Discounted Cash Flow

Under international investment law, States should compensate the investor for the damages incurred in connection to an international investment obligation breach.¹ In determining the damages to be awarded, the investment tribunal should primarily look at whether the treaty itself contemplates a given compensation standard.² If the treaty is silent, then the investor is owed damages in accordance with the customary international law principle of “full reparation”.³ This value can be calculated in different ways, but the income approach is the most common, and widely accepted, method to do so.⁴ This approach assumes that the value of an asset is equivalent to the present discounted value of its future cash flows.⁵ These anticipated future cash flows that the investment would have produced but-for the State’s breach are discounted taking into account the future risks and costs of capital.⁶ This method of valuating an asset’s income is referred to as “Discounted Cash Flow” (“DCF”) and is regularly applied by investment arbitration tribunals.⁷

In what follows, we intend to explain the discounted cash flow valuation method in further detail and describe its application in the context of international investment law.

The discounted cash flow method for calculating damages values an income-generating asset by discounting the asset’s future income streams to a net present value as of the valuation date.⁸ However, it may be admissible to rely on post-valuation date data as long as this information was foreseeable on the valuation date.⁹

Generally, as acknowledged by the CMS v. Argentina tribunal, there are two main ways to calculate a company’s discounted cash flows:¹⁰

“One can start computations with the cash flows to the firm debt repayments, discount such flows at the weighted average cost of capital (the ‘WACC’) and add the discounted cash flows to the firm to establish its value; then, the value of debt is subtracted and the residual value is the value of equity (‘the indirect equity value’). Alternatively, one can compute first the cash flows to equity (cash flows from operations, minus interest and debt repayments), discount them at the cost of equity (‘COE’) and add the discounted cash flows to equity to establish the value of equity (‘the direct equity value’); then, one adds the value of debt to establish the value of the firm…”

The WACC model has been the most heavily relied upon method of discounting cash-flows.¹¹ In what follows, we explain in further detail a simplified step-by-step algorithm to compound the discounted cash-flows using the WACC approach (although a similar method can be used if one were to follow the COE alternative):¹²

1. Determine the forecasting period. This involves assuming a given timeline for the company or project that the company is undertaking and the stage of the asset’s life span (including any ramp ups). For example, early businesses tend to grow at a much higher rate than others do.
2. Define the company’s future free cash flows (“FFCF”) for each year of the forecasting period. The yearly FFCF are calculated by taking the company’s normal cash inflows (revenues) and subtracting the cash outflows (capital expenditures, operational expenditures, taxes, etc.).
3. Calculate the discount rate. The most common discounting rate used is the weighted-average cost of capital (“WACC”),¹³ which is used in both valuation practice and investment treaty arbitration.¹⁴ This discount rate is construed by looking at the time value of money¹⁵ and other risks associated with the investment,¹⁶ including sectorial and country risks. After the WACC has been calculated, one can find the discount factor by relying on the following formula: Discount Factor for n year = 1/ [(1 + WACC)*number of years that the project has been operating].
4. Discount the yearly FFCF by the discount factor. This is another way of saying that the FFCF for each year should be multiplied by the discount factor to get the yearly discounted free cash flow (“YDFC”).
5. Sum up all YDFC to get the net present value of the company or asset. Note that if the company or project being evaluated has no “end-date”, then at this point one should also need to calculate the terminal value of the cash-flow producing asset.¹⁷ There are various ways of calculating the terminal value of a company, but most algorithms use the Gordon Growth formula. The formula used is the following: Terminal Value = [Final year projected cash flow * (1+company’s growth rate)] / [Discount rate – the company’s grow rate].

More recently, the tribunal in Tethyan Copper Company v. Pakistan has adopted what it has called a “modern DCF valuation method.”¹⁸ The main difference between this “modern DCF” and the traditional discounted cash flow lies in that the former introduces risk discount factors to each element of the cash flow instead of adopting an overall risk discount rate to the asset’s entire cash flow.¹⁹ This means that steps (b) and (c) of the algorithm described above will need to be revised to first discount the risk factor of every cash-flow and then adjust for the cost of capital.

