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I came across a section of a 20-F (10-K equivalent) and it had the following information:

From the 20-F

Impairment test

Further to the continuing volatility in the shipping industry as discussed in Note 1(b), as well as a decrease in its market capitalization value, the Company tested its assets for impairment, as of December 31, 2022. For the purpose of IAS 36, the Company, which operates an integrated liner network, has one cash-generating unit (hereinafter: CGU), which consists of all of its operating assets. The Company estimated its recoverable amount on the basis of its value-in-use, using the discounted cash flow (DCF) method.

The Company’s assumptions were made for a period of five years (2023-2027) and a representative terminal year intended to reflect a long-term steady state. The key assumptions are set forth below:

  • A detailed cash flow for the abovementioned period, based upon the Company’s business plan.

  • Freight rates: expected to decrease in 2023 and to be further affected by industry’s supply and demand dynamics, as well as by macroeconomic trends and uncertainties.

  • Carried volume (TEUs): expected to increase over the projected period, in accordance with the Company’s fleet structure and business plan.

  • Bunkering costs: according to the future price curves of fuel and liquefied natural gas (LNG).

  • Charter hire rates: according to contractual rates in effect as of December 31, 2022, and estimated market rates for future renewals.

  • Post tax discount rate of 11.5%.

  • Long-term nominal growth rate of 2.5%.

  • Payment of tax at the Company’s corporate tax rate of 23%.

The impairment test resulted with a recoverable amount exceeding the carrying amount of the CGU, therefore, no impairment was recognized.

The Company believes that the assumptions used in its analysis are reasonable and appropriate, considering past experience and current market trends and expectations. However, such assumptions are highly subjective and there can be no assurance that the Company’s assumptions will materialize, or whether freight rates, charter rates and bunker costs will increase or decrease by any significant degree.

The part I don't understand:

Change by 100 bps in the following assumptions will result in an increase (decrease) in the recoverable amount of the CGU, as follows:

Discount Rate by 100bps: Increase: (625M) Decrease: 766M

Terminal Growth Rate by 100 bps: Increase: 512M, Decrease: (406M)

What does those increases/decreases represent?

1 Answer 1

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They are essentially telling analysts how sensitive the company's valuation of its assets are to two main factors.

The Discounted Cash Flow model typically has two main factors (other then the actual cash flows) - the discount rate and the terminal growth rate. The cash flows are estimated up to a certain point in the future, discounted to the present using some discount rate, and then assumed to grow at a constant "growth rate" in perpetuity.

The discount rate that they use represents a certain rate of return that they require on the assets it's analyzing. If the discounted future cash flows from those assets are positive, then the rate of return if the business is higher than the (required) discount rate.

Essentially, the company is picking a discount rate that it believes matches its investor's required rate of return for investing in the company.

The Terminal Growth Rate of those assets is also estimated by the company.

The "100 bps increase" (which is 1% by definition) measure is showing how sensitive their results are to these inputs. If you increase the discount rate by 100bps (i.e. from 11.5% to 12.5%), the value of those assets goes down by 625 million. Investors can then use that sensitivity to get the equivalent value using their discount rates. If they want to use a 12% discount rate instead (a 50bps increase), they can just decrease the value by half of the 100bps amount.

Same with the growth rate - analysts can adjust their value by extrapolating the company's value and sensitivity to get results based on their own growth estimates.

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  • Why those two have a negative correlation? And how would one come up with a discount rate given their input? Apr 6, 2023 at 15:25
  • The higher the discount rate, the lower the present value of future cash flows (they are "discounted" more). The higher the growth rate, the higher the future values, and the higher the present values (given the same discounting rates). If you're not familiar with the concepts of present and future values (discounting) that would be a good place to start.
    – D Stanley
    Apr 6, 2023 at 16:00
  • You would not "come up with" a discount rate - you would use your own discount rate based on various factors - the company is just telling you how to translate their results into approximate results using other discount rates. Meaning "We calculated X based on discount rate Y - if you use a different discount rate Y2, you can estimate X2 by using this linear sensitivity"
    – D Stanley
    Apr 6, 2023 at 16:02
  • I'm familiar with DCFs in general, I usually use bloomberg to see the estimates and adjust it to what makes sense. But the concept of required return or discount rate is something I don't understand and I thought the company would let us know what the appropriate rate is. Apr 7, 2023 at 14:07
  • The "appropriate rate" is the rate that you would use for other companies of similar risk. Exactly what that rate is can be subjective. They're telling you the result for one rate and how to convert it for other rates. The alternative would be for you to figure out all of the cash flows and do the full DCF calculation yourself.
    – D Stanley
    Apr 7, 2023 at 16:43

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