Cost of Capital in Litigation: Applications and Examples / Edition 4

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Cost of Capital in Litigation: Applications and Examples

The "cost of capital" is the expected rate of return for the purpose of attracting funds, and its estimation has long been recognized as one of the most critical elements in business valuation and damages calculations. Addressing the many different methods of calculating value and different standards of value, Cost of Capital in Litigation delves deeply into the myriad reasons why and how courts may differ in their decisions based on the topic, jurisdiction, or available evidence.

Because cost of capital is critical to the valuation of any ongoing business, the thorough understanding, analysis, and presentation of cost of capital issues goes a long way toward winning in court. Navigating deftly between fundamentals and intricate nuances, Cost of Capital in Litigation addresses the needs of those in the valuation profession who require both introductory materials and detailed analysis. Shannon Pratt and Roger Grabowski—two major figures in the world of business valuation—draw on their decades of experience in business valuations and as expert witnesses to highlight major decisions as well as errors to avoid.

A valuable resource for attorneys and valuation experts, Cost of Capital in Litigation includes:

  • A useful summary of investment and valuation fundamentals, including explanations of economic theories and valuation models
  • The cost of capital and discount rates in various court cases, including estate and gift tax cases, intellectual property disputes, bankruptcies, and family law cases
  • Exceptionally detailed reviews of the methodology propounded by experts, and those accepted or rejected by courts, along with commentary on the experts' and courts' reasoning and analysis
  • Summaries of existing court decisions, plus discussion of flaws in reasoning, methodology, and analysis that should be considered in the future by litigants, experts, attorneys, and judges
  • A summary of how the Delaware Court of Chancery and the Delaware Supreme Court have viewed the discounted cash flow method
  • Summaries of cost of capital guidelines used by state assessment authorities in unitary assessment matters
  • Comprehensive discussion of cost of capital methods used in regulated industries for rate making

Complemented by a foreword by David Laro, Judge of the United States Tax Court, Cost of Capital in Litigation will help professionals in the legal, financial and accounting fields develop a thorough understanding of court decisions within the context of the theory of cost of capital.

The "father of business valuations," SHANNON P. PRATT is the author of several bestselling Wiley business valuation publications and also a sought-after speaker at business valuation industry conferences. He is the managing owner of Shannon Pratt Valuations, Portland, Oregon. He has served as supervisory analyst for over 3,000 business valuation engagements in forty years and as an expert witness in numerous state and federal courts on contested business valuations.

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Product Details

  • ISBN-13: 9780470880944
  • Publisher: Wiley
  • Publication date: 11/9/2010
  • Series: Wiley Finance Series
  • Edition number: 4
  • Pages: 301
  • Sales rank: 427,727
  • Product dimensions: 7.20 (w) x 10.00 (h) x 1.30 (d)

Meet the Author

Roger J. Grabowski is Manag-ing Director of Duff & Phelps LLC in Chicago, Illinois, and author of the annual Duff & Phelps Risk Premium Report. He is the co-author of Cost of Capital, Third Edition, and has authored several articles during the crisis that began in 2008, including "Cost of Capital Estimation in the Current Distressed Environment," featured in the Journal of Applied Research in Accounting and Finance. Grabowski has testified in court as an expert witness on many valuation issues.

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Table of Contents

About the Authors xi

Foreword xix

Preface xxi

Acknowledgments xxv

Notation System and Abbreviations Used in This Book xxvii

CHAPTER 1: Cost of Capital Basics 1

Introduction 1

Components of a Capital Structure 2

Characteristics of Cost of Capital 3

Cost of Capital Equals the Discount Rate 4

Net Cash Flow 6

Discount Rate Is Not the Same as Capitalization Rate 12

Cost of Capital Should Reflect Risk of the Investment 19

CHAPTER 2: Estimating the Cost of Equity Capital and the Overall Cost of Capital 25

