Page 15 - Economic Damage Calculations

Use of a Mid-Period Convention

The time value of money is also affected if the cash flow amounts are not scheduled to be received at the
beginning or the end of a period. In figure 2-1, the Period 1 cash flow receives exactly one period of dis-
counting because the cash flow amounts are assumed to be received as a lump sum at the end of each pe-
riod. But, if the cash flow amounts were to be earned evenly throughout the period, then a mid-period
convention would call for the amount to be discounted for one half of a period.

For example, the Period 2 cash flow in the lower discount rate scenario would be discounted for 1.5 pe-
riods. In that case, the Period 2 cash flow would be worth $867 instead of $826, which assumes an end-
of-period timing, calculated as follows:

1.5
$1,000 / (1 + 10%) = $867
Nominal Rates and Real Rates

Discount rates and interest rates can be expressed in nominal terms or in real terms. A nominal interest
rate represents an interest rate without an adjustment for inflation. In other words, a nominal interest rate
is the stated interest rate. By comparison, a real interest rate represents the interest rate after an adjust-
ment for inflation, such that the rate is calculated as follows:

Nominal Interest Rate = (1 + Expected Rate of Inflation) × (1 + Real Interest Rate) − 1

In practice, when cash flow amounts are presented in nominal dollars, then nominal discount rates
should generally be used. And, when cash flow amounts are presented in real dollars, real discount rates
should generally be used.

Cash Flows and Variability

Discounting a future income or cash flow stream to present value is a fundamental procedure in asset
valuation. fn 3 Rational buyers are assumed to be willing to pay no more for the subject asset than the
present value of what they expect to receive in the future. Similarly, rational sellers are expected to sell
the subject asset for a price no less than the present value of what they would expect to receive in the fu-
ture. Like a business or asset valuation performed for nonlitigation purposes, an economic damages
computation often takes into consideration the same factors as those considered by buyers and sellers
involved in a transaction. These factors include economic benefits to be received in the future and the
inherent risks of realizing those benefits.

The value to buyers decreases as the risk associated with the income stream increases. The definition of
“risk,” however, is not as simple as a percentage likelihood of achieving a forecasted result. At times,
the possible outcome alternatives are binary—either (1) achieve the forecasted cash flow level or (2)
completely fail. This binary outcome scenario is implied in figure 2-2.

Figure 2-2

fn 3 Shannon Pratt, with Alina Niculita, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th ed. (New
York: McGraw Hill, 2008), 56.

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