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Table of Exhibits
Foreword: Cost of Capital
Foreword: Family Law Perspective
Foreword: Insolvency Perspective
About the Authors
About the Contributing Authors
Preface
Acknowledgments
Table of Abbreviations

Part 1 - Cost of Capital Basics

Chapter 1 Defining Cost of Capital

Introduction
Cost of Capital Is Multifaceted
        Cost of Capital Is Forward-Looking
        Cost of Capital Is Based on Market Value
        Cost of Capital Is Usually Stated in Nominal Terms
Cost of Capital Equals the Discount Rate
Cost of Capital Should Reflect the Risk of the Investment
        Defining Risk
        Understanding the Role of Risk

Chapter 2 Valuing Equity Versus Invested Capital

Introduction
Equity Capital
Invested Capital
Relationship Between Equity and Enterprise Value
        Components of Common Equity
        Components of Senior Securities
Fully Diluted Common Shares
Personal Guarantees
Components of a Capital Structure
        Capital Structure at Book Value
        Capital Structure at Market Value

Chapter 3 Net Cash Flow: The Preferred Measure of Economic Income

Introduction
Definition of Net Cash Flow
        Net Cash Flow to Common Equity Capital
        Net Cash Flow to Invested Capital
Why Net Cash Flow Should be Probability-Weighted Expected Values
Why Net Cash Flow Is the Preferred Measure of Economic Income

Chapter 4 Discounting Versus Capitalizing

Introduction
The Concept of Discounting
The Concept of Capitalizing
The Basic Capitalized Cash Flow Model
        The Constant Income Capitalization Model
        The Income Capitalization Growth Model
The Basic Discounted Cash Flow Model
        The Discounted Cash Flow Model for a Limited
        Life Investment
        The Discounted Cash Flow Model Using a “Terminal Value”
        Capitalization Model Versus Market Multiples for Estimating Terminal Value
Concept and Estimation of Discount Rates
        The Concept of the Discount Rate
        Elements of the Discount Rate: A Risk-Free Rate and a Premium for Risk
        Estimating Discount Rates for Fixed-Income Securities
Equivalency of Discounting and Capitalizing Models
Discounting or Capitalizing—Which to Choose
Alternative Formulas for Discounting and Capitalizing
        Midyear Discounting Convention
        Midyear Capitalization Convention
        Midyear Convention in the Two-Stage Model
        Seasonal Businesses

Chapter 5 Estimating the Cost of Equity Capital

Introduction
The Build-Up Method
        Risk-Free Rate
        Equity Risk Premium
        Size Premium
        Industry Risk Factor
        Company-Specific Risk Premium
The Capital Asset Pricing Model
        Background of the CAPM
        Assumptions Underlying the CAPM
        Concept of Market or Systematic Risk
        Modification of CAPM to Incorporate Size Premium and Company-Specific Risk Premium

Chapter 6 Components of Cost of Equity Capital

Introduction
Components of the Risk-Free Rate
Equity Risk Premium
Market or Systematic Risk
        Using Beta to Estimate Market Risk
        Unlevering and Levering Beta
        Using Industry Risk Adjustment to Estimate Market Risk
Size Premium
Company-Specific Risk Premium
        Size Smaller Than the Smallest Size Premium Group
        Volatility of Returns
        Leverage
        Other Company-Specific Factors
Other Methods for Estimating the Cost of Equity Capital
        Fama-French Three-Factor Model
        Implied Cost of Equity Capital

Chapter 7 Adjusting a Discount or Capitalization Rate for Other Measures of Economic Income

Introduction
Converting a Capitalization Rate for Net Cash Flow to a Capitalization Rate for Another Economic Income Measure
        Converting a Capitalization Rate with Zero Growth
        Converting an After-Tax Discount Rate to a Capitalization Rate with Constant Growth
Converting an After-Tax Discount Rate to a Pretax Discount Rate with Constant Growth
Summary

Chapter 8 Overall (Weighted Average) Cost of Capital

Introduction
How to Compute WACC for a Public Company
How to Compute WACC for a Nonpublic Company
Whether to Use Actual or Hypothetical Capital Structures
Whether to Use Constant or Variable Capital Structures
When to Use WACC

Chapter 9 How Cost of Capital Relates to the Excess Earnings Method of Valuation

Introduction
Basic “Excess Earnings” Valuation Method
        Conceptual Basis for the Method
        Steps in Applying the Excess Earnings Method
        Example of the Excess Earnings Method
Cost of Capital Reasonableness Check
        Estimating a Capitalization Rate Using the Build-Up Method
        Computing the Weighted Average Excess Earnings Capitalization Rate
        Discussion of the Example
Vagaries of the Excess Earnings Method

