This presentation discusses the issue of whether a risk-free or risk adjusted discount rate should be used when calculating damages for lost profits. It shows that authorities overwhelmingly support the use of a risk-adjusted rate.

1. Proving Damages for
Lost Profits: The Proper
Discount Rate
Professor Robert M. Lloyd
University of Tennessee College of Law
(865) 974-6840
rlloyd@utk.edu

2. Risk-Free or Risk-Adjusted Rate?
The case law overwhelmingly holds that
when discounting lost profits, a riskadjusted rate is the more proper.
This is especially true of the more recent
opinions and the opinions by financiallysophisticated courts (e.g., bankruptcy
courts and the Court of Federal Claims)
and financially-sophisticated judges
(e.g., Posner and Easterbrook).

3. Where courts give thought to the issue,
they generally hold that a risk-adjusted
rate must be used because an income
stream that is certain is more valuable
than an uncertain income stream having
the same mathematical expected value.

4. Illustrative Cases:
I

5. Fishman v. Estate of Wirtz, 807 F.2d 520
(7th Cir. 1986)
In his dissenting opinion, Judge Easterbrook
characterized the District Court's use of
the T-bill rate to discount lost profits as
"a fantastic assumption. It has nothing to
do with business reality or the economics
of determining profits."

6. Douglass v. Hustler Magazine, Inc., 769
F.2d 1128 (7th Cir. 1985)
In an opinion by Judge Richard Posner, the
7th Circuit reversed a jury verdict
awarding lost profits because, among
other things, "the economist failed to
correct for the extreme riskiness of the
earnings stream for which he was trying
to find a present value."

7. Price v. Marshall Erdman & Assoc., 966
F.2d 320 (7th Cir. 1992)
In another Posner opinion, the Seventh
Circuit remanded the case for
recalculation of damages because, among
other things, the plaintiff's expert had
failed to adjust the discount rate to take
into account the volatility of the income
stream.

8. Energy Capital Corp. v. United States, 302
F.3d 1314, 1333 (Fed. Cir. 2002)
Concerning lost profits:
"[I]f the cash flow is risky, the normal
procedure is to discount its forecasted
(expected) value at a risk-adjusted
discount rate."

9. In re Clearwater Natural Resources, LP,
421 B.R. 392,399 (Bankr. E.D. Ky. 2009)
Concerning the lost profits from a mining
contract, the court said: “a fifteen
percent [discount] rate is more
reasonable in light of the normal,
attendant risks of mining coal . . . .”

10. Academic writings
support the use of a
risk-adjusted discount
rate

11. • R.F. Lanzillotti & A.K. Esquibel,
Measuring Damages in Commercial
Litigation: Present Value of Lost
Opportunities," 5 Journal of Accounting,
Auditing & Finance 125 (Winter 1990).
• James E. Meyer,et al., Loss of Business
Profits, Risk, and the Appropriate
Discount Rate, Journal of Legal
Economics (Winter 1994) at 27.

12. • Allen Michel & Israel Shaked, Valuation
of Damage Claims: An Application of
Corporate Finance, 19 Journal of
Business, Finance & Accounting 455
(1992)
• Denis Boudreaux, et al., Analysis and
Valuation of Closely Held Firms Involved
in Business Damage Cases and
Application of Certainty Equivalence, 9
Journal of Legal Economics (Winter 19992000) at 1.

13. Opinions authorizing a
risk-free rate in lost
profits cases have
limited applicability

14. Northern Helex Co. v. United States, 225
Ct. Cl. 194 (1980) presented the unusual
situation where the contract that had
been breached was essentially risk free
to the non-breaching party.
Later opinions of the Court of Federal
Claims have uniformly applied riskadjusted discount rates to lost profits.
See, e.g., Elk v. United States, 87 Fed.
Cl. 70, 93 (2010) (the appropriate
discount rate “must reflect risk")

15. American List Corp. v. U.S. News & World
Report, Inc., 549 N.E.2d 1161 (N.Y. 1989)
is based on the premise that when the
defendant commits an anticipatory
repudiation of a contract, there is an
irrebuttable presumption that the
defendant would have been able to
perform the contract and therefore there
is no risk to the plaintiff. Because of this,
the holding is limited to cases where
there is no risk.

16. Sophisticated
plaintiffs' experts
generally discount lost
profits at a riskadjusted rate

17. One expert representing a lost profits
plaintiff discounted future profits at
14.51%, deriving the discount rate from
the Ibbotson Cost of Capital Yearbook.
System Integration, LLC v. Computer
Sciences Corp., 2012 U.S. Dist. LEXIS
1120333 (N.D. Ill. 2012)

18. Still another plaintiff’s expert discounted
lost profits at a risk-adjusted rate of
20.6% that was based on the plaintiff’s
cost of capital.
RMD, LLC v. Nitto Americas, Inc., 2012 U.S.
Dist. LEXIS 158107 (D. Kan. 2012).

19. In a bankruptcy case, both experts based
the discount rate on the plaintiff’s cost
of capital, but they calculated the cost of
capital differently, apparently because
they differed in their estimates of the
riskiness of the project.
In re MSR Resort Golf Course, 2012 Bankr.
LEXIS 3702 (Bankr. S.D.N.Y. 2012)

20. To calculate the lost profits resulting from
the termination of a fast food
distributorship, the plaintiff’s expert
applied a discount rate of 17%, which he
said reflected the fact that the plaintiff’s
cash flows were subject to a number
unknowns and variables.
Mood v. Kronos Products, Inc., 245 S.W.3d
8 (Tex. 2009)

21. In a patent-infringement case, the
plaintiff’s expert used a discount rate of
19.4% to discount the lost profits. The
discount rate was based on the expert’s
determination that the rate of return for
public companies was 14.4% and his
estimate that the additional risk of the
device in question merited an additional
5% increase in the discount rate.
Olson v. Nieman’s Ltd., 579 N.W.2d 299
(Iowa 1998).