Proving Lost Profits: The Proper Discount Rate

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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.

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Proving Lost Profits: The Proper Discount Rate

  1. 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. 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. 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. 4. Illustrative Cases: I
  5. 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. 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. 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. 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. 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. 10. Academic writings support the use of a risk-adjusted discount rate
  11. 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. 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. 13. Opinions authorizing a risk-free rate in lost profits cases have limited applicability
  14. 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. 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. 16. Sophisticated plaintiffs' experts generally discount lost profits at a riskadjusted rate
  17. 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. 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. 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. 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. 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).
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