August 21, 2012 Articles

A Primer on Discount Rates Continued

Bankruptcy professionals encounter complex issues when dealing with fraudulent conveyance claims, and other issues related to analyzing solvency.

By Jeffrey L. Baliban

The previous installment in this series introduced the role of discount rates in determining whether or not an entity would have been insolvent after transferring assets or value. This is key to determining whether the transfer may have been constructively fraudulent and subject to avoidance and reclamation by the estate for the benefit of creditors. The following are a few key points:

  • Because “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 section 101(32)(A) (emphasis added)), analyzing the extent to which an entity is insolvent or not is first and foremost a valuation exercise.
  • The value of an income-producing going-concern entity can be defined as the present value of the future economic benefits stream to be generated by operating the business. The economic benefits stream is typically considered to be the cash flows the business is expected to generate in the future.
  • Such future cash flows are usually forecasted for five or more discrete periods (often years) into the future and then capitalized into perpetuity if appropriate. The future benefits stream can then be converted to a single present value through the application of a risk-adjusted discount rate. Because this discount rate considers both the time value of money as well as the riskiness embedded in cash flow forecasts, it is expressed as an interest rate and represents the entity’s cost of capital or an investor’s required rate of return.
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