By Ethan Giller
Special to the Legal
In economic analysis, the concept of “time value of money” is considered a fundamental axiom: a self-evident truth that needs no further proof or explanation. It is the simple fact that in all but the most unusual circumstances, a dollar received today is worth more than a dollar received in the future. To some, this statement may be so obvious that it hardly merits further discussion, but our professional experience indicates wide disagreement among financial experts at times, leading to substantially different loss computations based on discount rate assumptions alone. As forensic accountants, we handle a large number of economic damage claims that are subject to present value calculations, and this post will present a basic overview of the term as well as some considerations in its application to litigation matters. (For the purposes of this article, we do not discuss discount rates that are used in business valuations and lost profit calculations, which are different.)
At their core, the notions of present value (PV) and future value (FV) are based on a single premise: A given amount of money today can be invested at a positive annual rate of return (r) and be worth more subsequently than its current value. (While negative rates of return are theoretically possible, they are beyond the scope of this discussion.) Whether this money is actually invested or not is irrelevant; the theoretical ability to do so inherently changes its value at any future point in time. As such, by way of example, if you have one dollar today and invest it at an annual rate of 5 percent, in one year it will be worth a future value of $1.05. Conversely, one dollar one year from now is the equivalent of $0.95.
The reader can clearly determine mathematically that for all positive rates of return, the future value will be greater than the present value – as it should be, according to any introductory economics textbook as well as intuitive sense. It should be readily apparent that the assumed rate of return in this equation (also known as the discount rate) makes a substantial difference in the calculation. And so it should come as no great surprise that determining the proper value for this rate is often a point of contention among professional experts engaged in litigation claims. Once a discount rate is determined, experts must then build a model to consider a year-over-year basis the PV of this FV income stream – in industry terminology, the “present value of an annuity” or net present value (NPV) – that will be accepted by the courts.
The factors to consider when coming up with a proper discount rate for legal matters are substantial. Is it appropriate to use a spot rate (i.e., the most current interest rate available) or to use a historical average rate? For instance, the current yields of long-term investments of 20 and 30 years in maturity are at an all-time low. Is it appropriate to use the spot rate to discount into the next 20 years, or to look at a historical average of 20 years? It is commonly accepted that U.S. government securities and Triple-A-rated corporate and municipal bonds are relatively risk-free financial instruments to use as a discount rate, but which security, and for what term? Riskier, or longer-term, investments typically have higher rates of return but may not be appropriate for the individual circumstances of the case. One must also consider investment liquidity and yield lengths, among other factors. A major consideration is the presence of inflation and the expectation of inflation rates in the future. It is well established that a return earned on an investment is comprised of two critical factors: return on risk and the expectation of inflation. As inflation plays a key role in calculating future damages, the expert must be careful to account for it either separately or as part of a discount rate.
All of the aforementioned, of course, have their own individual issues of contention. The derived rates will be completely different depending on which method is selected and assumptions about inflation; even more importantly, the calculated results will be vastly different (millions of dollars in the damage estimates performed in certain damage estimates). Given the enormity of the task, many experts default to providing calculations with a variety of possible rates. While this tactic absolves the expert of a certain amount of responsibility, the burden then falls onto the trier-of-fact, who is almost assuredly less qualified to make this type of economic determination.
An additional complication is that regardless of the economic merits of a given assumption, case law sets a clear precedent in certain jurisdictions for what types of discount rates to use or not use, sometimes at the expense of basic financial concepts and common sense. In Pennsylvania, in non-medical malpractice personal injury cases, present value discounting is presumed to “total offset” (where wage growth and present value are considered to be equivalent), based on case law from the case of Kaczkowski v. Bolubasz, 421 A. 2d 1027 (Pa. Supreme Court, 1980). This means future awards are not present valued, even if the loss goes for another 50, 60 or 70 years in the future. This approach is in contrast to Pennsylvania personal injuries that are allegedly a result of medical malpractice, which are discounted under a different set of guidelines. It is interesting to note that two lawsuits could theoretically be brought for identical injuries, but based on their causal nature (i.e., medical malpractice or not), the calculations would be subject to separate criteria and thus the final estimates would be entirely different.
Ultimately, applying the time value of money concept and performing calculations or constructing models of economic damages requires the skilled application of general economic theory, specific discount rate assumptions, and relevant case law. Although the theory is straightforward and widely accepted, its implementation is complex and the judgments to be applied necessitate the use of an expert for dependable results.
Ethan Giller is an associate with Forensic Resolutions Inc. in Haddonfield, N.J., a firm that specializes in forensic accounting services. He can be reached at firstname.lastname@example.org or 856-857-9000.