Originally from the Journal of Damages in International Arbitration

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I. INTRODUCTION

Calculating damages in international arbitration often requires valuing firms or other financial assets.  Risk is a key driver of value, including in the widely used Discounted Cash Flow (DCF) method, but practitioners often disagree about how to factor risks into their DCF valuations. This article explains the framework for dealing with risk in valuations as taught by economics, business, and finance faculties around the world—and focuses on the widely accepted principles underlying this framework.  

We contrast this framework with some common approaches in which practitioners add various “supplemental risk premiums” to the discount rate. We explain that these supplemental risk premiums are often not consistent with this framework—either in principle or in their manner of calculation. We illustrate what we consider the shortcomings using two examples where such approaches are common: valuing start-ups, and country risk.

II. ANALYSIS OF RISK

DCF is one of the most common valuation approaches in corporate finance. Managers and investors routinely use DCF when making investment decisions,  and they are becoming increasingly prevalent in the quantification of damages in arbitration awards.