Files (Information to be obtained/evidence to be

Audit Procedures Detailed Work Steps

gathered)

DISCOUNT 1. Understand the nature of the asset or liability being valued. Investors typically require a price for bearing the risk that the future cash flows might be
different from what was expected at the time investment decision was made.
RATE
2. Ensure that the discount rate matches with the cash flow stream expected from the asset or liability.

For example, free cash flow to the firm should be discounted using the weighted average cost of capital (WACC) while free cash flow to equity should
be discounted using the cost of equity.

3. Ensure that discount rates reflect assumptions that are consistent with those inherent in the cash flows to avoid double-counting or omitting the effects
of risk factors.

For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using contractual cash flows of a loan
(i.e. a discount rate adjustment technique). Moreover, if the estimated cash flows are increased to take into account the compensation for assuming the
risk associated with the obligation, the discount rate should not be adjusted to reflect that risk.

4. Check the mathematical accuracy of the calculation of discount rate.

In estimating the pre-tax discount rate, please refer to the attached template.

Pre-tax Discount
Rate Template.xlsx
WEIGHTED 1. Obtain from the client the components of the WACC used in the valuation.
AVERAGE COST WACC is composed of the following:
OF CAPITAL a. Target mix between equity and debt
b. Cost of equity
i. Common shares
ii. Preferred shares
c. After tax cost of debt

The discount rate must include the opportunity costs of all investors –equity, debt and others – since free cash flow is available to all investors who
expect compensation from the risks they take.

2. Ensure that the components of discount rate, namely, the cost of equity, the cost of debt, and the tax rate used in the valuation are marginal in nature,
i.e., the cost or tax rate are applicable for additional capital in contrast to what is currently existing.

CAPITAL 1. Perform research on the industry where the company operates to obtain an understanding of the industry capital structure. Identify publicly listed
comparable companies to obtain data on their individual capital structures.
STRUCTURE
2. If publicly-listed comparable companies are not available, understand the company’s overall financing strategy and its target capital structure over the
long-term.
3. Ensure that the weights used for debt and equity are based on their market/fair values, and not on their book values.

COST OF 1. Understand the model used in estimating cost of equity to determine proper approaches in evaluating the discount rate.
EQUITY The most commonly used model is the capital asset pricing model (CAPM). Other models include build-up approach, Fama-French three-factor model
and the arbitrage pricing theory (APT).

2. Evaluate whether the risk-free rate used represents the rate of return on government securities that is consistent with:
a. the functional currency of the cash flows being discounted (e.g., PhP, USD, etc.) and
b. the duration of the cash flows being discounted (e.g. 5 years, 10 years, etc.).

3. Verify other components used in the cost of equity (e.g. beta and market risk premium for CAPM).

4. Assess whether other adjustments are applicable (e.g. country risk premium if functional currency is not the same as the currency in the locale of
operations and other risk premia).

COST OF DEBT 1. Review whether the pre-tax cost of debt is reflective of the company’s marginal cost of borrowing which takes into account the specific risk
characteristics of the cash flows being discounted (e.g. currency, duration, etc.).

2. When free cash flows are calculated in after-tax terms, ensure that the cost of debt is also computed after corporate taxes.

3. Validate the consistency between the marginal tax rate used in the computation of after-tax cost of debt and the tax rate used in the prospective
financial information.