Commercial Appraiser

Federal court asks experts for the ‘just right’ discount rate
Posted: 22 Jul 2011 02:30 PM PDT

A bankrupt chemical business didn’t owe $16.3 million in damages for breach of contract, because the claims were barred by the statute of limitations and a prior settlement. But just in case—the federal district court considered an issue that was certain to come up on an appeal: calculation of the discount rate to present value the future stream of contract payments. Not surprisingly, the plaintiff’s expert argued for applying a very low range (less than 3%), based on the “Ask Yield” rate for U.S. Treasury bonds. (When asked why he chose this rate, he essentially replied: because the plaintiff’s attorney told me to.) In contrast, the defendant’s expert used the company’s weighted average cost of capital (WACC) of 11.75% at the time of bankruptcy–which more accurately reflected its ability to perform on the contract, he said.
A ‘Goldilocks’ problem. The court agreed that the risk-free rate was too low—but found that the debtors’ proposed rate was “much too high.” The debtors’ WACC dealt with the company as it had evolved up and through bankruptcy, but only a subset of those risks would have impacted it at the time of the contract (1991). Not satisfied with either party’s research, the court did its own, finding Teachers Ins. & Annuity Ass’n of America v. Ormesa Geothermal, 791 F.Supp 401 (S.D.N.Y. 1991)—a case which rejects the risk-free rate in favor of a rate that reflects the same risk that the plaintiff would have made in a similar contract with an alternate obligor. Thus, the discount rate “must…correspond to the risk of nonperformance” at the time the parties originally entered the contract, the court held, but since neither had offered this evidence, it ordered them to “attempt to” agree on a discount rate, based
on its ruling. If they failed, “they can always come back to me,” the court added, leaving the door open for additional expert findings on the all-important discount rate in contract damages actions.
Read the entire digest of In re Chemtura Corp., 2011 WL 1496327 (Bkrtcy. S.D.N.Y)(April 19, 2011) in the next (August 2011) Business Valuation Update; the court’s opinion will be posted soon at BVLaw.

Has the Tax Court become almost too valuation-savvy?
Posted: 22 Jul 2011 11:47 AM PDT

The estate reported its 41.1% limited partnership (LP) interest in a family owned, timberland holding company at just over $12.6 million; the IRS said it was worth closer to $36 million and assessed a penalty of over $2.5 million. In finding that the “correct” value of the LP interest was roughly $27.5 million, the U.S. Tax Court (J. Morrison) determined the following:

The discounted cash flow (DCF) analysis by the taxpayer’s BV expert was better overall, because he extrapolated cash flows from the five prior years instead of the most recent and he pointed out the internal inconsistencies in the IRS expert’s DCF—but he also tax-affected the projected cash flows while also using a pre-tax rate of return to discount them to present value, an inconsistency the court found “problematic.”

Three out of the four components that the taxpayer’s expert used to build a discount rate were good (risk-free rate, beta-adjusted ERP, small stock ERP), but his partnership-specific risk premium was too high, given standard portfolio investment theory, resulting in a “correct” rate of 16.25%–nearly equal to the 16.22% rate posited by the IRS expert, but the court expressly rejected his method (risk-free rate plus small stock ERP).

Since the taxpayer’s expert failed to rebut the IRS expert’s contention that pre-IPO studies overstated the discount, the court accepted the latter’s 25% DLOM (versus 35% for the taxpayer).

Yet, even though the experts differed by only 10% on weighting the cash flow method (30% for the taxpayer vs. 20% for IRS), the court more than doubled the assigned weighting to 75%, based on a 75% probability that the partnership would have kept going rather than liquidating. The only cited authority: a 1995 law review article that states “the entire valuation process is a boundless subjective inquiry,” requiring the court to make numerous “guesses or assumptions about the future.”
The court also rejected the guideline public company method used by both experts (for poor comparables) and three hybrid methods used by the taxpayer’s expert, giving only their net asset values (NAV) the remaining 25% weight. It also waived any penalties, even though the estate’s original appraiser relied only on variations of the income and market approaches without considering the NAV. Read the entire digest of Estate of Giustina v. Commissioner, T.C. Memo. 2011-141 (June 22, 2011) in the September Business Valuation Update; the Tax Court’s opinion will be posted soon at BVLaw.
 


Thanks!
Curtis D. Harris, BS, CGREA, REB
Bachelor of Science in Real Estate, CSULA
State Certified General Appraiser
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