Discount Rates for Lost Profits Reviewed by Momizat on . A Question of Facts and Varying Rates “How could an expert apply such a high or low discount rate to a stream of future lost profits and the court find it accep A Question of Facts and Varying Rates “How could an expert apply such a high or low discount rate to a stream of future lost profits and the court find it accep Rating: 0
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Discount Rates for Lost Profits

A Question of Facts and Varying Rates

“How could an expert apply such a high or low discount rate to a stream of future lost profits and the court find it acceptable?” This article highlights my research looking into discount rates for lost profits and why there are so many variations of a theme when it comes to making such a calculation.

Discount Rates for Lost Profits: A Question of Facts and Varying Rates

When attending professional conferences, I enjoy talking with other experts involved in the litigation support field. During almost every discussion regarding commercial damages (lost profits or business destruction), there is a comment about the discount rate applied for calculating the present value of future lost profits.

The comment is usually along the lines of, “How could an expert apply such a high or low discount rate to a stream of future lost profits and the court find it acceptable?” This article highlights my research looking into discount rates for lost profits and why there are so many variations of a theme when it comes to making such a calculation.

My review of financial literature and court decisions shows a wide range of methods for assessing the lost cash flow and determining the appropriate discount rate. My brief review showed that courts have accepted discount rates ranging from 1.24 percent up to 36 percent. Obviously, the range of these rates is impacted by the period loss but also the way the cash flow was assessed.

Approaches for Assessing Lost Profits

Discounting lost profits to present value appears to be a relatively easy mathematical calculation. An expert will calculate the projected lost profits for each year in the future for which the loss is anticipated and then discount the future losses to their present value, applying the discount rate the expert believes appropriate.

Many experts have found that even though the math is straightforward, determining the appropriate numerator (lost profits amount) and denominator (the discount rate) is complex and troublesome. This is because, as variables in the equation, they may or will vary from expert to expert leaving opposing sides with sometimes quite different results coming from the same data.

The difference in approaches for the numerator and denominator was discussed by Robert Dunn and Everett Harry. “Some CPA experts project the plaintiff’s hoped-for income stream, modify those losses to realistic expectation by factoring in future risks and then discount 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.”[1]

These authors go on in their article to argue for the former approach, that is adjusting the future losses and applying a risk-reduced discount rate. They argue that “modeling” provides a more accurate analysis. Modeling is defined as “examining the interactive components of a financial outcome and analyzing various input factors.” An expert using “a spreadsheet program to address variables (risk) that influence projected earnings helps him or her to arrive at appropriate financial-damages information to offer the court.”[2]

Even if taken in its simplest form, the two models discussed by Dunn and Harry provide divergent paths for the numerator (lost profits) and the denominator (discount rates). Because these two methodologies require quite different approaches, two differing camps of opinions have been created, both championing their side. While both sides argue for the correctness of their approach, courts have found both methodologies acceptable for calculating the present value of lost profits.

Modeling Pro and Con

Modeling lost profit calculations remains controversial. It is not so much that adjustments made in a cash flow analysis are controversial but the impact that modeling has on risk-adjusted discount rates. In most commercial damage assignments, it is anticipated adjustments may be made to projections of future cash flows. In beginning an assignment, an expert’s records request may include prior financial statements, business tax returns, internal budgets, and projections created for internal use or to be provided to investors or lenders reflecting the anticipated profits during the loss period. In addition, interviews with people knowledgeable of the business, industry, and/or transactions involved in the litigation may also provide helpful information.

An expert should not accept the plaintiff’s projections at face value. Adjustments should be made to compensate for management’s optimism and/or actions other than those brought about by the alleged wrongful act.

Aswath Damodaran, of New York University’s Stern School of Business, has addressed the need to focus on adjusting cash flows for business valuations as opposed to the discount rate, “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’”[3]

A large percentage of financial experts estimating lost profits are also certified business appraisers. Because of this, the same type of thinking discussed by Damodaran has entered the process for determining the discount rate for lost profits. The business valuation community has argued that 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. Finally, they argue the Dunn and Harry framework is incompatible with conventional methods.

