                       T.C. Memo. 2002-34



                     UNITED STATES TAX COURT



               ESTATE OF RICHIE C. HECK, DECEASED,
         GARY HECK, SPECIAL ADMINISTRATOR, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 11619-99.          Filed February 5, 2002.



          Decedent owned 630 shares of F. Korbel & Bros.,
     Inc. stock representing a 39.62-percent ownership
     interest in the corporation.
          Held: Fair market value of the shares determined.
     Sec. 2031, I.R.C.



     Richard J. Sideman, Steven M. Katz, and George I. Hoffman,

for petitioner.

     Marion T. Robus, for respondent.
                                 - 2 -

                MEMORANDUM FINDINGS OF FACT AND OPINION


     HALPERN, Judge:     By notice of deficiency dated April 16,

1999, respondent determined a deficiency in Federal estate tax of

$5,427,983.    Of the adjustments giving rise to that

determination, the only one remaining in dispute is respondent’s

increase in the value of certain shares of stock included in the

gross estate.

     Unless otherwise noted, all section references are to the

Internal Revenue Code in effect at the time of decedent’s death,

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

                           FINDINGS OF FACT

     Some facts are stipulated and are so found.    The stipulation

of facts, with accompanying exhibits, is incorporated herein by

this reference.

Introduction

     Richie C. Heck (decedent) died on February 15, 1995 (the

date of death or the valuation date).    Gary Heck (sometimes,

petitioner) is the special administrator of decedent’s estate.

At the time of the petition, petitioner resided in Santa Rosa,

California.    Among the assets includable in decedent’s gross

estate are 630 shares of stock (the shares), representing

39.62 percent, of the outstanding common stock of F. Korbel &

Bros., Inc. (Korbel), a California corporation.    Petitioner
                                - 3 -

timely filed a Form 706, United States Estate (and Generation-

Skipping Transfer) Tax Return (the estate tax return) on May 15,

1996.    Petitioner did not elect alternate valuation.   See sec.

2032.    In the estate tax return, petitioner valued the shares at

$16,380,000, or $26,000 a share.    In determining a deficiency in

estate tax, respondent valued the shares at $30,177,000, or

$47,900 a share.

Organization and Operation of Korbel

     Korbel was formed in 1903.    Its business began in 1860, when

three Korbel brothers purchased property in Guerneville,

California, for the logging of timber.    A decade later, vinifera

grapes were planted on the property, and, in 1882, the first

bottle of champagne was produced.    Korbel has produced champagne

on the property, utilizing the traditional “methode

champenoise”,1 ever since.



     1
        Champagne or sparkling wine (although the name
“champagne”, technically, refers to sparkling wine produced in
the Champagne region of France, the terms “champagne” and
“sparkling wine” are often used interchangeably, and are so used
herein) is, in essence, wine that has been subject to a second
fermentation. Premium brands, such as Korbel, utilize the French
“methode champenoise”, pursuant to which the second fermentation
and all subsequent steps such as the removal of impurities and
the addition of flavoring components take place while the
champagne is in the bottle that is ultimately sold to the public.
That method is much more expensive and is considered far superior
to methods, such as the “Charmat process” or the “transfer
method”, pursuant to which certain steps do not take place in the
bottle.
                               - 4 -

     The Heck family purchased control of Korbel in 1954, and, in

1976, Adolf Heck (decedent’s husband) became the sole shareholder

of the 1,900 shares of common stock outstanding.   As of 1984,

Adolf and decedent each owned 950 shares.   In 1984, Gary Heck

acquired 380 shares (190 each from Adolf and decedent).   Also, in

1984, Adolf died, Korbel redeemed 310 of his remaining 760 shares

from his estate, and the remaining 450 shares passed in trust for

decedent’s benefit.   In or around 1987, Gary Heck purchased the

450 of the shares in trust, giving him 830 shares (52.2 percent

of the 1,590 shares outstanding) and leaving decedent with the

remaining 760 shares.   In 1989, decedent transferred 130 shares

in trust for the benefit of her two grandchildren.   That left

decedent with 630 shares, the value of which, on the date of

death, is in dispute herein.

     Primarily, Korbel produces economically priced premium

champagne.   During the 3-year period ending with 1994, champagne

sales represented approximately 70 percent of Korbel’s total

sales, brandy represented approximately 27 percent of such sales,

and still wine accounted for the approximately 3-percent balance.

 At the beginning of 1995, 95 percent of Korbel’s gross profits

were attributable to sales of champagne and just under 5 percent

to sales of brandy.

     As of the valuation date, Korbel’s facilities were located

on 1,800 acres of land, mostly in Sonoma County.   Of that
                                - 5 -

acreage, 1,099 acres were not used in Korbel’s business

activities, and, on the valuation date, such land had a value of

$2,000 an acre.

     In January 1986, Korbel elected to become an S corporation

(within the meaning of section 1361(a)(1)).     That election was in

effect on the valuation date.   Korbel’s financial statements and

tax returns are prepared on a calendar-year basis.

Distribution Agreement Between Korbel and Brown-Forman Corp.

     In 1965, Korbel signed a marketing agreement with Jack

Daniel Distillery, Lem Motlow, Prop., Inc. (Jack Daniel),

granting Jack Daniel worldwide rights to buy, sell, and

distribute all Korbel beverage products.     Thereafter, Jack Daniel

was consolidated into Brown-Forman Corp. (Brown-Forman), and, in

1987, Brown-Forman contracted to be the exclusive distributor of

Korbel products.

     In 1991, Korbel and Brown-Forman entered into a new

distribution agreement (the agreement or the Brown-Forman

agreement), effective through April 30, 2003, automatically

renewable on a year-to-year basis thereafter, and cancelable on

or after May 1, 1998, upon 5 years’ written notice by either

party to the other of its intent to cancel.     The agreement

granted to Brown-Forman the U.S. distribution rights for Korbel’s

champagne and brandy products, except for Korbel’s right to sell

through its on-premises wine shop.      The agreement was amended in
                               - 6 -

October 1994 to grant Brown-Forman worldwide distribution rights.

     In addition to dealing with the distribution of Korbel’s

products, the agreement grants to Brown-Forman a right of first

refusal with respect to offers of Korbel’s stock by family

members.   In that respect, the agreement provides:

          RIGHT OF FIRST REFUSAL. In the event any member
     of the Heck family desires to sell his or her shares of
     stock in KORBEL to a person who is not a lineal
     descendant of ADOLF L. HECK, he or she shall notify
     BROWN-FORMAN, in writing, giving the name of the
     prospective purchaser, a copy of the offer to purchase,
     the number of shares and the price per share. BROWN-
     FORMAN shall have thirty (30) days from receipt of such
     notice to elect to purchase and pay for the said stock
     at the price stated for cash. If BROWN-FORMAN does not
     purchase such stock within said 30 day period, it may
     be sold to the stated person at the stated price
     without any further obligation to BROWN-FORMAN, meaning
     that BROWN-FORMAN shall not have any further right to
     purchase any of the KORBEL stock sold. If KORBEL has a
     prospective purchaser for 50% or more of KORBEL stock
     who is not a lineal descendant of ADOLF L. HECK and
     BROWN-FORMAN does not exercise its prior right to
     purchase said stock, then BROWN-FORMAN shall have no
     further first right of refusal to buy that stock of
     KORBEL at any time. * * *

Financial Performance

     From 1985 through 1994, Korbel’s sales and net income were

as follows:

           Year           Revenues            Net Income
           1986          $76,955,000          $17,527,000
           1987           85,582,000           25,317,000
           1988           86,920,000           20,177,000
           1989           79,294,000           12,728,000
           1990           78,646,000           11,961,000
           1991           75,677,000            7,735,000
           1992           77,551,000            6,720,000
           1993           78,569,000            7,179,000
           1994           82,758,000           11,955,000
                               - 7 -


     As of December 31, 1994, Korbel’s audited balance sheet

showed assets valued at $83,985,000, liabilities of $10,115,000

(current liabilities of $5,456,000 and long-term obligations of

$4,659,000), and shareholder equity of $73,870,000.   Among

Korbel’s assets was a $2,209,000 interest-bearing note receivable

from KFTY Broadcasting (KFTY), a company owned by Gary Heck.

