Damages in many commercial litigation cases are “present valued” to an appropriate point in time, often the expected date of trial, in order to capture the concept that “a dollar today is worth more than a dollar tomorrow.” The present value rate or rates at which the damage amounts are brought forward, or discounted back, are often a point of contention between the parties.
The rate used to discount future payments back to the “present” (i.e., the discount rate) is essentially a forward-looking concept. There are three general components of this rate:
- The “real” rate of return – the amount the investors expect to obtain in exchange for letting someone else use their money with zero risk.
- Expected inflation – the expected depreciation in purchasing power while the money is tied up.
- Risk – the uncertainty as to when and how much cash flow or other economic income will be received.
Components 1 and 2 above are often considered together and referred to as the risk-free rate. A common choice for the risk-free rate is the yield on a U.S. Treasury security. The horizon of the chosen Treasury security often matches the horizon of whatever is being valued or discounted.
For example, if a future payment amount of $1,000,000 was to have occurred one year into the future (“but for” the wrong doing in the matter at hand) and there was reasonable certainty that this payment would have taken place, the proper discount rate used to discount this future amount back to the present as of February 2009 is the risk-free rate that currently approximates 0.5%, the rate of a 1-year Treasury bill at the end of February 2009. Today’s damage award would therefore approximate $994,000 (i.e., $1,000,000 divided by 1.005). Had the same scenario occurred 2 years ago when the 1-year Treasury bill rate approximated 5%, the damage amount would only have been approximately $952,000 (i.e., $1,000,000 divided by 1.05). More dramatically, given the same scenario in August 1981, when the 1-year Treasury bill rate was approximated 16.8%, the damage award would only have been approximately $857,000 (i.e., $1,000,000 divided by 1.168). 1
The last time yields on Treasury bills were as low as they are today was in the mid-1950’s. 2 As a consequence, discounting riskless future payments today yields higher present valued damage awards than at any time since the mid-1950’s. 3
1 The rates used in these examples can be found at http://www.federalreserve.gov/releases/h15/current/h15.pdf and http://www.treas.gov/offices/domestic-finance/debt-management/interest-rate/index.html.
2 http://research.stlouisfed.org/fred2/data/GS1.txt (yields on one year treasuries since the 1950’s).
3 This statement obviously assumes that the method of discounting used in the 1950’s was similar to today’s methods.