Page 33 - Economic Damage Calculations

tain but for income stream is reduced to a sum certain in the lost profits calculation by virtue of
damages being awarded at the date of judgment. fn 2

 Capital markets assess risk for securities (and the rates of return expected by an investor to as-
sume such variability of possible outcomes). These rates of return are observable and are based
on real transactions. fn 3

 The capital markets approach is testable and has received more peer review including a Nobel
Prize for Sharpe, Markowitz, and Miller in 1990 regarding the capital asset pricing model
(CAPM). By comparison, some of the adjustments made in the expected cash flow approach may
offer less empirical support, including determining appropriate probability factors for cash flow
scenarios.

 Although company-specific uncertainty may differ from the uncertainty faced by the average
market participant in the broader market averages, an adjustment factor to account for this may
be incorporated into a risk-adjusted rate.

 Even after explicitly considering certain risk elements, other uncertainties may remain which are
not addressed in the adjustments made to the expected cash flow projections or resolved by the
trier of fact. For example, economic conditions and the success of a business may not be estimat-
ed with certainty, such that even after calculation of an accurate or even "conservative" expected
cash flow, there may be a wide range of possible outcomes that may render a cash flow less val-
uable to potential owners of the cash flow projection. With risk defined as uncertainty in out-
comes, by comparing the subject company to the market in general or to an industry group, the
expert may estimate the effect of risks on guideline companies, which may have eluded an ex-
pected cash flow analysis. In so doing, it may be argued that the damages model has accounted
for systematic risks affecting similar companies—not only those explicitly considered and in-
cluded in an expected cash flow model.

 The Federal Judicial Center’s Reference Manual on Scientific Evidence, 2d ed., supports the
CAPM as a method to calculate a discount rate.

Risk Considered in the Cash Flows—Expected Cash Flow Approach

Experts using this approach account for risk by directly adjusting, to the extent possible, the cash flow
projection to estimate the expected outcome. In this way, the expert concludes that an adjusted cash flow
estimate would be more likely to be attained than an initial or unadjusted cash flow projection such as a

fn 2 A complication occurs if the risk associated with the actual scenario is less than that posed by the but for scenario. In such a cir-
cumstance, by applying a lower discount rate only to the actual scenario, this would serve to inflate the value of the actual scenario,
which would further decrease the value of the lost profits.
fn 3 Observed market data is seen in U.S. Treasury instruments that determine the risk-free rate, equity securities that determine equity
risk premiums used in discount rates, and debt securities that drive LIBOR, prime, and other rates. These data are consistent with the
thesis that estimated future cash flows with a wider range of outcomes generally have a certainty equivalent value that is normally less
than expected value.

© 2020 Association of International Certified Professional Accountants 31