     In 1994, although sales of Charmat process and transfer

method brands declined 11 percent, sales by domestic methode

champenoise producers increased by 4 percent.   Korbel’s sales of

champagne increased by 6 percent in 1994.   That year, although

Korbel was responsible for only 8.8 percent of total sales of

champagne in the United States, it represented 47.6 percent of

the domestic market for champagne produced by the methode

champenoise.

Respondent’s Expert

     Respondent offered Herbert T. Spiro, Ph.D. (Dr. Spiro), as

an expert witness, to testify concerning the valuation of closely

held companies.   Dr. Spiro is president of the American Valuation

Group, Inc. (AVG), and has directed and conducted valuation

studies of various types of business enterprises.   The Court

accepted Dr. Spiro as an expert in the valuation of closely held

companies and received written reports of AVG into evidence as

Dr. Spiro’s direct testimony and his rebuttal testimony,
                               - 8 -

respectively.   In his direct testimony, Dr. Spiro reached the

conclusion that the aggregate fair market value of the shares as

of the valuation date was $30,300,000, or $48,100 a share,

rounded.2

     In reaching his conclusion, Dr. Spiro utilized both a market

approach and an income approach, the latter of which is based

upon the discounted cashflow method.   He then applied to the

results under both approaches a 15-percent “liquidity discount”

and a 10-percent discount for “additional risks associated with S

corporations” including “the potential loss of S corporation

status and shareholder liability for income taxes on S

corporation income, regardless of the level of distributions.”

He reconciled the two approaches by applying a 70-percent

weighting factor to the “indicated value” of each share under the

income approach ($36,150) and a 30-percent weighting factor to

such value under the market approach ($65,209), resulting in a


     2
        The AVG report that constitutes Dr. Spiro’s direct
testimony is dated Apr. 26, 2000. The parties have stipulated,
and we have received into evidence, an earlier report from AVG to
respondent, dated Oct. 3, 1997, in which AVG concludes that the
fair market value of the shares on the valuation date was
$30,177,000. That value agrees with the value used by respondent
in preparing the notice of deficiency here in issue, but it is
lower than the value reached in the Apr. 26, 2000, report. On
brief, respondent asks us to find that, on the valuation date,
the fair market value of the shares was $30,177,000. We conclude
that respondent is not asking for any increased deficiency, even
though the report that constitutes Dr. Spiro’s direct testimony
finds a slightly higher valuation of the shares.
                               - 9 -

“weighted” share value of $44,868.     He explained that “[t]he

market approach is weighted less at 30 percent due to the lack of

perfect comparables”.   Lastly, he adjusted that value upward to

account for certain nonoperating assets:     1,099 acres of so-

called excess land with a stipulated value of $2,000 an acre

(total value:   $2,198,000) and $5.25 million of “excess cash”.

Before making that upward adjustment, however, he applied certain

discounts.   He applied a 25-percent “minority” discount and,

sequentially, the above mentioned 25-percent “liquidity” discount

to the stipulated value of the land, reducing such stipulated

value to $1,236,375, or $778 a share.     He applied the additional

25-percent “minority” discount in recognition of the fact that

the land value “cannot be readily realized by the minority

shareholder.”   He applied the same 25-percent minority discount

(but not the liquidity discount) to the so-called excess cash,

resulting in a value of $3,939,000, or $2,477 a share.     He

derived his share value for Korbel of $48,123 ($48,100 rounded)

and total value of decedent’s 630 shares (rounded) of $30,300,000

after making the aforesaid adjustments to the value of the

nonoperating assets.

Petitioner’s Expert

     Petitioner offered Mukesh Bajaj, Ph.D (Dr. Bajaj), as an

expert witness, to testify concerning the valuation of closely

held companies.   Dr. Bajaj is a managing director, finance and
                              - 10 -

damages practice, of LECG, Inc.   Dr. Bajaj has experience as a

university professor of finance and business economics, he has

lectured on valuation issues, and he has performed business

valuations for purposes of litigation.    The Court accepted

Dr. Bajaj as an expert in the valuation of closely held companies

and received his written reports into evidence as his direct and

rebuttal testimony, respectively.    In his direct testimony,

Dr. Bajaj reached the conclusion that the aggregate fair market

value of the shares as of the valuation date was $18,707,000, or

$29,694 a share.

     Dr. Bajaj rejected the market approach and relied

exclusively upon a discounted cashflow analysis.    He rejected the

market approach on the ground that there were no publicly traded

companies that were comparable to Korbel.

     Dr. Bajaj’s discounted cashflow analysis resulted in a net

operating asset value for Korbel of $72,041,711.    To that amount

he (like Dr. Spiro) added an additional amount for nonoperating

assets:   $5,517,000, consisting of $2,198,000 for the excess

land, $1,110,000 representing the proceeds from insurance

policies on decedent’s life, and $2,209,000 for the note

receivable from KFTY.   He then subtracted $4,918,000 of interest-

bearing debt, resulting in a fair market value for Korbel as of

the valuation date of $72,640,711.
                              - 11 -

      Dr. Bajaj then applied a 35-percent discount to the value

derived under his discounted cashflow approach, which consisted

of a 25-percent marketability discount and an additional

10-percent discount to reflect the negative impact of Brown-

Forman’s right of first refusal and what Dr. Bajaj refers to as

“agency problems” (the inability of a purchaser of decedent’s

minority interest to influence dividend distributions, which

would be at the discretion of the controlling shareholder, Gary

Heck).   Application of those discounts, totaling 35 percent,

resulted in Dr. Bajaj’s being of the opinion that the marketable

minority value of Korbel’s equity as of the valuation date was

$47,216,462, resulting in a value of $18,707,162 for decedent’s

630 shares, or $29,694 a share.

                              OPINION

I.   Introduction

      We must determine the fair market value of decedent’s 630

shares of Korbel on the valuation date.     The shares were included

in decedent’s gross estate and reported on the estate tax return

at a value of $26,000 a share.    Based upon the expert testimony

of Dr. Bajaj, petitioner now argues that the value of each share

on the valuation date was $29,694.     We interpret petitioner’s

change in position as a concession that the estate is liable for

a portion of the deficiency, and we accept that concession.     In
                              - 12 -

determining the deficiency in estate tax, respondent valued the

shares at $47,900 a share.

      Petitioner bears the burden of proof.   Rule 142(a).

II.   Law

      Section 2001(a) imposes a tax on “the transfer of the

taxable estate of every decedent who is a citizen or resident of

the United States.”   Section 2031(a) provides:    “The value of the

gross estate of the decedent shall be determined by including to

the extent provided for in this part, the value at the time of

his death of all property, real or personal, tangible or

intangible, wherever situated.”

      Fair market value is the standard for determining the value

of property for Federal estate tax purposes.      United States v.

