an asset has expected cash flows of cu780 in one year determined on the basis of the 612336

Expected present value techniques [IFRS 13.B27-B29]

An asset has expected cash flows of CU780 in one year determined on the basis of the possible cash flows and probabilities shown below. The applicable risk-free interest rate for cash flows with a one-year horizon is 5%, and the systematic risk premium for an asset with the same risk profile is 3%.

In this simple example, the expected cash flows of CU780 represent the probability-weighted average of the three possible outcomes. In more realistic situations, there could be many possible outcomes. However, to apply the expected present value technique, it is not always necessary to take into account distributions of all possible cash flows using complex models and techniques. Rather, it might be possible to develop a limited number of discrete scenarios and probabilities that capture the array of possible cash flows. For example, an entity might use realised cash flows for some relevant past period, adjusted for changes in circumstances occurring subsequently (e.g. changes in external factors, including economic or market conditions, industry trends and competition as well as changes in internal factors affecting the entity more specifically), taking into account the assumptions of market participants.

In theory, the present value (i.e. the fair value) of the asset”s cash flows is the same whether determined using Method 1 or Method 2, as follows:

(a) Using Method 1, the expected cash flows are adjusted for systematic (i.e. market) risk. In the absence of market data directly indicating the amount of the risk adjustment, such adjustment could be derived from an asset pricing model using the concept of certainty equivalents. For example, the risk adjustment (i.e. the cash risk premium of CU22) could be determined using the systematic risk premium of 3% (CU780 [CU780 × (1.05/1.08)]), which results in risk-adjusted expected cash flows of CU758 (CU780 CU22). The CU758 is the certainty equivalent of CU780 and is discounted at the risk-free interest rate (5%). The present value (i.e. the fair value) of the asset is CU722 (CU758/1.05).

(b) Using Method 2, the expected cash flows are not adjusted for systematic (i.e. market) risk. Rather, the adjustment for that risk is included in the discount rate. Thus, the expected cash flows are discounted at an expected rate of return of 8% (i.e. the 5% risk-free interest rate plus the 3% systematic risk premium). The present value (i.e. the fair value) of the asset is CU722 (CU780/1.08).