Chapter 10 Handling Discounts for Lack of Marketability and Liquidity

Introduction
Using Databases of DLOMs for Minority Ownership Interests to Quantify Discounts for Lack of Marketability
        Restricted Stock Transactions
        Pre–Initial Public Offering Transactions
Using Options to Estimate DLOM
        Chaffee Model
        Longstaff Model
        Finnerty Model
        Long-Term Equity Anticipation Securities Studies
        Comparison of Option Models to Empirical Data
Measuring Blockage (Illiquidity) Discounts for Public Companies
Using the Private Company Discount for Controlling Interests in Operating Businesses
        Relationship Between DLOM for Minority Interests and PCD
        Discounts Observed in Private Company Discount Studies
        Reasons for the Private Company Discount
Building the Discount for Lack of Marketability into the Discount Rate
        Venture Capitalists’ Required Rates of Return
        Discount Rate Adjustments for Lack of Marketability

Part II - Cost of a Capital in Specific Contexts

Chapter 11 Cost of Capital in Estate and Gift Tax Matters

Introduction
Acceptance and Rejection of DCF
Evaluation of Cash Flow Forecasts
Cost of Equity Capital Versus WACC
Build-Up, CAPM, or Something Else?
Cost of Equity Capital
        Small Company Risk Premium
        Company-Specific Risk Premium
        Failure to Account for Unsystematic Risk
        Impounding DLOM into Discount Rate
Consistency of Data
Courts Demand Supporting Detail
Cost of Capital for a Regulated Company
S Corporations
Summary

Chapter 12 Cost of Capital Considerations in Corporate Restructuring and Other Federal Tax Matters

Introduction
Legal Entity Valuations
        Legal Entity Valuations as Part of an Acquisition
        Legal Entity Valuations Outside of an Acquisition
        Income Tax Considerations
        Minority Interest Considerations
Example of Legal Entity Valuation Dispute
        Background
Intercompany Debt
Worthless Stock
Transfer Pricing Disputes
Tax Benefits Due to Asset Step-Ups
Discount for Lack of Marketability
Summary

Chapter 13 Cost of Capital Included in Damage Claims for Lost Profits

Introduction
The Importance of Discounting
Appropriateness of a Risk-Free Discount Rate
Cost of Capital Is the Appropriate Risk-Adjusted Discount Rate
Tax Effects
Common Errors in Discounting Lost Profits
Exclusion of Expert Testimony
Summary

Chapter 14 Cost of Capital in Intellectual Property Disputes

Introduction
Categories of Intellectual Property Rights
        Patent Infringement Damages
        Copyright Infringement Damages
        Trademark Infringement Damages
        Misappropriation of Trade Secret Damages
        Breach of Contract Damages
Court Guidance Regarding Discount Rate Selection
        Tax Effects
        Ex Ante or Ex Post Damages
Prejudgment Interest Rates
Developments in Patent Infringement Damages Law
        Injunctions Versus Ongoing Royalties
        Foreign Sales
        Applicable Revenues
        Comparable Licenses
        Noninfringing Alternatives
        Royalties in the Context of Standards
        Other Cases
Summary

Chapter 15 Cost of Capital in Bankruptcy

Introduction
Cost of Capital for Debt
        Debtor-in-Possession Lending
        Supreme Court’s Views on Cram Down Loans
Cost of Capital for a Business Enterprise
        Solvency Valuation for Fraudulent Conveyance and Preference Claims
        Enterprise Valuation for Secured Claims Analysis
        Reorganization Value for Plan Confirmation
        WACC for Highly Leveraged Enterprises
Summary

Chapter 16 Cost of Capital in Appraisal and Fairness Cases

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

Chapter 17 Cost of Capital in Family Law Matters

Introduction
Cost of Equity Capital Versus WACC
Capital Structure: Industry Versus Business
Market Value Weight Proportions and the Cost of Equity Capital
The Hidden Impact of Rounding
Cost of Capital in Family Law Courts
        New York
        Indiana
        Colorado
        Nebraska
        Connecticut
        Virginia
        Michigan
        Arkansas
Summary

Chapter 18 Cost of Capital in Ad Valorem Taxation

Introduction
Unitary Property Cost of Capital by State
        California
        Colorado
        Nevada
        Oklahoma
        Texas
        Washington
        Wyoming
Company Cost of Capital Versus Asset Cost of Capital
        Asset Valuation
        Definitions
        Special Use Property
        Variability of Cash Flow and Returns
        Difference Between Cost of Capital for a Business and a Single Asset
Assessed Value Versus Market Value
General Categories of Legislative Constraints That Necessitate Adjustments to the Cost of Capital
        Tangible Assets Including Assemblage or Enhancement
        Operating Property in Existence on a Lien Date
Capital Structure
Weighted Average Cost of Capital
        Cost of Equity Capital
        Cost of Preferred Equity Capital
        Cost of Debt Capital
Ad Valorem Tax Adder
Pretax Discount Rates
Flotation Costs
Cost of Capital in the Courts