Cartwright, 411 U.S. 546, 550-551 (1973).     Section 20.2031-1(b),

Estate Tax Regs., defines fair market value as:     “the price at

which the property would change hands between a willing buyer and

a willing seller, neither being under any compulsion to buy or

sell and both having reasonable knowledge of relevant facts.”

The willing buyer and willing seller are hypothetical persons,

rather than specific individuals or entities, and their

characteristics are not necessarily the same as those of the

actual buyer or seller.   Estate of Newhouse v. Commissioner, 94

T.C. 193, 218 (1990) (citing Estate of Bright v. United States,

658 F.2d 999, 1006 (5th Cir. 1981)).   The hypothetical willing
                                - 13 -

buyer and seller are presumed to be dedicated to achieving the

maximum economic advantage, which advantage must be achieved in

the context of market conditions, the constraints of the economy,

and, assuming shares of stock are to be valued, the financial and

business experience of the subject corporation existing on the

valuation date.     Estate of Newhouse v. Commissioner, supra.

       In valuing shares of stock in a corporation whose shares are

not publicly traded, the factors we take into account include net

worth, prospective earning power and dividend paying capacity,

and other relevant factors, including the economic outlook for

the particular industry, the company’s position in the industry,

the company’s management, the degree of corporate control

represented by the block of stock to be valued, and the value of

publicly traded stock or securities of corporations engaged in

the same or similar lines of business.     See sec. 2031(b);

sec. 20.2031-2(f)(2), Estate Tax Regs.; Rev. Rul 59-60, 1959-1

C.B. 237, 238-242.

III.    Expert Opinions

       A.   Introduction

       In this case, the parties rely heavily, if not exclusively,

on expert testimony to establish the fair market value of the

shares as of the valuation date.     Indeed, respondent’s only

witness was Dr. Spiro.     In addition to Dr. Bajaj, petitioner

called Gary Heck, decedent’s son and Korbel’s president and
                                - 14 -

chairman of the board, and David Faris, a Korbel assistant vice

president.    Formerly, Mr. Faris was a partner in the tax

department of Pisenti & Brinker, C.P.A.s.    In that role, he

oversaw the preparation of Korbel’s income tax returns, the

estate tax return filed on behalf of decedent’s estate, and the

valuation, for gift tax purposes, of the stock that, in 1989,

decedent transferred in trust for the benefit of her

grandchildren.       Mr. Heck did not testify as to the value of

the shares, and, although Mr. Faris testified that the Pisenti &

Brinker gift tax valuation, in part, formed the basis for the

value of the shares set forth on the estate tax return, it is the

value arrived at by Dr. Bajaj, not the value on the return, that

petitioner urges us to adopt.

     In deciding valuation cases, courts often look to the

opinions of expert witnesses.    Nonetheless, we are not bound by

the opinion of any expert witness, and we may accept or reject

expert testimony in the exercise of our sound judgment.

Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938); Estate

of Newhouse v. Commissioner, supra at 217.    Although we may

accept the opinion of an expert in its entirety, see Buffalo Tool

& Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980),

we may be selective in determining what portions of an expert’s

opinion, if any, to accept, Parker v. Commissioner, 86 T.C. 547,

562 (1986).    Finally, because valuation necessarily involves an
                                - 15 -

approximation, the figure at which we arrive need not be directly

traceable to specific testimony if it is within the range of

values that may be properly derived from consideration of all the

evidence.     Estate of True v. Commissioner, T.C. Memo. 2001-167

(citing Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir.

1976), affg. T.C. Memo. 1974-285).

      B.    Differences Between the Experts

      The major difference between Drs. Bajaj and Spiro is their

disagreement as to the propriety of utilizing a market approach

(i.e., the guideline company method) in valuing the shares.

Also, although both experts utilized a discounted cashflow

approach in valuing the shares (Dr. Bajaj, exclusively;

Dr. Spiro, in part), they disagree sharply over methodology in

applying that approach.    We shall analyze the arguments presented

by both experts in support of their respective positions.

IV.   Propriety of Dr. Spiro’s Application of the Guideline
      Company Method

      A.    Introduction

      The guideline company method of appraisal is commonly used

in valuing shares of stock in a closely held corporation.     When

appropriate, its usage is mandated by section 2031(b), which

provides that the value of unlisted shares of stock or securities

“shall be determined by taking into consideration, in addition to

all other factors, the value of stock or securities of
                               - 16 -

corporations engaged in the same or a similar line of business

which are listed on an exchange.”    See also sec. 20.2031-2(f),

Estate Tax Regs.; Rev. Rul. 59-60, 1959-1 C.B. 237, 242.

     The parties sharply dispute whether (1) the two guideline

companies chosen by Dr. Spiro, the Robert Mondavi Corp. (Mondavi)

and Canandaigua Wine Co. (Canandaigua), were comparable to Korbel

for purposes of section 2031(b), (2) Dr. Spiro actually utilized

only one company, Mondavi, as a guideline company, and (3) if so,

the use of a single guideline company is permissible.      The

parties also disagree as to the propriety of the financial ratios

chosen by Dr. Spiro and his adjustments to those ratios.

Petitioner also claims, and respondent denies, that Dr. Spiro’s

30-percent weighting of the result of his market approach was

essentially arbitrary.

     B.   Dr. Spiro’s Guideline Companies:   Mondavi and
          Canandaigua

           1.   Dr. Spiro’s Method

     Dr. Spiro first identified 1,317 companies listed under the

Standard Industrial Classification Code (SIC) 2084, wines,

brandy, and brandy spirits.   Of those companies he identified

only 11 that were publicly traded, and he rejected 9 of the 11 as

potential comparables because, for the most part, they were

either too large or diverse (or both), too small, unprofitable,

or conducted business in a different manner than Korbel.
                                    - 17 -

Dr. Spiro considered the remaining two companies, Mondavi and

Canandaigua, comparable to Korbel.

     Dr. Spiro valued Korbel’s stock under the guideline company

method (as of the valuation date), by reference to the 1994

fiscal yearend price to earnings (P/E) and price to operating

cashflow (P/OCF) ratios for Mondavi and Canandaigua.          For

Mondavi, those ratios, when reduced to multiples (of earnings and

OCF, respectively), were 17.51 and 9.57 and, for Canandaigua,

they were 22.09 and 14.54.         Dr. Spiro based Korbel’s

corresponding multiples on Mondavi alone, but he “adjusted” them

downward, to a P/E multiple of 13 and a P/OCF multiple of 8, “to

account for Korbel’s additional risk factors” (i.e., the

differences, discussed below, between Korbel and the guideline

companies in terms of size, product mix, consumption patterns,

etc.).   Those derived multiples were applied, and a mean value

was determined, which mean, $86,945, was Dr. Spiro’s valuation

(before discounting) of each share of Korbel under his market

approach.

            2.     Comparability

     Dr. Spiro treated Mondavi and Canandaigua as comparable

(guideline) companies despite acknowledging that, in many

significant respects, they differ markedly from Korbel.

     Size:       In 1994, in terms of both revenue and total assets,

Canandaigua was approximately 10 times as large as Korbel.
                              - 18 -

Mondavi’s gross revenue for its 1994 fiscal year was more than

twice that of Korbel for its 1994 calendar year ($176,236,000

versus $82,758,000), and Mondavi’s total assets at yearend were

approximately triple those of Korbel ($244,236,000 versus

$84,043,000).

     Product Lines:   Although Korbel produces some brandy and an

insignificant amount of still wine, it is essentially a single

product company, producing economically priced premium champagne.

