Cost of Capital: Applications and Examples, + Website, 5th Edition

APPENDIX 17A

Cost of Capital and the Valuation of Worthless Stock¹

Joanne Fong and Roger J. Grabowski

Introduction

Liquidating Value

Potential Value

Example

Possibility That Value of the Business Enterprise Exceeds the Face Value of Debt—Pricing Equity as a Call Option

Discounted Cash Flow Method Using Scenarios and Option Pricing Model

Guideline Public Company Method and Option Pricing Model

Potential Future Value: Probability That Value of the Business Enterprise Exceeds the Face Value of Debt

Discounted Cash Flow Method Using Scenarios and Option Pricing Model

Guideline Public Company Method and Option Pricing Model

Additional Considerations

Summary

INTRODUCTION

When is a taxpayer allowed a worthless security deduction under IRC §165(g) of the Internal Revenue Code? Revenue Ruling 2003-125 (issued December 29, 2003) states the following:

[T]he shareholder of [an] entity is allowed a worthless security deduction under §165(g) . . . if the fair market value of the assets of the entity, including intangible assets such as goodwill and going concern value, does not exceed the entity's liabilities such that on the deemed liquidation of the entity the shareholder receives no payment on its stock.

Furthermore, courts have concluded that stock is worthless only when the underlying corporation lacks both liquidating value and potential value.²

The liquidating value concept generally addresses whether the aggregate fair market value of the underlying assets of the business is determined ...