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Present value techniques

Learning objectives

  • Calculate a fair value using the discount rate adjustment technique and the expected present value technique on case data.L3
  • Justify the consistency between the estimated cash flows and the discount rate (risk, inflation, currency).L3

Normative references

  • IFRS 13 §B12Paras. B13 to B30 describe the use of present value techniques (discount rate adjustment, expected present value) without prescribing a single technique or limiting the techniques that may be used; the choice depends on the facts and the data available.
  • IFRS 13 §B13A present value measurement reflects, from the perspective of market participants: the estimated future cash flows, possible variations in their amount and timing, the time value of money (risk-free rate), the risk premium, other relevant factors and, for a liability, non-performance risk.
  • IFRS 13 §B14General principles of any present value technique: cash flows and rates based on market participant assumptions and only on factors attributable to the item; consistency between cash flows and rates (risk, inflation, taxes) to avoid double-counting or omission; rates consistent with the currency of the cash flows.
  • IFRS 13 §B15A present value measurement is made under conditions of uncertainty: the amount and timing of cash flows are estimates, even for contractually fixed amounts exposed to the risk of default.
  • IFRS 13 §B16Market participants generally seek compensation (a risk premium) for bearing the uncertainty inherent in the cash flows; the measurement includes it, and difficulty in determining it is not a sufficient reason to exclude it.
  • IFRS 13 §B17Present value techniques differ in how they adjust for risk and in the type of cash flows used: discount rate adjustment (risk-adjusted rate, contractual or most likely cash flows), expected present value method 1 (risk-adjusted expected cash flows, risk-free rate) and method 2 (expected cash flows, rate that includes the risk premium).
  • IFRS 13Discount rate adjustment technique: a single set of cash flows (contractual, promised or most likely), conditional on specified events, is discounted at an observed or estimated market rate of return for comparable items traded in the market.
  • IFRS 13The discount rate adjustment technique requires an analysis of market data for comparable items (nature of the cash flows, credit standing, collateral, duration, restrictive covenants, liquidity); if a single comparable does not fairly reflect the risk, the rate may be built up from several comparables and the risk-free yield curve (build-up approach).
  • IFRS 13Numerical illustration of the build-up approach: implied rates of return derived from the market prices of two assets comparable in risk, one maturing in one year and the other in two years (continued in para. B21).
  • IFRS 13 §B21Illustration of the discount rate adjustment technique: the rate is derived from the comparable item whose cash flow timing is closest or, failing that, built up from another comparable and the risk-free yield curve.
  • IFRS 13For fixed receipts or payments, the adjustment for risk is included in the discount rate; for cash flows that are not fixed, an adjustment to the cash flows may be necessary to achieve comparability with the observed item from which the rate is derived.
  • IFRS 13 §B23The expected present value technique starts from expected cash flows, the probability-weighted average of possible cash flows, which are not conditional on the occurrence of a specified event.
  • IFRS 13 §B24Under portfolio theory, market participants are compensated only for systematic (non-diversifiable) risk, not for the risk specific to the item.
  • IFRS 13 §B25Expected present value method 1: expected cash flows are reduced by a cash risk premium (certainty-equivalent cash flows), then discounted at the risk-free rate.
  • IFRS 13 §B26Expected present value method 2: unadjusted expected cash flows are discounted at a risk-free rate plus a risk premium (expected rate of return), which is generally lower than the rate used in the discount rate adjustment technique.
  • IFRS 13Illustration of methods 1 and 2 of the expected present value technique: expected cash flows computed as the probability-weighted average of several possible cash flows, with a given risk-free rate and systematic risk premium.
  • IFRS 13Expected cash flows are the probability-weighted average of the possible outcomes; it is not always necessary to model the full distribution: a limited number of discrete scenarios and probabilities may suffice, for example based on past realised cash flows adjusted for subsequent changes in circumstances, taking into account market participant assumptions.
  • IFRS 13In theory, methods 1 and 2 give the same present value: method 1 adjusts the expected cash flows for systematic risk (certainty equivalent) and discounts them at the risk-free rate; method 2 keeps the expected cash flows and includes the risk adjustment in the rate (risk-free rate plus the systematic risk premium).
  • IFRS 13 §B30For expected present value, either method 1 or method 2 may be used; the choice depends on facts specific to the item, the data available and judgement.

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

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