IDW Guideline 1/2023: Gearing in Company Valuation

Determining an objectified business valuation in accordance with IDW S1 poses challenges for business valuers of indebted companies, especially in the case of high levels of debt. The Technical Committee for Business Valuation and Business Administration (FAUB) provides specific recommendations for implementation in IDW Valuation Note 1/2023.

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This is new in IDW valuation note 1/2023

IDW Valuation Practice Note 1/2023 is an updated and renamed version of the previous IDW Practice Note 2/2018. It was adopted in its current version in September 2023 and published in issue 10/2023 of IDW Life. The most important changes include:

• Clarification of definitions, in particular with regard to capital structure and default risks.
• Detailed information on insolvency costs and their impact on operating and capital structure risks.
• Extended information on default risk indicators, including the importance of ratings.
• Supplement to the valuation of heavily indebted companies under the condition of a successful restructuring.

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Overview of different gearing levels

The note clarifies the distinction between highly indebted and excessively indebted companies:

• Highly indebted companies: These companies have a gearing that is associated with a material risk of default, either at the valuation dates or in the future. Even without an immediate default risk, they are considered highly indebted if their gearing is significantly higher than that of their peer group.
• Over-indebted companies: These companies cannot continue to exist in the medium term without successful financial restructuring negotiations.

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Capital structure and default risks

IDW Valuation Guideline 1/2023 emphasizes the complexity of capital structure and default risks and provides specific guidance for valuation experts.

Capital structure risks

• Capital structure risks: These relate to the increased fluctuation risks of the cash flows relevant to valuation due to increased gearing.
• Default risk: The risk of partial or complete interruption of expected or contractual cash flows over time, based on the individual probabilities of default of the cash flows to the various providers of capital.

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Insolvency costs and their impact on the valuation of companies

The note lists these key points for a comprehensive risk analysis:

• Consideration of insolvency costs: The costs associated with insolvency proceedings must be analyzed in detail and their impact on operational and capital structure risks must be understood.
• Expansion of default risk indicators: The note emphasizes the importance of ratings and proposes that further indicators for assessing default risks be taken into account.
• Insolvency costs in the narrower sense: Costs directly associated with the implementation of insolvency proceedings, such as court costs and consultancy fees, particularly relevant for companies with excessive debts.
• Insolvency costs in the broader sense: impact of increasing gearing on operating business models, including changes in cash flows due to stakeholder reactions.
• Analysis and adjustment: Auditors are required to carry out a plausibility assessment to check whether the management planning is appropriate and whether adjustments are necessary.
• Comparison of insolvency costs: The difference between companies with similar business models but different gearing can be determined by a peer group comparison.

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Influence on the company value

With increasing debt, default risks and insolvency costs have a significant impact on the total enterprise value and the market values of the investors. It is therefore recommended to take a differentiated view of the probability of default per investor, including the risk of default by other stakeholders.

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Indicators of default risks and their significance

IDW Valuation Guideline 1/2023 also deals in detail with the indicators for default risks, in particular the significance of ratings.

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Indications of high default risk

A high default risk can result from low credit ratings, rating downgrades or other indicators that point to a tense financing situation. The FAUB recommends a differentiated assessment of these indicators in conjunction with other indicators that reflect the financing situation, both at the overall company level and at the level of the individual investors.

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Credit spreads and structural models

Credit spreads from traded debt instruments or credit default swaps can be used to assess ratings and the calculated probability of default. In addition to the probability of default, these also include risk premiums and other pricing components.

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Wrapping it up

IDW Valuation Guideline 1/2023 offers comprehensive recommendations for taking gearing into account in business valuation. The precise analysis of capital structure risks, default probabilities and insolvency costs is crucial for an accurate valuation. smartZebra's tools and expertise can help to make these complex processes efficient and ensure accurate valuations.

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