Selecting an appropriate discount rate involves an element of subjective judgment, which can lead to dramatically different damage calculations. This article explains how an understanding of the basics of discounting helps build a strong case in support of damages positions.
Plaintiffs often seek damages for future losses — such as lost profits — expected to flow from a defendant’s alleged wrongdoing. Because a dollar today is worth more than a dollar tomorrow, however, future damages must be discounted to their present value.
In other words, what amount of damages, invested today at an assumed rate of return, would produce an amount equal to the future loss? Typically, future damages are discounted further to reflect business risk — that is, uncertainty over whether claimed lost profits would actually have been earned.
Selecting an appropriate discount rate involves an element of subjective judgment, which can lead to dramatically different damage calculations depending on the discount rates experts use. Nevertheless, the courts have provided slim guidance on the issue. An understanding of the basics of discounting will help you build a strong case in support of your damage positions.
The discount rate
The discount rate is the most critical component of the discounting formula. The rate is used to calculate a discount factor, which is multiplied by the projected loss to arrive at present value. The discount rate itself generally includes two components: 1) an assumed rate of return that recognizes the time value of money, and 2) a risk factor that recognizes the uncertainty of achieving profit expectations.
An expert might apply a lower discount rate, for example, if damages are based on profits that are less risky than the plaintiff’s normally anticipated profits. A higher discount rate might be appropriate if damages represent profits that carry a higher-than-normal risk.
Selecting a rate
Financial experts use several methods to determine an appropriate discount rate:
Safe rate. Also known as the Treasury rate method, this approach may be suitable for well-established businesses with relatively stable and predictable profits. The expert examines trends specific to the business to project lost profits for the relevant time period and assign a comparable rate — usually based on a T-bill rate.
Buildup. The buildup method is frequently invoked for newer businesses with inadequate earnings histories. Losses are typically projected based on industry trends, but a higher discount rate is used to reflect increased risk. An expert using the buildup method may start with the Treasury rate and adjust it based on industry- and company-specific risks.
The Capital Asset Pricing Model (CAPM), cited in the Federal Judicial Center’s (FJC’s) Reference Guide on Damages, is one example of a buildup method. Under CAPM, the expert calculates a risk-adjusted discount rate based on factors including the historical average risk premium for the stock market.
Rate of return. This approach relies on pertinent industry statistics to obtain an average rate of return (ROR) for a business in the industry. The ROR becomes the discount rate.
Capitalization factor. The FJC reference guide defines a capitalization factor as “the ratio of the value of a future stream of income to the current amount of the stream,” usually derived from market values of comparable companies. To determine the discounted value, the current annual loss in operating profit is multiplied by the capitalization factor.
Using multiple rates
In some cases, it may be appropriate to use multiple discount rates rather than one, constant rate. Some experts use different rates, for example, to account for potential increases in risk due to anticipated market changes.
Others note that T-bills carry different rates depending on their maturity dates. Thus, they assert, a different rate should be used for each year in a forecast, with the first year’s income discounted with the rate on a one-year T-bill, the fifth year’s income discounted at the rate paid on a five-year T-bill, and so on.
Know your case
Ultimately, the right discount rate hinges on a specific case’s facts and a thorough analysis of the risks associated with future losses. Keep in mind that a defendant who fails to challenge a plaintiff’s claim for undiscounted future damages might waive the argument altogether.
Sidebar: Reconciling discount rates
Some experts advocate minimizing the difference between opposing parties’ discount rates by modeling future damages. Modeling takes into account the variables that can affect future income. An expert projects the plaintiff’s desired income stream and modifies it to a reasonable expectation by factoring in future risks. The adjusted future loss is then discounted to present value at a relatively low, risk-reduced discount rate. Modeling differs from those approaches where experts project the intended income stream and then apply a higher discount rate to reflect risk.
The key to modeling is to identify the risks that might cause the plaintiff to achieve less-than-desired results and adjust lost profits accordingly. The goal is to generate a stream of undiscounted lost profits that reasonably approximates the most likely outcome but for the alleged wrongdoing. Once this is accomplished, the present value can be determined using a risk-abated discount rate.
Under the traditional approach, an expert starts with a risk-free interest rate and develops a discount rate that takes into account subjective risks — such as those related to the market, finances, management, products, company sales, and business environment — and systematic risks such as general equity risk. The modeling method minimizes the need for modifications to the discount rate.