Valuation of Sports Franchises: Discount Rate Calculation
In the previous article, we have already seen how the valuation of a sporting franchise can be found using the income approach. This approach relies extensively on finding out the cash flow that is likely to accrue to the sporting franchise and then discounting it at a predetermined discount rate in order to find out the present value of the firm.
Now, people who are familiar with the discounted cash flow process must also be aware of the fact that the present value of any firm is highly sensitive to its discount rate. This means that minor changes in the discount rate end up producing significant changes in the present value of the firm.
It is for this reason that selecting the appropriate discount rate is very important from the point of view of the discount rate calculation.
It is also a known fact that approximating the correct discount rate is a subjective and difficult process in general. This difficulty gets compounded when the discount rate is being derived in order to value a sports franchise.
In this article, we will have a closer look at how the discount rate is derived.
Weighted Average Cost of Capital (WACC)
There are many methods that are used to derive the weighted average cost of capital for any business. The most common method used is the weighted average cost of capital method.
This method assumes that the business is funded by debt and equity in a given proportion and hence the same proportion must be used as weights along with the respective cost of capital. This means that a weighted average cost of capital must be derived by multiplying the cost of debt with the proportion of debt in the overall funding of the firm and the same should also be done for equity. The blended rate derived after performing this calculation is called the weighted average cost of capital.
Now, it needs to be understood that deriving the cost of debt is easy since it is an actual payment that is made by the firm to other entities. However, this cannot be said about deriving the cost of equity.
The cost of equity is not really a payment that is actually made in cash. Hence, the cost of equity is a notional figure which needs to be derived. Across all industries, this is generally done by using the capital asset pricing model.
Cost of Equity as Per Capital Asset Pricing Model
The cost of equity as per the capital asset pricing model is as follows:
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
- Risk-Free Rate: The risk-free rate is the rate at which investors are willing to invest their money in case there is no risk.
The only scenario which can be technically considered risk-free is when the money is lent out to the government. This is because the government has the power to print additional money if required. Hence, the prevailing yield for government securities can be easily derived and used in the formula.
- Beta: Beta refers to the riskiness of the particular firm or industry with respect to the overall market. For instance, the riskiness i.e. the volatility in the price of a particular stock can be compared with an index such as S&P 500 in order to find the beta of that particular stock. Now when it comes to sports franchises, this creates a problem.
The stock price movements of the sports franchise are not available generally because the stock is not listed on the exchange and hence there is no price data available to compare to an index. In such cases, it is common to use a comparable industry in order to estimate the beta.
For example, data related to stocks from the entertainment industry can be used in order to estimate the beta applicable to sports franchises. However, it must be understood that this component is estimated and not mathematically derived from the equation.
- Equity Risk Premium: Equity risk premium is the additional compensation that shareholders demand in order to stay invested in equity. This equity risk premium can be derived by subtracting the risk-free rate from the return of the overall index. Now, both these numbers are easily available in the public domain and hence can be easily derived.
- Excess Small Company Risk Premium: We can see from the above formula that there is no component called small company risk premium mentioned. However, it is widely known and understood that the cost of equity calculated by using the capital asset pricing model is for larger companies.
Now, sports franchises are generally much smaller in terms of revenue and other financial parameters. Hence, investing in sports franchises is often considered to be akin to investing in smaller companies. Hence, it is common for some investors to add a small company risk premium to the figure derived by using the capital asset pricing model.
Hence, the fact of the matter is that estimating the discount rate for calculating the present value of sports franchises can be a very difficult task. This is because of a wide variety of reasons. Some of the reasons have been discussed in this article whereas some others will be discussed in the forthcoming articles.
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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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- Revenue Sharing in Sports Leagues
- Issues in Revenue Sharing in Sports Leagues
- How Salary Caps Work in Sports Leagues?
- Advantages of Salary Caps
- Disadvantages of Salary Caps
- Alternative To Salary Caps: Luxury Tax
- Sources of Revenue: Broadcasting Rights
- How are Broadcasting Rights Revenue Split Amongst Franchises?
- Common Issues with Revenue Generated from Broadcasting Right
- Digital Media Rights and Sports League Financing
- Sports League Sponsorships: A Primer
- Types of Sponsorships Given to Individual Players
- The Economics of Sports Leagues
- Why Do Sponsors Fund Teams in Sports Leagues?
- Title Sponsorship and its Disadvantages
- Advantages of Title Sponsorship
- Team Sponsorship: Advantages and Disadvantages
- Objectives of Sponsorships
- Factors Affecting Selection of Sponsorship of Sports Event
- Risks Associated with Sponsorship from Sponsor’s Perspective
- Risks Associated with Sponsorship from Sponsored Entity’s Perspective
- Level Based Sponsorship (Tiered Sponsorship)
- Issues With Sponsorship Levels
- Evaluating the Effectiveness of Sports Sponsorships
- Issues Related to Sponsorship Evaluation
- Source of Revenue: Fantasy Sports Leagues
- Benefits of Fantasy Sports Leagues
- Source of Revenue: Sports Merchandising
- Issues With Merchandising
- How are Organizational Aspects of Sports Leagues Linked to Finance
- The Optimal Size of a Sports League
- Why are Professional Sports Franchises Increasing in Value?
- Use of Price to Revenue Ratio in Valuing Sports Franchises
- Factors Impacting the Valuation of a Sports Franchise
- Income Approach to Valuation of Sports Franchises
- Valuation of Sports Franchises: Discount Rate Calculation
- Issues in Determining Discount Rate for Valuation of Sports Franchises
- Valuation of Sports Franchises: Discount Rate Calculation
- Replacement Cost Approach Advantages and Disadvantages
- Valuation of a Sports Franchise: Market Approach
- How Team Performance Affects Valuation?
- Issues With the Valuation of Sports Franchises
- Impact of Technology on Sporting Finance
- Revenue From Releasing Players for International Tournaments
- Private Equity Investments in the Sports World
- Disadvantages of Private Equity Investment in Sporting Franchises
- Why do Sporting Franchises Lease Out Stadiums?
- Disadvantages of Leasing Out Stadiums
- Accounting for Stadium Leases
- Lease Accounting: Right of Use Asset
- The Case Against Government Funding for Sports Stadiums
- Public-Private Partnership in Stadium Financing
- Advantages of Public Private Partnership Model
- Risks in Public-Private Partnerships
- What is Sports Tourism?
- Pros and Cons of Sports Tourism
- How Sporting Franchises Help Billionaires to Plan Their Taxes
- What is Jock Tax and How is it Calculated?
- Jock Taxes: Pros and Cons
- Valuation of a Player
- Financial Doping and Financial Fair Play
- Pros and Cons of Financial Fair Play Rules
- Debt Funding in Sports Franchises
- Involvement of the Franchisor in Debt Funding
- Debt Ceiling in Sporting World
- Pros and Cons of Debt Ceilings in Sports Leagues
- Securitization and Sports Finance
- Types of Securitizations in Sporting Franchises
- Advantages of Securitization in Sports
- Disadvantages of Securitization in Sports
- Accounting for Player Contracts
- Impairment in Sporting Franchises and Player Contracts
- Accounting for Players Who Have been Promoted Internally
- Why Government Should Not Invest Public Money in Sports Stadiums Used by Professional Franchises