Discount Rates Primer

Topics: Weighted average cost of capital, Finance, Debt Pages: 10 (3112 words) Published: March 27, 2013
A Primer on Discount Rates
By Jeffrey L. Baliban – May 30, 2012

This is the second in a four-part series addressing the complex issues bankruptcy professionals encounter when dealing with fraudulent conveyance claims and other issues related to analyzing solvency. Read Part I.

A transfer of a debtor’s interest in property made within two years before the date of the filing of a petition may be a constructively fraudulent transfer and subject to avoidance by a trustee if it can be shown that the debtor was insolvent on the date the transfer was made, or that the debtor became insolvent as a result of such transfer (see Title 11 § 548(a)(1)). Further, “‘insolvent’ means [a] financial condition such that the sum of [an] entity’s debts is greater than all of such entity’s property, at a fair valuation” (see Title 11 § 101(32)(A)). Therefore, analyzing whether an entity is insolvent at any particular time is essentially a valuation exercise. The value of a going concern can be defined as the present value of the stream of economic benefits the entity is expected to generate in the future. Economic benefits are typically defined as cash flows generated by the business, hence the term discounted cash flow model or DCF. Therefore, value becomes a combination of a forecast of future cash flows and a risk-adjusted discount rate to convert the future benefit stream to a present value. While the cash flow forecasts themselves can be the subject of many interesting and often complex assumptions, the eyes of many an experienced litigator glaze over when the discussion turns to discount rates. Make no mistake: Discount rates and cost of capital are complex finance issues on which many an authoritative texts, treatises, and doctoral dissertations have been written. It is certainly not my intention in this series to delve into quantitative finance or the mathematics of optimal capital structure estimation. However, I will discuss some of the fundamentals of discount rate determination with which litigators should be familiar, especially when taking opposing valuation expert's deposition.

Discount Rate Basics
The terms “discount rate,” “cost of capital,” and “required rate of return” are often used interchangeably in business valuation. The following example with a simple incomeproducing asset illustrates why: Assume you paid face value for a $10,000 bond that earns interest at five percent, to be paid annually, and which matures in five years. At the end of the first year, you would get the first in a series of five future annual $500 payments and, at the end of the fifth year, the $10,000 principal is also returned—meaning $10,000 goes out and $12,500 ultimately comes back in. If we assume the annual $500 payments also earn interest at five percent, then at maturity the investment would be worth $12,762.82. Alternatively, the “present value” of this series of future cash flows discounted at five percent for five years is $10,000. This shows that a discount rate is in fact an interest rate. In this case, five percent is the annual rate charged, expressed as a percentage of the principal, by the Published on the Bankruptcy & Insolvency webpage of the Section of Litigation’s Bankruptcy & Insolvency Litigation Committee, May 2012. © 2012 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

lender (bond purchaser) to the borrower (bond issuer) to use lender’s $10,000 for five years (i.e., the borrower’s cost of capital for this transaction is five percent, before any tax consideration). Similarly, because the bond purchaser agreed to invest, her required rate of return on this $10,000 investment to this issuer was five percent. In this simple example—and assuming there is zero...
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