The discounted cash flow method, or “DCF”, has become the generally accepted method of valuation in Delaware’s Court of Chancery.  The DCF method seeks to value a company by discounting the company’s projected future cash flows to present value based on the perceived risk of investing capital in that company.  As recently summarized by Vice Chancellor Parsons in Merion Capital, L.P. v. 3M Cogent, Inc., C.A. No. 6247-VCP, “the DCF method involves three basic components: (1) cash flow projections; (2) a discount rate; and (3) a terminal value.”  Slight variances in those components, however, can result in radically different valuations.

Calculating the discount rate is often the most complex aspect of a DCF valuation.  When computing the discount rate, courts are asked to analyze “betas,” “risk premiums” and “size premiums” – terms that are casually thrown around in the valuation world but which are foreign to many lawyers and shareholders unfamiliar with the appraisal arena.

The purpose of the discount rate is to quantify the risk of investing capital in the subject company.  The most common method applied by the Delaware courts in determining the discount rate under a DCF analysis is the weighted average cost of capital, or “WACC.”  In computing a company’s WACC, an appraiser must first determine the company’s capital structure:  how much of the company is equity, and how much of it is debt?  The appraiser then multiplies the company’s “cost of equity” by the percentage of the capital structure that is equity and adds that number to the company’s after-tax “cost of debt” multiplied by the percentage of the capital structure that is debt.  Thus, if a company’s capital structure is 75% equity and 25% debt, its WACC would equal 0.75 times its cost of equity plus 0.25 times its after-tax cost of debt.

While this calculation appears to be fairly simple, the process of determining the company’s cost of equity and cost of debt often polarizes the parties in valuation cases.  The cost of debt typically is easier to calculate than the cost of equity.  In calculating the cost of debt, the court must determine what interest rate a lender would charge the company to borrow money over the long term.

In calculating the cost of equity, the court must determine what rate of return an investor would demand in order to purchase the company’s stock.  Last year, the Court of Chancery has indicated a preference for calculating the cost of equity using the Capital Asset Pricing Model, or “CAPM.”  See In re Appraisal of Orchard Enterprises., C.A. No. 5713-CS.  The CAPM calculates the cost of capital by taking a “risk-free rate,” which is the return that an investor would expect on an investment with no perceived risk, such as a treasury bond, and adding an “equity risk premium” to that rate.  The equity risk premium is the difference between the risk-free rate and the expected return from the market.  However, because not all stocks perform alike, the equity risk premium is adjusted by a coefficient called a “beta.”  The beta measures a stock’s volatility.  A stock with a beta of one will perform in line with the market, but a stock with a beta higher than one will be more volatile than the market and a stock with a beta of less than one will be less volatile than the market.  Finally, when a smaller company is being valued, a “size premium” is added to account for the additional return an investor will require to offset the additional risk of investing in a smaller company.  Although valuation experts sometimes have advocated for adding a company-specific risk premium as well, Delaware courts have generally resisted including such a premium as inconsistent with the conventional CAPM method.

The CAPM cost of equity is thus calculated as follows:

Cost of equity = Risk-free rate + (Equity risk premium x Beta) + Size risk premium

It is important to understand the different WACC variables discussed above when seeking an appraisal.  Even seemingly minor variances in the WACC’s discrete components can have a significant impact on the ultimate valuation of a shareholder’s stock.  Also, while the Court of Chancery has expressed a preference for calculating WACC using the CAPM for the time being, it has also indicated its willingness to adapt to developments in the financial and valuation communities.  Thus, the method for computing the discount rate in appraisal cases is not set in stone and may well evolve along with developments in the financial and economic fields.