Chapter 19 Cost of Capital in Regulated Industries

Introduction
Overview of Regulatory Decision-Making Process
Role for Cost of Capital
Alternative Approaches to Setting Cost of Capital
        Base Rate Case
        California Cost of Capital Proceeding
        Special Adjustment Mechanisms
        Utility Cost of Capital Measurement Issues
Financial Metrics Used to Assess Financial Condition Under Current Rates
        Metrics Used by Credit Rating Agencies
        Special Issues
        Challenges in Estimation Due to Financial Conditions Leading to “Great Recession”
Specific Issues by Technique
        DCF Method
        CAPM
        Empirical CAPM
        Bond Rate Differential
Other Methods
        Fama-French Three-Factor Model
        Market-Derived Capital Pricing Model
        Predictive Risk Premium Model™
        Behavioral Finance
Railroad Cost of Capital Issues
        ECAPM
        Multistage DCF Method
Summary

PART III - Evaluating Experts

Chapter 20 Common Errors in Applying Cost of Capital

Introduction
General Errors
        Making Assumptions That Produce a Standard of Value Other Than That Specified in the Valuation Engagement
        Using a Safe Rate to Discount or Capitalize a Risky Return
        Confusing Discount Rates with Capitalization Rates
        Using the Same WACC to Value Different Businesses Owned by a Diversified Company
        Using the Firm’s Cost of Capital to Evaluate a More or Less Risky Acquisition or Project
        Using Both the Discounting and Capitalizing Methods and Weighting Them
        Selecting One Period from a Data Set for Estimating One Variable and Another Period from the Same Data Set to Estimate Another Variable
        Adjusting the Balance Sheet for Nonoperating Assets Without Adjusting the Income Statement (or Vice Versa)
Developing Discount and Capitalization Rates
        Subtracting a Short-Term Growth Rate from the Discount Rate to Get a Capitalization Rate
        Using an Industry Risk Premium with Noncomparable Companies
        Blindly Accepting the Long-Term Average as Today’s Equity Risk Premium
        Mistaking Historical Rates of Return for Expected Rates of Return
        Using Incorrect or Inadequately Supported Data in Estimating the Cost of Equity
        Using Different Betas to Estimate Beta for the Subject Company Than Are Used in the Guideline Company Method
        Using an Inappropriate Beta in the CAPM
        Using an Inappropriate Beta in a Multifactor Model
        Failing to Use the “Iterative Method” to Estimate the Proportions of Debt and Common Equity in the Capital Structure When the Value of Common Equity Is Unknown
Mismatching Economic Income
        Applying a Discount Rate Applicable to Net Cash Flow to Net Income
        Applying a Discount Rate in Real Terms to an Economic Income Projection in Nominal (Current) Terms
        Substituting EBITDA for Net Cash Flow
        Applying Costs of Capital Derived from After-Tax Returns to Pretax Net Cash Flows
Making Projections
        Projecting Growth Beyond That Which the Capital Being Valued Will Support
        Using the Most Likely Forecast Instead of the Probability-Weighted Forecast
        Making Pure Mechanical Projections from Past Results
        Accepting Management’s Projections Without Analysis
        Other Errors in Estimating Net Cash Flows
Terminal Value
        Discounting the Terminal Value for N + 1 Periods
        Using an Unattainable Growth Rate in Calculating the Terminal Value
        Using Market Multiples Without Adjusting for Differences in Growth
Capital Structure
        Internally Inconsistent Capital Structure Projection
        Overlooking the Current Portion of Long-Term Debt in the Capital Structure When Computing the Proportions of Debt in the Capital Structure
Excess Earnings Method
        Failure to Separate (or Even Recognize) Excess Assets
        Conformation of WACC to the Capitalization Rate as Developed in This Book
        Capitalization of Tangible Assets at the Risk-Free Rate
        An Excess Earnings Method Valuation That Results in an Unrealistic Cost of Capital
Failure to Provide Detailed Explanations
Errors in Discounting Lost Profits
        The Most Common Error in Discounting Lost Profits Is Using a Risk-Free Discount Rate
        Using the Methods Appropriate to the Discounting of the Lost Earnings of an Individual to Discount the Lost Profits of a Business
Exclusion of Expert Testimony
Summary

Chapter 21 Questions to Ask Business Valuation Experts

Introduction
Examination Outline
Questions on Admissibility and Impact of Expert
Questions on Expert’s Practice and Work Done on Engagement
Questions on Overview of the Assignment
Questions on the Income Approach: General
Questions on Discounting Method
Questions on Capitalization Method
Questions on Cost of Capital
Questions on the Build-Up Method
Questions on CAPM and Modified CAPM
Questions on Debt Capital of Subject Company
Questions on Marketability of Interest If Closely Held Entity Being Valued
Questions on Estimating Net Cash Flows

Appendix I: Bibliography
Appendix II: International Glossary of Business Valuation Terms
Table of Cases
Index