125 Old Broad Street

London

EC2N 1AR

Financial Economics

A thorough understanding of the principles and theory allows us to explain to a court or arbitration tribunal why a particular approach is right or wrong for specific circumstances.

 

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The valuation of damages, firms or assets in general is founded on the principles of finance and financial economics. The body of research and practice that is encompassed by the term “financial economics” involves:

  • Firm capital structuring
  • Cash flow forecasting for discounted cash flow (DCF) models
  • Asset risk and therefore discount rates or the cost of capital
  • Asset liquidity
  • Country risk and other specific risk
  • Comparable firms or assets for relative valuations
  • Options, futures and other derivatives
  • Structured products, such as CDOs and other asset backed securities
  • Commodity pricing, especially oil and other markets where futures are quoted and traded

At IEF we have financial economists with training from top universities.  Through a deep understanding of the financial economics discipline, our consultants can develop the best valuation choices for a given situation.  Furthermore, a thorough understanding of the principles and theory allows us to explain to a court or arbitration tribunal why a particular approach is right or wrong for specific circumstances.

Our experience is that many consultants use a rigid, rule-based approach to these problems. While they may adopt the techniques of financial economics (such as DCF analysis or option pricing) there is a risk that they do not apply a thorough understanding of the underlying reasoning and therefore do not fully support and explain the best approach for a given problem.   At IEF, we base our analyses on fundamental principles.

Although many arbitration awards are not made public, UK litigation remains public. In recent UK High Court cases in which Tim Giles was the testifying expert, (e.g., Saltri III Ltd v MD Mezzanine SA and Symrise AG v Baker & McKenzie), many of the financial economic issues were central to the judges’ findings.

The following were points that were specifically addressed in Mr Justice Eder’s decision in the above case:

  • The correct discount rate to be utilized in the valuation (in this case the WACC or weighted average cost of capital). Testimony covered the correct risk-free rate and market beta.
  • An important issue was whether a liquidity discount was warranted or not given that the valuation standard was fair market value in the prevailing market conditions.
  • Cash flow forecasting issues were also central, in particular, the speed of recovery from a crisis.
  • Appropriate multiples for a comparative valuation were also considered, especially the importance of growth prospects to a firm’s value.

In the latter case, the following were points that were specifically addressed in Mr Justice Burton’s decision:

  • The impact of substantial indebtedness of a subsidiary on the value of a parent company’s equity interest in the subsidiary.
  • The appropriate discount rate to apply given the business and country risk of the subsidiary.
  • The impact of complex corporate structures on the valuation of group subsidiaries.

These are financial economics questions and only through a thorough understanding of that discipline can clear advice and defensible evidence be given. While the issues are complex, if they are thoroughly understood and supported, the arguments can be clearly communicated to a wide audience.