market’s, assessment of future cash flows to be used. The standard is silent on whether the appropriate discount rate to be applied is the market’s discount rate or management’s discount rate. If the market rate is used this would offset any management overoptimism reflected in their assessment of future cash flows. This cannot have been the intended outcome as there would be no point in value in use being an allowable value measure for impairment testing if management’s over-optimistic cash flow forecasts could be used, but be offset by a higher market discount rate. Furthermore, there is no objective theoretical model to derive a discount rate to offset these biases.

¶13-040 What is the appropriate valuation framework? The market value of a specialised asset is usually required for tax or stamp duty purposes in cases where the market value of the specialised asset is not observable, but the market value of the entity which owns the asset is ascertainable. The application of the deprival value method which gravitates towards an ODRC-based method inherently overlooks this important reference point, whereas the deductive valuation method discussed in Chapter 12 utilises it. The key differences between the deductive valuation method and the deprival value method in

establishing the market value of specialised assets are: • the focus of the deductive valuation method is consistently market value as all the integers used under that method are based on observable or assessed market values, whereas the focus of the deprival value method is not market value (which is required for tax/stamp duty purposes) and in fact, due to inherent measurement difficulties, gravitates towards replacement costs or ODRC which may be different from market value • the deductive valuation method is readily reconcilable with the theoretically correct DCF method, whereas the deprival value method is not • replacement cost is used under the deductive valuation method as a cross-check for the reasonableness of the assessed market value of the specialised asset. It is not used in deriving the assessed market value in the first place. In contrast, under the deprival value method, replacement cost or ODRC is an input to the derivation of deprival value, which is implicitly but sometimes incorrectly equalised with market value.

¶13-050 In a nutshell Deprival value has been used in assessing the market value of specialised assets for tax purposes. However, there are several problems with the use of deprival value as a measure of market value, which have received little recognition in practice, despite having significant tax consequences. These include both conceptual and practical issues. At the conceptual level, the deprival value method has three main limitations. First, there is an inherent circularity in calculating deprival value to measure market value in the first place. Secondly, the deprival value method departs from the fundamental valuation tenet that the market value of an asset is the present value of the expected cash flows from the asset. Thirdly, the inputs to the calculation of deprival value, particularly depreciated replacement cost (or ODRC) and value in use are not based on market values and are subject to significant potential measurement errors. At the practical level the implementation of the deprival value method tends to gravitate towards an ODRC-based approach under which indexed historical costs are often used as a proxy for ODRC and the time delay for the replacement of the asset and opportunity costs associated with this time delay are often not taken into account, resulting in ODRC being significantly understated. In addition, the practical application of the seemingly intuitive proposition that a hypothetical WBNAB would pay no more for an asset than the cost of replacing the asset should not be taken for granted. It should be treated with caution, particularly when it is applied in assessing the market value of specialised assets, which are either irreplaceable or take such a long time to replace that market conditions and opportunities can change significantly during this time delay. This is principally because replacement cost can only form the true upper bound for market value if it is correctly derived, allowing for, inter alia, the time delay and opportunity costs associated with the replacement of the asset. Adopting a significantly understated upper bound creates an inherent downward bias on the assessed market value of the asset. Furthermore, in cases where the goodwill value of the going concern business which employs the subject specialised asset is readily ascertainable based on the appropriate conceptual framework for an understanding of the economic nature and value of goodwill, a technically sound alternative to the deprival value method is the deductive valuation method discussed in Chapter 12.

Problems with the restoration method ¶14-010 Overview When valuing assets which are an integral part of a larger whole, it is important to consider the purpose or required context of the valuation. In some circumstances, the requirement is to assess the market value of specific assets; in other circumstances, it is to assess the proportion of a larger total value represented by specific assets. The appropriate valuation process in each of these cases may differ. The critical point to note is that the value of the subject assets should be assessed in a consistent way, appropriate for the purpose. An example of an inconsistent approach used by some valuers, which produces inappropriate answers, is the application of the so-called “restoration method” for valuing specialised in-situ land assets. This has the key elements of: • starting with the observed market price for a transaction including both specialised in-situ land assets and other non-land assets (eg mining information) • assessing the value of the non-land assets by calculating the cost of restoring or recreating them “from scratch”, including time value/opportunity cost that would arise during the restoration period, and • calculating the value of the land assets as the residual after the calculated “restoration value” of the non-land assets is deducted from the observed market price for the whole transaction. The application of the restoration method in such a manner contains the following interrelated fundamental errors: • it uses a different basis of valuation for the non-land assets and land assets (it assesses non-land at the maximum cost that an owner of the land assets would pay to recreate the non-land assets (without checking whether total recreation cost “from scratch” is necessary or would be worthwhile to incur, nor whether there is a more cost-effective and timely way of restoring or maintaining operation). In contrast, it does not assess the land assets at the maximum the owner of the non-land assets would pay to obtain the land assets), and • it ignores the inconsistency between the observed market value of the whole (including internal synergies and “going concern” status) and the artificial constructed valuation paradigm for the nonland assets. As a result of these errors, the restoration method inherently understates the assessed value of the land assets.

¶14-020 Valuing the specialised in-situ land assets on an incorrect basis Under the restoration method, specialised in-situ land assets are valued on an incorrect standalone basis in isolation to the existing going concern entity which was sold. In fact, the restoration method depends upon the acceptance of the following counterfactual propositions: • the total cessation of the existing operations • the detachment of the subject land assets from the enterprise which has ceased operating to return to a standalone state • the recreation of the existing selected non-land assets from scratch, and • the recombination of the recreated non-land assets with the subject land assets (on a standalone basis) to recreate from “scratch” the going concern enterprise which has the same utility as the

existing going concern enterprise. The restoration method is based on this artificial non-going concern construct despite the fact that what is actually acquired in a transaction (which triggers the tax/liability stamp duty assessment) is normally an interest in a going concern which is fully operating and functioning. The market value of the subject land assets on a going concern basis should reflect a hypothetical WBNAB’s and a hypothetical WBNAS’s assessment of the relative contribution of these subject land assets to the overall value creation of the existing going concern business which employs these land assets, operating in concert with other assets of the business. Embedded in the restoration method is the flawed proposition that the exact replicas of the selected nonland assets and the existing enterprise would notionally be 100% recreated from scratch, that operations could not be recommenced until full recreation occurred, and the resulting recreation costs of the selected non-land assets would be used to represent market value of these assets and deduce the market value of the subject land assets, irrespective of: • the prevailing market conditions including expected commodity prices, currency movements, etc, as at the valuation date (ie the date of the notional recreation decision), and • whether or not the mechanistic notional full recreation decision given the prevailing market conditions as at that date represents a value maximising decision. The mechanistic notional recreation (“no matter what”) underpinning the application of the restoration method creates an inherent disconnect between the resulting recreation costs which are “pre-supposed” under the restoration method to represent the market value of the selected non-land assets and the true market value of these assets1 which are forward-looking in nature and inherently reflects prevailing market conditions as at the valuation date. Example When commodity prices are expected (as at the valuation date) to remain low, notionally recreating the exact replicas of the selected non-land assets and the existing enterprise (particularly when the existing enterprise involves a large scale, high fixed cost and capital intensive operation) would not likely be a value maximising investment decision (if not to say value destructing investment decision).

In simple terms, the premise underpinning the application of the restoration method in such a manner violates the fundamental economic principle of efficient allocation of scarce resources based on market signals. The acceptance of the restoration method implies that significant resources would be allocated to recreating the exact replicas of the selected non-land assets and the existing enterprise (in terms of scale, output, etc) even when such allocation of resources is at odds with market signals and hence economically inefficient. In addition, by using restoration costs (including consequential/opportunity costs) as a proxy for the market value of the selected non-land assets (putting aside the inherent disconnect between cost and value), the conceptual design of the restoration cost method is susceptible to an inherent mismatch whereby a cost-based input (ie the purported “value” of the selected non-land assets) is subtracted from a market value-based starting point (ie the ascertainable market value of total assets) to arrive at what is claimed to be the market value of the subject land assets. Footnotes 1

In Western Australia the relevant legislation excludes almost all recreation costs associated with (but not true market value of) chattels and also applies duty to the assessed market value of these assets (which would include virtually all mining information).

¶14-030 Inherently inflating the assessed “value” of the selected non-land assets A critical element of the restoration method is the assessment of the “value” of the selected non-land assets based on the costs of recreating these selected non-land assets “from scratch” and using these costs as a proxy for the “value” of these assets. In order to see why this is fundamentally flawed, it is necessary to: • apply the widely accepted definition of market value as a benchmark, and • examine why the purported “value” of the selected non-land assets assessed under the restoration method is different from, and in fact inherently overstates, the true market value of the selected nonland assets. The market value of the selected non-land assets is the price that would be negotiated in an open and unrestricted market between a knowledgeable WBNAB and a knowledgeable WBNAS acting at arm’s length within a reasonable timeframe. The purported “value” of the selected non-land assets assessed under the restoration method significantly overstates the true market value of these non-land assets because this purported value: • is special value, not market value • is a significantly inflated special value • reflects the value-enhancing characteristics of the subject land assets being inappropriately shifted from the subject land assets to the selected non-land assets • is artificially inflated by the inclusion of opportunity costs, and • is artificially inflated by other deficiencies in the measurement of restoration costs. Special value, not market value The opportunity costs conceptualised and quantified under the restoration method represent the profits foregone and the delay in receiving cash flows (in essence, time value rather than market value) by one specific hypothetical buyer (ie the hypothetical purchaser of the subject land assets) with the implicit dominant intention to recreate the non-land assets and hence restore the existing business to the same state. In addition, the costs of recreating the non-land assets as characterised under the restoration method may be only one consideration in the mental thought process adopted by this specific buyer in negotiating a price to pay for the selected non-land assets. It is inappropriate to assume (as implied under the mechanistic application of the restoration method) that the specific buyer would pay for the selected non-land assets at a price equal to the full (pre-tax) costs of recreating these assets. Furthermore, other WBNABs of the non-land assets which do not own the subject land assets could be expected to adopt a materially different mental thought process2 in determining what to pay for the nonland assets in the market place. The assumption of multiple WBNABs represents a better approximation of commercial reality and the definition of market value than the assumption of there being only one specific WBNAB which already owns the subject land assets. Accordingly, the costs of recreating the non-land assets including the opportunity costs, which are peculiar to only one individual hypothetical buyer who was a special purchaser, would not be the determinant of the market value of the selected non-land assets that would be established in the market place. In addition, implicit in the mechanistic application of the restoration method is the assumption of a special seller who owns all the selected non-land assets and is capable of obtaining an offer price for the selected non-land assets at the top end of the bargaining zone based on the costs of recreating the exact replicas of these assets, including consequential/opportunity costs. In simple terms, the purported “value” of the selected value of the non-land assets based on the costs of

recreating the non-land assets from scratch reflects special value, not market value. Significantly inflated special value The mechanistic application of the restoration method does not consider, either implicitly or explicitly, the likely bargaining range within which a hypothetical WBNAB and a hypothetical WBNAS of the selected non-land assets would negotiate a market value for these non-land assets. From the perspective of a hypothetical WBNAS, the restoration method ignores: • the large downside risks that a seller faces in the absence of the subject hypothetical transaction. For example, intangible assets (which largely represent the non-land assets in cases where the restoration method is adopted) are often unique and have little or no value in exchange to anyone else, and • the additional costs the seller of the selected non-land assets would incur if an acceptable sales price is not negotiated. For example, the “owner” of a skilled workforce would incur very large accrued leave payouts and substantial redundancy payments if the skilled workforce could not be “sold”. Under the restoration method, the hypothetical seller is effectively portrayed as being able to extract a monopolist’s best possible asking price from the hypothetical special purchaser. That is, the restoration method assumes the hypothetical seller can effectively demand and obtain an offer price from the hypothetical special purchaser which is equal to 100% of the costs of recreating the selected non-land assets from scratch, including opportunity costs. In simple terms, the restoration method is based on the achievability of a “ransom” price imposed by an unrealistic seller, prepared to make no concession to their asking price despite: • facing the risks of receiving (virtually) no value at all for the selected non-land assets in the absence of a transaction with the sole likely purchaser of the assets, and • facing significant downside costs unless the obligations associated with (at least some of) the selected non-land assets can be off-loaded. From the perspective of the hypothetical special purchaser, the mechanistic application of the restoration method assumes a hypothetical special and anxious purchaser who: • is not knowledgeable of the downside risks and costs borne by the hypothetical seller in the absence of the proposed transaction and their flow-on consequences on the relative bargaining position of the hypothetical seller • only considers the worst theoretical alternative available to that purchaser (being the theoretical total recreation of the selected non-land assets from scratch3) in a hypothetical negotiation artificially dominated and dictated by the seller, and hence only considers an offer price for the selected nonland assets at the top end of the WBNAS’s theoretical bargaining range, and • is prepared to pay a price over the top end of the theoretical bargaining range for the selected nonland assets, with the excess reflecting, for example, the value-enhancing characteristics of the subject land assets being incorrectly shifted to the “measured” restoration costs underpinning the purchase price of the selected non-land assets4. From the perspective of both the hypothetical seller and the hypothetical buyer, this does not represent a rational mental thought process that would be adopted in establishing an agreed price between a WBNAB and WBNAS negotiating a sale. It naturally follows that the resulting outcome of the assumed sellerdictated hypothetical negotiation underpinning the restoration method is far removed from a properly assessed market value. In addition, the restoration method does not recognise that the relative negotiating power of the hypothetical owner of the selected non-land assets and the hypothetical owner of the subject land assets may vary significantly at different times. For example, at low commodity prices, the next best alternative to some cooperative partnership of asset owners may be zero value for all parties. At high commodity

prices, the hypothetical owner of the subject land assets may still generate significant value on a standalone basis even actually recommencing from “scratch”, thus causing the non-land asset to become stranded and of little or no value. The failure of the restoration method to allow for this temporal dynamic further highlights the disconnect between cost and value which is ignored under the restoration method in using mechanistically calculated restoration costs as a proxy for the “value” of the selected non-land assets. Inappropriate value shift Under the construct of the restoration method, at least some of the advantageous characteristics of the subject land assets are inappropriately “shifted” to the value of the selected non-land assets because the value-enhancing attributes of the subject land assets such as access to cheap minerals, low mining costs, close proximity to infrastructure, etc, which underpin the operating margins of the business, directly increases the opportunity costs of profit foregone during the restoration period, and thus the calculated restoration costs of the selected non-land assets. This is conceptually flawed and creates an illogical commercial outcome as: • the value-enhancing attributes of the subject land assets are those attributes entrenched in those land assets and should not be transferred to the selected non-land assets • the selected non-land assets cannot be a substitute for the abovementioned value-enhancing attributes of the subject land assets, but the construct of the restoration method assumes the opposite, and • the value of these value-enhancing attributes of the subject land assets are subsumed into the purported “value” of the selected non-land assets (thereby inflating the purported “value” of the nonland assets and reducing the “value” of the subject land assets calculated under the restoration method), instead of value being allocated to where it should be, which is the assessed market value of the subject land assets. Under the mechanistic application of the restoration method, the greater the value-enhancing attributes of the subject land assets (which should enhance its assessed market value), the higher the opportunity costs of recreating the non-land assets, and hence the higher the purported “value” of the non-land assets given that opportunity costs, including time delay costs, are included in the “measured” recreation costs of the non-land assets. The interplay between the value-enhancing attributes of the subject land assets and net operating margin, which is then effectively used to maximise the opportunity costs under the restoration method, means that the restoration methodology produces an inflated estimate of the value of the selected non-land assets and, as a matter of mathematical logic, a downwards biased measure of the value of the subject land assets. Inclusion of opportunity costs The restoration method is based on the premise that the incremental cash flows that would be lost during the restoration period are entirely attributable to the assumed absence of the selected non-land assets at the beginning of that period5. The logical implication of accepting this proposition is that the cash flows that would be lost in the absence of these non-land assets would be created if the same assets were available at the beginning of the total restoration period. It naturally follows that, under the mechanistic application of the restoration method, the entire incremental cash flows that could have been otherwise generated from the total asset pool during the total restoration period are either wrongly attributed to the selected non-land assets or, alternatively, deferred to the end of the mine life and thus their present value, and the total land value, are artificially reduced. That is, under the restoration method, the selected non-land assets are valued first (or are those assets directly valued) and, due to this artificially imposed sequencing, are valued at no less than their cash replacement costs (their purported minimum value), plus the cash flows foregone/deferred due to the assumed circumstances of all assets no longer operating together until the non-land assets are fully recreated from “scratch”.

In contrast, the subject land assets which are being indirectly valued are: • not guaranteed a minimum value equal to even their cash (depreciated) replacement cost, and • attributed no element of cash flows foregone due to the assumed circumstances of all assets no longer operating together until 100% recreation of the non-land assets occurs from “scratch”. The consequences of these conceptual flaws is that: • whichever asset is valued directly (the selected non-land assets) has its value overstated consequently • whichever asset is valued indirectly as the residual (the subject land assets) has its value understated, and • the opportunity costs, representing the net cash flow foregone or deferred by not having the total asset pool working in concert during the recreation period is wrongly attributed to only a single asset class, namely the selected non-land assets, thereby artificially inflating the purported “value” of these assets, at the expense of the assessed market value of the subject land assets being artificially depressed. Put differently, under the mechanistic application of the restoration method, the notional economic loss associated with not having all the assets operating in concert during the restoration period (the concept of economic loss itself is distinct from the market value concept) is incorrectly subsumed into the purported “value” of the selected non-land assets. Example An enterprise comprises just two assets, asset A and asset B. If asset A is chosen as the subject valuation asset, then under the restoration method, the cost of acquiring and the time value/opportunity cost of having to acquire asset B will be deducted from the total value in order to arrive at the value of asset A. However, if asset B were chosen as the subject valuation asset, the cost of acquiring and the time value/opportunity cost of having to acquire asset A will be deducted from the total value in order to arrive at the value of asset B. The natural mathematical result is that the value attributed to the residual asset will be artificially discounted simply as a result of it being chosen to be the first subject of the valuation exercise. For the purpose of illustrating why this is so, assume asset A and asset B have direct recreation costs of $100 each, recreation time/opportunity costs of $25 (regardless of which asset is notionally recreated), and the total market value of the enterprise is $150. The mechanistic working of the restoration method is as follows:

Table 14.1: Impact of valuation sequencing $ Subject valuation asset is A Total market value

150

Less recreation cost of asset B

(100)

Less recreation time cost of asset B

  (25)

Assessed value of Asset A

    25

Subject valuation asset is B Total market value

150

Less recreation cost of asset A

(100)

Less recreation time cost of asset A

  (25)

Assessed value of Asset B

     25

As it can be seen, the valuation outcome applying the recreation methodology results in the anomalous valuation outcome where the value of an asset depends on the order in which it is valued:

Table 14.2: Valuation anomaly Subject valuation asset

Valuation of A Valuation of B $ $

A

25

125

B

125

25

In addition, because the opportunity cost element of the restoration cost method cannot be dealt with on an individual asset basis, in the circumstances where there is more than one non-land asset, the restoration method is not suitable for determining the value of the individual identifiable non-land assets. In fact, applying the restoration method to assess the purported “value” of an individual asset creates an anomalous situation where the aggregated purported “values” of the individual assets could significantly exceed the purported “value” of the collection of the constituent individual non-land assets as a whole due to common opportunity costs being counted multiple times in the sum of restoration costs/purported “values” of the individual non-land assets. Other measurement deficiencies Putting aside for the moment the fact that the market value of the subject land assets are assessed on an incorrect basis under the restoration method, this method implicitly assumes the hypothetical purchaser of the subject land asset on a standalone basis is mechanistically compelled to recreate from “scratch” an identical enterprise to that existing as at the valuation date without regard to: • cash flow maximising alternatives available to the hypothetical purchaser in exploiting the subject land assets as at the date of the notional recreation decision, and • the selected non-land assets that are either available from alternative sources (eg information lodged with the Department of Mines), or the recreation of which is unnecessary to exploit the subject land assets (eg information about mined-out areas). The implicit assumptions are not appropriate because they fail to take into account the following considerations. • Options available to minimise recreation costs and delays. Even assuming that restoration to the scale of the enterprise existing as at the valuation date represents the best option available, there are also numerous options available as to how this can be achieved to minimise recreation costs and delays. Example In a mining operation, instead of setting about a full restoration process in which the mine is assumed not to produce at all until full pre-existing information and scale can be totally restored, cash flows (and in particular, the present value of cash flows) may be maximised by: • continuing operating on an initial limited scale operation (eg to continue open cut mining along strike, to obtain drill data from regulatory bodies or previous professional advisers rather than do nothing and delay operations until everything is 100% recreated from “scratch”), or • commencing a limited but stepped increased level of production (ie to achieve smaller cash flows sooner), etc. In simple terms, not all costs would have to be incurred before at least some operations could continue and/or recommence. The further away in time costs are incurred, the lower their present value and the higher the present value of net cash flows.

• Skill and knowledge of the buyer. A knowledgeable industry buyer would be able to use their own skill and knowledge to continue operations even on the (unrealistic) assumption the non-land asset has ceased to exist. A simple example is being able to continue to mine a bulk commodity surface deposit or open cut deposit on a “visual” basis.

• Use of available information. Under the definition of market value, the hypothetical purchaser of the subject land assets should be knowledgeable of relevant facts which affect market value assessment (including the temporary knowledge of (but not permanent access to) available mining information). Such temporary knowledge implies that some costs would not have to be incurred again (eg exploration expenditure which confirmed the absence of any resources, information about mined-out areas, information in the public domain, etc) to exploit the subject land assets. Addressing the wrong question In fact, the mechanistic application of the restoration method addresses the wrong conceptual question. That is, in effect, the restoration method asks what would be the time period and costs it would take for a hypothetical purchaser of the subject land assets to recreate the selected non-land assets and to restore the existing going concern business from “scratch”. The relevant conceptual question in the calculation of the restoration costs (putting aside for the moment the inappropriateness of the restoration method) is what are the maximum cash flows that could be derived by the hypothetical purchaser of the subject land assets on a standalone basis? This is a subtly, but importantly different question as it does not confine the analysis to the creation of the existing operations for which contemporaneously existing “other” elements of the enterprise are assumed not to exist. In addition, to the extent that the hypothetical restorer of the selected non-land assets (ie the owner of the subject land assets) would get a tax deduction for the recreation costs6, not allowing for the extent to which these costs are tax-deductible would overstate the measured recreation costs and hence the purported “value” of the selected non-land assets, thereby understating the purported “value” of the subject land assets under the restoration method. Failing the reasonableness test The valuation outcome from the mechanistic application of the restoration method generally fails a basic reasonableness test in that the analysis infers a value for “land assets”, which includes mining properties and plant and equipment often significantly less than even the value attributed to these assets for financial reporting purposes and an unrealistically low value of land relative to total asset value. Footnotes 2

For example, other WBNABs of the non-land assets would consider the negotiating position of the WBNAS of the non-land assets and, in particular, that the next best alternative available to the WBNAS may be to receive no value for the non-land assets.

3

That is, to recreate the selected non-land assets from scratch to the “same state” regardless of the cost/benefit of doing so, or the time it takes, and to the exclusion of all other possible or more likely courses of action.

4

This is akin to the hypothetical owner anxiously accepting a kind of “ransom” asking price from the hypothetical seller, which is not only commercially absurd, but also reinforces the view that the outcome of the restoration method is not Spencer market value.

5

At the simplest level there is no basis to assume this counterfactual “non-existence” scenario.

6

The restoration method is undertaken on the assumption that the hypothetical owner of the entire subject land assets would recreate the selected non-land assets and an enterprise identical to that existing as at the valuation date. In cases where a pro-rata interest in the land holding entity is transacted and hence the market value of the pro-rata share in the subject land assets needs to be assessed, the understatement of the market value of the entire subject land assets assessed using the restoration method due to not allowing for the extent to which the recreation costs are tax-deductible would flow through to the assessed market value of the prorata share in the subject land assets. In addition, from the perspective of a hypothetical

WBNAB and a WBNAS of the pro-rata interest in the subject land assets, the application of the restoration method is even more problematic because the hypothetical WBNAB could not entirely control the notional recreation decision (depending, of course, on the size of the prorata interest involved), underpinning the restoration method.

¶14-040 Comparing the restoration method with the hypothetical development method The hypothetical development method used by real estate valuers attributes a value to land based on: • the selling value of the land developed to its highest and best use (ie completion value) • less: – allowance for the costs to develop the land to the highest and best use – allowance for the profit and risk that would be incurred by a developer of that land. The circumstances in which the hypothetical development method may be reliable in a real estate context, include: • the starting point is generally either raw land or improved land where the existing improvements can be “bulldozed” • the costs of conversion to highest and best use are known with a reasonable level of accuracy which reduces the possibility of identification and estimation errors • the task could be completed by a significant number of potential developers, and • the present value implications of the time value of money and risk are not wrongly attributed entirely to the value of non-land assets. These circumstances do not exist in the hypothetical restoration of some (often) large scale existing operations and the valuation of the subject land assets as part of an existing going concern entity. Put simply, the factual circumstances in which the hypothetical development method is applied are quite different from those in which the restoration method is applied.

¶14-050 The restoration method and negotiation range In a hypothetical (and highly artificial) transaction between an owner of the non-land assets and the owner of the land assets, there would be an extremely wide gap (or negotiation range) between the minimum and maximum possible values for the non-land assets. The minimum would be set by the value that could be obtained from the non-land assets if not sold to the land owner, which is likely to be minimal for many of the assets typically included (eg mining information). The maximum would be the reduction in the value of the total asset value if stripped of the non-land assets. It should be noted that this deprival cost will not exceed the restoration cost, but may be less if there are other alternative approaches to extracting value from the land which produce more value than a full restoration of the non-land assets. Where the negotiated price of the land asset(s) and non-land asset(s) reside within their respective negotiation range, this should reflect relevant comparable sales evidence or objective reliable forecasts of cash flows attributable to the respective asset(s). In the absence of the relevant objective evidence/data, the point within the respective negotiation range which is used as a proxy for market value of the respective asset(s) is ultimately a matter of judgment7, depending on the factual circumstances of the case and reflecting, in principle, a fair and reasonable sharing of the economic benefits from the notional owners of the land and non-land assets cooperating with each other (ie the sharing of the economic benefits of all the assets already operating in concert as factually is the case)8. Footnotes

Footnotes 7

Under the mechanistic application of the restoration method, the assessed market value of the non-land assets is at least at, or exceeds, the upper end of the rational negotiation range (to the extent that the measured so-called restoration cost is greater than the deprival cost).

8

When the total assets of the subject enterprise are comprised of more than two assets (whether they be land or non-land assets) which are difficult to replace and critical to the generation of cash flows/economic benefits by the enterprise, assessing the market value of each critical asset within this framework reflects the sharing of the economic benefits between the multiple assets.

¶14-060 In a nutshell The mechanistic application of the restoration method is susceptible to a number of significant conceptual and measurement errors. The combined effects of these errors result in the assessed market value of the subject land assets being inherently understated.

Re-evaluating the marriage value concept ¶15-010 Marriage value — the issues The concept of marriage value is controversial because there is a significant lack of consensus among valuers as to: • the conceptual understanding of marriage value • whether marriage value exists at all • whether marriage value is only an indivisible subset of the overall ascertainable market value of some portfolio of assets • whether marriage value is an asset in its own right • whether marriage value is a separate and additional asset to goodwill • whether marriage value needs to be quantified and apportioned, and • the appropriate method/framework to quantify and apportion marriage value in cases where it needs to be quantified/apportioned. The answers to these questions are complex and depend on the factual circumstances of the case in question. In simple terms, there is no “one-size-fits-all” answer. The aim of this Chapter is to develop a conceptual framework that provides some guidance for the thought processes that can be applied to deal with issues associated with marriage value in a given case. This conceptual framework is closely linked to the conceptual framework for understanding the economic nature of goodwill and goodwill value discussed in Chapter 7 and the common errors in applying the Spencer market value concept discussed in Chapter 2. In particular, the key components of the conceptual framework proposed in this Chapter to evaluate the debate on marriage value are comprised of: • the recognition of the appropriate unit of measurement (ie whole portfolio value as opposed to sum of the parts value discussed in Chapter 2) • the recognition of the evolutionary nature of asset value (discussed in Chapter 7) • the recognition of the temporal transfer of value from goodwill to specialised assets of a going concern business (discussed in Chapter 7), and • the correct identification of the asset being valued, including its inherent economic and commercial attributes (ie the asset focus of the Spencer market value concept discussed in Chapter 2).

