Page 65 - Calculating Lost Profits

rate should reflect the anticipated returns that the injured party could derive from an investment of the
award in an asset with a similar risk profile to the future profits, even if the injured party is effectively
forced into a reinvestment to replace the lost future income stream. These arguments often come down
to the question of who (that is, the plaintiff or the defendant) should bear the risks associated with ob-
taining the future lost profits.

Alternatively, under the second justification for discounting of future lost profits, proponents assess the
discount rate based on the market value of the income stream in question by estimating a market-based
discount rate, rather than a discount rate appropriate to or for a specific injured party or available in-
vestment opportunity. In this context, parties frequently disagree on how to estimate a discount rate and
how to account for risk in a lost profits damages calculation. For example, many practitioners choose to
use a market-based discount rate when calculating lost profits for reasons such as those described previ-
ously. Others use a risk-free rate with a model that the practitioner opines has already accounted for
"risk" in the development of the income or cash flow streams to be discounted. A variation on this ar-
gument is that conduct specific to the defendant’s wrongdoing accounts for much or all the incremental
risk, above a risk-free rate, of achieving the future lost profits.

It is important to have a clear picture of what "risk" represents in this context. For example, the right to
$100 if a coin toss comes up heads, and $0 if the coin toss comes up tails, has an expected value of $50,
given that there is a 50% chance of a $100 outcome and a 50% chance of a $0 outcome. In this circum-
stance, there is a probability of occurrence of 50%, which is incorporated into the expected value.

Probability of occurrence, however, is different from the risk that is part of capital markets' required rate
of return for riskier expected future income streams. This risk has long been observed in the return on
investment that capital markets expect from companies that have a wide range of possible outcomes.
The relationship between variability around an expected income value and the income that investors
demand has great empirical support in capital markets behavior.

For example, capital market transactions show that a 100% chance of receiving $50 is generally worth
more to investors than a 50% chance of $100 because of investors' aversion to variability — even
though the expected value of each of these investments is $50.

In this context, a market-based discount rate will normally be higher, for example, for an income stream
to be earned by a business in a riskier industry compared to another in a less risky industry. That will
apply even if the income stream in question has been reduced to an expected value (accounting for risk
of occurrence). However, given that there are multiple justifications for discounting future income (in-
cluding lost profits), parties may argue for a variety of discount rates, as appropriate, for the particular
income stream in question.

For additional details on discounting future damages to present value, see the practice aid Discount
Rates, Risk, and Uncertainty in Economic Damages Calculations.

(1983): "Once it is assumed that the injured worker would definitely have worked for a specific term of years, he is entitled to a risk-
free stream of future income to replace his lost wages; therefore, the discount rate should not reflect the market’s premium for inves-
tors who are willing to accept some risk of default. (p. 537), using "the appropriate discount rate, reflecting the safest available in-
vestment" (pp. 537–538).

© 2020 Association of International Certified Professional Accountants 63