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When $1 Isn't Worth a Dime
How the 'Discount Rate' Can skew Your Claims
No doubt you've heard the expression, "A dollar today is worth more than a dollar tomorrow." But in the world of financial analysis, this fundamental concept based on the time value of money is more than a truism.
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 health care 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 "buildup" approach to
develop an appropriate discount rate. The buildup 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 buildup 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.
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