When calculating economic damages, financial experts must discount lost profits to their net present value. But what discount rate is appropriate? The answer depends on market conditions and the risk of the business or product. A small difference in the discount rate can have a big impact on an expert’s conclusion, so it’s important to get it right.
Duration of losses
To project damages for losses, an expert first determines the relevant loss period. For example, this could be the term of a contract, the useful life of a product or the amount of time required for the plaintiff to reasonably mitigate losses. Undiscounted lost profits generally represent the difference between the plaintiff’s expected profits (or other measure of economic benefit), “but for” the alleged legal violations of the defendant, and the plaintiff’s actual profits.
An expert then uses discount rates to compute the present value of lost profits from each month or year. Each period’s discounted losses are combined to arrive at the net present value of lost profits. Discount rates must accurately reflect the time value of money and the risks a particular business faced in the absence of an injury — specifically, uncertainty that lost profits the business has claimed would actually have been achieved.
It’s important to note that the value of the entire business may be more appropriate for computing damages involving the destruction of a business, shareholder oppression, family law or tax issues — or when the loss is permanent and complete. In these cases, damages equal the difference between the company’s value before and after the defendant’s alleged wrongdoing, because the plaintiff is unlikely to ever fully recover.
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. If the company has a consistent earnings history and is likely to achieve its projected future earnings, a lower rate of return may be appropriate. Experts also consider relevant case law, contract terms and the lawsuit’s context when deciding on an appropriate discount rate, though never as a primary or sole support for calculations.
Common rates chosen by experts include:
Safe rate. The so-called safe rate, or Treasury rate, is often a good starting point. It reflects inflation and a “rental rate” for the use of funds.
Cost of equity. A financial expert can determine the cost of equity using one of several build-up methods or the capital asset pricing model, which considers market, industry and company-specific risks. The discount rate may begin with the Treasury rate and increase based on risk, using stock market benchmarks and qualitative assessments of the plaintiff’s operations.
Cost of debt. The use of this discount rate presumes that the plaintiff’s borrowing rate approximates both the time value of money and the risks the plaintiff faced in the absence of an injury.
Weighted average cost of capital (WACC). The WACC represents a weighted average of the returns paid to debt and equity holders for their investments, based on the costs of equity and debt.
Choosing the appropriate discount rate is just as critical as quantifying projected losses, but it often gets less attention by the parties. Subtle changes in the discount rate can have a major impact on an expert’s conclusion. For example, $100 discounted over five years is worth $56.74 using a 12% discount rate (assuming annual compounding). But the present value increases to $64.09 if you apply a 10% discount rate — a difference of nearly 10%.
Selecting an appropriate discount rate involves subjective judgment, which can lead to dramatically different damage calculations. An experienced financial expert knows how to develop a discount rate that’s supported by objective market data. Contact a Meaden & Moore expert today to learn more.