Page 64 - Calculating Lost Profits

Chapter 9

Discount Rates

Overview

As a general matter, lost profits damages are amounts that a wronged party (usually a plaintiff) has lost
as a result of one or more wrongful acts. The harmed party may have already experienced such lost prof-
its as of the time the lost profits calculation is made, may be anticipated to occur in the future, or both.
As a result, future lost profits (that is, profits that were expected to be earned after the date of the making
of a lost profits calculation, but in light of the wrongful act, are not expected to be earned) are often part
of a lost profits calculation, as explained in previous chapters. However, in an award of future lost prof-
its damages, the harmed party typically receives a monetary award that is deemed due as of a judgment
date, when that judgment date precedes the date or dates on which the profits in question would have
been earned and cash received. Because the award recipient is due this money before the profits would
have been earned in the but-for world, two economic justifications are typically cited as the basis to dis-
count future profits to their present value, as of the judgment date.

1. The plaintiff can invest the lost profits damages award received, and in that process, can expect
to receive income (for example, interest income) on the damages award invested — particularly
the future lost profits component. In the but-for world, the plaintiff would not have had this op-
portunity to invest because it would not yet have the amounts to invest.

2. As of the judgment date, the value of the expected future income stream (that is, the but-for in-
come stream, less the actual or mitigating income stream) is less than the future value amounts
that are expected, unless adjusting for the time value of money and possibly risk.

By way of example, if a business would have earned $1 million in the next year in the but-for world but
is now expected to earn $0, then the undiscounted lost profit damages of the business would be $1 mil-
lion (that is, $1 million of profits but-for the wrongful act, less $0 actual profits).

Although practitioners and courts generally agree that discounting of lost profits is appropriate, the rate
at which the lost profits should be discounted is a frequent subject of disagreement. These disagreements
often relate to the two alternative justifications cited previously for discounting future lost profits to pre-
sent value, which may be argued to justify different discount rates.

Per the first justification, the objective is to identify the discount rate that, when applied to the undis-
counted lost profits, accounts for the opportunity an injured party must invest the damages awarded in
order to achieve the future value of the lost profits. As would be expected, this discount rate would logi-
cally align with the rate at which the injured party can invest. Some argue that this should be a risk-free
rate, even if the profits in question had risk associated with them. fn 1 Others suggest that the discount

fn 1 In fact, as a general matter, damages in personal injury matters (for example, lost personal earnings) are frequently discounted at a
risk-free rate, even when this is risk associated with the injured party's lost future income. Courts have frequently cited two seminal
cases in support of this approach. Per Chesapeake & Ohio Railway Company v. Kelly, 241 U.S. 485 (1916): "[W]hen future payments
or other pecuniary benefits are to be anticipated, the verdict should be made on the basis of their present value only" (p. 491), and the
rate to be used should be based on "the best and safest investment" (p. 490). Per Jones & Laughlin Steel Corp. v. Pfeifer, 462 U.S. 523

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