INTM467200 - Establishing the arm's length price: gathering your own evidence - Discounted cash flow models

Introduction

A discounted cash flow model is one of the many ways in which third parties might attempt to value intangible property.

While discounted cash flow models may be useful tools, their use can encourage a formulaic approach to transfer pricing. It is important to look at every case in the round and exercise considered judgement.

In the commercial world, a fairly common method of valuing brands is to use a mathematical model to calculate the income stream that can be expected from exploiting the brand. As the model is often used to try and value the brand for the purposes of an outright sale, it needs to produce figures that take into account the value of money over time.

For example, Bodgit & Scarper (Plastic Tat) Ltd has been manufacturing and selling model railways for years. The activity has always been a profitable division of the company but, in order to raise money to fund a new venture, it is decided to sell the model railways division. The company estimates that the division will produce steady profits of £10 million over the next 10 years. So the company is giving up an income stream of £100 million. However the £10 million earned in year 1 is going to be worth more than £10 million earned in 10 years time. By estimating that £10 million next year is worth 5% less than £10 million this year (and that the £10 million it would make in year 3 is worth 5% less than the £10 million it would earn in year 2, and so on) the estimate of the net present value of the £100 million is £77 million.

This calculation can be performed using a discounted cash flow model, also known as a net present value model. As well as valuing brands, a discounted cash flow model can be used to calculate a royalty payable under a licence agreement. The following sections discuss how discounted cash flow models can be used and calculated and also consider the disadvantages of using such models.

Top of page

Information used to construct a discounted cash flow model

The foundation for a discounted cash flow model is a product line income statement for the brand or products - see INTM467160 on product line income statements. The method is usually used for single products or brands, but in theory a model can be used for a basket of products, if the products are similar.

The model will use projections of sales and the associated costs. The projections will need to be supplied by the company and should be based on information that was available at the time the licence agreement was granted.

A model can be constructed around a product line income statement that takes account of all the activities undertaken to manufacture a product, including costs such as:

• Raw materials
• Costs of manufacture
• Marketing and promotion
• Selling
• Distribution
• Administration
• Ongoing R & D costs related directly to the product

The costs of discovering and developing the product would not generally be included.

Alternatively the model might concentrate on one particular activity (say manufacture or distribution), allocating the costs and profit attributable to other activities by using OECD methods such as resale minus or cost plus.

Top of page

Length of the licence agreement

There is no minimum period for a licence agreement for which a discounted cash flow model can be used to determine the royalty rate. Clearly the longer the period covered by the model, the more the projected sales and costs are open to question. However, a discounted cash flow model is weighted in favour of the early years, when the projections are likely to be more reliable.

For example, consider a ten-year licence agreement which is forecast to produce £10 million profit each year. The total profits over the ten year period are £100 million. However using a discount rate of 10%, the net present value is £61.45 million.

If the profits in years 5 to 10 are estimated to be £12 million instead, the total return over the ten period is now £110 million, but the net present value is only £66.15 million.

For a new product, or an existing brand being launched in a new market, there must be a question mark over whether a long licence agreement would be granted, without some form of break clause.

Top of page

Problems with a uniform royalty rate

A discounted cash flow model is designed to give a royalty rate that is uniform over the period of the model. However, new brands and products require heavy initial promotion and marketing spend and profits may be low or even non-existent in the early years. At arm’s length it may be unrealistic to expect royalties to be paid during this start-up phase.

If the model is split, it is likely that the element for the first few years will show a minimal or even no royalty, and the element for the later years will show a rate slightly higher than the uniform rate. This might reflect what would happen at arm’s length. Overall the licensor and licensee should get the same allocation of profits - the licensor will get his share a little later in the licence agreement cycle.

Top of page

Allocating the profit

Using a discount cash flow model can give you a value for a brand, or basket of products, based on the profits that are likely to be generated. The more difficult part is working out to whom the profit should be allocated.

Consider a case where a parent company grants a subsidiary based in Singapore a ten-year licence to manufacture and sell a new drug. The drug was discovered by the parent company. Development work was carried out by the parent company and two subsidiaries in France and US. The active ingredient of the drug is manufactured in Singapore and then sold to a group company based in Switzerland. The Swiss company then sell the active ingredient to group distributor companies, which carry out secondary manufacture (turning the active ingredient into tablets) and then sell the drug.

A discounted cash flow model will produce a system profit for the drug. The resulting profit needs to be allocated between:

• The parent company (as licensor)
• The US and French subsidiaries (for their stake in developing the drug)
• Singapore subsidiary (for carrying out primary manufacture)
• Swiss subsidiary (for acting as a clearing house)
• Group distributors (for carrying out secondary manufacture and distribution)

The parent company must be allocated an arm’s length profit.

In practice the same principles need to be applied as when using a profit split method (see INTM467160).

