Page 17 - Economic Damage Calculations

Figure 2-4

In Distribution 2, the range of possible outcomes is tighter, although the mean expected outcome is the
same ($5 EPS). Also, there is a lower probability in Distribution 2 of outcomes with substantial diver-
gence from the expected $5 EPS than in Distribution 1. In the capital markets, although both of these
company scenarios offer the same $5 expected EPS as a weighted average of the EPS outcomes, the Dis-
tribution 2 expectation of less relative variation causes this probability-weighted expected EPS to be
worth more than that represented in Distribution 1. fn 4 The certainty equivalents of both EPS distribu-
tions in figure 2-4 are less than the mean expected EPS, with a greater penalty to the distribution with
greater risk, as seen in the variability of outcomes. This observation is consistent with a 1916 opinion
from the U.S. Supreme Court: "It is self-evident that a given sum of money in hand is worth more than
the like sum of money payable in the future." fn 5

The relationship between the expected value of an uncertain outcome and its certainty equivalent is af-
fected by an individual investor's risk tolerance. In other words, some investors may be more willing to
tolerate a wide range of outcomes for an individual investment, given the investor’s ability to diversify
away some of the risk. Also, an individual investor may be willing to accept outcomes within a certain
range. For example, Distribution 1, with a possible negative EPS, may be unacceptable to some inves-
tors.

In practice, experts often look at the variability of expected outcomes, represented statistically by the
standard deviation. The standard deviation measures how far from the mean the actual result is likely to

fn 4 The illustrative distributions are bell-shaped; however, in practice distribution curves may be skewed. For example, a mortgage
lender may have little opportunity to recover more than the note-related principal and interest, but it may face a variety of potential
scenarios for recovering part, or none, of the subject principal or interest.

fn 5 Chesapeake & Ohio Railway Co. v. Kelly, 241 U.S. 485, 489 (1916). See also 241 U.S. at 485, 490, 493.

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