VALUATION ISSUES IN SHAREHOLDER
DISSENT AND OPPRESSION CASES:
The Cost of Capital in Appraisal Cases
Gilbert E. Matthews, CFA
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•The cost of capital is a vital issue in DCF valuations
for appraisals in shareholder dissenter actions.
•Delaware has effectively set the standards for
•DCF is the preferred valuation method in Delaware.
•Delaware thus sets the standards for determining
the cost of capital.
oValuators should be guided by Delaware
approach for valuations generally, and
specifically for determining cost of capital.
•Most cases discussing details of methodology have
come from the Delaware Court of Chancery.
•Very few published non-Delaware decisions discuss
cost of capital.
oLower court decisions in other states are rarely
oAppellate cases rarely discuss the details of
oThere are few Federal District Court valuation
DCF Accepted in Weinberger
•Delaware Supreme Court said in 1983 that
determination of fair value “must include proof of
value by any techniques or methods which are
generally considered acceptable in the financial
community.” (Weinberger, 1983)
•Delaware Supreme Court approved using DCF in
appraisals, saying that “elements of future value . .
. which are known or susceptible of proof as of the
date of the merger . . . may be considered” in
•“While DCF analyses have become the dominant
approach in appraisal proceedings since Weinberger,
the ultimate selection of a valuation framework
remains within the court's discretion.” (Andoloro, 2005)
The Court of Chancery has rejected DCF valuations
on several occasions for various reasons, primarily
because quality of projections was inadequate.
•The courts continue to use other valuation methods,
principally guideline company method.
DCF in Delaware Law
CAPM in Delaware Law
•CAPM was used in Delaware in Technicolor (1990).
•The Court usually uses CAPM and has applied CAPM
even when future results are highly speculative.
•It rejected a 35%-45% venture capital cost of equity and
used a 21% CAPM-based number. (Gilbert, 1997)
•It accepted a 30% discount rate calculated using CAPM
and rejected a 17.7% rate. (Ryan, 1996)
•However, for a small biotech company, the Court used
the 50% that had been used by investment banker as
financial advisor. (Gray, 2002)
•Delaware accepts 20-year Treasury rate as measure
of the risk-free rate.
•Only Delaware decision that addressed this issue
rejected 30-year Treasury yield as risk-free rate and
stated that “using the 20-year Treasury rate is . . .
in keeping with the accepted practice.” (MedPointe,
•However, U.S. District Court in Nevada based risk-
free rate on 5-year Treasuries. (Steiner, 1998)
Cost of Equity – Ibbotson
•Delaware decisions which have used CAPM to
calculate cost of capital most frequently employed
equity risk premium of 7.0% to 7.2% based on
•Courts have used these rates because most
testimony used equity premiums based on
Ibbotson data using time periods starting in 1926.
•No case discusses expert testimony using lower
equity risk premiums based on shorter time
Cost of Equity – Fama-French
•Fama-French method has been favorably received in
recent years in limited number of cases in which
experts have used it.
•In 2004 Vice Chancellor Strine rejected 7.3% equity
premium and instead accepted 4.5% equity
premium derived using Fama-French, stating:
Although the Fama-French three-factor CAPM model
is not wholly accepted, neither is the original CAPM
itself. By better factoring in the real risks of
leverage, the Fama-French model captures useful
data that contributes to a more reliable and real-
world cost of capital. (Union Illinois, 2004)
Cost of Equity – Fama-French
•Equal weight was given to Fama-French and CAPM
in more recent decision. (PNB Holding, 2006)
•Given growing acceptance of Fama-French model in
financial community, testifying experts will likely
use it more frequently in the future.
Cost of Equity –
A Major Decision in 2010
•In 2010 Strine rejected 7.1% ERP based on historical
data and accepted 6.0% ERP based on expert’s
teaching experience, relevant literature, and supply
side ERP reported in the 2007 Ibbotson Yearbook.
[Global GT, 2010]
•There are “persuasive reasons support[ing] a lower
forward-looking real return on equity than the
return found in the historical data.”
Cost of Equity –
A Major Decision in 2010 continued
•Surveys cited by expert suggested that current
academic thinking would put the ERP closer to 6.0%
than to 7.1%.
