Page 42 - Economic Damage Calculations

1. Tax-effect the $1,000 pre-tax cash flow (A) to $650 (B).

2. Discount the after-tax cash flow (B) to present value (C).

3. Gross the after-tax present value (C) to pre-tax present value (D).

This same result can be achieved by using a one-step process, discounting the pre-tax cash flow (A) at
the after-tax discount rate to arrive at the pre-tax present value (D) ($1,000 / (1 + 12%) = $893). The
three-step process is often used in situations in which there is a difference in tax rates across time peri-
ods. This situation could arise if taxes are to be awarded in one time period and a tax rate paid that is not
what would have been paid were the income to have been earned in future periods. Absent this compli-
cation, the simplified model with an after-tax discount rate is commonly used. fn 13

Additional Considerations in Discounting

Underlying the implementation of a method to discount future cash flows to a present value is the prem-
ise on which the model is calculated. The following sections provide additional considerations relevant
to the premise; these issues may guide the expert in the implementation of a particular methodology.

Willing or Unwilling Transaction?

In the context of a typical lost profits calculation, most plaintiffs allege to have been unwillingly de-
prived of some income stream over a number of periods, and the instant litigation has been brought to
provide the appropriate remedy. That is, consistent with the discussion of the wrongdoer’s rule (see the
section titled "Reasonable Certainty" in chapter 4, "Present Value and Discount Rates Within a Litiga-
tion Context"), the plaintiff did not willingly enter into this "transaction." The litigation evolved because
of the actions of the defendant. In bringing the litigation, the plaintiff will incur new costs and risks in-
cluding spending time on the matter, losing the case, and possibly hurting customer or supplier relation-
ships.

Moreover, the plaintiff has also borne the risk that the defendant will default on the judgment or that the
trier of fact may not reach a correct result. fn 14 As a result, even if "made whole," injured parties are
usually "differently" well off. fn 15 That is, the same asset is typically not returned. Instead, an estimate
has been made to provide the plaintiff with the value of what has been lost.

As the court concluded in General Outdoor Advertising Co. v. LaSalle Realty Corp., 141 Ind. App. 247,
266, 218 N.E.2d 141, 151 (1966), a forced transaction may lead to a different conclusion than a transac-
tion between a willing buyer and seller.

fn 13 See also, Harold Dilbeck, "The Time Value of Money," Chap. 38 in Litigation Services Handbook: The Role of the Accountant as
Expert, 2d ed., eds. Roman L. Weil, Michael J. Wagner, and Peter B. Frank (New York, NY: Wiley), 1995; and Greg Hallman and
Michael Wagner, "Tax Effects of Discount Rates in Taxable Damage Awards," CPA Expert, Winter 1999.
fn 14 Franklin M. Fisher and R. Craig Romaine, "Janis Joplin’s Yearbook and the Theory of Damages," Journal of Accounting, Audit-
ing and Finance (Winter 1990), 147–48.

fn 15 Robert Goodin, "Theories of Compensation," 9 Oxford Journal of Legal Studies (1989), 56, 60.

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