Top 10 Mistakes When Performing Discounted Cash Flow Calculations for Impairment Testing

One of the most widely misunderstood and misapplied valuation techniques is the Discounted Cash Flow (DCF) calculation for impairment testing.

Here, we provide an overview of the 10 most common mistakes that may prevent you from performing a technically sound DCF calculation that meets the requirements of Australian Accounting Standards Board (AASB) 136 – Impairment of Assets (AASB 136). Our comments refer to value in use (VIU) calculations performed under AASB 136.

COMPLEXITY

Valuation techniques are complex. Their proper application requires specialised experience and a sound knowledge of core valuation principles. Added to this, the technical requirements of AASB 136 are also complex. As a result, there are a number of mistakes that are commonly made when undertaking impairment testing. Drawing on our experience, here are the 10 mistakes we see most frequently.

1. Application of a discount rate that is not consistent with the cash flow

Matching the correct type of discount rate to the correct type of cash flow is essential to perform meaningful DCF calculations. Cash flows and discount rates can be pre or post-debt (drawdowns, repayments and interest), and pre or post-tax.

2. Importance of the comparable company dataset

It is important to carefully select the listed entities that will comprise the comparable company dataset. The comparable companies should ideally be operating in the same (or similar) industry as the cost generating units (CGU), and therefore face similar risks and opportunities. It is important to ensure that the comparable companies selected provide an accurate guide as to the systematic risks and gearing levels, as this data is used to determine an appropriate beta and debt/equity weighting.

3. Incorrect matching of real and nominal cash flows and discount rates

Cash flows which incorporate the effect of inflation are on a nominal basis, whereas cash flows that exclude the effect of inflation are on a real basis. Where real cash flows are utilised, the impact of inflation needs to be factored into the discount rate (i.e. a real discount rate needs to be calculated). We often see errors made when matching real and nominal cash flows and discount rates, and in adjusting from nominal to real discount rates (and vice versa).

4. Applying a company’s discount rate to value specific assets

Specific assets and CGUs often have different risk and return profiles to the overall group (Consolidated Group). In these circumstances, the asset or CGU may have a different required rate of return and therefore a different discount rate to the Consolidated Group. Likewise, country-specific risk premiums should be considered for assets held in different jurisdictions. Consideration should also be given to where the risk is applied; and avoiding double-up of risks included in the valuation where the cash flows incorporate entity specific risk. Care should be taken when determining a discount rate that is appropriate to apply these cash flows.

5. Inappropriate timing regarding discounting of cash flows.

Consideration should be given as to when cash flows are actually received and the point at which they should be discounted back to net present value. For example, where cash flows are derived evenly throughout a period, midpoint discounting may be more appropriate than year-end discounting.

6. Adopting a tax rate which does not reflect the long-term tax rate for the asset / CGU being valued.

In order to reflect expected future cash flows, forecasts should be based on the expected effective tax rate applicable to the asset or CGU being valued, not necessarily the corporate tax rate at the time.

7. Failure to adequately consider required capital expenditure and investment in working capital.

In our experience, explicit cash flow forecasts and terminal value calculations often overlook the investment in capital expenditure and working capital required to achieve the forecasts. VIU cash flows should incorporate capital expenditure associated with maintenance of the asset base/operations and exclude any expansionary or growth capital costs. Further, the annual investment required in working capital should be considered and specifically addressed. Both are business critical cash flows and should be analysed in conjunction with historical and forecast growth rates.

8. Misapplication of the constant growth perpetuity formula in calculating a terminal value.

The constant growth perpetuity formula is highly sensitive to the variables adopted, particularly to the growth rate adopted. To avoid any doubt, the growth rate adopted implies a level of growth into perpetuity. Perpetual growth rates that are higher than long term industry growth rates, or significantly higher than forecast inflation rates, may be unrealistic and may overstate value. We recommend that when terminal values are calculated using this method, they are cross-checked to implied earnings multiples.

9. Incorrect comparison of valuation outcomes to carrying amount(s).

Depending on the type of cash flows and discount rate adopted, the valuation outcome should reflect a VIU calculation either before or after debt. Failing to understand whether the VIU calculated is before or after debt can lead to confusion as to that the valuation outputs reflect. This can lead to major errors in what this value is compared to, and in assessing whether impairment has occurred. Further, care should be taken in regard to which assets are included or excluded from the carrying value comparison. Mistakes here can have significant impact on results.

10. Inappropriate application of implied multiple cross checks.

In our experience, price earnings multiples are often confused with EBIT and EBITDA multiples. Consequently:

• Implied multiples are either calculated incorrectly; or

• The implied multiple is incorrectly compared to a different type of benchmark multiple.

Importantly, a price earnings multiple is a geared multiple (multiple of equity value), whereas EBIT and EBITDA multiples are un-geared multiples (multiples of enterprise value).