The assessment of the reduction of damages awarded for a future loss now has a new and sophisticated tool: the application of the Weighted Average Cost of Capital, or WACC.
The WACC has been used by companies for many years as a means of assessing the rate of return a company must achieve in order to meet investors' requirements. But, better late than never, the legal world has now latched on to its potential.
Let us first explain what the WACC is and why it is important in its application to damages awarded for future loss. We will also set out some unresolved issues as to how it should be applied in certain circumstances and when it can be used to great effect.
We will not attempt to detail how one comes to calculate a WACC. This, apparently, is the standard formula used:
or to put it more simply:
WACC = weight of preferred equity × cost of preferred equity
+ weight of common equity × cost of common equity
+ weight of debt × cost of debt × (1 - tax rate)
If this means anything to you, you are probably an accountant. Even if it does make sense to you (frankly it is a foreign language to this writer) you will nevertheless need an independent expert accountant to come up with a WACC in any given circumstances. They can do this by you providing them with a surprisingly small amount of information about the nature of the future losses.
A definition of WACC
The WACC is the average cost of capital invested in a company, weighted by that company’s relative proportions of equity and debt in its capital structure. The joy that the WACC brings is that it seeks to weigh known values against each other so no-one has to re-invent the wheel every time they need to produce a WACC for a certain situation. The trick of the accountant is in knowing the knowns and then weighting them correctly. It is not a precise science – more of an art.
As noted above it was developed as a means of calculating what level of return on capital was required to achieve shareholder satisfaction. However, its application has spread in to, for example, the regulatory sector as a means of setting caps on the capital returns of regulated businesses. It is not clear when, but some bright spark thought of using it as a tool to reduce damages for future losses, rather than having to acquire complex and matter specific actuarial evidence.
Use in practice
How the WACC is applied and the effect it has on future damages is best explained by use of an example.
Two companies decide to enter into a biofuels development JV in the US. The JV parties project the following pre-tax profits:
However, one of the parties reneges on the JV and pulls out. The other starts an arbitration to recover the profits it would have made if the deal had proceeded as planned.
Half of the above net profits is $12,229,000 but biofuels projects such as this carry a relatively high WACC due to their risk profile. The fact that the country in which the profits are expected to be generated has a very low risk is a more beneficial variable to be weighted into the calculation. We have therefore taken a theoretical WACC of 11.85% for illustrative purposes. As can be seen from the table below, the WACC has a dramatic effect on the amount of damages that can be recovered.
The WACC is applied at a compounded rate from the year when the project would/should have gone live. Thus, the further forward the project goes, the more impact the WACC has (e.g. For 2011, the net profits are reduced from $5.75m to $2.68m). If, in contrast to the above profit profile, a big bang is predicted with profits tailing off from the beginning of the project, the effect of the WACC is much less pronounced.
Application of the WACC is, we would submit, a far simpler way of calculating the benefit of advanced receipts in respect of damages. It seems that its application may end up being the norm.
But there are areas of dispute other than those of a purely technical weighting nature (which for the most part are likely to be resolved between two sensible accountant experts). These are:
If damages are to be assessed from the date of breach, should the WACC be applied back to that date, or should interest be applied to damages incurred up to the date of the Award and then the WACC applied from that point onwards?
If there is a negative loss (i.e. no damages would have been incurred during a particular year) should any WACC be applied to that negative loss?
Until these issues are examined and determined by a court, they will continue to be fertile ground for argument.
Use the WACC to your advantage
Why is knowing about the application of the WACC important? In certain circumstances, throwing a WACC at the other side can immediately create a strategic and/tactical advantage. For example:
You can use it to reduce damages being claimed against you.
You can use it to reduce your own damages, thereby demonstrating the care and attention you have taken to present a realistic calculation of loss and not an inflated sum designed to force a settlement.
In any event, the WACC is, in the writer’s view, the future. The sooner it is embraced and the issues surrounding its application are resolved the better for all involved in claims involving future losses.