Have WACCs changed for December 2022 financial year ends?
Publication date: 09 Dec 2022
gx In brief INT2022-20
Whether preparing or reviewing an IAS 36 impairment test for December 2022 year ends, careful consideration of the inputs into WACC-reliant discount rates will be of particular importance.
In the current climate of global economic uncertainty, some key inputs into WACCs might have changed.
Current economic trends should not be readily dismissed from WACC calculations on the basis of being short term.
What is the issue?
The weighted average cost of capital (WACC)
is often used as an important reference point when determining the discount rate to be used when testing the assets in a cash-generating unit (CGU) for impairment in accordance with IAS 36. The WACCs of many entities are publicly available, although it is worth noting that they are reliant on certain judgmental assumptions - in particular, the equity risk market premium. The WACC of an entity will be reliant on some publicly available inputs, such as the risk-free rate. WACCs are usually nominal (that is, they include the impact of inflation).
A WACC relies on the market’s current expectation of future long-term assumptions, for example the long-term rate of inflation and risk-free rates. These long-term assumptions in WACCs are affected by many different economic factors and both the impact and the extent will differ between countries and even industries.
In the current climate of global economic uncertainty, with many countries experiencing rising inflation and interest rates, this raises the question whether these increases represent a change in the market’s current expectations of future long-term assumptions, or whether they represent an anomaly resulting from short term volatility in the markets.
Paragraph 16 of IAS 36 states that “short-term interest rates may not have a material effect on the discount rate used for an asset that has a long remaining useful life”. It is therefore necessary to understand whether an observable rise in short-term interest rates is limited to the short-term, or whether there is a simultaneous change in the market’s current expectation of long-term interest rates (cost of debt) and also the risk-free rate.
What is driving the increase in inputs to observable WACCs?
We have observed a notable increase in the market’s current expectation of long-term risk-free rates in a number of countries. While the risk-free rate is by no means the only variable that has changed or is changing, it is arguably the variable in the WACC calculation showing the largest relative change over the last year in many instances.
Below is an extract of the yields on 20-year government bonds (often assumed to represent the long-term risk-free rate):
These figures indicate that, for these countries, there has been a change in the market’s current expectation of long-term risk-free rates. This increase in long-term risk-free rates will increase WACCs, although this increase is not necessarily on a one-for-one basis - a 1% increase in the risk-free rate will not necessarily result in a 1% change in the WACC.
Where a similar trend is observed in other countries, it is likely that this will also result in an increase in those WACCs.
There are other components of a WACC which might have been impacted by the current economic climate, such as the target level of gearing and equity risk premium. It is therefore important to consider all components of the WACC.
What is the impact?
Given the market movements outlined in this In brief, whether preparing or reviewing an IAS 36 impairment test for December 2022 year ends, careful consideration of the inputs into WACC-reliant discount rates will be of particular importance. Current economic trends should not be readily dismissed from WACC calculations on the basis of being short term.
Caveats to this In brief
This In brief provides a high-level summary of observable market trends as applicable to December 2022 financial year ends. It does not negate the need to consult with experts on entity-specific fact sets where necessary.
* WACC comprises the cost of equity, the cost of debt and an assumption on gearing. The risk-free rate is a component of the capital asset pricing model often used to determine the cost of equity. The risk-free rate is also fundamental to the cost of debt.
PricewaterhouseCoopers LLP. This content is copyright protected. It is for your own use only - do not redistribute. These materials were downloaded from PwC's Viewpoint (viewpoint.pwc.com) under licence.