Note, however, that the “modern DCF model” is a much more complex model than the traditional discounted cash flow which needs more data and an accurate prediction of the evolution of the price traded assets.²⁰

In this final section, we briefly discuss the applicability of the discounted cash flow model from a legal and factual standpoint.

First, damages arising from any breach of an international investment agreement affecting an income producing asset - such as a violation of national treatment, most-favoured nation, fair and equitable treatment,²¹ and unlawful expropriation²² - could be quantified using the discounted cash flow method unless otherwise provided for in the applicable international investment agreement.²³ Indeed, the DCF, being a but-for method for calculating damages, is an appropriate method to put the investor in the position it would have been had it not been for the State’s unlawful conduct in accordance with the “full reparation” customary rule. Consequently, investment tribunals have found that the DCF method is consistent with the Chorzow principle.²⁴

However, in cases of “lawful expropriation”, i.e. when the expropriation was carried out for a public purpose, non-discriminatorily, in accordance with due process, and against the payment of compensation, investment agreements usually require “adequate” compensation.²⁵ This does not always coincide with “full compensation.”²⁶ See further Compensation for Lawful Expropriation.

The applicability of the discounted cash flow method depends on whether tribunals can make explicit assumptions or “informed estimation[s]” on a company’s prospective cash flow.²⁷

To this extent, the historical data of the asset in question is an important aspect of tribunals’ analysis,²⁸ which consists in assessing whether an investment is a “going concern.”²⁹ Tribunals have alternatively looked at the probability of securing future incomes.³⁰ For instance, the ICC arbitration tribunal in the EMG v. Egyptian General Petroleum case focused on the reasonableness of the foreseeable future income of the asset in question: “JWC [the Respondent] has, additionally, raised an objection as to the accuracy of a DCF model, given the lack of record of EMG’s profitability. The Tribunal sees no reason for concern. The important fact is not whether EMG can prove its profitability in the past, but rather whether it is reasonable to presume that, were it not for EGAS’ wrongdoing, it would have obtained a foreseeable stream of income in the future. In the case of a 15 year-long gas supply deal, secured by an interlocking mesh of contracts (…) the Tribunal entirely satisfied of the reasonableness of such presumption.”³¹

Generally, tribunals have not been inclined to follow the DCF model in cases where there is less certainty regarding an investment’s future profits.³² Conversely, where there is more predictability and stability of future cash flows, tribunals have followed the DCF method even if the project is in its early stages.³³

Some tribunals have attempted to provide guidelines on when is the DFC model applicable. Although these do not carry precedential value, they provide useful insights onto tribunals’ “rules of thumb”. For example, the Rusoro v. Venezuela tribunal determined that in deciding whether it should apply the DCF model it would look at some or all of the following factors, which were also taken into account by other tribunals:³⁴

1. The enterprise has an established historical record of financial performance;³⁵
2. There are reliable projections of its future cash flow,³⁶ ideally in the form of a detailed business plan adopted in tempore insuspecto, prepared by the company’s officers and verified by an impartial expert;³⁷
3. The price at which the enterprise will be able to sell its products or services can be determined with reasonable certainty;³⁸
4. The business plan can be financed with self-generated cash, or, if additional cash is required, there must be no uncertainty regarding the availability of financing;³⁹
5. It is possible to calculate a meaningful WACC,⁴⁰ including a reasonable country risk premium, which fairly represents the political risk in the host country;⁴¹
6. The enterprise is active in a sector with low regulatory pressure, or, if the regulatory pressure is high, its scope and effects must be predictable: it should be possible to establish the impact of regulation on future cash flows with a minimum of certainty.⁴²

Finally, the Masdar Solar v. Spain tribunal determined that it should not give deference to a Spanish court’s rejection of the DCF method to calculate damages since compensation should be calculated in accordance with international law.⁴³

Given that investment arbitration tribunals are increasingly relying on the discounted cash flow method,⁴⁴ it is important for practitioners to become acquainted with the way in which the method works since a slight modification of one of its parameters can completely alter the final number. Moreover, the proper application of the discounted cash flow model will rest in the factual underpinnings of the case and the available economic information of the asset in question.