Introduction 25

Estimating the Cost of Equity Capital by the Build-up Method 26

Estimating the Cost of Equity Capital by the Capital Asset Pricing Model 32

Other Methods for Estimating the Cost of Equity Capital 41

Overall (Weighted Average) Cost of Capital 45

CHAPTER 3: Other Cost of Capital Considerations 54

Introduction 54

Standard of Value 55

Handling Discounts for Lack of Marketability 55

How the Cost of Capital Relates to the Excess Earnings

Method of Valuation 58

Adjusting the Discount Rate to Alternative Economic Income Measures 63

Converting from After-Tax Rates to Pretax Rates 64

CHAPTER 4: Cost of Capital in Estate and Gift Tax Matters 67

Introduction 67

Acceptance and Rejection of DCF 67

Evaluation of Cash Flow Forecasts 70

Equity Rate versus WACC 70

Build-up, CAPM, or Something Else? 71

Cost of Equity 71

Consistency of Data 73

Courts Demand Supporting Detail 74

Cost of Capital for a Regulated Company 76

S Corporations 76

Summary 77

CHAPTER 5: Cost of Capital Considerations in Corporate Restructuring and Other Federal Tax Matters 79

Introduction 80

Legal Entity Valuations 81

Intercompany Debt 93

Worthless Stock 95

Transfer Pricing Disputes 96

Summary 100

CHAPTER 6: Cost of Capital Included in Damage Calculations 101

Introduction 101

Why Discounting Is Necessary 101

Is a Risk-free Discount Rate Appropriate? 103

Cost of Capital Is the Appropriate Risk-Adjusted Discount Rate 109

Tax Effects 114

Common Errors in Discounting Lost Profits 114

Exclusion of Expert Testimony 117

Summary 119

CHAPTER 7: Cost of Capital in Intellectual Property Disputes 120

Introduction 121

Categories of Intellectual Property Disputes 122

Cost of Capital Issues in Intellectual Property Disputes 129

Court Guidance Regarding Discount Rate Selection 131

Other Considerations 135

Summary 139

CHAPTER 8: Cost of Capital in Bankruptcy 141

Introduction 141

Cost of Capital for Debt: Cram Down Interest Rates 142

Cost of Capital for Assets 147

Cost of Capital for a Business Enterprise 152

Summary 159

CHAPTER 9: Cost of Capital in Appraisal and Fairness Cases 161

Introduction 161

Discounted Cash Flow in Delaware Law 162

Capital Asset Pricing Model 163

Components of Weighted Average Cost of Capital 164

Build-up Method 181

Additional Points 182

Role of the Expert 182

Summary 184

CHAPTER 10: Cost of Capital in Family Law Matters 185

Introduction 185

Cost of Equity Capital versus WACC 186

Capital Structure: Industry versus Business 193

Solving for Market Value Weight Proportions

and the Cost of Equity Capital 197

The Hidden Impact of Rounding 197

Cost of Capital in Family Law Courts 199

Summary 202

CHAPTER 11: Cost of Capital in Ad Valorem Taxation 203

Introduction 204

Unitary Property Cost of Capital by State 206

Company Cost of Capital versus Asset Cost of Capital 209

Assessed Value versus Market Value 214

General Categories of Legislative Constraints That

Necessitate Adjustments to the Cost of Capital 216

Capital Structure 219

Weighted Average Cost of Capital 220

Ad Valorem Tax Adder 228

Flotation Costs 229

WACC versus WARA 230

Cost of Capital in the Courts 232

Summary 232

CHAPTER 12: Cost of Capital in Regulated Industries 233

Introduction 234

Overview of Regulatory Decision-making Process 234

Role for Cost of Capital 236

Alternative Approaches to Setting Cost of Capital 238

Specific Issues by Technique 251

Other Methods Being Developed 257

Railroad Cost of Capital Issues 258

Summary 262

CHAPTER 13: Questions to Ask Business Valuation Experts 264

Introduction 264

Examination Outline 264

Appendix I Bibliography 273

Appendix II International Glossary of Business Valuation Terms 277

Index 285

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