How the 'Discount Rate' Can skew Your Claims

According to Doug King, senior manager for Gleason & Associates, the discount rate — the financial rate used to reflect risk and convert a future payment or series of payments into a present value — impacts every engagement in one way or another.

“Claims are almost always worth less than their stated face value. That can be good or bad, depending on whose side you’re on,” notes King. “Because the logic used to determine the discount rate is often at least partially subjective, a sound financial analysis of the appropriate discount rate can increase or decrease a damage claim.”

How we determine the discount rate
Discount rates vary based on several factors:

• Time horizon
  The longer money is tied up, generally the higher the discount rate. “Financial markets typically reward the risk associated with longer term investments with a larger return,” explains King. “As a result, the present value of a claim has to take into consideration the expected returns associated with the same time horizon used to estimate future cash flows.”
• Interest rates
  When interest rates are high, discount rates are high, and vice versa.
• Industry and market conditions
  Lower discount rates typically apply to “all-weather” industries that survive and do well in weak economic conditions, such as healthcare and financial services. Conversely, higher discount rates often apply to technology-dependent industries in which the market outlook for products and services and a company’s long-term cash flows are less predictable.

Build-up accounting
Gleason & Associates typically utilizes the “build-up” approach to develop an appropriate discount rate. The build-up approach starts with a determination of the risk-free rate of return. If the government is paying 4 percent on a 10-year Treasury note with no risk to the principal investment, then the discount rate applicable to future estimated profits that are risky to achieve is higher. A build-up rate that is greater than the risk-free 4 percent rate is then based on a variety of empirical data that shows the amount that different types of stocks and other investments have typically returned over the same time horizon and in the industry in question.

The excess return over the risk-free rate is determined on a build up by evaluating and assessing a dollar amount to the risks associated with generating the estimated lost profits in the given time period for that business. Based on this type of assessment, in a recent case we arrived at a discount rate that pegged the present value of a company’s future lost profits at approximately $3 million, or $2 million less than the $5 million face value because of the time value of money and the risks inherent in the company’s ability to achieve the estimated lost profits.

‘I’ll gladly pay you Tuesday for a hamburger today’
There are scenarios in which $1 today will be more valuable tomorrow. For example, if your client owed another party $3 million five years ago, the bill today is apt to be significantly higher, thanks to lost “opportunity costs,” or interest.

“Opportunity cost, or interest, is the discount rate concept in reverse,” notes King. “While the discount rate reflects the risk and uncertainty of a claim, in this case, it was certain that the company owed the money. Certainty — or lack thereof — is always an underlying factor in a discount rate calculation.”

Excerpted from Briefly Speaking, a complimentary newsletter published by Gleason & Associates. Subscribe