¶15-020 Marriage value as an indivisible subset of the market value of land assets When the appropriate unit of measurement is portfolio value on a going concern basis, and all the constituent specialised assets of the coherent combination/portfolio are treated as land assets for tax/stamp duty purposes1, the assessed market value of the portfolio of specialised land assets on a going concern basis is the appropriate focus of valuation. Although one may use the term “marriage value” to colloquially2 describe the accumulated value increments which have become part and parcel of the value of the collection of specialised land assets, “carving up” a portion of the assessed market value of the portfolio of land assets to attribute to marriage value is unnecessary and incorrect. This is because there is no separate marriage value.

Marriage value not part of goodwill In this case, the colloquially termed “marriage value” is an indivisible subset of the portfolio value of specialised land assets as a whole. Thus, it is distinct from goodwill value3. In addition, as noted in Chapter 7, although some of the accumulated increments in the value of the specialised land assets over time can be a direct result of conscious management decisions in the past, it is inappropriate to attribute those value uplifts solely to goodwill value. To the extent that the outcome of past value-accretive management decisions has become impounded into the specialised land assets, it increases the market value of those assets and is neither goodwill nor marriage value (eg “buy the land, get the lot”). Buy the land, get the lot In cases where marriage value is an indivisible subset of the portfolio value of specialised land assets, debates on marriage value are not just academic and unnecessary, they can detract from the commercial reality of “buy the land, get the lot” and create a false impression that marriage value is an asset separate from the portfolio of specialised land assets. This results in an artificial quantification of marriage value (and the valuation errors associated with it), and an artificial transfer of value from the portfolio of specialised land assets to some “non-land” asset4 to which marriage value is artificially and incorrectly allocated. Footnotes 1

For land rich stamp duty assessment purposes, specialised land and buildings are both treated as land assets.

2

It should be noted that marriage value is a not an original valuation/finance concept.

3

It is necessary to make a distinction between existing marriage value and expected future marriage value. From a valuation perspective, existing marriage value is embedded in the value of the collection of existing specialised assets. Future marriage value may be reflected in economic goodwill value in that economic goodwill value is, as discussed in Chapter 7, forward-looking and reflects market participants’ expectations of the incumbent management’s continued superior ability to generate incremental organic enhancements in the existing marriage value and/or identify unique opportunities to create expected future synergies/marriage value from potential mergers/acquisitions.

4

Whether it be goodwill or some separate non-land asset.

¶15-030 Marriage value as an indivisible subset of the market value of land and nonland assets Conceptual and practical difficulties and confusion about marriage value are elevated in cases where the portfolio of specialised assets includes both land and non-land assets. Example: Mining operations For CGT principal asset test purposes, an integrated mining operation is comprised of specialised assets, including: • mining rights (representing access to ore in the ground) • specialised mining plant and equipment including, where applicable, specialised transport infrastructure, and • mining information. While mining rights are taxable Australian real property (TARP) assets, specialised mining plant and equipment, other than fixtures and, where applicable, mining information are non-TARP assets.

The so-called marriage value embedded in a portfolio of specialised land and non-land assets is inherently an indivisible subset of the portfolio value. It is not an asset which is separate and distinct from the assessed market value of the portfolio. In this circumstance, marriage value is also not part of goodwill value because goodwill value is, from a valuation perspective, separate and distinct from the value of the portfolio. While the market value of the portfolio is often ascertainable, there is generally no comparable sale transaction to refer to as a guide to the market value of the constituent specialised land and non-land assets, nor is there readily observable cash flows separately attributable to each constituent specialised asset/asset class to derive the market value of the relevant asset/asset class under the income approach. In simple terms, a hypothetical WBNAB and a hypothetical WBNAS are assumed to enter into a hypothetical negotiation to derive the market value of the relevant constituent assets if direct indicia of market value and cash flows are not available. The practical application of the Spencer market value concept in such cases should be based on the assumption that the hypothetical buyers and sellers of the constituent assets would be cognisant of the following: • the most logical outcome would be for the parties to negotiate some mutually beneficial arrangement to exploit the mining rights, and • that in the absence of coming to some mutually beneficial arrangement, the alternative scenarios available to each of the parties is likely to be highly value destructive to all of them. In this context, the negotiations that would take place would involve each party considering both: • their own potential best possible outcome and that of each of the other parties • their own worst case scenario and that of each of the other parties, and • the fair and reasonable sharing of the economic benefits from cooperating with each other. Example: Mining operations (cont) Continuing with the mining operations example above, in broad terms, the best and worst case scenarios for the notional holder of each asset are as follows:

Table 15.1: Negotiating range Asset holder

Best case scenario

Worst case scenario

Mining rights

Acquire the mining information for a nominal amount and acquire the plant and equipment for secondhand exit value.

Resume operations by acquiring new plant and equipment (at replacement cost) and by recreating the mining information (at replacement cost), and incurring the economic cost of delay in so doing. Given the practical difficulties in acquiring plant, it is likely that the cost necessarily incurred in obtaining an alternative plant will be at, or near full “replacement cost — new”, and that often there will be no practical opportunity to acquire plant and equipment at a “depreciated replacement cost” amount. There is also a risk that the government could resume the mining rights if it were perceived that the holder of the rights were not using their best endeavours to exploit the deposits but that other parties were willing to do so.

Plant and equipment

Extract full replacement cost, plus a full allowance for the

Receives second-hand exit or scrap value.

economic cost of delay avoided by acquiring plant from the current holder rather than acquiring plant from another source, installing that plant and fully commissioning same. Mining information

Extract full replacement cost of necessary information1, plus a full allowance for the economic cost of delay avoided by reproducing the information.

$nil or nominal amount only.

Notes 1 Some information will be of little or no use (eg mined out areas) and would not be needed to continue operating. The best case scenario determines the maximum achievable price for an asset, whereas the worst case scenario determines the minimum achievable price for that asset.

The outcome of this analysis is to derive a bargaining zone within which the hypothetically negotiated price/market value of, particularly, the mining information and the specialised plant and equipment would reside. Where the negotiated price resides within this bargaining zone would reflect relevant comparable sales evidence or objective reliable cash flow forecasts where the relevant evidence/data is available. In the absence of evidence/data, the abovementioned framework provides a useful analytical tool to approximate the market value of the relevant constituent assets, although which point within the bargaining zone is used as a proxy for market value is ultimately a matter of judgment depending on the factual circumstances of the case. In view of this context, the debate on marriage value then involves whether selecting a point within the bargaining zone as a proxy for market value of the relevant constituent asset (whether it be a land/TARP asset or a non-land/non-TARP asset) requires introducing the marriage value concept. If the marriage value concept is introduced, the following questions arise: • To which assets/asset classes is marriage value attached? It is a matter of logic that marriage value should generally be attached to, or apportioned between, only those assets which are not readily replaceable, and are critical to the generation of cash flows to the going concern entity. Marriage value should not be apportioned to readily replaceable assets because the notional owners of these assets cannot demand a share of the marriage value (if any) in a hypothetical commercial negotiation when they can be readily replaced by the notional owners of the critical assets. • What is the appropriate boundary between marriage value and the value of the (critical) constituent assets in isolation of marriage value? • Can marriage value be reliably measured and apportioned between the (critical) constituent assets? Debates over these questions have been inconclusive to date. The resolution of the relevant issues raised is obviously case-specific.

¶15-040 Marriage value portrayed as special value Marriage value portrayed as special value is one of the valuation issues which arose in CCM Holdings Trust Pty Ltd v Chief Commissioner of State Revenue5 (CCM Holdings) already outlined in Chapter 2. This case provides an interesting setting in which to evaluate the nature of marriage value from the

combination of two economically heterogeneous assets (as opposed to the coherent combination of economically homogenous specialised assets discussed earlier in this Chapter), and how it can distort the assessment of the Spencer-type market values of the individual subject assets on an “as is and where is” basis. The distortion principally arises from the major alteration of the existing characteristics of the subject assets as at the valuation date to achieve the marriage value/tax optimisation outcome and treating the value of the altered assets (which are different from the subject assets) created during this transformation as the Spencer-type market values of the subject assets. Within the context of this case, the effects of this distortion are further analysed below. The market value world is one where the subject assets are valued as what they are at a given valuation date (ie on an “as is and where is” basis). Whereas the special value world is one where the characteristics of the subject assets (being valued) can be fundamentally and permanently altered to achieve a financial/tax optimisation outcome. Problems with value maximisation The fundamental and permanent alteration of the existing characteristics of the assets being valued is inconsistent with the Spencer-type market value concept, which is built on the premise that a hypothetical WBNAB and a hypothetical WBNAS are knowledgeable of the existing characteristics (as at the valuation date) of the asset being valued. Altering the existing characteristics is conceptually equivalent to assessing the Spencer-type market values of the subject individual assets in the special value world, rather than the market value world. In CCM Holdings, the plaintiff’s expert justified this valuation approach by referring to what is called the “value maximisation” concept where the values of the multiple subject individual assets are assessed conditional upon the potential proceeds from a hypothetical sale of the multiple assets being maximised, and irrespective of the fact that the value of one individual asset is not maximised or may even be destroyed. The problems with the “value maximisation” approach to assessing the Spencer-type market values of multiple assets (like the land lease and the intercompany loan in CCM Holdings) are discussed below. Distortion of the land rich ratio Firstly, focusing on maximising the potential proceeds from the hypothetical sale of combined assets by altering the characteristics of the subject individual assets and marrying the altered assets to achieve a better financial/tax optimisation outcome removes the important individual (land/non-land) asset value demarcation, the absence of which distorts the land rich ratio. This distortion is exacerbated by the fact that the purported “value maximisation” is achieved at the expense of the value of one individual asset (eg the value of the land lease in CCM Holdings) being destroyed. Inconsistent with Spencer market value Secondly, the “marriage value” or “value maximisation” is neither achievable nor consistent with the Spencer market value concept when the realisation of the “marriage value” (even if allowable from a Pt IVA of the Income Tax Assessment Act 1936 (Cth) perspective) is predicated on one knowledgeable hypothetical partner/asset contributor to the “marriage” (eg the hypothetical owner of the land lease in CCM Holdings) effectively and irrationally accepting significant value losses and the other knowledgeable hypothetical partner/asset contributor to the “marriage” (eg the hypothetical owner of the intercompany loan in CCM Holdings) effectively achieving significant value gains. The “value maximisation” created in this manner is substantively different from synergies which are expected to be realised from corporate mergers in that the former creates a (commercially unattainable) win-lose situation, whereas the latter creates a win-win situation. Inconsistent with the highest and best use principle Thirdly, the “value maximisation” approach is also inconsistent with the highest and best use principle because this principle does not require each subject individual asset to be transformed into a different asset. Assessing the market value of a subject individual asset on a highest and best use basis does not mean altering the attributes which define or constitute the subject asset being valued in the first place. In CCM Holdings (subject to Pt IVA), marriage value is created in the special value world and is separate from Spencer-type market values of the subject land lease and intercompany loan being valued as at the

valuation date. The value of the altered land lease and altered intercompany loan in the special value world to create the marriage value do not represent the Spencer-type market values of the subject assets as at the valuation date. Footnotes 5

CCM Holdings Trust Pty Ltd & CCT Motorway Company Nominees Pty Ltd v Chief Commissioner of State Revenue NSW 2013 ATC ¶20-409; [2013] NSWSC 1072.

¶15-050 In a nutshell The characterisation of marriage value is both complex and controversial. In order to correctly evaluate the debates on marriage value, it is necessary to recognise: • the factual circumstances and idiosyncratic characteristics of the case in question • the purposes for which the valuation is undertaken (eg a stamp duty land rich assessment or a principal asset test assessment) • the asset focus of the Spencer market value concept and the appropriate unit of measurement • the evolutionary nature of the value of specialised assets • the transfer of value from goodwill to the critical specialised assets of the business over time, and • the forward-looking (as opposed to backward-looking) nature of economic goodwill.

Value allocation between upstream and downstream segments ¶16-010 Valuation at a notional point of transfer In many commercial circumstances, the primary commercial focus is on total value assessment and there is no real commercial need to apportion the total value between different components. However, value allocation is required in some tax and stamp duty assessment circumstances in respect of integrated mining or gas-to-liquid (GTL) projects. For those projects, the value allocation exercise typically involves an intermediate point dividing, in some way, the supply chain between the upstream segment and the downstream segment. The upstream assets typically include the upstream resource base and associated upstream infrastructure facilities, whereas the downstream assets typically include the downstream processing facilities (eg the liquefaction plant) and the downstream transport infrastructure assets (eg rail, pipeline and port facilities, etc). Depending on the type of commodities involved and the applicable tax legislation, the intermediate point is at the mine gate or well head or some other point. What needs to be determined at this intermediate point for tax and duty purposes is usually the notional market value of a relevant mineral or feedstock gas1 and/or a notional arm’s length charge for access to the downstream infrastructure assets. It is notional in that the subject market value or access charge needs to be determined on a first principle basis because there is usually no actual arm’s length price or access charge that can be observed at that point. Assessing the notional market value of a commodity or an arm’s length access charge is complex, casespecific and controversial. However, in order to illustrate how this valuation exercise is assessed in practice, this Chapter discusses the application of what is referred to as the netback method, which highlights the key principles underpinning the determination of an arm’s length access charge and the market value of a commodity at an intermediate point of the supply chain for an integrated mining project. This does not indicate that the netback method should be applied in all circumstances. The factual circumstances of a given case may warrant the application of a different method. Footnotes 1

Feedstock gas or sales gas is the raw gas which is liquefied generally for export.

¶16-020 The netback method Under the netback method, the market value of the relevant commodity at the relevant intermediate point separating the upstream and downstream segments is determined starting with the observable or ascertainable arm’s length value of the end product, and then deducting the allowable downstream costs which are incurred subsequent to the notional point of disposal and up to the point of the end product sale. Example The relevant downstream costs of transporting, converting feedstock gas into liquefied natural gas (LNG) and loading LNG for export are deducted from the ascertainable free on board (FOB) price of LNG to arrive at the assessed market value of the feedstock gas at the relevant intermediate point. Similarly, the relevant downstream costs of processing, transporting and loading coal and iron ore for export are deducted from the observable FOB price of coal and iron ore to arrive at the notional mine gate price of coal and iron ore.

Given that the price of the end product (generally, the readily exportable product) is ascertainable or observable, essential to the implementation of the netback method is the correct assessment of the relevant downstream costs including downstream capital costs and operating costs. The appropriate conceptual framework to assess the downstream costs in the form of notional arm’s length access charges or tolls2 is the “building block” framework. Footnotes 2

A separate notional arm’s length access charge can be determined for each downstream infrastructure asset (eg separate notional access charges for the downstream pipeline and for the port assets).

¶16-030 The “building block” framework Within the “building block” framework, the downstream costs are determined to provide the hypothetical arm’s length independent downstream developer/owner(s) with sufficient revenue to cover their reasonable operating costs, earn an adequate return on capital and recoup their invested financial capital and/or replace the asset at the end of its remaining economic life if it is worth replacing. In simple terms, determining the fair and reasonable downstream costs is conceptually akin to determining a fair and reasonable access charge (or access charges) to the downstream infrastructure assets. The key elements of the building block approach are: • return on capital — this is determined based on a fair and reasonable rate of return on assets taking into account the risk involved and the asset base. The return on capital is calculated as the appropriate rate of return times the appropriate value of the asset base • return of capital — an allowance for depreciation and the consequent reduction in the value of the assets over time, and • operating and maintenance costs — an allowance for efficient administrative and operating costs required for providing access to the infrastructure asset. A related component of the building block approach is a (corporate) tax charge, which is also treated as a cost of providing access to the relevant infrastructure asset because this is an expense that needs to be met from the revenue generated by the infrastructure asset. As explained later, there is an inherent link between this tax component and the return on capital component. The abovementioned building block elements are calculated and used to establish, say, an annual required revenue (ARR)3 that can be earned by the plant or infrastructure asset owner for the use of the downstream infrastructure asset as follows: ARR = Appropriate rate of return (return on capital) × Asset base value + Depreciation (return of capital) + Operating expenses (opex) + Cost of tax For a given year, an ARR can be converted into a raw access charge (eg $/gigajoule (GJ) of feedstock gas transported or processed, or $/tonne of coal railed or loaded, etc), based on the projected volume for the relevant year4. It is important to adopt a holistic approach (as opposed to a mechanistic approach) to the practical application of the building block approach in assessing the notional arm’s length access charge. A holistic approach requires the assessment of input value for each building block component (asset base value, return on capital, return of capital and tax charge) be undertaken in conjunction with each other, rather

than in isolation of each other. Footnotes 3

The “building block” framework can be used to derive other periodic required revenue (eg quarterly required revenue), depending on the frequency at which tax liability is assessed.

4

The building block approach can be easily modified to derive the required revenue for a different period (eg a quarterly period). The modification simply involves converting the annual return on capital, return of capital, operating expenditure (opex) and corporate tax payable into quarterly equivalent inputs.

¶16-040 Appropriate value of asset base Determining the appropriate value for the asset base is important because, under the building block approach, both the return on capital (rate of return) and return of capital (depreciation) are calculated with reference to that asset value. Assessing the appropriate asset value requires the application of the appropriate asset valuation methodology to the appropriate asset base. The value of the asset base can be determined using the value-based approach or the cost-based approach. An inherent issue in access pricing determination for monopoly type infrastructure assets is circularity whereby the price charged for a product or service will determine the economic value of the assets used to produce the product or service, but the economic value of the assets is needed to determine the price to be charged. The presence of the circularity problem makes it difficult to use value-based asset valuation methodologies under the building block approach. Given the difficulty in applying the value-based asset valuation methodology in this setting, notional or actual cost-based asset valuation methodologies have been commonly used in practice for access pricing, given that the application of these methodologies can overcome or break the circularity between market value and access charges. In the case of a brand new infrastructure asset, the actual costs of constructing the infrastructure asset generally forms the appropriate starting point in establishing the value of the asset base for access charge determination because they are objective, relatively easy to measure and less prone to measurement errors5. When using actual costs/capex in assessing the value of the asset base, it is necessary to allow for the following issues: • the type of costs which should be allowed into the asset base value • the quantum and timing of eligible direct costs and indirect costs (eg construction and design costs and eligible overhead costs) incurred over time • financial costs, which depend on the quantum of direct and indirect costs, the schedule over which these costs are incurred, and the extent to which they are financed by debt and equity capital and the relevant costs of each type of capital • the consistency between the asset base value and the rate of return component (discussed below) • the extent to which the downstream infrastructure asset is also used for other purposes. For example, when a portion of the transmission pipeline is used for the delivery of gas into the domestic market, rather than for the delivery of gas to the liquefaction plant to be converted into LNG for export, an appropriate share of the capital costs associated with the transmission pipeline should be allocated to the volume of gas delivered to the domestic market and excluded from the asset base value used to

calculate the notional arm’s length access charge for the LNG feedstock gas transported through the pipeline • for a greenfield downstream development, the extent to which the design and construction costs already reflect the intangible assets associated with the construction and operation of the downstream infrastructure assets (eg the liquefaction technology used in the LNG plant of a LNG project), and • the symbiotic nature of the relationship between the owner(s) of the upstream assets and the owner(s) of the downstream infrastructure assets. Footnotes 5

It is necessary to note that the actual costs do not necessarily represent the “current” costs as at the date of completion if the construction period is reasonably long and the commencement and completion of construction are at different points in the construction cycle. For example, construction costs can decrease in the intervening period between when construction commences (turnkey contracts signed, etc) and when construction is completed.

¶16-050 Rate of return (return on capital) The rate of return used to calculate the return on capital component is measured by the weighted average cost of capital (WACC). In assessing the form of WACC to apply in establishing the access charge, it is necessary to recognise and maintain the consistency between: • the form of WACC used to calculate the return on capital component and the asset base value on which the return on capital component is calculated. If the nominal WACC is used (as is conventionally the case in commercial valuation practice), the initial asset base value should not be rolled forward or updated to allow for the general inflationary gains when the asset is reasonably expected not to be replaced at the end of its economic life. However, this may be appropriate if the asset is reasonably expected to be replaced at the end of its economic life. For example, in the case of a port coal loader the asset base is escalated and nominal WACC is used. This is justifiable in that: – when the coal reserve/resource is so large that the economic life of the upstream far exceeds the physical life of the downstream infrastructure – the downstream infrastructure is reasonably expected to be replaced at the end of its economic life, and – the cost of replacing the asset’s service potential is reasonably expected to increase (at CPI as a rough approximation) • the form of WACC used to calculate the return on capital element and the cost of tax element. If the post-tax WACC is used, the tax charge component should be calculated allowing for tax on the ARR itself, net of tax deductible expenses except without a reduction for tax deductions on interest (since tax deductibility of interest is already factored in determining the after-tax WACC). That is, the impact on the ARR of the lower return on capital component calculated based on the post-tax WACC is offset by the higher tax charge component calculated without taking into account the tax deductibility of interest.

¶16-060 Depreciation (return of capital) The return of capital element is inextricably linked to which concept of capital maintenance is adopted. If the concept of real financial capital maintenance is adopted, the return of capital represents the periodic

return (in real purchasing power terms) of the financial capital originally invested by the asset owner. In contrast, if the concept of operating capital maintenance is adopted, the return of capital element represents the periodic recovery of replacement costs required to replace the asset with an asset having similar service potential at the end of the remaining economic life of the original asset. Maintenance of real financial capital In the case of a downstream infrastructure asset with a finite economic life due to a finite economic life of the upstream reserves/resource base (whether they be equity reserves or accessible third party reserves), the downstream infrastructure asset is not to be replaced at the end of its economic life. Example The shortfall of gas reserves to meet LNG export commitments implies that the economic life of the downstream infrastructure assets is constrained by the existing size of the upstream reserves (unless the existing upstream gas reserves are expected to be expanded significantly and a large proportion of the additional reserves can be used for LNG exports).

If the downstream infrastructure asset is not to be replaced at the end of its economic life, the return of capital element should reflect the maintenance of real financial capital, rather than the maintenance of operating capital. In this case, the return of capital component under the building block approach enables the owner of the downstream infrastructure asset to periodically recoup, in real terms over the economic life of the asset, the financial capital originally invested in the asset. In addition, the periodic return of capital component depends on the expected economic life of the asset, which is inherently linked with the size of the upstream reserves and resources. As a result, unexpected changes in the size of the reserves over time due, for example, to new drilling results or changes in economic factors such as commodity prices or currency fluctuations may result in material changes in the economic life of the downstream infrastructure asset and the periodic return of capital component with respect to that asset. Maintenance of operating capital When the asset is to be replaced at the end of its remaining economic life, it is appropriate to apply the concept of operating capital. The end-of-life replacement assumption is generally appropriate in cases of: • infrastructure assets which provide essential services such as electricity and gas transmission, and • (downstream) mining transport infrastructure assets where the size of the integrally linked upstream reserves/resources is so large that the replacement of the downstream infrastructure assets at the end of their remaining economic/physical life is economically justifiable (given prevailing commodity price and foreign currency (FX) expectations). When the concept of operating capital maintenance is adopted, the access charge applied by the infrastructure asset owner under the building block approach should be sufficient to allow the owner to cover the costs of replacing the asset with an asset having similar service potential at the end of the remaining economic life of the original asset. In simple terms, the determination of the access charge should allow the asset owner to get the initially invested capital back in real terms, plus an additional amount to cover an (ex-ante) expected increase6 in the cost of constructing a modern equivalent asset at the end of the economic life of the existing asset. What is often unrecognised in practice is: • the distinction between maintenance of operating capital and maintenance of real financial capital • the circumstances in which each concept should be used • applying the concept of operating capital maintenance in cases where the concept of real financial capital maintenance should be used and vice versa • double-counting for general inflation in cases where the concept of real financial capital should be used

• not allowing for the need to reinvest in maintaining the operating capital in cases where the concept of operating capital should be used7, and • not allowing for the change in the users of the infrastructure asset over time, particularly, in cases where the existing users (as opposed to future new users) contribute to the construction of the asset in the first place and the subsequent maintenance of the asset in a good working order. Footnotes 6

The infrastructure asset owner should not be further compensated for an ex-post increase in the replacement cost over and above the expected (ex-ante) increase by uplifting the asset base value by the corresponding excess amount. This is because the infrastructure asset owner has already been compensated for this risk in the rate of return component.

7

Brownfield capex can also extend the physical/economic life of a downstream infrastructure asset (eg a marine wharf facility).

¶16-070 Operating expenses The opex that are included in the ARR should be: • downstream opex (attributable to the relevant downstream activities). In cases where the downstream infrastructure asset is subject to common use (eg both for export and domestic use), the downstream opex need to be appropriately apportioned in deriving the market value of the relevant commodity for export, and • “efficient” opex (although it is difficult to assess the efficiency of opex from an outsider’s perspective). This is because it would neither be fair nor reasonable to effectively overcharge the upstream users in an actual arm’s length context or inadvertently increase the notional tolls in a hypothetical arm’s length context because of accepting inefficient opex. Comparable cost benchmarks (if available) should be used to identify the cost inefficiency.

¶16-080 Cost of tax As mentioned earlier, the ARR should include the tax liability or notional tax liability that the owner of the downstream infrastructure assets has to pay in relation to the receipt of access charges. This is because if the ARR which is derived based on an after-tax return on capital does not include an allowance for the corporate income tax payable, then when the infrastructure asset owner receives the ARR and actually pays corporate income tax, they will not earn the expected after-tax return on capital used to derive the ARR in the first place. If a post-tax WACC is used in calculating the return on capital component (as it should be), then the tax deductions used in calculating the (notional) tax liability (ie the cost of the tax component within the building block framework) do not include the interest charges. In addition, it is also necessary to note that the asset life and tax depreciation charges used in calculating the tax liability are subject to tax legislation and may differ from the expected economic life of the asset and the periodic depreciation, which constitutes the return of capital component. Another factor which affects the cost of tax component under the building block approach is imputation credits. Under the imputation tax system in Australia, investors can utilise some or all of the corporate tax paid to reduce their personal tax liability8. Therefore, for this type of investor, the effective corporate tax rate can be lower than the current statutory corporate tax rate (30%). In contrast, overseas investors are not generally entitled to the full benefit9 of imputation credits. As a result, for a 100% foreign owned infrastructure asset, imputation credits do not generally10 result in the totality of the effective corporate tax rate being lower than the statutory corporate tax rate.

For regulated infrastructure assets, the impact of imputation credits on the effective corporate tax rate can be accounted for through a gamma factor. In essence, the gamma factor is the percentage of the total possible imputation tax credit that is likely to be available to the underlying owners after allowing for factors such as the percentage of profits paid out as dividends, the value of imputation credits once distributed via the payment of franked dividends, the identity of the marginal trader, the time value of money, etc. Australian regulators generally adopt a gamma factor of between 0.25 and 0.5011, although this regulatory practice is continually subject to debate and review. In contrast, independent experts and valuers in the private sector generally do not make adjustments to the cost of capital for dividend imputation. In regulatory settings, the benefit of imputation tax credits to the underlying owners under the building block approach are typically reflected in the calculation of the tax charge component (by reducing the corporate tax rate levied on taxable income) rather than in the return on capital component. Footnotes 8

In more recent years, some owners can get a full tax refund for imputation credits.

