Tuesday, January 15, 2013

Critiquing an Expert Report: Step 7 - Discounting Future Damages

Step 7 to critiquing an expert report on damages in a commercial dispute involves identifying the extent to which the damages period extends beyond the current date (or anticipated trial date) and assessing whether or not the expert reasonably present valued the future damages (e.g. lost profits) to the breach date or the trial date at an appropriate discount rate.
The discount rate used to present value future losses in a commercial dispute is often one of the major assumptions underlying a damages calculation which, if altered, can have a significant impact on the conclusions.
As you review the expert report, the following questions should be addressed:
  1. Does the damages period extend into the future (beyond the trial date)?
  2. Have the future damages been present valued to the trial date or the breach date?
  3. What discount rate was used to present value the future damages and does it accurately reflect the risks underlying the projections?
According to The Litigator’s Guide to Expert Witnesses:
"Where a stream of future income is being analyzed to determine damages, an appropriate discount rate has to be determined.  The discount rate, when applied to monetary sums receivable in the future, expresses these sums at their current worth, taking into account the time value of money and the future risk that these future sums may not be received."
 "In several provinces, there is a prescribed discount rate. However, in cases of commercial litigation, careful consideration must be given to the appropriateness of this prescribed discount rate which always carries with it two assumptions:
    • All revenues and costs will increase in line with the rate of inflation; and
    • The long-term rate of return is equivalent to that available on Government of Canada bonds.
If one or both of these assumptions are inappropriate in a commercial situation, then a different discount rate will have to be calculated." [1]

Prescribed rates reflect risk-free rates and are commonly used in personal injury matters.  They are generally not appropriate in commercial disputes as cash flows associated with a business are not risk-free (i.e. the long-term rate of return for businesses is generally not equivalent to the rate of return on Government of Canada bonds).  In other words, where an expert has present valued future losses in a commercial dispute you should expect the discount rate applied to be higher than the prescribed rates.  

This is an important point because applying a higher discount rate to future losses will result in a lower value being attributed to the breach.  Conversely, a lower discount rate will increase the value attributed to the breach.  As a result, the application of prescribed or risk-free rates in a business loss matter is a red flag that the expert’s damages conclusion may be overstated. 
Where the expert’s discount rate assumption is not reasonable under the circumstances, you should consider the impact of using a more appropriate discount rate assumption on the conclusions.  The assistance of an independent expert CBV may be required in this regard. Determining an appropriate discount rate requires a comprehensive assessment as to the business, financial and economic risks facing the business along with research regarding industry transactions and/or public company trading multiples as well as experience and judgment on the part of an expert trained in this area.
The discount rate used to present value future damages is often a major assumption underlying a damages calculation.  Taking the time to understand what the expert assumed in this regard and assess its reasonableness in light of the facts and circumstances of the case is critical to conducting an effective review of that expert’s report.
1.  The Litigator's Guide to Expert Witnesses, Mark J. Freiman and Mark L. Berenblut, 1997, pages 91 - 92.

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