Page 16 - Economic Damage Calculations

Promised Probability of Failure Cash Probability of Total Expected
Period Cash Flow Delivery Flow Failure Cash Flow
1 $1,000 50% $0 50% $500

2 $1,000 50% $0 50% $500
3 $1,000 50% $0 50% $500
4 $1,000 50% $0 50% $500

5 $1,000 50% $0 50% $500
Total $5,000 $0 $2,500

In the previous example, there are only two possible results each year: $1,000 or $0. With a 50 percent
likelihood of achievement applied uniformly, the probability weighted expected value is $2,500. There
is no time value of money calculation applied in this example.

The capital markets approach expresses risk in terms of the variability of results around the expected
income (or cash flow) value. As depicted in figure 2-3, given investors’ aversion to risk and variability,
a future value that is certain (the bar graph on the left side) typically is valued higher than a 50 percent
chance of twice the same future value (the bar graph on the right side).

Figure 2-3

The bar graph on the left side of figure 2-3 represents a certain outcome, while the bar graph on the right
side has two different possible outcomes. Investors typically pay more for the same expected value when
the variability of the outcome is less than an alternative investment with the same expected value but
more variability.

A certainty equivalent is the amount that an investor would accept in exchange for the rights to an out-
come that is uncertain. This concept is represented in an example of earnings per share (EPS) variation
in figure 2-4. In figure 2-4, Distribution 1 includes possible outcomes ranging from a loss to a gain in
excess of $10 per share and a mean expected earnings of $5 per share. However, given the range of pos-
sible outcomes and investors' risk aversion, the certainty equivalent is less than the expected EPS of $5
in Distribution 1.

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