In 1992, Canandaigua’s products included table wines, dessert

wines, sparkling wines, imported beer, and distilled spirits.

Sparkling wines constituted only 3.79 percent of the firm’s total

shipments for 1993.

     As of the valuation date, Korbel marketed its champagne

under two labels, Armstrong Ridge and Korbel.   Canandaigua

marketed its products under many brand names including Paul

Masson, Inglenook, Manischewitz, Almaden, and Taylor California

Cellars, for wine, and Corona, for beer.   Although Canandaigua

also produced and marketed six different brands of sparkling wine

and maintained a 32-percent share of the sparkling wine market

for 1994, all of its sparkling wines were produced using the less

expensive Charmat process or transfer method, whereas Korbel

utilized the methode champenoise exclusively.   Canandaigua

produced for the low end of the champagne market, whereas Korbel

was the leading producer of premium champagne, controlling almost
                              - 19 -

50 percent of the methode champenoise or high-end market and

8.8 percent of the total domestic market.    For the period 1985

through 1994, the low-end and high-end champagne markets fared

differently.   Sales of champagne produced by means of the Charmat

process or transfer method (the low-end market) fell steadily

between 1985 and 1994.   In 1994, sales of the lower priced

domestically produced Charmat process and transfer method labels

dropped 11 percent, when compared to 1993.    Canandaigua’s

sparkling wine sales reflected that trend in 1994, declining by

about 8 percent from 1993.   In sharp contrast, led by Korbel’s

6-percent increase in champagne sales for 1994, 1994 sales by

domestic methode champenoise producers as a whole grew 4 percent,

when compared to 1993.

     Mondavi markets premium still wine under seven different

labels, but it produces little or no sparkling wine.3

     Other Factors:   Dr. Spiro testified that, as of the

valuation date, compared to Mondavi and Canandaigua, Korbel was

smaller, more profitable, and growing more slowly.    It also had


     3
        Both Drs. Bajaj and Spiro state that Mondavi does not
produce any champagne. Gary Heck testified, however, that
Mondavi produces “about 1500 cases [of champagne] that they only
sell through their wine shop, kind of like we do with still
wines.” Even if Mr. Heck is correct, the amount of champagne
produced by Mondavi is negligible in comparison with its wine
production, which, for 1994, was 4,274,000 cases. Thus, as a
practical matter, Mondavi was a producer of still wines, whereas
Korbel was a producer of high-end champagne and a small amount of
brandy.
                              - 20 -

substantially lower debt to asset and debt to equity ratios than

either Canandaigua or Mondavi.

     Dr. Spiro summarized the totality of the differences between

Korbel and both Mondavi and Canandaigua as follows:

     Whereas both comparable companies produce and/or market
     many products, Korbel essentially only produces two
     products, champagne and brandy. Korbel also has less
     revenue and greater revenue variability during the
     course of a fiscal year than the two comparables.
     Korbel’s greater revenue variability results from the
     nature of champagne consumption in the U.S., which is
     closely linked to celebrations and parties. This
     results in a seasonal sales pattern with most sales
     coinciding with the holiday season between Thanksgiving
     and New Year’s Eve. In contrast, wine is consumed more
     steadily throughout the year, often with dinner or as a
     social drink. Korbel’s lack of product diversification
     and comparatively small size tend to increase investor
     risk, necessitating a greater investment return. * * *

     Gary Heck testified to the following significant differences

between the production and marketing of wine as opposed to

methode champenoise champagne:   The second fermentation in the

bottle, which makes production of the latter more complex,

expensive, and time consuming than the production of wine;     the

fact that sales of champagne do not benefit from the so-called

“French Paradox” (i.e., reports that link the moderate daily

consumption of red wine to cardiovascular health); and the fact

that champagne sales are subject to higher Federal excise taxes

than are sales of wine.

          3.   Dr. Spiro’s Opinion

     In Dr. Spiro’s opinion, comparability is established by the

fact that both Mondavi and Canandaigua, like Korbel, produce, a
                              - 21 -

form of wine (“While Korbel occupies a specialized niche, it

crushes grapes, ferments the juice and bottles the product like

other producers.   To argue that comparables do not exist is

incorrect.”).4

     C.   Rejection of Mondavi and Canandaigua as Guideline
          Companies

     Dr. Spiro discussed the similarities and differences between

both Mondavi and Canandaigua and Korbel, and he computed price to

earnings and price to operating cashflow multiples for both

Mondavi and Canandaigua.   Nevertheless, when he applied those

multiples to Korbel, he referred only to Mondavi, and he adjusted

downward from the Mondavi figures.     We fail to see how

Canandaigua influenced Dr. Spiro’s guideline analysis.      It

appears to us that Dr. Spiro, himself, effectively disregarded

Canandaigua as a guideline company.     Assuming that to be the

case, respondent has failed to persuade us that we should have

any confidence in Dr. Spiro’s guideline analysis.     In Estate of

Hall v. Commissioner, 92 T.C. 312 (1989), the Commissioner’s

expert selected only one comparable company.     The proposed

comparable, American Greetings Corp. (American Greetings), was

selected because it, along with Hallmark Cards, Inc. (Hallmark),


     4
        Dr. Spiro’s oral testimony echoed that view: “Sir, we
selected * * * [Mondavi and Canandaigua] as guideline companies,
as the only game in town. We did not say they were exactly like
Korbel. We say they have the same general production approach.
They have the same general customer base. They are all in the
grape processing business. In that sense they are comparable.”
                               - 22 -

the company subject to valuation, were the two leaders in the

greeting card industry.    The Commissioner’s expert concluded that

American Greetings “was the only reasonably comparable company to

Hallmark because it had a similar product mix and capital

structure and served the same markets.”     Id. at 331.   We rejected

the valuation report submitted by the Commissioner’s expert in

light of his reliance on a single comparable company in employing

the market approach.   In so doing, we observed that “[a]ny one

company may have unique individual characteristics that may

distort the comparison.”    Id. at 340.   A sample of one tells us

little about what is normal for the population in question.5

Dr. Spiro has failed to convince us of the reliability of his

guideline analysis.

     Even if we were to accept that Dr. Spiro relied on both

Canandaigua and Mondavi as guideline companies, as respondent

argues, we would still reject Dr. Spiro’s use of the market

approach in this case.    Respondent points out that we have

approved the use of the market approach based upon as few as two

guideline companies.   See Estate of Desmond v. Commissioner, T.C.

