Page 21 - Economic Damage Calculations

Unsystematic risk (also called unique, diversifiable, or firm-specific risk) is specific to an individual se-
curity. fn 3 Examples of unsystematic risk include issues such as a company's product or process obsoles-
cence; the activities of key employees, including departures or inventions; geographic or customer con-
centrations; and potential competition.

As an example, a pharmaceutical company that owns a patent on only one drug in clinical trials has high
unsystematic risk. If the sole product of the company does not make it past the clinical trial stage, the
company may never make a sale and its stock may become virtually worthless. Alternatively, the drug
may end up being a blockbuster and exceed forecasted results. By comparison, a pharmaceutical compa-
ny may have a relatively low level of systematic risk if its earnings are not sensitive to general market
changes.

Estimating a Discount Rate

A discount rate may be used to account for the different types of risk previously identified, as well as
other factors influencing the value of a future stream of income. When designed for this purpose, a dis-
count rate typically consists of a number of components to reflect the rate of return demanded by a seller
(or in a litigation context, the plaintiff) and paid by a buyer (or in a litigation context, the defendant).The
quantitative inputs used to measure these components are typically influenced by the particular circum-
stances of the matter in which the expert is engaged, but they may be based upon one or more of the fol-
lowing inputs:

 A rate defined by an agreement

 A rate at or approaching a risk-free rate

 A rate established by the cost of debt

 A rate based upon the return of a specific investment, an investment portfolio, or similar invest-
ments

 The cost of equity

The selection of a discount rate based on one of these inputs at any given point in time may result in a
higher or lower rate due to then prevailing market conditions. For example, the risk-free rate in 2011
was different than it was in 2006.

Figure 3-1 summarizes long-term average annual returns by investment types, as well as the variability
risk for these investment classes.

Figure 3-1

fn 3 A thorough discussion of portfolio diversification is beyond the scope of this practice aid. See Harry M. Markowitz, "Portfolio
Selection," Journal of Finance 7 (1952), 77–91; John Lintner, "The Valuation of Risk Assets and the Selection of Risky Investments
in Stock Portfolios and Capital Budgets," The Review of Economics and Statistics 47 (1965), 13–39; William F. Sharpe, "Capital asset
prices: A theory of market equilibrium under conditions of risk," Journal of Finance 19 (1964), 425–42; and James Tobin, "Liquidity
preference as behavior towards risk," The Review of Economic Studies 25 (1958), 65–86.

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