Applied Economic Theory in the Law : Present Value Discount Rate Calculation in Legal Valuations

The present value discount rate (PVDR) is the expected rate of return on the best alternative asset (BAA) the investor forgoes when purchasing an asset. How do we calculate it in the competitive market context? The Discounted Future Income Model projects an asset’s annual future income or return, which is discounted to present value (PV) using the PVDR. Through the demand-side, this PV combines with the supply-side to determine market value. Accepted practice adjusts the CAPM-calculated rate of return for unsystematic (diversifiable) risk/marketability defects, by adding risk premiums. This practice, however, contradicts the competitive market, and – due to the subjective nature of risk adjustments – has given rise to wide variation in PVDR calculations. The Principle of Substitution and investment arbitrage should pull expected market rates to equality for all financial assets. We explain how Marshallian Competitive Market Theory is faithfully applied in valuation practice, and develop an objective empirical method to calculate PVDRs using market data for competitively-traded Exchange Traded Funds. Forward-looking competitive expected market rates of return are found empirically to be within a 2.77% to 3.00% range. The range is much narrower, and more precise in its calculation, than typically found in valuation practice and legal precedent