Revisiting Modeling and Discounting Future Damages Reviewed by Momizat on . The Case for Use of a Risk-Adjusted Rate in Damages Cases Robert Dunn and Everett Harry laid out a process for modeling and discounting future lost profits to p The Case for Use of a Risk-Adjusted Rate in Damages Cases Robert Dunn and Everett Harry laid out a process for modeling and discounting future lost profits to p Rating: 0
You Are Here: Home » Litigation Consulting » Revisiting Modeling and Discounting Future Damages

Revisiting Modeling and Discounting Future Damages

The Case for Use of a Risk-Adjusted Rate in Damages Cases

Robert Dunn and Everett Harry laid out a process for modeling and discounting future lost profits to present value in their article, Modeling and Discounting Future Damages. Not all experts agreed with the position presented by Dunn and Harry. In March, we revisited modeling and its level of acceptance. This article revisits the more controversial portion of the Dunn and Harry article, determining the discount rate. Dunn and Harry believed modeling the projected income stream reduced uncertainty and risk in an expert’s estimates. Therefore, they stated a lesser discount rate could be applied to determine the present value of these future losses. Strong criticism of the use of lesser discount rates has come from the business valuation sector. Harry and others in the commercial damages community have responded to this criticism in a form of push back. This article will review each sides’ positions and what the courts have said about using a higher, lower, or risk-free discount rate.

[su_pullquote align=”right”]Resources:

The Reasonable Certainty Requirement in Lost Profits Litigation—Best Practices for Proving Your Damages Calculation

Explaining Damages to Judges and Juries

Special Considerations for Lost Profits Calculations

Advanced Concepts in Lost Profits Calculations

The Ins and Outs of Present Value Calculations Review of the Three Commonly Accepted Methods

[/su_pullquote]

Robert Dunn and Everett Harry published their oft-cited article, Modeling and Discounting Future Damages in 2002.[1]  In March, Revisiting Modeling reviewed the process they discussed for assessing future lost profits.[2]  Dunn and Harry argued that adjusting the hoped-for income stream to reflect realistic expectations allowed the expert to apply a risk reduced, relatively low discount rate.  This article revisits their comments regarding the discount rate and the ongoing controversy regarding the rate to use.

Modeling and its Tie to the Discount Rate

Dunn and Harry tied the appropriate discount rate to the approach followed by the expert in calculating the future lost profits.  “Some CPA experts project the plaintiff’s hoped-for income stream, modify those losses to a realistic expectation by factoring in future risks, and then discounting the adjusted future losses to a present value at a risk-reduced, relatively low discount rate.  Other experts project the hoped-for but lost amounts and then apply a higher discount rate that already incorporates risk or uncertainty to determine the present value.”[3]

Their belief was that the first approach was easier for judges and juries to understand.  In addition, they felt the second approach sometimes did not provide the desired results.

“When, as in the second approach, higher discount rates are applied in a short, finite damages period, they may not achieve the expert’s desired result—that is, the present value of future damages.”[4]  Dunn and Harry concluded modeling and the application of a lower discount rate provided a more accurate reflection of the present value of future damages.

Dunn and Harry on Discount Rates

In their article, Dunn and Harry stated calculating the present value of future business damages is a two-step process.  First, the expert projects the lost income stream based on predicted lost net sales less saved costs.  The second step is discounting these losses to present value using a discount rate determined by the expert.

“Experts’ approaches to addressing risks or uncertainties can be very different.  Some CPA experts use discount rates that are a return on U.S. Government securities or, alternatively, the cost of funds (interest on business loans) the plaintiff will face in the future.  The rates are applied to a reasonably predictable or risk-adjusted stream of lost profits…  Others might use higher discount rates to arrive at a present value calculating lost profits streams that have not been risk-adjusted.”[5]

They expected the higher discount rates to be determined through the Build-up Method.  These discount rates would be comprised of three inputs: a risk-free rate of return, additional return for general equity and company size risk, and premia (subjective) risk based on the specifics of the company.