Memo. 1999-76.   But in that case, all three companies were in the

same, and not just a similar, line of business (manufacture and


     5
        In his rebuttal report, Dr. Bajaj states: “The superior
quality of Mondavi’s wines, its innovative packaging [a new
bottle with a flange top that prevented dripping and used a dot
of wax instead of a foil capsule as a seal] and strong
advertising coupled with its reputation as an environment-
friendly producer * * * [were attributes that] were largely
unique to * * * [Mondavi]”. (Fn. ref. omitted.) Respondent does
not challenge Dr. Bajaj on that point, which point indicates that
Mondavi may not be reflective of the norm.
                               - 23 -

sale of paint and coatings).   Here, Mondavi and Canandaigua were,

at best, involved in similar lines of business.   Under section

2031(b) and section 20.2031-2(f), Estate Tax Regs., publicly held

companies involved in similar lines of business may constitute

guideline companies, and we have so held.   See, e.g., Estate of

Gallo v. Commissioner, T.C. Memo. 1985-363, where, in valuing the

stock of the largest producer of wine in the United States, we

approved the use by taxpayer’s experts of comparables consisting

of companies in the brewing, distilling, soft drink, and even

food processing industries.    But, in that case, the experts used

at least 10 companies as guideline companies.   See also Estate of

Hall v. Commissioner, supra at 325, where we adopted an expert

report utilizing a market approach based upon a comparison with

six somewhat similar companies.    As similarity to the company to

be valued decreases, the number of required comparables increases

in order to minimize the risk that the results will be distorted

by attributes unique to each of the guideline companies.   In this

case, we find that Mondavi and Canandaigua were not sufficiently

similar to Korbel to permit the use of a market approach based

upon those two companies alone.6




     6
        Dr. Bajaj argues that only companies that are “primarily
champagne/sparkling wine producers like Korbel” constitute
permissible guideline companies. Because no such publicly traded
company existed, Dr. Bajaj rejected the market approach. We find
Dr. Bajaj’s approach to be unduly narrow (in theory), in light of
the case law cited in the text. Nonetheless, we agree, albeit
for different reasons, that respondent improperly applied the
market approach in this case.
                                - 24 -

      Our conclusion that Dr. Spiro improperly applied the

guideline company approach based upon Mondavi and Canandaigua

makes it unnecessary to address petitioner’s other criticisms of

Dr. Spiro’s application of that approach:    The selection of

inappropriate financial ratios, the arbitrary adjustment of those

ratios, and the arbitrary nature of the weight given to the

result reached by Dr. Spiro under the market approach.

      D.   Conclusion

      Dr. Spiro improperly applied the guideline company approach

in valuing the stock of Korbel.

V.   Utilization of the Discounted Cashflow Method in Valuing the
     Stock of Korbel

      A.   Introduction

      This Court considers the discounted cashflow (DCF) method

employed by both experts to be an appropriate method for use in

valuing corporate stock.    See, e.g., N. Trust Co. v.

Commissioner, 87 T.C. 349, 379 (1986).    Moreover, where we have

rejected use of the market approach as unreliable, we have based

the value of a closely held corporation on the DCF approach

alone.     See Estate of Jung v. Commissioner, 101 T.C. 412, 433

(1993).    We, therefore, find that the DCF method utilized by both

experts in this case is an appropriate method for valuing the

stock of Korbel as of the valuation date.
                                 - 25 -

     B.   Analysis of the Experts’ Application of the Discounted
          Cashflow Method

           1.   Introduction

     Recently, in Estate of True v. Commissioner, T.C. Memo.

2001-167, we described the DCF method as follows:

          The discounted cash-flow method is an income
     approach based on the premise that the subject
     company’s market value is measured by the present value
     of future economic income it expects to realize for the
     benefit of its owners. This approach analyzes the
     subject company’s revenue growth, expenses, and capital
     structure, as well as the industry in which it
     operates. The subject company’s future cash-flows are
     estimated, and the present value of those cash-flows is
     determined based on an appropriate risk-adjusted rate
     of return.

     Drs. Bajaj and Spiro are in agreement as to the elements of

the DCF valuation method:      The discounted present value of

cashflow projections for Korbel over a 5-year (1995-1999) period,

plus Korbel’s residual value at the end of the fifth year (also

discounted back to present value), plus the value of nonoperating

assets, less long-term debt, and less appropriate discounts,

e.g., for lack of marketability.      They disagree, however,

regarding the computation of almost every element, including

projected revenues, operating costs, capital expenditures, the

rate of return to be incorporated into the discount factor, the

nature and amount of the nonoperating assets, the amount of long-

term debt, and the nature and amount of the discounts.       We find

neither of the experts totally persuasive.       We accept, however,

portions of the testimony of each.        We shall discuss and evaluate
                                - 26 -

the various elements of both experts’ DCF computations in

arriving at a value for the shares.

          2.     Projected Cashflows

          a.     Sales

     In projecting post-1994 sales growth for Korbel, Dr. Bajaj

determined that there would be 2-percent sales growth for 1995,

that the growth rate would steadily increase to 4.5 percent in

1999, and that the latter rate would prevail indefinitely for

post-1999 years.    Dr. Bajaj considered his forecast optimistic in

light of wine industry analysts’ predictions of a 2.9-percent

decline in champagne consumption during the 1995-1999 period.

Dr. Spiro projected a 4.5-percent sales increase for 1995,

increases of 4.0, 3.5, and 3.0 percent for 1996, 1997, and 1998,

respectively, and 3-percent annual increases thereafter.    Dr.

Spiro’s forecast was primarily based upon the strong growth in

Korbel’s sales during 1994 and the first quarter of 1995.

     We find Dr. Spiro’s sales growth assumptions to be the more

realistic.     Projected growth for 1995 is based upon Korbel’s 1994

sales growth, and subsequent years’ growth is assumed to

gradually decrease to the 3-percent growth rate applicable to

1992-1994, which does not differ materially from the annual

compound growth rate of 3.1 percent since 1984.    Dr. Bajaj’s more

modest sales growth projections for the early years are based

upon projected sales for the champagne industry as a whole, which
                              - 27 -

includes low-end Charmat and transfer process brands.    Moreover,

we find no evidence in Korbel’s recent sales history to justify

an assumed 4.5-percent sales growth for 1999 and thereafter.

          b.   Operating Margin

     Dr. Bajaj’s projected annual operating (pretax)7 margin

(total revenues less cost of goods sold, excise taxes,

depreciation, officers’ compensation, and selling, general, and

administrative expenses (SG&A)) for 1995 and all subsequent years

is 12 percent of sales revenues.   He bases his projection upon

the 5-year simple average of operating margins for the 1990-1994

period.   Dr. Spiro’s projected annual operating margin for 1995-

1999 and subsequent years is 13.3 percent of sales revenues.

Dr. Spiro computes each element of cost entering into his

projection of operating margin separately, in some cases based

upon 2-year averages, in others, based upon 5-year averages.    In

computing average annual SG&A for 1990-1994, Dr. Spiro fails to

include $420,000 of promotional expenses incurred by Korbel in

1993, which Dr. Spiro attributes to the launching of a new

product (Armstrong Ridge champagne).   Dr. Spiro considers that to

be a special, nonrecurring cost that, in future years, will be

borne by Brown-Forman pursuant to the Brown-Forman agreement.     We

do not agree with Dr. Spiro’s treatment of the 1993 promotional


     7
        The parties agree that the only tax applicable to the
income of Korbel is California’s 1.5-percent income tax on
S corporations.
                                - 28 -

expense as a nonrecurring cost.    Mr. Heck testified that new

label promotional expenditures are a recurring feature of

Korbel’s business.   Although the Brown-Forman agreement relieves

Korbel of any responsibility to pay marketing or selling expenses

(“Brand Expense”) for Korbel champagne or brandy, Korbel incurred

the promotional expenses in question subsequent to the 1991

effective date of the agreement, and Mr. Heck testified that a

similar “spike” in Korbel’s promotional costs could occur at any

time.   Projecting the mean annual SG&A costs for a 5-year period

that includes a year of extraordinary promotional expenses

associated with the introduction of a new label does not seem

unreasonable.

