IFRS 16: Discount rate, impairment & valuations

29 October 2019

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IFRS 16 business impacts

Systems & Processes― System solution― ERP integration― Future process design

Finance― Transition options― Data collection― Tax― KPIs

Investor relations― External communication― Analyst queries

Other impacts― Management reporting― Management remuneration― Training

Strategy― Lease vs buy― Lease structuring ― Sale and leasebacks

Treasury― Covenants― Credit rating― Discount rates

IFRS 16 accounting

change

Finance― Transition options― Data collection― Tax― KPIs― Impairment & Valuations― Complex accounting

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Questions…

How many of you have determined the discount rate to determine the lease liability/RoU asset?

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Options for determining the discount rate in line with IFRS 16 guidelines

WACC Risk-freerate

The lessee’s incremental borrowing rate (IBR)

The rate implicit in the lease, if readily available OR

In practice, generally lessee will calculate/use IBR

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Key considerations in determining the IBR in line with IFRS 16 guidelines

To capture the lease specific risk

Adjustment for the nature of the lease

4

To capture the lessee’s credit risk

Credit risk spread of the lessee

To capture the economic environment and term of the lease

Risk-free rate

Country risk and economic factors

Incremental borrowing rate

1

2

3

The above considerations of determining the IBR are captured in the following pillars:

As per IFRS 16, the following elements should be reflected in the IBR:

Lessee

It should be a company specific rate that reflects the credit worthiness of the company

3

Term

It should reflect a rate of interest over a similar term1

Economic environment

The rate should relate to the encompassing jurisdiction, currency and the date at which lease started

2

Security

The rate should relate to similar nature and quality as of the underlying asset

4

Amount of borrowing

The rate should relate to funds needed to obtain an asset of a similar value to the right-of-use asset

4

Please note that the application of the above methdology involves certain nuances such as the application of the concept of duration / weighted average life, amongst others. Also, other methodologies could be applied to determine the IBR. The above methodology is the most popular methdology seen in the market.

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Question..

So how does IFRS 16 impact valuations and impairment testing?

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IFRS 16 will have an impact on valuations

Treatment of lease liabilities

Discount rateCash flow forecast and discounted

cash flow models

Valuation

Valuation multiples also impacted

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Impact on free cash flow to firm

WITH IFRS 16 31/12/2017 31/12/2018 31/12/2019 31/12/2020 31/12/2021

Revenues 10,000,000 10,200,000 10,404,000 10,612,080 10,824,322% growth 2.0% 2.0% 2.0% 2.0%

Gross profit 3,000,000 3,060,000 3,121,200 3,183,624 3,247,296% gross profit margin 30.0% 30.0% 30.0% 30.0% 30.0%

Rental expensesPersonnel expenses (200,000) (204,000) (208,080) (212,242) (216,486)% personnel expenses -2.0% -2.0% -2.0% -2.0% -2.0%

EBITDA 2,800,000 2,856,000 2,913,120 2,971,382 3,030,810% EBITDA margin 28.0% 28.0% 28.0% 28.0% 28.0%

Depreciation non-cash (200,000) (200,000) (200,000) (200,000) (200,000)

EBIT 2,600,000 2,656,000 2,713,120 2,771,382 2,830,810% EBIT margin 26.0% 26.0% 26.1% 26.1% 26.2%

Interest expense (50,000) (40,951) (31,450) (21,474) (10,999)

EBT 2,550,000 2,615,049 2,681,670 2,749,909 2,819,811% EBT margin 25.5% 25.6% 25.8% 25.9% 26.1%

WITHOUT IFRS 16 31/12/2017 31/12/2018 31/12/2019 31/12/2020 31/12/2021

Revenues 10,000,000 10,200,000 10,404,000 10,612,080 10,824,322% growth 2.0% 2.0% 2.0% 2.0%

Gross profit 3,000,000 3,060,000 3,121,200 3,183,624 3,247,296% gross profit margin 30.0% 30.0% 30.0% 30.0% 30.0%

Rental expenses (230,975) (230,975) (230,975) (230,975) (230,975)Personnel expenses (200,000) (204,000) (208,080) (212,242) (216,486)% personnel expenses -2.0% -2.0% -2.0% -2.0% -2.0%

EBITDA 2,569,025 2,625,025 2,682,145 2,740,408 2,799,835% EBITDA margin 25.7% 25.7% 25.8% 25.8% 25.9%

Depreciation non-cash

EBIT 2,569,025 2,625,025 2,682,145 2,740,408 2,799,835% EBIT margin 25.7% 25.7% 25.8% 25.8% 25.9%

Interest expense

EBT 2,569,025 2,625,025 2,682,145 2,740,408 2,799,835% EBT margin 25.7% 25.7% 25.8% 25.8% 25.9%

Reclassification of rental expenses

WITHOUT IFRS 16 31/12/2017 31/12/2018 31/12/2019 31/12/2020 31/12/2021BOP 1,000,000 819,025 629,002 429,477 219,976Interest (50,000) (40,951) (31,450) (21,474) (10,999)Redemption (180,975) (190,024) (199,525) (209,501) (219,976)EOP 819,025 629,002 429,477 219,976 -

Depreciation non-cash (200,000) (200,000) (200,000) (200,000) (200,000)

Value of leased assetWITHOUT IFRS 16 31/12/2017 31/12/2018 31/12/2019 31/12/2020 31/12/2021Lease payments P&L 230,975 230,975 230,975 230,975 230,975Discount factor 0.952 0.907 0.864 0.823 0.784Present value of lease payments 219,976 209,501 199,525 190,024 180,975Value of lease 1,000,000