While arguing for a reduced rate when modeling is used to project the lost income, Dunn and Harry did not argue exclusively for a risk-free rate to be applied.  “If the expert believes the damages model represents the lost income stream with a high degree of certainty, he or she may elect to use only a safe rate for discounting.  But a discount rate greater than the risk-free rate “[6]

Finally, Dunn and Harry argued discount rates behave in unexpected ways.  “Discount rates in general, and subjective risk premia in particular, do not behave in linear and intuitive ways compared to the outcome probabilities of various events considered in the damages model.  Except for a perpetuity—a very long time horizon—there is no obvious relationship between the probability of an outcome and the subjective risk premia in the total discount rate.  For finite damage periods, the subjective risk premia do not change linearly with the expected outcome (the risk-adjusted but undiscounted lost profits).”[7]

In closing, Dunn and Harry said, “Although opposing experts typically present damages scenarios as impartial and based upon the experts’ experience or market-derived data, they are likely to be related to other companies’ data, may not be comparable, and usually, are not defined for plaintiff’s risks.  Therefore, damages assessments that address risk through model adjustments and sensitivity analyses (evaluation of changing input factors), and minimize risk considerations in the discount rate can better serve the court.”[8]

Common Criticism of Dunn and Harry

Over the years, criticism has been leveled against the Dunn and Harry article.  A large portion of the criticism has come from the business valuation community.  They argue Dunn and Harry misunderstood the use of hoped-for cash flows.  They also argue it is impossible to remove all risk from projections of lost future income and attempts to do so are unreliable.  And, the Dunn and Harry framework is incompatible with conventional methods.

Two leading experts in the business valuation field, Shannon Pratt and Roger Grabowski, summarized these points when they said, “Lost profits determination must be consistent with business valuation principles.”[9]

They appeared to be particularly concerned with the use of a risk-free rate for discounting future lost profits.  “The most common error in discounting lost profits is in using a risk-free discount rate.  …Plaintiffs often argue that lost profits should be discounted at a risk-free rate of interest.  This is incorrect.  Economics literature supports the use of a risk-adjusted rate, as do the judicial opinions that consider the issue carefully”[10]

They go on to say, “Would the market only demand the risk-free rate of return for taking on the variability of the net cash flows?  The answer is no.  The market will demand compensation (added return) for accepting the risk that the actual cash flows will differ from the expected net cash flows in the future periods and the added return will increase depending on the amount of expected dispersion that could occur.” [11]

As Dunn and Harry argued the higher rates do not provide the desired result, Pratt and Grabowski argue the use of a risk-free rate or even a lesser discount rate would overcompensate the plaintiff.

“Because the plaintiff no longer has to bear the investment’s risk, the plaintiff is not entitled to be compensated for the risk factors.  In short, the plaintiff’s damage award should not include the amount of the risk premium (the excess of the present value of the profits discounting at the risk-free rate over discounting at the cost of capital adjusted to the risk of the project).  Since damages for the future profits should not include the amount of the risk premium, the plaintiff’s award should be calculated using the cost of capital adjusted to the risk of the project.”[12]

Responses to the Business Valuation Community Criticism

As with any disagreement, points and counterpoints have been made.  In 2010, Everett Harry addressed the differences between lost profits and lost business valuation measurements.[13]

“Some experts argue that certain principles of finance and economics developed based upon our free market system, including its capital markets, necessarily guide and constrain the calculation of business damages for litigation.  In particular, these experts believe that lost profits damages cannot materially exceed, if at all, the lost business value of an enterprise.  The debate on this topic continues perhaps, in part, because a growing number of professionals are attaining business valuation accreditations and applying the related body of knowledge for free market asset valuations to litigation damages computation assignments.”[14]

Harry highlights the similarity to these two different damage models particularly when the income approach is used to value a damaged business.  “Plaintiff’s loss may be measured either as lost profits or as the lost business value, particularly when the lost business value is determined based upon the Income Approach.  Since both lost profits and lost business value may be based upon the discounted cash flow methodology, some practitioners believe the alternative damage values rely upon the same financial and economic principles, including a discount rate commensurate with the risk plaintiff would have borne.”[15]

