Determining the Cost of Capital in the Context of International Accounting

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published on 20 February 2024 | reading time approx. 4 minutes


A key component of purchase price allocation and impairment testing is the cal­cu­la­tion of the cost of capital. The weighted average cost of capital (WACC) is regularly used for this purpose. WACC is derived from the weighted cost of equity, which consists of a risk-free interest rate, a beta factor and a market risk premium, and the weighted cost of debt, which consists of a risk-free interest rate, a credit spread and a tax shield. It is important to note that the cost of equity and the cost of debt are determined based on the assumptions that market participants would make in pricing the asset or liability.



Determining fair value under IFRS

Business combinations resulting from a transaction in which an entity obtains control of a business are accoun­ted for using the purchase method in accordance with IFRS 3. In addition to identifying the acquirer and determining the acquisition date, this requires the measurement of assets acquired, liabilities assumed and goodwill.

Assets and liabilities are measured at fair value. According to IFRS 13, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is therefore a market-based, rather than an entity-specific measure and is determined on the basis of assumptions that market participants would use in determining the price for the asset or liability. An entity’s intention to hold an asset or settle a liability is not relevant to the determination of fair value.

One of the measurement methods specified in IFRS 13 is the present value method, in which future amounts (e.g. cash flows or income and expenses) are converted to a present amount (= present value) by discounting. The determination of the cost of capital is required for valuation purposes such as impairment testing or purchase price allocation (PPA).


Determining the Cost of Capital Using the WACC

The discount rate to be applied is generally derived from the weighted average cost of capital (WACC). In contrast to conventional valuations of companies or shares in companies (see IDW S1), IFRS 13 requires that each parameter of the WACC be formulated from the perspective of a market participant when determining fair value.

International accounting requires the use of a market-based discount rate for the WACC. The WACC is derived from the cost of equity and the cost of debt (see chart below).


The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) and is composed of a (quasi-)risk-free interest rate (prime rate), a market risk premium and the beta factor.

The market risk premium is the difference between the return on a (quasi-)risk-free investment (base rate) and the return on a risky market portfolio (e.g. DAX). It thus measures the yield premium that investors expect for investing in risky securities compared to risk-free investments.

The prime rate represents the return on a risk-free investment.

The beta factor represents the company-specific risk. A linear regression is used to measure how the risk of the individual value (of a stock) relates to the overall market risk (of a market portfolio). This is calculated from the variation in the stock's return relative to the variation in the market's return.

Since the beta factor must be determined from the perspective of market participants, the use of the com­pa­ny's own beta factor (valuation object) is excluded. Consequently, a peer group beta factor must be used. How­ever, this does not exclude the inclusion of the valuation object in the peer group.

The indebted beta factors are adjusted for the financing risk in the course of unlevering. This results in unlevered beta factors (unlevered beta), which are aggregated to an average unlevered beta. In the course of relevering, the beta is then adjusted to the financing structure of the peer group. For this purpose, the average debt-equity ratio is used. In determining the average, either the arithmetic mean or the median can be used. The company-specific capital structure should not be taken into account, as this approach would violate the obligation to consider current market assessments.



Borrowing costs represent the cost the company has to pay for the capital provided by lenders (= interest on borrowed capital). The credit spread is the difference between the yield on a risky (corporate) bond and the yield on a (quasi) risk-free (government) bond. It is calculated from the base interest rate and a premium derived from the market for default risks (= credit spread).

Interest on debt is tax deductible and is adjusted by the tax shield. The tax rate consists of trade tax and corporate income tax.

Since both the tax rate and the credit spread must be determined from the perspective of market participants, the peer group must also be taken into account. Standardised tax rates or even the company's own tax rates (valuation object) are not used. Interest rates of similar market participants with the same credit rating should be used as a benchmark for the cost of debt.

The calculation of the WACC is shown in the following table. The items that deviate from a conventional com­pa­ny valuation according to IDW S1 are marked in color.



Conclusion

In summary, it can be said that the determination of the cost of capital in the context of international accoun­ting differs from the determination in the context of national accounting (in this case German accounting) in one key point, namely the perspective used to determine the cost of capital. While the determination of fair value according to IFRS 13 is strictly based on the perspective of a market participant, the valuation according to IDW S1 is based on the perspective of the company.

This can be seen, for example, in the relevering of the beta factor. Here, the leverage ratio of the valuation object is taken into account instead of that of the peer group. Consequently, the weighting of equity and debt capital costs also depends on the financing structure of the valuation object.

In determining the cost of debt, the default risk of the subject company is also taken into account. For sim­pli­ci­ty, this is determined on the basis of the effective interest rate (= net interest income/net debt) less the base rate. Interest rates of similar market participants with the same credit rating are not used. The tax shield is based on the effective tax rate of the subject of the valuation. Depending on the location of the company, the amount can vary significantly and affect the cost of debt and thus the WACC.

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