Cost of capital in litigation : application and examples

329 Pages·2010·3.598 MB·English

by  Grabowski, Roger J., Pratt, Shannon P

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Cost of Capital
in Litigation
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E1FFIRS 09/07/2010 11:17:51 Page3
Cost of Capital
in Litigation
Applications and Examples
SHANNON P. PRATT
ROGER J. GRABOWSKI
John Wiley & Sons, Inc.
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Pratt,ShannonP.
Costofcapitalinlitigation:applicationandexamples/ShannonP.Pratt,RogerJ.Grabowski.
p.cm.—(Wileyfinanceseries)
Includesbibliographicalreferencesandindex.
ISBN978-0-470-88094-4(cloth);978-0-470-94491-2(ebk);978-0-470-94936-8(ebk);
978-0-470-94937-5(ebk)
1. Capitalinvestments. 2. Capitalinvestments—Lawandlegislation—UnitedStates. 3. Business
enterprises—Valuation. 4. Businessenterprises—Valuation—Lawandlegislation—UnitedStates.
I. Grabowski,RogerJ. II. Title.
HG4028.C4P7242011
658.152—dc22
2010019071
PrintedintheUnitedStatesofAmerica
10 9 8 7 6 5 4 3 2 1
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Dedication
To ourfamiliesfortheirsupportandencouragement,withoutwhichourcareers
andthisbookwouldnothavebeenpossible
Millie
SonMikePratt DaughterSusieWilder
Daughter-in-law BarbaraBrooks Son-in-law TimWilder
RandallandKenny John,Calvin,andMeg
Portland,OR Springfield,VA
SonStevePratt DaughterGeorgiaSenor
Daughter-in-law Jenny Pratt Son-in-law TomSenor
AddyandZeph Elisa,Katie,andGraham
Portland,OR Fayetteville,AR
MaryAnn
SonRogerGrabowski,Jr. DaughterSarahHarte
Daughter-in-law Misako Takahashi Son-in-law MichaelHarte
Rob andSayaka KevinandRosemary
Tokyo,Japan Evanston,IL
DaughterJuliaGrabowski,MD SonPaulGrabowski
Pittsburgh,PA Daughter-in-law MelissaRuiz,MD
Chicago,IL
E1FTOC 09/07/2010 11:20:49 Page7
Contents
AbouttheAuthors xi
Foreword xix
Preface xxi
Acknowledgments xxv
NotationSystemandAbbreviationsUsedinThisBook xxvii
CHAPTER1
CostofCapitalBasics 1
Introduction 1
Componentsofa CapitalStructure 2
CharacteristicsofCostofCapital 3
CostofCapitalEqualstheDiscountRate 4
NetCashFlow 6
DiscountRateIsNottheSameasCapitalizationRate 12
CostofCapitalShouldReflectRisk oftheInvestment 19
CHAPTER2
EstimatingtheCostofEquityCapitalandtheOverallCostofCapital 25
Introduction 25
EstimatingtheCostofEquityCapitalbytheBuild-upMethod 26
EstimatingtheCostofEquityCapitalbytheCapitalAssetPricingModel 32
OtherMethodsforEstimatingtheCostofEquity Capital 41
Overall(WeightedAverage)CostofCapital 45
CHAPTER3
Other CostofCapitalConsiderations 54
Introduction 54
StandardofValue 55
HandlingDiscountsforLack ofMarketability 55
How theCostofCapitalRelates totheExcessEarnings
MethodofValuation 58
vii
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viii CONTENTS
AdjustingtheDiscountRatetoAlternativeEconomicIncomeMeasures 63
ConvertingfromAfter-Tax RatestoPretax Rates 64
CHAPTER4
CostofCapitalinEstateandGiftTaxMatters 67
Introduction 67
AcceptanceandRejectionofDCF 67
EvaluationofCashFlow Forecasts 70
EquityRateversusWACC 70
Build-up,CAPM,orSomethingElse? 71
CostofEquity 71
ConsistencyofData 73
CourtsDemandSupportingDetail 74
CostofCapitalfora RegulatedCompany 76
SCorporations 76
Summary 77
CHAPTER5
CostofCapitalConsiderationsinCorporate
RestructuringandOther FederalTaxMatters 79
Introduction 80
LegalEntityValuations 81
IntercompanyDebt 93
WorthlessStock 95
TransferPricingDisputes 96
Summary 100
CHAPTER6
CostofCapitalIncludedinDamageCalculations 101
Introduction 101
WhyDiscountingIsNecessary 101
Isa Risk-freeDiscountRateAppropriate? 103
CostofCapitalIstheAppropriateRisk-AdjustedDiscountRate 109
Tax Effects 114
CommonErrorsinDiscountingLostProfits 114
ExclusionofExpertTestimony 117
Summary 119
CHAPTER7
CostofCapitalinIntellectualPropertyDisputes 120
Introduction 121
CategoriesofIntellectualPropertyDisputes 122
CostofCapitalIssuesinIntellectualPropertyDisputes 129
CourtGuidanceRegardingDiscountRateSelection 131
OtherConsiderations 135
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Contents ix