1926 . . . has no magic as a starting point for
estimating long-term equity returns. . . . [W]ell-
respected scholars have made estimates in peer-
reviewed studies of long-term equity returns for
periods much longer than Ibbotson, and have come
to an estimate of the ERP that is closer to the supply
•Strine noted that ERP for companies operating in
foreign markets may be lower than for a domestic
Cost of Equity –
A Major Decision in 2010 continued
•He explained why he no longer relied on Historic
ERP, which the Court had previously used.
[W]hen the relevant professional community has mined
additional data and pondered the reliability of past
practice and come, by a healthy weight of reasoned
opinion, to believe that a different practice should
become the norm, this court's duty is to recognize that
practice if, in the court's lay estimate, the practice is
the most reliable available for use in an appraisal.
•Strine recognized that ERP remains an estimate
based on uncertainty and leaves responsibility for
resolving debate to valuation profession: “[T]he
relevant academic and professional community and
not this court should develop the accepted
Cost of Debt
•The Court has determined that a company’s pre-
transaction borrowing cost is the appropriate cost
of debt in an appraisal.
•The reason is that the entity being appraised is the
company as it existed before the transaction.
Cost of Debt – Technicolor
•The one case in which pre-transaction borrowing cost
was not used is not, in fact, actually an exception:
oTechnicolor was acquired in a two-step transaction,
a third-party tender offer followed somewhat
belatedly by a squeeze-out.
oTherefore, it was valued under a new business plan
which became operative after the tender offer but
before the squeeze-out occurred .
oTherefore, the Court did not use Technicolor’s pre-
tender offer borrowing cost but instead used the
interest rate on the acquirer’s debt. (Technicolor,
Cost of Debt After Tax
When the Court of Chancery computes WACC for a
C Corporation, it tax-effects the cost of debt based
on the company’s marginal corporate tax rate.
•When the Court appraised an S Corporation in 1991,
it did not tax-effect the cost of debt. (Radiology
oHowever, in a recent case valuing a debt-
S corporation, the Court tax-effected earnings
based on taxes payable by shareholders.
(Delaware Open MRI, 2006)
oThus, the Court is likely similarly to tax-
S Corporation debt in the future.
Cost of Debt After Tax continued
•When there were NOLs, the Court of Chancery
applied a full tax rate, because “deductions for
interest payments would allow the Company to
save its NOLs for subsequent years.” (Gholl, 2004)
•When a company could only deduct part of its
interest for U.S. taxes, a Federal court prorated
the tax effect. (Steiner, 1998)
•The Court accepts the concept that the equity risk
premium must be adjusted for an appropriate beta.
•When shares of the company being appraised were
actively traded, customary practice is to determine
beta by reference to its own market prices.
•If a company is private or if it is thinly traded, the
Court looks at the betas of guideline companies.
[Using] the median beta of comparable
companies . . . is the customary method
of determining a beta for a privately held
company. (Hintmann, 1998)
The Court Questions Beta Based
on Guideline Companies
•However, Vice Chancellor Strine expressed concern
about determining beta for private companies
based on the betas of guideline public companies:
I am chary about concluding that corporations
that issue illiquid securities for which beta . . .
is indeterminable have a lower cost of equity than
publicly-listed corporations whose durability is
reflected in a trading history producing a reliable
beta. (PNB Holding, 2006)
Beta Should Not Be Based on a
•The Court generally prefers betas based on long
•However, one decision gave equal weight to two-
year betas and five-year betas of guideline
companies. (Andaloro, 2005)
oFor both periods, the Court gave greater weight
to betas of companies deemed to be more
Beta Based on Guideline Companies
Should Consider Relative Risk
•Beta should be adjusted to reflect incremental risk
when subject company is smaller and more
vulnerable than guideline companies:
The plaintiff's expert derived Cell Tech's beta
of 2.0 from th[e] ‘comparable’ company's beta
of 2.2, thereby suggesting that Cell Tech involved
lower risk than did the ‘comparable’ company. The
comparison is factually unsupported. (Ryan, 1996)
•The Court rejected beta of 0.63 for a thinly traded
limited partnership’s units and used defendant’s
expert’s beta of 3.35. (Gotham Partners, 2000)
Raw Beta or Adjusted Beta?