     Dr. Spiro criticizes Dr. Bajaj for relying on a simple

5-year average in projecting an annual operating margin.    Yet for

cost of goods sold, where Dr. Spiro uses a 2-year average to make

projections, he testified, in rebuttal:    “The * * * [rate chosen

by Dr. Bajaj] appears reasonable although we once again question

the use of a simple average.”    Dr. Spiro, himself, uses a 5-year

average in projecting officers’ compensation and SG&A.    Korbel’s

annual operating margins for the 1990-1994 period do not show a

trend, and Dr. Spiro has failed to convince us that Dr. Bajaj’s

use of a 5-year simple average is inappropriate.    At least, it

has the virtue of consistency, and for that reason, we prefer it

to Dr. Spiro’s approach, the inconsistency of which he did not
                                - 29 -

adequately explain.    We modify Dr. Bajaj’s approach only to take

into account small amounts of other income, which he takes into

account in his rebuttal testimony.       Dr. Bajaj’s projected profit

margin, based upon an unweighted arithmetic average of operating

margins from 1990-1994, and including “other income” (interest

and “Heck Cellars” revenue), is 12.3 percent.      We find that to be

the proper assumed operating margin for purposes of determining

Korbel’s value on the valuation date under the DCF method.

          c.     Cashflow Adjustments

     To determine cashflow, it is necessary to modify after-tax

income by adding back depreciation and subtracting working

capital additions and capital expenditures.

     Depreciation averaged 3.8 percent of sales revenues during

the 1990-1994 period and 4.1 percent for 1993 and 1994.

Dr. Bajaj, relying on a 5-year average, projected depreciation at

3.8 percent of gross sales and Dr. Spiro, relying on a 2-year

average, projected it at 4.0 percent of gross sales.      Although,

for 4 out of the 5 years, total depreciation grew as a percentage

of sales revenues, the question is whether the most recent

2 years is a better measure of the trend than the last 5 years.

Neither expert took the other head-on with respect to this point,

and, since, in general, we found Dr. Bajaj’s analysis to be more

thorough than Dr. Spiro’s, we shall rely on his 5-year average as

determinative.
                              - 30 -

     Both Drs. Bajaj and Spiro project inventory expenditures to

remain constant at 50 percent of sales revenue.   However,

Dr. Bajaj projects “other working capital” (including cash) at

5 percent of sales whereas Dr. Spiro projects noninventory

working capital at 3.5 percent of sales (in both cases, based on

historical data).   Dr. Spiro justifies his lower figure by

discounting the 1993 and 1994 average working capital level

(11.7 percent) on the ground that it was largely attributable to

“excess cash”.   As we discuss, infra (in connection with our

analysis of Korbel’s nonoperating assets), we do not believe

Korbel retained excess cash in 1993 and 1994.   We are persuaded

that Dr. Bajaj’s projection of working capital levels is

justified based on historical performance, and we find in

accordance with his calculation.

     Dr. Spiro projected annual capital expenditures by Korbel

equal to $4 million for 1995 and every year thereafter.

Dr. Bajaj projected annual capital expenditures on the assumption

that they would equal depreciation plus 30 percent of Korbel’s

annual sales increases.   Dr. Bajaj projected that capital

expenditures would increase in an amount adequate to maintain

Korbel’s net fixed asset to sales ratio at 30 percent, which is

slightly below the average of such ratios for the 1990-1994

period.   Each expert points to unreasonable aspects of the

other’s approach:   Dr. Bajaj to the fact that Dr. Spiro’s
                                   - 31 -

approach will eventually lead to negative net asset value,

Dr. Spiro to the fact that Dr. Bajaj’s projected increases in

capital expenditures more than double his projected sales

increases over the 1995-1999 period.

      Korbel’s financial statements for the 1985-1994 period show

that, whereas depreciation increased annually, capital

expenditures (“property, plant and equipment purchased”) have

fluctuated significantly over that same period, the low of

$2,315,000 occurring in 1990 and the high of $6,142,000, in 1991.

Average annual capital expenditures for the 1990-1994 period were

$3,817,000.      Therefore, we consider Dr. Spiro’s projection of $4

million in annual capital expenditures to be reasonable, and we

adopt it.     Conversely, we find nothing in Korbel’s financial

history to support Dr. Bajaj’s projection of ever-increasing

annual capital expenditures.

            3.    Rate of Return

      The DCF method involves the computation of the present value

of expected future cashflows.       The present value of a cashflow

equals the cashflow multiplied by a discount factor (less than

1).   The discount factor is usually expressed as the reciprocal

of 1 plus a rate of return:        Discount factor (for one period) =

1/(1 + r).8      Drs. Bajaj and Spiro agree that the rate of return


      8
        See Brealey & Myers, Principles of Corporate Finance 16
(6th ed. 2000) (“The rate of return r is the reward that
                                                   (continued...)
                                 - 32 -

to be used in applying the DCF method to Korbel’s cashflows is

Korbel’s “weighted average cost of capital” (WACC).9      Dr. Bajaj

computed the WACC as 14.22 percent; Dr. Spiro computed it as

16.54 percent.    Their only significant disagreement is as to one

component of the WACC, the cost of equity capital.10      Dr. Bajaj

computed the cost of equity capital as 14.70 percent; Dr. Spiro

computed it as 16.71 percent.

     We need not engage in an extended discussion of the

appropriate cost of equity capital since, in computing the WACC,

other things being equal, the higher the cost of equity capital

(i.e., the larger the percentage), the larger the WACC.      Given

the DCF method, the larger the WACC, the lower the present value

of expected cashflows.      The parties endorse the DCF method,

differing only as the value of certain variables.       Since we are



     8
      (...continued)
investors demand for accepting delayed payment.”).
     9
          As expressed by Dr. Spiro:

                     WACC = Wd x Kd x (1-t) + We x Ke

     Where:
          WACC   =   weighted average cost of capital,
          Wd     =   weight of debt in capital structure,
          Kd     =   estimated pretax cost of debt,
          t      =   income taxes at 1.5 percent,
          We     =   weight of equity in capital structure, and
          Ke     =   cost of equity capital.
     10
        Dr. Spiro defined the cost of equity capital as follows:
“[T]he rate of return required by an investor as sufficient
compensation for committing equity funding to the business.”
                              - 33 -

deconstructing each expert’s DCF analysis, and assembling our

own, our adopting Dr. Bajaj’s cost of equity capital cannot, in

isolation, be objectionable to respondent, since respondent has

proposed that we find a higher, 16.71-percent cost of equity

capital.   Dr. Bajaj relied on the capital asset pricing model

(which takes into account exclusively systematic (or market)

risk) to compute the cost of equity capital, while Dr. Spiro

relied on the so-called buildup method (which pays attention to

the unsystematic (or individual) risk that an investor would face

in investing in Korbel).   Neither expert convinced us that his

approach was significantly better (on the facts at hand) than the

other expert’s approach, and we are satisfied that 14.70 percent

(the percentage reached by Dr. Bajaj) is a reasonable figure for

Korbel’s cost of equity capital, and we so find.11   We find that

the WACC is 14.22 percent.




     11
        In recent cases, we have criticized the use of both the
capital asset pricing model (CAPM) and WACC as analytical tools
in valuing the stock of closely held corporations. See Furman v.
Commissioner, T.C. Memo. 1998-157. See also Estate of Maggos v.
Commissioner, T.C. Memo. 2000-129 and Estate of Hendrickson v.
Commissioner, T.C. Memo. 1999-278, which reaffirm that view,
citing Furman, and Estate of Klauss v. Commissioner, T.C. Memo.
2000-191, where we rejected an expert valuation utilizing CAPM in
favor of one utilizing the buildup method. In other recent
cases, however, we have adopted expert reports which valued
closely held corporations utilizing CAPM to derive an appropriate
cost of equity capital. See BTR Dunlop Holdings, Inc. v.
Commissioner, T.C. Memo. 1999-377; Gross v. Commissioner, T.C.
Memo. 1999-254, affd. 272 F.3d 333 (6th Cir. 2001)
                               - 34 -

          4.    Present Value Computation:   Yearend Versus Mid-
                Year Cashflow Convention

     In computing the present value of all cashflows, Dr. Bajaj

adopted a yearend convention (cashflows discounted as of

yearend), while Dr. Spiro adopted a midyear convention (cashflows

assumed to be received at, and discounted from, midyear).

