May 30, 2012 Articles

A Primer on Discount Rates

This is the second in a four-part series addressing the issues bankruptcy professionals encounter when dealing with fraudulent conveyance claims and other issues related to analyzing solvency.

By Jeffrey L. Baliban

This is the second in a four-part series addressing the complex issues bankruptcy professionals encounter when dealing with fraudulent conveyance claims and other issues related to analyzing solvency. Read part one

A transfer of a debtor’s interest in property made within two years before the date of the filing of a petition may be a constructively fraudulent transfer and subject to avoidance by a trustee if it can be shown that the debtor was insolvent on the date the transfer was made, or that the debtor became insolvent as a result of such transfer (see Title 11 § 548(a)(1)). Further, “‘insolvent’ means [a] financial condition such that the sum of [an] entity’s debts is greater than all of such entity’s property, at a fair valuation” (see Title 11 § 101(32)(A)). Therefore, analyzing whether an entity is insolvent at any particular time is essentially a valuation exercise. The value of a going concern can be defined as the present value of the stream of economic benefits the entity is expected to generate in the future. Economic benefits are typically defined as cash flows generated by the business, hence the term discounted cash flow model or DCF. Therefore, value becomes a combination of a forecast of future cash flows and a risk-adjusted discount rate to convert the future benefit stream to a present value. While the cash flow forecasts themselves can be the subject of many interesting and often complex assumptions, the eyes of many an experienced litigator glaze over when the discussion turns to discount rates. Make no mistake: Discount rates and cost of capital are complex finance issues on which many an authoritative texts, treatises, and doctoral dissertations have been written. It is certainly not my intention in this series to delve into quantitative finance or the mathematics of optimal capital structure estimation. However, I will discuss some of the fundamentals of discount rate determination with which litigators should be familiar, especially when taking opposing valuation expert's deposition.

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