•In 1998 Vice Chancellor Steele use raw beta:
Although “adjusted" beta may be appropriately used
in future cases when supported by a record subject
to the crucible of cross-examination, I find that
petitioner did not meet his burden to prove why
“adjusted” beta should be used in this case. (Gilbert,
•Later, Chancellor Chandler questioned the use of
raw beta and instead utilized adjusted beta:
Betas based on observed historical data are
more representative of future expectations
when they are adjusted. (JRC Acquisition, 2004)
Beta or Adjusted Beta? continued
•In 2010 Vice Chancellor Strine rejected an adjusted
beta for a foreign company, commenting that "no
reliable literature or evidence was presented” to
show that the beta of a company operating in
Russia would revert to 1.0. (GT Global, 2010)
•Instead, he looked at raw beta and industry betas.
•He concluded, "I find that a beta that gives 2/3
weight to the Bloomberg historic raw beta of 1.32
and 1/3 weight to the 1.24 industry beta is the best
approach to this DCF analysis.”
•In appraisal cases, Delaware uses the actual capital
structure at the valuation date rather than a hypo-
thetical capital structure based on industry norms.
oDebt incurred in the transaction leading to the
appraisal is not considered.
oThe Court rejected a debt-free capital structure
when the company being appraised had a
oOn the other hand, it did not accept an
assumption that the control shareholder would
have perpetually rolled over a leveraged
subsidiary’s existing debt. (Andoloro, 2005)
Capital Structure continued
•In contrast, a U.S. District Court applying Nevada
appraisal law did not accept the company’s actual
capital structure, saying that it was “not precluded
from using the industry average . . . [even though] .
. . management has ‘no plans’ to change the capital
structure.” (Steiner, 1998)
•It should be noted that in fairness cases, Delaware
does consider acquisition value and accepts the use
of “an ‘optimal’ debt/equity structure.” (Wacht, 1994)
•No decision discusses the fact that the cost of
equity itself is a function of the capital structure.
Capital Structure Circularity
•A 2004 decision discussed the issue of
indeterminate equity value in determining capital
[The] assumed $10.38 per share . . . and . . .
assumed $41.16 per share ‘enterprise value[s]’
are identical to the ultimate ‘fair value’ that
each expert determined . . . exemplify[ing] the
ultimate circularity inherent in WACC.
The only sensible way (in the Court's view) to
avoid the circularity . . . is to use an enterprise
valuation . . . that is not litigation-driven.
(Emerging Communications, 2004)
Industry Risk Premium
•The Court has rarely discussed the industry risk
premium in CAPM context.
•The only extensive discussion was by Vice
Chancellor Strine when he treated a negative
industry risk premium as a proxy for a private
Under the CAPM, the equity risk premium is . . .
adjusted by an estimate of the systematic risk
of the subject company reflected by its actual
or estimated beta. The industry return data
that Mitchell uses is an acceptable substitute
for that adjustment in this situation when a
beta cannot be estimated. (Delaware Open MRI, 2006) 27
•Court “has traditionally recognized the
existence of a small stock premium in appraisal
matters.” (ONTI, 1999)
oThere is finance literature supporting position
that stocks of smaller companies are riskier than
securities of large ones and, therefore, command
higher expected rate of return in market.
(Emerging Communications, 2004)
•Court of Chancery recognizes that concepts of
beta and small company premium are distinct
and that size premium measures risk that is
not measured by beta. (JRC Acquisition, 2004)
Size Premium May Be Rejected
•Court may decide, however, that based on facts
and circumstances, size premium should not be
I cannot conclude that it has been persuasively
shown that the statutory fair value of Technicolor
stock would more likely result from the inclusion of
a small capitalization premium than from its
exclusion. (Technicolor, 1990)
Size Premium in Alabama Case
•Alabama appraisal decision accepted defendant’s
expert’s size premium that used both:
a) “micro-capitalization risk premium” of 3.5%
(because “[t]he typical small company has a
higher degree of investment risk than a similar,
but larger company”) and
b) “company size premium” of 4.35% (“[s]ince a
small, closely-held company is usually restricted
to narrower markets than publicly-traded
companies, an additional small company
premium is warranted”) (Baron Services, 2003)
Size Premium Data
•The Court must consider whether to use size
premiums based on data starting in 1926 or
starting at a later date.
•In one case, the Court weighted the historical
premium data for various periods:
[T]he difference in returns over sixty-nine
years is much greater than that over other,
perhaps equally valid periods of time. . . .
