Page 34 - Economic Damage Calculations

budget, forecast, or business plan. fn 4 For example, the adjustments to the cash flow projection may in-
clude factors such as the probability of winning a particular contract or set of contracts or the likelihood
of obtaining approval on a drug.

The expected cash flow approach anticipates that with an accurate stream of expected cash flows, the
discount rate to be used may be overestimated if it is derived from capital markets. This is because the
risk inherent in the well-defined cash flow projection may be less than that seen in the cash flow projec-
tions that were part of a capital markets analysis. As a result, experts employing the expected cash flow
approach typically use a rate that does not include the same degree of risk as, for example, a company's
weighted-average cost of capital (WACC), and in some circumstances they use a risk-free rate.

The use of the expected cash flow approach in a damages calculation is often based on consideration of
the following factors:

 Some elements of uncertainty can be reduced (and possibly eliminated) by using less "aggres-
sive" or more-likely-to-be-attained assumptions. As it becomes more certain that a plaintiff could
attain a given projection (potentially decided by the trier of fact), a relatively lower discount rate
may be more suitable. For example, a claim in litigation may relate to a breach of contract. In the
hypothetical, an important business risk that underlies the subject company’s business, and
thereby its cost of capital, is whether the company will be able to obtain contractual rights and
performance on the contract. However, if the trier of fact determines that there was in fact a con-
tract, and that the defendant was required to perform, then the risk of the cash flow projection
may be less than that reflected in the company’s historical WACC. In this way, a discount rate
estimated using the capital markets approach, which incorporates uncertainty about the future,
may overstate the risks inherent to the cash flows in question—especially when the trial takes
place years after the damages event.

 It may be simpler for an expert to present a model that has directly accounted for risk in the cash
flow projection. For example, consider a dispute involving a 10-year, $100,000 per year cash
flow projection, discounted at 25 percent. If the expert accounted for risks directly in the model
by reducing the expected cash flow to $50,000 per year, then the expert may choose to discount
the income stream using a relatively lower risk-based rate of, for example, 5 percent, which
yields approximately the same total present value of just under $400,000.

 It may be possible to present different scenarios in an analysis performed in a litigation context
with the trier of fact left to use the different scenarios in evaluating damages. In this setting it
may be inappropriate to use a discount rate that includes risk related to the factors that have been
presented in a scenario analysis.

 Although some investors may apply a "high" discount rate to reduce an inflated cash flow stream
to an accurate present expected value, adjustments in a discount rate for risk of achievement of-
ten do not model the risk of an investment properly. This is because a discounting calculation
typically increases geometrically as the multiplier grows with the addition of more time. For ex-

fn 4 Sources that advocate this approach include Robert L. Dunn and Everett P. Harry, "Discounting Future Damages," Journal of
Accountancy, January 2002; and Hal Rosenthal, "A New Look at Expected Cash Flows and Present Value Discounts," CPA Expert,
Winter 2004. See the appendix in this practice aid for a list of cases, resources, and research.

32 © 2020 Association of International Certified Professional Accountants