Unpacking the Discount Rate: Part I
A common question faced by tribunals in international arbitration is “what is the value of a business or asset that has been expropriated?” Expert evidence is generally submitted on behalf of both the investor and the state and often the two experts arrive at very different conclusions. A key disagreement is often the discount rate applied in the valuation, and in particular the component of the discount rate referred to as the country risk premium.
This is the first of two articles in which we explain what the discount rate represents, how it is estimated and how it is adjusted when valuing an asset outside mature economic markets such as the United States or United Kingdom. As we discuss, this is particularly salient in the light of recent awards that have taken contrasting approaches to assessing an appropriate discount rate to value investments in Venezuela.
The Basics of Discount Rates
Discount rates are used in Discounted Cash Flow (“DCF”) valuations. The DCF method projects future cash flows that are expected to be generated by an asset, and then converts those future cash flows to a present value at a single point in time by applying a discount rate.
The discount rate is estimated by considering the rate of return, or compensation, that investors require for accepting delayed payment. In other words, the rate of return they require for receiving cash at a future date, rather than cash today.