9

There are allowable credits against Australian withholding tax and some jurisdictions allow a credit for the underlying rate of tax in (specified) countries.

10

In some countries, an allowance is made for the underlying rate of tax.

11

For example, a gamma factor of 0.5 implies that an investor can utilise 50% of Australian corporate tax paid in present value terms.

¶16-090 Ex-post uplifts in capital value Updating the asset base value under the building block approach to reflect the periodic return of capital, additional brownfield capex and/or expected (ex-ante) changes in the costs of constructing a modern equivalent asset at the end of the economic life of the existing asset is distinct from “resetting” the asset base value to reflect current market value due to ex-post external changes. The latter is incorrect because in an ex-ante sense, expected changes in the capital value of the relevant downstream asset are already allowed for in the rate of return component, which conceptually reflects both the income and capital gain elements of the return required by a hypothetical owner of the asset at the time of the joint development decision. It follows that, from the perspective of a hypothetical arm’s length developer of the upstream assets and a hypothetical arm’s length developer of the downstream assets, it is double-counting to allow any ex-post increment or decrement in the capital value of the downstream asset into the asset base value on which the rate of return is calculated. This also implies that any capital value increment crystallised from an (expost) spin-off and sale of a downstream infrastructure asset (eg the transmission pipeline) to an arm’s length third party should be excluded in assessing the notional access charges in respect of the relevant downstream infrastructure asset and hence the netback value at the relevant taxing point. Calculating the notional toll based on the ex-post capital value increment and the resulting higher asset base value is also inconsistent with the fact that the tolls which have been calculated and charged to a hypothetical arm’s length owner of the upstream assets already includes a return of capital component which, in substance, compensates a hypothetical arm’s length owner of the downstream asset for the economic depreciation of the asset. Accepting the ex-post capital value increment in calculating the notional toll following the spin-off/sale of the downstream asset is conceptually similar to accepting that the asset has not experienced economic depreciation (or has actually experienced a degree of economic appreciation), indicating the over-repayment of capital and hence overstated tolls in the periods prior to the spin-off/sale.

It is also important to distinguish between a pre-determined method (eg the netback method) to calculate a notional toll (eg a transport toll) and the expected toll stream arising from the application of this method over time. The pre-determined method to calculate, for example, a transport toll should be fair and reasonable to a hypothetical arm’s length developer/owner of the upstream assets and a hypothetical developer/owner of the downstream assets at the time it is agreed between the two parties. Once a toll calculation method has been established, it should remain effective for the expected economic life of the downstream asset because this method is directly relevant to the application of the pricing method over time. Market participants’ valuation of the expected cash flow/toll stream calculated under the pre-determined netback method, which determines what they would bid for the asset if and when it is spun off and sold. Market participants’ valuation of the expected cash flow/toll stream can be different from the residual asset base value of the asset at the time of spin-off/sale, due, for example, to market participants’ differing abilities to use franking credits and/or financial leverage and/or nature of the utility type infrastructure assets. In simple terms, the ex-post valuation of the downstream infrastructure asset is consequential from the application of the pre-determined method to calculate the toll over time and hence should not alter the pre-determined method in the first place.

¶16-100 Allowance for end-of-life value and remediation costs The calculation of a downstream notional toll under the building block approach is also affected by: • the present value of the higher of the end-of-life residual (scrap) value (if any) and the end-of-life alternative use value, which needs to be subtracted from the starting/invested capital to establish the (net) asset base value on which the return on capital and return of capital components are calculated, and • the expected end-of-life remediation costs, which require a periodic amount be collected via the toll charge over the life of the downstream infrastructure asset to build up the sinking funds to meet the remediation costs. Despite the fact that the scrap value/alternative use value and remediation costs need to be recognised in a method/formula to establish market value at the notional taxing point as a matter of principle, it should be noted that the longer the expected economic life of the relevant downstream infrastructure asset, the lower the scrap value/the sinking funds and the lower the impacts of these end-of-life value inputs on the notional tolls calculated under the building block approach. In addition, given the usual long expected economic life of the downstream infrastructure asset, there are uncertainties as to: • the alternative use of the asset at the end of its expected economic life and the value of the asset in that end-of-life alternative use, and • the measurement of other end-of-life value inputs, including the extent to which end-of-life remediation costs are mitigated by scrap value or alternative use value. The appropriate practical way of allowing for these end-of-life value inputs in calculating the downstream notional toll involves: • calculating the notional toll assuming away the end-of-life value inputs (scrap value, alternative use value, remediation costs), but • requiring a retrospective adjustment be made at the end of the expected economic life of the asset when the end-of-life value inputs are either known or able to be reliably measured. The retrospective adjustment is designed to make good the difference between the notional tolls that have actually been used to calculate the netback value and those that should be used, taking into account the then ascertainable (higher of) the scrap value and alternative use value, net of remediation costs, plus

interest (if applicable).

¶16-110 Commercial reasonableness of the calculated netback value A relevant commercial yardstick against which the assessed netback value is assessed is the costs of extracting and delivering the feedstock gas to the notional taxing point, including the capital costs12 and operating costs associated with the existing resource base and, where applicable, the incremental investments in the upstream development (ie the upstream cost plus benchmark). There are three levels of upstream cost plus benchmark, namely: • absolute upstream cost plus • incremental upstream cost plus, and • ongoing post-production upstream cost plus. Absolute upstream cost plus benchmark includes: • upstream capital costs associated with the implied value of the resource in the ground, plus • upstream capital costs associated with the starting upstream capex (including, where applicable, capitalised pre-production upstream opex) accumulated up to the date of production commencement, plus • upstream capital costs associated with the ongoing post-production upstream capex, plus • upstream ongoing post-production opex, plus • associated corporate tax payable. Incremental upstream cost plus benchmark includes: • upstream capital costs associated with the starting upstream capex (including, where applicable, capitalised pre-production upstream opex) accumulated up to the date of production commencement, plus • upstream capital costs associated with the ongoing post-production upstream capex, plus • upstream ongoing post-production opex, plus • associated corporate tax payable. Ongoing upstream cost plus benchmark includes: • upstream capital costs associated with the ongoing post-production upstream capex, plus • upstream ongoing post-production opex, plus • associated corporate tax payable. While the incremental upstream cost plus benchmark and the ongoing upstream cost plus benchmark are objectively and readily calculable, the absolute upstream cost plus benchmark is not. This is because the calculation of the capital costs in respect of the economically developable resource base is subject to circularity. This circularity arises from the fact that the calculation of the capital costs (including return on capital and return of capital components) depends on the value of the existing resource base (or the assessed value of the production rights and associated mining information), but the assessed value of the resource base depends on cash flows attributable to that asset (ie comprising return on capital and return of capital components). Given the passage of commodity price risk and FX risk upstream, the netback-based price would fluctuate

with the “normal” volatility of commodity prices and FX fluctuations. This means that the hypothetical developer/owner of the upstream assets is exposed to price risk and has to bear normal profits and losses caused by the normal volatility of commodity prices and FX risks. However, allowance should be made for the “abnormal” volatility of the A$ denominated netback-based price arising from: • abnormal declines in commodity prices (denominated in US$) to which the netback-based price is linked • material appreciation in the A$ • reduction in the expected economic life of the downstream infrastructure asset, which is linked to the size of the upstream reserves, and • a combination of the abovementioned factors. When one or more of these material adverse circumstances arise for a prolonged period of time, it is necessary to monitor the A$ denominated netback-based price against the various upstream cost plus benchmarks to ensure that the relationship between the arm’s length owner of the upstream assets and the arm’s length owner of the downstream assets would not become parasitic in the sense that the latter keeps earning their market rate of return at the expense of the former sustaining prolonged economic losses. This, in the longer term, is obviously not sustainable in commercial reality because the lossmaking upstream operations would eventually be closed down, rendering the downstream infrastructure assets stranded. In these material adverse circumstances, although the netback method/formula is the appropriate method to establish market value at the relevant taxing point in an ex-ante sense, circumstances could arise where it is not a commercially sustainable method in an ex-post sense. In particular, the decline of the netback-based price below the ongoing upstream cost plus benchmark for a prolonged period of time can trigger the implied term of renegotiation13 to maintain the symbiotic relationship between the hypothetical arm’s length developer/owner of the upstream assets and the hypothetical arm’s length developer/owner of the downstream infrastructure assets. The renegotiation may allow the hypothetical developer/owner of the downstream assets to temporarily accept the earning of a rate of return lower than its required rate of return and to pay the hypothetical developer/owner of the upstream assets a price higher than the netback-based price in return for offsetting future gain in the form of credits against the normal netback prices when the material adverse circumstances cease to exist. This is consistent with anecdotal evidence that, in the face of significant declines in coal and iron prices, downstream operators/contractors which had take-or-pay arrangements with the upstream producers were prepared to accept lower tolling prices in the short-term in return for higher future gains, in order to maintain the symbiotic relationship. Within the building block framework, the reduction in the downstream notional tolls and higher netback price, to allow the upstream operator to continue operating in the event of material adverse circumstances, can be allowed for by recognising a credit against such reduction which is rolled forward into the asset value base in respect of which the notional tolls are calculated in future periods and offset against future higher commodity prices if and when the price downturn is reversed. Such an adjustment maintains the overall expected rate of return for the hypothetical upstream developer/owner of the downstream infrastructure assets. Footnotes 12

Being return on capital plus return of capital.

13

In a regulatory setting, this can trigger an ad hoc regulatory review.

¶16-120 In a nutshell Assessing market value at a notional taxing point separating the downstream and upstream segments of an integrated mining or GTL project is a complex and intellectually challenging exercise — and the subject of much controversy. While there is no “one-size-fits-all” valuation method, the application of the netback method provides a practical case study on how such a complex valuation exercise is undertaken. Central to the implementation of the netback method is the building block framework which is used to derive fair and reasonable downstream costs in the form of downstream notional arm’s length toll(s) or access charges. The value inputs to the building block framework need to be correctly assessed if the appropriate downstream notional tolls (and hence the netback price/market value given that they are inextricably linked) at the relevant notional taxing point are to be achieved.

Re-evaluating the application of the comparable uncontrolled price method ¶17-010 Overview Chapter 16 discusses the application of the netback method to assess the notional market value of a commodity (the subject of a controlled transaction1) at an intermediate point of the supply chain, where there is no actual arm’s length price (the subject of an uncontrolled transaction2) that can be observed at that point. In some cases, there are observable (or reliably calculated3) arm’s length prices at the relevant point. This Chapter discusses whether the comparable uncontrolled price (CUP)4 method under which the observable arm’s length price is used to represent the notional market value of the commodity can be readily applied in these cases. Although the discussion focuses on the application of the CUP method in assessing the market value of a commodity at an intermediate point in an integrated commodity export supply chain, it also contributes to the current debate on base erosion and profit shifting (BEPS) in respect of commodity transactions. Footnotes 1

A controlled transaction refers to a transaction between two related parties.

2

An uncontrolled transaction refers to a transaction between two independent parties acting at arm’s length.

3

Arm’s length prices are observed at a different point but simple adjustments (such as allowance for differences in transport costs) can be made to obtain equivalent arm’s length prices at the relevant point.

4

This term is used in the OECD Transfer Pricing Guidelines.

¶17-020 Choice of valuation methodology There is a general perception that the CUP method is the preferred methodology to determine a notional arm’s length price for the controlled transaction, particularly when both the controlled transaction and the uncontrolled transaction involve exactly the same commodity product (eg the same petroleum). However, such a perception potentially creates an incorrect tendency to inadvertently place too much focus on the “apparent” homogeneity of the commodity being transacted and overlook many other factors which cause the observable uncontrolled price not to be representative of the appropriate price for the uncontrolled transaction. In simple terms, an observable uncontrolled price is not necessarily a comparable uncontrolled price. The availability of observable uncontrolled prices should not be taken for granted as readily representing CUPs. The choice of the valuation methodology for commodity transactions should be determined on a case-bycase basis, depending on, inter alia, the factual circumstances and the reliability of the relevant information available.

¶17-030 Valuations based on comparable transactions

Theoretically, the CUP method is the preferred method to assess the market value for a controlled commodity transaction when there is an exact CUP or, in the absence of an exact CUP, price-relevant differences between the controlled transaction and the uncontrolled transaction can be reasonably allowed for in arriving at a reliably constructed CUP. Practically, in order to determine if an observable uncontrolled price is an exact CUP, it is necessary to evaluate both the controlled transaction and the uncontrolled transaction in terms of (at least): • the type of commodity transacted (eg conventional gas or coal seam gas) • the nature of the relationship between the producer and the entity to which the relevant commodity has been, or will be, disposed of (eg is it a symbiotic long-term relationship or a short-term relationship5?) • the risks assumed and functions performed by the counterparties (eg are price and volume risks passed upstream?) • the counter-party risks posed to the respective counter-parties (eg in respect of an arm’s length buyer, the counter-party risks reflect the supply risks which, in turn, depend on the size of the reserve/resources, and uncertainty associated with them), the location of the resources, the availability of transport infrastructure and capacity, the cost structure, the credit risk and other risk characteristics of the seller. These factors differ across suppliers/sellers, resulting in differing levels of counter-party risk and differing observable prices • the timing of the controlled and uncontrolled transactions. Under the CUP method, changes in the market value of the commodity can only be observed if and when uncontrolled transactions occur. In addition, the occurrence of the uncontrolled transactions may or may not be contemporaneous with that of the controlled transactions. Thus, the observed changes in the observable uncontrolled prices may or may not be contemporaneous with the underlying changes in the market value of the commodity, the subject of the controlled transactions • the economic circumstances surrounding the controlled transaction and uncontrolled transaction/contract (eg contracts entered into in different commodity price environments) • the contractual terms (eg payment terms, delivery terms, force majeure, take-or-pay provision, banking provision, claw back provision, etc), and • the pricing formulae and the inputs to those formulae. Observable uncontrolled prices may be the outcome of applying a contractual pricing method/formula. Importantly, the application of the CUP method depends on the ability to obtain reliable information to conduct the above comparative evaluation at a reasonable cost. The probability of having an exact CUP is the cumulative probability of: • the controlled transaction and the uncontrolled transaction being similar, at least, in all of the material respects discussed above, and • being able to obtain all the information to verify these similarities at a reasonable cost. In the absence of an exact CUP, a constructed CUP requires that all the material price-relevant differences can be identified and reasonably reliably allowed for, and the information to do so is available or can be collected without excessive costs. The cumulative probability of having a reasonably reliably constructed CUP reflects the probabilities of all the above conditions being met. Thus, the probability of having either exact CUPs or reasonably reliably constructed CUPs may be small given that it reflects the cumulative probability of all the abovementioned conditions being met. Footnotes

5

The non-substitutability of long-term contract pricing with spot or short-term contract pricing is supported by anecdotal evidence in the iron ore market where long-term benchmark pricing for iron ore between major iron ore producers and Asian steel mills was abolished around April 2010 and replaced with index/spot pricing. Following the abolition of long-term benchmark pricing, there were disputes on whether royalty formulae which had been determined using benchmark iron ore prices would be workable. Had spot/short-term iron ore prices and longterm benchmark prices been substitutable, the workability of the royalty formula would not have been in dispute.

¶17-040 Related party transactions An observable contract price for petroleum can be established between two related parties or two unrelated parties. Whether the observable price can be rejected or accepted as the CUP in determining the commercial amount for petroleum is not a function of whether the counter-parties are unrelated or related, per se. It is a function of whether the observable price in the related party transaction can be considered an arm’s length price and, if so, whether the observable arm’s length price can be considered the CUP (subject to the set of conditions discussed earlier being met). The relevant considerations to determine whether or not the contract price between two related parties is an arm’s length price in the first place include: • how the terms of the overall transaction compare with those of any comparative transactions on an arm’s length basis • the nature and content of the bargaining process (ie whether the parties (despite their potentially related nature) have dealt with each other as unrelated parties would normally do or engaged in a process of real bargaining) • impacts of the transaction on the financial performance and financial position of the counter-parties (eg whether it is too onerous or generous for one party), and • the alternative options available to each counter-party.

¶17-050 Formula-based prices For a long-term symbiotic relationship between a hypothetical arm’s length developer of upstream assets and a hypothetical arm’s length developer of downstream assets, there is an inherent link between the process agreed prior to the joint development (ie the method/formula) and the subsequent outcome. When a transaction subsequently occurs, provided that the formula-based price for that transaction is calculated correctly according to the agreed method/formula, that price would be the price agreed between the two hypothetical arm’s length parties at the time of the transaction and, by definition, would constitute the Spencer-type market value at that time. A distinction should be made between the choice of the method/formula agreed for a long-term symbiotic relationship between two hypothetical arm’s length parties, and the inputs to implement that methodology to determine the formula-based prices for the subsequent transactions. The inputs reflect the prevailing economic circumstances around the controlled transactions. In simple terms, while the choice of method/formula is assessed just before the joint development proceeds, the input values to apply the method/formula to determine the market value of the commodity at the time of disposal are effectively assessed at that time (although certain input values such as rate of return are not likely to vary as frequently as other input values such as commodity end product prices and exchange rates).

¶17-060 The use of subsequent arm’s length transactions

When an arm’s length contract is executed subsequent to the time at which the market value of the commodity, the subject of the controlled transaction is to be determined, it is firstly necessary to establish whether or not the pricing method/formula (not necessarily the inputs to that method/formula) in the subsequent arm’s length contract is the appropriate pricing method. Subject to the pricing method/formula in the arm’s length contract being appropriate for the controlled transaction, it is then necessary to establish if the input values to the pricing method/formula in the arm’s length contract reasonably reflect the contemporaneous input values to the pricing method/formula at the (historic) relevant time for the controlled contracts. This should take into account not just the time lapse between the relevant time and the execution of the arm’s length contract, but all the factors underpinning the value of the relevant inputs such as counter-party risks, contractual terms, volume, governmentimposed constraints, subsidies, etc. If the pricing method/formula is appropriate, but the input values from the arm’s length contract are not appropriate for the controlled contract at the relevant time, the input values for the controlled transaction may be assessed at the relevant time on a first principle basis, reflecting the idiosyncratic characteristics of the controlled transaction.

¶17-070 Allowing for volume and duration differences Allowing for volume and duration differences in determining a constructed CUP is case-specific. In order to avoid making mechanistic and incorrect allowances, it is useful to refer to the “unit of measurement” concept. Example: How the unit of measurement can change One share of a major listed company is traded on the stock exchange at a price of $20 (per share). A block of shares representing 20% of the total shares outstanding is likely to be traded at more than $20 per share because it is likely to convey some level of control or at least significant influence. A block of shares representing only 0.5% of the total shares outstanding is likely to be traded at less than $20 per share because it is not likely to convey control, but it will be difficult for the market to absorb without a price concession due to its significant size compared to the normal trading volume. In simple terms, each block of shares may not be homogeneous, resulting in the price per share (the unit of measurement) for each block of shares being different. In fact, they can be traded in different markets with different market participants.

Triangulating the “unit of measurement” concept to analyse the impacts of significant volume and contract duration differences on the unit price of commodities transacted suggests that, other matters being equal, the smaller the differences between volume and contract duration, the higher the likelihood that the uncontrolled transaction is a suitable basis of pricing comparison for the controlled transaction. For example, the differences in the daily and total contract volume alter the next best alternatives available to the hypothetical arm’s length counter-parties (and costs associated with those alternatives) under the uncontrolled transaction compared to those under the controlled transaction, causing the former to negotiate a different sale price than that calculated under the controlled transaction. Example: Volume differences Comparing a contract involving the supply of 100 terajoules of coal seam gas (CSG) each day for 20 years with a contract involving the supply of 10 terajoules of CSG each day for 20 years, it may be harder for the buyer in respect of the former to obtain the replacement volume from alternative sources to meet the contracted supply commitments with end users. Conversely, it may also be harder for the seller in respect of the former to sell such a large volume of CSG in the spot market without suffering material negative price impacts.

Similarly, differences in the contract duration alter the risk borne by the counter-parties to the controlled transaction compared to those borne by the counter-parties to the uncontrolled transaction. Example: Duration differences

Taking the CSG example above, a shorter term CSG purchase contract (eg 10 years) may cause the buyer of the CSG, who has a significantly longer off-take agreement with end users (eg 20 years), to be exposed to the uncertainties associated with securing the supply CSG beyond the expiry of the 10-year period to meet the remaining contractual supply commitments. The different risk exposure would result in different pricing considerations.

¶17-080 Multiple comparable transactions In cases where there are multiple uncontrolled transactions which can be used to establish the CUP, it is necessary to evaluate the nature, characteristics and timing of the controlled transactions and those of the uncontrolled transactions based on the set of criteria discussed earlier. Theoretically, the uncontrolled transactions which are more similar to the controlled transactions in these respects should be preferred to those which are not. However, it may be the case that none of the uncontrolled transactions are suitable as a basis of comparison with the controlled contract (eg all of the uncontrolled contracts are spot or short-term contracts, whereas the controlled contract is a very long-term contract). In this case, averaging the observable uncontrolled prices under the multiple uncontrolled transactions is not likely to produce the suitable CUP for the uncontrolled transaction. In using the observable uncontrolled prices from multiple arm’s length contracts to determine the CUP for the controlled transaction (assuming it is appropriate to do so), it is necessary to, at least, examine: • whether the multiple arm’s length prices are determined at the same point of disposal and, if not, what adjustments need to be made to derive the adjusted arm’s length price at that point • whether the observable prices are contemporaneous with the time at which the notional market value under the controlled transaction is to be determined • the number of observable uncontrolled prices (ie the sample size) • the statistical properties of the sample, including: – are there any outliers? – what caused the outliers? – should they be excluded? – the dispersion of the sampled prices, and – should arithmetic average, median or volume-weighted average be used? It should be noted that when the sample includes outliers, median is less sensitive to outliers than mean (simple average). Volume-weighted average inherently gives more weight to observable prices associated with high-volume transactions. If these high volume uncontrolled transactions are less comparable to the controlled transactions, then the use of volume-weighted average prices is unlikely to produce a more accurate notional market value under the controlled transactions or vice versa. Theoretically, the regression technique may be used to examine the relationship between the observable uncontrolled prices and a number of hypothesised drivers of these prices (eg contract duration, daily and total volume, take-or-pay provision, banking/claw back provision, etc). Assuming this relationship can be reliably established, it is then extrapolated to the controlled transaction, taking into account the values of the variables associated with the controlled transaction to effectively derive a constructed CUP for the controlled transaction. The difficulties with applying the regression technique to derive the constructed CUP include: • the large number of drivers of the constructed CUP (statistically referred to as independent variables) that need to be hypothesised and included in the regression

• the lack of reliable information to identify the independent variables • the lack of observable uncontrolled prices to construct a sufficient sample of observations to derive statistically reliable regression results, and • the technical complexities involved. Theoretically, if there are differences between the controlled transaction and each of the multiple uncontrolled transactions, it would be necessary to make adjustments to the observable uncontrolled prices. Practically, however, it would be a complex, information intensive, resource intensive and costly process given the number of multiple transactions, the number of observable prices that need to be adjusted under each uncontrolled transaction for each taxing period, and the number of adjustments that need to be made (putting aside for the moment whether they are technically correct and reliable adjustments). A practical alternative approach is to examine whether a consistent pricing method/formula is used in the uncontrolled contracts (albeit with different value inputs). If so, the common pricing method/formula should be applied to determine the market value of the commodity under the controlled contract, with input values reflecting the idiosyncratic characteristics, timing and circumstances of the underlying controlled transaction.

¶17-090 In a nutshell The availability of observable uncontrolled prices should not be taken for granted as readily representing CUPs. The choice of the valuation methodology for commodity transactions should be determined on a case-bycase basis, depending on, inter alia, the factual circumstances and the reliability of the relevant information available.

Re-evaluating the valuation treatment of accommodation bonds in the residential aged care sector ¶18-010 The background Prior to 1 July 2014, a residential aged care facility (RACF) could provide either low-care1 bed places or high-care2 bed places or a mixture of both. Extra service care could be offered to residents of low and high-care bed places at an additional cost to the residents based on usage3. Accommodation bonds were only payable by residents of low-care bed places, low-care bed places with extra services and high-care bed places with extra services. They were not payable by residents of high-care bed places without extra services. Since 1 July 2014, the distinction between low-care and high-care bed places has been removed. Accommodation bonds (now referred to as refundable accommodation deposits) are payable by residents of (formerly called) high-care bed places4. The amount of an accommodation bond is driven by the location of the facility, the local residential property market, and the timing of the bond-paying resident’s entry into the facility. In cases where accommodation bonds are paid, the provider of an approved RACF is able to retain interest-earnings on the accommodation bonds received and/or use the cash proceeds from the receipt of the bonds to meet development capex in relation to that RACF or other RACFs (including greenfield projects) owned by the same provider/business. Upon the repayment of an accommodation bond to a departing resident, the provider of the RACF can also deduct a set administration charge from the bond (known as an allowable retention amount), depending on the resident’s length of stay5. Footnotes 1

Low-care RACFs, commonly called “hostels”, provide hostel-type accommodation for residents having a low level of dependency and requiring a lower level of care, such as assistance with personal hygiene, dressing, laundry, cooking, shopping or supervision of medication.

2

High-care RACFs, commonly known as “nursing homes”, provide 24-hour nursing care for residents with a high level of dependency (including the very elderly and those in the later stages of dementia, etc).

3

Extra service care may include a higher standard of accommodation and non-care services (such as a higher standard of entertainment and food services).

4

In the remainder of this Chapter, the term “accommodation bonds” will be used when discussing the nature of accommodation bonds/refundable deposits.

5

Deductions cease once a resident has been in occupation for more than five years.

