- 59 -
would be meaningful with regard to firms that are similar to
petitioner. Because (1) Hakala’s CAPM analysis makes reasonable
compensation vary directly with the debt-equity ratio,18 and (2)
Hakala contends that his CAPM analysis enables him to determine
Jack’s maximum reasonable compensation to the dollar, it becomes
important for us to have confidence in the correctness of
Hakala’s determination of 11.70 percent as the debt-equity ratio
to use.
Because of the above-noted omissions, we have no idea what
debt-equity ratio is appropriate to use in a CAPM analysis. This
makes us reluctant to rely on a CAPM analysis based on the record
in the instant case, whether or not CAPM analyses are viewed as
conceptually appropriate for firms such as petitioner.
Finally, we note that, in his expert witness report,
Hakala’s arithmetic was inconsistent with his narrative
description of the process of moving from WACC to pretax
operating return on net operating assets. The arithmetic was
consistent with an assumed combined State and Federal tax rate of
about 41 percent, while the narrative states that Hakala used 38
percent. In his rebuttal report, Sledge pointed out the error
18 Under Hakala’s approach, the cost of debt capital is
substantially less than the cost of equity capital. Thus, a
greater debt-equity ratio leads to a lesser weighted average cost
of capital (WACC). This means that under the CAPM, the greater
the debt-equity ratio, the less the net profit that an
independent investor would require, and so the independent
investor could afford to pay more compensation.
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