How Sporting Franchises Help Billionaires to Plan Their Taxes
Over the years, the sporting business has quietly metamorphosized into a big business. The amount of money changing hands in the sports business today would have been considered unthinkable even a few years ago. It is common for franchises to be valued in billions of dollars. Star players also make millions of dollars while playing […]
Why Do Corporations Get Away With Tax Avoidance ?
Some of the well-paid engineers in companies like Amazon pay about 45% of their income in taxes. They do so every year, and it seems unfair to them why the company that employs them gets away with paying about 1% taxes. Warren Buffet once famously remarked that he pays a smaller tax rate as compared […]
Point of Sale (PoS) System – Meaning, Importance and Benefits
With the advent of technology, more and more people have started accepting digital payments. This means that corporations have to provide their customers the option to make payments using a wide variety of payment methods. Some of these payment methods are electronic whereas others are not. Commercial banks have identified the possibility of providing good […]
Cultural Influences on Financial Decisions
The financial decisions made by an investor are actually influenced by several factors that are present in their thought process. We have discussed about the rational aspects of traditional financial theory. We have also discussed about emotional aspects and behavioral biases in the previous articles. However, emotions are not the only thing that impact behavior. […]
Role of Social Media In Start-Up Funding
In the past couple of decades, social media has literally dominated the world of business. It has touched almost every single aspect of business. The funding of start-up companies by venture capitalists as well as angel investors is no exception. Several studies have been conducted to ascertain the impact of social media presence on the […]
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.
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.
The cost of equity as per the capital asset pricing model is as follows:
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
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.
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.
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.
Your email address will not be published. Required fields are marked *
