No time like the present: Discounting future damages
In commercial cases, plaintiffs often recover lost profits they would have earned in the future but for the defendant’s wrongful conduct. In those contexts, experts typically discount future damages to present value. It’s important, therefore, to recognize the impact discounting can have on a damage award — and the dangers of overlooking it.
Present and accounted for
The difference between discounted and undiscounted damage awards can be substantial, and a defendant who fails to object to an undiscounted award may end up overpaying. Suppose that a plaintiff recovers damages for lost profits of $300,000 per year for five years. Without discounting, damages would total $1.5 million. But discounting those damages to present value (using a 10% discount rate) would reduce the award by more than $350,000.
If an award is discounted, parties on both sides must ensure the discount rate is reasonable. Even small rate variations can significantly affect the damage amount. Using the previous example, a 10% discount rate results in a damage award of $1,137,235. Increase the rate to 12% and the amount drops to $1,081,432 — a difference of almost $56,000. Boost the rate to 20% and damages fall to less than $900,000.
Risk factors
Essentially, 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.
Valuation experts can choose from several methods of calculating a discount rate. Each method, however, involves a risk factor analysis. The “build-up” method, for example, begins with a “risk-free” rate of return (typically the yield on long-term government bonds). The expert methodically increases that rate to reflect various systematic risks (such as general equity risk and company size risk) and unsystematic risks (such as general economic conditions and company-specific risk factors).
2 approaches
Financial experts can use two distinct approaches to calculate lost profits damages:
1. Determine the plaintiff’s expected future income stream and then discount it to present value using a risk-adjusted discount rate.
2. Incorporate risk considerations into the future income projection, and then reduce projected income to present value using a low-risk discount rate.
The first approach seems to offer greater simplicity, but in practice the second approach may be easier for a judge or jury to grasp. Triers of fact may have trouble understanding how risk factors are used to modify the discount rate but more readily comprehend the impact of risk on a plaintiff’s future earnings potential.
Don’t underestimate the impact
Discounting future losses to present value can have a significant impact on the size of a damage award. As such, valuation experts should put as much effort into calculating present value and adjusting for risk as they put into projecting the lost profits themselves.