He notes lost profits and lost business value damages will be equal if the alternative calculations use the same premises and factors.  This would include, but not be limited to, the same valuation date, standard of value, information set, unresolved risk factors, loss period, discount rate, and offsetting mitigation.[16]  But, he goes on to say, “Lost business value and lost profits often are different approaches to measuring damages, which may result in markedly different damages amounts.”[17]

Harry noted a specific difference in these alternative measurements relative to the discount rate.  “[T]he discount rate used for the business valuation to reflect an asset transfer price from a willing seller to a willing buyer is greater than the discount rate appropriate for a plaintiff suffering a constructive forced sale of an asset.”[18]

“Even assuming that the trier-of-fact can resolve all material risk in the projected stream of economic income used as the foundation for either a business valuation or lost profits computation, a more important issue arises.  Should a trier-of-fact determined highly-certain stream of projected economic income be discounted at 1) the rate of return that an investor would have sought to purchase the subject asset in a non-litigation, free market exchange, or 2) at a relatively lower rate to recognize and quantify plaintiff’s loss by constructive forced sale of the asset’s ability to return an element of owner economic profit above plaintiff’s marginal cost of capital?”[19]

Craig Enos and Greg Regan provided support for Dunn and Harry in their 2009 article, Discount Rates and Lost Profits…Where’s the Risk?[20]  Whichever approach applied, it is “a reality check to the plaintiff’s ‘hoped-for’ income stream.  In other words, the CPA expert should analyze the achievability of the plaintiff’s projections and challenge any speculative components or assumptions.  Once, the ‘hoped-for’ income stream has been adjusted, the expert will apply a discount rate consistent with the level of risk determined to be remaining in the projected cash flows.”[21]

Enos and Regan agree with Dunn and Harry that modeling the projected lost income stream and discounting it by a lesser rate is beneficial to the expert explaining their findings to the trier-of-fact.  “The advantage of reducing risk in the damage model is transparency.  Supporters argue that, whereas the CPA expert understands the volatility that alternative discount rates may stimulate, a judge or jury is less likely to be in the same position.”[22]

Other criticism of not adjusting projected lost profits and applying a higher discount rate has come from the business valuation sector.  Aswath Damodaran of New York University’s Stern School of Business has written, “When your valuations go awry, it is almost never because of the mistakes you made on the discount rate and almost always because of errors in your estimates of cash flow (with growth, margins, and reinvestment).  Therefore, you should focus on making the most accurate cash flow projections possible and include all risks, instead of ‘obsessing about the minutiae of discount rates’”[23]

It appears Damodaran’s position is making its way into the standards for measuring fair value.  “Language in FASB ASC 820 Fair Value Measurement suggests a conceptual preference for capturing risk in cash flows rather than in a discount rate adjustment.  …[T]here’s a perception that too many valuation experts simply accept the projections they are given without question and then dump some extra percentage points into the discount rate for the DCF [discounted cash flow] analysis.”[24]

In the conclusion in his 2010 article, Harry notes that the courts have not dictated the methodologies or discount rates to be used.  This leaves the possibility that business damages may be determined by using alternative methodologies and discount rates.  “The expert’s choices are not necessarily limited or constrained by certain purported ‘laws’ or principles of finance and economics when derived from ‘immediate situations’ not germane to a plaintiff forced away from its ‘but-for’ world.  Instead, an expert may select from a range of theories, practices, and metrics developed outside of the litigation system.  For example, rates of return like risk-free, cost of debt, and WACC [weighted average cost of capital] are all evidenced in and derived from the capital markets.”[25]

Courts Opinions on Discount Rates

Both sides of this argument agree on one point.  The courts have not provided a definitive answer as to the methodology or discount rate to use in assessing business damages.  Unlike the Pfeifer decision for personal damages and the Till decision in Chapter 13 bankruptcies, the U.S. Supreme Court has not provided a precedent setting opinion on this topic.[26]

Both sides can find court decisions supporting their arguments.  For those seeking to use a risk-free rate or a conservative (lesser) discount rate, Northern Helex Co. v U.S. and Knox v Taylor provide support.[27]  The Northern Helex opinion allowed for the usage of a conservative discount rate in calculating the present value of lost future profits.  The Knox court noted that the use of a risk-free discount rate to calculate lost profits damages was not erroneous as a matter of law.