¶18-020 The accommodation bond conundrum A conundrum arises from the divergence between the legal/accounting approach and the economic approach to the treatment of accommodation bonds. A legal/accounting approach

From a legal/accounting perspective, existing accommodation bonds are technically non-interest-bearing liabilities6. Proponents of the legal/accounting approach to the treatment of accommodation bonds argue that the purchaser of an RACF will generally agree to take on certain liabilities, including accommodation bonds, as part of acquiring the facility. It follows, in this view, that the assumed liabilities (including interest-bearing debt (if any) and particularly the face value of existing accommodation bond liabilities) should be added to the purchase price consideration (for the equity) when assessing the market value of the facility. As discussed in detail later, this is incorrect in terms of both assessing the “value” of the existing accommodation bonds at their face value and adding this assessed value to the purchase price consideration for the equity when assessing the market value of total assets. An economic approach In contrast, the economic approach to accommodation bond “liabilities” focuses on the impacts on the cash flows (and their timing) to the facility of the receipt and discharge of accommodation bonds and the economic substance of accommodation bond “liabilities” as opposed to their legal form. In many cases, the actual cash flow impacts of accommodation bond “liabilities” reflect the fact that the discharge of an accommodation bond liability on a resident’s departure would be fulfilled by the almost immediate receipt of a new and generally larger bond paid by an incoming bond-paying resident, thereby, prima facie, not requiring any utilisation of the facility’s own economic resources until far (say, 50 years or more) into the future. From an economic perspective, given that the value of an RACF is theoretically and technically the present value of the net cash flows expected to be generated by the facility, that is, the discounted cash flow (DCF) approach, the cash flow impacts of both existing and new accommodation bonds are, and should naturally be, reflected in the theoretically and technically correct cash flow-based assessment of the value of the facility that is shared between the providers of debt and equity investment capital to the facility. It logically follows under the economic approach that accommodation bond “liabilities” should already be allowed for in the cash flows used to assess the market value of equity and debt. How the two approaches diverge The divergence between the legal/accounting approach and the economic approach to the treatment of existing accommodation bonds creates significant confusion among market participants when the proper valuation treatment of accommodation bonds is required in valuation exercises undertaken for commercial, tax and stamp duty purposes. In particular, the adoption of the legal/accounting approach implies that the face value of the existing accommodation bonds has to be added to the (correctly assessed) purchase price consideration for equity and the market value of debt (if any) in assessing the market value of an RACF. Conversely, the face value of the existing accommodation bonds and the market value of interest-bearing debt (if any) have to be subtracted from the (correctly assessed) market value of the total assets of the business in assessing the market value of the equity. In contrast, the adoption of the economic approach shows that the valuation treatment of accommodation bonds under the legal accounting approach is incorrect. In fact, it is double-counting. Consequently, each approach can result in significantly different valuation outcomes for the same RACF, with significant flow-on commercial, tax and stamp duty implications. In most cases, these outcomes are exacerbated by the significant face value of the existing accommodation bonds relative to either the purchase price consideration for equity and the market value of debt (if any), or the assessed value of the total assets of the facility. The commercial perspective From a commercial perspective, the choice of approach to the treatment of accommodation bonds (particularly, existing accommodation bonds) has a substantial impact on the assessed value of the total assets of the facility or, given the assessed value of the total assets of the facility, the assessed value of equity and the resulting purchase price consideration offered for the equity. In particular, the confusion as to the correct valuation treatment of accommodation bonds causes an uncertainty as to whether the accommodation bond inflow should be treated as operating cash flows or financing cash flows. Such a choice has important flow-on valuation impacts because the valuation of a going concern

business is generally undertaken based on the ability of the business to generate free cash flows from its investment and operating activities, rather than its financing cash flows. Stamp duty implications From a stamp duty perspective, the valuation treatment of accommodation bonds has direct implications under a land rich landholder regime. Under this taxing regime, a land rich test is performed to determine whether a relevant landholder is land rich7. The test involves assessing whether the unencumbered value of the land holdings of the landholder is equal to, or exceeds a specified proportion of the unencumbered value8 of all its property, other than certain excluded property9. The valuation treatment of accommodation bonds has direct implications for assessing the market value of the non-excluded property (or relevant property) of an RACF, which forms the denominator of the calculated land rich ratio to be compared against the percentage threshold in the land rich test. For example, if the “observed” purchase price consideration for equity is correctly assessed (which is not always so), adding the face value of the existing accommodation bonds to the observed purchase price consideration for equity and the market value of debt (if any) when assessing the market value of the nonexcluded property is not only incorrect but it also artificially and significantly inflates the market value of the non-excluded property. This, in turn, results in significant value being artificially created and incorrectly attributed to goodwill, thereby “diluting” the proportion of land value in the significantly inflated value of the non-excluded property (that is, the denominator of the land rich ratio). In cases where the market value of the relevant property of the facility needs to be apportioned between the market value of land assets and non-land assets, getting the market value of the total assets correct (which requires the correct valuation treatment of accommodation bonds and the resulting correctly assessed market value of the facility) is also an essential starting point in order to correctly assess the market value of the land assets. In this regard, the valuation treatment of accommodation bonds has stamp duty implications not only under the land rich landholder regime, but also under the landholder regime. CGT and GST implications The valuation treatment of accommodation bonds also has capital gains tax (CGT) and goods and services tax (GST) implications because it directly affects the assessment of the consideration for both the direct and indirect sale of an RACF. In the latter case, the question of whether the face value of the existing accommodation bonds should be added to the “observed” purchase price for the equity in the facility when assessing the sale consideration for the facility is important for CGT and GST purposes. In the absence of an appropriate conceptual framework to determine the correct valuation treatment of accommodation bonds in a given case, valuation certainty or consistency has inevitably proved elusive. The primary objective of this Chapter is to address the accommodation bond conundrum and provide a systematic conceptual framework to resolve the resulting valuation uncertainty associated with valuing RACFs (which has flow-on commercial, stamp duty and tax implications). Implications for resident loans in retirement villages The counterpart to accommodation bonds in the context of retirement villages is resident loans. This is because: • like an accommodation bond, a resident loan is paid in return for the occupancy right of a dwelling in a retirement village, which is typically in the form of a long-term lease or a licence to occupy • upon the termination of the lease/licence, the owner of the village is obliged to repay the departing resident the face value of the loan net of a deferred management fee, and • the owner of the village may also retain all or part of any “in substance” capital gain or loss. There has been also much confusion about the valuation treatment of resident loans. Given the conceptual similarities between accommodation bonds and resident loans, resolving the accommodation bond conundrum has direct implications for resolving the resident loan conundrum. Footnotes

Footnotes 6

In order to meet the requirements of AASB 101 Presentation of Financial Statements, existing accommodation bonds are classified as “current” liabilities on the balance sheet of the reporting entity. The technical justification for this accounting treatment is that the operator of an RACF does not have an unconditional right to defer settlement for at least 12 months after the balance sheet date and therefore under the accounting standard definitions, the bonds are “current” liabilities. The fact that in commercial reality the bonds are rolled over (almost “in perpetuity” in many cases) and are, in economic substance, proceeds from the sales of occupancy rights (discussed further below) is ignored for accounting purposes.

7

There has been a recent shift from a land rich landholder regime to a landholder regime in which the land rich test is abolished. However, the land rich test and its outcome are still relevant to the duty implications for transactions that occurred when the land rich landholder regime was in place.

8

The term “unencumbered value” has the same meaning as the term “market value”, which is the price that would be negotiated in an open and unrestricted market between a knowledgeable WBNAB and a knowledgeable WBNAS acting at arm’s length within a reasonable timeframe.

9

This threshold has varied over time and might be different across states at a given point in time.

¶18-030 Sources of confusion In order to resolve the accommodation bond conundrum, it is important to recognise the sources of the current confusion about the treatment of accommodation bonds. This confusion is attributable to the failure to: • distinguish two different questions: – Are accommodation bonds technically legal/accounting liabilities? – What impact does the technical existence of these legal/accounting liabilities have on the market value of an RACF? • recognise the variation in the idiosyncratic characteristics of each case and appreciate that there is no “one-size-fits-all” answer to the valuation of accommodation bonds • establish a conceptual valuation framework or thought process that is capable of taking into account the idiosyncrasies of each specific case in order to produce the appropriate valuation answer for that case, and • understand: – the interplay between how the market value of an RACF is, or should be derived and the way in which accommodation bonds are, or should be allowed for – the relevancy (or irrelevancy) of the face value of the existing accommodation bonds (recorded on the balance sheet of the facility) in the assessment of the market value of the facility on a going concern basis, and – what the “observed” purchase price consideration truly represents in a given case and the interplay (or its absence) between existing accommodation bonds and the “observed” purchase price consideration in assessing the market value of the facility.

¶18-040 The relevant focus The appropriate treatment of accommodation bonds in assessing the market value of an RACF is inherently a valuation question. Consequently, in order to understand the value impacts of accommodation bonds, it is necessary to understand how value is derived in the first place. The value of any asset is the present value of future (net) cash flows expected to be generated by the asset. There are three critical aspects of present value assessment: • the amount of the expected future cash flows • the timing, and • the riskiness of these cash flows. Other things being equal, the further away in time the occurrence of a cash flow, the lower its present value and vice versa. Understanding the timing aspect of present value assessment is particularly important in assessing the value impacts of accommodation bonds. Given that the value of an RACF on a going concern basis is driven by its ability to generate future (net) cash flows, the true value impact of a liability depends on whether the satisfaction of that liability materially affects the present value of the (net) cash flow stream expected to be generated by the facility. It naturally follows that in assessing the appropriate valuation treatment of accommodation bonds in a specific case, the relevant focus should not be on the technical existence of accommodation bond “liabilities”. The true focus should be on the economic materiality of these liabilities and in particular how and when the fulfilment of these liabilities is achieved in practice (and the consequential impacts on the net cash flows to, and value of, the facility). The use to which the cash from the receipt of the existing accommodation bonds have been (or will be) put is also important in understanding how the cash flow impacts of existing accommodation bonds are reflected in a forward-looking DCF approach (discussed below) and assessing the appropriate valuation allowance for the bonds on a given valuation date. Given that the cash flow impacts of accommodation bonds are case-specific, there is obviously no single valuation allowance for accommodation bonds that is correct in all cases. The key to finding the correct answer for a specific case is to establish the appropriate conceptual framework that provides market participants with a clear and correct thought process in considering and analysing the factual circumstances of the specific case to arrive at the right valuation answer for that case.

¶18-050 The appropriate conceptual framework The theoretically and technically correct approach to valuing an RACF on a going concern basis is the DCF valuation approach under which the value of the facility is the present value of the (net) future cash flows expected to be generated by the facility. Thus, the DCF approach is inherently a forward-looking valuation approach. The correct treatment of accommodation bonds for valuation purposes requires an understanding of the interplay between a multitude of factors, including: • the expected cash flows associated with an accommodation bond • the way that accommodation bonds are allowed for in a forward-looking DCF model, and • the distinction between an existing accommodation bond and a new accommodation bond, and the use to which the cash from the receipt of existing accommodation bonds has been or will be put. A good way of understanding the interplay between these factors is to examine the return to the provider of a brand new facility over the life of the underlying property. Considering the expected cash flows to the provider of the brand new facility over the life of the underlying property is useful for valuation purposes because doing so helps separate, on a given valuation date, forward-looking expected cash flows, which

are relevant to the DCF valuation of the facility from the backward-looking historical cash flows reflected in the balance sheet value of bond liabilities, which accounting value is not relevant to the DCF valuation. The return to the provider of a brand new facility, in present value terms, comes from the following sources: • the receipt of the initial accommodation bonds that, in economic substance, represent the proceeds from the effective initial “sales” of the occupancy rights of the underlying bed places (and the implicit development profit) with the obligation to buy-back these occupancy rights at the initial face values of the bonds, net of allowable retention amounts10 PLUS • uplifts in underlying property prices expected to be realised upon the turnover of existing and future bond-paying residents when higher bonds are collected from incoming new bond-paying residents to repay the lower bonds to the departing bond-paying residents11 PLUS • allowable retention amounts realised upon the turnover of bond-paying residents; plus accommodation charges on places for which accommodation bonds have not been paid either in full or in part PLUS • operational profits (or losses) from the provision of care to elderly residents LESS • normal maintenance capex that is required to comply with ongoing building, safety and other operational requirements LESS • any development capex (over and above the normal ongoing maintenance capex) that is required to keep the facility operational and allow the operator to continue the bond rollover LESS • accommodation bonds that have to be repaid to the bond-paying residents when the facility is eventually closed down. This framework provides useful insights into various important conceptual issues associated with the treatment of accommodation bonds. These conceptual issues need to be correctly understood and appreciated if the confusion about valuation treatment of accommodation bonds is to be resolved. Footnotes 10

In contrast with conventional property development projects, the development profit implicit in the initial “sales” of the occupancy rights (ie the receipt of initial accommodation bonds) are not subject to income tax.

11

This is similar to (subsequent) property trading profits which can be realised/fully retained by the developer/owner of the facility in addition to the initial development profits. Like the initial implicit development profits, what are, in economic substance, the subsequent property trading profits are also not subject to income tax.

¶18-060 “Sales” of underlying bed places versus “sales” of occupancy rights

From a commercial perspective, the receipt of the initial accommodation bond for a bed place represents the “sale” of the redeemable12 occupancy right of the bed place13. This is because unlike conventional sales of residential properties, the owner of an RACF still retains the legal ownership of the underlying bed places whose occupancy rights have been sold, and is still effectively entitled to the capital appreciation of the underlying properties upon the redemption of the occupancy rights and the subsequent on-sales of these occupancy rights and the ongoing right to manage these properties. In fact, the ability to capture effectively tax-free the cash flows corresponding to initial development profits, while still retaining entitlement to subsequent effectively tax-free property trading profits associated with the underlying bed place and a portion of the accommodation bond (ie the allowable retention amount that represents in substance a deferred management fee) upon the turnover of residents, are attractive features of the RACF sector providing additional investment returns/incentives and significant value to operators of RACFs. From the residents’ perspective, paying an accommodation bond is akin to paying for a “home”, except that the payment of the bond is not subject to stamp duty. The value of an RACF at a particular point in time depends on whether such value is measured using the forward-looking DCF approach before or after the initial “sales” of the occupancy rights or the receipt of the initial accommodation bonds and, in the case of the latter, whether the cash proceeds from the receipt of the bonds have been reinvested in brownfield or greenfield development projects and reflected in the assessed values of these projects at the relevant time, or they have been kept in interest-earning accounts by the operator. In reality, the value of the facility is usually assessed at a point where not all of the saleable occupancy rights have been “sold”. The fundamental principle of relying on forward-looking cash flows when assessing value still applies. In this case, the forward-looking cash flows reflect the cash flows associated with the entitlement to the capital appreciation and management rights of the bed places whose occupancy rights have been sold and the cash flows associated with the future sales of the presently “unsold” occupancy rights and the entitlement to the capital appreciation and management rights of the bed places underpinning those presently “unsold” occupancy rights following their future sales. Footnotes 12

The redemption actually coincides with the departure of the bond-paying resident or the closure of the facility (ie the redemption can be exercised by either the bond-paying resident (or appointed representative) or the operator of the facility, depending on the circumstances). The frequency at which the redemption occurs is generally driven by the turnover of bondpaying residents, which may vary but generally takes place, on average, every three to four years for bed places and 10 to 12 years for retirement village occupancy rights. In this regard, from a bond-paying resident’s perspective, the payment of an accommodation bond is required to secure, in substance, a relatively short-term lease of the bed place and a relatively long-term lease of a retirement village unit.

13

In addition, many facilities maintain a certain level of “periodic” accommodation bonds where residents are allowed to pay only some portion or none of the face value of the accommodation bonds at the time of entry, and pay interest in lieu of the unpaid portion of the bonds. In these cases, the uplifts in the periodic accommodation bonds expected to be realised upon the turnover of periodic bond payers are reflected in the uplifts in the combination of the paid portion of the periodic bonds and the interest payable in lieu of the unpaid portion of the bonds. In any event, the method of payment for the (non-concessional) bonds does not alter the economic substance of the bonds, although it affects the cash flow pattern, risk profile, tax payable and capital/financing requirements of the operator of the facility.

¶18-070 Economic substance over legal form

Legal form — accommodation bonds are a legal liability The common tendency of characterising accommodation bonds as an interest-free liability14, while a substantial improvement on valuing them at their face value, actually creates a source of conceptual confusion about the true economic nature of accommodation bonds and the appropriate valuation treatment of these bonds when assessing the market value of an RACF. When a new facility is built, the proceeds from sales of the rights to occupy the brand new places in the facility can be used to reinvest in buying and developing new brownfield and/or greenfield sites. The subsequent use of the proceeds does not alter the fact that they are part of the cash flows generated from a normal operating activity of the aged care business in the first place, being developing new aged care places. Characterising accommodation bonds as interest-free loans inadvertently focuses too much attention on the subsequent use of the cash flows generated, rather than the generation of the cash flows in the first place. It is the latter which underpins the assessment of value. In addition, portraying accommodation bonds as an interest-free liability creates a conceptually false impression that the accommodation bond payers are a true provider of capital to the RACF, whereas they are, in economic substance, the purchasers of the occupancy rights of the underlying bed places (with the right to return these occupancy rights to the operator of the facility at the face value of the bonds net of an allowable retention amount). Put simply, accommodation bonds are the consideration for the occupancy rights of the underlying bed places provided by the facility, rather than the true capital invested in the facility in an economic and financial sense. The true providers of debt and equity capital to the development of these underlying bed places are typically normal debt and equity providers. This is similar to the way in which a typical property development project is financed and the return to the providers of capital to the project is realised upon completion. However, while the total return to the providers of capital to a typical residential property development project (eg a complex of strata titled units) arises from the transfer of the complete economic ownership of the units upon completion, the total return to the providers of capital to a typical aged care development project is comprised of: • the proceeds from the transfer or “sale” of only temporary (albeit largely “redeemable”) occupancy rights of the underlying bed places in return for the receipt of the accommodation bonds PLUS • the residual economic benefits associated with the continued legal ownership of the underlying properties, including: – the entitlement to any capital appreciation (realised upon the turnover of bond-paying residents)15, and – the right to manage the underlying bed places in return for an allowable retention amount, which is described as a deferred management fee16. Given that the value of the whole business can be established by adding the values of the financial securities (eg equity, straight debt, convertible notes, etc) held by the providers of capital to the business, portraying the accommodation bond payers as providers of capital to the business effectively ascribes to accommodation bonds the same valuation status as normal debt and, as a result, creates an incorrect tendency or “justification” to mechanistically add the face value of the existing accommodation bonds to the value of normal debt and equity when assessing the value of the facility. Economic substance — accommodation bonds are consideration for occupancy rights This confusion can be avoided for valuation purposes by focusing on the true economic substance of accommodation bonds (ie consideration for occupancy rights) instead of their legal form (ie a legal liability). This is so not only in cases where accommodation bonds are characterised as an interest-free, and effectively a “perpetually” deferred liability, but also in cases such as in older RACFs where they are viewed as a non-perpetual, interest-free liability (ie where the legal “liability” is expected to be crystallised in the relatively near future). For newer RACFs, the repayment of the accommodation bond to a departing bond-paying resident is, in economic substance, the repurchase of the occupancy right of the underlying bed place which can then

be on-sold to a new bond-paying resident. In other words, unlike the repayment of debt or repurchase of shares, the repayment of the accommodation bond in fulfilment of the liability in the legal sense involves two integrally linked components, the payout of cash in return for getting back the occupancy right which can be on-sold or monetised, generally at a net cash gain, almost immediately. For older RACFs, the repayment of the accommodation bonds also involves the two abovementioned integrally linked components, that is, cash flows and occupancy rights, although for these facilities the occupancy rights are not on-sold due, for example, to the closure of the facility but redeemed making the interest-free legal “liability” non-perpetual. However, repaying the existing accommodation bonds and getting back the occupancy rights allows the operator of the facility to redeploy the assets of the facility to a better alternative use17. In both cases, the repayment of accommodation bonds is, in economic substance, part of the operational or investment side of the business, not the financing side. What is commonly characterised as the repayment of accommodation bond liabilities actually hides the true investment or operational nature of the activity, which is the repurchase of occupancy rights either for subsequent on-sale or for enabling the redeployment of the assets of the facility to alternative uses. In practice, however, the appearance of the existing accommodation bonds on the balance sheet as accommodation bond “liabilities” creates a mechanistic tendency to (incorrectly) equalise the nature of existing accommodation bonds to the nature of pure debt instruments. The natural extension of this (incorrect) mechanistic tendency is an attempt to “value” the on-balance sheet accommodation bond liabilities at their face value, the same as debt instruments are valued under normal circumstances. Even within this incorrect comparative construct, if the “value” of the existing accommodation bond liabilities is assessed based on the (negative) cash flow impacts associated with the future settlement of these liabilities, the assessed “value” must be lower than the face value of the existing bonds. This is due to the time lapse between the valuation date and the expected date of bond repayment and the absence of interest payments in the intervening period. In many cases where the current occupancy level is maintained into a far distant future, the assessed “value” of the existing accommodation bonds is substantially lower or closer to zero than it is to the face value of the existing bonds. This is due to the fact that the ultimate settlement of the existing bond liabilities is pushed back so far into the future that the present value of the payout is immaterial. This illustrates the sheer incorrectness of “valuing” the existing bond liabilities at their face value, let alone adding the full face value of the bonds to the (correctly assessed) “observed” purchase price consideration for equity when assessing the market value of the facility. Footnotes 14

Under the assumption of continued occupancy, accommodation bonds are commonly viewed as an almost “perpetual” interest-free liability.

15

The facility owner’s continued exposure to subsequent increments in the underlying property value which are crystallised upon turnover of residents reflects an integral part of the valuecreating ability of the business and should be reflected in the assessment of its value (having also allowed for the risk of decrements in the underlying property value).

16

For retirement villages, depending on the contractual arrangements, it is in economic substance an interest in real estate.

17

Depending on the specific circumstances, the bed licences can be sold in the market or transferred to brownfield or greenfield development projects owned by the same entity to generate future accommodation bonds.

¶18-080 Sharing of expected cash flows with providers of equity capital

Conceptually, the provider of debt capital to a business at a given point in time is entitled to receive the contracted interest rate (which represents a pre-determined amount of the expected (net) cash flows generated by the business), whereas the provider of equity capital to the business is entitled to the residual share of the expected cash flows. The expected cash flows that are shared between the providers of debt and equity investment capital reflect the cash flow impacts of accommodation bonds from the operating or investment side of the business. The present value of the share of the expected cash flows to the provider of debt capital represents the market value of debt, whereas the present value of the residual share of the expected cash flows to the provider of equity capital represents the market value of equity (on a 100% basis) and should underpin a correctly assessed purchase price consideration for the equity. This indicates that the provider of debt capital at a given point in time shares, on a contractually committed basis, the overall expected (net) cash flows generated by the business with the provider of equity capital. Thus, the market value of interest-bearing debt (which is, in normal circumstances, usually proxied by the face value of debt) can and should be added to the market value of equity in establishing the market value of the facility on a going concern basis which is the present value of expected cash flows accruing to providers of both debt and equity capital. In the case of RACFs18, the accommodation bond payers obviously do not share the total expected cash flows with the providers of equity capital. Thus, accommodation bonds should not be treated as being identical to interest-bearing debt capital and added to the observed purchase price consideration for equity when assessing the market value of the facility. Conversely, once the value of the total assets of the facility has been derived based on the present value of the overall expected (net) cash flows to the providers of debt and equity capital that already reflects the cash flow impacts of existing (and future) accommodation bonds, the face value of the existing accommodation bonds should not be deducted from the assessed value of total assets in assessing the market value of equity and the resulting purchase price consideration for equity. Accordingly, recognising the true economic substance of accommodation bonds, being consideration for the “sales” of occupancy rights that is reflected in the expected (net) cash flow to both providers of debt and equity capital, as opposed to mechanistically relying on the accounting and legal “liability” of bond repayment, is essential to resolving the confusion about the valuation treatment of accommodation bonds. Footnotes 18

In the case of retirement villages, depending on the contract, they may.

¶18-090 Timing of accommodation bond repayment As the physical conditions of an RACF deteriorate over time, the operator of the facility has two options19. One is to incur the development capex to refurbish or rebuild the facility, allowing the rollover of accommodation bonds to continue. The other is to close the facility, repay the accommodation bonds, and sell or put the assets of the facility to an alternative use. From a valuation perspective, it is not purely the fact that development capex has to be incurred or accommodation bonds have to be repaid at some point in time that really matters. What really matters from the valuation perspective is: • the length of the period between the valuation date and the occurrence of the development capex (required for refurbishment or replacement) or, alternatively, between the valuation date and the closure of the facility and the repayment of the accommodation bonds • whether the occupancy level (hence, the rollover of bonds and realisation of bond uplifts and allowable retention amounts) is maintained during the abovementioned period of time, and • whether the occupancy level can be recreated at the existing (or an alternative) facility. Bond repayment far into the future

If the facility has a significant remaining physical life (ie it is a relatively new facility) and over that significantly long period of time there is, given the prevailing conditions of the RACF sector, a reasonable expectation that occupancy levels will be maintained (allowing the rollover of accommodation bonds to continue during that period), the ultimate repayment of the accommodation bonds or the occurrence of the development capex (whatever the case might be), would effectively be pushed so far into the future that the present value of the development capex or ultimate payout of the bonds is only a small fraction of the face value of the bonds20, such that the impact of these obligations on the DCF valuation of the facility at the valuation date would often not be material. Even for a relatively old facility, it is often likely that the development capex will be spent on either building a new facility on the same site or on a new site to which the bed licences, the existing residents and operations are transferred, thereby effectively enabling the existing accommodation bonds to be rolled over21. In this case, while the occurrence of the development capex would have a material impact on the DCF valuation of the facility, the ultimate repayment of the existing accommodation bonds would be, assuming the occupancy level is maintained at the newly refurbished facility, pushed back so far into the future that the present value of the ultimate payout would be a small portion of the face value of the bonds. Consequently, in a valuation sense, the ultimate repayment of the existing accommodation bonds (which is commonly used to emphasise the technical existence of a legal liability) often has no material impact on the DCF valuation of the facility. Early bond repayment There are cases where the repayment of accommodation bonds has a material impact on the DCF valuation of an RACF, particularly if the facility is a standalone RACF, rather than part of a portfolio of RACFs22. For example, when the accommodation bonds (net of allowable retention amounts) have to be repaid upon the closure of the facility that is expected to occur in the relatively near future, the present value of the expected payout can be so significant that it exceeds the present value of the sum of the bond uplifts, allowable retention amounts and operational cash flows expected to be generated during the finite period to the closure of the facility. Another way of thinking about the value impacts of the bond repayment in these cases is that the imminent closure of the facility brings forward the repayment of the accommodation bonds, magnifying the present value effect of such repayment. This is exacerbated by the fact that the bond repayment coincides with the discontinuation of the rollover of the bonds and the positive cash flows to the facility operator associated with it. The value impacts of the “early” bond repayment also depend on whether the facility is operated on a freehold or leasehold basis. In the former case, the present value effect of the “early” bond repayment is offset by the present value effect of the reversionary value of land23 (bed licences and other assets) being also brought forward, whereas the offsetting effect of the early realisation of the reversionary value of land is not present in the latter case. Consequently, the value impacts of “early” bond repayment are more pronounced in cases where the facility is operated on a leasehold basis (other things being equal). Valuation outcome depends on the facts and assumptions of each case This analysis points to the fact that the value impacts of bond repayments are case-specific and conceptually depend on whether the assumption of continued occupancy (at the existing site or at another site) is realistic for a particular case. Confusion will inevitably arise if one fails to recognise the basic tenet that valuation outcome depends on the factual circumstances considered and the resulting assumptions adopted for valuation purposes. Indeed, while cases where the assumption of continued occupancy is not realistic obviously highlight the value impacts of the legal “liability” of bond repayment, it is, from a valuation perspective, incorrect to conclude or generalise that the valuation impacts of the legal “liability” of bond repayment are also significant in cases where the assumption of continued occupancy is realistic and reasonable. Using the legal “liability” of bond repayment as a lens through which to view or assess the value impacts of accommodation bonds in every single case will naturally result in both confusion and valuation errors. Furthermore, using such lenses blurs the right valuation focus, which should be on the true economic substance and cash flow impacts of accommodation bonds. On the contrary, using the forward-looking DCF valuation approach and treating the receipt of accommodation bonds as the proceeds from the “sales” of the occupancy rights of the underlying bed

places, and treating the repayment of these bonds as the repurchases of these occupancy rights, provide market participants with the appropriate conceptual tools to arrive at the correct valuation allowance for accommodation bonds in virtually all cases. This is not unexpected because the appropriate valuation allowance for accommodation bonds is ultimately a valuation question to which the correct answer should be based on the true economic nature of the bonds. A correct valuation treatment and a technical accounting or legal treatment of the bonds can legitimately differ. Footnotes 19

The operator/owner of the facility can sell the facility to a purchaser who would also have these two options.

20

This is simply a manifestation of the time value of money. In cases where the development capex is spent on refurbishing the facility, the ultimate repayment of the accommodation bonds is effectively pushed back even further into the future, further reducing the already immaterial present value of the ultimate payout.

21

Whether or not the development capex is spent to maintain the rollover of the existing accommodation bonds is an investment decision that depends on the present value of the sum of the bond uplifts, the allowable retention amounts and the operational cash flows net of maintenance capex, relative to the amount of the development capex.

22

In cases where a portfolio of RACFs is the subject of valuation, the closure of one facility may not result in a discontinuation of the rollover of the complete portfolio of existing bonds at this facility. This is so if some bond-paying residents (and the associated bed licences) are transferred to other facilities within the portfolio, allowing the rollover of the underlying bonds to continue.

23

The reversionary value of land can be realised by putting the land to a better alternative use.

