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How Discount Rates, Inflation and Uncertainty Factor Into Economic Damage Calculations

 

How Discount Rates, Inflation and Uncertainty Factor Into Economic Damage Calculations

Interest rate considerations figure into almost every litigation project. Any situation involving pecuniary damages requires a thorough analysis of the expected timing of lost cash flows as well as an understanding of “time value of money” and risk inherent in the litigated financial transaction.

Time value of money is a widely accepted tenet in litigation support The concept refers to the fact that a dollar received today is worth more than a dollar received in the future. The presence of damages accumulating over a past period generally requires an examination of interest accruing to the plaintiff. A plaintiff who sustains monetary damages cannot be made whole without considering interest on the funds they lost due to a defendant’s wrongful conduct. Damages accruing over a period of time represent financial opportunities lost, or interest, in its purest economic sense. The presence of damages projected over a future time period likewise warrants an examination of time value of money and a resultant calculation of present value.

The obvious place to start any time value of money calculation is with interest rates. Money can be invested, which means any current award of future or past financial damages should take into consideration the applicable interest rates. The choice of a proper interest rate is influenced by the type of litigation project, the time period of the loss and an assessment of risk inherent in the proposed loss calculation.

Interest rates, however, are only a part of the puzzle in many litigation contexts, as real-life factors such as case-specific considerations, inflation, the state of the economy, industry expectations and wage growth rates influence the magnitude of but-for cash flows. Developing a reliable discount rate should consider:

  • Expected cash flow or income stream (taking into account the risk of achievement).
  • The degree of penalty for risk of variability in the return.
  • The timing of cash flows or income stream.
  • Risk-free rate of return.1

In certain situations, such as a personal injury or wrongful death calculation, examining risk-free interest rates may prove to be a sufficient basis for a present value calculation. In others, reference to state-specific statutes establishes the guidelines for interest rate computations.

Every lawsuit is different, however, and case-specific as well as jurisdictional considerations influence a financial specialist’s approach to establishing a supportable discount and/or interest rate. Two of the most common litigation contexts and related interest rate considerations are discussed below.

Personal Injury, Wrongful Death and Wrongful Termination Cases

 Personal injury types of cases typically necessitate projecting an individual’s earnings over a future time period. The time period involved must be supported with statistical data, research and pertinent publications. Although relevant case law must be examined in each litigation project, it is generally accepted that a risk-free rate should be used in such calculations. As stated in the “Discount Rates, Risk, and Uncertainty in Economic Damage Calculations” publication by the American Institute of Certified Public Accountants (AICPA):

It is generally accepted that the discount rate to be applied in these matters [personal injury, wrongful death and wrongful termination cases], after consideration of earnings growth, should not submit the plaintiffs to undue risk considerations, which has often resulted in the use of risk-free discount rates. The justification of such rate is that this rate will permit the plaintiff to replicate the lost earnings stream by reinvesting the amount paid in a judgment in the “best and safest investments.”1

The litigation support specialist in personal injury cases has the responsibility of choosing a supportable risk-free rate based on the timeframe of the damage period. They should give additional consideration to the relationship between the chosen discount rate and the wage growth rate, as well as inflation expectations inherent in a lost wage calculation.

Certain types of cases may require a separate calculation for medical costs. As they require a deeper examination of the relationship between interest rates and medical costs inflation, future medical costs computations add an extra layer of complexity to a financial specialist’s report. Medical service costs have historically increased at rates unseen in other industries, and medical inflation must be scrutinized in order to obtain a viable conclusion of the present value of future medical expenditures.

Lost Profits

 Lost profits cases present unique issues in computing discount rates. Although consideration of risk-free rates is to be expected in a lost-profits scenario, the risk inherent in a business venture may be greater than a historical risk-free rate. In order to determine the appropriate interest rate, a specialist must examine the reliability of the projected cash flows as well industry and market conditions under which a given business operates.

The variability of outcomes in a business projection may be implicitly or explicitly considered in a lost profits calculation.1 An interest rate that explicitly takes into consideration the business risks inherent in a particular transaction may be appropriate under certain circumstances. As an alternative, use of multiple models or scenarios may be justified where significant uncertainty as to projected amounts exists.

As you can see, the breadth of litigation-related economic calculations is hard to overstate. Leveraging a witness who specializes in litigation support calculations provides a supportable opinion as to the amount of damages, the appropriate time period for the calculation and a viable interest rate. Such service is certain to have a meaningful and positive impact on the outcome of a litigated monetary award.

If you want to learn more about interest rate considerations or engage a specialist for litigation support, contact Wipfli.


[1] “Forensic & Valuation Services Practice Aid: Discount Rates, Risk, and Uncertainty in Economic Damages Calculations,” AICPA, 2013

Author(s)

Abdrasilova_Natalya
Natalya S. Abdrasilova, CPA, MAFF
Senior Manager
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