The discount rate for discounted cash flow valuations of intangible assets

Abstract

PurposeThe purpose of this paper is to determine the required return of intangible assets for eight different business sectors by means of an empirical study of companies from the US Standard & Poor's 500 index. The resulting required return is subsequently compared with proxies for the required return on intangible assets used in practice, such as the weighted average cost of capital (WACC).Design/methodology/approachTo determine the discount rate of the intangible assets the paper applies the weighted average return on assets method (weighted average return on assets (WARA) method). The paper finds the return on intangible assets (RIA) by setting the WARA equal to the WACC and solves the equation forRIA.FindingsFor all the identified sectors, theRIAis higher than the WACC. It is also shown that this return is higher than the levered or unlevered cost of equity of the company as a whole. In six of the eight sectors, the levered cost of equity appears to be the best proxy for the required return on intangible assets.Practical implicationsThe paper shows how the required return on intangible assets can be estimated. The required return is needed for discounted cash flow valuations of intangible assets.Originality/valueThis paper adjusts the WARA method applied by Smith and Parr. In contrast to Smith and Parr, the tax shield is included as a separate asset in the model. Consequently, the WACC before tax is used instead of the WACC after tax.