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# Lost profits -discount rate-- part 2

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This presentation explains why and how damages for future lost profits should be discounted at the weighted average cost of capital (WACC).

Published in: Economy & Finance, Business
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### Lost profits -discount rate-- part 2

1. 1. Proving Damages for Lost Profits: Discounting at the Cost of Capital Professor Robert M. Lloyd University of Tennessee College of Law rlloyd@utk.edu 865.974.6840
2. 2. 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
3. 3. 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.
4. 4. 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.
5. 5. 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
6. 6. 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%
7. 7. 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%.
8. 8. 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
9. 9. 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
10. 10. 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
11. 11. 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.
12. 12. 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
13. 13. For extensive discussion of the cost of capital, see Shannon P. Pratt & Roger J. Grabowski, Cost of Capital: Applications and Examples (3d ed. 2008)
14. 14. 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.
15. 15. 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)
16. 16. 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)
17. 17. Other cases using the plaintiff’s cost of capital to discount lost profits
18. 18. 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).
19. 19. 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).
20. 20. Even plaintiff’s experts use cost of capital to discount future profits
21. 21. 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
22. 22. 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).