Abstract
International Financial Reporting Standards (IFRS) 13 Fair Value Measurement lays down two methods to adjust Expected Present Value (EPV) for risk. According to Method 1, expected cash inflows should be risk-adjusted by subtracting a risk-premium and discounted at the market risk-free rate, see (IFRS 13, B25). In contrast according to Method 2, expected cash inflows should be discounted at the risk-free rate augmented by a risk-premium addendum, see (IFRS 13, B26). Standard IFRS 13, B29 leaves the freedom to choose between the two methods. The aim of this note is to identify the relationship between the Risk-Adjusted EPVs rolled out from Method 1 and Method 2. First we introduce a theoretical solution to risk-adjustments compliant with the Standard IFRS 13, B29. Then, we set up a user-oriented proxy to connect the risk-premium present in Method 1 with the risk-adjusted rate present in Method 2. This proxy spots light on the key role played by the Macaulay Duration of expected inflows, rather than that of the lifetime of the project. As a consequence, projects expiring at the same redemption date and endowed with the same EPV and/or the same total inflow may differ considerably in risk-adjustments, due to different Macaulay Durations. A user-oriented method to properly to fast evaluate risk-adjustments for multi-cash inflow projects is provided. Sensitivity analysis of the impact of the Macaulay Duration on Risk-Adjusted EPV is also rolled out through numerical examples.
Highlights
International Financial Reporting Standard 13 (IFRS 13) Fair Value Measurement defines the fair value as the ‘price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principle market at the measurement date’
Net Present Value (NPV) of risk-premium cash flow NPVP (i) used in Method 1 (IFRS 13, B25) and risk-adjusted rate r used in Method 2 (IFRS 13, B26) are approximately related as follows where D = D (i) is the Macaulay Duration discounted at the market risk-free rate i
One might think that projects with the same redemption date and equal Expected Present Value (EPV) or equal total inflow should be risk-adjusted by similar cash-premium amounts
Summary
International Financial Reporting Standard 13 (IFRS 13) Fair Value Measurement defines the fair value as the ‘price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principle (or the most advantageous) market at the measurement date’. Fair Value View is the most effective way to satisfy lenders and investors needs of information in their process of financial resources allocation, as stated in Whittington (2008, 2015). Their needs will be served because: ‘Investors’, lenders’ and other creditors’ expectations about returns depend on their assessment of the amount, timing and uncertainty of (the prospects for) future net cash inflows to the entity.’ (Conceptual Framework OB3). IFRS 13 defines fair value as “the standard” in market valuation and examines consequences from the application of this “standard”, when, in valuating assets and liabilities, no directly observable market information is available.
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