Prior to Shannon Pratt’s death, Shannon Pratt and Roger Grabowski, summarized their position by saying, “Lost profits determination must be consistent with business valuation principles.”[4] They were 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”[5]

Guidance from Energy Capital Corp. v U.S.

While SCOTUS[6] has not rendered a verdict on discount rates for calculating the present value of lost profits, the Court of Appeals provided guidance in its Energy Capital decision.[7]

In Energy Capital, the trial court applied a risk-free rate to discount the future lost profits to present value. The government argued this was incorrect. They argued the discount rate should represent the return an investor would require risking investing capital in a particular venture and that such a rate must incorporate any risk that cash flows would not be realized.[8]

The appellate court response was, “It depends.” “We do not hold that in every case a risk-adjusted discount rate is required. Rather, we merely hold that the appropriate discount rate is a question of fact. In the case where lost profits have been awarded, each party may present evidence regarding the value of those lost profits, including an appropriate discount rate.”[9]

In explaining its reasoning, the appellate court said, “Energy Capital argues that once the Federal Claims Court determined that its profits were reasonably certain, no further consideration of risk was appropriate, because risk already had been considered in determining whether there would be any profits. We disagree. … Therefore, the fact that the trial court has determined that profits were reasonably certain does not mean that risk should play no role in valuing the stream of anticipated profits. In other words, by finding that Energy Capital’s lost profits were reasonably certain, the trial court determined that the probability that the AHELP venture would be successful was high enough that a determination of profits would not be unduly speculative. The determination of the amount of those profits, however, could still be affected by the level of riskiness inherent in the venture.”[10]

“Energy Capital argues that the sole purpose in discounting is to account for the time value of money. Again, we disagree. When calculating the value of an anticipated cash flow stream pursuant to the DCF [discounted cash flow] method, the discount rate performs two functions: (i) it accounts for the time value of money; and (ii) it adjusts for the value of the cash flow stream to account for risk.”[11]

Lost Profits, Financial Literature, and the Courts: Question of Fact

Energy Capital held that the discount rate was a question of fact to be argued by each side in the litigation. Other federal and state decisions have held this same position.[12]

A review of financial literature shows three popular categories for determining the discount rate for calculating the present value of future lost profits:

  1. A rate of return on a safe investment (determined as a matter of law);
  2. The injured party’s rate of return when investing the award (determined as a matter of fact); and
  3. The rate of return commensurate with the risk in receiving the lost profits (determined as a matter of fact).[13]

The rate of return on safe investments has typically meant the rate of return on U.S. Treasury securities.

The rate of return when investing the award covers a broad spectrum of options. This category includes:

            Rate of return on a conservative investment;

            Rate of return on an investment portfolio;

            The injured firm’s cost of debt;

            The injured firm’s weighted average cost of capital;

            The injured firm’s cost of equity;

            Rate of return from an investment similar to the injured if the business was destroyed.[14]

The rate of return commensurate with the risk in receiving the lost profits ties into the modeling approach discussed by Dunn and Harry. “Some of the legal cases that discuss the appropriate discount rate related to a rate of return that is commensurate with the risk that the injured firm would have incurred if it had received the lost profits (but for the injury). Some call this rate the ‘risk-adjusted’ discount rate. The term is somewhat misleading because the investment rate of return also includes risk (i.e., risk from the relevant investment).”[15]

Many experts prefer to apply the rate of return when investing the award. Financial literature supports applying the cost of equity or a weighted cost of capital (WACC) as the discount rate for lost profits. Even if this is considered, the discount rate would, more than likely, be different from the rate applied for business destruction.

“[I]t is important to recognize that while the same theory may apply, the facts and circumstances will dictate inputs to the WACC. That is, the WACC used in the business valuation methodology may differ from the WACC used in the lost profits methodology for the same lost profits analyses.

