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Cost of Capital in Appraisal and Fairness Cases

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  • Sutter Securities Financial Services, San Francisco
Chapter

Cost of Capital in Appraisal and Fairness Cases

Abstract

The cost of capital is a central issue in judicial business valuations in statutory appraisal, stockholder oppression, and “entire fairness” cases. The Delaware courts have effectively set the standards for valuations related to corporate disputes because Delaware law is widely accepted on corporate legal issues. This article primarily discusses Delaware Court of Chancery and Delaware Supreme Court opinions involving the discounted cash flow (DCF) method and its crucial component, the cost of capital. Most of the Delaware decisions discussing cost of capital have come from statutory appraisal cases, and the Court does not differentiate in its approach to cost of capital in fairness cases. The Delaware Court of Chancery has declared its preference for the DCF method of valuation, including all elements of the expanded capital asset pricing model (CAPM) to determine the cost of capital. It has, however, rejected the company-specific adjustment in the calculation of weighted average cost of capital (WACC) unless there are unusual circumstances to validate it.
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CHAPTER 9
Cost of Capital in Appraisal and
Fairness Cases
Gilbert E. Matthews
Introduction
Discounted Cash Flow in Delaware Law
Capital Asset Pricing Model
Components of Weighted Average Cost of Capital
Risk-free Rate
Cost of Equity
Cost of Debt
Capital Structure
Beta
Industry Risk Premium
Size Premium
Company-specific Risk Premium
Build-up Method
Additional Points
Role of the Expert
Summary
INTRODUCTION
The cost of capital is a central issue in business valuations in statutory appraisal,
stockholder oppression, and ‘‘entire fairness’’ cases. The Delaware courts have effec-
tively set the standards for valuations related to corporate disputes because Dela-
ware law is widely accepted on corporate legal issues. This chapter primarily
discusses Delaware Court of Chancery and Delaware Supreme Court opinions
involving the discounted cash flow (DCF) method and its crucial component, the
cost of capital. Most of the Delaware decisions discussing cost of capital have come
from statutory appraisal cases in the Court of Chancery, and the Court does not
differentiate in its approach to cost of capital in fairness cases.
Michelle Patterson, J.D., Ph.D., assisted with research, organization, and writing.
161
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It should be noted that some Delaware valuation decisions—and most other
states’ published valuation decisions—contain neither an explanation of the court’s
methodology nor its calculations. State appellate court decisions seldom address
these issues. Indeed, a federal court decision under Missouri law commented:
It is unfortunate that, after performing such a well-reasoned and thorough
review of the record, the District Court was not more explicit in elaborating
how it reached its final calculation of price per share. Regardless, the district
court is not required to provide explicit detail or mathematical precision
in fair value cases [emphasis added], since ‘‘the very nature of most cases
precludes proof of value and damage with the precision of mathematical
computation.’’ It is also permissible for a district court to arrive at a deter-
mination of fair value that is not advocated by any of the experts.
1
Moreover, there are very few published state trial court decisions outside of
Delaware.
DISCOUNTED CASH FLOW IN DELAWARE LAW
In Weinberger v. UOP, Inc., the Delaware Supreme Court decided that a determina-
tion of fair value
2
‘‘must include proof of value by any techniques or methods which
are generally considered acceptable in the financial community.’’
3
It added that ‘‘ele-
ments of future value, including the nature of the enterprise, which are known or
susceptible of proof as of the date of the merger and not the product of speculation,
may be considered’’ in appraisals under Delaware law.
4
It is in this decision that the
Supreme Court first approved the use of the DCF method in a Delaware appraisal
case, pointing out that the acquiring company’s officers had used the DCF method
in evaluating UOP’s earnings potential.
Since Weinberger, Delaware courts have adopted the DCF method as their pre-
ferred method of valuation.
5
A 2005 decision stated:
The DCF model of valuation is a standard one that gives life to the finance
principle that firms should be valued based on the expected value of their
1
Swope v. Siegel-Robert, Inc., 243 F.3d 486, 494-5 (8th Cir. 2001), citing Phelps v. Watson-
Stillman Co., 293 S.W.2d 429, 432 (Mo. 1956).
2
Delaware’s statutory standard of value for dissenting stockholder actions (as in most other
states) is ‘‘fair value.’’ Fair value for statutory appraisals is the value of an entity as it is being
run, with no control premium and no discount for lack of marketability or minority interest.
See DEL.CODE ANN. Tit. 8, §262 (h).
3
Weinberger v. UOP, Inc., 457 A.2d 701, 713 (Del. 1983), a seminal ‘‘entire fairness’’ case.
4
Weinberger, 457 A.2d 701, 713.
5
See, e.g., Grimes v. Vitalink Comm. Corp., 1997 Del. Ch. LEXIS 124 (Aug. 26, 1997) at
3
(‘‘[The] discounted cash flow model [is] increasingly the model of choice for valuations in this
Court.’’); Gholl v. eMachines, Inc., 2004 Del. Ch. LEXIS 171 (July 7, 2004) at
20 (‘‘This
[DCF] method is widely accepted in the financial community and has frequently been relied
upon by this Court in appraisal actions.’’); Henke v. Trilithic Inc., 2005 Del. Ch. LEXIS 170
(Oct. 28, 2005) at
20 (citing Gholl).
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future cash flows, discounted to present value in a manner that accounts for
risk. The DCF method is frequently used in this court and, I, like many
others, prefer to give it great, and sometimes even exclusive, weight when it
may be used responsibly.
6
While DCF analyses have become the dominant approach in appraisal proceed-
ings since Weinberger, the ultimate selection of a valuation framework remains
within the court’s discretion. In fact, the Court of Chancery has rejected valuations
based on the DCF method on several occasions for various reasons, primarily be-
cause of the quality of the projections.
7
The Delaware courts continue to use other
valuation methods, principally the guideline company method,
8
but they do not
value operating companies based on asset value.
9
CAPITAL ASSET PRICING MODEL
The Capital Asset Pricing Model (CAPM) is the method by which the Court of
Chancery most often determines the cost of capital in a DCF method.
10
CAPM was
first introduced in the 1990 Technicolor decision.
11
Since then, experts in most Del-
aware appraisal cases have used the CAPM to calculate the weighted average cost of
capital (WACC) for their DCF analyses, and subsequent decisions show that the
Court of Chancery is comfortable using it.
6
Andaloro v. PFPC Worldwide, Inc., 2005 Del. Ch. LEXIS 125 (Aug. 19, 2005) at
35.
7
Harris v. Rapid-American Corp., 1990 Del. Ch. LEXIS 166 (Oct. 2, 1990) at
17–18,
22
(speculative nature of forecasts) aff’d in part and rev’d in part on other grounds,LeBeau v.
M.G. Bancorp, Inc., 1998 Del. Ch. LEXIS 9 (Jan. 29, 1998) at
36 (the Court could not rely
on DCF valuation of either expert), aff’d, 737 A. 2d 513 (Del. 1999); Bomarko, Inc. v. Inter-
national Telecharge, Inc., 794 A.2d 1161 (Del. Ch. 1999) at 1185 (unsupported projections);
aff’d 766 A.2d 437 (Del. 2000); Gray v. Cytokine Pharmasciences, Inc., 2002 Del. Ch. LEXIS
48 (Apr. 25, 2002) at
26 (unreliable projections, terminal value high percentage of total
value); Doft & Co., Inc. v. Travelocity.com, Inc., 2004 Del. Ch. LEXIS 75 (May 21, 2004) at
32 (unreliable projections).
8
For a discussion of Delaware appraisal decisions, see Gilbert E. Matthews, ‘‘A Review of
Valuations in Delaware Appraisal Cases, 2004–2005,’’ Business Valuation Review (Summer
2006): 44–63.
9
TV58 Limited Partnership v. Weigel Broadcasting Co., 1993 Del. Ch. LEXIS 146 (July 22,
1993) at
8, citing Shannon P. Pratt, Valuing a Business: The Analysis and Appraisal of
Closely Held Companies, 2d ed. (New York: Irwin Professional Publishing, 1989), 106 (‘‘The
notion that a business interest is worth the value of its underlying assets is basically fallacious
in most cases, at least for an operating company.’’).
10
Both experts performed a DCF analysis in the first Delaware appraisal case after Wein-
berger, but neither expert used a discount rate based on CAPM. Both used arbitrary rates:
one expert chose a discount rate range of 20% to 25%, the other chose 15% to 20%, and the
Court chose to use the midpoint, 20%. Cavalier Oil Corp. v. Harnett, 1988 Del. Ch. LEXIS
28 (Feb. 22, 1988) at
59.
