How do you calculate fair value in use?

Calculating an asset's fair value in use (often referred to as Value in Use or VIU) is a critical valuation technique that determines the present value of the future cash flows an asset is expected to generate through its continued use and eventual disposal by an entity. This entity-specific valuation is essential for various purposes, including impairment testing of assets and strategic investment decisions.

The primary method for calculating fair value in use is the Discounted Cash Flow (DCF) analysis. Accountants utilize this approach to derive an asset's value by meticulously assessing the cash inflows generated from using the equipment over its useful life and carefully considering the cash outflows associated with its initial acquisition and subsequent operational needs.

The Discounted Cash Flow (DCF) Methodology

The DCF method for calculating fair value in use involves projecting the net cash flows an asset will generate over its useful life and then discounting these future cash flows back to their present value using an appropriate discount rate.

Key Components of the Calculation

To accurately determine an asset's fair value in use, several critical components must be carefully estimated and analyzed:

1. Estimating Future Cash Flows

   This is the most crucial and often challenging step. The cash flows should be directly attributable to the asset and represent the economic benefits derived from its continued operation.

   • Inflows: These typically include revenues generated directly by the asset, cost savings achieved, or other economic benefits.
   • Outflows: These encompass all cash expenditures necessary to achieve those inflows. This includes:
     • Direct operating costs (e.g., labor, materials, utilities directly linked to the asset).
     • Maintenance and repair costs.
     • Future capital expenditures required to maintain the asset's capacity (e.g., component replacements).
     • Any necessary cash outflows related to the initial acquisition (if evaluating a potential investment) or ongoing operational requirements to sustain the asset's use.
   • Terminal Value/Salvage Value: The estimated cash flow from the asset's disposal at the end of its useful life is also included.
   • Exclusions: Cash flows from financing activities (e.g., interest payments) and income tax receipts or payments are generally excluded as the discount rate typically accounts for these. Cash flows from activities not directly related to the asset's use (e.g., general corporate overhead) are also excluded.

2. Determining the Discount Rate

   The discount rate reflects the time value of money and the risks associated with the asset's projected cash flows. It's essentially the rate of return an investor would require to undertake an investment of similar risk.

   • Purpose: To convert future cash flows into their present-day equivalent, accounting for the inherent uncertainty and opportunity cost.
   • Common Approaches:
     • Weighted Average Cost of Capital (WACC): Often used for entity-level valuations, WACC reflects the average rate of return a company expects to pay to its debtholders and equity holders. For asset-specific valuations, it may need adjustment to reflect the specific risks of the asset.
     • Pre-tax Discount Rate: In some accounting standards (like IFRS), the discount rate used should be a pre-tax rate that reflects current market assessments of the time value of money and the specific risks associated with the cash flows.
   • Considerations: The discount rate should be consistent with the cash flow projections (e.g., if cash flows are nominal, the discount rate should include inflation).

Step-by-Step Calculation Process

Here's a breakdown of the steps involved in calculating fair value in use:

1. Estimate the Asset's Useful Life: Determine the period over which the asset is expected to generate cash flows.

2. Project Annual Net Cash Flows: Forecast the incremental cash inflows and outflows attributable to the asset for each year of its useful life.

3. Determine the Terminal Value (if applicable): Estimate the residual value or salvage value of the asset at the end of its projected useful life.

4. Select an Appropriate Discount Rate: Choose a discount rate that accurately reflects the risks associated with the asset's cash flows and the time value of money.

5. Calculate the Present Value of Each Cash Flow: Discount each annual net cash flow and the terminal value back to the present using the chosen discount rate. The formula for present value is:
   $$PV = \frac{CF_t}{(1+r)^t}$$
   Where:

   • $PV$ = Present Value
   • $CF_t$ = Cash Flow in period $t$
   • $r$ = Discount Rate
   • $t$ = Period (year)

6. Sum the Present Values: Add up all the present values of the individual annual cash flows and the terminal value. The sum represents the asset's fair value in use.

Example Scenario

Consider a specialized manufacturing machine with an estimated useful life of 5 years.

In this simplified example, the fair value in use of the machine, discounted at 10%, is approximately \$80,066.

Practical Insights and Importance

• Impairment Testing: Fair value in use is a cornerstone of impairment testing for assets. If an asset's carrying amount on the balance sheet exceeds its recoverable amount (which is the higher of fair value in use or fair value less costs to sell), the asset is considered impaired, and its value must be written down.
• Subjectivity: The calculation of fair value in use involves significant estimates and assumptions (e.g., future revenues, costs, discount rates). These assumptions must be reasonable, supportable, and consistently applied.
• Entity-Specific Value: Unlike fair value less costs to sell (which is market-based), fair value in use reflects the unique value an asset provides to a specific entity based on its operational plan.
• Decision Making: Understanding an asset's fair value in use helps management make informed decisions about continuing to use an asset, investing in upgrades, or considering its disposal.

For further information on discounted cash flow analysis, you can explore resources from Investopedia: Discounted Cash Flow or specific accounting standards like IFRS Foundation: IAS 36 Impairment of Assets.