Discount rates are often one of the most heavily scrutinized inputs to a business loss quantification or fair market valuation in the context of an expropriation, and for good reason. lthough discount rates may be used in different contexts, the most common uses are to present value future cash flows or develop a capitalization rate for a fair market valuation. In practice, discount rates are typically derived through an estimate of the cost of capital (meaning the cost of a company’s debt and equity or that of a prospective purchaser), however, market transactions are often used as a benchmark to check for reasonability.
What does the discount rate represent?
The discount rate represents a rate of return that a hypothetical investor would likely require to invest their capital in the subject business or stream of cash flows. This rate of return considers two distinct components:
- The time value of money; and
- Risk or uncertainty of achieving future cash flows
TIME VALUE OF MONEY
The concept of time value of money is relatively straight forward. It follows the fundamental economic principal that a dollar today is worth more than a dollar tomorrow [1]. Since compensation to an owner in an expropriation context is generally awarded as a lump sum and not on a periodic basis, losses attributable to future periods must be converted into a present value as at an appropriate valuation date (often date of trial or tribunal) in order to properly indemnify the owner. Since this component is based on the time value and not on the underlying risk of achieving the cash flows, a risk-free rate of return such as a government bond rate tailored to the specific time-horizon of the cash flows is often the most appropriate measure. This risk-free rate fluctuates, but at the present it is generally between 1% to 4%. Benchmark data, such as government bond rates (U.S. or Canada) are used because they are relatively riskless and cause little debate among experts when used.
RISK OF ACHIEVING FUTURE CASH FLOWS
The second, and much less straight forward, component of a discount rate is the risk or uncertainty of achieving future cash flows. To complicate matters, the risk of a business achieving future cash flows as a whole may be different from the risk associated with a particular stream of cash flows. For example, the discount rate used in a fair market valuation of an automotive company may be 20% [2] but the discount rate used to quantify a business loss for the truck manufacturing division of the same automotive company may be 30%. The reason why these discount rates may differ is because the automotive company and the truck division may have different underlying risks associated with achieving their respective cash flows. In this case, it is possible that the truck division of the business has more competition, is dependent on one key customer and has only one product, whereas the automotive company, as a whole, may have a very broad customer base, a wide range of products and a long operating history. Although the automotive company assumes the risks of its truck division, when looking at the entire automotive company the risk profile may be lower. In addition, a fair market valuation may consider the capital structure (levels of debt and equity) of the automotive company whereas business loss quantification may not. Despite this example, it is quite common for the discount rate of an operating division and the company as a whole to be the same. However, the important takeaway is that the discount rate may vary depending on the context of the assignment (fair market valuation vs. business loss quantification) and whether the level of risk or uncertainty associated with the future cash flows is different (i.e. a division of a company vs. the entire company).
In essence, the cost of equity (equity component of the cost of capital) in any business or stream of cash flows can be broken down into two elements of risk:
- Market Risk
- Company/Cash Flow Specific Risk
MARKET RISK
Market risk is the unavoidable risk that is inherent in an industry or market as a whole and cannot be controlled. It is frequently measured based on the volatility (the “Beta”) of publically traded comparable companies in a specific industry relative to the market as a whole. Market risk can also be derived from a published industry risk premium [3]. The more volatile the industry, the greater the risk and vice-versa. This component of risk is generally less subjective than a company/cash flow specific risk premium since it is based on actual market data, however, the selection of public comparable companies used in the analysis or industry in which the business is classified can produce a range of results.
In addition to industry risk, market risk typically includes equity risk and size premiums which adjust the cost of equity by the additional return required by investors to hold equities over bonds, and for the risk associated with the size of the subject business. These premiums are also based on benchmark market data and are less subjective than the company specific risk premium and often not as heavily criticized.
COMPANY/CASH FLOW SPECIFIC RISK
Company and cash flow specific risk is often where the art of business valuation and loss quantification takes over and science takes a backseat. Each company and stream of cash flows has its own unique characteristics with both positive and negative factors that influence the level of risk. The list below sets out some common examples of factors considered:
Positive |
Negative |
High barriers to entry in the market |
Reliance on key customer / supplier |
Strong operating history and stable earnings |
Reliance on key management employee |
Highly diversified customer / supplier base |
Obsolescence of technology |
Long-term contracts with customers |
Lack of product/service diversification |
Stable and developed management structure |
High staff turnover / lack of available skilled labour |
Ownership of valuable intellectual property |
High political / environmental risk |
At this point, you are likely wondering how a range of different positive and negative risk factors translates into a company specific risk rate. As mentioned earlier, it’s more of an art than a science and each factor needs to be considered independently and weighted based on the expert’s evaluation of the impact to the cash flows or business as a whole. There is no commonly used approach and professional judgement is required, however, a range of different techniques can be used by an expert to evaluate the reasonability of the company specific risk premium selected.
In conclusion, if you use expert valuation and business loss reports in your cases, having a solid understanding of the factors that influence a discount rate will put you a step ahead when navigating through complex valuation matters with your client.
