Calculation Of Value In Use

Year	Projected Cash Flow	Discount Factor	Present Value

What is Value in Use?

Value in Use (VIU) is a valuation measure defined under International Financial Reporting Standards (IFRS), specifically IAS 36 Impairment of Assets. It represents the present value of the future cash flows expected to be derived from an asset or a cash-generating unit (CGU) in its current condition. It reflects the value the specific entity expects to derive from the asset, as opposed to its market value or fair value less costs to sell.

The calculation of Value in Use is crucial when assessing whether an asset is impaired. If an asset’s carrying amount (book value) exceeds its recoverable amount (the higher of its fair value less costs to sell and its Value in Use), an impairment loss must be recognized.

Who Should Use It?

Accountants, financial analysts, and business valuators regularly calculate Value in Use, particularly when preparing financial statements under IFRS or when making investment or divestment decisions. It’s essential for:

• Annual impairment testing of goodwill and indefinite-lived intangible assets.
• Impairment testing of other assets (like property, plant, and equipment) when there’s an indication of impairment.
• Internal decision-making regarding the continued use or disposal of an asset.

Common Misconceptions

A common misconception is that Value in Use is the same as fair value. Fair value is the price that would be received to sell an asset in an orderly transaction between market participants, while Value in Use reflects the value to the specific entity using the asset. They can be different, especially if the entity uses the asset in a unique way or has different expectations about future cash flows than the market.

Value in Use Formula and Mathematical Explanation

The Value in Use is calculated by discounting the expected future cash flows from the asset (or CGU) to their present value. The formula is:

VIU = Σ [CF_t / (1 + r)^t] + [TV_n / (1 + r)ⁿ]

Where:

• Σ denotes the sum from t=1 to n.
• CF_t = Net cash flow expected in year t.
• r = Discount rate (pre-tax, reflecting the time value of money and the risks specific to the asset).
• t = Year (from 1 to n).
• n = Number of years in the explicit projection period.
• TV_n = Terminal Value at the end of year n, representing the present value of cash flows beyond the projection period.

The Terminal Value (TV_n) is often calculated using the Gordon Growth Model (perpetual growth model) assuming cash flows grow at a constant rate (g) indefinitely after year n:

TV_n = [CF_n * (1 + g)] / (r – g)

Where CF_n is the cash flow in the last year of the explicit projection, and g is the perpetual growth rate (which must be less than r).

Variables Used:

Variable	Meaning	Unit	Typical Range
CF1	Initial annual cash flow (Year 1)	Currency	Positive value
Growth Rate	Annual cash flow growth rate during projection	%	-10% to 20%
n	Number of projection years	Years	3 to 20
g	Perpetual growth rate after projection	%	0% to 3% (long-term inflation)
r	Discount rate	%	5% to 15% (depending on risk)
TVn	Terminal Value at year n	Currency	Calculated
VIU	Value in Use	Currency	Calculated

Practical Examples (Real-World Use Cases)

Example 1: Manufacturing Machine

A company owns a manufacturing machine. They project the following to calculate its Value in Use:

• Initial Annual Cash Flow (from using the machine): $50,000
• Annual Growth Rate (due to efficiency gains): 2% for 5 years
• Number of Projection Years: 5
• Perpetual Growth Rate (long-term inflation): 1%
• Discount Rate (WACC adjusted for machine’s risk): 10%

Using the calculator with these inputs would give a specific Value in Use. If this is lower than the machine’s book value, an impairment loss might be needed.

Example 2: Cash-Generating Unit (Retail Store)

A retail chain is assessing a specific store (a CGU) for impairment.

• Initial Annual Cash Flow: $200,000
• Annual Growth Rate (expected market growth): 1% for 10 years
• Number of Projection Years: 10
• Perpetual Growth Rate: 0.5%
• Discount Rate: 9%

The calculated Value in Use helps determine if the store’s assets are carried at an appropriate value on the balance sheet.

