June 2012
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 AASB 136. Our
comments refer to value in use (VIU)
calculations performed under AASB 136.
cash flows and to utilise and disclose
a pre-tax weighted average cost of
capital (WACC) discount rate.
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
flows
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 postdebt (drawdowns, repayments and
interest), and pre or post-tax.
2. Incorrect calculation of the pre-tax
discount rate
AASB 136 requires calculations to
be based on pre-debt and pre-tax
Many valuation practitioners
prefer to perform calculations
using either a post-tax WACC or
a post-tax cost of equity discount
rate (with appropriately matching
cash flows) as they believe this
to be a more technically correct
approach to the valuation.
When utilising cash flows and
discount rates different to those
prescribed by AASB 136, the implied
pre-tax WACC should be calculated
for disclosure purposes.
3. Incorrect matching of real and
nominal cash flows and discount
rates
Cash flows which incorporate the
effects of inflation are on a nominal
basis, whereas cash flows that
exclude the effects 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 cost generating
units (CGUs) often have different risk
and return profiles to their parent
entity. In these circumstances, the
asset or CGU may have a different
required rate of return and therefore
a different discount rate to the
consolidated parent. Likewise,
country-specific risk premiums should
be considered for assets held in
different jurisdictions.
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.
Both are business critical cash
flows and should be analysed in
conjunction with historical and
forecast growth rates.
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Top 10 Mistakes When Performing Discounted
Cash Flow Calculations for Impairment Testing
For Further Information
Please contact your local advisor:
Andrew Fressl
Principal
Corporate Finance Sydney
Tel +61 2 9619 1669
Mobile 0416 212 093
andrew.fressl@crowehorwath.com.au
Nathan Timosevski
Manager
Corporate Finance Sydney
Tel +61 2 9619 1783
Mobile 0421 890 973
nathan.timosevski@crowehorwath.com.au
Lachlan McColl
Senior Manager
Corporate Finance Melbourne
Tel +61 3 5224 7753
Mobile 0402 040 702
lachlan.mccoll@crowehorwath.com.au
Harley Mitchell
Principal
Corporate Finance Brisbane
Tel +61 7 3233 3501
Mobile 0408 115 453
harley.mitchell@crowehorwath.com.au
Darryl Norville
Principal
Corporate Finance Perth
Tel +61 8 9481 1448
Mobile 0403 153 193
darryl.norville@crowehorwath.com.au
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. Confusion over whether the
valuation outputs reflect a geared
or un-geared valuation
Depending on the type of cash flows
and discount rate adopted, the
valuation outcome should reflect either
an un-geared or a geared valuation. In
other words, the VIU calculated will be
either before or after debt.
Failing to understand whether the
VIU calculated is before or after debt
can lead to major errors in assessing
whether impairment has occurred.
10.Inappropriate application of
implied multiple cross checks
In our experience, price earnings
multiples are often confused
with EBIT and EBITDA multiples.
Consequently:
n implied multiples are either
calculated incorrectly; or
n 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).
Where to Next?
If you require assistance with impairment
testing calculations, please contact our
valuation team at Crowe Horwath.
Our valuation team provides valuations
of businesses, shares and other
securities to assist shareholders,
management teams and Boards
to analyse merger and acquisition
transactions and to make decisions
around landmark events, including the
preparation of public and listed company
Independent Expert’s Reports.
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