IBR

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Determination of WACC pre-IFRS 16

Weighted Average Cost of Capital 31-12-2018IAS17

Risk-free rate 1.0%Unlevered beta 0.687Debt/Equity ratio 20.1%Relevered beta 0.825Market risk premium 6.0%Cost of Equity 6.0%

Risk-free rate 1.0%Debt spread 1.7%Pre-tax cost of debt 2.7%Marginal tax rate 20.5%Cost of Debt 2.1%

Debt/ Total Capital 16.7%Equity/ Total Capital 83.3%

WACC 5.3%

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Weighted Average Cost of Capital 31-12-2018 31-12-2018IAS17 IFRS16

Risk-free rate 1.0% 1.0%Unlevered beta 0.687 0.592Debt/Equity ratio 20.1% 39.5%Relevered beta 0.825 0.825Market risk premium 6.0% 6.0%Cost of Equity 6.0% 6.0%

Risk-free rate 1.0% 1.0%Debt spread 1.7% 1.7%Pre-tax cost of debt 2.7% 2.7%Marginal tax rate 20.5% 20.5%Cost of Debt 2.1% 2.1%

Debt/ Total Capital 16.7% 28.3%Equity/ Total Capital 83.3% 71.7%

WACC 5.3% 4.9%

Hypothesis - Levered betas remain unchanged as IFRS 16 should not provide new information to the market

Debt spread remains unchanged as cost of financial leverage should not be affected as IFRS 16 should not provide new information to the lenders

Net debt increases due to the classification of operational leases as debt

Please note that the above WACC calculations are for illustrative purposes. The above example does not take into account unlevered betas as at a pre-IFRS 16 date and a post-IFRS 16 date. The unlevered betas have been recalculated based on the hypothesis that levered betas remain unchanged as IFRS 16 should not provide new information to the market. Typically, the unlevered beta is derived based on the regression analysis of listed companies, which is not the case above.

As a result, Cost of capital (WACC) would decrease

The level of debt depends on the assumption regarding the tenure of the lease liability

Data providers need to provide the information explicitly

Determination of WACC post-IFRS 16

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Carrying amount vs. recoverable amount

Net present value

― Cash flows includingoperating lease payments

― WACC: operating leases not part of leverage

IAS 171

Net LT assets

NWC

Equity

Net debt

Net LT assets

NWC

Carrying amount

Reco-verableamount

Head-room

Balance sheet

Carrying amount

Recoverable amount

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Net present value

Approach 1

“The converted”― Cash Flows excluding

lease payments― WACC: leases part of

leverage― Deduct lease liability ― Model replacement

capex ROU assets

Approach 2

“Quasi IAS 17”― Cash Flows including

lease payments― WACC: leases not part

of leverage

Carrying amount vs. recoverable amount

Balance sheet

Carrying amount

Recoverable amount

IFRS 162

Reco-verableamount

Head-room

Net LT assets

NWC

Carrying amount

Right-of-use asset

Lease liability

Net LT assets

NWC

Equity

Net debt

Right-of-use asset

Lease liability

Under this approach, WACC must contain a component in respect of the cost and weighting of leases. In the near term, it may be challenging to find the appropriate gearing ratios that include the optimal level of leasing.

Make sure the leverage in the WACC does not take into account the IFRS 16 related lease liability weighting only. A potential challenge could be distinguishing between financial leases and operating leases in the market data.

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Impact on valuation: market approach - equity value multiples

Equity value multiples should remain the same……..

Equity value multiple

Equity value

Net income

But could be impacted due to the front loading effect of interest on net income

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Impact on valuation: market approach - enterprise value multiples

Enterprise value multiple

Enterprise value

EBITDA

Enterprise value multiples is uncertain

- EV market multiples (pre-IFRS 16 vs post-IFRS 16): Historical pre-IFRS 16 market multiples will not be comparable to the multiples that apply post-IFRS 16.

- EV market multiples (across companies post-IFRS 16): The comparability of multiples across companies post-IFRS 16 will be affected by the level of lease liabilities, which depends on a range of factors, one of which is the remaining lease term.

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Keep your eye on the ball

― Gearing ratios (comparability pre- and post-IFRS 16): The reported gearing levels of a company pre- and post-IFRS 16 will not be comparable.

― EV market multiples (pre-IFRS 16 vs post-IFRS 16): Historical pre-IFRS 16 market multiples will not be comparable to the multiples that apply post-IFRS 16

― EV market multiples (across companies post-IFRS 16): The comparability of multiples across companies post-IFRS 16 will be affected by the level of lease liabilities, which depends on a range of factors, one of which is the remaining lease term.

― Impact of GAAP differences on key metrics and multiples: Peer groups typically consist of companies from various countries. However, not all companies may apply IFRS or a GAAP treating leases similar to IFRS 16.

― Consistency between cash-flows and discount rate: In case cash flows exclude lease payments, ensure the WACC takes into account the lease liability weighting. If cash flows include lease payments, make sure the leverage in the WACC does not take into account the IFRS 16 related lease liability weighting only.

― Replacement capex after the end of the remaining term: Replacement should be assumed either via entering into a new lease, assuming renewal of the existing lease or by acquiring an asset as a replacement at the end of the lease term.

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© 2019 KPMG Advisory N.V., registered with the trade register in the Netherlands under number 33263682, is a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (‘KPMG International’), a Swiss entity. All rights reserved.