Page 20 - Economic Damage Calculations

Chapter 3

Financial Principles for Estimating Discount Rates

Introduction

A company’s cost of capital represents the opportunity cost of the assets of a company. The cost of capi-
tal is often seen in the costs the company pays in raising those funds, which is affected by the perceived
riskiness of the company’s operations and expected returns. The cost of capital is a topic that has been
the subject of significant study, including evaluation of capital market behavior, the role of risk, and the
influence of new information on the pricing of investments. fn 1

As discussed in chapter 2, "Overview of Time Value of Money," in this practice aid, a discount rate can
be defined as a rate of return (or a cost of capital) used to convert a monetary sum, payable, or receiva-
ble from a future time period into a present value. Consequently, the discount rate should account for
both the time value of money and the risk or reward of the subject investment.

Types of Risk

As discussed previously, discount rates incorporate consideration of otherwise available interest rates,
including those on U.S. Treasury securities and corporate debt. In addition, discount rates incorporate
consideration of the risks associated with the subject investment cash flow or income stream. This con-
sideration is seen in the risk premium (the excess of the discount rate over the risk-free rate), which is
influenced by both the amount of risk and the extent to which investors require a higher return for in-
creases in risk. For example, in some economic environments, risk may be more acceptable as seen in
relatively low penalties for risk, such as during the late 1990s. In other times, risk may be heavily penal-
ized, such as during late 2008 and 2009 (the global recession). As a result, the effect of risk on the rela-
tive value of companies and investments can widely vary. The total risk associated with an individual
investment can be disaggregated into two components: systematic risk and unsystematic risk.

Systematic risk (also called market risk or nondiversifiable risk) is the risk that is common to all securi-
ties and investment assets in a similar asset class; it cannot be eliminated through investment portfolio
diversification. Systematic risk includes (a) country risk, (b) interest rate risk, (c) macro-economic fac-
tors, (d) certain industry risks, and (e) legislative-judicial risk. These risks may lead to either increases
or decreases in future income or cash flow. A common measure of systematic risk related to publicly
traded stocks is the beta coefficient. fn 2 Beta is a measure of the correlation between the movement in a
stock’s price and the movement of the securities market as a whole. The beta for an individual security
(Bi) can be estimated based on a regression analysis between changes in the subject security prices com-
pared to changes in a market index.

fn 1 See the appendix, "Resource and Reference List," in this practice aid for a list of references and resources.

fn 2 For a more in depth discussion of Beta and its derivation, see Myron Scholes and Joseph Williams, "Estimating betas from non-
synchronous data," Journal of Financial Economics 5 (1977), 309–27; and Charles P. Jones, Investments: Analysis and Management,
6th ed. (New York: John Wiley & Sons), 1998, 138, 141, 175, 230, and Chapters 6, 7, and 9. See also the appendix in this practice aid
a reference list.

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