Converting Future Damages to Present Value
When it’s time to calculate damages, a skillful financial expert can discount future damages to present value, providing the ammunition businesses need to receive a just award.
Here is an example focusing on how to ensure a reasonable discount rate. Let’s say a company fires an employee for stealing trade secrets. It goes to court to recover the lost profits it likely would have earned in the future if the employee had not divulged the secrets to a competitor.
What’s the best way to determine the lost profits?
It’s not an easy answer. But a skillful financial expert can discount future damages to present value, providing the ammunition businesses need to receive a just award.
Recognize the Impact
Many plaintiffs don’t recognize the impact that discounting can have on damages awards. The difference between discounted and undiscounted damages awards, however, can be substantial. A defendant who fails to object to an undiscounted award may end up overpaying. Suppose that a plaintiff recovers damages for lost profits of $500,000 per year for five years. Without discounting, damages would total $2.5 million. But discounting those damages to present value (using a 10 percent discount rate) would reduce the award by more than $250,000.
If an award is discounted, parties on both sides must ensure the discount rate is reasonable. Even small rate variations can affect the damages amount.
Understand What Affects the Discount Rate
The discount rate is the rate of return a hypothetical investor would demand, given the level of risk or uncertainty associated with the plaintiff’s “but for” profits and, specifically, with the probability those profits would materialize.
If the plaintiff’s company has a track record of consistent earnings and its risk of falling short of projected future earnings is low, a modest rate of return may be appropriate. But if the plaintiff’s company is in a high-risk industry or has volatile earnings, an investor would require a higher return to compensate for the risk.
Financial experts choose from several methods of calculating a discount rate; each involves a risk factor analysis. The “build-up” method, for example, begins with a “risk-free” rate of return—typically the yield on government bonds. The expert methodically increases that rate to reflect the risks associated with the projected lost cash flows.
Know How to Approach Damages
Once they have a discount rate, financial experts can use two approaches to calculate lost profits damages. They can determine the plaintiff’s expected future income stream and then discount it to present value using a risk-adjusted discount rate. Or, they can also incorporate risk considerations into the future income projection and then reduce projected income to present value using a lower-risk discount rate.
The first approach may offer greater simplicity. But in reality, the second approach may be easier for a judge or jury to grasp—critical in any case. Triers of fact may have trouble understanding how risk factors are used to modify the discount rate but readily comprehend the impact of risk on a plaintiff’s future earnings potential.
No Easy Task
Many plaintiffs simply don’t recognize the impact that discounting can have on damages awards. As a result, it’s critical that they retain a financial expert who understands the ins and outs of discounting future losses to present value.
WILLIAM P. ALLEN, CPA/ABV, CFE
Bill is a member of the American Institute of Certified Public Accountants accredited in Business Valuations (ABV); a Certified Fraud Examiner (CFE) accredited by the Association of Certified Fraud Examiners; and the New York State Society of Certified Public Accountants. He has more than 5 years’ experience in public accounting serving both commercial businesses and nonprofit organizations. As a member of the Brisbane team, Bill is responsible for valuation, forensic accounting, and litigation support services. Bill is a graduate of Le Moyne College and has worked with our Firm since graduating in 2006.