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Present value calculations: Know what’s reflected in your discount rate

Nov 17, 2020

Economic damages can take many forms, from historical amounts to the projection of financial losses into the future.

When you translate the future amounts back to the present time, it’s generally referred to as “present value discounting.” One important variable in this calculation is the selection of a discount rate.

Before you 1) propose a present value calculation that has been accepted (or at least not rejected) in the past or 2) accept the methodology proposed by another interested party, know what is reflected in the discount rate.

What is a discount rate?

Discount rates — or their better-known mirror image, interest rates — can be viewed as a series of premiums that are additive to the base compensation required to induce a person to maintain their financial assets in a form other than cash.

This base compensation is frequently referred to as the real cost of money, the cost of delayed consumption or, most simply, “the real rate.” Many people consider the four-week U.S. Treasury yield less short-term inflationary expectations to be a reasonable proxy for the real rate.

Assuming that the real rate is acceptable as a starting point, let’s talk about the premiums that are likely to be additive to that starting point. Here are three commonly cited premiums:

  • Future inflationary expectations premium
  • Liquidity premium
  • Credit risk premium

While the real rate is typically not disputed, the premiums are variable, sensitive and potentially excludable. Most importantly, the size of the premiums are subject to interpretation because of their impact on the calculated present value amount.

1. Future inflationary expectations premium

This premium tends to grow as the time interval of delayed consumption increases. Accordingly, payments that are projected far into the future should command a larger premium than payments expected over a shorter time horizon.

2. Liquidity premium

The ability to “liquidate” an investment in the future is an additional premium that should be considered.

Holding unique assets that may not be easily converted back to cash at full value at some point in the future should require a premium; greater difficulties in conversion leads to greater premiums.

3. Credit risk premium

When determining an appropriate discount rate, you should also consider the risk that a borrower will be unable, or unwilling, to fund the return of investment to the lender. As the possibility of nonpayment or default increases, the credit risk premium should increase.

How Wipfli can help with your present value calculation

Almost all future anticipated payments are subject to inflationary expectations, liquidity concerns and credit risk. Before simply adopting a present value calculation that may have worked in the past, consider whether the three premiums are adequately represented for your particular circumstance.

Wipfli professionals have significant experience in quantifying these premiums, with the ability to testify as expert witnesses about their conclusions. Click here to learn more about our litigation support services, or continue reading on:

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Allen E. Jacque, CFA, CFE
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