The weighted average cost of capital (WACC) is the most commonly used discount rate in the IFRS impairment test. This article explains the special features to be considered when determining the WACC and the difference between the WACC in business valuation.
The IFRS standard IAS 36 regulates the impairment tests for assets. Various discount rates are proposed for use in capital value-oriented procedures for determining the fair value or the utility value. In many cases, the WACC proves to be the most suitable discount rate. You can find more information here.
WACC stands for Weighted Average Cost of Capital, which indicates the weighted total capital costs of a valuation object. The cost of equity is derived on the basis of the CAPM. The cost of debt should include an appropriate premium for creditworthiness. The weighting of the cost of equity and debt is market value-weighted.
The concept of WACC was developed in business valuation. Using WACC as the discount rate for individual assets is always appropriate when the cash flows attributed to the asset are comparable to a company. Comparability means the same risk profile, term and currency.
This is the case with goodwill and intangible assets. WACC is less suitable for impairment tests on financial assets that fall under IAS 36, e.g. companies consolidated at equity.
Can the company WACC simply be used in the impairment test? Not always, because in addition to many similarities, there are differences between the two versions of the WACC.
Where do they agree?
Where do the WACC for impairment tests and business valuations differ?
The differences mentioned can indeed lead to significant deviations between the two versions and are briefly presented here.
The WACC in business valuation usually weights the cost of capital with the target debt-to-equity ratio of the company. The WACC in the impairment test, on the other hand, requires a target debt-to-equity ratio based on peer group companies. Neither the company's financing structure nor any acquisition financing is relevant, as the standard explicitly states (IAS 36.A19).
This means that the credit spread on the cost of debt must also be adjusted to this financing structure and may differ from the company's credit spread. Finally, a different gearing ratio also results in a difference in the levered beta.
The risk-free interest rate can differ between the WACC for business valuation and for the impairment test. The reason for this lies in the "lifespan" of the object to be valued.
Business valuation: As a rule, an infinite lifespan is assumed. This usually means that the weighted (present value equivalent) interest rate is heavily influenced by the risk-free interest rate of the last available year. This is usually an interest rate with a 30-year term.
Impairment test: The same premise is used for most assets that are subject to regular review – goodwill and intangible assets with an infinite term. This is not the case for assets with a limited term, such as brands or customer bases. Here, significantly shorter terms are used.
Whenever the yield curve is sharply rising or falling, there are significant differences in the risk-free interest rate for finite maturities.
The IFRS standard IAS 36 prescribes the use of a pre-tax interest rate. The use of a pre-tax rate means that the cash flow relevant to the valuation must also be defined before corporate taxes. However, the fact that pre-tax rates cannot be observed and derived without further ado is somewhat more problematic.
There are two ways to deal with this problem:
So-called "upward adjustment" of the interest rate by dividing it by [ 1 – tax rate ]: for example, a 7% post-tax interest rate would be converted into a 10% pre-tax interest rate and applied to a pre-tax cash flow. However, this method is mathematically equivalent to a post-tax valuation only if the cash flows are constant.
Iterative calculation of the pre-tax interest rate: The impairment calculation is carried out on a post-tax basis, and then a pre-tax rate is determined in the pre-tax calculation by iteration, which leads to the same value. The pre-tax rate is therefore only an information in the appendix.
Both approaches have their weaknesses. This is unavoidable and ultimately due to the fact that a pre-tax valuation is not a correct valuation method. In practice, the iterative calculation dominates.
To determine the WACC, the beta factor and the credit spread, as well as a peer group-based gearing, are required, which are determined by database research. When selecting a database, the following points should be considered:
Search functionality and scope: To determine the beta factor, it is necessary to select a suitable group of listed comparable companies; good search aids and a sufficiently large database are therefore important.
Documentation: The data and results used should be well documented, ideally directly in the database report format, as the discount rate is an important lever in the impairment test and is discussed intensively with the group auditor.
Efficiency and updates: Simultaneous determination of all parameters increases efficiency. It should also be possible to determine the WACC in a reproducible file format or with the help of appropriate software, which allows for a quick update in the following year or when a so-called "trigger event" occurs. This is a huge time-saver, especially for large corporations with several CGU-specific WACCs.
A comparison of different databases can be found here.
The weighted average cost of capital (WACC) plays a central role in the IFRS impairment test in accordance with IAS 36, especially when valuing assets such as goodwill and intangible assets. In contrast to business valuation, where the WACC is also used, there are specific adjustments that must be taken into account in the impairment test. These differences relate in particular to gearing, the risk-free interest rate and the application of a pre-tax interest rate. Determining the WACC requires careful database research. Good documentation when determining the WACC is crucial for the credibility and acceptance of the valuation results in the context of the consolidated financial statements.
We support you in researching the data — e.g. putting together the peer group — with a short training session on how to use the platform. We are happy to do this based on your specific project.
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