11
Cede & Co. v. Technicolor, Inc., 1990 Del. Ch. LEXIS 259 (Oct. 19, 1990) at
92–100,
rev’d on other grounds, 634 A.2d 345 (Del. 1993). This case spawned 17 Chancery and Su-
preme Court decisions over a 20-year span.
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The Court has elected to use the CAPM even in situations where future results
are highly speculative. In one case, it rejected a 35% to 45% cost of equity based on
‘‘a survey of venture capitalist [sic] firms’’ in favor of an approximately 21%
CAPM-based rate.
12
In valuing another speculative venture, the Court accepted a
30% discount rate calculated using the CAPM and rejected a 17.7% rate that the
Court believed inadequately reflected the company’s risk.
13
When cash flows are
speculative, the Court may allow the use of a venture capital rate. In a case apprais-
ing a small biotech company, the Court used a discount rate of 50% based on a
report by the investment banker who was an advisor in the transaction.
14
COMPONENTS OF WEIGHTED AVERAGE COST OF CAPITAL
Delaware law requires that an appraisal be based on information known or know-
able at the valuation date. All inputs into the WACC should therefore be based on
market information as of the valuation date.
15
Inputs to the WACC are discussed in
the following pages.
Risk-free Rate
Delaware accepts the 20-year Treasury rate as the measure of the risk-free rate. The
risk-free rate is rarely a matter of dispute. In fact, only one Delaware decision has
addressed this issue. In a 2004 decision, the Court rejected the 30-year U.S. govern-
ment bond yield as the risk-free rate and stated that ‘‘using the 20-year U.S. govern-
ment bond rate is more reasonable under the circumstances and in keeping with the
accepted practice.’’
16
However, in a non-Delaware appraisal case, the U.S. District
Court in Nevada based the risk-free rate on 5-year U.S. government bond yield at
the time the transaction closed.
17
Cost of Equity
Until a few years ago, the Delaware decisions that used the CAPM to calculate the
cost of capital most frequently used an equity risk premium (ERP) of 7.0% to 7.2%.
The Court of Chancery and other courts relied on experts who used the older and
12
Gilbert v. MPM Enterprises, Inc., 709 A.2d 663, 672–3 (Del. Ch. 1997), aff’d, 731 A.2d
790 (Del. 1999).
13
Ryan v. Tad’s Enterprises, Inc., 709 A.2d 682, 703 (Del. Ch. 1996), aff’d, 693 A.2d 1082
(Del. 1997).
14
Gray v. Cytokine Pharmasciences, Inc., 2002 Del. Ch. LEXIS 48 (Apr. 25, 2002) at
31–33.
Prior to the transaction, ‘‘the parties decided to save money by asking Merrill Lynch to value
the stock of both companies, without opining as to fairness.’’ Gray, 2002 Del. Ch. LEXIS 48
at
14.)
15
See, e.g., Gilbert v. MPM Enterprises, Inc., 1998 Del. Ch. LEXIS 60 (Apr. 24, 1998) at
5,
aff’d, 731 A.2d 790; Cede & Co. v. JRC Acquisition Corp., 2004 Del. Ch. LEXIS 12 (Feb. 10,
2004) at
6–7.
16
Cede & Co. v. MedPointe Healthcare, Inc., 2004 Del. Ch. LEXIS 124 (Sept. 10, 2004)
at
69.
17
Steiner Corp. v. Benninghoff, 5 F.Supp.2d 1117, 1133-35 (D. Nev. 1998).
164 COST OF CAPITAL IN LITIGATION
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more widely accepted ERP estimates of 7.0% listed in the SBBI historical data (the
‘‘Historic ERP’’).
18
In 2003, however, highly regarded valuation experts and academics began to
question the automatic use of the historic ERP. Shannon Pratt wrote that he was
‘‘now convinced that the long-term arithmetic average general equity risk premium
(currently 7.0%) is too high.’’
19
Pratt, discussing the results of recent empirical re-
search published by Roger Ibbotson and Peng Chen in 2003,
20
as well as work con-
ducted by Roger Grabowski and others, stated that their results suggested that the
ERP is actually ‘‘about 1.25 percentage points lower than the historical
estimates.’’
21
The Court of Chancery began to accept lower cost of capital estimates derived
from the Fama-French (FF) 3-factor model. In 2004, Vice Chancellor Strine rejected
a 7.3% premium determined by the Historic ERP and accepted instead a 4.5%
equity premium derived as a component of the FF model. Relying on the alternate
estimate, he stated:
Although the Fama-French three-factor CAPM model is not wholly ac-
cepted, neither is the original CAPM itself. By better factoring in the real
risks of leverage, the Fama-French model captures useful data that contrib-
utes to a more reliable and real-world cost of capital.
22
Shortly thereafter, Vice Chancellor Noble cited this language when he employed
the cost of equity capital obtained from applying the FF 3-factor model
In calculating the risk premium, [petitioner’s expert] used the relatively new
research by Fama and French to find a value of 4.5%. In contrast, [respon-
dent’s expert] employed the older and more widely accepted practice of
using the Ibbotson Associates data and used a value of 7.3%. The Com-
pany’s main argument against the use of the Fama and French research is
that because it is ‘‘brand-new’’ and ‘‘still under significant academic de-
bate’’ it cannot satisfy the standard that a valuation methodology be
18
See, e.g., Swope, 243 F.3d 486, 893 (‘‘Empirical evidence from Ibbotson’s includes a long-
term equity risk premium representing incremental rates of return realized on large capitaliza-
tion common stocks over the risk-free rate historically reported from 1929 [sic] to 1996.’’);
Cede & Co. v. Technicolor, Inc., 2003 Del. Ch. LEXIS 146 (Dec. 31, 2003) at 177 (7.2%),
aff’d, 884 A.2d 26 (Del. 2005); Lane v. Cancer Treatment Centers of America, 2004 Del. Ch.
LEXIS 108 (July 30, 2004) at 43 (7.1%); Andaloro, 2005 Del. Ch. LEXIS 125 at
57
(7.0%); Delaware Open MRI Radiology Associates v. Kessler, 898 A.2d 290, 339 (Del Ch.
2006) (experts used 7.2% and 7.0%, respectively).
19
Pratt, ‘‘Valuers Should Lower Equity Risk Premium Component of Discount Rate,’’ Busi-
ness Valuation Update (Nov. 2003): 1,6, at 1.
20
Robert G. Ibbotson & Peng Chen, ‘‘Long-Run Stock Returns: Participating in the Real
Economy,’’ Financial Analysts Journal (Jan./Feb. 2003): 88–98, at 94.
21
Pratt, ‘‘Valuers Should Lower Equity Risk Premium Component of Discount Rate’’ at 1.
Pratt then ‘‘urged his readers who still use an ERP of 7% to immediately make a downward
adjustment to reflect recent research results,’’ at 6.
22
Union Illinois 1995 Inv. Ltd. Partnership v. Union Financial Group, Ltd., 847 A.2d 340,
363 (Del. Ch. 2004).
Cost of Capital in Appraisal and Fairness Cases 165
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‘‘generally considered acceptable in the financial community,’’ as required
by Weinberger v. UOP.
The mere fact that it is new does not make this research unreliable or
outside of the Weinberger standard. A valuation such as this is built on
assumptions that will always be under debate or attack in the academic
community.
23
His decision rejected the equity risk premium based on the historic SBBI data
and accepted the lower cost of equity capital obtained from applying the FF 3-factor
model.
24
The cost of equity capital obtained from applying the FF 3-factor model
was also used in a 2006 decision that gave equal weight to both the FF estimate and
the Historic ERP.
25
Vice Chancellor Strine centered on the debate over how to calculate ERP in the
recent and important 2010 Global GT decision.
26
He sided with the petitioners by
rejecting a 7.1% ERP based on SBBI historical data and accepting instead an ERP of
6.0%. He made his decision based on the petitioner’s expert’s teaching experience,
the relevant academic and empirical literature, and the supply side ERP reported in
the 2007 Ibbotson Yearbook.
27
The Vice Chancellor pointed out that the petitioners had substantial support in
the professional and academic valuation literature for arguing that the continued use
of the simple historic ERP is unjustifiable and that there are ‘‘persuasive reasons
[that] support a lower forward-looking real return on equity than the return found
in the historical data.’’