Top of page

OECD reservations

The OECD Transfer Pricing Guidelines consider that a discounted cash flow model may be useful in a start-up situation, where projections can be estimated with a reasonable degree of certainty. They caution that the discount rate, which must resemble what third parties would agree, will help determine how reliable the model is. The industry-wide risk premiums used to calculate the discount, are just that, industry-wide. They do not differentiate between different companies, let alone segments of businesses. The Guidelines also warn that you can encounter problems in estimating the relative timing of receipts to be included in the model.

The OECD Transfer Pricing Guidelines recommend that discounted cash flow models should be used with caution, and should be supplemented where possible by information derived from other methods.

Top of page

Using Excel to produce an NPV calculation

A discounted cash flow model can be constructed quite easily using Excel to perform the NPV calculations.

To calculate the NPV of a series of values (e.g. sales or marketing and promotion expenditure) select FUNCTION from the drop down menu INSERT. You will then be presented with a choice of function category; you will find the NPV function under the FINANCIAL section.

You will then be presented with a box with various entries to be filled in.

• Rate - enter the discount rate, e.g. '10%'.
• Value 1 - enter the cell for the first year in the series of values.
• Value 2, etc - enter the cells for the second year, and so on.

The calculation is carried out by taking the values as a snap shot at the year end. In the following extract from an Excel spreadsheet, the calculation treats the sales and cost of sales for each year as falling at the end of the year. This can provide a distorted picture as, of course, sales and cost of sales occur during the year, as opposed to just in one day at the end of the year.

An alternative method would be to get the calculation to take the values as falling at the beginning of the year. This is easily achieved by removing the first value in the series from the NPV calculation, and adding it to the amended NPV calculation.

So instead of the calculation for the NPV of sales being

The calculation becomes

And the spreadsheet now looks like this:

However, this might not have such a large effect on a royalty rate calculated using the model, as demonstrated in the example below.

To be precise, an average of the two results could be taken, which would treat the sales and cost of sales as arising uniformly throughout each year.

Top of page

Factors that will affect a discounted cash flow model

A discounted cash flow model should always be subjected to a high degree of scrutiny and judgement. The following factors are those that may be need to be viewed with extra care. It is very important to bear in mind that, individually, changes may only account for a fraction or a full percentage point change in the royalty rate. However, analysis may demonstrate that there are a number of factors that must be questioned. Taken together, these can significantly affect the royalty rate returned by the original model.

1. One of the two key factors is the reliability of the figures included in the model. The figures used should be projections derived from contemporaneous information. The model will not be based on actual results. You may need to look at the prime data that was used to produce the model - how were the figures arrived at? Have projections been produced for any other purposes - if so how do these compare with those used in the model? What assumptions and estimates have been made and on what basis? While you should not use hindsight, actual results that differ significantly from the projected results might suggest the projections are not particularly robust.
2. The aim of the model is to produce net present value of expected profits and then derive a royalty rate based on a proportion of those profits. What profits should the model calculate? Should it be operating profit, profit before taxes or profit after taxes? The best target when using discounted cash models to value intangible property is operating profit. At arm’s length, the licensor and licensee might not take account of each other’s tax position. Profit before tax takes account of interest payable, exceptional and extraordinary items. Looking at profit after taxes means estimating the taxes for all the parties involved. This can lead to problems with more than one variable - changing the royalty rate (the key variable) will also change the tax, introducing another variable. Accounting for the tax payable by the licensor can also produce problems. It is not a simple case of just including the tax payable as a cost in the model.
3. The second key factor is allocating net present value of the anticipated profits to the parties involved. The principles for allocating profit in a discounted cash flow model are the same for allocating the profits using a profit split model - see INTM467160.
4. Changing the discount rate will have an effect on the model. The discount is designed to counter two factors: inflation and the risk premium. The risk premium attached to a very popular brand, with a very strong track record of sales, is going to be relatively low. For a new product, or a new drug that has not yet received regulatory approval and needs more tests, the risk premium will be higher. Business analysts use benchmark discount rates when constructing forecasting models. Shares and Assets Valuation has some experience in using discount rates and will be able to advise on rates to be used for a particular industry. Note however the OECD reservations which are mentioned above.
5. The number of years included in the model will influence the royalty rate. In the majority of cases the length of the licence agreement will dictate how many years should be used when putting together the model. There may be situations however where, although the rights to a product or brand are sold to an affiliate, an outright sale would not have taken place at arm's length and a licence agreement would have been granted instead. In such cases, the number of years included in the model will need to be considered carefully. Factors such as the length of comparable licence agreements or the expiration of key patents will influence the number of years to be included.
6. You may on occasion see very complicated models which include adjustments to balance sheet assets and liabilities such as stock, capital expenditure, debtors and creditors. You need to ensure that such models do not include elements of double counting, such as including both capital expenditure and depreciation of fixed assets.