¶18-100 Allowing for uncertainty as to the amount of net bond flow In a typical forward-looking DCF valuation of an RACF, cash flows associated with accommodation bonds are allowed for by calculating the net bond flow (NBF). For a given year in the forecast period, the projected NBF should reflect: • (higher) bonds to be paid by new bond-paying residents for existing occupied bed places PLUS • bonds to be paid by new bond-paying residents for currently vacant existing bed places PLUS • bonds to be paid by new bond-paying residents for new bed places which come online in that year (as a result of greenfield or brownfield extension projects being completed) LESS • bonds to be returned to departing residents of existing occupied bed places net of allowable retention amounts deducted from the bonds paid to departing residents. This is obviously projected NBF and there is risk that the actual (future) NBF can deviate from the projected NBF. Depending on the RACF being valued, the downside risk associated with the NBF normally arises from the fact that a significant increase24 in supply could have an adverse impact on the occupancy rate and the ability to keep increasing bond prices, which would have a flow-on adverse

impact on the magnitude and timing of the bond uplifts on existing occupied bed places as well as the amount and timing of bonds to be received from the “sales” of occupancy rights of existing vacant bed places or new bed places which come online following the completion of brownfield expansion or greenfield development projects. Again, the legal “liability” of the bond repayment is highlighted in cases where the downside risk materialises and occupancy level is not maintained. However, from a valuation perspective, the projected NBF should technically be calculated as the probability-weighted NBF, taking into account the NBF forecasts in various reasonably likely scenarios (eg at the most basic level the downside case, the upside case and the base or central case). The assignment of probabilities to different possible scenarios (which can be undertaken explicitly or implicitly in practice) is designed to obtain best estimates or unbiased forecasts of future NBF. This is fundamental to the correct application of the DCF valuation approach and is consistent with how knowledgeable WBNAB and WBNAS assess value. In addition, within the DCF valuation framework, the probability-weighted (unbiased) NBF is discounted at a discount rate which can be determined using objective verifiable market evidence. Basically, this discount rate is the prevailing risk-free rate plus a risk premium. The use of the risk premium recognises that the probability-weighted or expected NBF is not risk-free and compensates the providers of capital to the facility for, inter alia, the (systematic) risk that the actual future NBF may deviate from the expected NBF (eg if future accommodation bonds are lower than expected) and such variation is driven by marketwide factors such as interest rate movements, inflation and other macro-economic factors. It is important to note that while the mere presence of risk associated with the NBF may be likened to the technical existence of the legal “liability” of bond repayment, what really matters for value assessment is how to allow for such risk and whether it has been appropriately and adequately allowed for in the assessed value of the facility. The DCF valuation framework provides a systematic mechanism under which allowance for the riskiness of the NBF can be made. In fact, adding the face value of the existing accommodation bonds to the correctly risk-adjusted DCF valuation when assessing the market value of total assets (on the grounds that there is a risk that the existing accommodation bond “liabilities” have to be crystallised at some point in the near future) is counter-intuitive. This is because doing so would increase, rather than decrease, the assessed market value of total assets, which is inconsistent with the basic tenet that there should be an inverse relationship between asset value and risk (more precisely, the riskiness of the future cash flows expected to be generated by the subject asset). Footnotes 24

Logically, a significant decline has the reverse effect but in practical terms this is less likely.

¶18-110 Allowing for the use of proceeds from existing accommodation bonds Understanding the subtle interplay between the use to which the cash proceeds from the receipt of existing accommodation bonds has been, or will be, put and the expected (net) cash flows used in the forward-looking DCF valuation is also necessary in determining the correct valuation treatment of existing accommodation bonds. This can be seen by considering two scenarios. One is where the cash proceeds have been or will be retained as cash; the other is where the cash proceeds have been, or will be, reinvested by the provider of the facility in greenfield or brownfield development projects. Proceeds kept in cash In cases where the cash proceeds from the receipt of existing accommodation bonds are kept in cash, a hypothetical WBNAB would take into account the cash holding of the facility (which reflects the carrying amount/face value of the existing accommodation bonds) and the investment return thereof25, plus the present value of the future cash flows expected to be generated by the facility. It is incorrect to add the face value of the existing accommodation bonds to the “observed” purchase price for equity in assessing the market value of the facility because the “observed” purchase price for equity (if correctly assessed) should already reflect the market value of cash holdings of the facility26.

Proceeds reinvested In contrast, in cases where the proceeds from the existing accommodation bonds have been reinvested by either reducing bank debt (thus, increasing future debt capacity that can be utilised to finance the capex associated with development projects), or directly offsetting development capex27. In these cases, the proceeds from the existing accommodation bonds do not represent the retained cash holdings. Instead, they have been (or will be) effectively reinvested in those development projects whose expected future cash flows (including those associated with the receipt of the new accommodation bonds and subsequent uplifts thereon following the completion of these development projects) have already been captured in the forward-looking DCF valuation. Consequently, the resulting DCF valuation would conceptually have already captured the value expected to be realised from reinvesting the cash from the historical receipt of the existing accommodation bonds in the existing development projects. In fact, the DCF valuation would have already captured the (higher) value arising from reinvesting such cash proceeds to create the value embedded in these development projects, instead of being pure idle (excess) cash holdings. In substance, the otherwise excess cash assets of the business have already been effectively transformed into the value of the development projects in which the cash has been, or will be, invested. How the use of proceeds affects valuation From a valuation perspective, a knowledgeable hypothetical WBNAB of a portfolio of RACFs as at the valuation date (at which time the proceeds from accommodation bonds from mature facilities have been, or would be effectively reinvested in the existing development projects) should be only concerned with the (forward-looking) cash flows expected to be generated by the portfolio of RACFs when assessing the value of that portfolio. Put another way, the buyer should not be concerned with the historical “sales” of the occupancy rights of the existing bed places and the subsequent historical decision of reinvesting the “sales” proceeds in the existing development projects. What matters in assessing the value of the portfolio of RACFs as at the valuation date is, inter alia, the forward-looking outcome of that past decision in terms of expected future cash flows and particularly the cash flow contribution from the existing development projects (in which the cash proceeds from the receipt of the existing accommodation bonds have been, or will be, invested). These forward cash flows would conceptually have already been reflected in the DCF valuation of the portfolio of RACFs. Thus, adding the face value of the existing accommodation bonds to the DCF valuation of the overall portfolio of RACFs constitutes double-counting in that the proceeds from the existing accommodation bonds from the mature facilities is conceptually reflected in both: • the forward-looking expected cash flow (to the providers of equity and debt capital), and the resulting value contribution of the existing development projects, which is inherently reflected in the DCF valuation of the overall portfolio of facilities being acquired, and • the absolute face value of the existing accommodation bonds which is added to the abovementioned DCF valuation. Footnotes 25

On the assumption of maintained occupancy level, the full amount of the existing cash holdings can be used to earn an investment return during the entire life of the facility. This is because the repayment of bonds to the existing residents when they leave is met by the payment of bonds from the incoming residents. At the end of the economic life of the facility, the existing cash holdings plus (after-tax) investment returns thereon can be used to meet any shortfall between the proceeds from the disposal of the land and the outstanding bond liability, net of retention income at that time.

26

See also the discussion in Chapter 11 on why the market value of cash holdings may differ from the face value.

27

Cash flow statements and the comparison of the cash balances against the carrying amount

of the existing accommodation bonds provide some indication about the extent to which the proceeds from the existing accommodation bonds had been reinvested as at the balance date.

¶18-120 Funding gap — accommodation bond not paid in a lump sum In cases where the accommodation bond received from an incoming resident is not a lump-sum payment, and the incoming resident pays a part accommodation bond and a part daily accommodation payment (DAP), or pays only DAP, there is generally a funding gap between the upfront amount received from the incoming resident (if any) and the amount of the accommodation bond, net of retention income accrued to the operator, payable to the departing resident. This funding gap only reflects the fact that the facility owner provides funding for all or part of the incoming resident’s payment for the occupancy rights and requires allowance for the financing costs (based on a government set interest rate) in the DAP. This does not alter the facility owner’s continued exposure to changes in the underlying property value. Furthermore, unlike the lump-sum accommodation bonds, the interest in lieu embedded in the DAP (net of associated funding costs) can be used to cover operating costs and directly increase the operating profit and dividend paying capacity of the aged care business. In cases where part or all of the accommodation payment is paid in the form of DAP, the amount of the interest in lieu embedded in the DAP would reflect the change in the notional accommodation bond, reflecting, in turn, the change in the underlying property value over time.

¶18-130 In a nutshell Despite being subject to extensive debate for many years, there is still much confusion about the valuation treatment of accommodation bonds for commercial, stamp duty and tax purposes. This Chapter proposes a systematic conceptual framework which enables the sources of such confusion to be exposed and the resultant valuation uncertainty associated with valuing RACFs to be resolved. The conceptual framework focuses on the cash flow impacts of accommodation bond “liabilities”, rather than their existence in a legal or accounting sense and is effectively based on the economic approach to the treatment of accommodation bonds. Applying this conceptual framework helps to resolve the accommodation bond conundrum and defuse confusion about the valuation treatment of accommodation bonds in that it demonstrates the following: • The true economic substance of accommodation bonds is the consideration for the occupancy rights of the underlying bed places. The receipt and repayment of accommodation bonds represents the sale and repurchase of occupancy rights of the underlying bed places (for either on-sale at a net cash gain or deployment of the assets of the facility to a better alternative use). • Accommodation bond payers are, in substance, purchasers of the occupancy rights of the underlying bed places, which is conceptually part of the investment side of an RACF, not the financing side. Thus, they are not providers of debt capital to the facility. Accordingly, accommodation bonds cannot be ascribed the same valuation status as interest-bearing debt. • The cash flow impacts of accommodation bonds are and should be naturally reflected in the overall expected (net) cash flows to providers of debt and equity capital. • In common cases where the cash proceeds from the existing accommodation bonds from mature facilities have been, or will be reinvested in development projects, the cash proceeds have already been effectively transformed into the forward-looking expected future cash flows of these development projects, which are naturally reflected in the forward-looking DCF valuation of the portfolio of facilities being valued. As a result, it is incorrect to add the face value of the existing accommodation bonds to the “observed” purchase price consideration for equity and the market

value of interest-bearing debt (if any) in assessing the market value of an RACF. • While the presence of risk associated with future occupancy level and size of accommodation bonds received may be likened to the technical existence of the legal “liability” of bond repayment, what really matters for value assessment is how to allow for this risk and whether or not it has been appropriately and adequately allowed for in the forward-looking DCF valuation of the facility. The presence of risk is not a valid reason to use the legal “liability” of bond repayment as a lens through which to view or assess the value impacts of accommodation bonds in every single case. In fact, doing so blurs the right valuation focus, which should be on the true economic substance and cash flow impacts of accommodation bonds. The application of the conceptual framework developed in this Chapter to resolve the accommodation bond conundrum in the context of RACFs has direct implications for the resolution of resident loans in the context of retirement villages, given the conceptual similarities between the accommodation bonds and resident loans.

Traps in valuations for land rich assessment ¶19-010 Overview The valuation of specialised fixed assets is a challenging valuation exercise which requires a thorough conceptual and practical understanding of intertwining complex valuation issues if a correct valuation outcome is to be achieved. The complex nature of the valuation exercise also creates several potential traps which, if mishandled, create valuation distortions with flow-on distorted tax consequences. In this Chapter, the following potential valuation traps are analysed: • incorrectly triangulating a valuation method used for a different purpose • misinterpreting financial statements as being statements of value • uncritically equalising market value and accounting fair value • ignoring observable market-based inputs • overlooking the evolutionary nature of asset values • overlooking the economic nature of goodwill • applying legal/accounting form over economic substance, and • dictating that the assessment of goodwill value always has to be calculated as a residual. This is not an exhaustive list of potential valuation traps, but rather focuses on the more frequently occurring fundamental valuation traps with serious tax consequences. An understanding of these traps helps practitioners identify the errors arising in valuations and deal with them. This Chapter supplements the discussion on the common errors in applying the market value concept in Chapter 2 and highlights the practical flaws directly arising from failure to deal with the various conceptual issues discussed in the subsequent Chapters.

¶19-020 Incorrectly triangulating a valuation method used for a different purpose In some cases, specialised fixed assets have monopoly characteristics, and charges to users of such assets may be subject to some form of regulation. The valuations of these assets for regulatory pricing purposes are inherently subject to a circularity problem whereby access charges to users are a function of, inter alia, the value of the assets whose value is, in turn, a function of the access charges. The approach commonly adopted to break this circularity is to adopt a cost-based measure of asset value such as optimised depreciated replacement cost (ODRC) which is used to establish the capital base for setting the user charges or prices. The problem with mechanistically triangulating the cost-based valuation methodology used for regulatory pricing purposes to assess the market value of specialised fixed assets is that the need to adopt a costbased approach to break the circularity between asset value and access charge is not present in valuations for stamp duty and tax purposes. This is because the objective of these valuations is to establish the market value of the specialised fixed assets, whereas the objective of regulatory valuation is to establish the total regulatory asset base on which return on capital and return of capital are calculated to determine user charges. In addition, the market value of specialised fixed assets is often determined after the inherent circularity between asset value and access charge has been broken and the regulatory asset base has been established to allow user charges to be determined1. In simple terms, valuations for regulatory pricing purposes and valuations for stamp duty and tax

purposes may have different subjects of valuation. Different subjects of valuation warrant the application of different valuation thinking. Footnotes 1

Obviously, future user charges (and hence the base used to set these) are clearly relevant in assessing the market value of the specialised fixed assets.

¶19-030 Misinterpreting financial statements as statements of value Another trap in valuations arises from uncritically accepting the carrying amount of the specialised assets in the financial statements as their market value. Underpinning this flawed acceptance is the misconception that financial statements are statements of value. In fact, this is not so for several reasons. Carrying amounts determined in different ways Firstly, accounting standards generally rely on a variety of measures to determine the carrying amounts on the balance sheet for the different assets which comprise a business. Some of those measures allow alternative accounting treatments, while others are mandatory, although not necessarily logically consistent with either each other or with market value principles. Under the accounting standards framework, the measure of equity is dependent on the measure of assets and liabilities. It is only by coincidence that the aggregate amounts of equity correspond with the market value of the shares. Furthermore, AASB 108 Accounting Policies states that where no specific Australian standard deals with an issue, then other “similar or related issues” in other standards, the accounting standards framework, pronouncements of other standard-setting bodies with similar frameworks, accounting literature and industry practices be used as a guide. Inconsistent use of different measures of value Secondly, different measures of “value” may be used inconsistently throughout a single set of financial statements, eg one asset class recorded on a cost basis and another on a “fair value” or even a “value in use” basis. However, in assessing market value for tax purposes, the value of the whole entity and the value of its constituent assets should be assessed on a consistent market value basis. Consequently, the carrying “value” of an asset or group of assets disclosed in financial statements is commonly different from their market value. Changing accounting conventions Thirdly, financial statements are based on various accounting conventions, which may change over time. There are many examples, including depreciating assets on a time basis rather than a units of production basis, the allowable use of either straight line or diminishing value rates of depreciation, non-recognition in financial statements of contingent liabilities, etc. Not all assets recorded at market value Fourthly, financial statements are audited to provide reasonable assurance as to whether the financial statements are free of significant deviations from the treatment required by the relevant accounting standards. Since accounting standards do not necessarily require that all of the individual assets/asset classes be recorded on financial statements at market values, audited financial statements are also not statements of (market) value. Example: Mining and transport infrastructure These misconceptions are particularly prevalent in the valuation of specialised mining and transport infrastructure assets under the principal asset test (PAT) for capital gains tax (CGT) purposes at their (depreciated) historical costs recorded on the balance sheet. This is incorrect because depreciated historical costs are not only an unreliable indicator of market value, but also a significantly downward biased measure of the market value of these assets due to the critical importance of these infrastructure assets in growing volumes. This is particularly so when the “free kick” period from high commodity prices is limited and there are significant

time, costs and risks associated with rebuilding these critical assets.

¶19-040 Uncritically equalising market value and accounting fair value “Measured” accounting fair value and Spencer market value not necessarily equal Fair value is defined under accounting standards as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” or “The amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.” It appears, but this is not really the case, that the accounting standard definition of fair value is the same as the Spencer market value concept. It would follow, if this was so, that fair value accounting, which is required when accounting for business combinations, is the same as market value. Unfortunately, this is not the case. Accounting fair values still reflect accounting conventions and do not necessarily reflect market value. “Measured” accounting fair value of goodwill Accounting fair value utilises the conventional top-down residual method (TDRM) to derive the goodwill amount for financial reporting purposes. That is, a business combination’s accounting fair value is calculated as the price paid per share times the number of shares acquired less the value of net identifiable assets, including identifiable intangible assets, producing a residual called goodwill. As stated earlier, the problem with the TDRM is that all valuation errors in the elements in the TDRM calculation are reflected in whatever is chosen as the residual asset being valued. It is mathematically self-evident that if some other asset was chosen as the residual, the valuation errors would be reflected in the assessed value of that other asset. In order to understand why “measured” accounting “fair value” of goodwill does not necessarily represent market value, it is necessary to analyse the reasons why measuring goodwill value for financial reporting purposes using the TDRM can be problematic. Problems with calculating acquisition costs in a share offer The purchase price calculation is cost of acquisition focused. However, the cost of acquisition, assuming it is a share offer, is a mechanistic calculation. That is, it multiplies 100% of the shares issued as acquisition consideration by the headline takeover cash price of the bidder’s shares on the date that control passes. As a result, the acquisition cost is viewed as a single purchase of 100% of the shares acquired in the target on one day. It also assumes that every share of the target is of equal value regardless of what percentage of the target’s capital is involved. This calculation makes no allowance for various factual matters such as: • the lack of unanimity among accountants as to whether the bidder’s share price used as consideration for the target’s shares is a buy price, a sell price, a mid-price or a volume weighted average price (VWAP) (and if so over how many days) • whether the market value of the shares of the target (ie the cash price the total number of shares issued could be sold for) is at a premium, or more likely a blockage discount to the stock exchange value of minority share transactions given the number of shares involved • other details such as how to account for stepped acquisitions where the bidder’s earlier purchases of shares in the target were made at higher or lower values at earlier dates, and • if part of the bidder’s offer price is contingent on, for example, future profitability, the contingent

consideration is not probability adjusted as it would be if the market value of shares in the target was being measured. Furthermore, any subsequent downward revision of the contingent consideration does not reduce the accounting fair value of the shares issued nor the resulting value of goodwill of the target shown as a liability. Rather, the downwards revision reduces the amount of consideration payable for the shares and the difference is shown (unbelievable as this may sound) as a profit2. Changes in the measurement date To complicate matters further, accounting standard practice on how to assess the value of shares issued as consideration has changed over time with the market value of shares issued now being measured on acceptance date, not offer date. The idiosyncrasies of accounting conventions are demonstrated by the history of the measurement date issue. Briefly, in Australia and in the UK, the accounting standards previously required that the shares issued be valued at the offer date value. In the USA, the Financial Accounting Standards Board (FASB) Accounting Standard required that the shares issued be booked at acceptance date (ie when the bidder obtained control). This issue was considered as part of the International Accounting Standards (IAS)/FASB Accounting Standards Convergence Program. The IAS agreed to change its standard to acceptance date. The FASB agreed to change its standard to offer date. Thus, both standard setters not only reversed their positions, but ultimately reversed them again with IAS, and thus, Australia is now required to book the value of shares issued at acceptance date value. What these different starting points, and two reversals, of accounting standard principles demonstrate is that what is really a simple issue of market value and what the accounting conventions require can be widely disparate. Non-contemporaneous issue The market value principle involved, which from a valuation perspective3 should require the valuation of the bidder’s shares at offer date, not acceptance date, has a basis in legal principles, ie the offer date is the relevant contractual date that the bidder can be legally obliged to honour. In addition, offer date value represents a contemporaneous assessment of the value of the whole target entity by sophisticated market participants and hence provides contemporaneous reliable evidence on the market value of the whole entity. There may also be a disconnect between the market value of the target entity and the cash amount that could be realised by the sale of the bidder’s consideration shares as at the acceptance date, because the number of the bidder’s consideration shares was determined at the offer date (reflecting the contemporaneous relative equity values of the target and the bidder at the offer date), not the acceptance date, unless any dilution effect is fully reflected in the bidder’s share price as at the acceptance date. There may be CGT roll-over relief for vendors of the target’s shares who accept the bidder’s shares. However, this is a vendor shareholder benefit, not goodwill. Unit of measurement issue The market value of the bidder’s shares issued as consideration for shares in the target should be calculated as the cash amount the former could be sold for, not a minority interest price on acceptance date, times the number of bidder’s shares issued as consideration. Given the prevalence of, and magnitude of, placement discounts, rights issue discounts, brokerage fees, etc, it is almost inevitable that the actual sale of the bidder’s shares for cash would have produced a lower cash amount than the prevailing stock market minority interest share price times the number of shares issued. Bidder’s intervening share price movements The distorted impact on “measured” accounting fair value of goodwill of bidder’s share price movements in the intervening period between the offer date and the acceptance date can be demonstrated by a simple example of, say, an iron ore company bidding (in a script bid) for a company in a different sector, say a gold mining company. It is clear that fluctuations in the value of the shares in the iron ore company could not reasonably be seen as increasing or decreasing the value of the gold mining company, and in particular, the value of its goodwill. Yet this is precisely what happens under the TDRM calculation of accounting fair value of goodwill. That is, part of the “fair value” of accounting goodwill for the gold mining

company is due to idiosyncratic changes in the bidder’s share prices between the offer and acceptance date which may be completely unconnected to the market value of the target gold mining company and its goodwill value. Inclusion of transaction costs A further example that demonstrates the muddled thinking reflected in measuring accounting “fair value” of goodwill is the (now superseded) practice of including in the value of goodwill the transaction costs, such as stamp duty and professional fees. Such costs are clearly not, and never were, an “asset”. Inclusion of deferred tax liabilities Another anomaly that arises in measuring accounting “fair value” and, consequently, the measurement of accounting “fair value” of goodwill relates to deferred tax liabilities (DTL). Briefly, the accounting standards require a DTL to be recognised as the tax effect on the timing differences between tax payable and tax expenses and on the difference between the accounting carrying value of underlying investments and their tax cost base. Under valuation principles, the market value of an investment on a going concern basis is the present value of future cash flows after-tax (including income tax on the intervening cash flows and CGT (if any) upon exit reflecting the existing tax cost base). Income tax on the underlying cash flows has already been allowed for in the valuation of the underlying investment. To the extent that the investment is a long-term buy and hold, a DTL in respect of the difference between the market value of the underlying investment and its tax cost base would (most likely) never be realised. Thus, its market value would either be nil or at most a significantly lower present value of that DTL which would be, at the least, deferred in its realisation as long as possible. When the (often immaterial) present value of that DTL has been allowed for in deriving the present value of the future cash flows after-tax, it is double-counting to subsequently allow for this “mezzanine” level DTL in establishing the accounting fair value of goodwill, to make the matter worse, at its full face (accounting) value, not its immaterial present value. The impact of such an incorrect treatment is to inflate the carrying value of DTL, thereby artificially reducing the carrying value of net identifiable assets and increasing the accounting value of goodwill under the TDRM. The distortions flowing to accounting “fair value” of goodwill In simple terms, the idiosyncratic conventions in the measurement of total consideration paid for shares in the target creates a disconnect between the measured total consideration and true market value and naturally creates distortions in using the total consideration (as required by accounting conventions) to represent the Spencer market value of total assets acquired. To make matters worse, these distortions (together with other distortions such as the inclusion of DTL at face value) are mathematically filtered through to the residual amount which is used to represent the assessed market value of goodwill under the TDRM. The need for a reasonableness check In order to keep accounting distortions from being inadvertently reflected in the assessed Spencer market value of goodwill, any reasonably experienced financial person should consider a reasonableness check as to whether an entity is likely to have material goodwill value on a first principles basis using a consistent conceptual framework (like the one discussed in Chapter 7). For example, if what is being valued is a gold mining company, one would expect generally minimal or no material goodwill value. This is because: • gold is a homogenous product • gold is commoditised • there is no product differentiation • there is no attraction of custom, and

• mining/extraction processes for gold are common knowledge in the industry. Notwithstanding this simple cross-check for reasonableness, many valuers (wrongly) argue that very substantial goodwill value exists in the gold mining industry, and in other industries, where, on a first principles basis, this is clearly not the case. In summary, the truth about accounting goodwill value is that it does not equate with the market value of goodwill. In addition, as noted in Chapters 7 and 8, while companies and businesses may have legal goodwill, this is not the same as goodwill that has a large market value. Footnotes 2

Such treatment is also based on a non-contemporaneous comparison between the value of the consideration (including the present value of the contingent payments unadjusted for the probability of occurrence) as at the acceptance date and the market value of the entity’s total assets as at the adjustment date (ie the date by which the ex-post outcome of the contingency had been known).

3

The relevant stamp duty legislation often requires that the acceptance date be used.

¶19-050 Ignoring observable market-based inputs The accounting standard framework and the accounting standards and pronouncements which comment on the valuation principles involved in establishing market value form only a minor part of the accounting literature. However, those comments are basically consistent between the USA, Canada, International Accounting Standards (IAS) and Australia (which requires adoption of IAS standards). While the evolution of an agreed set of valuation principles took many years and is still on-going, and was focused on financial instruments, it was facilitated by an International Joint Working Group set up by the International Accounting Standards Board (IASB) in the 1990s. Some basic valuation principles were therefore promulgated more than a decade ago. For example, at its 31 March 2004 meeting, the USA FASB ratified the consensus reached by the Emerging Issues Task Force (EITF) which, among other issues, considered the following: “Issue 1(b) — whether the effects of anticipated fluctuations in the future market price of minerals should be considered when an entity allocates the purchase price of a business combination to mining assets.” and “Issue 3 — whether an entity should consider the effects of anticipated fluctuations in the future market price of minerals in the cash flow analysis used to test mining assets for impairment under Statement 144.”4 In response, the EITF reached the following conclusions: “On Issue 1(b), the Task Force reached a consensus that an entity should include the effects of anticipated fluctuations in the future market price of minerals in determining the fair value of mining assets in a purchase price allocation in a manner that is consistent with the expectations of marketplace participants. Generally, an entity should consider all available information including current prices, historical averages, and forward pricing curves. Those marketplace assumptions typically should be consistent with the acquiring enterprise’s operating plans with respect to developing and producing minerals. The Task Force observed that it generally would be inappropriate for an entity to use a single factor, such as the current price or a historical average, as a surrogate for estimating future prices without considering other information that a market participant would consider.”

and “On Issue 3, the Task Force reached a consensus that an entity should consider the effects of anticipated fluctuations in the market price of minerals when estimating future cash flows (both undiscounted and discounted) used for determining whether a mining asset is impaired under Statement 144. The Task Force noted that estimates of those effects should be consistent with estimates of a market participant. Generally, an entity should consider all available information including current prices, historical averages, and forward pricing curves. Those marketplace assumptions typically should be consistent with a company’s operating plans and financial projections underlying other aspects of the impairment analysis (for example, amount and timing of production)5. The Task Force observed that it generally would be inappropriate for an entity to use a single factor, such as the current price or a historical average, as a surrogate for estimating future prices without considering other information that a market participant would consider.”6 These conclusions were documented in EITF Abstract Issue 04-3. In 2005, the Canadian Institute of Chartered Accountants issued “EIC-152 Mining Assets — Impairment and Business Combinations” which adopted fundamentally the same wording as the USA pronouncement. Similarly, the USA FASB issued FAS 157 which established a fair value hierarchy. FAS 157 was issued with an effective date for financial years commencing after 15 November 2007. FAS 157 emphasises that fair value is a market-based measurement and that the measurement of fair value should “maximise the use of relevant observable inputs based on market data obtained from sources independent of the reporting entity” including: • exchange market values (which would include futures7 market prices) • dealer markets (which would include forward market prices) • brokered markets (see second point above) • principal to principal markets (see second point above), and that level 1 inputs “are quoted prices”8. It is noticeable that “consensus” forecasts and the “valuer’s best estimates”9 do not even rate a mention in the FAS 157 hierarchy of observable inputs. The FASB Accounting Standards are more “rule based” than Australian Accounting Standards or IAS. Like FASB, the IASB addressed issues relating to fair value in the context of financial instruments including IAS 39. The IASB issued FAS 157 in the form of a preliminary views document10. The principles in FAS 157 are consistent with those set out in the IAS standards and the Australian standards11 on financial instruments. AASB 136 Impairment of Assets also states in respect of fair value: • the best evidence of fair value is a price in a binding sale agreement12 • if there is no binding sale agreement and the asset is traded in an active market, fair value is the asset’s market price13. AASB 139 Financial Instruments: Recognition and Measurement sets out fair value measurement consideration in the following order14: • active market quoted prices: – in the “most advantageous active market to which the entity has immediate access” – “the existence of published price quotations in an active market is the best evidence of fair value and when they exist they are used to measure the financial asset or financial liability”15

• no active market — valuation technique: – valuation techniques include recent arm’s length transactions, current fair value of comparable assets and the valuation technique commonly used by market participants to price the instrument16 – making the maximum use of market inputs17 – obtaining foreign currency exchange prices from active currency exchange markets18 – commodity prices — “there are observable market prices for many commodities”19. Unfortunately, despite the emphasis on the maximum use of observable market-based inputs in assessing market value, there are many instances where observable contemporaneous market-based inputs (eg forward curve prices) are ignored and non-market inputs such as a valuer’s “best estimate” or “consensus forecasts” are adopted, with flow-on tax and stamp duty consequences. In addition, at a practical level, there continues to be significant shortfalls in most accountants’ understanding of what market value really means, and continuing examples of even large audit firms failing to apply proper market value principles in statutory accounts. Footnotes 4

EITF Abstract Issue 04-3, Mining Assets: Impairment and Business Combinations.

