How to Calculate Pre-tax Rate for Value in Use
Dealing with impairment of assets, or cash generating units (CGU), involves one quite difficult task – to determine asset’s / CGU’s recoverable amount. Sometimes it might be an easy job, especially when fair value can be established and it is probably higher than value in use. But when there is no fair value available (or for any other reason), then we have to cope with calculation of asset’s / CGU’s value in use.
What is value in use? You could find definition in several standards, including IAS 36, but let’s try it quickly: Value in use is present value of future cash flows expected to be derived from asset / CGU under review. And, in order to arrive at present value, we must ensure that both future cash flows and discount rate are pre-tax.
Now here is the difficulty. As you know, you always look at the market for some appropriate market rate that you can use in your value in use calculation. But! The rates in the market, especially for equity, are stated post-tax. So what to do?
Solution 1 – Simple, but not precise way
One solution to this problem could be simple grossing up your post-tax market rate and tax rate, like in the following formula:
pre-tax rate = post-tax rate / (1 – tax rate)
Now let me say although this method is very simple, in my opinion it should be used just rarely, if in any case. For example, when asset or CGU is not that material to your company, or variance in a discount rate does not cause any material errors in value in use.
Why not to use this simple method as the basic one? The main reason is that in most cases, the timing of your tax payments is never the same as timing of your tax base (income and expenses). Many entities pay taxes one year after obtaining taxable revenues and expenses. And that might cause significant difference in your real pre-tax rate and pre-tax rate calculated this way. You should bear in mind that pre-tax rate must take not only asset’s / CGU’s post-tax rate and relevant tax rate into account, but also asset’s / CGU’s useful life and timing of future cash flows.
So how to calculate pre-tax rate more precisely?
Solution 2 – “Top-down” calculation
If you have obtained market rate that is post-tax and you have pre-tax cash flow projections for your asset / CGU under review, you can try to use this method. It’s kind of other way round and I’ll try to draft it in 3 steps:
Step 1 – Estimate post-tax cash flows
First of all, we shall calculate asset’s / CGU’s value in use with application of post-tax rate. But hang on a minute – we have post-tax rate and pre-tax cash flows and this inconsistency would not give us the answer even close to correct. Therefore, I would do the following:
- Estimate future tax payments from our pre-tax cash flow projection. Do it on a year-by-year basis. But be careful here. If you want to be really precise, you should take various tax issues into account – for example, future tax allowances related to asset / CGU, utilization of future tax losses, temporary differences, etc. Simply – try to estimate tax payments as realistic as possible, not by multiplying tax base and tax rate.
- Deduct estimated future tax payments from pre-tax cash flows. And also do it on a year-by-year basis.
Fine, thus we arrive at post-tax cash flows.
Step 2 – Calculate value in use on post-tax basis
That is clear. You have post-tax cash flows in your table and you also have post-tax discount rate. So using discounting technique, get present value of your post-tax cash flows.
Before I get to the last step, let me remind simple consistency rule: when calculating value in use, you should be consistent to avoid double counting. And, you should arrive to the same result. So, when you calculate value in use using post-tax cash flows and post-tax discount rate, that rate shall be the same as calculated from pre-tax values. In other words:
post-tax cash flows discounted by post-tax rate
= pre-tax cash flows discounted by pre-tax rate
= value in use
The step 3 is derived from this logic.
Step 3 – Calculate pre-tax rate from value in use and pre-tax cash flows
That’s why I call it “top down” calculation. You just work out the rate at which the present value of pre-tax cash flows equals the value in use. Sure, this is not as easy as it seems, because it requires using certain iteration technique. But all is doable!
Now you might ask: Why to bother with pre-tax rate when we already have value in use from post-tax values? The answer is that you might be required to disclose your pre-tax discount rate in the notes to the financial statements or elsewhere when necessary.
Please watch the video with the explanation here:
If you’d like to review numerical calculation of pre-tax rate together with demonstration of simple iteration technique in MS Excel, please check out the video on this topic that is part of our IFRS Kit.
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Hello Silvia,
Thanks for the article. I have a question with the discount rate before tax derived from the second method (top down). When should this method be used to derive the rate? Can I in any period estimate my future cash flows after taxes discounted by my WACC (for example) and assume that this present value is the value in use with which I carry out the iteration process with my cash flows before taxes? The example of IAS 36, BCZ85 seems to tell us that this iteration process must be carried out at the beginning of the useful life of the asset or CGU. If that’s correct, how do I apply this method if I’m at the close of a later period? Should I go see the first estimates?