28
Acknowledging that ‘‘the debate is not nearly so stark,’’ he remarked that
‘‘[e]ach technique depends to a certain extent on taking some combination of past
data and using it to predict a necessarily uncertain future.’’
29
He noted that petition-
er’s expert had relied upon the fact that
Ibbotson and his co-authors have themselves developed an alternative
model to forecast the long-term expected equity return because of their
view that the historic approach wrongly assumes that the relationship be-
tween stocks and bonds observed in the past would remain stable into the
future. . . . The supply side estimate that Ibbotson publishes uses the Ibbot-
son historical sample from 1926 to the present, but estimates which compo-
nents of the equity risk premium are driven by the price-to-earnings ratio of
a stock, and which components are driven by expected earnings growth.
The supply side rate assumes that actual returns to equity will track real
earnings growth, not the growth reflected in the price-to-earnings ratio.
30
23
MedPointe Healthcare, 2004 Del. Ch. LEXIS 124 at
69–70.
24
MedPointe Healthcare, 2004 Del. Ch. LEXIS 124 at
72.
25
PNB Holding at
114.
26
Global GT LP v. Golden Telecom, Inc., 993 A.2d 497 (Del. Ch. 2010).
27
Global GT, 993 A.2d 497, 514.
28
Global GT, 993 A.2d 497, 516, n.114, citing Jeremy J. Siegel, ‘‘Perspectives on the Equity
Risk Premium,’’ Fin. Analysts J. (Nov./Dec. 2005): 61–71, at 70.
29
Global GT, 993 A.2d 497, 514.
30
Global GT, 993 A.2d 497, 515.
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Vice Chancellor Strine went on to state that the surveys cited by petitioners’
expert suggested that current academic thinking would put the ERP closer to 6.0%
than to 7.1%. He commented,
[T]o cling to the Ibbotson Historic ERP blindly gives undue weight to Ibbot-
son’s use of a single data set. 1926 . . . has no magic as a starting point for
estimating long-term equity returns....[V]ery well-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 side rate Ibbotson himself now publishes as
a reliable ERP for use in a DCF valuation. For example, Professor Jeremy
Siegel has examined the period from 1802 to 2004 and come up with an
ERP of 5.36%. Likewise, Professors Eugene Fama and Kenneth French con-
sidered the period from 1872 to 2000, and calculated an average ERP of
5.57%.
31
Additionally, the Vice Chancellor stated that ‘‘the literature also suggests that
the ERP for companies operating in foreign markets [such as Golden GT] is, if any-
thing, lower than the Historic ERP for a domestic company.’’
32
Determining the cost of equity continues to be a major disagreement among val-
uation experts. Vice Chancellor Strine recognized this controversy when he carefully
set out his reasons for no longer following an approach – Historic ERP – which
‘‘ha[d] met withthe approval of this court onprior occasions.’’
33
Elaborating, he said:
Ibbotson’s reasoning comports with the strong weight of professional and
academic thinking, which is accurately represented by [petitioner’s] view
that the most responsible estimate of ERP is closer to 6.0% than
7.1%....[W]hentherelevantprofessionalcommunityhasminedaddi-
tional 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. In reaching this conclusion, I give heaviest weight to the pub-
lished literature, but also find the admittedly squishier academic survey data
supportive. Although that data is far from perfect, it does reveal that the
weight of academic thinking at our nation’s finest finance departments
places the ERP much nearer to [petitioner’s expert]’s estimates than
[respondent’s]. For all these reasons, I adopt petitioner’s ERP of 6.0%.
34
31
Global GT, 993 A.2d 497, 516, citing Michael Devaney, ‘‘Will Future Equity Risk Pre-
mium Decline?’’ J. of Fin. Planning (Apr. 2008): 46–53, at 47; Jeremy J. Siegel, ‘‘Perspectives
on the Equity Risk Premium,’’ Fin. Analysts J. (Nov./Dec. 2005): 61–71, at 63; and Eugene F.
Fama & Kenneth R. French, ‘‘The Equity Premium,’’ J. of Fin. (April 2002): 637–659, at 638.
32
Global GT, 993 A.2d 497, 517.
33
Global GT, 993 A.2d 497, 517.
34
Global GT, 993 A.2d 497, 517–8.
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Although coming to the conclusion that, in this case, there was solid academic
and professional thinking supporting the lower ERP, Vice Chancellor Strine fully
realized that any estimate of ERP remains just an estimate based on uncertainty. He
appropriately leaves to the valuation profession the final responsibility for resolving
the debate: ‘‘[T]he relevant academic and professional community and not this court
should develop the accepted approach.’’
35
Cost of Debt
In an appraisal, the acquirer’s cost of debt is not relevant because the entity being
valued is the company as it existed prior to the transaction. Thus, the appropriate
cost of debt for determining cost of capital is the company’s borrowing cost before
it was acquired.
36
There is one apparent exception to this rule that is not, in fact, actually an
exception: the Chancery Court’s 2003 use of the acquirer’s cost of debt in Techni-
color. The Supreme Court directed the Chancellor to appraise Technicolor based
on the acquirer’s business plan because the acquirer had begun implementing its
changes to Technicolor shortly after it had taken control through a 1982 tender
offer and prior to the 1983 squeeze-out merger.
37
Because the entity being valued
was Technicolor under the new business plan which became operative after the
tender offer (but before the squeeze-out), not the old business plan prior to the ten-
der offer, the Chancellor ruled that it was not appropriate to use Technicolor’s pre-
tender offer borrowing cost. He decided that Technicolor’s cost of debt at the time
of the squeeze-out merger was the interest rate being paid on the acquirer’s debt.
38
When the Court of Chancery computes a company’s WACC, it normally
tax-effects the cost of debt based on the company’s marginal corporate tax
rate.
39
The procedure for subchapter S corporations, which do not pay entity
level federal income taxes, differs: in one situation where the Court appraised a
subchapter S corporation in 1991, it did not tax-effect the cost of debt.
40
The
Court of Chancery took the same position in a 1992 valuation case.
41
However,
it is unlikely to take the same position in the future; in a 2006 case valuing a
35
Global GT, 993 A.2d 497, 517.
36
See, e.g., Hintmann v. Fred Weber, Inc., 1998 Del. Ch. LEXIS 26 (Feb. 17, 1998) at
17; In
Re Emerging Communications, Inc. Shareholders Litigation, 2004 Del. Ch. LEXIS 70 (May
3, 2004) at
61; MedPointe Healthcare, 2004 Del. Ch. LEXIS 124 at
41,
53; In Re United
States Cellular Operating Company, 2005 Del. Ch. LEXIS 1 (Jan. 6, 2005) at
60.
37
Cede & Co. v. Technicolor, Inc., 684 A.2d 289, 300 (Del. 1996). The company being ap-
praised was not Technicolor as it existed at the time of the tender offer, but as it existed at the
time of the squeeze-out merger under its new management, excluding the acquisition debt.
The cost of debt determined by the Court was applied only to Technicolor’s pre-acquisition
debt.
38
Technicolor, 2003 Del. Ch. LEXIS 146 at
177–178.
39
See, e.g., Technicolor, 2003 Del. Ch. LEXIS 1 at
178 (‘‘Using the 46% tax rate agreed
upon by both experts, the resulting after-tax cost of debt is 7.54%.’’)
40
In re Radiology Associates, Inc. Litigation, 611 A.2d 485, 492 (Del. Ch. 1991).
41
MacLane Gas Company Limited v. Enserch Corporation, 1992 Del. Ch. LEXIS 260 (Dec.
9, 1992) at
51–2.
168 COST OF CAPITAL IN LITIGATION
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debt-free subchapter S corporation, the Court tax-effected earnings based on
taxes payable by shareholders.
42
For a company that could deduct only a portion of its debt for U.S. taxes, a
federal court prorated the tax effect:
[D]ebt is not as valuable to Steiner as to other companies, due to the fact
thatonly62%ofitsinterestexpensefunctionsasashield....Atleast
62% of interest expense would serve as a tax shield, so debt should have
some value to Steiner.
43
----
No one [who testified] attempted to show that, although Steiner does
have limited deductibility of its interest expense, it is some percentage other
than 62%. Thus we find that, in effect, Steiner can only deduct 62% of its
interest expense. The WACC formula must consequently be adjusted by
multiplying Steiner’s tax rate of 43% by 62% before inserting it into the
WACC formula.
