Value-in-use (VIU) is where the technical work happens in impairment testing: cash flow projections, discount rate (WACC), terminal value. This guide walks through WACC calculation, cost of equity (CAPM), terminal growth, and the sensitivity analysis auditors demand.
WACC Components
| Component | Definition | Example |
|---|---|---|
| Cost of Equity | Return shareholders expect (CAPM) | 8— 12% (higher for risky businesses) |
| Cost of Debt | Interest rate on borrowings | 3— 6% (lower for stable, investment-grade firms) |
| Tax Shield | Debt provides tax deduction | Cost of debt × (1 −’ tax rate) |
| Capital Structure | E/V (equity %) and D/V (debt %) | 60% equity, 40% debt |
Cost of Equity via CAPM
Formula: Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium
- Risk-free rate: Government bond yield (e.g., 10-year UK gilt: ~4%)
- Beta: Stock volatility vs market (1.0 = market, >1.0 = riskier)
- Equity risk premium: Market return −’ risk-free rate (historically ~5— 6%)
Worked Example: WACC Calculation
Company: Mid-cap retailer with acquisition
- Capital structure: 70% equity, 30% debt
- Cost of equity: 4% (risk-free) + 1.2 (Beta) × 5% (ERP) = 10%
- Cost of debt: 4.5%, tax rate 20%
- After-tax cost of debt: 4.5% × (1 −’ 20%) = 3.6%
- WACC = (70% × 10%) + (30% × 3.6%) = 7% + 1.08% = 8.08%
Terminal Value (Perpetuity)
Projects beyond explicit forecast period assume perpetual growth:
Terminal Value = Final Year Cash Flow × (1 + g) / (WACC −’ g)
Where g = long-term growth rate (typically 2— 3%, capped at GDP growth)
Audit Red Flags: WACC & Terminal Value
- WACC too low: Company uses 5% WACC when market data suggests 7— 8%. Auditor recalculates and increases WACC, reducing VIU and triggering impairment.
- Terminal growth too high: Assumes 5% perpetual growth in flat industry. Auditor reduces to 2%; impacts terminal value significantly.
- No sensitivity analysis: Impairment is borderline; changing WACC by 0.5% flips the result. Auditor requires sensitivity table.
Real-Life Case Study: Building a Value-in-Use Model
Scenario. A CGU is expected to generate cash flows of £2m per year for five years, then a terminal value. The pre-tax discount rate is 11%.
- PV of five years at 11%: £2m × 3.696 = £7.39m
- Terminal value (2% growth): £2.04m ÷ (0.11 − 0.02) = £22.7m, discounted five years ≈ £13.5m
- Value in use ≈ £20.9m
Takeaway. Value in use is dominated by two inputs, the discount rate and the terminal growth rate, and small moves in either swing the answer by millions. IAS 36 also bars future restructurings and enhancing capex from the cash flows, a common way models get inflated.
Illustrative composite scenario for educational purposes. Figures are indicative and do not represent any specific company.