A common error is to incorporate uncertainty into both the cash flow forecasts and adjust the discount rate for this uncertainty.
Appendix A expressly states that discount rates are to be free from bias.
Entity B has a pre-tax WACC of 10%.
It has three business units, two profitable and in well-established sectors (X&Y), and a third business sector (Z) that is only marginally profitable, in a highly competitive market and in a sector that is experiencing declining demand.
It would be wrong to apply a 10% discount rate to business line Z.
Using an unadjusted incremental borrowing rate as the discount rate
In many cases, an entity’s borrowing rate will be reduced, either because the lender has security over assets that are not being evaluated for impairment, or because of the impact of other revenue streams of the entity. Unless an entity is a single asset entity, it is unlikely the incremental borrowing rate reflects an asset specific discount rate.
Not adjusting WACC for security over assets that are not being evaluated for impairment, or the impact of other revenue streams of the entity
Entity C has two operating businesses - one is to operate as an investment property business, renting out commercial buildings, and the other is a retail operation in the garden centre sector.
Entity C’s borrowings are fully secured against all of its properties and it therefore has a reduced cost of borrowings because of the security given to the lender.
It would be wrong to apply an unadjusted WACC to the garden centre business because of the impact on the borrowing rate of the security given on the investment properties.
Not using a pre-tax discount rate
Entity D is a single asset business and has a WACC of 10%. Entity D uses 10% as the discount rate in the VIU model.
This is not in line with the requirements of NZ IAS 36 to use a pre-tax discount rate because WACC is a post-tax discount rate.
Incorrectly calculating a pre-tax discount rate
Entity E is a single asset business and has a WACC of 10%.
Entity E calculates the pre-tax discount rate (assuming a corporate tax rate of 30%) to be 14.28% (10%/0.7) as the discount rate in the VIU model.
Unfortunately, calculating a pre-tax discount rate is not as simple as grossing up the post-tax discount rate. If a post-tax borrowing rate or WACC is used as a starting point for determining a pre-tax discount rate, a two-step process needs to be adopted, i.e.:
- Determine the post-tax cash flows by modelling out the quantum and timing of tax payments to arrive at post-tax cash flows, which can then be discounted using the WACC (post-tax discount rate) to arrive at ‘recoverable amount’, and then
- Use the ‘recoverable amount’ and pre-tax cash flows to determine the internal rate of return/pre-tax discount rate.
In next month’s article we look at common errors made when determining ‘fair value less costs of disposal’.
For more on the above, please contact your local BDO representative