44
When the Court of Chancery was faced with the issue of how to tax-effect the
cost of debt of a company with tax-loss carryforwards, it applied a 40% rate to an
8% cost of debt, reasoning
NOLs are to be calculated after applying the Code’s other deductions, and
any deductions for interest payments would allow the Company to save its
NOLs for subsequent years. Based on the foregoing, the Court will apply a
4.8% after-tax cost of debt.
45
Capital Structure
Once the cost of debt is determined, the court must determine the amount of
debt to which it applies. To determine debt in appraisal cases, the Delaware
courts consistently favor using the company’s actual capital structure at the valu-
ation date rather than a hypothetical capital structure based on industry norms.
46
As stated in 1998:
[Respondent’s expert] weighted FWI’s cost of debt and equity in accordance
with FWI’s actual capital structure on the date of the merger: 98% equity
and 2% debt. As with all other areas of business valuation, this Court
42
Delaware Open MRI, 898 A.2d 290, 330.
43
Steiner, 5 F.Supp.2d 1117 at 1126.
44
Steiner, 5 F.Supp.2d 1117 at 1135.
45
Gholl, 2004 Del. Ch. LEXIS 171 at
49.
46
See, e.g., In Re Radiology Associates, 611 A.2d 485, 493; MedPointe Healthcare, 2004
Del. Ch. LEXIS 124 at
67 (‘‘While [petitioner’s expert] may well be correct than [sic] an 80/
20 capital structure would be typical for a company of this nature, Carter-Wallace’s tradi-
tional aversion to debt could be expected to continue.’’)
Cost of Capital in Appraisal and Fairness Cases 169
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prefers to use a company’s actual information when possible, unless it is
shown that the actual information would yield unreliable results.
47
The amount of debt incurred in the transaction leading to the appraisal cannot
be considered part of the debt of the acquired company.
48
The Court rejected a debt-free target capital structure that the defendant’s
expert based on similar companies when the company being appraised actually had
a leveraged structure. On the other hand, it did not accept the plaintiff’s expert’s
assumption that the control shareholder would have rolled over the leveraged sub-
sidiary’s existing debt perpetually:
The minority stockholders had no right to benefit from PFPC’s access to
preferred financing from [parent] and then turn around and demand that
[parent] not receive a full repayment of principal and interest.
49
The Vice Chancellor assumed repayment of debt at maturity, and discounted
the debt to present value at a 13.5% equity rate.
50
In contrast to Delaware, a U.S. District Court judge applying Nevada appraisal
law did not accept the company’s actual capital structure:
[W]e are not precluded from using the industry average, as Steiner contends,
because the existing Steiner management has ‘‘no plans’’ to change the capi-
tal structure.
. . . [W]hile assuming that the particular capital structure envisioned
by a specific investor will be implemented after the merger would not be
appropriate, considering changes that market actors would assume on aver-
age in placing a rational value on the company would. Using Steiner’s actual
debt to equity ratio, which has been established as a result of the particular
needs and desires of the Steiner family, would be as improper as using the
speciccapitalstructureofanyotherparticularinvestor....Themarket
places a value on how it expects a company to perform in the future. And
over time, market participants will expect a company to move to its optimal
position in terms of variables like debt structure. . . .
. . . [T]he 20%/80% ratio used by [plaintiff] is not the actual industry
average. Rather, it is significantly lower. . . . The market would thus expect
a capital structure for Steiner to incorporate more than 4% debt, although
not as much as the actual industry average. Therefore, we will use the 20%/
80% ratio.
51
47
Hintmann, 1998 Del. Ch. LEXIS 26, at
18.
48
Technicolor, 2003 Del. Ch. LEXIS 146 at
169 (‘‘The [amount of] debt used to acquire the
company cannot be figured into the calculation when determining Technicolor’s long-term
debt.’’)
49
Andaloro, 2005 Del. Ch. LEXIS 125 at
54.
50
Andaloro, 2005 Del. Ch. LEXIS 125 at
55.
51
Steiner, 5 F.Supp.2d 1117 at 1125–26.
170 COST OF CAPITAL IN LITIGATION
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Although Delaware uses the company’s own capital structure in appraisal cases,
it typically looks at optimal capital structure in fairness cases. The valuation stan-
dard for entire fairness in Delaware differs from the appraisal standard. In fairness
cases, the Court considers acquisition value and gives weight to what a potential
acquirer might pay. Thus, in a 1994 fairness case, the Court accepted a WACC that
was computed using ‘‘an ‘optimal’ debt/equity structure.’’
52
Although the amount of debt is normally determinable from a company’s finan-
cial records, the value of the equity is not in the financial records, but is indeed the
very basis of the litigation. This problem of indeterminate equity has rarely been
discussed in Delaware decisions, and it appears that experts have used either the
book value of equity or the transaction price to determine the debt/equity ratio.
However, a 2004 decision does examine the issue of circularity in determining the
equity portion of capital structure:
The difficulty is both that [defendant’s expert’s] assumed $10.38 per share
‘‘enterprise value’’ and [plaintiff’s expert’s] assumed $41.16 per share
‘‘enterprise value’’ are identical to the ultimate ‘‘fair value’’ that each expert
determined for ECM. Those values exemplify the ultimate circularity inher-
ent in WACC. . . . [T]he Court is unable to adopt the ‘‘enterprise value’’
assumed by either expert with any degree of confidence.
. . . [T]he only sensible way (in the Court’s view) to avoid the circular-
ity in this case is to use an enterprise valuation of ECM that is not litigation-
driven. On this record, the only such valuation is the $27.84 per share
value...that the RTFC determined and actuallyusedfor purposes of
financing the Privatization. Having no better or more reliable information,
the Court adopts that value for purposes of determining the percentage of
ECM’s capital structure represented by long term debt and by equity on the
merger date.
53
Interestingly, no decision discusses the fact that the cost of equity itself is a func-
tion of the capital structure. For any given company, the cost of equity will be lower
with an unleveraged structure and greater if it is highly leveraged.
54
Beta
The Court of Chancery accepts the concept that the ERP must be adjusted for
an appropriate beta. When shares of a company being valued are publicly traded
in an active market, customary practice is to determine beta by reference to
52
Wacht v. Continental Hosts, Ltd., 1994 Del. Ch. LEXIS 171 (Sept 16, 1994) at
17.
53
Emerging Communications, 2004 Del. Ch. LEXIS 70 at
67-68. The issue of circularity was
subsequently addressed in relation to the size premium in In Re Sunbelt Beverage Corp. Share-
holder Litigation, 2010 Del. Ch. LEXIS 1 (Jan. 5, 2010), discussed below at pp.176–7.
54
See Chapter 7 in Cost of Capital:Applications and Examples, 4th ed. (Hoboken, NJ: John
Wiley & Sons, 2010) for a discussion on the relationship between leverage and the cost of
equity.
Cost of Capital in Appraisal and Fairness Cases 171
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the company’s own market prices. However, if a company is private or if it is thinly
traded, the Court will look at the betas of guideline publicly traded companies.
55
The Court wrote in 1998 that using ‘‘the median beta of comparable companies . . .
is the customary method of determining a beta for a privately held company.’’
56
However, in 2006, 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—a measure of covariance of the company’s trading price
with overall market prices—is indeterminable have a lower cost of equity
than publicly-listed corporations whose durability is reflected in a trading
history producing a reliable beta. The real world capital markets seem to
reject that odd notion.
57
The period during which beta is determined should exclude dates on which
the market was influenced by the transaction which led to the appraisal. In
Technicolor in 1990, Chancellor Allen rejected a beta of 1.7 based on the com-
pany’s market prices in a period which included the tender offer through which
control was purchased and instead adopted a beta of 1.27, based on Technicol-
or’s pre-tender market prices.
58
On remand 13 years later, Chancellor Chandler
adopted a beta of 1.6 based on the single month preceding the squeeze-out
merger, reasoning that the beta for earlier periods reflected prior management’s
business plan that the Supreme Court had ruled was not applicable under the
facts of the case.
59
The Court generally prefers betas based on longer time periods:
[Petitioner’s expert] calculated a beta of .62 based on a period beginning six
months after JR Cigar’s IPO. [Respondent’s expert] calculated a beta of .67
based on a period beginning a week after the IPO. Neither period is pre-
sumptively valid. A longer period of time . . . is generally preferred. A five-
year period, longer than the period used by either expert, is the most
common.
