Courts recognize that they must discount awards of lost future profits in contract disputes to avoid overcompensating the plaintiff. The required return to equity capital is not directly observable. Different asset pricing models can be used to estimate the cost of equity. The most widely used model in financial analysis, litigation and regulatory settings is the CAPM. Alternatives to the CAPM include multi-factor models such as the Fama-French three-factor model or Cahart's four-factor model.
You are hired as the expert witness for teh plaintiff against company KO case. The breach of contract has cost the plaintff a stream of profits estimated at $100,000 for six years in row (end of year payments)
You have performed the analysis for this company and would like to bring a discount rate to the courts that would be most favorable to the plaintiff.
You have gathered the following information. The yearly return on the market portfolio has averaged to 6% and its expected value is also 6%, the risk free rate is 0% and is expected to stay at that level, the return on SMB factor has been 4.5% (and expected value is also equal to that) and that of the HML is 1% (expected value equals 1% as well). You have estimated both the CAPM and the 3-factor Fama French models and you have the results of the regression as follows:
CAPM: beta with respect to market in a CAPM estimation 0.45
FF-3: beta with respect to the market is 0.7, beta with respect to SMB is -0.75, beta with respect to HML is -0.4
would you push CAPM or the FF-3 model in court? Why?