How to find Pre-Tax rate in a Nutshell
When conducting Value in Use (VIU) calculations as part of an Impairment Review under IAS 36, it is essential to determine the appropriate pre-tax discount rate. Below are the various methods used to derive the pre-tax discount rate: View/Download Example
Method 1:
Gross Up Approach
This is the most straightforward and commonly
used method. To convert a post-tax discount rate (such as WACC) to a pre-tax
discount rate, the formula is:
Post-Tax
rate / (1-Tax Rate)
After deriving the pre-tax rate, you can discount the pre-tax cash flows using this rate to determine the Value in Use. (IFRS recommended)
Method 2:
Real Pre-Tax Approach
This method is straightforward. As
demonstrated in the video, I initially used 14% as an estimate for the pre-tax
discount rate. I then calculated the pre-tax cash flows and
discounted them using this 14%. Afterward, I calculated the present value
of both the post-tax and pre-tax discounted cash flows and identified the
difference between them.
To ensure alignment with IFRS guidelines,
I used Goal Seek to adjust the pre-tax discount rate so that the present
value of pre-tax cash flows matched the present value of post-tax cash
flows. By reverse engineering the process, the pre-tax discount rate
adjusted from 14% to 17%.
(a pre-tax discount rate is not generally observable. It is generally derived by first discounting post-tax cash flows using a post-tax discount rate to determine a present value, and then using reverse engineering (back solving) to find the pre-tax discount rate that must be applied to the pre-tax cash flows to obtain the same present value;) BCZ85
Method 3:
Pre-Tax Rate Using Gearing
In this method, the pre-tax discount rate
is derived by adjusting the WACC for the firm’s gearing
(debt-to-equity ratio). You use the firm's actual debt/equity structure to
adjust for risk, ensuring that the discount rate reflects the capital
structure's impact on the cost of capital. The formula remains the same:
Method 4:
Cash-on-Cash Market Risk (Beta)
While this method is not widely used or
recommended by IFRS, it involves using beta to adjust the discount
rate for market risk. The method is as follows:
βunlevered=βlevered1+(1−Tax rate)×E/D
2.
Re-lever the beta based on the company's gearing ratio:
βlevered=βunlevered×(1+D/E)
3.
Substitute the levered beta into the CAPM
formula to calculate the pre-tax cost of equity:
Ke=Rf+βlevered×(Rm−Rf)
Pre-tax WACC=(E/V×Pre-tax Ke)+(D/V×Pre-tax Kd)
This method is more complex and less commonly applied in VIU calculations. However, you can take it to the review to assess its use and find out more about it.
Applicable to IndAS.
**Note:** The method we've used to convert cash flows to pre-tax cash flows (i.e., future cash flows divided by (1 - tax rate)) is a time-saving shortcut for calculating actual pre-tax cash flows as prescribed by IAS 36. Please remember to replace this method or refer to my impairment post for detailed guidance. However, you have learnt accurately, how to find pre-tax rate by using Goal Seek.
To determine VIU cashflows, start by gathering all relevant profit and loss (P&L) items from your financial statements. Next, classify each line item appropriately to ensure accurate organization. Finally, decide which items to include or exclude in your VIU cashflow analysis, ensuring that your selections align with the specific requirements in IAS 36. The checklist below provides a guide to calculate VIU cashflows:
Good luck!
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