Calculating Future Damages—The Importance of the Discount Rate
Projecting future losses can be a substantial component of a plaintiff’s damage calculation. The discount rate used can have a significant impact on the amount of damages being litigated. Knowing how your legal position may be impacted by the discount-rate methodology chosen may be critical to the outcome of your case.
It is not uncommon to see small businesses involved in litigation. In that context, lost profits are typically pursued as a significant portion of the overall damages being litigated. Future losses, such as profits—once projected—need to be discounted to a present value calculation. This reality reflects the time value of money. A dollar today—since it is available for investment—is more valuable than a dollar tomorrow.
But it’s not just the interest rate selected that has an impact on the present value calculation. An additional discount is typically built into the calculation to reflect uncertainty about the possible realization of claimed lost profits.
The Discount Rate and Factor
The discount rate itself is comprised of two parts: (1) an assumed rate of return that recognizes the time value of money and (2) a risk factor that recognizes the uncertainty associated with achieving future profit forecasts. The discount rate an expert applies in a given situation is both an art and a science. An expert may need to factor in a lower overall rate if the profits at issue are relatively more likely to be achieved. On the other hand, a higher interest rate would be appropriate in a situation where there is less likelihood of achieving the profits at issue and, therefore, a larger than normal risk is involved.
Not All Rates Are Equal
Experts employ various methods to arrive at an appropriate discount rate. A fair amount of discretion and professional judgment needs to be exercised, as there may not be a clear standard to be applied in a particular case. The “safe rate,” “buildup,” “rate of return” and “capitalization factor” are terms commonly used in this context.
The safe rate, also known as the Treasury rate, typically applies a T-bill rate and may be best suited for well-established businesses with stable and predictable profits. The expert assesses specific business trends to project the business’ lost profits for the relevant time frame -- and then applies a discount rate to the calculated amount.
The buildup rate is frequently associated with newer businesses. Projections may be based on industry trends since a new company has an inadequate earnings history on which to base an assessment. Using the Treasury rate as a starting point, adjustments are made to it to reflect company- and industry-related risks.
The rate of return method analyzes industry statistics to arrive at a rate of return for a typical business in the industry. The rate of return becomes the discount rate.
The Federal Judiciary Center’s Reference Guide on Damages defines a capitalization factor as “the ratio of the value of a future stream of income to the current amount of the stream.” Any current annual loss in operating profit is factored into the calculation.
Multiple Rate Approach
Certain instruments, such as T-bills, have various interest rates associated with them—depending on the maturity date of the security. Longer maturity investments, including Treasury notes, typically have a higher interest rate than shorter dated paper. Accordingly, multiple calculations may have to be combined to determine lost profits spanning multiple years. So the first year’s income (or lost profits) may be discounted at a rate associated with a one-year T-bill, the second year’s income discounted based on a two-year Treasury rate, etc.
Conclusion
The discount rate to be applied may be based on several factors, including the facts and circumstances of a particular case, as well as the analysis of the likelihood of achieving forecasted lost profits. Having a qualified expert assess the relevant factors in determining an appropriate discount rate will help you build a stronger case in support of your damage positions. Please contact a member of Somerset's Litigation & Valuation Team for your litigation support needs.
Projecting future losses can be a substantial component of a plaintiff’s damage calculation. The discount rate used can have a significant impact on the amount of damages being litigated. Knowing how your legal position may be impacted by the discount-rate methodology chosen may be critical to the outcome of your case.
It is not uncommon to see small businesses involved in litigation. In that context, lost profits are typically pursued as a significant portion of the overall damages being litigated. Future losses, such as profits—once projected—need to be discounted to a present value calculation. This reality reflects the time value of money. A dollar today—since it is available for investment—is more valuable than a dollar tomorrow.
But it’s not just the interest rate selected that has an impact on the present value calculation. An additional discount is typically built into the calculation to reflect uncertainty about the possible realization of claimed lost profits.
The Discount Rate and Factor
The discount rate itself is comprised of two parts: (1) an assumed rate of return that recognizes the time value of money and (2) a risk factor that recognizes the uncertainty associated with achieving future profit forecasts. The discount rate an expert applies in a given situation is both an art and a science. An expert may need to factor in a lower overall rate if the profits at issue are relatively more likely to be achieved. On the other hand, a higher interest rate would be appropriate in a situation where there is less likelihood of achieving the profits at issue and, therefore, a larger than normal risk is involved.
Not All Rates Are Equal
Experts employ various methods to arrive at an appropriate discount rate. A fair amount of discretion and professional judgment needs to be exercised, as there may not be a clear standard to be applied in a particular case. The “safe rate,” “buildup,” “rate of return” and “capitalization factor” are terms commonly used in this context.
The safe rate, also known as the Treasury rate, typically applies a T-bill rate and may be best suited for well-established businesses with stable and predictable profits. The expert assesses specific business trends to project the business’ lost profits for the relevant time frame -- and then applies a discount rate to the calculated amount.
The buildup rate is frequently associated with newer businesses. Projections may be based on industry trends since a new company has an inadequate earnings history on which to base an assessment. Using the Treasury rate as a starting point, adjustments are made to it to reflect company- and industry-related risks.
The rate of return method analyzes industry statistics to arrive at a rate of return for a typical business in the industry. The rate of return becomes the discount rate.
The Federal Judiciary Center’s Reference Guide on Damages defines a capitalization factor as “the ratio of the value of a future stream of income to the current amount of the stream.” Any current annual loss in operating profit is factored into the calculation.
Multiple Rate Approach
Certain instruments, such as T-bills, have various interest rates associated with them—depending on the maturity date of the security. Longer maturity investments, including Treasury notes, typically have a higher interest rate than shorter dated paper. Accordingly, multiple calculations may have to be combined to determine lost profits spanning multiple years. So the first year’s income (or lost profits) may be discounted at a rate associated with a one-year T-bill, the second year’s income discounted based on a two-year Treasury rate, etc.
Conclusion
The discount rate to be applied may be based on several factors, including the facts and circumstances of a particular case, as well as the analysis of the likelihood of achieving forecasted lost profits. Having a qualified expert assess the relevant factors in determining an appropriate discount rate will help you build a stronger case in support of your damage positions. Please contact a member of Somerset's Litigation & Valuation Team for your litigation support needs.
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