Contents - AL-Tax

174 12 Decentralized Ownership of Intellectual Propertyentitled to retain any portion of associated intangible income. However, USP’s arm’slength JV agreements do not provide for the payment of trademark royalty fees; assuch, there is no mechanism in place to channel marketing intangible income toUSP. Lastly, the JV companies in which USP has a 50% stake have consistentlyinvested substantially less in the marketing and promotion of their sites than FS.In short, FS makes far greater contributions to the development and operationof sites in its territory, in the nature of working capital, risk-bearing, marketing,promotion and the development of USP’s trademarks, than USP’s third party JVpartners. It is therefore entitled to retain substantially more than 50% of its freecash flows. Equivalently, USP makes substantially fewer contributions to FS than itmakes to the JV companies in which it has a 50% stake: It bears virtually no riskvis-a-vis FS’ international sites, contributes no working capital to FS to speak of,and assumes no responsibility for developing and defending its trademarks in FS’territory. It is therefore entitled to substantially less than 50% of FS’ free cash flows.12.4.3 Quantitative AnalysisAs noted, USP contributes the same tangible and intangible assets (servers, an ITplatform and its brand identity) to both affiliated and independent joint ventures,and provides the same ongoing IT support to both. However, USP does not bear riskvis-a-vis FS’ operations, and does bear risk vis-a-vis the arm’s length joint ventures.Therefore, among other things, we adjust USP’s return on the latter investments toreflect this differential risk. Stated differently, we estimate the risk-free return thatUSP would have earned on its investment in the JV companies in which it owns a50% interest, expressed as a percentage of their free cash flows. All other thingsequal, the same percentage of FS’ free cash flows should accrue to USP. However,additional refinements, to account for FS’ greater contributions of working capital,its development of USP’s brand identity and its more intensive marketing andpromotion activities, are necessary as well.We assume that the risk-free rate of return during the relevant period is 4% (basedon prevailing Treasury bill rates). The market risk premium is approximately 6.5%.On a consolidated basis, USP’s and FS’ beta is 1.35, and their cost of equity capital(equivalently, their required return on equity) is therefore 12.78%. We assumethat the JV companies in which USP has a 50% ownership interest have the samerequired return on equity. 6 Therefore, the risk-free portion of the jointly-owned JVcompanies’ required return on equity is equal to 31.0% (calculated by dividing 4%by 12.78%). Stated differently, if one breaks down USP’s, FS’ and the 50%-ownedJV companies’ required return on equity capital into its component parts, slightlyless than one-third of the total required return would compensate investors for theircommitment of capital per se, and the balance would compensate investors for therisks they assumed thereby.6 In view of the fact that these entities operate in the same industry and employ the same tangibleand intangible assets, this is a plausible working assumption.