ICAI issues Concept Paper on Estimating Discount Rates in Valuation brought out by ICAI and ICAI RVO

1. Introduction

Discount rate used in valuation reflects the riskiness of the asset and is one of the critical inputs of Discounted Cash Flow method.

ICAI Valuation Standards 2018 defines “Discount Rate” as the return expected by a market participant from a particular investment and shall reflect not only the time value of money but also the risk inherent in the asset being valued as well as the risk inherent in achieving the future cash flows.

ICAI Valuation Standards recognize the following three approaches in valuation and they are globally accepted approaches as well: –

1) Market Approach
2) Income Approach
3) Cost Approach

Income approach is considered as one of the most appropriate approach under-going concern as it determines the intrinsic value of an asset by estimating the present value of future earnings of assets. Income Approach is also not as vulnerable to accounting conventions (like depreciation, inventory valuation) in comparison with the other techniques/ approaches since it is based on cash flows rather than accounting profits.

The Income Approach includes a number of methods, such as Discounted Cash Flow (DCF) Method, Relief from Royalty (RFR) Method, Multi-Period Excess Earnings Method (MEEM), With and Without Method (WWM) and Option pricing models such as Black-Scholes-Merton formula or binomial (lattice) model.

Discounted Cash Flow Method (DCF) is the most commonly used method in valuation and it arrives at a value by projecting the cash flows in the future and then discounting the cash flows back to the date of the valuation using the Discount Rate.

While discount rate is an important factor in valuation but at the same time estimating discount rate is difficult and also prone to judgement. Therefore, understanding the methodology and concepts in determining an appropriate discount rate is extremely critical for valuers.

2. Discount Rate & Relationship between Risk and Return

Discount Rate is the return expected by a market participant from a particular investment and shall reflect not only the time value of money but also the risk inherent in the asset being valued as well as the risk inherent in achieving the future cash flows.

An Investor expects to be compensated for both risk and the time value of money which together forms the expected return on investment. An investor selects between different investments options on the basis of the assessment and comparison of the risk involved and the expected rate of return from each investment option.

Theoretically, the time value of money on an investment without any risk is normally represented by a risk-free rate of return but hardly any investment is completely risk-free. Hence there is always a need to compensate the investor for the higher level of risk by giving a higher rate of return. The fundamental relationship between risk and return is “Higher the risk associated with an investment higher is the expected return from it” and this is what drives an Investors decision.

The diagram hereunder clearly depicts how an expected rate of return varies basis the risk involved in the asset (the percent range given below is only an example).

The discount rate measures the risk associated with the investment, i.e., the danger of low returns that is different from the expected return on investment. It determines what should be the idle expected rate of return to compensate/reward for the danger or risk undertaken by an investor. This together with the risk-free market rate of return forms the Discount rate for Discounted Cash Flow method.

3. Types of Discount Rates

Following are the commonly used Discount Rates in Discounted Cash Flow Method:-

i) The Cost of Equity (“COE”) – It reflects the return expected by the equity shareholders, to compensate for the risk assumed through their investment in the business.

ii) The Weighted Average Cost of Capital (“WACC”) – It is based on the proportionate weights of each component of the source of capital, i.e., weighted average of COE and COD wherein the ratio of Equity/Debt on total capital is the proportionate weights. WACC constitutes all capital sources:

• Equity shares
• Preference shares
• Long term debts
• Short term debts

The discount rate to be selected typically depends on the type of projected cash flow used in valuation which in turn depends on the purpose of valuation as defined in the terms of engagement. There are two widely used variants of the DCF methodology, while one determines the Equity Value the other helps in determining the Enterprise Value.

The key difference between the two is that Equity value is the total value of all outstanding stock of the company whereas Enterprise Value is the total worth of a company without factoring in the financial structuring involved.

i) Enterprise Value: Enterprise Value is the value attributable to the equity shareholders plus the value of debt and debt-like items, minority interest, preference share less the amount of non-operating cash and cash equivalents. It can also be formulated as:

Enterprise Value

= Free Cash Flow to the Firm (FCFF)/ Weighted Average Cost of Capital

= (Earnings Before Interest and Tax * (1-tax rate) + Depreciation/Non- Cash Expenditure – Capital Expenditure – Increase in Non-Cash Working Capital)/ WACC

ii) Equity Value: Equity Value is the value of the business attributable to equity
shareholders after all expenses, reinvestments and debt obligations have been met by the
company.

Equity Value

= Free Cash Flow to Equity (“FCFE”)/ Cost of Equity
= (Net Income or Profit After Tax + Depreciation & Amortization – Capital Expenditure – Increase in Non Cash Working Capital + Change in Debt)/ Cost of Equity

Hence for calculating Equity Value using Free Cash Flow to Equity, we use Cost of Equity (COE) as discount rate while for calculating Enterprise Value using Free Cash Flow to Firm approach, Weighted Average Cost of Capital (WACC) is used to discount the future cash flows. Of course, to both the COE and WACC, suitable premiums or discounts may be adjusted to arrive at the discount rate based on the factors such as liquidity, control, size, specific risks etc.

Equity Value can be determined from Enterprise Value by eliminating following:

Add/(Less) : Adjustments

Add : Cash & Cash Equivalents (to the extent it is in excess of routine business)
Add : Fair Value of Surplus Assets including Land
Add : Fair Value of Investments and Deposits
Add : PV of MAT Credit
(Less) : Fair Value of Contingent Liability
(Less) : Fair Value of Long-Term Debt
(Less) : Fair Value of Short-Term Debt

(“Further adjustments would be required if there are preference shares and / or non-controlling interests are involved, which have not been considered in the above example”).

As per ICAI Valuation Standards 2018 a valuer may consider the following factors while determining the discount rate:

i) type of asset being valued, example: debt, preference shares, business, real estate, intangibles, etc.;

ii) life of the asset such as the risk-free rate used for determining the cost of equity in the CAPM model differs for an asset with a one-year life vs an indefinite life;

iii) geographic location of the asset;

iv) currency in which the projections have been prepared;

v) type of cash flows;

vi) risk in achieving the projected cash flows;

vii) cash flows used for the projections as FCFE needs to be discounted by Cost of Equity whereas FCFF to be discounted using WACC;

viii) discount the cash flows in the functional currency using a discount rate appropriate for that functional currency; and

ix) pre-tax cash flows need to be discounted by pre-tax discount rate and post-tax cash flows to be discounted by post-tax discount rate;

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