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.