60
55
Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 855 A.2d 1059, 1077 (Del. Ch.
2003) (‘‘Given what Gotham itself contends was an ‘inefficient’ market in the Partnership’s
units...,thejudgmentthatthePartnershipspublishedbetawasoutoflinestrikesmeas
reasonable.’’).
56
Hintmann, 1998 Del. Ch. LEXIS 26 at
14.
57
PNB Holding, 2006 Del. Ch. LEXIS 158 at
113 n. 149.
58
Technicolor, 1990 Del. Ch. LEXIS 259 at
96–97.
59
Technicolor, 2003 Del. Ch. LEXIS 146 at
174. Using this very short period for determin-
ing beta was unique to the facts and judicial history of the protracted litigation.
60
JRC Acquisition, 2004 Del. Ch. LEXIS 12 at
39 n. 94, citing Pratt, Cost of Capital: Esti-
mations and Applications, 2d ed. (Hoboken, NJ: John Wiley & Sons, 2002), 82.
172 COST OF CAPITAL IN LITIGATION
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A 2005 decision gave equal weight to two-year betas and five-year betas of
guideline companies. For both periods, it gave greater weight to betas of companies
deemed to be more comparable.
61
The use of a ‘‘predictive beta’’ from Barra was rejected by Vice Chancellor
Strine in 2010. He observed, ‘‘No neutral academic support for the predictive power
of the Barra beta has yet been published.’’
62
The Vice Chancellor explained his res-
ervations about the Barra model:
[T]he Barra forecasting model is proprietary, and cannot be reverse-engi-
neered. The Barra predictive beta, which is a forecast of a stock’s future
looking beta using past data, is based on a thirteen-factor model, but the
weight given to each of the factors is not publicly available. In fact, Barra
has used three different versions of its model without explaining why or
what changes have been made, and it is not apparent whether Barra retro-
actively updates its past beta calculations. . . . The only thing [petitioner’s
expert] knows about the model is that it lists certain valuation-relevant fac-
tors, including factors relevant to the historical beta such as volatility, lever-
age, and trading activity, and throws them in a stew pot in undisclosed
proportions to come up with an outcome.
63
However, he added:
I wish to emphasize that I do not reject the Barra beta for use in later cases. .
. . If the Barra beta is to be used in appraisal proceedings, a more detailed
and objective record of how the Barra beta works and why it is superior to
other betas must first be presented.
64
The Court’s view as to whether to use ‘‘raw beta’’ or ‘‘adjusted beta’’ is un-
settled. In 1998 Vice Chancellor Steele stated that he had not heard testimony that
explained to his satisfaction the reasons why raw beta should be adjusted, and
wrote:
Based on the remaining evidence in the record, I conclude that ‘‘raw’’ beta
should be used to calculate the discount rate. 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.
65
Six years later, however, Chancellor Chandler questioned the use of a raw beta
and instead utilized an adjusted beta:
61
Andaloro, 2005 Del. Ch. LEXIS 125 at
57–60.
62
Global GT, 993 A.2d 497, 520.
63
Global GT, 993 A.2d 497, 520.
64
Global GT, 993 A.2d 497, 521.
65
Gilbert, 1998 Del. Ch. LEXIS 60 at
9.
Cost of Capital in Appraisal and Fairness Cases 173
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Petitioner suggests that [the company’s] raw beta is more appropriate than
the adjusted beta. Petitioner’s own expert did not use the raw beta, proba-
bly because doing so is inaccurate. Betas based on observed historical data
are more representative of future expectations when they are adjusted.
66
In 2010 Vice Chancellor Strine did not accept a Bloomberg adjusted beta, com-
menting that ‘‘no reliable literature or evidence was presented to show that the beta
of a telecom company like Golden, which operates in a risky market [Russia], will
revert to 1.0.’’
67
Instead, he looked at industry betas:
According to the Ibbotson telecom (SIC 4813) beta, which gives the beta
values for approximately 50 telecom companies that are traded in the
United States including Golden, the median industry beta as of December
2007 was 1.45, and the SIC composite beta was 1.24....Goldenwasa
much larger, less levered company than the median company on the Ibbot-
son SIC 4813 list and, therefore, the composite beta of 1.24 is more appro-
priate than the median beta of 1.45.
68
The Court 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 ap-
proach to this DCF analysis.’’
69
When beta is determined based on guideline companies, it is important to con-
sider the risks of those guideline companies relative to the subject company. It may
be appropriate to adjust the selected beta to reflect the incremental risk when the
court does not incorporate a company-specific risk premium and when the subject
company is smaller and more vulnerable than the guideline companies.
70
The Court
of Chancery adopted this approach in a 1996 case:
The plaintiffs’ expert relied primarily upon a New York Stock Exchange-
traded company that had a beta of 2.2. . . . The plaintiff’s expert derived
Cell Tech’s beta of 2.0 from this ‘‘comparable’’ company’s beta of 2.2,
thereby suggesting that Cell Tech involved lower risk than did the ‘‘compa-
rable’’ company. The comparison is factually unsupported.
71
----
The defendants calculated a discount rate of 26.5% using the CAPM.
The defendants’ expert explained that on the basis of his experience, he con-
siders 30% to be more appropriate, given the risks associated with Cell
Tech.
72
66
JRC Acquisition, 2004 Del. Ch. LEXIS 12 at
39 n. 96, citing Pratt, Cost of Capital, 2d
ed.: 89.
67
Global GT, 993 A.2d 497, 523.
68
Global GT, 993 A.2d 497, 523.
69
Global GT, 993 A.2d 497, 524.
70
See, e.g., Matthews, ‘‘Errors and Omissions in DCF Calculations: A Critique of Delaware’s
Dr. Pepper Appraisal,’’ Business Valuation Update (October 2007): 1, 8–11 at 9.
71
Ryan, 709 A.2d 682, 703.
72
Ryan, 709 A.2d 682, 703. n. 26.
174 COST OF CAPITAL IN LITIGATION
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----
I recognize that the defendants’ 30% discount rate is unusually high,
but the record demonstrates that Cell Tech, at the time of the Merger, was
an unusually risky investment. . . . Accordingly, I adopt 30% as the appro-
priate discount rate . . .
73
In another case, the Court rejected a market beta of 0.63 for thinly traded
limited partnership units and accepted defendant’s expert’s beta of 3.35.
74
The
Courtthenruledthatthe3.35betasubsumedotheradjustmentstothecost
of equity:
What I believe unreasonable, though, is compounding that substantial ad-
justment to beta—based on firm specific characteristics of the Partnership—
with the further addition of small company and specific company adjust-
ments. Although such adjustments have been accepted in certain decisions
of this court involving different circumstances, I find them to be in-
appropriate here. The adjustment to beta alone was sufficient to account
adequately for those factors.
75
Industry Risk Premium
In corporate valuation cases, courts have rarely discussed the concept of adjusting
the cost of equity by applying an industry risk premium. The only extensive discus-
sion was in a decision by Vice Chancellor Strine that treated a negative industry risk
premium as a proxy for a private company’s beta:
More important, I regard [plaintiff’s expert’s] consideration of the
lower industry risk for companies like Delaware [Open MRI] Radiology
to be a fair proxy for beta in a circumstance when beta cannot be meas-
ured directly. Under the CAPM, the equity risk premium is not used in
isolation to estimate the subject company’s cost of capital. Rather 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 indus-
try return data that [plaintiff’s expert] uses is an acceptable substitute
for that adjustment in this situation when a beta cannot be estimated.
[Plaintiff’s expert] testified that the negative risk premium he employed
was consistent with market return data from Ibbotson’s indicating that
investments in a health care industry business present less market risk
than average.
76
73
Ryan, 709 A.2d 682, 704.
74
Gotham Partners, 855 A.2d 1059, 1077.
75
Gotham Partners, 855 A.2d 1059, 1077.
76
Delaware Open MRI, 898 A.2d 290, 340.
Cost of Capital in Appraisal and Fairness Cases 175
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Size Premium
Courts have often considered the application of a size premium in calculating the
cost of equity. A small company premium was first applied in Delaware to a cost of
equity calculation in a 1991 decision.
77
In 1999 the Court of Chancery wrote, ‘‘This Court has traditionally recognized
the existence of a small stock premium in appraisal matters.’’
78
The role of a testify-
ing expert is to demonstrate whether the size premium is appropriate in a given situ-
ation and, if so, the amount of the premium.
