Impairment of Assets Computing Value in Use

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Impairment of AssetsComputing Value in Use

• Prof. Larry Tan
• Asian Institute of Management
• Franklin Baker Co. of the Phils.

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Value in Use

• Present value of expected future cash flows from
  the asset
• Two-step process
• Estimate future cash flows
• Apply an appropriate discount rate to these cash
  flows to calculate the present value

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Estimating Future Cash Flows

• Projections must be based on reasonable
  assumptions
• To obtain meaningful results, avoid
• Exaggerated revenue growth rates
• Significant anticipated cost reductions
• Unreasonable useful lives for plant assets
• In general, recent past experience is a fair
  guide to the near-term future

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Estimating Future Cash Flows

• Consider only pretax cash flows
• Normal, recurring cash inflows and outflows from
  the continuing use of the asset
• Estimated salvage value at the end of the assets
  useful life
• Exclude
• Possible future enhancements of the asset
• Noncash costs, such as depreciation
• Cash flows related to financing the assets, e.g.,
  interest and principal repayments
• Income tax payments

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Cash generating unit

• When cash flows cannot be identified with
  individual assets, assets must be grouped in
  order to permit an assessment of future cash
  flows
• Grouping should be performed at the lowest level
  possible
• The smallest aggregation of assets for which
  discrete cash flows can be identified
• Independent of other groups of assets

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Components of Discount rate

• Current market rate - should be identical for all
  impairment testing at any given date
• Asset class risk adjustment
• Includes country risk, currency risk, cash flow
  risk, pricing risk
• In practice, this can be built into the cash flows

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Approaches to present value calculation

• Traditional approach - forecast cash flows are
  discounted using a rate that is adjusted for
  uncertainties
• Expected value method - forecast cash flow are
  directly adjusted to reflect uncertainty and then
  discounted at the market rate

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Identifying the appropriate risk-adjusted cost
of capital

• By reference to the implicit rates in current
  market transactions (e.g., leasing transactions)
• From the weighted-average cost of capital of
  publicly traded enterprises operating in the same
  industry grouping

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Steps to develop a discount rate if risk-adjusted
rates are not available

• Identify the pure time value of money for the
  requisite time horizon over which the asset will
  be utilized
• Add an appropriate risk premium to the pure
  interest factor, which is related to the
  variability of future cash flows
• Greater variability of future cash flows
  (technical definition of risk) is associated with
  higher risk premiums

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Discount rate

• Use nominal interest rate, and cash flow should
  reflect monetary amounts expected to be received
  in the future
• Must reflect current market conditions as of the
  balance sheet date

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Corporate Assets

• Such as headquarters buildings, shared equipment
  that do not themselves generate identifiable cash
  flows, need to be tested for impairment as are
  all other long-lived assets
• Should be allocated among or assigned to the cash
  generating unit or units which they are most
  closely associated.

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Theory of Discount Rate

• The weighted-average cost of capital (WACC)
  measures a companys cost of capital based on
• Its after-tax cost of equity and debt
• The respective proportion of equity and debt in
  its financial structure
• WACC cost of debt after tax and cost of equity

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WACC Computation

• WACC kd x D/(DE) ke x E/(DE)
• Where
• kd cost of debt
• ke cost of equity
• D companys net financial debt
• E companys equity at fair market value

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Cost of Debt

• Based on the subject companys expected credit
  rating
• Market-driven (yields) and not based on coupons
• After-tax
• Note
• for computing value in use, use before tax cost
  of debt

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Cost of Equity Computation

• The cost of equity is generally assessed thru the
  Capital Asset Pricing Model (CAPM)
• Ke Rf ?(Rm - Rf)
• Where
• Ke cost of equity
• Rf risk-free rate
• ? companys beta
• Rm market return

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Components of Ke

• Risk-free rate (Rf) - 10-year or 30-year
  government bonds, as of the valuation date
• Market risk premium (Rm - Rf) - expected excess
  return on equity market over-and-above the
  long-term government bond rate
• Beta - a statistically-driven measure of the
  volatility of a stock, relative to the stock
  index
• In some cases, add specific risk premium (e.g.,
  small size, limited customer portfolio)

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Steps to determine Beta (?)

• Collect from available databases the ? of the
  comparable companies retained in each sample
  (Bloomberg is frequently used database)
• Adjust each ? of the gearing it bears (unlever
  the ? based on its capital structure)
• Compute an industry/peer beta
• Re-lever the ? to account for the subject
  companys capital structure

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Company ?

• Co. ? Industry ? x 1 D/E x (1 - t)
• Where
• Co. ? company risk co-efficient
• Industry ? industry risk co-efficient
• D net financial debt market value
• E equity market value
• t normal corporate tax rate

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In practice, discount rate used is

• Risk-free government bond yield
• Risk-free rate plus credit spread used by
  international banks