How to Use This Value in Use Calculator

1. Enter Initial Annual Cash Flow (CF1): Input the net cash flow expected from the asset or CGU at the end of the first year.
2. Enter Annual Growth Rate During Projection (%): Input the percentage rate at which you expect cash flows to grow annually during the explicit forecast period.
3. Enter Number of Projection Years: Specify how many years you want to project individual cash flows before applying a terminal value.
4. Enter Perpetual Growth Rate After Projection (%): Input the constant rate at which cash flows are expected to grow indefinitely after the projection period. This must be lower than the discount rate.
5. Enter Discount Rate (%): Input the rate used to discount future cash flows. This should reflect the time value of money and the risks associated with the cash flows.
6. Click Calculate: The calculator will display the Value in Use, total present value of projected cash flows, terminal value, and present value of the terminal value. It will also show a table and chart of cash flows.
7. Review Results: The primary result is the Value in Use. Compare this to the carrying amount of the asset or CGU to assess for impairment. The table and chart help visualize the cash flow projections and their present values.

Decision-making: If the calculated Value in Use is significantly lower than the asset’s carrying amount, and also lower than its fair value less costs to sell, you may need to recognize an impairment loss.

Key Factors That Affect Value in Use Results

• Future Cash Flow Projections: The most significant factor. Higher expected cash flows lead to a higher Value in Use. These projections should be realistic and based on reasonable and supportable assumptions.
• Discount Rate: A higher discount rate (reflecting higher risk or time value of money) will result in a lower Value in Use, as future cash flows are discounted more heavily.
• Projection Period Length: A longer explicit projection period can increase or decrease the Value in Use depending on the growth rates and discount rate, but it mainly defers the impact of the terminal value.
• Perpetual Growth Rate: A higher perpetual growth rate applied to cash flows beyond the projection period increases the terminal value and thus the Value in Use. It must be lower than the discount rate and generally not exceed the long-term average growth rate of the economy.
• Asset’s Condition and Remaining Useful Life: These implicitly affect the cash flow projections and the length of the projection period. An older asset near the end of its life will have different cash flow expectations.
• Economic and Market Conditions: Overall economic climate, industry trends, and market competition can significantly influence future cash flow projections and the discount rate applied.

Frequently Asked Questions (FAQ)

Q: What is the difference between Value in Use and Fair Value?
A: Value in Use is the present value of future cash flows expected from an asset’s continued use and disposal by a specific entity. Fair Value is the price it would fetch in an open market transaction. They are different perspectives on value.

Q: Why is the discount rate important in calculating Value in Use?
A: The discount rate adjusts future cash flows for the time value of money and the risk associated with receiving those cash flows. A higher risk means a higher discount rate and a lower present value (Value in Use).

Q: What happens if the discount rate is lower than the perpetual growth rate?
A: The formula for terminal value becomes invalid (division by zero or a negative number), implying infinite value, which is unrealistic. The perpetual growth rate must be less than the discount rate.

Q: How far into the future should I project cash flows?
A: Typically, detailed projections are made for 5-10 years, or until cash flows stabilize. Beyond that, a terminal value is used. The period should reflect the remaining useful life or the period over which reliable forecasts can be made.

Q: What cash flows should be included in the Value in Use calculation?
A: Include future cash inflows and outflows directly attributable to the asset or CGU, including those from its ultimate disposal, but excluding financing activities and income tax.

Q: Is Value in Use calculated pre-tax or post-tax?
A: IAS 36 requires Value in Use to be calculated using pre-tax cash flows and a pre-tax discount rate.

Q: When is an asset impaired?
A: An asset is impaired when its carrying amount (book value) exceeds its recoverable amount, which is the higher of its Value in Use and its fair value less costs to sell.

Q: Can an impairment loss be reversed?
A: Yes, if the recoverable amount of an asset (other than goodwill) increases in a subsequent period, the impairment loss previously recognized may be reversed, but only up to the carrying amount that would have been determined (net of depreciation/amortization) had no impairment loss been recognized.