79
The Court stated in 2004:
There is finance literature supporting the position that stocks of smaller
companies are riskier than securities of large ones and, therefore, command
a higher expected rate of return in the market. Our case law also recognizes
the propriety of a small firm/small stock premium in appropriate circum-
stances. The issue, therefore, is not whether a small firm/small stock pre-
mium is permissible theoretically, but whether the defendants have shown
that a premium of 1.7% is appropriate in this particular case. The Court
concludes that the defendants have made that showing.
80
An Alabama appraisal case also accepted a size premium for calculating a dis-
count rate. That Court accepted the defendant’s expert’s testimony as to both a ‘‘mi-
cro-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 a ‘‘com-
pany size premium’’ of 4.35% (‘‘[s]ince a small, closely held company is usually re-
stricted to narrower markets than publicly-traded companies, an additional small
company premium is warranted’’).
81
The Court may decide, however, that based on facts and circumstances, a size
premium should not be applied:
In these circumstances, 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. In this circumstance, I conclude it should not be considered.
82
In a very recent 2010 case, Chancellor Chandler raised another issue with re-
gard to determining the size premium. He termed it the ‘‘issue of circularity,’’ which
arises from the fact that the selection of a size premium is a function of the assumed
value of the enterprise:
77
In Re Radiology Associates, 611 A.2d 485, 490.
78
ONTI, Inc. v. Integra Bank, 751 A.2d 904, 920 (Del. Ch., 1999). See also, e.g., Hintmann,
1998 Del. Ch. LEXIS 26 at
14 (‘‘This Court has accepted the addition of small stock pre-
mia.’’); Delaware Open MRI, 898 A.2d 290, 340 ([‘‘The expert’s] inclusion of a small stock
premium is consistent with a good deal of academic and practitioner thinking about CAPM.’’)
79
ONTI, 751 A.2d 904, 921.
80
Emerging Communications, 2004 Del. Ch. LEXIS 70 at
71.
81
Ex parte Baron Services, Inc., 874 So.2d 545, 552 (Ala. 2003).
82
Technicolor, 1990 Del. Ch. LEXIS 259 at
99.
176 COST OF CAPITAL IN LITIGATION
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[A] discounted cash flow analysis both values the size of a company (and
thus points to the appropriate Ibbotson premium to use) 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?
83
He criticized the defendant’s expert for his ‘‘methodologically problematic’’
argument:
[He] goes as far as to say that because his selection of a 5.78% premium
results in a valuation that places Sunbelt in the tenth decile—the decile with
a corresponding premium of 5.78%—I should take this as evidence that the
5.78% premium is appropriate. I cannot accept this asserted mathematical
proof and proposed flow of causality.
84
The Court concluded that it was appropriate to use the weighted average of the
Ibbotson SBBI size premiums for the two deciles into which the subject company’s
value might fall:
According to Ibbotson, the 3.47% premium is a weighted balance between
the ninth-decile premium of 2.65% and the tenth-decile premium of 5.78%.
Given the uncertainty in Sunbelt’s own value and whether Sunbelt falls on
the smaller or larger side of the line between the ninth and tenth deciles, I
believe it is more appropriate to select 3.47%, a small-firm risk premium
that accounts for the possibility that the company is on either side of the
line and that Ibbotson itself seems to have applied to all firms within (or
between) the ninth and tenth deciles.
85
The Court of Chancery understands that the size premium measures risk that is
not measured by beta, and recognizes that the concepts of beta and the small com-
pany premium are distinct:
[T]he size premium is not dependent on the beta of the firm. In fact, it is
because the beta does not capture all the systematic risk that a size premium
is included. ‘‘Even after adjusting for the systematic (beta) risk of small
stocks, they outperform large stocks.’’
86
An additional issue is that the Court must consider is whether to use size premi-
ums 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:
Thus, it seems to me that a small stock premium exists, but just as the
difference in returns over sixty-nine years is much greater than that over
83
Sunbelt Beverage, 2010 Del. Ch. LEXIS 1 at
41.
84
Sunbelt Beverage, 2010 Del. Ch. LEXIS 1 at
43.
85
Sunbelt Beverage, 2010 Del. Ch. LEXIS 1 at
44.
86
JRC Acquisition at
39, citing Pratt, Cost of Capital, 2d ed. at 82.
Cost of Capital in Appraisal and Fairness Cases 177
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other, perhaps equally valid periods of time. . . . I think the better ap-
proach is to weight the more recent results more heavily than the older
ones. To accomplish that, I will take the returns over the past 14, 28,
42, 56, and 69 years and average them, generating a weighted return
over the past 69 years for both the smallest quintile and the entire NYSE
universe of stocks. This will have the effect of weighting the most recent
period five times as much as the first period, the second most recent pe-
riod four times as much as the earliest, and so on. I believe this to be a
more accurate method of determining the existence and magnitude of
any small stock premium.
87
The application of the size premium to foreign businesses was discussed in a
2006 Court of Chancery decision. The Vice Chancellor reviewed the academic liter-
ature and concluded:
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.
88
Company-specific Risk Premium
The Chancery Court has expressed skepticism as to the use of a company-specific
risk premium in computing WACC:
The calculation of a company specific risk is highly subjective and often is
justified as a way of taking into account competitive and other factors that
endanger the subject company’s ability to achieve its projected cash flows.
In other words, it is often a back-door method of reducing estimated cash
flows rather than adjusting them directly. To judges, the company specific
risk premium often seems like the device experts employ to bring their final
results into line with their clients’ objectives, when other valuation inputs
fail to do the trick.
89
The Court has accordingly declined to apply a company-specific risk premium
on several occasions, stating its view that company-specific risk premiums cannot be
included without ‘‘fact-based evidence produced at trial’’ by expert testimony that
persuades the Court to accept the adjustment.
Vice Chancellor Steele,
90
in a 1998 Delaware decision, was the first to discuss
extensively the rejection of a company-specific risk premium. Although he did note
that this premium could occasionally be appropriate, he concluded, ‘‘Respondent
87
ONTI, 751 A.2d 904, 922. The valuation date was in 1995, so that the periods started in
1981, 1967, 1953, 1939, and 1926, respectively.
88
Gesoff v. IIC Industries Inc., 902 A.2d 1130, 1161 (Del. Ch. 2006).
89
Delaware Open MRI, 898 A.2d 290, 339.
90
Now Chief Justice of the Delaware Supreme Court.
178 COST OF CAPITAL IN LITIGATION
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has failed to carry its burden of proving the appropriateness of adding a 3% com-
pany specific risk premium.’’
91
He explained:
An investment specific premium may be appropriate to account for risks not
captured in the equity risk premium and the small size premium. Unlike
those two premia, which are commonly determined by reference to the pub-
lished results of empirical research, a company specific risk premium ‘‘re-
mains largely a matter of the analyst’s judgment, without a commonly
accepted set of empirical support evidence.’’ Thus, the factors relied upon
in assessing an investment specific premium should be carefully explained
to the Court. As with all aspects of a party’s valuation for purposes of sec-
tion 262, the proponent of a company specific premium bears the burden of
convincing the Court of the premium’s appropriateness.
92
The company-specific risk premium was rejected again in a 2004 decision:
By adding a second incremental premium to ECM’s cost of equity to ac-
count for the risk of size, [defendant’s expert] appears to have performed a
mechanical exercise, rather than make a nuanced, textured judgment.
Accordingly, the Court determines that the defendants have not established
a credible justification for their incremental ‘‘supersmall’’ firm premium,
and declines to add that premium to the cost-of-equity.
93
Rejection of this premium persisted in a 2006 case, in which defendant’s expert
applied company-specific risk premiums to each constituent business of the subject
company. The Court of Chancery stated ‘‘[O]ur courts have not applied company-
specific risk premia without fact based evidence produced at trial on which to base
that discount.’’
94
It then concluded, ‘‘In this case, the Court finds that the defendants
did not carry their burden of proving the appropriateness of company-specific pre-
mia for IIC constituent companies.’’
95
In the latest denial of a company-specific premium, the Court, in the 2010 Sun-
belt Beverage decision, reiterated the rule regarding the evidentiary burden for
accepting a company-specific risk premium. The Chancellor said:
Defendants offer three primary justifications for including a company-specific
risk premium: (1) the at-will termination of supplier agreements that prevails
throughout the wholesale alcohol distribution industry; (2) the competition
Sunbelt faces from specific players such as Southern Wine & Spirits; and
(3) the level of optimism contained in Sunbelt’s management projections.
