Saturday, February 22, 2014

Review of discount rate / WACC in a discounted cash flow analysis ("DCF") of different subsidiaries within the client Group

Your client may have a number of subsidiaries in different countries / different regions. From holding company, the Company records investments in subsidiaries on its company's balance sheet. When there is indication of impairment, the holding company is usually required to estimate the recoverable amount via the following:

- estimated value-in-use; or
- fair value less cost of disposal

The recoverable amount is higher of one the above.

In estimating the value-in-use, a discount rate will be applied in estaming the value-in-use. Developing an understanding of client's discount rate estimation process is essential for the auditor the test the reasonableness of the discount rate. Typically, your audit client would use weighted average cost of capital (i.e. WACC) as its discount rate. Hence, it is important to know how client gather cost of debt, cost of equity, market premium and beta. These need to be supported by proper source (i.e. print out from Bloomberg).

When a discount rate has been estimated, it is important to perform the review of the discount rate against the industry disocunt rate/ country discount rate/ or even the discount rate within the Group.

Of course, country risk need to be considered. Generally, we would expect the discount rate for a developed nation is lower than the discount rate in an emerging market. As the risk is higher for emerging market.

Hence, it is important to understand and test the discount rate estimation process and perform review of the end result.

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