Of Forensic Interest

Nothing simple about interest

The takeaway from current research and practice within the forensic financial analyst profession is to stay current on methodology and to conduct your analysis in such a manner that can be explained and defended.

Until recently, I thought that business valuation analysts were the only community of professionals divided on capitalization rates, discount rates, and the best method to derive them. That was until I reviewed a 2013 conference paper submitted to the National Association of Forensic Economics (NAFE) concerning the use of historical averages or current interest rates in deriving a present value discount. After further review and research, I am confident that the interest rate is the most disputed factor between forensic financial analysts, economists, and lawyers.

Overview

Valuation of economic damages in cases of personal injury or wrongful death requires the forensic financial analyst or economist to determine an appropriate discount rate to apply to a given benefit stream and derive its present value. The pivotal factor in the discount rate tends to be the interest rate used. Generally, the analyst will base the discount on either historical rates or current market rates. The premise for use of historical interest rate averages is that it provides result stability by long-term averaging of any volatile periods. Advocates of using current market rates cite greater objectivity and the changes in economic conditions and policy reflected in historical rates. What is certain is that forensic financial analysts and economists do not agree on appropriate discount rates and the methodology in determining an economic damage claim. This should be of no surprise and sound all too familiar to those valuation analysts who also wrestle with capitalization rates and the debates relating to Morningstar, Duff and Phelps, Beta, and company specific risk premia (CSRP).  Perhaps the best course of action for the forensic financial analyst is to acknowledge areas of factual agreement, remain current in trends of professional theory, and prepare to defend their methodology.

Current Findings

Based on my research and review of current forensic financial theory and trends, I reached the following conclusions.

• The premise that historical interest rates (averages) provide greater stability of results over time has no empirical support.
• The number of forensic financial analysts and economists using a historical average rate is declining.

The National Association of Forensic Economics (NAFE) conducts a periodic survey of its members relating to their methods, preferences, estimates, and perspective in calculating lost earnings and economic damages. The results of the survey are reported and published in its Journal of Forensic Economics (JFE) and to a lesser degree by the American Academy of Economic and Financial Experts (AAEFE) in its Journal of Legal Economics (JLE). One of the questions asked of members concerns what interest rate for present value purposes is used for over 30 future years. Based on survey results for 1990, 1997, 2006, 2009, and 2012, the use of an historical average has seen a consistent decline from 57.6 percent to 44.6 percent of the respondents. Similarly, use of current interest rates increased from 24.6 percent to 38.6 percent of respondents.

• In total, forensic financial analysts and economists are closely split on whether current interest rates or a historical average interest rate should be the basis of a 30-year discount rate.
• Use of current interest rates most often results in a lower discount rate and higher present value calculation. Many analysts believe this occurs when low current interest rates are paired with a historical growth rate. The alternative is use of a projected growth rate that matches current and projected economic forecasts.
• Applying a risk-free rate, whether a historical average or current rate, does not always follow state statute. As an example, a state statute may instruct the forensic financial analyst to calculate present value by determining the amount of money that, if reasonably invested today, will provide the plaintiff with the amount of his or her future damages. Surely, a prudent investor would not invest his or her long-term portfolio entirely in U.S. government treasury obligations. U.S. government securities are appropriate for damage periods that are only a few years from the date of injury or trial.

Practice Points Summary

The take away from current research and practice within the forensic financial analyst profession is to stay current on methodology and conduct your analysis in such a manner that can be explained and defended. Be aware that use of current interest rates in deriving a present value is growing in popularity and acceptance. However, at this point in time, the use of either a historical interest rate average or current interest rate is acceptable as long as the analyst can explain his or her methodology and reasoning. Similar to the Earnings Approach in business valuation, the forensic financial analyst needs to match up the nature of the interest rate and growth rate before application to the earnings or benefit stream. Before choosing an interest rate and methodology, consult state statute, court jurisdiction, and legal counsel as to any binding definition or procedure. Suffice to say, there is nothing simple about forensic interest (rates).

[author] [author_image timthumb=’on’]http://m.c.lnkd.licdn.com/mpr/mpr/shrink_200_200/p/1/000/01a/3ed/2456370.jpg[/author_image] [author_info]Jeff Harwell, CVA, MAFF, CMEA, is principal of Harwell & Company, a Dallas/Fort Worth area valuation analyst, economic damages, and litigation support firm. Mr. Harwell received his BBA. from the University of Texas at Arlington and his MBA from the Neeley School at Texas Christian University. He currently serves on the National Association of Certified Valuators and Analysts (NACVA) Standards Committee as well as NACVA’s State Chapter Committee.  Mr. Harwell’s clients include attorneys, business owners, and CPAs. Mr. Harwell can be reached at jharwell@bfval.com.[/author_info] [/author]