I think the better approach is to weight the
more recent results more heavily than the
older ones. . . . I will take the returns over
the past 14, 28, 42, 56, and 69 years and
average them. (ONTI, 1999)
Size Premium for Foreign Business
•Application of size premium to foreign businesses
was discussed in 2006 Court of Chancery decision.
The general weight of the scholarship, in
summary, seems to be that the small-size
premium might well apply in the same way
as in the U.S. in more highly developed
foreign markets, and would not apply to
the same extent, or at all, in newly developing
markets (Gesoff, 2006).
Size Premium Circularity
•Court recently raised “issue of circularity” that
arises because selection of a size premium is
function of assumed value of enterprise:
[A] discounted cash flow analysis both values
the size of a company . . . and relies on the
appropriate Ibbotson premium to determine
the value of the company. This process is
circular; which should come first, the valuation
of the company or the selection of the Ibbotson
risk premium? (Sunbelt Beverage, 2010)
•Court decided to use weighted average of Ibbotson
size premiums for the two deciles into which the
subject company's value might fall.
The Court Is Reluctant to Apply a
Company-Specific Risk Premium
•In past ten years, Court has usually declined to
apply company-specific risk premium.
•Company-specific premiums can only be included
with evidence produced at trial that persuades
Court to accept adjustment. (Gesoff, 2006; Sunbelt
•On balance, current reluctance of courts to accept
company-specific premiums means that expert who
uses this premium should expect strong challenge
on the stand.
The Court Accepted Company-
Specific Risk Premiums in the 1990s
•However, in Delaware fairness case, Court criticized
plaintiff’s expert for not using company-specific
premium in calculating WACC. (Wacht, 1994)
•Court accepted company-specific risk premium in
1999 appraisal, noting that no beta had been
calculated by the experts, and explained:
I am willing to accept that the addition of a
company-specific premium is appropriate in the
absence of beta [emphasis added]. (ONTI, 1999)
•Court usually rejects build-up method because
CAPM “offers more complete information.”
oHowever, build=up model has been accepted in
some later decisions. (Gholl, 2004; Henke, 2005)
oIn contrast to its approach in CAPM, Court
accepts use of the company-specific premium in
applying build-up method.
Build-Up Method continued
•Court has used build-up method and company-
specific premium when Beta has been unavailable:
[N]ot all public companies have a sufficient public
float for trading in their shares to provide a reliable
beta for use in calculating their cost of capital,
forcing a resort to the use of data from the industry
or so-called comparable companies. (Delaware Open
•U.S District Court appraisal under Missouri law
applied the build-up method. (Swope, 2001)
•Mid-year convention has been accepted in every
Delaware case where Court stated that a testifying
expert had used it.
oSeveral other jurisdictions have also accepted
the mid-year convention. (NY: United States Dredging,
2008; VA: U.S. Inspect, 2000)
•DCF valuations should not be adjusted for an
implied minority discount.
Cases discussing cost of capital
Andaloro v. PFPC Worldwide, Inc., 2005 Del. Ch. LEXIS 125 (Aug. 19, 2005)
Bomarko, Inc. v. International Telecharge, Inc., 766 A.2d 437 (Del. 2000)
Bomarko, Inc. v. International Telecharge, Inc., 794 A.2d 1161 (Del. Ch. 1999)
Cavalier Oil Corp. v. Harnett, 1988 Del. Ch. LEXIS 28 (Feb. 22, 1988)
Crescent/Mach I Partnership, L.P. v. Turner, 2007 Del. Ch. LEXIS 63 (May 2, 2007)
Delaware Open MRI Radiology Associates v. Kessler, 898 A.2d 290 (2006)
Doft & Co., Inc. v. Travelocity.com, Inc., 2004 Del. Ch. LEXIS 75 (May 21, 2004)
In Re Emerging Communications, Inc. Shareholders Litigation, 2004 Del. Ch. LEXIS 70 (May 3, 2004)
Gesoff v. IIC Industries Inc., 902 A.2d 1130 (Del. Ch. 2006)
Gholl v. eMachines, Inc., 2004 Del. Ch. LEXIS 171 (July 7, 2004)
Gilbert v. MPM Enterprises, Inc., 1998 Del. Ch. LEXIS 60 (April 24, 1998)
Gilbert v. MPM Enterprises, Inc., 709 A.2d 663 (Del. Ch. 1997)
Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 855 A.2d 1059 (Del. Ch. 2003)
Gray v. Cytokine Pharmasciences, Inc., 2002 Del. Ch. LEXIS 48 (Apr. 25, 2002)
Grimes v. Vitalink Comm. Corp., 1997 Del. Ch. LEXIS 124 (Aug. 26, 1997)
Global GT LP v. Golden Telecom, Inc., 993 A.2d 497 (Del. Ch. 2010).