5

This also implies that the pricing assumption (eg forward versus long-term historical average) depends on whether the subject entity actually choose to hedge commodity or FX risks and whether, given the prevailing market conditions, it is value-adding to hedge.

6

EITF Abstract Issue 04-3.

7

Futures contracts contain standardised terms and are traded on a futures market. Forward contracts whose values are based on the same principles are non-standardised contracts traded between the contracting parties.

8

FAS 157, para A20 and A22.

9

Those valuation inputs are still claimed to be preferable indications of market value by some accounting firms even today.

10

FAS 157, para C116.

11

One of the co-authors of this book was a member of the IAS sub-committee on financial instruments for some three years and a member of the Australian Accounting Standards Board for seven years.

12

AASB 136, para 25.

13

AASB 136, para 26.

14

AASB 139, para AG69 to AG82.

15

AASB 136, para AG72.

16

AASB 139, para AG74.

17

AASB 139, para AG75.

18

AASB 139, para AG82(c).

19

AASB 139, para AG82(d).

¶19-060 Applying legal/accounting form over economic substance Interestingly, the evolution of accounting thinking in respect of mark-to-market reporting has been a “mark to contract” focus rather than “mark to (true) market value”. Thus, the accounting standards require bank core deposits, resident loans for retirement villages and accommodation bonds for residential aged care facilities (RACFs) to be recorded at their full face value as liabilities. Furthermore, they also have to be shown as current liabilities. The market value reality of these “liabilities” is that they generate substantial positive cash flows and that they are not really current liabilities, as they are continually rolled over (on average, once a decade for initial residents or every five years for roll-over residents in the case of resident loans20 and about every three years in the case of accommodation bonds21). Similarly, the core deposit liabilities of banks, which technically are repayable virtually at call, are really a source of valuable low cost long-term funds to these financial institutions. However, for financial reporting, these economic benefits and values are ignored and they are required to be shown as current liabilities. Footnotes 20

“Retirement village resident duration: an empirical analysis” by Lois Towart, University of Technology, Sydney presented at the 19th Annual Pacific Rim Real Estate Society Conference in Melbourne (13–16 January 2013). Initial residents are those occupying new units, whereas roll-over residents are those occupying a previously owned unit.

21

Residential aged care and aged care packages in the community 2012–13, prepared by the Australian Institute of Health and Welfare, accessed 16 November 2016 at www.aihw.gov.au/aged-care/residential-and-community-2012-13.

¶19-070 Overlooking the evolutionary nature of asset value Dividing an income producing land asset into land and building components and valuing the underlying land on a notional “as though” vacant basis and the building improvements at their ODRC under the bottom-up valuation approach or valuing the specialised mining and transport infrastructure assets on the basis of their depreciated historical costs is conceptually analogous to valuing the coherent collection of specialised fixed assets in their original state, rather than at the contemporaneously higher stage of their evolutionary process. The mirror image of this distortion is that the adoption of the cost-based valuation approach creates artificial existence of material goodwill value because, what is often incorrectly considered as an indication of goodwill is actually a manifestation of the unrecognised accumulated increments in the value of the specialised fixed assets over time.

¶19-080 Overlooking the economic nature of goodwill In many cases, the business which owns the specialised fixed asset is a single purpose business which has monopoly or quasi monopoly characteristics due to its ownership of the specialised fixed assets. The

application of the conceptual framework discussed in Chapter 7 in these cases indicates that the single purpose business has no material goodwill value. This is principally because it is only a passive recipient of custom and the regulated nature of the business provides little scope for management to exercise future decisions to generate excess return over and above the rate of return on the physical assets that could be generated by another operator. In the absence of material goodwill value, the market value of the specialised fixed assets can be assessed based on the present value of the net cash flows expected to be generated by the single purpose business net of the ascertainable market values of non-specialised assets (eg net working capital assets, financial assets, small items of moveable plant and equipment, etc). An uncritical acceptance of the assumption that the business which employs the specialised fixed assets always has material goodwill value may cause a valuer to incorrectly dismiss an important reference point, ie the market value of the business owning these assets, which should be considered in assessing the market value of specialised fixed assets or cross-checking the reasonableness of the assessed market value of these assets based on other methods of valuation.

¶19-090 Dictating goodwill value as a residual There is a perception in practice that goodwill is always to be valued as a residual under a TDRM of valuation. Under this method of valuation, goodwill value is what is left after the market values of all tangible and identifiable intangible assets have been determined and deducted from the total market value of the entity’s assets. The problem with this perception is that it allows the measurement errors which arise from some or all of the abovementioned traps and other misconceptions in valuing, in particular, specialised assets to be reflected in the assessed value of goodwill. Put simply, any errors in the valuation of any of the calculated values in the TDRM flows through to the assessed value of goodwill. Furthermore, by defining goodwill, not in terms of its attributes, but in terms of the way in which its value is measured as a residual, the assessed value of goodwill can be, via a feedback loop, used (inadvertently or otherwise) to justify the incorrectly assessed value of the specialised fixed assets which suffer these very misconceptions in the first place. In fact, it is inappropriate to uncritically accept a residual amount mathematically calculated under the TDRM as representing the correct goodwill value without assessing the appropriateness of both the assessed values of identifiable assets, particularly the assessed value of the specialised fixed assets (and identifiable intangible assets) and the drivers of the goodwill value of the business. Goodwill value should be assessed based on a correct understanding of its economic attributes, not purely as a mathematically calculated residual. The appropriate way to deal with this valuation trap is to recognise that, although certain guidelines on the valuation of goodwill (eg the Australian Taxation Office (ATO) guide to market valuation) discuss the TDRM to the assessment of goodwill value, this does not mean that goodwill is “dictated” to be valued as a residual. There are several reasons why this is so. Firstly, as their names suggest, valuation guidelines only serve as a broad guide to the apportionment of the whole entity value between various asset classes in assessing goodwill value. The appropriate method to apply is ultimately case-specific (ie there is no “one-size-fits-all” answer). Secondly, even under the TDRM of valuing goodwill, adopting a wrong view of the value of residual goodwill means accepting an incorrectly assessed value of the other assets or rejecting the correctly assessed value of these assets. That is, at the very least, a correct understanding of the economic attributes of the goodwill of the subject business is essential to cross-checking the assessed market value of the other assets. In this regard, the ATO guide to market valuation indicates the underlying interdependency between the assessed market value of goodwill (as a residual) (or the reasonableness thereof) and the correctness of the assessed market value of the other assets. Thirdly, the order in which goodwill should be assessed is ultimately a fact-driven valuation question. As discussed more fully in Chapter 7, if the a priori view is that goodwill has no material value, there is clearly no need to value all the identifiable assets to confirm the obvious. In fact, doing so would unnecessarily introduce valuation errors in valuing, in particular, specialised fixed assets, with such errors

flowing through to the assessed goodwill value under the TDRM. The practical conceptual flaw arising from the incorrect perception that goodwill must always be valued as a residual is also reflected in the incorrect valuation approach adopted by property valuers whereby, for tax and stamp duty purposes, the specialised fixed assets are generally valued using the traditional hypothetical rent capitalisation method, regardless of the virtual absence of contemporaneous comparable sales and rental market evidence and without any regard to the application of the deductive valuation method discussed in Chapter 12.

¶19-100 In a nutshell It is important to recognise traps in valuations for tax purposes if the correct valuation and resulting tax outcome is to be achieved. The traps discussed in this Chapter involve fundamental interrelated valuation issues with potentially significant flow-on tax consequences. Despite the potentially significant tax consequences, these traps have received little recognition in practice. In order to deal with these traps, it is necessary to: • identify the correct subject of valuation for tax purposes • caution against the triangulation of valuation methodologies designed for different purposes to valuations for tax purposes • recognise that financial statements are not statements of value • not equate accounting fair value of goodwill measured in business combinations with the market value of goodwill • maximise the use of observable market-based inputs • be aware of circumstances where legal or accounting form is used over economic substance of what is being valued • recognise the evolutionary nature of asset values • have a correct conceptual understanding of goodwill for valuation purposes and recognise that assessing the market value of specialised fixed assets and assessing the goodwill value of the business which owns the specialised fixed assets are interrelated, and • recognise that the order in which goodwill value should be assessed is case and circumstancespecific.

Re-evaluating the concept of trading stock: the case of vendor finance loans ¶20-010 Trading stock — the traditional view An increase in the value of trading stock over the financial year increases assessable income whereas a decrease reduces assessable income. The way this arises is not a result of specific tax provisions, rather, it arises mathematically through the calculation of the cost of goods sold, which is: • opening stock, plus • purchases, less • closing stock. An increase in the market value of trading stock on hand increases the market value of closing stock, which, in turn, reduces the cost of goods sold, thereby increasing assessable income. Conversely, a decrease in the market value of trading stock on hand decreases the market value of closing stock, which, in turn, increases the cost of goods sold, thereby reducing assessable income. Thus, what constitutes trading stock and changes in its value have natural implications for income tax purposes. Section 70-10 of the Income tax Assessment Act 1997 defines “trading stock” as follows: “Trading stock includes: (a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business; and (b) live stock.” The application of this definition to physical assets is generally straightforward. However, its application to financial assets poses conceptual and practical challenges and requires a more multifaceted assessment of the trading stock concept. Case study: Vendor finance loans To briefly highlight these challenges, this Chapter discusses whether a portfolio of vendor finance loans (ie a portfolio of financial assets) owned by a property developer can be conceptually regarded as trading stock. Vendor finance loans are sometimes used by property developers to facilitate the sale and financing of properties to their retail customers who have difficulty in accessing financing. While the use of vendor finance depends on interest rates, competition between loan providers and expected future property market conditions, the focus of this Chapter is not its use, but on whether vendor finance loans are conceptually trading stock of the property developer/vendor. Vendor finance is typically a two to three-year interest only mortgage loan. The loan generally commences from the settlement date of the relevant property. Pre-payment of monthly interest and lumpsum principal may be allowed with or without early pay-out penalties depending on the terms of the loan. Vendor finance is normally required to be discharged or refinanced upon the expiry of the loan term.

¶20-020 Alternative approaches to trading financial assets A financial asset or a portfolio of financial assets can be exchanged or traded for cash directly or indirectly. Direct trading is a conventional sale or liquidation of the asset. Indirect trading can be

implemented via an artificial liquidation of the asset. Indirect trading has become increasingly popular with the continued development and use of derivative securities and the widespread use of financial innovations such as securitisation. Indirect trading is best illustrated by an example. Example Suppose an investor holds a portfolio of shares which have been purchased at different prices. The investor can indirectly trade the portfolio of shares by writing a series of call options at different exercise prices depending on the required rate of return, trading horizon, expectations about future market conditions and liquidity requirements. In indirect trading, the shares are not sold (expected gains realised) until (and if) the relevant call options are exercised by the counter-parties. Under the conventional sale approach, the investor sells each individual parcel of shares when the share price reaches the expected sale price, which is equivalent to the exercise price of the call option under the indirect trading approach.

In the case of a vendor finance loan, the loan is generally made with what is, in substance, a call option granted to the borrower to repurchase (ie repay) the loan at any time within the term of the loan. In a rising market, a vendor finance loan is particularly attractive to an investor/speculator. The investor utilises the vendor loan to acquire a property, sells it after the market value of the property has increased and exercises the embedded call option to repay the loan early1. This is conceptually analogous to the property developer/vendor indirectly “trading” the individual vendor finance loan. The exercise of the embedded call options transfers cash back to the property developer/vendor. A portfolio of vendor finance loans held by the property developer/vendor at a given point in time is likely to comprise relatively heterogeneous individual loans which were attached to the properties, sold at different prices and when interest rates/mortgage rates were different. Thus, the frequency of the indirect “trading” as a result of the exercise of the embedded call options (which, in turn, determines the extent of the loan portfolio turnover for a given year) can vary. This variation depends on the proportion of the loans with embedded call options that are deep-in-the-money. That is, only loans attached to properties which have experienced substantial price increases, or for which replacement loans at a lower interest rate can be obtained, are likely to be repaid or indirectly “traded” prior to maturity. Concurrent with the recurring partial liquidation of the loan book as individual loans are indirectly “traded”, the property developer/vendor may also seek to liquidate or securitise the whole vendor finance loan portfolio to generate cash in favourable market conditions and to manage risk concentration in the event a property market downturn occurs (discussed further below). Footnotes 1

However, in a falling market, the average effective duration of the vendor finance loan increases as the early exercise of the borrower’s call option is less likely to occur.

¶20-030 Commercial motivations for systematically “trading” the loan book In a falling market, a property developer with a vendor finance loan book is exposed to both market risk (from the development side of the business) and credit risk (from the financing side of the business). These risks are highly correlated and reinforce each other. Consequently, having a development business and a financing business increases the risk concentration of the property developer. The level of downside risk concentration rises as the size of the loan book grows, creating a natural limit to the size of the vendor finance loan book. This is exacerbated by the fact that the property developer’s vendor finance loan book consists entirely of loans on its constructed properties and borrowers/purchasers who tend to rely more on vendor financing when banks tighten property lending policies or when the properties are overpriced. This creates a commercial propensity for the property developer to systematically “trade” the loan book (in

part or in whole) either directly or indirectly for cash when market conditions are still favourable to contain the level of downside risk concentration. In fact, the exercise of the embedded call options in a rising market enables the property developer/vendor to reduce the size of its loan book when market conditions are still favourable and mitigates downside risk concentration in the event a property market downturn occurs. The reverse arises in a property downturn as the exercise of the embedded call option which underpins the indirect “trading” of the loan is less likely to occur.

¶20-040 In a nutshell This Chapter provides a brief conceptual re-evaluation of whether a portfolio of vendor finance loans is conceptually trading stock of a property developer. While such an exercise is highly fact specific, the conceptual re-evaluation highlights the importance of recognising: • the ability to indirectly trade financial assets, and • the commercial propensity of the property developer (ie the holder the portfolio of vendor finance loans) to systematically “trade”, indirectly or directly, its vendor finance loan book when market conditions remain favourable and hence reduce its exposure to downside risk concentration in a property market downturn.

Valuing partly completed development projects ¶21-010 Valuations for the GST margin scheme Division 75 of the A New Tax System (Goods and Services Tax) Act 1999 (Cth) allows (where a development project was partially completed as at 1 July 2000) a property developer to use the margin scheme when calculating how much GST is included in the selling price of the project upon completion. Under the margin scheme, GST is effectively calculated on the increase in the value of a project between 1 July 2000 and the completion of the project. The value of the project upon completion is usually directly observable based on the price at which the completed property or strata units within the property are sold. However, the value of the partly completed project as at 1 July 2000 is not generally directly observable. Consequently, determining the value of the project as at 1 July 2000 is critical to working out the amount of GST payable under the margin scheme. The methods that can be adopted to value partly completed projects as at 1 July 2000 for the purpose of working out the amount of GST payable under the margin scheme are outlined in GSTR 2000/21. Under this ruling, the value of a partly completed project as at 1 July 2000 can be determined using any of the following two methods: • Method 1 — the market value of the property determined in writing by a professional valuer, and • Method 2 — value as determined using a costs of completion method. In cases where the first method is adopted, the valuer is required (under GSTR 2000/21) to have regard to: • the market value of the completed premises • the cost to complete the partly completed premises, and • the profit margin and holding costs that are attributable to the period on or after the valuation date. Although GSTR 2000/21 indicates the key factors that need to be taken into account in valuing partly completed projects as at 1 July 2000, the valuation methods adopted to deal with these factors can have material impacts on the amount of GST payable under the margin scheme. While these valuation issues were primarily relevant for determining GST under the margin scheme in the early 2000s, the principles discussed in this Chapter continue to remain relevant to the valuations of partly completed property development projects for trading stock valuation and income tax purposes.

¶21-020 Valuation method adopted by property valuers: “sum of the parts” The method commonly adopted by property valuers to determine the value of partly completed projects as at 1 July 2000 under the GST margin scheme is the “sum of the parts” or “components” method. This method is also commonly used by property valuers in valuing partly completed property development projects for trading stock valuation and income tax purposes. Under the “sum of the parts” method, the value of a project is comprised of the land value as at a valuation date, construction costs incurred and profit/holding costs realised or earned up to that date. The value of the first component (land) and the third component (profit/holding costs) are usually estimated using the valuer’s experience. The land value as at the valuation date is assessed on the basis of the valuer’s experience as to what is the appropriate percentage of the estimated gross realisation value of the project represented by land value. The total profits and holding costs which had been realised or earned up to the valuation date is again assessed at another experience-determined percentage of the total profits/holding costs component for the project. This component is derived by subtracting the estimated total construction costs and the

land value (estimated earlier) from the estimated gross realisation value of the project upon completion. The construction costs incurred up to the valuation date are typically estimated based on the percentage of work completed as provided by an independent quantity surveyor and the total construction costs of the project. The value of the project is, under the “sum of the parts” method, determined by adding up the values of the three individual components estimated above. The following example illustrates the way in which the “sum of the parts” method is applied to determine the value of a partly completed project as at a valuation date. Example A partly completed project with the following input variables needs to be assessed as at 1 July 2000 for GST margin scheme purposes:

Table 21.1: Input variables Estimated gross realisation value as at 1 July 2000

[a]

$100m

Estimated total construction costs

[b]

$40m

Percentage of completion as at 1 July 2000

[c]

20%1

Land value as a percentage of gross realisation value

[d]

25%2

Profits/holding costs realised up to 1 July 2000

[e]

40%3

Construction costs incurred up to 1 July 2000

[f] = [b] × [c]

$8m

Land value as at 1 July 2000

[g] = [a] × [d]

$25m

Total profits/holding costs

[h] = [a] − [b] − [g]

$35m

Profits/holding costs realised up to 1 July 2000

[i] = [h] × [e]

$14m

Notes 1 Based on an independent surveyor’s assessment. 2 Based on the valuer’s experience. 3 Based on the valuer’s experience. 4 The extent to which profits/holding costs (in percentage terms) were realised as at July 2000 can, under the “sum of the parts” method, be greater than the percentage of completion. This is usually justified on the basis that the receipt of DA approval generally results in a significant uplift in the value of the undeveloped land. Given the above inputs, the value of the partly completed project is, under the “sum of the parts” method, estimated as follows:

Table 21.2: Outcome of applying “sum of the parts” method Construction costs incurred up to 1 July 2000

[f]

$8m

Land value as at 1 July 2000

[g]

$25m

Profit/holding costs realised up to 1 July 2000

[i]

$14m

Value of partly completed project as at 1 July 2000

$47m

As it can be seen from the above example, the use of the “sum of the parts” method requires each individual component to be valued separately. The key issue with this method is that the value of the land component and the profits/holding component are based on the valuer’s experience about which professional views could legitimately differ. In addition, it should be noted that under GSTR 2000/21, while a valuer is required to have regard to the individual components in determining the value of a partly completed project, the valuer is not required to determine a separate value for each component. Consequently, the need to rely on inputs determined by a valuer’s experience in estimating the value of each individual component can be avoided if the valuation method adopted can produce an estimate of the value of the project as a whole.

¶21-030 Discounted cash flow (DCF) method of valuation It is almost universally accepted in both valuation theory and practice that the value of an asset is the present value of the future cash flows expected to be generated by the asset. The most scientifically rigorous methodology used to determine present value is the DCF method. In order to arrive at the value of the asset, the expected future cash flows are discounted using a discount rate which reflects the timing and risk associated with the cash flow stream. Using the DCF method, the value of a partly completed project as at the valuation date is the present value of cash flows expected to be generated by the project after that date. That is, the DCF method is, by construction, a forward-looking method of valuation. From a theoretical perspective, all cash flows which occurred prior to the valuation date are virtually irrelevant to the value of the project as at that date (except as they affect future tax cash flows and/or in circumstances where they can be used for crosscheck purposes). The expected net cash flows reflect the proceeds expected to be received from the sale of strata units (within the completed development project) less the expected building costs and direct selling costs incurred up to the completion of the construction and sales process. The expected cash flows are, as a matter of commercial logic, a function of the proposed use to which the site is put (eg residential apartments versus office buildings). An asset is normally valued under the assumption that it is put to the “highest and best use”. The DCF method is, for the purpose of valuing a partly completed project, conceptually consistent with the requirements specified in GSTR 2000/21 para 30 in that the expected net cash flows take into account the expected sales proceeds (expected market value of the completed project), building costs and direct selling costs (cost to complete the project), whereas compensation for risk and holding costs (time value of money) are captured in the discount rate and, where required, via probability adjustments. The DCF method also explicitly allows for the timing of these expected cash outflows and inflows. There are two key advantages of using the DCF method in valuing partly completed projects. Firstly, the inputs to the DCF valuation can be verified by reference to objective verifiable market data and other supporting evidence. Secondly, while incorporating all the factors required under GSTR 2000/21 para 30, the DCF method does not require the valuation of each individual component such as land value and profit/holding costs. Without having to value each of these individual components, the DCF method mitigates the need to rely upon subjectively determined inputs (particularly when objective and verifiable inputs can be used) and the resultant valuation opinion differences that may arise in the apportionment in total value. While conceptually sound, the implementation of the DCF method is technical in nature. In simple terms, the DCF method requires the projection of net cash flows (inflows less outflows) and the determination of an appropriate discount rate. However, the way in which the DCF method is applied is normally project-specific and involves a wide range of technical considerations. In applying the DCF method, specific risks such as potential delays in obtaining the DA or completion timeframes are normally allowed for through the use of probability adjustments. A discount rate is usually applied to reflect market risk, which is the risk pertaining to the deviation of actual cash flows (eg construction costs and sales proceeds) from the developer’s expected cash flows due to the sensitivity of the project’s payoffs to changes in macro-economic factors. An appropriate benchmark against which the discount rate can be determined is the rate of return required by investors in publicly-listed property developers as at the relevant valuation date. Estimating this required rate of return requires the consideration of a wide range of factors, including business risk, funding model, tax (eg whether beforetax or after-tax rate of return should be used) and the extent to which listed developers’ cost of capital has been impacted by leverage and the use of trust capital. The discount rate applicable to a particular project should then be assessed relative to the rate of return required by an average property developer based on the idiosyncratic features of that project, such as percentage of completion or project duration. Implicit in the derivation of the DCF value of the project is the assumption that there are sufficient competing hypothetical buyers for the partly completed project. These hypothetical buyers are likely to include comparable publicly-listed property developers who would factor their required rate of return into the price they would bid for the site. Put differently, the DCF method produces, from a theoretical perspective, an estimate of the market value of a partly completed project. In addition, if the development

site was acquired in a “bargain purchase”, the price at which a development site was originally acquired is not necessarily comparable to the DCF value of the project and can be a poor reference point for the market value of the partly completed project. There are also several other specific valuation issues that need to be dealt with when using the DCF method to value partly completed projects. For example: • Should expected (ex-ante) cash flows or the actual (ex-post) cash flows be used? • Should the expected cash flows be inclusive or exclusive of GST? • Should the project be valued on a standalone basis or as part of a portfolio of projects undertaken by a property developer? • If the project is valued on a portfolio basis, how should the interest tax shields generated by the project in the early loss-making years be valued? These valuation issues should be dealt with on a case-by-case basis. Appropriate treatment of these issues and proper determination of an applicable discount rate are necessary to obtain a reasonable estimate of the value of a partly completed project.

¶21-040 In a nutshell Inherent in the “sum of the parts” method to value a partly completed project is the need to rely on a valuer’s experience to determine the value of each individual component. Given the highly subjective nature of this valuation method, different professional views could naturally arise as to the value of the partly completed project. The application of the DCF method reduces the need to rely on valuers’ experience in determining the value of each individual component. This is because the DCF method produces an assessment of the value of the project as a whole. The DCF method and particularly the determination of an appropriate discount rate are technical in nature. However, when applied correctly, it provides a much more transparent and scientifically rigorous framework within which the value of a partly completed project can be estimated using objective and verifiable market data. The principles underpinning the application of the DCF method can also be triangulated to the valuation of partly completed property development projects for trading stock and income tax assessment purposes.

Assessing a fair and reasonable royalty rate ¶22-010 Relief from royalty method Assessing the market value of an identifiable intangible asset such as a patent or trade mark is relevant for tax purposes in cases where the identifiable asset is a significant asset of the business and the ascertainable market value of the bundle of total assets needs to be apportioned either between the constituent assets (such as goodwill and specialised fixed assets) or between pre and post-capital gains tax (CGT) assets, for example if the trade mark was developed before the introduction of CGT. A common valuation method used to assess the market value of such assets is the relief from royalty method. This method is derived from the economic theory of deprival value, whereby it is assumed that the business does not own the identifiable intangible asset under consideration and therefore has to pay a royalty to the owners of the asset for its use. The value of the identifiable intangible asset under this method is the value of the royalties (which are usually expressed as a percentage of sales) that the business is “relieved” from paying as a result of ownership of the asset. Put differently, it is the royalty rate that the owner of the asset would have had to pay to license the asset from a third party had it not owned it. Essential to the implementation of this valuation method is the determination of a “notional” market-based royalty rate that the notional licensee would be prepared to pay for the right to use the asset had it not owned it. The resulting “notional” royalty payments are then used as a surrogate for the gross cash flow stream attributable to the relevant asset. Where appropriate, allowance is then made for any recurring licensing, marketing and administrative costs incurred by the licensor, and for any necessary working capital. The net income/cash flow is then capitalised, or present valued at an appropriate earnings multiple or discount rate. Thus, when the market value of an identifiable intangible asset is a focal point of a tax dispute, it is important to have an understanding of the appropriate conceptual framework to assess a fair and reasonable royalty rate. A fair and reasonable royalty rate can be assessed by having regard to royalty rates observed from the licensing of “comparable” identifiable intangible assets. However, when the subject asset is relatively unique and hence there are virtually no “comparable” assets or, even if comparable assets are available, but there are no contemporaneous observable royalty rates for those assets to use as a guide, it is problematic to rely on comparables to assess a fair and reasonable royalty rate. In such circumstances, it is necessary to consider “first principle” approaches under which a fair and reasonable royalty is determined based on the economic affordability of the underlying business to pay the royalty, while allowing debt holders (if any) to earn a contractual market rate of return on the debt provided, and the royalty payer to earn a reasonable return on their equity investment. This Chapter discusses the two main interrelated “first principle” approaches; being the royalty cover and NPV approaches. These approaches can also be used to assess a fair and reasonable royalty rate in various commercial and litigation contexts such as assessing a fair and reasonable royalty rate between the owner of an undeveloped mineral resource and the developer of that resource into a productive mining asset, or assessing compensation in patent infringement disputes.