I would really appreciate your answer.
Regards.
You are considering buying a machine which costs $1 200, has a 5-year life and would be depreciated straightline to a salvage value of $200. The machine would start generating revenues one year from now. Annual revenues and operating costs would be $400 and $150 respectively. If your tax rate is 30 percent and your cost of capital is 10 percent, what is the NPV of this project, assuming that you should evaluate the project on a pre-tax basis?
a. $250.00
b. $100.00
c. – $204.00
d. – $128.05
I am trying to find the answer about that. if I want to know using pre-tax basis, can I use after-tax formular first? Or can you give me some advice. thanks
Hi Dona,
On trying your question, I think the answer is $-128.05;
Cost of asset=1200
Dep=(1200-200)/5=200 p.a
Salvage value=200
Cash flows p.a=400-150=250
NB can deduct dep and add it back, the answer is the same.
Tax rate 30%
Cost of capital assuming it’s pre-tax rete=10%
Present value of an annuity factor=3.790786769
Present value of an annuity=250*3.790786769=947.6966924
Present value of salvage value=200*0.620921323=124.1842646
Total discounted cash flows=1071.880957
NPV=1071.880957-1200=$-128.119043
NB only tried your question and is subject to corrections.
Hello, IAS 36 is very crucial topic in accounting and avoids overstatement of assets values. I am still confused on items of Pre-tax cash flows to be included in the computation of VIU. Please provide me format of pre-tax cash flows when the entity is in normal operations and when adopted IFRS 5.Providing Practical solutions in this respect will be highly useful. Thank you.
Hi Silvia,
In the calculation of present value of future cash flows expected to be derived from asset / CGU , do we include loan repayment if im assessing the value in use of entity which has a huge loan liabilities
Thanks
Hi Igmed,
no, you don’t include it in the cash flows from the asset or CGU, because the loan itself has already been included in the liabilities.
But I don’t quite understand what you assess – the value in use of entity as a whole? So is your entity single cash generating unit and are you testing recoverable amount of entity’s assets? Because if yes – than no including the loan repayment into future cash flows.
But if you are trying to value your entity and set the fair value of its net assets (for example, in order to set the price of this entity in some sort of sale transaction), that’s the different story.
Silvia
Hi guys…i would like to ask a slightly different question about the use of pre-tax discount in calculating differed tax on non-current assets in accordance with IFRS. Where and how do you use the pre-tax discount, with the applicable income tax rate given. I came accross a question which has both the pre-tax discount and the applicable tax rate, so in what instance should i make use of the pre-tax rate, or it doesn’t apply in calculating differed tax on non-current assets.
Thanks
Hi, Mhlengi, deferred tax should never be discounted with any rate. Silvia
Hi Silvia,
The standard prescribes the use of pre tax cash flows, hence the need to compute the pre tax discount rate.
However, I think valuation experts prefer to use after-tax cash flows as the computed value would be different from before tax cash flows. This is mainly because a Company’s effective tax rate might differ from the statutory rate and grossing up the discount rate may not be accurate.
I would like to ask why IASB prefers the use of before tax cash flows. Is this because we assume that the asset is a long term asset which a company has no intention to sell, hence there will not be any potential taxes on capital gains/losses?
Also, how would you reconcile the different views held by the valuation guys and accountants?
Thanks Silvia
Jonathan
Hi Jonathan,
I really like your questions 🙂
I think the answer lies in what you value.
If you value the whole company based on the projected future cash flows to be generated from it, then what cash flows are you looking at? Probably post-tax, right? Because basically you are projecting future profits, dividends received or whatever (all post-tax) and you are looking to cash flows from “outside” the company. That’s why valuation experts use post-tax rates in this field.
However, if you are looking at cash flows from the asset or CGU (when we talk about IAS 36 on impairment), you are looking at pre-tax cash flows, because you are basically “inside” the company, that is – you have some expenses to maintain the asset, some revenues from the asset – but all these cash flows are pre-tax, right? Only after you realize these cash flows inside the company, you calculate PBT, tax and net profit/loss.
That’s probably why IASB prefers to use pre-tax cash flows in calculating value in use – to make it consistent with the fact that you are always estimating pre-tax cash flows for your projections.
Best regards
Silvia