Page 25 - Economic Damage Calculations

The build-up model should yield a cost of equity capital that is conceptually equivalent to what would
be derived under a modified CAPM model. An example of the estimation of the cost of equity capital
using the build-up model follows:

Risk-Free Rate (Rf) 5.8%

Plus Equity Premiums:
General Market Risk Premium (RPm) 7.8%
Size Related Risk Premium (RPs) 3.3%

Industry-Specific Risk Premium (RPi) (1.0%)
Company-Specific Risk Premium (RPc) 2.0%
Total Equity Risk Premium 13.1%
Estimated Cost of Equity Capital 18.9%

Example Discount Rate Implementations

The following sections provide examples of methodologies used in the estimation of discount rates and
rates of return on investments. As previously described, some discount rates may be composed of a
combination of, for example, a debt rate and an equity rate of return. Alternatively, in some circum-
stances, a debt or equity rate may be appropriate without adjustment or combination.

Cost of Debt as a Discount Rate

The cost of debt may provide a suitable discount rate in a situation such as when a company pursued a
new business venture with a key customer. In this hypothetical, the venture was to be financed by the
parties with debt bearing an interest rate of 9.0 percent and no equity investment was required. Subse-
quently, the customer breached the contract and the company sought lost profits under the terms of the
contract. In this situation, it may be appropriate to use a discount rate based on the lending rate of 9.0
percent because that rate reflects the assessment of the risk associated with the contract, as assigned by
the parties via the interest rate on the debt to fund the venture. The use of this rate is consistent with the
idea that the cash flow stream in question may not always be best estimated by using cost of capital in-
formation derived from data for the company as a whole, especially if a significant risk factor related to
the cash flow stream is to be determined by the litigation. fn 8

Weighted-Average Cost of Capital

As previously described, in some circumstances, a discount rate may be estimated using both an equity
component and a debt component, along with an estimated capital structure that defines the composite
rate. In such an analysis, the weighted-average cost of capital (WACC) is measured as the relative pro-
portion of equity and debt in a company’s capital structure. Depending on the purpose and objective of

fn 8 Nevertheless, an argument could be made that in this example that the loan for the venture was made based on one of the compa-
ny’s equity position and with possible guarantees from the company as a whole, such that the company’s equity did play a part in the
transaction.

© 2020 Association of International Certified Professional Accountants 23