Those seeking higher discount rates can look to Fishman v Estate of Wirtz and In Re: Magna Cum Latte, Inc.[28]  The Fishman court rejected a risk-free rate calling it a “fantastic assumption” and called for the risks related to “doing business” to be considered.  The Magna Cum Latte decision states, “It holds that a risk-adjusted discount is the more appropriate discount rate for calculating a business’ lost profits.”[29]

It appears both sides agree that currently the most significant opinion regarding discount rates in lost profits cases is Energy Capital Corp.[30]  This case does not decide the argument over modeling and determining a discount rate or give clear guidance.  It does confirm the appropriate discount rate is a question of fact.  “In a case where lost profits have been awarded, each party may present evidence regarding the value of those profits, including an appropriate discount rate.”[31]  It also goes into greater detail of the appeals court’s thinking in assessing the appropriate discount rate.

Energy Capital had presented a value for lost future profits that had been discounted with a risk-free rate of 5.9%.  This rate was the rate of return on 10-year U.S. Treasury Notes with constant maturity on the date of judgement.  The U.S. argued a risk-adjusted rate should have been applied.  The Claims Court judge agreed with Energy Capital.

On appeal, the Court of Appeals disagreed with Energy Capital’s argument and the lower court’s judge.  “Energy Capital argues that the sole purpose in discounting is the time value of money.  Again, we disagree.  When calculating the value of an anticipated cash flow stream pursuit to the DCF method, the discount rate performs two functions: (i) it accounts for the time value of money and (ii) it adjusts the value of the cash flow stream to account for risk.”[32]

The appeals court goes on to say in footnote nine, “There are other situations where a risk-free discount rate may also be appropriate.”[33]  In this footnote, the court cites and then discusses the Dunn and Harry 2002 article.  This is one of two occasions in which the Dunn and Harry article is cited in the Energy Capital opinion.

Conclusion

Dunn and Harry’s 2002 article provided direction for those calculating the value of future lost profits.  It also created a controversy.  On one side of the controversy are those who agree with Dunn and Harry that experts should model the plaintiff’s projected losses to provide more realistic, risk reduced profits and in doing so, use a lesser discount rate for calculating the present value of the future losses.  On the other side are many from the business valuation community who argue the plaintiff’s projected losses should be accepted as is and a higher discount rate be applied to the future losses to account for the additional risk in achieving those profits.  I side with Dunn and Harry in this argument.  I believe it is better to model the income stream to adjust downward for risk and then apply a lesser discount rate.

A review of commercial damages literature shows three methods discussed for determining the appropriate discount rate: the safe rate of return (risk-free or close to risk-free rate), rate of return from investing the award, and the rate of return commensurate with the risk in receiving the lost profits.[34]

While the safe rate of return is seldom used, it has been accepted as the appropriate discount rate in state and federal cases.  However, these cases had special sets of case-specific facts that allowed for the use of a risk-free rate in discounting future lost profits.

I agree with the Energy Capital decision.  The discount rate should account for the time value of money and account for the risk to the projected cash flow stream.

The Build-up Method provides an ideal method for determining the appropriate discount rate.  It begins with the risk-free rate and adds various risk premiums as assessed by the expert.  The total of the risk-free rate and the risk premiums provides the discount rate.  The lesser the risk premia, the lesser the discount rate and conversely, the greater the risk premia, the greater the discount rate, all other things being equal.[35]

When using the Build-up Method, the time value of money should play a role in determining the discount rate along with the risk premiums.  The time value of money may be reflected in the risk-free rate used as the foundation of the discount rate.

Generally, investors expect the longer the maturity for an investment, the greater the yield.  This is reflected in a traditional yield curve.  Choosing a risk-free rate that coincides with the length of the future loss period allows for the consideration of the time value of money.  As an example, the risk-free rate for a five-year loss period, under normal circumstances, would be less than the risk-free rate for a ten-year loss period.  Including a risk-free rate whose yield is tied to the future loss period allows the discount rate to capture both the risk for the projected income stream and the time value of money.

