Discounting Future Lost Profits Damages
In calculating lost profit damages, one of the final steps is to discount the future lost profits damages to present value by utilizing a discount rate. The discount rate selected by the expert can significantly impact the present value calculation, and thus the amount of damages awarded to the plaintiff. What discount rate should be used by the expert? Like most things in litigation, the answer is “It depends”.
Courts have provided little guidance with regard to the selection of an appropriate discount rate. Courts tend to look at the discount rate as a question of fact rather than a matter of law. Thus, it is important for the financial expert to objectively review his or her lost profits damages calculation in order to be certain the calculation is supported by the facts and circumstances of the case.
Financial experts typically select a discount rate that matches the risk (or uncertainty) embedded in the projected future lost profits. If the projections are conservative and the risk associated with achieving the projections is low, the financial expert will usually apply a low-risk discount rate. However, if the projections are not conservative and the risk associated with achieving the projections is high, the financial expert will apply a high-risk discount rate.
When selecting a discount rate, there are a number of different benchmarks from which a financial expert can choose. Some examples of potential discount rates include:
- A risk-free rate, such as a U.S. Treasury rate
- The company’s cost of debt
- The company’s weighted average cost of capital
- The company’s cost of equity
Again, the key in selecting the appropriate discount rate is to match the discount rate to the risk embedded in the projections, all of which should take into consideration the facts and circumstances of the case.
Here is an example to illustrate the impact that a discount rate has on the calculation of lost profits damages. Assume that ABC Company has projected lost profits of $200,000 per year for the next five years, or $1,000,000 before discounting to present value. Three experts have been asked to prepare a present value calculation.
- Expert 1 uses a risk-free rate of 3%.
- Expert 2 uses the company’s weighted average cost of capital of 12%.
- Expert 3 uses the company’s cost of equity of 22%.
Here is a comparison of each expert’s present value calculation (using a mid-year discounting convention):
|Discount Rate||Present Value|
If you would like more information on the calculation of lost profits damages, please contact the Forensic & Valuation Service group at Anders.