91
Hintmann, 1998 Del. Ch. LEXIS 26 at
20.
92
Hintmann, 1998 Del. Ch. LEXIS 26 at
18–19, citing Pratt, Robert F. Reilly, and Robert P.
Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3d ed.
(New York: Irwin Professional Publishing, 1996), 164. Section 262 is the section of the Dela-
ware Corporation Law relating to appraisals (see n. 2 above).
93
Emerging Communications, 2004 Del. Ch. LEXIS 70 at
76.
94
Gesoff, 902 A.2d 1130, 1158.
95
Gesoff, 902 A.2d 1130, 1158.
Cost of Capital in Appraisal and Fairness Cases 179
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I conclude that none of these justifications merits inclusion of a com-
pany-specific risk premium for Sunbelt. The first and second justifications
clearly relate to the industry as a whole, rather than specifically to
Sunbelt.
96
Defendants thus have failed to meet their evidentiary burden to dem-
onstrate to me that it was riskier for Sunbelt to rely on its specific man-
agement projections than it is for all companies to rely on management
projections....Idonotbelieveacompanyshould be able to manufac-
ture justification for a company-specific risk premium (and all the quan-
titative uncertainty accompanied therewith) simply by adjusting its
management projections such that there is a heightened risk in relying on
those projections, no matter how unique that risk-thirsty practice may be
to the company.
97
The Court further stated, ‘‘It is important for any proposed company-specific
risk premium to be based on a specific financial analysis, so that the Court can verify
both the propriety of including the risk premium and the appropriate level of the
premium.’’
98
This explicit instruction regarding the necessity for both factual evi-
dence and specific financial analysis is a warning to any expert that without these
two essentials, the Court is unlikely to accept a company-specific risk premium.
It should be noted, however, that the Court accepted a company-specific risk
premium in a 1999 decision in which Chancellor Chandler reviewed the prior status
of this adjustment in Delaware. He found that ‘‘the party seeking to add the pre-
mium,’’ who bore ‘‘the burden of showing that the premium [was] appropriate,’’
had ‘‘only partly met that burden.’’
99
Noting that no beta had been calculated by
the experts, he explained, ‘‘I am willing to accept that the addition of a company-
specific premium is appropriate in the absence of beta [emphasis added].’’
100
He reviewed the six factors that respondent’s expert listed in support of the pre-
mium, and concluded that since the expert’s valuation ‘‘does not state how much
impact on the company specific premium each of these factors has, I will estimate
that they are approximately equal; therefore, because I have eliminated half of
them, I reduce [defendants’ 3.4%] company specific risk premium by an equal
amount, to 1.7%.’’
101
In contrast, in a 1994 Delaware decision in a fairness case, the Court criticized
the plaintiff’s expert for not using a company-specific premium.
102
The Court
rejected certain factors that defendant’s expert considered in support of a 5% com-
pany-specific premium, accepted other factors, and ruled that ‘‘an appropriate pre-
mium is 3%, based on the other factors considered by [defendant’s expert] in
96
Sunbelt Beverage, 2010 Del. Ch. LEXIS 1 at
47.
97
Sunbelt Beverage, 2010 Del. Ch. LEXIS 1 at
49–50.
98
Sunbelt Beverage, 2010 Del. Ch. LEXIS 1 at
50.
99
ONTI, 751 A.2d 904, 920.
100
The Chancellor noted that in Gilbert, 1998 Del. Ch. LEXIS 60, ‘‘Vice Chancellor Steele
applied . . . a beta . . . with the beta perhaps acting as a surrogate company specific risk pre-
mium.’’ ONTI, 751 A.2d 904, 920.
101
ONTI, 751 A.2d 904, 920.
102
Wacht, 1994 Del. Ch. LEXIS 171 at
13.
180 COST OF CAPITAL IN LITIGATION
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determining the target rate of return, such as pending litigation ...andthecompet-
itive environment in which Continental operated.’’
103
On balance, the reluctance of
the courts to accept company-specific premiums means that the expert who includes
this premium in his calculation of WACC may expect a strong challenge on the
stand. However, as discussed in the following section, the company-specific risk pre-
mium is acceptable in the build-up method.
BUILD-UP METHOD
Most expert testimony in Delaware has used CAPM for calculating cost of capi-
tal, but the Court has sometimes utilized the build-up method instead. The Del-
aware Court of Chancery explicitly rejected the build-up method in a 1998
decision, stating that ‘‘[t]he CAPM would seem to be more useful than the
‘build up’ method because it offers more complete information.’’
104
It has, how-
ever, been accepted in later decisions,
105
and in Delaware Open MRI in 2006,
the Court not only explicitly accepted the build-up method, but also provided
the rationale for doing so and also for accepting a company-specific risk pre-
mium in that case. Observing that the build-up method could reluctantly be ac-
cepted as a substitute for CAPM, Vice Chancellor Strine wrote:
[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. . . .
The experts in this case have used the proxy [for CAPM] that has
found the most favor among professional appraisers: the so-called
‘‘build-up model.’’ The build-up model begins with the core factors con-
sidered by CAPM, a risk-free rate and an equity premium rate. From
there, however, the build-up model begins to diverge from CAPM. Under
the build-up method, beta is not considered. A size premium, used con-
sistently with the practice of most current users of CAPM in the ap-
praisal and valuation context, is de rigueur under the build-up model.
Much more heretical to CAPM, however, the build-up method typically
incorporates heavy dollops of what is called ‘‘company-specific risk,’’ the
very sort of unsystematic risk that the CAPM believes is not rewarded by
the capital markets and should not be considered in calculating a cost of
capital [emphasis added].
106
The build-up method has seldom been discussed in other jurisdictions. How-
ever, in a Missouri appraisal case in federal court, the decision discussed both
experts’ use of the build-up method and applied it.
107
103
Wacht, 1994 Del. Ch. LEXIS 171 at
21.
104
Hintmann, 1998 Del. Ch. LEXIS 26 at
16.
105
Gholl, 2004 Del. Ch. LEXIS 171 at
47,
49; Henke, 2005 Del. Ch. LEXIS 170 at
40.
106
Delaware Open MRI, 898 A.2d 290, 338–9.
107
Swope, 243 F.3d 486, 893–898 and 903.
Cost of Capital in Appraisal and Fairness Cases 181
E1C09 09/04/2010 Page 182
ADDITIONAL POINTS
The Delaware courts have considered two additional and unrelated points that
should be noted by valuation experts: (1) the mid-year convention is acceptable, and
(2) DCF valuations using CAPM should not be adjusted for a minority discount.
The mid-year convention has been explicitly used in DCF calculations in every
Delaware case where the Court stated that a testifying expert had used it.
108
Several
other jurisdictions have also accepted the mid-year convention.
109
The Delaware courts recognize that DCF analyses based on discount rates de-
rived either using CAPM (using SBBI data, for example), the FF 3-factor model, or
the build-up method should not be adjusted for an implied minority discount. The
Court of Chancery first rejected this adjustment in 1991
110
and, except for one anom-
alous exception,
111
it has continued to reject adding a control premium to DCF valua-
tions. A 2001 decision cited Shannon Pratt’s reasoning for not permitting the
discount:
Some analysts believe that the income approach always produces a publicly
traded minority basis of value because the Capital Asset Pricing Model
(CAPM) and the build-up model develop discount and capitalization rates
from minority transaction data in the public markets. This is a very com-
mon and highly flawed conclusion. There is little or no difference in the rate
of return that most investors require for investing in a public, freely tradable
minority interest versus a controlling interest [emphasis on original].
112
ROLE OF THE EXPERT
Testifying experts need to be familiar both with pertinent valuation literature and
relevant case law regarding cost of capital and related issues. This base of knowledge
108
See, e.g., Hintmann, 1998 Del. Ch. LEXIS 26 at
16; PNB Holding, 2006 Del. Ch. LEXIS
158 at
105.
109
See. e.g., Steiner, 5 F.Supp.2d 1117, 1136; U.S. Inspect, Inc. v. McGreevy,57Va.Cir.
511, 524 (2000); 2000 Va. Cir. LEXIS 524 (Nov. 7, 2000) at
28; Shareholders in United
States Dredging Corp. v. United States Dredging Corp., slip op., Index No. 002640/2006 (N.
