Page 35 - Economic Damage Calculations

ample, consider the previous example of the pharmaceutical company. The approval of the com-
pany’s drug by the Federal Drug Administration is a binary outcome. It is not possible to present
value the success scenario of the drug’s approval with a "high" discount rate to reflect the likeli-
hood of occurrence. The risk of success can only reasonably be considered in the development of
the expected cash flows and developing a probabilistic weighted-average of the possible out-
comes.

 Similar to the previous point, the risk of certain ventures does not necessarily match the distribu-
tions called for by capital markets approach models. For example, a pharmaceutical company
may have a significant amount of risk in the first few years of activity. But, after that time, the
entity may either have a successful drug or not, and the volatility or risk of those scenarios may
not match the risk profile in the development and drug approval stage.

 The market’s valuation of risks in similar companies may not be as good of an estimate of the
subject company or of the plaintiff’s valuation of risk as the owner and possibly manager of the
business. In other words, the risk of a minority interest investor may be greater than the risk to a
plaintiff as owner of the business harmed as modeled in a lost profits calculation.

 Historical returns on securities investments are a function of investors’ individual assessment of
future financial performance, which form the basis for the financial models that make up the cap-
ital markets approach. These projections are not typically directly observable. Additionally, the
capital markets approach cost of equity estimation methods may involve subjective adjustments
or application of estimates, such as beta, that are subject to criticism based on factors such as
comparability. For example, if a guideline company is larger, more diversified, better funded,
more mature, or more profitable than the subject company, these differences may present chal-
lenges in performing a capital markets approach analysis.

 Financial Accounting Standards Board (FASB) Statement of Financial Accounting Concepts No.
7, Using Cash Flow Information and Present Value in Accounting Measurements, while not di-
rectly addressing the computation of economic damages, supports the expected cash flow ap-
proach. fn 5 Specifically, paragraphs 39–40 of FASB Concept No. 7 articulate two approaches to
compute the present value of an asset: the expected cash flow approach and the traditional ap-
proach (referenced in this practice aid as the capital markets approach). As described in para-
graphs 23, 44–45, and 75–88 of FASB Concept No. 7, FASB asserted that the expected cash
flow approach was a more effective tool than the traditional approach (that is, the capital markets
approach) in some situations.

Hybrid Approach

Accounting for risks in the development of the expected cash flow projection does not preclude a risk-
adjusted discount rate to account for risks not addressed in the cash flow projection. fn 6 Alternatively,
some experts have employed a risk-free rate discount rate to certainty equivalent cash flows. fn 7

fn 5 Financial Accounting Standards Board Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and
Present Value in Accounting Measurements.

fn 6 Robert L. Dunn and Everett P. Harry, "Discounting Future Damages," Journal of Accountancy, January 2002

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