Because, under the midyear convention, the cashflow for a year is

deemed to have been received 6 months earlier, the discount

factor for the year is slightly greater (and the dollar amount of

the discount itself is slightly smaller) than if the yearend

convention is adopted.    Given the same cashflow but a greater

discount factor, the present value of the cashflow is greater.

     The parties agree that (1) approximately 60 percent of

Korbel’s champagne sales occur during the last quarter of the

calendar year and (2) as much as 20 percent of such sales occur

during the last week of December.    Since Korbel’s revenues are

not spread evenly throughout the year, we are unconvinced that

Dr. Spiro’s use of the midyear convention results in a more

accurate valuation than Dr. Bajaj’s use of the yearend

convention.    We adopt the yearend convention.

          5.    Increase in Korbel’s Value for Nonoperating Assets

          a.    Introduction

     The question here is whether the value of certain

nonoperating assets should be added to the value determined under

the DCF method in determining the value of the shares.
                              - 35 -

          b.   Excess Land; Insurance Proceeds; KFTY Receivable

     The parties agree, and we find, that the excess land

constitutes a nonoperating asset to be added to the present value

of Korbel’s cashflows at a value of $2,198,000 and that insurance

proceeds in the amount of $1,110,000 likewise are to be so added.

Although they differ in exactly how a receivable from KFTY in the

amount of $2,209,000 is to be taken into account, they agree that

it is to be taken into account.   We agree and so find.   The total

of the aforesaid nonoperating assets is $5,517,000

          c.   Excess Cash

     Dr. Spiro considered $5,250,000 of cash held by Korbel on

December 31, 1994, to be a nonoperating asset, which he referred

to as “excess cash”.   Dr. Spiro reached that conclusion by

examining historical cash levels in relation to gross revenue, in

order to determine the appropriate “normalized” cash level, which

he determined to be 6.55 percent of gross revenue.   Applying that

percentage to 1994 gross revenue, Dr. Spiro concluded that Korbel

had excess cash in the amount stated.   In determining the value

of the shares, he included only a portion of the excess cash to

reflect the inability of minority shareholders to force a

distribution of such cash.   Dr. Bajaj concluded that there was no

excess cash, and, in his rebuttal testimony, he persuasively

explained his basis for that conclusion.   We were impressed with

his interpretation of the historical data, in light of the
                                - 36 -

information he received (the need to retain funds for a number of

contingencies) on interviewing Mr. Heck.     On the basis of his

testimony, we find that there was no nonoperating asset

consisting of excess cash.

          6.     Decrease in Korbel’s Value by Amount of
                 Long-Term Debt

     Putting aside Drs. Bajaj and Spiro’s disagreement over the

treatment of the KFTY receivable, see supra p. 35, the remaining

disagreement is over whether the current portion of long-term

bank borrowings is a component of working capital or a long-term

liability.     On brief, respondent states that any resulting

difference in the value of the shares is immaterial, and the

choice of treatment is “a valid choice of the appraiser”.       We

shall treat such current portion as a long-term liability.

          7.     Discounts

          a.     The Expert Testimony

     Dr. Bajaj determined that the shares were subject to a 25-

percent basic marketability discount.     Dr. Bajaj then added an

additional 10 percent to his basic marketability discount, which

addition was attributable to both the right of first refusal

(ROFR) held by Brown-Forman and what he refers to as “agency

problems”, the fact that the shares represented a minority

interest unable to influence the majority shareholder’s control

over cash distributions.     The addition of those two discounts
                               - 37 -

resulted in Dr. Bajaj’s determination of an overall 35-percent

discount, which he treats, in total, as a marketability discount.

     Dr. Spiro determined a basic 15-percent liquidity

discount,12 increased by an additional 10 percent for risks

associated with Korbel’s status as an S corporation.      Thus, Dr.

Spiro’s total liquidity discount is 25 percent, which he applies

to the values that he determined under his market and income

approaches (i.e., values exclusive of the value of nonoperating

assets).   Dr. Spiro applied specific, separate discounts to

nonoperating assets:   A 25-percent minority discount followed by

his overall 25-percent liquidity discount applicable to “excess

land”13 and a 25-percent minority discount applicable to “excess

cash”.

           b.   Marketability Versus Minority Discounts

     We have recognized that there is a distinction between a

discount for lack of marketability and a discount for the

minority position of the interest to be valued.   As we stated in

Estate of Andrews v. Commissioner, 79 T.C. 938, 953 (1982):

     The minority shareholder discount is designed to
     reflect the decreased value of shares that do not
     convey control of a closely held corporation. The lack
     of marketability discount, on the other hand, is


     12
        We interpret Dr. Bajaj’s references to a “marketability”
discount and Dr. Spiro’s references to a “liquidity” discount as
references to the same type of discount.
     13
        Because Dr. Spiro applies the two discounts
consecutively, the total discount is 43.75 percent:    0.25 + (0.25
x 0.75) = 0.4375.
                               - 38 -

     designed to reflect the fact that there is no ready
     market for shares in a closely held corporation.
     Although there may be some overlap between these two
     discounts in that lack of control may reduce
     marketability, it should be borne in mind that even
     controlling shares in a nonpublic corporation suffer
     from lack of marketability because of the absence of a
     ready private placement market and the fact that
     flotation costs would have to be incurred if the
     corporation were to publicly offer its stock. * * *

           c.   Basic Discount for Lack of Marketability

     Dr. Bajaj’s 25-percent marketability discount is based upon

a number of empirical studies, his critical evaluation of those

studies, and his own multiple regression analysis of the

“explanatory variables”.   Dr. Spiro, in his rebuttal testimony,

finds no fault with Dr. Bajaj’s methodology.

     Dr. Spiro cites many of the same empirical studies as

suggesting that liquidity discounts can range from 10 to 45

percent.   He states that the average discounts were “often in

excess of 35 percent.”   Yet, Dr. Spiro concludes that the basic

liquidity discount for the shares, taking into account the ROFR,

is appropriately set at 15 percent.     Dr. Spiro fails to make

clear, in either his primary or rebuttal report, the basis for

his determination that the appropriate liquidity discount is at

the low end of the acceptable range of such discounts.     In his

oral testimony, he set forth his theory that there was a

specialized group of purchasers who would value the shares on

other than an investment basis (who would eye Korbel as a

possible future joint venture partner).     Dr. Spiro failed to
                                - 39 -

quantify or explain how he adjusted his analysis to take account

of that factor.    Indeed, such factor has recently been rejected

by the Court of Appeals for the Ninth Circuit, the likely venue

of any appeal in this case.     Estate of Simplot v. Commissioner,

249 F.3d 1191, 1195 (9th Cir. 2001), revg. 112 T.C. 130 (1999).

We did not find Dr. Spiro’s oral testimony to be persuasive.    It

did not bolster what we found to be weak analysis in his written

reports.

