When determining damages in commercial cases, especially in the context of business valuations or financial disputes, the selection of an appropriate discount rate is crucial. A discount rate is used to convert future monetary amounts into present value, reflecting the time value of money and risks associated with the investment. In the finance and legal fields, there are two common methods for selecting a discount rate: using the cost of equity (business valuations) and using a safe rate (personal Injury and wrongful death).
Cost of Equity
The cost of equity is a rate of return that an investor would expect to earn from investing in a particular company’s stock (business valuation). It reflects the risk associated with owning equity in that company. When calculating damages using the cost of equity, experts typically consider factors such as the company’s beta (a measure of the stock’s volatility relative to the market), the risk-free rate (e.g., the yield on government bonds), and a market risk premium (the additional return investors expect for taking on equity risk).
Using the cost of equity as a discount rate is commonly employed in commercial damages cases. It aligns the damages calculation with the risk involved in investing in the specific company or industry, making it more tailored to the circumstances of the case.
Safe Rate
The safe rate (personal injury and wrongful death), on the other hand, is a more conservative approach to discounting future damages. It refers to a discount rate that represents a low-risk investment, such as a long-term government bond or a stable, well-established company’s stock. The safe rate is generally lower than the cost of equity, as it assumes a lower level of risk.
The Use of a Safe Rate for Commercial Damages can be Speculative
Simplicity and Conservatism
The safe rate simplifies the calculation and provides a conservative ball park estimate of damages. It disregards the specific risk associated with the defendant’s business and assumes a lower return, which can be considered fair in some cases.
Counterfactual Scenario
In some instances, the safe rate can be appropriate when considering the counterfactual scenario—i.e., what would have happened if the wrongdoing or breach of contract had not occurred. This approach assumes the plaintiff would have invested in a safe, low-risk investment in the absence of the defendant’s actions.
Less Information Required
Calculating the cost of equity might require more data and information about the specific company and market, while the safe rate can be derived from more readily available market data.
However, using a safe rate also has its limitations
Potential Under Compensation
The safe rate might not adequately account for the actual risks and opportunity costs faced by the plaintiff, potentially resulting in an underestimation of damages.
Lack of Tailoring
The safe rate assumes a generic level of risk, neglecting the individual circumstances of the case and the industry in which the plaintiff operates.
Splitting the Baby
Often I see a commercial damage case where the expert is using a safe-rate of return to determine the present value of the damages. The safe-rate is typically used in personal injury and wrongful death cases. In a 1983 U.S Supreme Court decision, the court stated “…he is entitled to a risk-free[1] stream of future income to replace his lost wages, therefore, the discount rate should not reflect the market’s premium for investors who are willing to accept some risk of default.”
Since the risk-free rate of return is a rate that does not accept a default risk, it should not be used for a closely held company that has suffered a damaging event. An example will explain how this impacts the concept of splitting the baby.
Assume a damage period is for five years and the amount of damages increases $50,000 per year. A current safe-rate is approximately 1.5% and a reasonable discount rate for a commercial damage case is 25%. The total present value of damages using a safe-rate is $2,862,467 and the present value of damage using a commercial damage rate is $1,554,816. The midpoint for splitting the baby is $2,208,641. So your case settles for the midpoint value. One of the attorneys have relied on the safe-rate calculation and it is incorrect because it assumes no default risk. The other attorney has used recognized, acceptable damage theory. Therefore, one attorney has received an unjust enrichment for their client while the other attorney has incurred unnecessary settlement costs.
Example:
In my opinion, splitting the baby is a bad decision. I see reports where it is obvious that the expert is not familiar with the theory and practice of damage claims. One side of the case is being rewarded for not having a true expertise. I also believe that splitting the baby in this manner is not equitable to either party.
In conclusion, the decision to use a safe rate or the cost of equity for calculating commercial damages depends on the specific context of the case and the level of accuracy and detail required. Both methods have their merits and drawbacks, and it is essential to consult financial and legal experts to determine the most appropriate approach for a particular situation.
Summary
I help attorneys by converting complex financial matters into understandable concepts. This makes it easier for the attorney to explain the complex issues to their clients.
I have earned the most difficult business valuation designations for valuations of closely held companies.
I have earned a Master’s Degree in Business Valuations and apply those skills to my everyday business valuations.
Richard Claywell has been valuing closely held companies since 1985. He has earned two of the highest designations in the business valuation field , the Certified Business Appraiser (“CBA”) and Accredited Senior Appraiser (“ASA”), Richard is a Certified Public Accountant, has a Master’s in Business Valuation (MBV) and holds the ASA, CBA, ABV, ICVS, CVA, MAFF, CFD, ABAR, CVGA, ICVS-A credentials.
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[1] Risk-free means the same as safe rate.