Increasingly, financial experts are asked to project damages for losses that a plaintiff will incur in the future and discount those losses to present value. With business litigation such as infringement and breach-of-contract cases showing little sign of letting up, attorneys need to understand how such discounting works.
Purpose of Discount Rates
To project damages for losses, an expert first determines the relevant loss period. This could be derived from the:
- Term of a contract,
- Useful life of a product, or
- Amount of time required for the plaintiff to reasonably mitigate losses.
Undiscounted lost profits generally represent the difference between the plaintiff’s expected net cash flow (or other measure of economic benefit), “but for” the alleged legal violations of the defendant, and the plaintiff’s actual net cash flow.
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 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.
Discount rates should reflect the probability that a plaintiff’s lost profits would have materialized “but for” the defendant’s alleged wrongdoing. 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.
No Simple Matter
Calculating lost profits damages is rarely as straightforward as it may seem. If a financial expert applies the wrong discount rate, the result could significantly under- or overestimate lost profits. That’s why it’s important to engage someone with extensive damages experience.
TheKFORDgroup litigation team holds extensive knowledge and experience in expert witness engagements, forensic accounting, and business valuations. Our experts are trained and experienced in the litigation process. We have the extensive damage experience to assist you or your client with their lost profits calculation. For more information, please call us at 210-340-8351.
Additional information included in this report was provided by PDI Global / Thomson Reuters © 2014