Calculating the present value of lost profits is a two-step process.  The first step requires modeling the lost income stream to make the projected losses.  Financial modeling is widely used outside of litigation.  These same techniques can help experts provide a realistic and reasonable assessment of projected future lost profits.  Modeling helps reduce uncertainty in the expert’s estimates.

The reduction of uncertainty in the projected cash flow should reduce the risk relative to the projected lost profits.  The expert should consider the impact the modeling adjustments have had upon the cash flow stream and the risk to the plaintiff having achieved these adjusted results were it not for the damaging act.  Any discount rate should include, not only the risk-free rate, but the remaining risk to the projected cash flow.

Attention to the entire two-step process, the projecting of the lost profits then discounting them to present value, will help an expert in determining the appropriate discount rate and create the transparency needed for explaining this approach to the trier-of-fact.  It will also prepare the expert for defending these calculations against criticism from other experts.

(I want to thank Jeremiah Grant of Arrowfish Consulting, Salt Lake City, Utah, for providing information and insight regarding criticism of the Dunn and Harry article and contributing to this article.—Dr. Needham)

[1] Robert Dunn, Everett Harry, “Modeling and Discounting Future Damages,” Journal of Accountancy, January 2002.

[2] Allyn Needham, “Revisiting Modeling for Calculating Future Lost Profits”, QuickRead, March 17, 2017.

[3] Dunn, Harry, 1

[4] Ibid. 1

[5] Ibid. 2

[6] Ibid. 3

[7] Ibid. 4

[8] Ibid. 6

[9] Shannon Pratt, Roger Grabowski, Cost of Capital in Litigation Applications and Examples.

[10] Pratt, Grabowski

[11] Ibid.

[12] Ibid.

[13] Everett, Harry, Lost Profits and Lost Business Value—Differing Damages Measures, Dunn on Damages, Issue I, Winter 2010.

[14] Harry, 6

[15] Ibid.

[16] Ibid.

[17] Ibid.

[18] Ibid.

[19] Ibid. 8

[20] Craig Enos, Greg Regan, “Discount Rates and Lost Profits…Where’s the Risk?”, CPA Expert, Summer 2009.

[21] Enos, Regan, 9

[22] Ibid.

[23] Focus on “CF” more than the “D” says Damodaran, BVWire Issue #173-1, 2/1/2017, Business Valuation Resources.

[24] Time to end the ‘dumping ground’ for cash flow risk?, BVWire Issue#176-3, 5/17/2017, Business Valuation Resources.

[25] Harry, 9

[26] Jones & Laughlin Steel Corp. v Pfeifer, 462 U.S. 523 (1983), Till v SCS Credit Corp., 541 U.S. 465 (2004).

[27] Northern Helex Co. v United States, 634 F.2d 557, (Ct. Cl. 1980), Knox v Taylor, 992 S.W.2d 40 (Tex. App. 1999).

[28] Fishman v Estate of Wirtz, 807 F.2d 520 (7th Cir. 1986), In Re: Magna Cum Latte, 2008 Bankr. LEXIS 3736, (Bankr S.D. Tex. 2008).

[29] In Re: Magna Cum Latte, Inc., 2008 WL 2047937 (Bankr. 2008).

[30] Energy Capital Corp. v United States, 302 F.3d 1314, (Fed. Cir. 2002).

[31] Energy Capital, 1333

[32] Energy Capital, 1333

[33] Energy Capital, fn 9, 1334

[34] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd Ed., Nancy Fannon, Jonathon Dunitz, BVR, 2014, Vol. 1, 346-354.

[35] See Allyn Needham, “The Present Value of Future Lost Profits and the Time Value of Money”, QuickRead, December 16, 2015, for a more detailed discussion.


Allyn Needham, PhD, CEA, is a partner at Shipp, Needham & Durham, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp, Needham & Durham, he was in the banking, finance, and insurance industries for over twenty years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial economics and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation and bar association meetings.
Dr. Needham can be reached at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

Number of Entries : 2537

©2024 NACVA and the Consultants' Training Institute • Toll-Free (800) 677-2009 • 1218 East 7800 South, Suite 301, Sandy, UT 84094 USA

event themes - theme rewards

Scroll to top
G-MZGY5C5SX1
lw