Summary 139
CHAPTER8
CostofCapitalinBankruptcy 141
Introduction 141
CostofCapitalforDebt:CramDownInterestRates 142
CostofCapitalforAssets 147
CostofCapitalfora BusinessEnterprise 152
Summary 159
CHAPTER9
CostofCapitalinAppraisalandFairnessCases 161
Introduction 161
DiscountedCashFlow inDelawareLaw 162
CapitalAssetPricingModel 163
ComponentsofWeightedAverageCostofCapital 164
Build-upMethod 181
AdditionalPoints 182
RoleoftheExpert 182
Summary 184
CHAPTER10
CostofCapitalinFamilyLawMatters 185
Introduction 185
CostofEquityCapitalversusWACC 186
CapitalStructure:IndustryversusBusiness 193
SolvingforMarketValueWeightProportions
andtheCostofEquityCapital 197
TheHiddenImpactofRounding 197
CostofCapitalinFamilyLaw Courts 199
Summary 202
CHAPTER11
CostofCapitalinAdValoremTaxation 203
Introduction 204
UnitaryPropertyCostofCapitalbyState 206
CompanyCostofCapitalversusAssetCostofCapital 209
AssessedValueversusMarketValue 214
GeneralCategoriesofLegislativeConstraintsThat
NecessitateAdjustmentstotheCostofCapital 216
CapitalStructure 219
WeightedAverageCostofCapital 220
AdValoremTax Adder 228
FlotationCosts 229
WACCversusWARA 230
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x CONTENTS
CostofCapitalintheCourts 232
Summary 232
CHAPTER12
CostofCapitalinRegulatedIndustries 233
Introduction 234
Overview ofRegulatoryDecision-makingProcess 234
RoleforCostofCapital 236
AlternativeApproachestoSettingCostofCapital 238
SpecificIssuesbyTechnique 251
OtherMethods BeingDeveloped 257
RailroadCostofCapitalIssues 258
Summary 262
CHAPTER13
QuestionstoAskBusinessValuationExperts 264
Introduction 264
ExaminationOutline 264
AppendixIBibliography 273
AppendixIIInternationalGlossaryofBusinessValuationTerms 277
Index 285
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About the Authors
Dr. Shannon P. Pratt, CFA, FASA, ARM, MCBA, ABAR, CM&AA, is the
chairman and CEO of Shannon Pratt Valuations, Inc., a nationally recognized
business valuation firm headquartered in Portland, Oregon. He is also the
founder and editor emeritus of Business Valuation Resources, LLC, and one of
the founders of Willamette Management Associates, for which he was a man-
aging director for almost 35 years.
Hehasperformedvaluationassignmentsforthesepurposes:transaction(acquis-
ition, divestiture, reorganization, public offerings, public companies going private),
taxation (federal income, gift, and estate, and local ad valorem), financing (securiti-
zation,recapitalization,restructuring), litigationsupportand dispute resolution(in-
cluding dissenting stockholder suits, damage cases, and corporate and marital
dissolutioncases),andmanagementinformationandplanning.Hehasalsomanaged
a variety of fairness opinion and solvency opinion engagements. He regularly
reviewsbusinessvaluationreportsforattorneysinlitigationmatters.
Dr. Pratt has testified on hundreds of occasions in such litigated matters as dis-
senting stockholder suits, various types of damage cases (including breach of con-
tract,antitrust,andbreachoffiduciary duty),divorces,andestateandgifttax cases.
Among the cases in which he has testified are Estate of Mark S. Gallo v. Commis-
sioner,CharlesS.Foltz,etal.v.U.S.News& WorldReportetal.,Estate of Martha
Watts v. Commissioner, and Okerlund v. United States. He has also served as an
appointedarbitratorinnumerouscases.
Previous Experience
BeforefoundingWillametteManagementAssociatesin1969,Dr.Prattwasa profes-
sor of business administration at Portland State University. During this time, he di-
rected a research center known as the Investment Analysis Center, which worked
closelywiththeUniversityofChicago’sCenterforResearchinSecurityPrices.
Education
DoctorofBusinessAdministration,Finance,Indiana University.
BachelorofArts,BusinessAdministration,UniversityofWashington.
Professional Affiliations
Dr. Pratt is an accredited senior appraiser and fellow (FASA), certified in business
valuation, of the American Society of Appraisers (their highest designation) and is
xi