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The Guide to Damages in International Arbitration - Second Edition

Income Approach and the Discounted Cash Flow Methodology

Introduction

When applying the income approach, the theory of business valuation determines the value of a business by assessing the present value of its future net cash flows.[2] Since the requirement of full compensation is generally interpreted to put the damaged party into the same economic (i.e., financial) situation it would have been in but for the wrongful act, the methodology and approaches widely accepted for business valuation are also applied in the determination of damages.[3]

The following sections briefly introduce the discounted cash flow (DCF) methodology and its approaches, and then discuss, in the context of international arbitration, its application to the assessment of damages, the assumptions required to adequately and reliably use this methodology and the documentation required to support its results.

The discounted cash flow methodology

Introduction

The DCF methodology determines the business value as the present value of expected future net cash flows discounted at a rate reflecting the time value of money and the risks attributable to these cash flows.[4] Within the different approaches applied for valuing a business, it ‘comes with the best theoretical credentials’[5] and ‘remains a favourite of practitioners and academics because it relies solely on the flow of cash in and out of the company, rather than on accounting-based earnings’.[6] It is, therefore, less prone to manipulation through the use of accounting policies[7] and avoids divergent results from the use of different accounting principles (e.g., International Financial Reporting Standards (IFRS), US-Generally Accepted Accounting Principles (US-GAAP)).

The DCF method distinguishes two general approaches, depending on whether the value is determined for only the equity investment in the business (known as ‘equity valuation approach’) or the entire business (known as ‘enterprise valuation approach’). Both approaches are broadly accepted but vary with regard to the relevant cash flows and discount rates.[8]

The equity valuation approach

The equity valuation approach calculates the value of equity by discounting the future net cash flows after debt payments and reinvestment needs (known as ‘free cash flow to equity’) at a rate reflecting only the cost of equity.[9]

The enterprise valuation approach

The enterprise valuation approach calculates the enterprise value of the business through discounting the future net cash flows before debt payments and after reinvestment needs (known as ‘free cash flow to the firm’) at a rate reflecting the cost of all sources of capital, applying a blended cost of capital.[10] The equity value can be derived from the enterprise value by deducting the market value of non-equity claims[11] (i.e., primarily interest-bearing debt).

The weighted average cost of capital (WACC) approach is the most commonly used enterprise valuation approach.[12] It is often used applying a constant discount rate, which would require a stable capital structure (i.e., a constant ratio of the market value of debt to the market value of equity). But, since the capital structure typically changes over time, the use of a constant WACC may not be appropriate. Instead, it needs to be adjusted throughout the valuation period to reflect the changes in the capital structure.[13]

Application of the discounted cash flow methodology to the assessment of damages in international arbitration

Introduction

The use of the DCF methodology will generally require some modification to quantify damages in international arbitration, as the required full compensation may necessitate a ‘damages computation that is markedly different than a standard business valuation’.[14]

First, the standard approach to determine full compensation is a comparison of the damaged party’s actual situation with the situation it would have been in ‘but for’ the wrongful act (i.e., the ‘but-for method’).

Second, depending on the facts and circumstances, damages will be assessed as a loss in business value or as lost profits.

Third, while business valuation is typically based on the information available at the valuation date (the ex ante approach) the quantification of damages also regularly considers information available up to the date of the assessment (the ex post approach).

Fourth, notwithstanding the above, in some instances the quantification of damages may be easier by directly assessing the cash flow resulting from the wrongful act (direct assessment) than by comparing two sets of cash flows with and without the influences of the wrongful act (indirect assessment).

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