Harris v. Rapid-American Corp., 1990 Del. Ch. LEXIS 166 (Oct. 2, 1990)
Harris v. Rapid-American Corp., 603 A.2d 796 (Del. 1992)
Henke v. Trilithic Inc., 2005 Del. Ch. LEXIS 170 (Oct. 28, 2005)
Hintmann v. Fred Weber, Inc., 1998 Del. Ch. LEXIS 26 (Feb. 17, 1998)
Cede & Co. v. JRC Acquisition Corp., 2004 Del. Ch. LEXIS (Feb. 10, 2004)
Lane v. Cancer Treatment Centers of America, 2004 Del. Ch. LEXIS 108 (July 30, 2004)
LeBeau v. M.G. Bancorp., Inc., 1998 Del. Ch. LEXIS 9 (Jan. 29, 1998)
M.G. Bancorp., Inc. v. LeBeau, 737 A. 2d 513 (Del. 1999)
MacLane Gas Company Limited v. Enserch Corporation, 1992 Del. Ch. LEXIS 260 (Dec. 9, 1992)
Cede & Co. v. MedPointe Healthcare, Inc. 2004 Del. Ch. LEXIS (Sept. 10, 2004)
Cases discussing cost of capital p. 2
MPM Enterprises, Inc. v. Gilbert, 731 A.2d 790 (Del. 1999)
ONTI, Inc. v. Integra Bank, 751 A.2d 904 (Del. Ch., 1999)
In Re PNB Holding Co. Shareholders Litigation, 2006 Del. Ch. LEXIS 158 (Aug. 18, 2006)
In Re Radiology Associates, Inc. Litigation, 611 A.2d 485 (Del. Ch. 1991).
Ryan v. Tad's Enterprises, Inc., 693 A.2d 1082 (Del. 1997).
Ryan v. Tad's Enterprises, Inc., 709 A.2d 682 (Del. Ch. 1996)
In Re Sunbelt Beverage Corp. Shareholder Litigation, 2010 Del. Ch. LEXIS 1 (Jan. 5, 2010)
Taylor v. American Specialty Retailing Group, Inc., 2003 Del. Ch. LEXIS 75 (July 25, 2003)
Cede & Co. v. Technicolor, Inc., 1990 Del. Ch. LEXIS 259 (Oct. 19, 1990)
Cede & Co. v. Technicolor, Inc., 2003 Del. Ch. LEXIS 146 ( Dec. 31, 2003)
Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993)
Cede & Co. v. Technicolor, Inc., 684 A.2d 289 (Del. 1996)
Cede & Co. v. Technicolor, Inc., 884 A.2d 26 (Del. 2005)
TV58 Limited Partnership v. Weigel Broadcasting Co., 1993 Del. Ch. LEXIS 146 (July 22, 1993)
Union Illinois 1995 Inv. Ltd. Partnership v. Union Financial Group, Ltd., 847 A.2d 340 (Del. Ch 2003)
In Re United States Cellular Operating Company, 2005 Del. Ch. LEXIS 1 (Jan. 6, 2005)
Wacht v. Continental Hosts, Ltd., 1994 Del. Ch. LEXIS 171 (Sept 16, 1994)
Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983)
Ex parte Baron Services, Inc., 874 So.2d 545 (Ala. 2003)
Steiner Corp. v. Benninghoff, 5 F.Supp.2d 1117 (D. Nev. 1998).
Swope v. Siegel-Robert, Inc., 243 F.3d 486 (8th Cir. 2001)
U.S. Inspect, Inc. v. McGreevy, 57 Va. Cir. 511 (2000), 2000 Va. Cir. LEXIS 524 (Nov. 7, 2000)
Shareholders in United States Dredging Corp. v. United States Dredging Corp., slip op., Index No.
002640/2006 (N.Y. Supr., Nassau Cty., May 19, 2008)