lost profits -discount rate-- part 2
DESCRIPTION
This presentation explains why and how damages for future lost profits should be discounted at the weighted average cost of capital (WACC).TRANSCRIPT
Proving Damages for
Lost Profits:
Discounting at the Cost
of CapitalProfessor Robert M. Lloyd
University of Tennessee College of
Law
865.974.6840
Most financial economists believe the
weighted-average cost of capital
(“WACC) is the appropriate rate for
discounting lost profits
• WACC is what it costs the plaintiff to obtain
the money it needs in its business
• WACC includes the cost of equity as well as
the cost of debt
The basic idea is that by receiving the lost
profits award at the time of judgment
instead of over time, the plaintiff has
avoided the necessity of paying for that
amount of capital.
The cost of borrowing is not an
appropriate measure of the discount rate
• A common fallacy is that the discount rate
should be based on the interest that would
be saved if the plaintiff used the damage
award to pay down its debt.
• This fails to account for the fact that an
enterprise with less debt has to pay less for
its equity capital.
WACC is calculated by:
• Determining the cost of each of the firm’s
sources of capital
• Multiplying that cost of by the percentage of
the firm’s capital attributable to that
component
• Summing the results
Example: Firm has two sources of capital,
debt that costs 5%, and equity that costs
12%. The total capital is 40% debt and
60% equity.
WACC = (.05 x .40) + (.12 x .60) = 0.092 or
9.2%
Determining the cost of debt:• Interest expense is tax-deductible, so the cost of
loans must be adjusted to show the after-tax
cost.
• Example: Firm pays 8% interest on a loan. Firm’s
marginal tax rate is 25%. Firm’s after-tax cost of
the loan is 6%.
Determining the cost of equity capital is
complex
● A variety of methods are used
● The methods are the same as those used to
value future cash flows when determining
the value of a firm
For large publicly-traded companies, the
capital asset pricing model (“CAPM”) is
most often used
● CAPM is based on the premise that a cash flow
certain to be received is more valuable than an
uncertain cash flow with equivalent expected
value
● The developers of CAPM received a Nobel Prize
in Economics for their work
Under CAPM,
Cost of equity = Rrf + (Beta x RPM)
where
Rrf = the risk-free rate of return
Beta = (volatility of this stock)/(volatility of
the market as a whole)
RPM = the risk premium of the market as a
whole
The build-up method is the most
commonly used method for smaller
companies.
As the name indicates, the cost of equity
is determined by summing the
components of the various factors that
affect it.
As with CAPM, the analyst begins with a
risk-free rate and adds to it a premium
for risk.
This premium may include:
● A general equity risk premium
● A small company premium
● A company-specific premium
For extensive discussion of the cost of
capital, see Shannon P. Pratt & Roger J.
Grabowski, Cost of Capital: Applications
and Examples (3d ed. 2008)
Where possible, the cost of capital used to
discount profits lost on a discrete project
is the cost of capital attributable to that
project.
● If the project is riskier than the plaintiff’s
business as a whole, the cost of capital will
reflect that and so should the discount rate.
Where Marriott International sought lost profits
on a management contract for a new hotel, the
court noted that Marriott’s WACC was 6.5%, but
it discounted the lost profits at 7.5% because
this income stream was “more risky than
Marriott’s aggregate stream of income.”
In re M Waikiki LLC, 2012 Bankr. LEXIS 2398 (Bankr.
D. Haw. 2012)
In a similar case, another bankruptcy court
discounted lost profits by adding 1% (for risk) to
the plaintiff’s WACC with respect to each of
two breached contracts and 2% to the WACC
with respect to a third contract involving
slightly more risk.
In re MSR Resort Golf Course,LLC, 2012
Bankr. LEXIS 3702 (Bankr. S.D.N.Y. 2012)
Other cases using the
plaintiff’s cost of
capital to discount lost
profits
A judge of the United States Court of
Claims performed a sophisticated cost of
capital analysis to determine that a 17%
discount rate was the proper rate to
apply to profits lost when the
government breached a contract.Spectrum Sciences & Software, Inc. v. United
States, 98 Fed. Cl. 8, 26 (2011).
When an expert in a coal-mining case used
a 10% discount rate based on the
company’s cost of capital, a bankruptcy
judge increased the rate to 15% “in light
of the normal attendant risks of mining
coal.”In re Clearwater Natural Resources, L.P., 421 B.R.
392, 399 (Bankr. E.D. Ky. 2009).
Even plaintiff’s
experts use cost of
capital to discount
future profits
One plaintiff’s expert discounted income
at the plaintiff’s cost of equity capital,
which he calculated at 20.6%.RMD, LLC v. Nitto Americas, Inc., 2012 U.S. Dist.
LEXIS 158107 (D. Kan. 2012) at *24
Another plaintiff’s expert discounted lost
profits at the plaintiff’s “weighted
average costs of capital and funding,
which was 7.44%.”
NCMIC Finance Corp. v. Artino, 637 F.
Supp.2d 1042, 1074 (S.D. Iowa 2009).