Page 32 - Economic Damage Calculations

Chapter 5

Accounting for Risk in a Damages Calculation

This chapter addresses general approaches to account for risk in the development of a damages model.
These approaches may affect both the cash flow projections and the discount rate used. One of these ap-
proaches, the capital markets approach, favors the use of risk-adjusted discount rate. A second ap-
proach, the expected cash flow approach, favors adjustments for risk directly in the cash flow, with a
relatively low discount rate typically used to discount the expected future cash flows back to present
value.

Proponents of each of these approaches appear to agree with the idea that the cash flow projections and
the discount rate call for parity in risk. That is, a cash flow stream with risk would generally call for a
discount rate that accounts for that risk, and a risk-reduced cash flow stream should be accompanied by
a relatively lower discount rate. In other words, risks should be accounted for somewhere. In theory, the
selected model should suit the particular circumstances of the matter in which the expert is engaged, and
the conclusions reached by the expert should not be significantly different solely based upon the selec-
tion of the approach.

In practice, these two risk adjustment methodologies are not mutually exclusive. Other discounting
methods and rates are also used, as discussed in following sections.

Risk Considered in the Discount Rate—Capital Markets Approach

Some experts have argued that a discount rate used in a damages calculation should include premia for
the risk associated with the expected future income stream lost with the cash flows being the projections
used in the normal course of business or developed by other expert analysis. As an example, this may
include the use of the plaintiff’s cost of capital. fn 1

The use of the capital markets approach in a damages calculation is often based on consideration of the
following factors:

 An expert opining on damages in the context of litigation should develop a measure of cash flow
that reflects the best and most objective "expected value" estimates. This process is similar to
that employed in the capital markets. After developing the expected cash flow projection, the ex-
pert should apply a discount rate that considers the uncertainty attributable to the variability of
outcomes, given that an expected cash flow is not a certain cash flow. This is because the uncer-

fn 1 Sources that advocate this approach include Franklin M. Fisher and R. Craig Romaine, "Janis Joplin’s Yearbook and the Theory
of Damages," Journal of Accounting, Auditing and Finance (Winter 1990), 145–157; and Michael Crain, Bonnie Goldsmith, and Mi-
chael Wagner, "Response to One Man’s Opinion," CPA Expert, Spring 2004, 4–6. See the appendix, "Resource and Reference List,"
in this practice aid for a list of cases, resources, and research.

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