We can all concur on the age-old adage, “nothing is certain except death and taxes.” However, how to account for uncertainty can be an area of stark disagreement. Gaining a clear understanding of how financial expert(s) have adjusted a damage calculation for risk can aid counsel tremendously.
There are two approaches that are not widely known for accounting for risk in the development of a damages model. One is the capital markets approach, which favors using a higher, risk-adjusted discount rate. The second is the expected cash flow approach, which favors adjustments for risk directly in the cash flow, using a relatively low rate to discount the future cash flows back to present value. The underlying idea is that both the cash flow projections and the discount rate call for parity in risk. In other words, a cash flow stream unadjusted for risk would generally call for a higher discount rate to account for risk. Conversely, a risk-reduced cash flow stream should be accompanied by a relatively lower discount rate.
Capital Markets Approach
Some experts believe that a discount rate used in a damages calculation should include a premium for the risk associated with the loss of future income streams, with the cash flows being the projections used in the normal course of business. Keep in mind there are degrees of ordinary risk that cash flows are exposed to such as economic conditions and industry-specific conditions, as well as company-specific risk.
The use of the capital markets approach in a damages calculation is often based on the following considerations:
- Expected cash flow is not certain; therefore, the discount rate applied to projections should consider the variability of outcomes.
- Capital markets assess risk for securities and the rates of return expected by an investor. These rates of return are observable and are based on real transactions.
- Although company-specific risk may differ from the uncertainty in the broader market averages, an adjustment factor to account for this may be incorporated into the risk-adjusted rate.
- Additional uncertainties may remain such as economic conditions or the probability of continued success. Even after calculation of probable expected cash flows, there may be a wide range of possible outcomes that render a cash flow less valuable.
Expected Cash Flow Approach
When the cash flow is based on conservative assumptions, this approach removes some, but not all, the risk. This approach accounts for risk by directly adjusting the cash flow projection. The belief here is that an adjusted cash flow estimate is more attainable and might include factors such as the probability of winning a contract or the likelihood of a drug obtaining FDA approval.
The expected cash flow approach anticipates that with an attainable stream of expected cash flows, the discount rate used may be overestimated if it is derived from capital markets. This is because the risk inherent in a well-defined cash flow projection may be less than that in a capital markets analysis. As a result, experts employing this approach typically use a rate that is lower than a company’s weighted-average cost of capital, or even a risk-free rate in some circumstances.
The use of the expected cash flow approach in a damages calculation is often based on the following considerations:
- A discount rate estimated using the capital markets approach, which incorporates uncertainty about the future, may overstate risk when a trial takes place years after the damages event.
- It may be simpler for an expert to present a model that has directly accounted for risk in the cash flow projection.
- If different scenarios are presented, it may be inappropriate to use a discount rate that already accounts for the risk factors associated with the various scenarios.
- The risk of certain ventures does not necessarily match the distributions called for by capital markets approach models. For example, a pharmaceutical company may have a significant amount of risk in the first few years of activity, but later either has a successful drug or not.
In some instances, a hybrid approach may be appropriate. Accounting for risks in the development of the cash flow projection does not preclude a risk-adjusted discount rate to account for risks not addressed in the projection. In addition, some courts look at a reinvestment rate – that is, an amount that, if reinvested, will replace the lost economic income. This measurement suggests that the risk premium included in the discount rate and the reinvestment rate should be equal. However, this may not be appropriate, because the plaintiff may not have an available investment with a level of risk that could have been managed similarly to the impaired business.
While experts may disagree on how to adjust for risk, it is imperative that the reason for choosing a risk-adjustment method is well-founded, appropriate for the specific circumstances, and adequately explained in the expert’s report.
By SHERI F. SCHULTZ, CPA/ABV/CFF and
KATIE GILDEN, CPA/CFF, CFE, CVA
Fiske & Company
Offices in Ft. Lauderdale, Miami, and
South Florida Legal Guide 2014 Edition