Division Pitfalls in the Methodology of LECG

The estimation made by the LECG study, leading to a discount factor of 5,15 %, is methodologically flawed. LECG claimed that the right proxy for the weighted average cost of capital (WACC) is the realised Return on Assets (ROA) of one, or possibly two, competitors (Pinewood and Babelsberg).

First of all, the accounting returns, such as ROA, should in general not be considered as a correct measure for an investor’s expected average return for at least three reasons^f1. Accounting returns are calculated on an annual basis, whereas a rational investor will consider the return over the entire life time of the project. Secondly, accounting information is historical information about the company and therefore better adapted to evaluate ex post performance of the firm than ex ante expected performance on the investments. Finally, investors are not really interested in accounting earnings but rather in monetary gains, i.e. the cash flows they receive from their investment.

Furthermore, LECG should have compared the WACC measure with the ROCE (Return on Capital Employed), and not with ROA. The WACC measure refers to the total capital, i.e. equity and financial debt. However, in the liabilities side of a typical balance sheet, you find not only equity and financial debt but also current liabilities, i.e. payables to suppliers. Therefore, total assets are equal to or higher than total capital and for a given return, ROA is lower than or equal to ROCE^f2. Hence, it is the ROCE that should be compared with the WACC and not the ROA. A project realises positive value if and only if the realised return on capital employed is equal to or greater than the WACC.