With impairment testing and fair value measurement once again a key focus for ASIC in relation to the 31 December 2015 reporting period, you and your board will want to ensure the process is robust, including selecting discount rates that are reasonable.
The following chart presents a summary of the overall change in weighted average cost of capital (WACC) for the market as a whole.
Market discount rates remain stable
This chart shows that there has been limited movement over the period save for a small increase in the risk free rate and corresponding decrease in the credit spread (difference between the risk free rate and the large business weighted average lending rate) and a small increase in market gearing, primarily due to changes in the energy industry. All other things being equal, this will lead to similar discount rates and therefore little change to asset values over the period. With the stability of market discount rates for the past few reporting periods the focus has generally moved towards other aspects of the impairment analysis including the cash flow assumptions.
Notwithstanding the regulator’s focus on cash flow forecasts, we have observed many businesses that based their impairment testing on unreliable and/or unsupported discount rates in recent periods. An important issue for you and your board is therefore whether the discount rates adopted for impairment testing in prior periods were realistic and supported. This update helps you understand the assumptions we make and why, as recognised experts, you can rely on Leadenhall for a justifiable outcome.
Leadenhall Solution: It is important to understand and be able to justify changes that are occurring in your projected cash flows and WACC as well as ensuring cross-checks to market metrics are undertaken where observable. Leadenhall can assist with this analysis.
“ASIC encourages people preparing financial reports and their auditors to consider carefully the need to impair goodwill and other assets. ASIC continues to find impairment calculations using unrealistic cash flows and assumptions, as well as material mismatches between the cash flows used and the assets being tested for impairment.”
ASIC – focus areas for 31 December 2015 Financial reports
We have used the same framework as our previous analysis, to allow easy comparison between periods – based on the standard WACC and capital asset pricing models.
Weighted Average Cost of Capital
Note: the proportion of debt and equity should be calculated at current market values
Capital Asset Pricing Model
Selecting the risk free rate (Rf)
The risk free rate should be in the same currency as the asset being valued and its maturity should best match the life of the investment. In Australia, the most common proxy for the long term risk-free rate is the yield on ten-year Commonwealth Government bonds:[responsive][/responsive]
Source: Reserve Bank of Australia Statistical Table F2
This small increase in the risk free rate over the last twelve months may lead to a modest increase in overall discount rates, all other things being equal. However, this is offset by a corresponding small decrease in the credit spread.
Risk free rates are still near historically low levels. Rather than adopting current market observed risk free rates, some valuers are adjusting observed risk free rates to reflect a long-term average rate. However, some are then not adjusting other parameters accordingly – leading to inconsistent and unreliable discount rate conclusions.
Leadenhall Solution: We avoid the dangers of normalising by using market observed risk free rates coupled with a contemporaneous assessment of the EMRP. This better reflects the current views implicit in capital markets and responds to changes in market pricing.
Assessing Beta (ß)
Beta is a measure of the relative riskiness of a business compared to the market as a whole. An appropriate beta needs to be selected for each cash generating unit, based on the relative riskiness of that business.
Source: SIRCA as at 30 September 2014 and 30 September 2015 (latest available)
There have been a number of moderate changes over the past year with 15 of the 24 industries reported showing a change in beta of 0.1 or greater (top ten changes shown in the table above). In the consumer durables and apparel industry, most of the top ten companies recorded a fall in their beta, with the second largest, Billabong, recording a fall of 1.03 from 4.03 to 3.00. In the telecommunication services industry the increase was mainly due to a 0.28 increase in the beta of Telstra, the largest company in the industry, and the delisting of Singapore Telecomm, which had a beta of 0.08 in 2014.
Leadenhall Solution: Rather than simply adopting an industry beta, we undertake a detailed analysis of the companies in a sector that have comparable risk to the business being valued. The betas for comparable companies generally need to be ‘ungeared’ to remove the impact of actual debt levels and then ‘re-geared’ to the optimal debt level (which is not necessarily the actual debt level of the company being valued).
Cost of debt (Kd)
The cost of debt is generally related to the risk free rate, with the difference being a credit spread. The following table shows that small and large business lending rates have fallen slightly over the past year, although yields on corporate bonds have increased.
Rates remain low and relatively stable
Source: Reserve Bank of Australia Statistical Tables F3 and F5
Leadenhall Solution: Instead of historical borrowing costs, the cost of debt should be based on the current borrowing cost – as if the business were to be refinanced in the current market at ‘optimal’ gearing levels.
Equity Market Risk Premium (EMRP)
Equity market movements can be broken down into changes in earnings, changes in growth expectations and changes in discount rates. We then disaggregate the change in discount rates into movements in the risk free rate and movements in the market risk premium in the following chart.[/responsive]
The equity market risk premium implied by market trading decreased slightly over the period. However, we have left our assessment of the equity market risk premium at 6.5% as the reduction was modest. This may initially appear counterintuitive as stock market indices also fell over the same period. However, the fall in market prices was caused by reduced earnings as opposed to increased risk aversion.
Debt levels across various industries have remained fairly stable over the past year, thus changes in optimal gearing are unlikely to significantly impact your discount rates.
The increase in information technology is primarily due to the listing of MYOB with a market cap of $1.9 billion and gearing of 35%. The decline shown for telecommunications is primarily driven by the delisting of Singapore Telecom (owner of Optus) and significant increase in the market capitalisation of Telstra and TPG. The increase in gearing in the Energy Sector is mainly due to a decline in the market cap of a number of large oil and gas companies. The decrease in gearing in the utilities sector was primarily because of an increase in the market cap of AGL, APA Group and Duet Group.
Leadenhall Solution: As with the cost of debt, the proportion of debt used in the calculation of WACC should be based on an optimal capital structure. This is not necessarily the actual level of debt in the company. The efficient or optimal level of debt included in a discount rate should be an assessment of the level of debt that can be sustained by the specific business or cash generating unit (“CGU”) over the medium to long term.
Our other concerns that may attract attention
Given the stable discount rate environment it is not surprising that ASIC’s attention has shifted from the discount rates adopted to the cash flows themselves. Some of our key observations in relation to cash flows include:
- Overly complex financial models with material errors
- Optimistic forecasts with insufficient allowance for reasonable investor assumptions and/or for capital investment
- Failure to update forecasts to reflect changes in market conditions such as movements in commodity prices
- Inconsistencies between the discount rate and cash flows
- Inconsistencies between the carrying values of the CGU and the valuation
- Relying on a single valuation methodology without considering any cross-checks or other available market evidence
- Failing to explain movements in the value or key assumptions across periods
- Ignoring or improperly allocating corporate assets and costs