Y. Supr., Nassau Cnty., May 19, 2008) at 27.
110
In re Radiology Associates, 611 A.2d 485, 494 (‘‘The discounted cash flow method pur-
ports to represent the present value of Radiology’s cash flow. . . . The discounted cash flow
analysis, as employed in this case, fully reflects this value without need for an adjustment.’’)
111
The Court added a 20% control premium (based on ‘‘control premia paid for publicly-
held companies’’) to a DCF valuation in Hintmann, 1998 Del. Ch. LEXIS 26 at
31. In con-
trast, the Court has frequently added a premium to guideline company valuations to offset a
supposed ‘‘implicit minority discount.’’ This adjustment has, however, been questioned by
some legal and valuation commentators. See, e.g., Lawrence A. Hamermesh and Michael L.
Wachter, ‘‘The Short and Puzzling Life of the ‘Implicit Minority Discount’ in Delaware Ap-
praisal Law,’’ University of Pennsylvania Law Review 156(1) (February 2007); Matthews,
‘‘Misuse of Control Premiums in Delaware Appraisals,’’ Business Valuation Review (Summer
2008): 107–118 at 113.
112
Pratt, Business Valuation Discounts and Premiums (New York: John Wiley & Sons,
2001), 30, cited in Lane, 2004 Del. Ch. LEXIS 108 at
118.
182 COST OF CAPITAL IN LITIGATION
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will not only help experts assist the judge, but will also protect them in cross-
examination.
Even when experts are well-qualified, the courts often express skepticism as to
testimony regarding discount rates. Vice Chancellor Strine writes:
Testimonial feuds about discount rates often have the quality of a debate
about the relative merits of competing alchemists. Once the experts’ tech-
niques for coming up with their discount rates are closely analyzed, the
court finds itself in an intellectual position more religious than empirical in
nature, insofar as the court’s decision to prefer one position over the other is
more a matter of faith than reason.
113
This citation illustrates why an expert fails to serve the judge and the client by
acting as a partisan in court. Testifying experts are most valuable when they can
inform and educate the judge to understand, and then hopefully adopt, the reason-
ing underlying the expert’s report, testimony, and methodologies.
Sometimes the Court merely needs help in understanding technical issues. For
example, one Vice Chancellor appears to have misunderstood the definition of
deciles:
[Defendant] asserts [in its brief] that ‘‘the Ibbotson yearbook clearly states
that the capitalization cut-off between deciles 10a and 10b is $48,345,000.
That is, all companies with market capitalizations of $48,345,000 or less
fall within decile 10b, while companies with market capitalizations greater
than $48,345,000 but no greater than $84,521,000 fall within decile 10a.’’
This is not what the Ibbotson Associates yearbook says. Rather, it merely
provides that the largest company within decile 10b has a market capitaliza-
tion of $48,345,000 and the company with the largest capitalization within
decile 10a has a market capitalization of $84,521,000. There is no indica-
tion of whether a company with a market capitalization of less than
$48,345,000 may nonetheless fall within decile 10a or even decile 9 given
certain characteristics.
114
The Court’s misunderstanding of deciles demonstrates the importance of articu-
late testimony by an expert witness to explain concepts to a judge. If an experienced
Delaware Vice Chancellor can be confused by a basic statistical concept, experts
must be even more clear in their testimony when testifying in other jurisdictions
where judges are usually less familiar with valuation methods and literature.
Sometimes, as Vice Chancellor Strine articulates above, the Court’s fear that the
judge must operate ‘‘more [from] a matter of faith than reason’’ is much more seri-
ous. The Court’s apprehension arises from what Strine calls the ‘‘status of principles
of corporate finance,’’
115
that is, the valuation profession’s continuing but in-
complete development of the academic and intellectual principles which underlie
113
Delaware Open MRI, 898 A.2d 290, 338.
114
Taylor v. American Specialty Retailing Group, Inc., 2003 Del. Ch. LEXIS 75 (July 25,
2003) at
17 n. 18.
115
Delaware Open MRI, 898 A.2d 290, 338.
Cost of Capital in Appraisal and Fairness Cases 183
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valuation methodologies. In these situations, the Court does not expect the expert to
cure the theoretical inadequacies. What it requests is that experts aid the judge by, in
Strine’s words, ‘‘trying to come up with a proxy that takes into account concerns
addressed by CAPM.’’
116
As Strine elucidated:
Even as to public companies, there is much dispute about how to calculate
the discount rate to use in valuing their future cash flows, even when one
tries to stick as closely as possible to the principles undergirding the Capital
Asset Pricing Model and the semi-strong form of the efficient capital mar-
kets hypothesis. Witness the serious academic debate about whether the so-
called size premium received by investors in smaller public companies is a
durable indicia of their greater risk, or whether there are attributes of stocks
with a low book-to-market ratio that require the consideration of that fac-
tor in estimating a discount rate.
117
In addition, he points out that a reliable beta cannot be calculated directly for
thinly traded public companies, so that valuators are forced to employ the less desir-
able alternative of using guideline companies or industry data, as discussed previ-
ously in relation to the build-up model. He continues:
Situations like [Delaware Open MRI] inspire even less confidence, when
experts are required to calculate a cost of capital for a very small, non-pub-
lic company, for which neither of the experts has identified reliable public
comparables. In this context, the ability of the experts or the court to hew
literally to the teaching of the high church of academic corporate finance is
essentially non-existent. At best, the experts and the court can express their
reverence by trying to come up with a proxy that takes into account con-
cerns addressed by CAPM and ECMH [Efficient Capital Market
Hypothesis].
118
SUMMARY
The Delaware Court of Chancery is the leading court on valuation issues in corpo-
rate disputes. That Court has declared its preference for the DCF method of valua-
tion, including all elements of the expanded CAPM to determine the cost of capital.
It has, however, rejected the company-specific adjustment in the calculation of
WACC unless there are unusual circumstances to validate it.
116
Delaware Open MRI, 898 A.2d 290, 338
117
Delaware Open MRI, 898 A.2d 290, 338.
118
Delaware Open MRI, 898 A.2d 290, 338.
184 COST OF CAPITAL IN LITIGATION
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Article
Full-text available
In statutory appraisal cases, Delaware Courts sometimes apply premiums that are based on questionable reasoning. They commonly adjust guideline company valuations for an ‘‘implicit minority discount’’, they apply acquisition premiums to subsidiaries, and they often rely upon average premiums in acquisitions as a basis for calculating control premiums. This article discusses the flaws in the reasoning underlying these adjustments.
Article
The "implicit minority discount," or IMD, is a fairly new concept in Delaware appraisal law. A review of the case law discussing the concept, however, reveals that it has emerged haphazardly and has not been fully tested against principles that are generally accepted in the financial community. While control share blocks are valued at a premium because of the particular rights and opportunities associated with control, these are elements of value that cannot fairly be viewed as belonging either to the corporation or its shareholders. In corporations with widely dispersed share holdings, the firm is subject to agency costs that must be taken into consideration in determining going concern value. A control block-oriented valuation that fails to deduct such costs does not represent the going concern value of the firm. As a matter of generally accepted financial theory, on the other hand, share prices in liquid and informed markets do generally represent that going concern value, with attendant agency costs factored or priced in. There is no evidence that such prices systematically and continuously err on the low side, requiring upward adjustment based on an "implicit minority discount."Given the lack of serious support for the IMD in finance literature, this Article suggests that the Delaware courts may be relying on the IMD as a means to avoid imposing upon squeezed-out minority shareholders the costs of fiduciary misconduct by the controller. Where either past or estimated future earnings or cash flows are found to be depressed as a result of fiduciary misconduct, however, or where such earnings or cash flows fail to include elements of value that belong to the corporation being valued, the appropriate way to address the corresponding reduction in the determination of "fair value" is by adjusting those subject company earnings or cash flows upward.This approach to the problem of controller opportunism is more direct, more comprehensive in its application, and more in keeping with prevailing financial principles, than the implicit minority discount that the Delaware courts have applied in the limited context of comparable company analysis. The Delaware courts can therefore comfortably dispense with resort to the financially unsupported concept that liquid and informed share markets systematically understate going concern value.
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Pratt, ''Valuers Should Lower Equity Risk Premium Component of Discount Rate'' at 1. Pratt then ''urged his readers who still use an ERP of 7% to immediately make a downward adjustment to reflect recent research results,'' at 6.
Given what Gotham itself contends was an 'inefficient' market in the Partnership's units . . . , the judgment that the Partnership's published beta was out of line strikes me as reasonable
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