Discount rate

Learning objectives

• Explain the characteristics of the discount rate: pre-tax, reflecting current market assessments of the time value of money and of the risks specific to the asset that are not reflected in the cash flows, independent of the financing structure.L2
• Justify the choice of a starting rate (weighted average cost of capital, incremental borrowing rate, other market borrowing rates) and its adjustments, without double counting of risks.L3, L4
• Calculate a present value using a single discount rate or separate rates for different periods.L2, L3

Normative references

• IAS 36 §55The discount rate is a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the asset for which the cash flow estimates have not been adjusted.
• IAS 36 §56The rate that reflects the time value of money and the risks specific to the asset is the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those of the asset; it is estimated from the rate implicit in current market transactions for similar assets or from the weighted average cost of capital of a listed entity that has a single asset (or a portfolio) similar in terms of service potential and risks.
• IAS 36 §57When an asset-specific rate is not directly available from the market, the entity uses surrogates, Appendix A providing additional guidance.
• IAS 36 §A15Whichever approach is adopted, the discount rate must not reflect risks for which future cash flow estimates have already been adjusted; otherwise, their effect would be double-counted.
• IAS 36 §A16When an asset-specific rate is not observable in the market, the entity uses surrogates to estimate the market assessment of the time value of money up to the end of the useful life and of the risk factors (variations, price for bearing uncertainty, other factors) not already reflected in the cash flows.
• IAS 36 §A17As a starting point, the entity may take into account its weighted average cost of capital determined, for example, using the capital asset pricing model, its incremental borrowing rate and other market borrowing rates.
• IAS 36 §A18These starting rates are adjusted to reflect the way the market would assess the specific risks associated with the asset's cash flows and to exclude risks that are not relevant or already reflected in the cash flows; country risk, currency risk and price risk are among the factors to be considered.
• IAS 36 §A19The discount rate is independent of the entity's capital structure and of the way the entity financed the purchase of the asset.
• IAS 36 §A20The discount rate is determined on a pre-tax basis; a post-tax starting rate must therefore be converted.
• IAS 36 §A21A single discount rate is normally used, but separate rates for different periods are used when value in use is sensitive to differences in risks for different periods or to the term structure of interest rates.

Original summaries of the paragraphs (reference register), never a quotation of the standard.

18 questions

• Since the value in use discount rate is a pre-tax rate, how must the cash flows be estimated?L2
• The value in use calculation memo for a wind farm at Jarnelle sets out the following choices. Which one is wrong?L3
• True or false? The value in use discount rate is a post-tax rate, since the entity bears income tax on the profits generated by the asset.L2
• True or false? Ulvarède acquired a vessel with a subsidised loan at 2%: this borrowing rate must be used as the discount rate for the vessel's value in use.L2
• True or false? Vimorel has already adjusted the cash flows of its subsidiary in an unstable country by weighting business interruption scenarios linked to country risk. The discount rate must therefore not include a premium for that same country risk.L3
• Which description matches the discount rate to be used to calculate value in use?L2
• No asset-specific rate is observable in the market for a Wendrac plant. Which approach complies with IAS 36 for estimating the discount rate?L3
• The rate that reflects the time value of money and the risks specific to an asset corresponds to which return?L2
• Xaintrel is adjusting its weighted average cost of capital, used as a starting rate, to discount the cash flows of a plantation located abroad. Which of the following items are among the adjustment factors to consider?L3
• Yzerande's audit committee is examining the methodology note on the discount rate used in its impairment tests. Which of the note's statements are correct?L4
• At 31 December 20X1, Zélandre is estimating the value in use of an injection moulding press with a remaining useful life of three years. The expected pre-tax net cash flows are {flow_20x2} in 20X2, {flow_20x3} in 20X3 and {flow_20x4} in 20X4, received at year-end. The pre-tax discount rate, a single rate for the whole period, is {pre_tax_rate}. What is value in use?L2
• A refrigerated truck owned by Aldivar has only two years of operation left. It should bring in {net_inflow_1} at the end of the first year and {net_inflow_2} at the end of the second, net pre-tax amounts. The market requires a pre-tax return of {rate} for an asset with this profile. Determine its value in use.L2
• The value in use of a network of charging stations owned by Bérivane is sensitive to the term structure of interest rates. The expected pre-tax net cash flows are {cf_year_1} at the end of year 1 and {cf_year_2} at the end of year 2. The appropriate pre-tax rates are {rate_year_1} for the one-year maturity and {rate_year_2} a year for the two-year maturity; each cash flow is discounted at the annual rate for its own maturity. Calculate value in use.L3
• A car park concession held by Cassignol expires in three years. Its pre-tax net cash flows, received at year-end, would be {inflow_a} in the first year, {inflow_b} in the second and {inflow_c} in the third. As risks differ by horizon, management uses a separate annual pre-tax rate for each maturity: {spot_rate_a} for one year, {spot_rate_b} for two years and {spot_rate_c} for three years, each cash flow being discounted at the rate for its maturity over its term. What value in use is obtained?L3
• Dravelle is determining the discount rate for a plant located in an emerging country. It starts from its pre-tax weighted average cost of capital of {wacc_pre_tax}. The market would require a premium of {country_premium} for country risk, which the cash flows do not reflect. It would also require a premium of {price_premium} for raw material price risk, but the cash flows already include this risk through weighted price scenarios. The plant was financed with a subsidised loan at {subsidised_loan_rate}. Which pre-tax discount rate should be used?L3
• For a solar plant operated abroad, Escalvin uses as its starting point its pre-tax incremental borrowing rate of {incremental_borrowing_rate}. The cash flows do not take currency risk into account, for which the market would require an extra {currency_risk_premium}. Country risk, valued by the market at {country_risk_premium}, is however already built into the cash flows through weighted interruption scenarios. The plant is financed by an intragroup loan at {intragroup_rate}. Determine the pre-tax discount rate.L3
• Fontrebel is testing the cash-generating unit of its distribution subsidiary located in a country with high monetary instability. Management proposes discounting the cash flows, estimated pre-tax, at the group's post-tax weighted average cost of capital, with no adjustment. It points out that the subsidiary benefits from very favourable intragroup financing and that the cash flows already include, through weighted scenarios, the expropriation risk specific to the country. The cash flows, prepared in local currency, do not, however, reflect any currency risk. Write a judgement memo on the discount rate.L4
• As no observable rate specific to a hydroelectric dam exists, Gerbaude uses a surrogate rate. What must this rate reflect?L3