The most important distinction about the lost profits methodology is that it considers all information available up to the date of the ex-post analysis, which is typically close to the trial date and may be many years after the alleged legal violation. By this date, there may be additional information that can be used to produce an improved estimate of loss or a refined but-for set of projections, particularly for the period between the date of harm and the ex-post date. While not all uncertainty can be eliminated, it is likely some of the uncertainty can be eliminated between the date of harm and the ex-post date, given that the intervening events are observed in hindsight.[16]

The lost profits methodology discount rate should reflect the state of the markets as of the trial date, not the date of harm, if the damages analysis is performed ex post. In some cases, this will result in a lower discount rate as of the trial date; in some cases, it will result in a higher discount rate.”[17]

Conclusion

Financial experts regularly receive assignments asking them to estimate the lost profits of a business claiming to have been harmed. During the expert’s analysis, he or she may determine that the lost profits may occur in the future. If so, the projected future lost profits must be discounted to their present value. Several approaches are available for determining the appropriate discount rate. An expert should select the approach that best serves the analysis for each assignment.

The selection of the approach and the ultimate discount rate is important because the discount rate is a question of fact. Both sides (plaintiff and defense) may present opposing opinions as to the appropriate discount rate. The reasoning for each side’s rate will assist the trier-of-fact in assessing which rate should be applied. Ultimately, the trier-of-fact may accept one rate and reject the other or create its own discount rate based on the opposing experts’ testimonies.

Research has shown that the facts of the case have provided a range of acceptable discount rates. Case information reviewed showed discount rates ranging from 1.24 percent to 36 percent.[18] If nothing else, these results prove that the discount rate for lost profits is not a one-size fits all analysis.

Experts aware of this contentious issue should be prepared to explain their reasoning to the trier-of-fact. They should also be better able to defend the approach selected and testify at deposition or trial than those not experienced in the ways the courts have viewed these important economic damages analyses.

[1] Modeling and Discounting Future Damages, Robert Dunn, Everett Harry, Journal of Accountancy, Online Issues, January 2002, p. 2.

[2] Ibid., 2.

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

[4] Cost of Capital in Litigation Applications and Examples., Shannon Pratt, Roger Grabowski, John Wiley & Sons, Inc.

[5] Ibid.

[6] Supreme Court of the United States (SCOTUS).

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

[8] Energy Capital Corp. v. United States, 302, F.3d 1314, 1330 (Fed. Cir. 2002).

[9] Ibid., 1333.

[10] Ibid.

[11] Ibid.

[12] E.g., Sonoma Apartment Associates v. United States, 302 Fed. Cl. 90 (2017); Elk v. United States, 87 Fed. Cl. 70 (2009); Franconia Associates v. United States, 61 Fed. Cl. 718 (2004); PSKS, Inc. v. Leegin Creative Leather Products, Inc., 171 Fed. Appx. 464 (5th Circuit., 2006).

[13] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd Ed., Vol. 1, Nancy Fannon, Jonathan Dunitz, BVR, 2014, 347.

[14] Ibid., 347–350.

[15] Ibid., 350.

[16] Most lost profits are analyses use an ex-post method discounting future lost profits to the date of trial. Applying an ex-ante approach would discount the lost profits to the date of harm. Because ex post is the most commonly used method, this discussion has focused on that approach.

[17] Lost Profits: Principles, Methods, and Applications, 2nd Ed., Everett Harry, III, Jeffrey Kinrich, VPS, 2022, 547.

[18] Purina Mills, LLC v. Less, 295 F. Supp. 2d 1014 (N.D. Iowa 2003) and Fairmont Supply co. v. Hooks Industrial, Inc., 177 S.W.3d 529 (Tex. App. 2005), respectively.


Allyn Needham, PhD, CEA, is a partner at Shipp Needham Economic Analysis, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp Needham Economic Analysis, he was in the banking, finance, and insurance industries for over 20 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 areas of financial and forensic economics, and provided continuing education presentations at professional economic, vocational rehabilitation, and bar association meetings. In 2021, Dr. Needham received a NACVA Outstanding Member Award. He is also a member of NACVA’s QuickRead Editorial Board.

Dr. Needham can be contacted 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.

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