this example is based on determining the wacc for a listed company with a similar ri 612425

Calculating a discount rate

This example is based on determining the WACC for a listed company with a similar risk profile to the CGU in question. Because it is highly unlikely that such a company will exist, it will usually have to be simulated by looking at a hypothetical company with a similar risk profile. The following three elements need to be estimated for the hypothetical listed company with a similar risk profile:

• gearing, i.e. the ratio of market value of debt to market value of equity
• cost of debt; and
• cost of equity.

Gearing can best be obtained by reviewing quoted companies operating predominantly in the same industry as the CGU and identifying an average level of gearing for such companies. The companies need to be quoted so that the market value of equity can be readily determined.

Where companies in the sector typically have quoted debt, the cost of such debt can be determined directly. In order to calculate the cost of debt for bank loans and borrowings more generally, one method is to take the rate implicit in fixed interest government bonds – with a period to maturity similar to the expected life of the assets being reviewed for impairment – and to add to this rate a bank’s margin, i.e. the commercial premium that would be added to the bond rate by a bank lending to the hypothetical listed company. In some cases, the margin being charged on existing borrowings to the company in question will provide evidence to help with establishing the bank’s margin. Obviously, the appropriateness of this will depend upon the extent to which the risks facing the CGU being tested are similar to the risks facing the company or group as a whole.

If goodwill or intangible assets with an indefinite life were being included in a CGU reviewed for impairment the appropriate Government bond rate to use might have to be adjusted towards that for irredeemable bonds. The additional bank’s margin to add would be a matter for judgement but would vary according to the ease with which the sector under review was generally able to obtain bank finance and, as noted above, there might be evidence from the borrowings actually in place of the likely margin that would be chargeable. Sectors that invest significantly in tangible assets such as properties that are readily available as security for borrowings, would require a lower margin than other sectors where such security could not be found so easily.

Cost of equity is the hardest component of the cost of capital to determine. One technique referred to in the standard, frequently used in practice and written up in numerous textbooks is the ‘Capital Asset Pricing Model’ (CAPM). The theory underlying this model is that the cost of equity is equal to the risk-free rate plus a multiple, known as the beta, of the market risk premium. The risk-free rate is the same as that used to determine the nominal cost of debt and described above as being obtainable from government bond yields with an appropriate period to redemption. The market risk premium is the premium that investors require for investing in equities rather than government bonds. There are also reasons why this rate may be loaded in certain cases, for instance to take account of specific risks in the CGU in question that are not reflected in its market sector generally. Loadings are typically made when determining the cost of equity for a small company. The beta for a quoted company is a number that is greater or less than one according to whether market movements generally are reflected in a proportionately greater (beta more than one) or smaller (beta less than one) movement in the particular stock in question. Most betas fall into the range 0.4 to 1.5.

Various bodies, such as The London Business School, publish betas on a regular basis both for individual stocks and for industry sectors in general. Published betas are levered, i.e. they reflect the level of gearing in the company or sector concerned (although unlevered betas (based on risk as if financed with 100% equity) are also available and care must be taken not to confuse the two).

The cost of equity for the hypothetical company having a similar risk profile to the CGU is:

Cost of equity = risk-free rate + (levered beta × market risk premium)