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Beware of the Discount Rate

February 19, 2013

By Michael E. DiGiacomo, CPA/CFF, CFE, CIRA
Senior Manager

The objective of an expert’s opinion of damages in a lost profit engagement is deceptively simple: measure in financial terms, the extent of harm a plaintiff has suffered because of defendant’s alleged wrongdoing. The purpose of awarding damages is to restore an injured party to a position they were in prior to being injured.

Frequently, an expert is required to express an opinion on the value of damages that extend into the future, requiring the expert to discount future damages to present value. Often, much scrutiny and debate is related to the projection of the injured party’s lost income stream, unit costs or incremental costs. However, one equally important, but often overlooked, component of a damage calculation is the discount rate used to discount projected future damages to present value.

Discounting future income streams is a concept based on the idea that a sum of money invested today will grow in value and be worth more in the future. In other words, money has time value – a dollar today is worth more than a dollar tomorrow. Discounting is also based on the concept of uncertainty; a safe dollar is worth more than a risky dollar.

This concept reflects the notion that most rational people would avoid risk when they can do so without sacrificing return. In a litigation context, the idea of discounting is indisputable, though the ambiguity lies in how to account for the risk of uncertainty and the proper discount rate to use to calculate present values.

In a litigation context, courts held that future damages ought to be discounted, but have provided very little guidance on the appropriate rate to use. Two common methods of discounting future lost profits is to either account for risk in the projected lost income stream or to account for it in discount rate.

To account for risk in the projected lost income stream, the expert estimates the projected lost income modifies such losses to account for uncertainty and then discounts the risk adjusted future losses to a present value using a risk adjusted, relatively low discount rate. To account for risk in the discount rate, the expert would project hoped-for lost income stream and then apply a higher discount rate incorporating risk or uncertainty to determine the present value.

A “risk-inclusive” rate is comprised of three components: a risk-free rate, additional risk premiums for general equity investments and company size, and a premium for company specific uncertainties. The first two components are based on objective data and represents systematic or market risk.

The third component is subjective and represents company specific risk. Accounting for company specific risk by augmenting the discount rate is subjective and difficult to substantiate. When questioned, the expert will have difficulty providing empirical evidence to support the use of a subjective risk premium.

It may be more intuitive and easier for an expert to present a damage analysis that directly accounts for risk in the cash flow projection, as opposed to substantiating and explaining a “risk-inclusive” discount rate. For example, assuming a 15% base discount rate, a two-year damage period, a level income stream of $1,000 and a 50% outcome probability, a 88% discount rate (a subjective risk premium of 73%) is required to achieve the same present value as discounting risk-adjusted income stream at 15%. This concept may be difficult for the expert to explain and for the court to understand.

Regardless of the method used, future damages will be misstated if the expert does not properly match the income stream with an appropriate discount rate. Inappropriately using a high discount rate applied to a risk-adjusted, certain stream of income could potentially undercompensate a plaintiff, whereas applying a low discount rate to a highly variable and uncertain income stream would overstate a plaintiff’s damages.

The appropriate selection of a discount rate is case specific; a risk-adjusted or stable income stream may call for a risk-abated or low discount rate while a highly variable, uncertain income stream may call for the use of a higher discount rate.


Michael E. DiGiacomo is a Senior Manager with BlumShapiro, the largest regional accounting, tax and business consulting firm based in New England, with offices in Connecticut, Massachusetts and Rhode Island. The firm, with 340 professionals and staff, offers a diversity of services which includes auditing, accounting, tax and business advisory services. In addition, BlumShapiro provides a variety of specialized consulting services such as succession and estate planning, business technology services, employee benefit plans, litigation support and valuation and financial staffing. The firm serves a wide range of privately held companies, government and non-profit organizations and provides non-audit services for publicly traded companies.
 

 

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