     We found Dr. Bajaj’s analysis in support of his 25-percent

basic discount to be both thorough and convincing, and we find

that a basic discount for lack of marketability in the amount of

25 percent is appropriate.

           d.    Additional Discounts

           (1)    Discount for Lack of Control

     Dr. Bajaj describes his entire 35-percent discount as a

discount for lack of marketability.      We view his proposed

discount for “agency problems”, however, as a discount for

minority status (or lack of control), as it is based upon the

inability of the owner of the shares to force the majority

shareholder, Gary Heck, to make dividend distributions.

Dr. Bajaj’s discount for minority status takes into account

factors similar to what Dr. Spiro took into account in addressing

problems associated with Korbel’s S corporation status, at least

to the extent that Dr. Spiro’s discount relates to the same lack
                                - 40 -

of control problem.14   Thus, we view Drs. Bajaj and Spiro in

basic agreement as regards the need for a discount for lack of

control, which we view as a minority status discount.

          (2)   Discount for Brown-Forman’s ROFR

     Both experts agree that some discount for the ROFR is

warranted.   Dr. Spiro includes the ROFR as part of his basic

15-percent liquidity discount, Dr. Bajaj as part of his

additional 10-percent discount for both the ROFR and the minority

interest’s lack of control.

     Dr. Bajaj views the ROFR as a much more serious impediment

to marketability than does Dr. Spiro.    He argues that, because of

its ROFR, Brown-Forman is always a potential bidder for an

available block of Korbel stock.    He further argues that, because

it had been the sole distributor of Korbel champagne and brandy

for a number of years, Brown-Forman knows more about Korbel than

any potential outside bidder.    As a result, any other outside

bidder would have to expend a great deal of effort and money to

even approach Brown-Forman’s knowledge level concerning Korbel,

without which it may offer too little and risk losing out to

Brown-Forman, or too much and risk making a bad deal.    Also,

because Brown-Forman has a special interest in retaining its sole


     14
        Dr. Spiro also states that, as an S corporation, Korbel
is subject to several restrictions impairing liquidity, including
restrictions on the number and type of persons that can be
shareholders. Nevertheless, he views S corporation status as a
benefit and fails to quantify the relevant advantages and
disadvantages.
                              - 41 -

distributor position, it will have a tendency to drive up the

price beyond what a potential buyer would be willing to pay based

upon the present value of anticipated cashflows.   According to

Dr. Bajaj, both of those factors act as a significant deterrence

to would-be bidders for the shares, and, therefore, they reduce

the value of the shares.

     In his rebuttal testimony, Dr. Spiro responds that Korbel is

not “such a complex organization that the costs of analyzing the

company for bidding purposes would be prohibitively high.”

Dr. Spiro argues that Dr. Bajaj’s concerns regarding Brown-

Forman’s ROFR “are more appropriately applied to * * * [complex

high-tech companies] where the ‘hidden’ value of * * *

[intellectual property] can make accurate analysis difficult and

expensive, especially for an outsider.”   Dr. Spiro agrees,

however, that some discount is warranted for the ROFR and, as

noted above, has included it as part of its basic 15-percent

liquidity discount.

          (3)   Amount of Additional Discounts

     We agree with Dr. Bajaj that an additional 10-percent

discount for Brown-Forman’s ROFR and the purchaser’s lack of

control over future dividend-liquidation policy (i.e., the

purchaser’s minority status) is warranted.   We ascribe most of

that discount to the minority status issue, which both Drs. Bajaj

and Spiro agree deserves recognition.   Both Drs. Bajaj and Spiro
                               - 42 -

also believe that the ROFR would reduce value, but disagree both

as to rationale and quantum.    We are satisfied that some amount

of discount is attributable to the ROFR and that 10 percent is an

appropriate discount for both the ROFR and the purchaser’s

minority status, given Dr. Spiro’s addition of a 10-percent

discount for only Korbel’s status as an S corporation.

          (4)    AVG’s Discounts From the Value of Nonoperating
                 Assets

     Dr. Bajaj applied an overall 35-percent marketability

discount to his total valuation of Korbel, which included

nonoperating assets.    Dr. Spiro applied a 25-percent liquidity

discount to his valuation of Korbel, not including nonoperating

assets.   As noted supra p. 37, he then applied separate

additional discounts to what he considered nonoperating assets.

We reject Dr. Spiro’s 25-percent minority discount applied to

“excess cash” on the basis of our finding that Korbel retained no

excess cash as of the valuation date.    We also reject Dr. Spiro’s

43.75-percent combination minority/liquidity discount applied by

him to the excess land in favor of Dr. Bajaj’s 35-percent overall

discount applied to his total valuation of Korbel, including such

excess land.    We see no reason to limit a minority discount to

particular assets of Korbel even if they are    nonoperating assets

and, therefore, more readily available for distribution to

shareholders than are Korbel’s operating assets.    As we observed

in Estate of Fleming v. Commissioner, T.C. Memo. 1997-484, a
                              - 43 -

minority discount generally “reflects the minority shareholder’s

inability to compel liquidation and thereby realize a pro rata

share of the corporation’s net asset value”; i.e., the minority

shareholder’s share of total corporate net asset value.

      C.   Conclusion

      On the basis of the foregoing application of the DCF method,

taking into account certain discounts, we find that the fair

market value of the shares as of the valuation date was

$20,269,736, or $32,174 a share.   See Appendix.

VI.   Conclusion

      We shall redetermine a deficiency in Federal estate tax

commensurate with our finding that the value of the shares as of

the valuation date was $20,269,736.


                                           Decision will be entered

                                      under Rule 155.
                                                           - 44 -
Appendix:
                                Valuation of 630 Shares of R. Korbel & Bros., Inc. as of 2/15/95

Projected Items                     1994            1995              1996           1997           1998          1999

Sales                           $82,757,920     $86,482,026         $89,941,307   $93,089,252    $95,881,929    $98,758,386

Net Income
Pre-Tax Income                                   10,637,289         11,062,780    11,449,977     11,793,477     12,147,281
     (@ 12.3% op. margin)
Income Taxes (@ 1.5%)                              (159,559)          (165,942)     (171,750)      (176,902)      (182,209)

Net Income                                       10,477,730         10,896,838     11,278,227    11,616,575      11,965,072

Cashflow Adjustments
+ Depreciation                                    3,286,317          3,417,770      3,537,391      3,643,513      3,752,819
      (3.8% of sales)
(-) Working Capital Additions                    (2,048,258)        (1,902,605)    (1,731,370)    (1,535,972)    (1,582,051)
   (55% of incremental sales)
(-) Capital Expenditures                         (4,000,000)        (4,000,000)    (4,000,000)    (4,000,000)    (4,000,OOO)
Yearend Cashflow                                  7,715,789          8,412,003      9,084,248      9,724,116     10,135,840
Discount Rate (WACC)                                 14.22%             14.22%         14.22%         14.22%          14.22%
Present Value Interest                                .8755              .7666          .6712          .5876           .5145
      Factor (1/(1.1422)n)
Present Value of Cashflows                        6,755,173          6,448,641      6,097,347      5,713,891      5,214,890

Total Present Value of Cashflows                           $30,229,942
Present Value of Reversion:
      10,135,840 (1.03/.1422-.03)                          47,861,436
                 ( (1 + .1422)5)
      =10,135,840 (4.722)

Present Value of Operating
      Assets                                               78,091,378
Value of Nonoperating Assets                                5,517,000
Long-Term Debt                                             (4,918,000)
Enterprise Value of Korbel (w/o discount)                  78,690,378

Enterprise Value of Korbel with 35% Discount               51,148,745
Value of 39.629% interest (630 shares)                     20,269,736

Value of each share                                            32,174