¶22-020 Royalty cover approach Royalty cover is the number of times the total of all royalties payable is covered by the expected profitability or cash flows of the underlying project.

Underpinning the concept of royalty cover is the recognition of the need for there to be a symbiotic relationship between the royalty payer and royalty recipient. Under this symbiotic relationship, either: • the royalty recipient contributes an undeveloped asset (eg a technically proven but yet-to-be commercialised patent), whereas the royalty payer incurs substantial costs and risks of developing the asset to produce marketable products (eg commercialising the technically proven patent), or • the royalty recipient contributes a developed/established asset (eg a well-established trade mark) whereas the royalty payer bears the costs and risks of exploiting the asset. Central to the concept of royalty cover on the one hand is the affordability of the proposed royalty rate based on expected sales or profits from the development or exploitation of the relevant asset by the royalty payer. On the other hand, the royalty rate needs to be sufficiently attractive to the royalty recipient to cover their costs, provide a return on the cost of development and to effectively discourage the exploitation of the relevant asset by the intangible asset owner. A fair and reasonable royalty rate is determined as that which the royalty payer can reasonably afford to pay given the costs associated with either developing or exploiting the asset and the expected sales and profitability therefrom. Royalty cover is an important indicia against which the fairness and reasonableness of a royalty rate is assessed. This is because unless forecast profits/cash flows cover the royalties paid by a significant margin, the royalty payer would not be able to meet its other financial obligations, earn a fair and reasonable return and recoup their substantial incremental investments in developing the asset over its life and to compensate them for the risks taken. A significant margin or buffer is required for the following reasons: • At the time the royalty rate is determined, the future sales, profits and cash flows of the project are often estimates only. There is a substantial risk that the actual outcome will differ from the outcome that was forecast1. This risk is substantially (but not entirely) borne by the royalty payer, affecting their capacity to pay royalties over time. In simple terms, a significant margin and buffer should be in place to enable the royalty payer to meet their royalty payment obligations even in the event of adverse market conditions, but at the same time not be so low as to generate excessive profits by the royalty payer. • If the royalty rate is too high a percentage of forecast profits (ie insufficient margin/buffer or inadequate royalty cover), there will be insufficient residual profits from the project available to the royalty payer to cover fixed and variable operating costs, meet other financial obligations (eg interest payment obligations), earn a fair and reasonable rate of return on their substantial investments in developing or exploiting the asset, and achieve a return of investment capital commensurate with the risks involved. In simple terms, the significant margin/buffer and royalty cover recognises the existence of other financial obligations the royalty payer needs to meet and the need for the royalty payer to achieve a reasonable return on capital and return of capital from the overall net cash flows of the project. • Leaving a significant margin/buffer or royalty cover: – enables the royalty to be sustainable over the long-term as adverse market conditions erode profit margin (either temporarily or permanently) and therefore restrict the ability of the royalty payer to continue paying the royalty, and – provides the royalty payer with an adequate return on capital and return of capital with respect to their capital outlays to develop or continue exploiting the asset and encourages the royalty payer to continue and grow their operations and hence the associated royalty stream. The 25% rule The “25% rule” was popularised by Robert Goldscheider2 in 2002. In essence, royalty costs should not

exceed 25% of the royalty payer’s gross profit. Of course the 25% figure needs to be fine-tuned depending, for example, on factors such as whether the royalty payer is a wholesaler or retailer, how capital intensive the project is, etc. The 25% rule is consistent with a rule of thumb that is often cited when consideration is given as to how a fair profit sharing arrangement can be determined for the commercialisation of a product that incorporates licensed intellectual property (IP). The 25% rule suggests that a useful starting place in the determination of an equitable royalty is a rate that is equivalent to 25% of the licensee’s expected operating profit from the product that incorporates the licensed IP. This is another way of saying that the royalty cover should be four times gross earnings before royalties. In Goldscheider’s opinion: “The [25%] Rule, [which is] based on historical observations, provides useful guidance for how a licensor and licensee should consider apportioning the benefits flowing from use of the IP”, but he also comments that: “The precise ‘split’ of profits should be adjusted up or down depending on the circumstances of each case and relative bargaining positions of the two parties.” However, as noted earlier, the application of the 25% rule can be adjusted depending on factual circumstances. For example, when the royalty payer has debt in its capital structure and the payment of debt obligations ranks ahead of the payment of royalties, the assessment of royalty cover should be based on profits after interest payment (and taking into account any required principal repayments). In addition, the higher the level of uncertainty as to the economics of the project developing or exploiting the subject identifiable intangible asset, the greater the buffer and royalty cover (and the lower the implied royalty rate) required to allow the royalty payments to be sustainable over the long-term in the face of uncertainty, while maintaining the symbiotic relationship between the royalty payer and the royalty recipient. Furthermore, assessing an appropriate royalty rate, particularly for start-up businesses or new products, is complicated by a number of issues, including reliance on forecasts of sales and profits and the fact that product development and marketing expenses are incurred well before sales revenues are achieved. Future sales and earnings from start-up companies, or a new product, cannot generally be determined accurately in advance. Forecasts may prove to be highly optimistic and upside variations are generally capped by factors such as the overall size of the market, potential substitute products and existing and new competitors, whereas downside variations can result in significant cash outgoings due to the existence of fixed costs. Thus, the total amount actually received from a running royalty based on a percentage of forecast sales may be substantially different to the forecast amount. The level of royalty cover should be high enough to cover launch and other costs while providing sufficient profit incentive for the royalty payer to undertake the project. New products often generate losses for a number of years before generating profits. Royalty cover should be sufficiently high to allow the licensee/royalty payer to recover those losses (plus compound interest thereon) quickly once the product becomes profitable. The period before the losses are recovered has to be sufficiently short, and sufficiently likely to be achieved, to make it attractive to undertake the product launch/project. In any event, the increased risk (volatility of earnings) for a start-up business, or the launch of a new product, means that a benchmark for an established cyclical business would represent the minimum level of cover required because although its earnings may vary with a cycle, they are still less risky than those of a start-up business or new product launch. Example: Application of the royalty cover approach The application of the royalty cover approach to assess the royalty rate as a percentage of sales is illustrated by way of the following simplified example where the royalty cover is between three and four times and the net profit margin (after interest payment and taxes, but before royalties) is 24%.

Table 22.1 Scenario 1

Scenario 2

Net profit margin

24%

24%

[a]

Royalty cover

3 times

4 times

[b]

Royalty as a percentage of net profit margin 33.3%

25%

[c] = [1/b]

Royalty rate (as a percentage of sales)

6%

[d = [a] × [c]

8%

There are a number of practical issues arising from the application of the royalty cover approach, including: • the differences between earnings and cash flows, noting that strictly speaking royalties are paid from cash flows, not earnings • the allowance for the tax benefits arising from carrying forward losses in earlier years to offset against taxable profits from the project in later years • the circularity arising from the assessment of royalty cover based on profits after-taxes and the tax deductibility of royalty payments • depending on the point of assessment, the early stage nature of the project at the time a fair and reasonable royalty is to be determined • the higher volatility of operating cash flows relative to that of royalties as a percentage of sales due to the presence of operating leverage. The practical solution to the above issues is for the analysis to be conducted on a net present value (NPV) basis (“NPV approach”), which is discussed below. Footnotes 1

In the case of a private mining royalty, this is usually exacerbated due to the geological complexity of the resource, the significant size of the project, the associated development complexities, the heightened likelihood of cost overruns, the likely volatile nature of commodity prices and the volatility of FX rates.

2

R Goldscheider, et al (2002) Use of the 25% rule in valuing IP, les Nouvelles 37(4):123–133. See also R Razgaitis (1999) Early-stage technologies: valuation and pricing, John Wiley & Sons, New York, Chapter 6.

¶22-030 The NPV approach The NPV approach compliments the royalty cover approach in that it allows royalty cover to be determined by the economic capacity to pay, given the expected cash flows from the underlying project/business in which the subject asset is developed or exploited, rather than by relying solely on a simplistic rule of thumb (eg the 25% rule). Under the NPV approach, the royalty cover is measured based on: • the present value of the cash flows before royalties (but after-tax) expected to be generated from the project (the reasons for using cash flows before royalties, but after-tax are explained further below) • the present value of the royalty stream on an after-tax basis, and • the ratio of the present value of cash flows before royalties to the present value of the royalty stream on an after-tax basis mentioned above (after allowing for the tax deductibility of royalty payment).

The NPV approach explicitly allows for: • the fact that royalties are paid out of operating cash flows and present value calculations are typically performed in respect of cash flows, rather than earnings • the fact that the riskiness of the royalty stream calculated as a percentage of sales is less than that of the overall expected operating cash flows of the project due to the volatility of operating cash flows being exacerbated by the operating leverage of the project (in the same manner in which the volatility of cash flows to equity is exacerbated by the use of financial leverage). The differential riskiness warrants the application of differential discount rates in determining the present values of the royalty stream and the overall expected operating cash flows (before all royalties but after-tax) from the project • the timing of revenue being received and hence the timing of royalty as a percentage of sales being payable as well as the timing of operating cash flows from the project, and • the tax benefits arising from carrying forward losses in the earlier years to offset future taxable profits from the project in later years. A variant of the NPV approach is to calculate the NPV of the project (before the payment of the relevant royalty). Such NPV obviously takes into account the rates of return required by the royalty payer and the debt holder (ie the weighted average cost of capital (WACC)), the size of the investment capital, timing and quantum of the operating cash flows, etc. If it is positive, there is some economic capacity to pay the royalty, which then leads to the question of its amount. For example, in deriving a reasonable bargaining zone, hypothetical market participants may calculate: • a royalty rate which makes the NPV equal zero, or • a royalty rate which reduces the NPV, say, by half. The technical advantage of the NPV approach is that if a royalty rate within the range is selected, it implies that the debt holder earns their required rate of return and the royalty payer earns at least their required rate of return on their total investment capital used to finance reasonably (expected) capex of the project3. The bargaining zone, and where the royalty rate lies in that bargaining zone, is highly case and factspecific, depending, inter alia, on the characteristics of the licensee’s business, the industry in which it operates, the reliability of the forecast sales, profitability, invested capital (including, where applicable, launch and marketing costs) and cash flows, and in particular, whether or not those forecasts are overly optimistic4, etc. The use of cash flows before all royalties and after-tax The reasons for the use of cash flows before royalties and after-tax are that: • it recognises that royalties are paid out of cash flows, not earnings • it allows for the tax loss carried forward as mentioned above. This tax benefit increases the quantum of operating cash flows after-tax available to pay royalties • it maintains the consistency between the discount rate and the cash flows to which the discount rate is applied. The discount rate which can be derived using objective verifiable capital market inputs is an after-tax discount rate and hence it should be applied to after-tax cash flows, and • it allows for the early stage nature of the project at the time the royalty rate is to be determined. Footnotes 3

If the actual capex is significantly greater than the expected capex due to a cost blowout, the selected royalty rate based on the actual capex under the NPV approach is obviously

significantly less than that based on the expected capex to allow the capital providers (debt holder and royalty payer) to earn a reasonable return on the significant additional capital injected to cover the cost blowout. 4

In cases where the forecasts are overly optimistic, the true economic capacity to pay royalties and hence the negotiated royalty rate should be less.

¶22-040 In a nutshell Assessing a fair and reasonable royalty rate is technically complex and susceptible to dispute. Truly “comparable” royalty rates may not be available. The combination of the royalty cover approach and the NPV approach provides a practical “first principle” conceptual framework to assess a fair and reasonable royalty rate. The application of those first principle approaches is highly case and fact-specific.

Re-evaluating the discounts/premia to base valuation ¶23-010 Determining discounts/premia — the issues Many valuation exercises which are undertaken for tax purposes involve the valuation of equity (or equitylike) interests in either a publicly-listed or privately-held entity. The valuation method commonly adopted is to assess the base value of the subject equity interest and then apply discounts and/or premia to the base value in arriving at the assessed market value of the subject equity interest. It is not uncommon in these instances for disputes (with flow-on tax consequences) to arise from the discounts and/or premia applied to the base value, rather than the base value itself. The disputes usually involve the type of discount/premia to apply, the size of the discount/premia, whether or not they overlap and the extent of any overlap. The objective of this Chapter is to provide a conceptual re-evaluation of the discounts/premia (other than the control premium and the small company risk premium1) which are commonly applied and commonly subject to dispute. Such a re-evaluation focuses on the nature of the relevant discounts/premia and identifies the conceptual delineation or overlap between these discounts/premia. Valuation errors in practice usually arise from the failure to recognise these delineations or overlaps. Although this Chapter discusses the alternative methods to quantify the relevant discounts/premia, its focus is not on presenting and reviewing the (significant) body of empirical evidence used to implement these methods. Rather, the focus is on the need to understand the nature of what is being valued and the type of empirical evidence suitable for the subject of valuation. The “matching” between the two has not received adequate attention and debate in practice. The size of the discounts/premia applicable in a given case is ultimately fact-specific, reflecting, inter alia, the application of the suitable type of empirical evidence to that case. The discounts/premia which are conceptually re-evaluated in this Chapter include: • private company discount • minority interest discount • discount for lack of marketability (DLOM) • blockage discount/premium • negative signalling discount, and • key person discount. The market value of the interest being assessed is based on the ascertainable market value of the listed entity “comparables” to which the relevant value discounts (discussed below) are applied. Footnotes 1

A conceptual re-evaluation of these premia is separately undertaken in Chapters 5 and 6.

¶23-020 Private company discount A private company discount is conceptually the discount at which a minority or controlling interest in a

privately-held company is traded relative to its listed counterparts. Minority interests in private companies are generally an unattractive investment in comparison to listed shares for a variety of reasons, including: • the articles of private companies frequently contain restrictions on their transfer • there may also be pre-emptive clauses that give the existing shareholders the right not only to acquire the shares, but to have the price fixed by the auditors if the existing shareholders consider the asking price is too high • minority shareholders in a private company are effectively at the mercy of the controlling shareholders in respect of not only their annual dividend income but, because of the flow-on effect of dividend policy to share value, the capital value of the shares, and • private companies usually have less depth and breadth of management than their listed counterparts. At a whole of entity level such unattractive characteristics can be eliminated (eg by changing the constituent documents). However, even at a whole of entity level, private companies generally sell at lower earnings multiples than subsidiaries of, or former, public companies. This is the result primarily of size differences (although smaller entities may possess significant market position in a small local market or operate in a profitable niche sector). But other factors also contribute. For example, the ability of a private company to obtain additional equity capital as and when needed is less than for a subsidiary of a, or a former, listed company. In cases where the subject of valuation is a controlling interest in a private company (or a 100% interest in an unlisted wholly owned subsidiary of a listed entity), the private company discount can be assessed by having regard to empirical evidence on the transaction earnings multiples at which private companies are acquired, relative to those at which “comparable” listed larger entities are acquired. This type of empirical evidence is useful as a measure of the private company discount applicable to a 100% shareholding in a private company because it takes into account the interaction between control, marketability and size in assessing the earnings multiple to apply for a 100%/controlling shareholding in a private entity based on the observed transaction multiples of its listed larger counterparts. This type of evidence captures both differences in marketability and non-marketability factors. Conversely, this type of evidence cannot be used to represent DLOM alone. However, it is necessary to recognise and allow for the potential sample selection bias arising from the triangulation of private company discounts observed from a sample of private companies which have been acquired to those which have not been acquired.

¶23-030 Minority interest discount The reference to minority interest is typically assumed to denote lack of control. It is therefore necessary to consider the dispersion of ownership that may influence the size of the discount or premium and hence value2. Under normal commercial circumstances, minority interests are worth less than their pro-rata share of the whole equity because minority shareholders are unable to access cash flows as they arise, nor direct operating, investing, financing activities or dividend policies3. The minority interest discount is typically thought of as the mirror image of control premium. If there is a distinction between ex-post and ex-ante premium, it follows that there is also a distinction between exante and ex-post minority interest discount, particularly, for listed companies. The quantum of minority interest discounts is relatively less controversial because of the widespread availability of data on control premia paid in takeovers. This is because it is believed that if takeover premia average, say, 33%, the minority interest discount is, as a matter of simple mathematics, 25%. Confidence in this proposition is questionable on a number of grounds, including that: • the appropriate takeover premium is company, economic environment and industry-specific, so an

“average” premium may be inappropriate • the share price of the acquired company pre-bid may already reflect speculative buying pressure due to expectations of a takeover • the acquired entity may have idiosyncratic attractive features (eg large synergy potential) justifying a higher premium, and • the acquired entity may have been badly managed (depressing its pre-bid price). The quoted share prices of publicly traded firms are generally minority interest trades. Thus, minority interest discounts associated with minority shareholding in listed companies have already been captured in the price earnings multiples and dividend yields derived from observed share prices. However, the appropriate minority interest discount of a minority interest in a private company with a significant controlling shareholder may be significantly higher than the minority interest discount reflected in the share price of a widely-owned listed entity which complies with best practice corporate governance principles (other things being equal). Or the reverse may be the case. Footnotes 2

For example, a 40% interest in an otherwise widely-held company would normally represent control.

3

Refer to Chapter 5 for a fuller discussion on control premia.

¶23-040 Discount for lack of marketability The concept Marketability is of value to investors as it allows them to utilise opportunities to shift capital to avoid further losses, achieve higher return on investments, or for alternative uses. The reduced or lack of marketability results in missing these opportunities. Consequently, investors require extra returns to hold investments subject to reduced or lack of marketability. Accordingly, a security subject to marketability constraints should be valued at a discount to an equivalent, but readily marketable security. The DLOM associated with a minority interest in a privately-held entity reflects the difficulty or inability of the owners to sell their interests owing to the fact that there is no established market for interests in privately-held entities. The absence of a market and the much lower extent of publicly-available information about private companies, relative to otherwise comparable public companies, means that there are much higher transaction costs and time delays associated with trading in the shares of private companies. For prospective sellers, the costs are predominantly the likely delays and significant search costs associated with locating a purchaser for a minority shareholding in a private company even if, as a practical matter, a purchaser can be found at all. For prospective buyers, the costs are predominantly the search costs associated with finding suitable potential investments and the costs and delays in obtaining sufficient information in order to properly assess the value of the shares (ie a due diligence process). The existence of these high transaction costs associated with minority holdings in private companies reduce their value, relative to otherwise comparable holdings in listed companies, because costs reduce the net cash flows available to the owners of the shares and the delays result in time value costs and having to forego other investment opportunities.

Measurement — the restricted stock method There have been numerous USA studies on restricted stock discounts4. These studies measured the price discounts to the quoted market price of securities that do not have trading restrictions. In the USA such restrictions are contained in the Securities Act 1933 r 144, which governs the purchase and resale of restricted securities. The difference in transaction prices between the restricted stock and its freely tradeable counterpart provides evidence of the DLOM and an element of placement discount. This is because the sale of a large block of even freely tradeable shares usually occurs at a discount to the contemporaneous quoted market price. In addition, it is important to note that a minority interest in a private company is often subject to lack of marketability for a much longer period of time than the resale restriction period of the restricted stocks used in the restricted stock studies (ie ranging between six months and 24 months). Other things being equal, the longer the resale restriction period, the larger the size of the DLOM. Measurement — the put option approach The assessment of the DLOM is also relevant to the valuation of escrowed shares. Escrowed shares are shares in newly-listed companies which cannot be sold for a certain period of time referred to as the “lockup period”. The owners of escrowed shares are typically “insiders” (major shareholders, senior executives, etc) of the newly-listed company. In assessing the DLOM for escrowed shares, apart from the evidence inferred from the restricted stock studies, a put option approach is also often used. While the holder of a non-escrowed share can sell their share at any time, the holder of an escrowed share can be guaranteed to at least receive the initial public offering (IPO) price by buying a put option exercisable at the end of the escrow restriction period or by entering into a synthetic forward sale5. The put option method of valuation recognises that the magnitude of the DLOM is a positive function of the length of the lock-up period and the volatility of the underlying shares. The larger those variables, the higher the opportunity cost of not being able to trade. It is important to note that long-term traders trade less frequently and are less sensitive to transaction costs and liquidity than short-term traders. Measurement — the pre-IPO transaction method There is a strand of empirical studies which estimates the DLOM by comparing the price at which shares in a private company were transacted in a pre-IPO period to the IPO price when the private entity subsequently went public6, making the equity interest in the entity more marketable. The main problem with using the empirical evidence provided in these studies to measure the DLOM is sample selection/survivorship bias. This is because the sampled transactions used in these studies include only those entities which did well in the period between the private transaction and the IPO and exclude those which did poorly after the private transaction (due, for example, to intervening events) and were unable to go public or were delayed in doing so. However, when the subject of valuation is an equity interest in a private company at a point in time when the entity is about to go to an IPO and market participants are knowledgeable of the expected IPO price7, the expected IPO price and the empirical evidence on the pre-IPO discount to the IPO price are appropriate reference points against which the market value of the pre-IPO equity interest may be assessed. This also highlights the need to have a correct understanding of both the factual circumstances (and the nature of the equity interest being valued) and the characteristics of the empirical evidence to determine a valuation method to achieve an appropriate valuation outcome. Double counting issues It is also important to avoid double-counting for lack of marketability in both the discount rate (through the use of a significant size/specific company risk premium8) and the DLOM applied to the resulting discounted cash flow (DCF) value (which already reflects the size premium). Although size discounts are different to DLOM, the size discount also reflects the fact that small stocks are less liquid than large stocks.

DLOM for a controlling interest There is also significant debate as to the application of a DLOM to a controlling interest in a private company. There is no “one-size-fits-all” answer. The answer in a given case partly depends on the recognition that there is an interrelationship between control and marketability. This is because the disadvantages from the lack of marketability are generally less for a controlling interest than for a minority interest in the same unlisted entity, as the controlling interest is devoid of the agency problem and more capable of responding to, and mitigating the negative impacts of, external and internal factors on the value of the underlying investment; whereas a holder of the minority interest lacks this ability. In addition, the market for controlling interests or corporate control is different from the market for minority interests in private companies, attracting different types of market participants and having a different level of liquidity. Footnotes 4

The length of this time period has decreased over time from two years to six months.

5

Buying an option to sell and selling an option to buy.

6

DLOM can also be estimated based on the costs and time delays involved in listing the private company.

7

For example, a private entity which is 100% owned by its employees may go through a restructure prior to its IPO. The restructure usually involves the employees or their controlled entities surrendering their respective interests in the private operating entity in exchange for shares in a corporate vehicle which is to be floated on the stock exchange. The subject of valuation is the “consideration” shares in the corporate vehicle prior to the IPO.

8

Refer to Chapter 6 for a detailed discussion on size premium.

¶23-050 Blockage discount/premium Depending on the size of the equity interest, the dispersion of other shareholdings, and equity market conditions, a block of shares may attract a premium if it conveys (partial) control of the entity. Generally, however, blockage discounts apply due to the adverse market impact of the sale of a large block of shares. The DLOM is used to convert the value of a share subject to lack of marketability into an equivalent fraction of the value of a fully marketable, but otherwise identical share. A discount of, for example, 35% for lack of marketability implies that the value of the share subject to lack of marketability is equivalent to 65% of the value of its fully marketable counterpart. The DLOM does not take into account the size of the equivalent block of marketable shares and the resultant difficulty and hence costs associated with realising a monetary value from the (notional) sale of that block. This is best illustrated by considering the blockage discount for a large block of shares in a listed entity, which does not convey control. The concept of blockage discount recognises that the sale of a large parcel of shares (commonly known as a block sale) is normally executed at a discount to the prices determined in normal stock market trading of small parcels. In normal stock market trading, to sell a stock, a seller must cross the bid-ask spread and hit the existing bid orders in the schedule. If the seller wants to sell a large parcel of shares, say, 1,000,000 shares and there is only 100,000 shares available at the best (highest) bid, then the seller must decrease the price until there is adequate volume in the order book to absorb the complete order. That is, the seller incurs

market impact costs, which are the difference between prices at which parts of the large parcels of shares are executed and the best (highest) bid price at the time those parcels of shares are introduced to the market. This difference arises from the fact that because the volume able to be sold at the best bid price is too small to absorb a large order. Therefore, parts of the large sell orders must be executed at lower prices than the best bid price prevailing at the time the disposal commences. This is analogous to “going deeper and deeper” into the buy order book and hence getting lower and lower prices. Market impact costs are significant when trading volume and depth of the buy order schedule are low and trading activity is dominated by retail investors, rather than institutional investors and vice versa. In practice, the sale of a large block of shares (which does not convey control, or at least significant influence) is normally executed off-market, with a broker locating the counter-party to the trade. Although the parcel of shares can, in principle, be broken down into small lots to be gradually executed over a period of time, significant opportunity costs may be incurred. This is because the longer the period of sales execution, the higher the risk of adverse price movements causing the expected sales proceeds to be even lower than when the sale is executed immediately via an off-market trade. This problem is exacerbated by the “stock overhang” problem as market participants become aware of consistent selling.

¶23-060 Negative signalling discount The negative signalling effect arises from the information asymmetry between outside investors and corporate insiders such as senior executives. Because corporate insiders know more about the future prospects of the company than outside investors, outside investors normally attempt to deduce information about the future prospects of the company from (inter alia) the behaviour of corporate insiders. It is a matter of local market experience, confirmed by empirical evidence, that directors’ sales of shares are generally perceived by investors to be value-eroding signals. From a theoretical perspective, the negative signalling from on-market sales by “insiders” (eg large shareholders, senior executives, etc) could be partly mitigated through the use of an off-market sale, whereby the true underlying motive (eg liquidity) of the sale could be communicated to a single or a small number of counter-parties more effectively. That is, the level of information asymmetry which underpins the negative price reaction to insiders’ on-market sales could theoretically be reduced in the case of offmarket sales. In practice, however, although the large parcel of shares could be sold off-market, the off-market trade would subsequently have to be reported to the market, which would, consistent with empirical evidence, trigger a negative price reaction. The counter-party to the off-market trade (who would reasonably anticipate this adverse price reaction) would, as a matter of commercial logic, require a discount, which is conceptually over and above the price concession discount required for only acting as a pure liquidity supplier to facilitate the disposal of a large parcel of shares (ie the blockage discount). There is a degree of interaction between the blockage discount and the negative signalling discount. If the sale of a large parcel of an insider’s shares is broken down into smaller lots to reduce the level of market impact cost (ie blockage discount), this is likely to result in a decrease in the value of the remaining shares which are yet to be sold as a result of multiple negative signals impacting the market price of the shares (in essence a combination of the adverse effect of “stock overhang” and negative signalling). Accordingly, the application of the blockage discount and negative signalling discounts is highly factspecific. There is also a subtle distinction between a placement discount and a blockage discount in that the former may reflect, inter alia, liquidity constraints at the issuer level, whereas the latter reflects the difficulty/cost associated with selling a block of existing shares (ie liquidity constraints at the issued share level).

