G. Marzo, Real Options Valuation and the Impairment Test. Compliance with IAS/IFRS and Value Relevance

IAS 36 states that both tangible and intangible assets must be subjected to impairment test. This is based on net-selling price and value-in-use, the latter being measured by “…(a) estimating the future cash inflows and outflows to be derived from continuing use of the asset and from its ultimate disposal; and (b) applying the appropriate discount rate to these future cash flows.” In order to calculate value-in-use, the Appendix A to IAS 36 clearly offers a Discounted Cash Flows (DCF) approach for the impairment test, where the appropriate discount rate can be calculated as «...the entity’s weighted average cost of capital determined using techniques such as the Capital Asset Pricing Model;...» (IAS36: Paragraph A17). A large body of literature developed within Finance theory has plainly demonstrated that a CAPM-based DCF approach suffers from many pitfalls that systematically lead to a huge under-valuation of both assets and investment projects. In particular, when uncertainty is combined with managerial flexibility, the implementation of a CAPM-based DCF approach produces the highest undervaluation. On the basis of such evidence, it is expected the CAPM-based DCF approach proposed by IAS 36 for the impairment test results in over-impairment of assets, therefore depressing companies’ book and market values. The Real Options Analysis and Valuation (ROV) approach has been developed in order to overcome the under-valuation problem. It could be contended, therefore, that ROV could be employed in order to carry on the impairment test required by IAS 36. However such view should be carefully analysed, since the compliance of ROV with IAS 36 and the effects of a ROV-based impairment test (ROVIT) should be assessed. The paper shows that ROVIT is a theoretically feasible alternative since it is compliant with IAS 36, and it is also better than a CAPM-based impairment test (CAPMIT) as for the effects on investors’ decision-making. From a value relevance perspective, ROVIT results in higher correlation between book and economic (market) values and returns. The paper discusses the theoretical acceptability of ROVIT from the analysis of its consistency with the letter of IAS 36, and works on a simulation model in order to analyse and presents pros and cons of ROVIT versus CAPMIT. Finally, the paper highlights some peculiar problems related to the employing of ROV for impairment test, especially from the point of view of prudence/conservatism