¶23-070 Key person discount The market price of shares in an entity may include a key person value element which, in substance,

reflects the extent to which the benefit of the continued services of a key person is impounded into the market price of the shares. A key person’s shareholding in an entity may represent a significant percentage of the issued capital and/or a substantial proportion of the key person’s personal wealth. The potential, or actual, discontinuation of services by the key person to the entity may have an adverse effect on the market value of the shares. As mentioned earlier, significant sales of shares by a key person in a listed company are generally perceived by market participants to be value-eroding signals. Accordingly, the share price of the company tends to fall following the announcement of the key person’s sales. However, this price fall overstates the real key person risk. When a key insider of a company decides to sell equity in the company, the disposal signifies to market participants that: • the future operating and financial prospect of the company could have deteriorated • the key person has less financial incentive to be as committed to the company. That is, the key person’s interest would no longer be as material (and thus perceived) by the market as warranting the same level of his/her personal involvement and the key person’s financial interests would no longer be as closely aligned with those of other shareholders as before, or • the key person might discontinue or at least reduce involvement in the company (ie he/she would no longer be a key person). A method of estimating the key person value element, as distinct from the negative signalling discount, is to examine the share price reaction to sudden deaths of high-profile key executives of listed public companies. The rationales behind this method are as follows: • The value of a company is the present value of expected future cash flows discounted at an appropriate discount rate. Consequently, the value of the company is affected by fluctuations in cash flows or changes in systematic risk (ie discount rate). If a key person is, for example, successfully managing the company (or a key division thereof) prior to death, it is reasonable to expect that the market would, at least temporarily, revise downward the company’s cash flow estimates following the key person’s death, resulting in a fall in the company’s share price (other things being equal). • As opposed to a key person’s sales of shares, the death of a key person is an event which is not associated with any perceived implications of that person’s assessment of the fundamental operating and financial prospects of the company. In other words, sudden deaths of high-profile key persons provide a relatively “clean” setting in which the share price reaction can be appropriately attributed to the loss of the key person’s continued service to the company. However, it should be noted that sudden deaths of high-profile key persons are only of use as an experimental setting in which the usually unobservable key person value element can be separated, observed and estimated. • Given that the sudden death of a key person is generally unanticipated, the observable share price reaction upon the announcement of death would be more reflective of the market assessment of the key person’s continued contribution or loss thereof to the value of the company. • A key person who has a high profile or who has the status of a successful founder may be seen as the personality of a company, or “the mover and shaker” behind a company. In other words, the key person may be highly recognisable and closely followed by the market. Consequently, share price reaction to the sudden death of such a key person provides a reasonable estimate of the market assessment of the key person’s future superior contribution or loss thereof to the value of the company.

¶23-080 In a nutshell The discounts/premia to base valuations may be more contentious than the base valuations. This is exacerbated by the lack of understanding and debate about the conceptual delineation/overlap

between these discounts/premia and how they are reflected in the empirical evidence used in practice in quantifying them. While the application of the discounts/premia is highly case and fact-specific, a correct understanding of the conceptual issues is necessary to achieve an appropriate valuation and tax outcome.

List of Abbreviations AIFRS

Australian International Financial Reporting Standards

API

Australian Property Institute

ARR

annual required revenue

ASX

Australian Securities Exchange

ATO

Australian Taxation Office

CAPM

capital asset pricing model

capex

capital expenditure

CBD

central business district

CGT

capital gains tax

CPI

consumer price index

DA

development approval

DAP

daily accommodation payment

DCF

discounted cash flow

DLOM

discount for lack of marketability

DTL

deferred tax liabilities

EITF

Emerging Issues Task Force

EV

enterprise value

FASB

Financial Accounting Standards Board

FOB

free on board

FX

foreign exchange

GFC

global financial crisis

GJ

gigajoule

GST

goods and services tax

GTL

gas-to-liquid

IAS

International Accounting Standards

IASB

International Accounting Standards Board

IFRS

International Financial Reporting Standards

IP

intellectual property

IPO

initial public offering

IT

information technology

LNG

liquefied natural gas

NBF

net bond flow

NPV

net present value

ODRC

optimised depreciated replacement cost

opex

operating expenses

ORC

optimised replacement cost

PAT

principal asset test

R&D

research and development

RACF

residential aged care facility

RTA

Roads and Traffic Authority of New South Wales (now Roads and Maritime Services)

SIRCA

Security Industry Research Centre of Asia Pacific

TARP

taxable Australian real property

TDRM

top-down residual method

USA

United States of America

WACC

weighted average cost of capital

WBNAB

willing but not anxious buyer

WBNAS

willing but not anxious seller

Index A Above-market rate lease contract intangibles Absolute upstream cost plus

¶9-030 ¶16-110

Access rights mining information Accommodation bonds in the residential aged care sector

¶10-020; ¶10-030 ¶1-020; ¶18-010; ¶18-130

DCF valuation approach

¶18-050

— net bond flow (NBF) calculation

¶18-100

— reinvestment of proceeds

¶18-110

— use of cash proceeds

¶18-110

economic approach

¶18-020

funding gap

¶18-120

interest-free liability

¶18-070

legal/accounting approach

¶18-020

occupancy rights consideration

¶18-070

present value assessment

¶18-040

sales of bed places versus sales of occupancy rights

¶18-060

sharing of expected cash flows with providers of equity capital

¶18-080

sources of confusion

¶18-030

timing of bond repayment

¶18-090

Accounting approach accommodation bonds

¶18-020

goodwill

¶7-030

— accounting and economic goodwill value, interrelationship

¶7-030

— dangers in misinterpreting empirical evidence

¶7-030

— distortions in the measured value

¶7-030

Agency risk

¶5-030

Annual required revenue (ARR) asset base value

¶16-040

building block approach

¶16-030

cost of tax

¶16-080

operating expenses — downstream opex

¶16-070

— efficient opex

¶16-070

Arm's length contract

¶17-060

Asset base value

¶16-040

Asset focus marriage value

¶2-020 ¶15-010

Australian Accounting Standards (AASB) AASB 3 Business Combinations

¶7-030

AASB 101 Presentation of Financial Statements

¶18-020

AASB 108 Accounting Policies

¶19-030

AASB 136 Impairment of Assets

¶19-050

AASB 139 Financial Instruments: Recognition and Measurement

¶19-050

Australian International Financial Reporting Standards (AIFRS) Australian Property Institute (API) Valuation and Property Standards Australian Securities Exchange (ASX) listed companies

¶7-030 ¶13-020 ¶3-050

B Base erosion and profit shifting (BEPS)

¶17-010

Blockage discount/premium

¶23-050

Bond repayment legal liability

¶18-090

Bottom-up valuation method

¶12-010

Broad share market index

¶6-010

Building block approach annual required revenue calculation

¶16-030

cost of tax — imputation credits

¶16-080

end-of-life value allowance

¶16-100

ex-post external changes

¶16-090

notional arm's length access charge

¶16-020

operating and maintenance costs

¶16-030

remediation costs

¶16-100

return of capital

¶16-030

return on capital

¶16-030

value-based asset valuation method

¶16-040

Business value

¶4-010; ¶12-030

Buyer/seller argument rational and knowledgeable

¶11-030

C Canadian Institute of Chartered Accountants (CICA) EIC-152, Mining Assets — Impairment and Business Combinations

¶19-050

Capital asset pricing model (CAPM)

¶6-010

double-counting for risk

¶6-040

lack of marketability

¶9-070

Capital expenditure (capex)

¶3-040

Capital gains tax (CGT)

¶1-010

accommodation bonds

¶18-020

cash holdings

¶11-010

control premium mining information

¶5-010 ¶10-010

principal asset test — see Principal asset test (PAT) ramifications of deprival value ramifications of marriage value

¶13-010 ¶15-030; ¶15-050

Cash flow accommodation bonds — expected cash flow

¶18-080

— net bond flow calculation

¶18-100

“contracted” and “uncontracted” cashflows

¶9-060

discounted cash flow method of valuation

¶2-050

total expected cashflow

¶9-040

use of cash flows before all royalties and after-tax

¶22-030

Cash holdings

¶11-010

“Cashed up” buyer argument cash holdings

¶3-050 ¶11-020

Comparable sales method unit of measurement concept Comparable uncontrolled price (CUP) method

¶2-040 ¶1-020; ¶17-010; ¶17-090

allowing for volume and duration differences

¶17-070

choice of methodology

¶17-020

comparable transactions — controlled

¶17-030

— multiple

¶17-080

— uncontrolled

¶17-030

formula-based prices

¶17-050

related party transactions

¶17-040

use of subsequent arm's length transactions

¶17-060

Componentisation case Conceptual errors

¶2-040 ¶1-020; ¶2-010

Spencer market value concept — adoption of incorrect financial unit of measurement

¶2-040

— adoption of incorrect view of impact of non-transferability

¶2-070

— failure to recognise the asset focus

¶2-020

— failure to recognise the negotiated price focus

¶2-030

Conceptually convergent approach evolutionary nature of asset values

¶7-050

existence versus materiality

¶7-050

gross versus net attraction of custom

¶7-050

pull versus push

¶7-050

sources of profit versus sources of goodwill

¶7-050

Contract intangibles

¶1-020; ¶9-080

above-market rate lease

¶9-030

allowance for lack of marketability

¶9-070

bundle of assets offered for sale

¶9-010

discount rate impact

¶9-060

risk-mitigating value contribution

¶9-040; ¶9-050

special payment arrangements

¶9-030

value contribution of asset class, measurement

¶9-020

“Contracted” and “uncontracted” cashflows

¶9-060

Control premium

¶1-020; ¶5-060

corporate control, definition

¶5-020

distinction between observed ex-post takeover and ex-ante control premium

¶5-040

ex-ante control premium, determination

¶5-050

importance

¶5-030

role

¶5-010

Corporate cash holdings

¶1-020; ¶11-070

“cashed up” buyer argument

¶11-020

dollar of cash is worth a dollar

¶11-010

drivers of value

¶11-050

interaction with goodwill

¶11-060

rational and knowledgeable buyer/seller argument

¶11-030

WBNAB for the whole entity versus holders of minority interests

¶11-040

Corporate control, definition

¶5-020

Cost-based valuation method building block approach

¶16-040

optimised depreciated replacement cost (ODRC)

¶2-040

unit of measurement

¶2-050

Custom pull and push goodwill

¶7-050

D Daily accommodation payment (DAP) funding gap

¶18-120

Decile statistics

¶6-030

Deductive valuation method

¶1-020

compared to deprival value method

¶13-040

specialised fixed assets

¶12-040

— assessing unobservable market value

¶12-020

— challenges

¶12-010

— methodology

¶12-030

Deferred tax liabilities (DTL)

¶19-040

Depreciation (return of capital) operating capital maintenance

¶16-060

real financial capital maintenance Deprival value method

¶16-060 ¶1-020; ¶13-010; ¶13-050

compared to deductive valuation method

¶13-040

measurement

¶13-020

represent market value

¶13-030

valuation framework

¶13-040

“value in use”

¶13-020

Dilution risks

¶3-030

Direct trading approach

¶20-020

Discount

¶1-020; ¶23-010; ¶23-080

blockage

¶23-050

discount for lack of marketability (DLOM)

¶2-070; ¶23-040

— contract intangibles

¶9-070

— controlling interest

¶23-040

— double counting issues

¶23-040

— pre-IPO transaction method

¶23-040

— put option approach

¶23-040

— restricted stock method

¶23-040

discounted cash flow (DCF) method of valuation — accommodation bonds — correct conceptual framework

¶2-050 ¶18-050 ¶3-040

— net bond flow calculation

¶18-100

— partly completed projects

¶21-030

— small company risk premium

¶6-010

— use of proceeds

¶18-110

key person

¶23-070

minority interest

¶23-030

negative signalling

¶23-060

private company

¶23-020

Discount rate, impact

¶9-060

Discounted cash flow (DCF) method of valuation

¶2-050

Diversifiable risks and non-diversifiable risks double-counting

¶6-010; ¶9-020; ¶9-050 ¶6-040

Double-counting for risk Downstream infrastructure assets

¶6-040 ¶16-010

ex-post valuation — transport toll calculation

¶16-090

E Economic approach accommodation bonds

¶18-020

goodwill — notional securitisation framework

¶7-020

Economic goodwill

¶11-060

marriage value

¶15-020

Economic replacement costs useful subset of mining information

¶10-030

Empirical evidence corporate cash holdings

¶11-040

discounts/premia

¶23-010

misinterpretation

¶7-030

USA equities market — incorrect triangulation

¶6-030

Enterprise value (EV)

¶4-010

control premium

¶5-020

distinction with market value of equity

¶4-050

going concern EV assessment

¶4-030

— versus liquidation basis

¶4-040

Equity dilution

¶3-040

Equity value

¶4-010

EV plus add-on method

¶4-010

Ex-ante control premium

¶5-040

determination

¶5-050

extent of lower investment risk

¶5-050

size of private benefits of control

¶5-050

unlockable value

¶5-050

Ex-ante outcome

¶7-020

Ex-post realisation

¶7-020

F Fair value, definition

¶19-040

Feedstock gas valuation at a notional point of transfer

¶16-010

Financial Accounting Standards Board (FASB) Emerging Issues Task Force (EITF) — EITF Abstract Issue 04-3

¶19-050

FAS 157

¶19-050

Financial statements misinterpretation as statements of value Financing risks

¶19-030 ¶1-020; ¶3-030; ¶3-060

“cashed up” buyer argument

¶3-050

conceptual and practical challenges

¶3-010

correct conceptual framework

¶3-040

cost blowouts

¶3-020

dilution risks

¶3-030

equity dilution

¶3-020

highest and best use principle

¶3-020

significant delays

¶3-020

“First principle” approach NPV approach

¶22-030

royalty cover

¶22-020

Formula-based prices

¶17-050

G Gas-to-liquid (GTL) projects value allocation

¶16-010

Global Financial Crisis (GFC)

¶1-020

conceptual and practical challenges

¶3-010

Goods and services tax (GST)

accommodation bonds GST margin scheme Goodwill

¶18-020 ¶21-010; ¶21-020 ¶1-020; ¶7-010; ¶7-090

accounting approach

¶7-030

— accounting and economic goodwill value, interrelationship

¶7-030

— distortions in the measured value

¶7-030

— misinterpretation of empirical evidence

¶7-030

conceptually convergent approach — see Conceptually convergent approach conventional accounting approach

¶8-060

definition

¶8-020

derived from identifiable asset or assets

¶8-070

economic approach

¶7-020

fortune of business

¶8-050

going concern basis

¶7-070

interaction with cash holdings

¶11-060

legal approach

¶7-040

legal demarcation

¶8-020

management decisions — ex-post realisation versus ex-ante outcome “measured” accounting fair value

¶7-020 ¶19-040

Murry case — see Murry case notional securitisation framework

¶7-020

potential valuation traps — dictating goodwill value as a residual

¶19-090

— economic nature of goodwill, overlooked

¶19-080

readily assembled management and skilled workforce

¶7-020

specialised fixed assets, temporal transfer of value

¶7-060

synergistic benefits

¶7-080

unprofitable businesses

¶8-080

Gross attraction of custom goodwill GST margin scheme

¶7-050 ¶21-010

H Highest and best use principle

¶3-020

value maximisation, inconsistencies

¶15-040

Hostels

¶18-010

Hypothetical development method compared to restoration method

¶14-040

Hypothetical rent capitalisation method specialised fixed assets

¶12-010

I Illiquidity premium

¶9-070

Imputation credits cost of tax

¶16-080

Income-based valuation method

¶2-050

Incremental upstream cost plus

¶16-110

Indirect trading approach

¶20-020

Initial public offering (IPO) price put option approach

¶23-040

K Key person discount

¶23-070

L Land, contract intangibles — see Contract intangibles Land rich assessments potential valuation traps

¶1-010 ¶1-020; ¶19-010; ¶19-100

— application of legal/accounting form over economic substance

¶19-060

— dictating goodwill value as a residual

¶19-090

— ignoring observable market-based inputs

¶19-050

— incorrectly triangulating cost-based valuation method

¶19-020

— misinterpretation that financial statements are statements of value

¶19-030

— overlooking economic nature of goodwill

¶19-080

— overlooking evolutionary nature of asset values

¶19-070

— uncritically equalising market value and accounting fair value

¶19-040

Land rich landholder taxing regime land rich test

¶1-010

Land rich ratio distortion

¶15-040

Legal approach accommodation bonds goodwill

¶18-020 ¶7-040

Legal demarcation goodwill

¶8-020

Legal goodwill

¶8-020

Long-term government bonds investment into risk-free securities

¶6-010

Long-term take-or-pay contracts

¶9-040

ascertainable market value Lower investment risk

¶12-020 ¶5-050

M Management decisions ex-post realisation versus ex-ante outcome

¶7-020

Marketability of assets

¶9-070

Marriage value concept

¶1-020; ¶15-010; ¶15-050

buy the land, get the lot

¶15-020

distinction between existing and expected future marriage value

¶15-020

indivisible subset of market value of land and non-land assets

¶15-030

indivisible subset of market value of land assets

¶15-020

negotiating range

¶15-030

portrayed as special value

¶15-040

Measurement errors Mining information permanent ownership and access rights

¶2-010 ¶1-020; ¶10-040 ¶10-020; ¶10-030

conceptual linkage — mining rights

¶10-020

— ore body

¶10-020

importance

¶10-010

negotiating range

¶15-030

Mining rights conceptual linkage to mining information

¶10-020

negotiating range

¶15-030

Minority interest discount

¶23-030

Murry case

¶1-020; ¶8-100

conventional accounting approach

¶8-060

fortune of a business

¶8-050

goodwill value

¶8-050; ¶8-060; ¶8-080; ¶8-090

— derived from identifiable asset or assets

¶8-070

legal demarcation

¶8-020

profitable businesses

¶8-090

residual valuation uncertainties

¶8-010

unprofitable businesses

¶8-080

value demarcation

¶8-020

— appropriate approach

¶8-040

— inadequacy of legalistic approach

¶8-030

N Negative signalling discount

¶23-060

Negotiated price focus failure to recognise

¶2-030

Net attraction of custom goodwill

¶7-050

Net bond flow (NBF) calculation

¶18-100

Net present value (NPV) approach

¶22-030

Netback method valuation at a notional point of transfer

¶1-020; ¶16-020 ¶16-010

Non-diversifiable risks and diversifiable risks Non-TARP assets

¶6-010; ¶9-020; ¶9-050 ¶1-010

cash holdings control premium

¶11-010 ¶5-010

Notional arm’s length access charges building block approach Notional securitisation framework Nursing homes

¶16-020 ¶7-020 ¶18-010

O Observed ex-post takeover premium

¶5-040

empirical evidence

¶5-040

Ongoing post-production upstream cost plus

¶16-110

Operating capital maintenance

¶16-060

Operating expenses (opex)

¶16-070

Opportunity cost inclusion

¶14-030

Optimised depreciated replacement cost (ODRC)

¶13-020

cost-based method

¶2-040

valuation traps

¶13-020

— incorrectly triangulating a valuation method

¶19-020

Optimised replacement cost (ORC)

¶13-020

Ore body conceptual link to mining information

¶10-020

P Partly completed development projects

¶1-020; ¶21-040

discounted cash flow (DCF) method

¶21-030

GST margin scheme

¶21-010

— “sum of the parts” method

¶21-020

Permanent ownership mining information

¶10-020; ¶10-030

Plant and equipment negotiating range

¶15-030

Portfolio case

¶2-040

clientele effect

¶2-040

economies of scale

¶2-040

Positive net present values (NPV)

¶3-020

Pre-IPO transaction method

¶23-040

Premium

¶1-020; ¶23-010; ¶23-080

blockage

¶23-050

discount for lack of marketability (DLOM)

¶23-040

key person

¶23-070

minority interest

¶23-030

negative signalling

¶23-060

private company

¶23-020

Primary or producing assets

¶4-030

Principal asset test (PAT)

¶1-010

capital gains tax — see Capital gains tax (CGT) cash holdings control premium ramifications of deprival value ramifications of marriage value

¶11-010 ¶5-010 ¶13-010 ¶15-030; ¶15-050

Private benefits of control

¶5-050

Private company discount

¶23-020

Property value

¶12-020

Put option approach

¶23-040

initial public offering (IPO) price

¶23-040

R Readily replaceable asset deprival value

¶13-030

Real financial capital

¶16-060

Recreation costs options to minimise Remediation costs

¶14-030

downstream notional toll calculation

¶16-100

Resident loans

¶18-020

Residential aged care facilities (RACFs) accommodation bonds

¶1-020; ¶18-010; ¶18-130

— DCF valuation approach

¶18-050

— economic approach

¶18-020

— funding gap

¶18-120

— “hostels”

¶18-010

— interest-free liability

¶18-070

— legal/accounting approach

¶18-020

— net bond flow calculation

¶18-100

— “nursing homes”

¶18-010

— occupancy rights consideration

¶18-070

— present value assessment

¶18-040

— sales of underlying bed places versus sales of occupancy rights

¶18-060

— sharing of expected cash flows with providers of equity capital

¶18-080

— sources of confusion

¶18-030

— timing of bond repayment

¶18-090

— use of proceeds

¶18-110

specialised fixed assets

¶12-010

Residual valuation uncertainties Restoration method

¶8-010 ¶1-020; ¶14-010; ¶14-060

compared to hypothetical development method

¶14-040

fundamental errors

¶14-010

inappropriate value shift

¶14-030

negotiation range

¶14-050

opportunity costs, inclusion

¶14-030

reasonableness test

¶14-030

significantly inflated special value

¶14-030

specialised in-situ land assets, valuing on an incorrect standalone basis

¶14-020

Restricted stock method discount measurement

¶23-040

Retirement villages implications for resident loans

¶18-020

Risk-mitigating value contribution

¶9-040

valuation

¶9-050

Royalty cover approach symbiotic relationship between the payer and recipient

¶22-020

25% rule

¶22-020

Royalty method relief

¶22-010

Royalty rate fair and reasonable assessment

¶1-020; ¶22-010; ¶22-040

— NPV approach

¶22-030

— relief from royalty method

¶22-010

— royalty cover approach

¶22-020

S Security Industry Research Centre of Asia Pacific (SIRCA) decile statistics Small company risk premium

¶6-030 ¶1-020; ¶6-010; ¶6-050

double-counting for risk

¶6-040

empirical evidence from the USA markets, incorrect triangulation

¶6-030

failure to recognise true subject of valuation

¶6-020

Special payment arrangements contract intangible

¶9-030

Special value marriage value

¶15-040

significantly inflated

¶14-030

Specialised fixed assets deductive valuation method

¶12-040

— assessment of unobservable market value

¶12-020

— challenges

¶12-010

— hypothetical rent capitalisation method

¶12-010

— methodology

¶12-030

— summation method

¶12-010

temporal transfer of value from goodwill Specialised in-situ land assets

¶7-060 ¶14-010

valuation on incorrect standalone basis Spencer market value

¶14-020 ¶1-020; ¶2-010; ¶2-080

adoption of incorrect view of impact of non-transferability

¶2-070

asset focus, failure to recognise

¶2-020

associated errors — conceptual

¶2-010

— measurement

¶2-010

“cashed up” buyer argument

¶3-050

conceptual and practical challenges

¶3-010

correct conceptual framework

¶3-040

definition

¶2-010

dilution risks

¶3-030

failure to recognise negotiated price focus

¶2-030

financing risks highest and best use principle

¶3-030; ¶3-060 ¶3-020

unit of measurement — choice of valuation methodology

¶2-050

— incorrect adoption

¶2-040

— market value — other valuation contexts

¶15-020 ¶2-060

value maximisation, problems — highest and best use principle, inconsistencies

¶15-040

— land rich ratio, distortion

¶15-040

— Spencer market value, inconsistencies

¶15-040

Stabilising assets

¶4-030

Stamp duty accommodation bonds

¶18-020

mining information

¶10-010

Standard of value

¶4-020

“Sum of the parts” method

¶21-020

Summation method specialised fixed asset Systematic risk

T

¶12-010 ¶6-010

Take-or-pay contracts

¶9-070

long-term

¶9-040

Taxable Australian real property (TARP) assets

¶1-010

cash holdings control premium mining information

¶11-010 ¶5-010 ¶10-010

Top-down residual method (TDRM) control premium “measured” accounting fair value of goodwill, valuation errors Total assets value

¶5-010 ¶19-040 ¶1-020; ¶4-060

business value

¶4-010

enterprise value

¶4-010

going concern business

¶4-020

standard of value

¶4-020

Trading stock definition

¶20-010

Transaction costs “measured” value of goodwill assessment

¶7-030

Transfer restrictions

¶2-070

U “Uncontracted” and “contracted” cash flows

¶9-060

Unit of measurement choice of valuation methodology

¶2-050

comparable sales method — incorrect adoption marriage value other valuation contexts volume and duration differences

¶2-040 ¶15-010 ¶2-060 ¶17-070

Unlockable value

¶5-050

Upstream assets

¶16-010

Upstream cost plus benchmark absolute

¶16-110

incremental

¶16-110

on-going post-production

¶16-110

USA equities market decile statistics

¶6-030

incorrect triangulation of empirical evidence

¶6-030

V Value allocation: upstream and downstream segments

¶16-120

appropriate value of asset base

¶16-040

building block approach — see Building block approach cost of tax

¶16-080

depreciation

¶16-060

end-of-life residual value allowance

¶16-100

ex-post uplifts in capital value

¶16-090

netback method

¶16-020

operating expenses

¶16-070

rate of return

¶16-050

remediation costs

¶16-100

upstream cost plus benchmark

¶16-110

valuation at a notional point of transfer

¶16-010

Value contribution contract intangibles — see Contract intangibles Value demarcation appropriate approach

¶8-040

goodwill

¶8-020

inadequacy of legalistic approach

¶8-030

Value in use

¶13-020

Value maximisation, problems inconsistencies — highest and best use principle

¶15-040

— Spencer market value

¶15-040

land rich ratio, distortion

¶15-040

Value-based asset valuation methodologies building block approach

¶16-040

Vendor finance loans

¶1-020; ¶20-010; ¶20-040

approach to trading financial assets — direct trading

¶20-020

— indirect trading

¶20-020

commercial propensity to systematically “trade” the loan book

¶20-030

W Weighted average cost of capital (WACC) rate of return

¶6-010 ¶16-050

Weighted average market capitalisation

¶6-030

Willing but not anxious buyer (WBNAB)

¶2-010

asset focus

¶2-020

“cashed-up” buyer argument

¶3-050

highest and best use principle

¶3-020

negotiated price focus

¶2-030

transfer restrictions

¶2-070

whole entity versus holders of minority interests

¶11-040

Willing but not anxious seller (WBNAS)

¶2-010

asset focus

¶2-020

“cashed-up” buyer argument

¶3-050

negotiated price focus

¶2-030

transfer restrictions

¶2-070

Working capital assets going concern EV assessment

¶4-030

— versus liquidation basis

¶4-040

Case Table C Paragraph CCM Holdings Trust Pty Ltd & CCT Motorway Company Nominees Pty Ltd v Chief ¶2-020; ¶15-040 Commr of State Revenue NSW 2013 ATC ¶20-409; [2013] NSWSC 1072 Churton v Douglas [1901] AC 217

¶8-080

Crutwell v Lye (1810) 34 ER 129

¶7-040

M Paragraph Muller, Re (1952) 86 CLR 387

¶8-020

Muller & Co’s Margarine Ltd; IRC v (1901) AC 217

¶7-040

Murry, Re 96 ATC 4703

¶7-040

Murry; FC of T v [1998] HCA 42; 98 ATC 4585

¶1-020; ¶7-010; ¶7040; ¶8-010

N Paragraph Nischu Pty Ltd v Commr of State Taxation (WA) 90 ATC 4391 ¶10-010

R Paragraph Resource Capital Fund III LP v FC of T 2013 ATC ¶20-386; [2013] FCA 363

¶10-010

Resource Capital Fund III LP; FC of T v 2014 ATC ¶20-451; [2014] FCAFC 37 ¶9-010

S Paragraph Spencer v Commonwealth [1907] HCA 82; (1907) 5 CLR 418

¶2-010; ¶2-080; ¶12-030

Section Finding List A New Tax System (Goods and Services Tax) Act 1999 (Cth) Section Paragraph Div 75

¶21-010

Income Tax Assessment Act 1936 (Cth) Section Paragraph Pt IVA

¶15-040

Income Tax Assessment Act 1997 (Cth) Section

Paragraph

70-20

¶20-010

Generally ¶1-010 Securities Act 1933 (US) Section Paragraph 144

¶23-040