MAY/JUNE 2024IN THIS ISSUE... Investigating the Sensitivity of the Size Premium By Derek Zweig, CFA, FRM, Timothy Sumner, and Adam Luke, PhD This article demonstrates the importance of granular assumptions and modeling decisions when calculating size premiums. While baseline size premiums reflect common practice, we find that small, reasonable deviations from common practice can result in material differences in size premiums. We offer alternative size premiums along with guidance indicating when they may be appropriate. ON THE COVER Discount Rates for Lost Profits: A Question of Fact and Appropriate Approach By Allyn Needham, PhD, CEA Discounting lost profits to present value appears to be a relatively easy mathematical calculation. But many experts find that even though the math is straightforward, determining the appropriate numerator (lost profits amount) and denominator (discount rate) is complex and troublesome. These variables may vary from expert to expert, leaving litigating parties with sometimes quite different results from the same data. This article reviews lost profits decisions in trial and appellate courts, as well as financial literature supporting various approaches. ON THE COVER 16 4 The Value Examiner 2SUBMISSION DATES Issue Submission Date Publish Date Nov./Dec. Aug. 19 Dec. 2, 2024 Jan./Feb. Oct. 21 Feb. 3, 2025 Mar./Apr. Dec. 17 Apr. 1, 2025 SUBMISSION STANDARDS The Value Examiner is devoted to current, articulate, concise, and practical articles on business valuation, litigation consulting, fraud deterrence, matrimonial litigation support, mergers and acquisitions, practice management, exit planning, and building enterprise value. Articles submitted for publication should range from 1,500 to 6,000 words. Manuscripts should be submitted via the Scholastica professional journal management platform. For more information, or to submit an article, please visit: https:// www.nacva.com/tveauthors. By clicking on the “Submit via Scholastica” button, you can view detailed editorial and submission guidelines. If you have questions, please contact Dan Shiffrin, Editor, at DanS1@NACVA.com, or Lynne Johnson, Associate Editor, at LynneJ1@NACVA.com. REPRINTS Material in The Value Examiner may not be reproduced without express written permission. Article reprints are available; call NACVA at (800) 677-2009 and/or visit the website: www.NACVA.com. © 2024 NACVA. All rights reserved. NACVA members (except Affiliate members) are automatically provided a subscription to The Value Examiner with membership. If you do not want to receive this publication, upon request, we will reduce your annual dues by $25. EDITORIAL STAFF CEO & Publisher: Parnell Black, MBA, CPA, CVA Editor: Daniel Shiffrin, JD Associate Editor: Lynne Johnson EDITORIAL BOARD Chair: Michael D. Pakter, CPA, CFF, CGMA, CFE, CVA, MAFF, CA, CIRA, CDBV Past Chair: Lari B. Masten, MSA, CPA, ABV, CFF, CVA, ABAR, MAFF Ashok Abbott, MBA, PhD John E. Barrett Jr., MBA, CPA, ABV, CVA, CBA Gary W. Baum, MBA, CPA, CVA Neil J. Beaton, CPA, ABV, CFF, CFA, ASA Rod P. Burkert Lorenzo Carver, MS, MBA Wolfgang Essler (Germany) Michael Goldman, MBA, CPA, CVA, CFE, CFF Dorothy Haraminac, MBA, CFE, MAFF, CCI, PI Hubert Klein, CPA, ABV, CVA, CFE, CFF Andrew M. Malec, PhD Z. Christopher Mercer, FASA, CFA, ABAR Michael J. Molder, JD, CPA, CFE, CVA, MAFF Judith H. O’Dell, CPA, CVA Danny A. Pannese, MST, CPA, ABV, CVA, CSEP Kevin A. Papa, CPA, CVA, ABV, CVGA Donald Price, CVA, ASA Angela Sadang, MBA, CFA, ASA, ABV Keith Sellers, DBA, CPA, ABV Todd Zigrang, MBA, MHA, FACHE, CVA, ASA, ABV The Value Examiner ® is a publication of: National Association of Certified Valuators and Analysts ® (NACVA ® ) 1218 East 7800 South, Suite 301 | Sandy, UT 84094 Tel: (801) 486-0600, Fax: (801) 486-7500 E-mail: NACVA1@NACVA.com Production and Design: Chris Peterson, Creative Director, Digital Paint Booth, DigitalPaintBooth.com Inquiries concerning advertising should be directed to NACVA1@NACVA.com COLUMNS & DEPARTMENTS Financial Forensics Cryptocurrency in Litigation Practice: Tips and Pitfalls for the Financial Forensics Practitioner By Dorothy Haraminac, MBA, CFE, MAFF, CCI, PI This column discusses blockchain forensics, cryptocurrency valuation, and other cryptocurrency issues in litigation. The author provides financial forensics practitioners with tips and practice tools, and alerts them to the many potential pitfalls in these cases. The subject of this installment is “Measuring Volatility in Cryptocurrency.” Legal Insights Courtside View: Valuation and Financial Forensics Perspectives from the Bench By Michael J. Molder, JD, CPA, CFE, CVA, MAFF Courtside View highlights recent decisions by federal and state courts addressing significant valuation, financial forensics, and expert witnessing issues. In this issue, the author reviews two cases involving determinations of whether business interests are separate property or part of the marital estate: Demenno v. Demenno (Alaska 2024) and Smith v. Smith (Miss. App. 2024). 32 38 May | June 2024 3Discounting lost profits to present value appears to be a relatively easy mathematical calculation. An expert calculates the projected lost profits for each year in the future for which the loss is anticipated and then discounts the future losses to present value. Lost profits are the lost cash flows the expert believes to be appropriate, and the discount rate used to complete this calculation is the rate the expert believes to be appropriate. The formula for this exercise is straightforward: Y/(1+r) t where: Y is the amount of lost cash flows being discounted for a specific period of time r is the discount rate t is the specific period of time being discounted For example, assume an expert has estimated a five-year future loss. The projected loss for each year is $1,000, and the expert has assumed a discount rate of 5 percent. Each year will need to be discounted separately. The specific calculations for year two would provide a present value of $907.03: $1,000/(1 + 5%) 2 $1,000/(1.05 × 1.05) $1,000/1.1025 $907.03 The resulting present values for this five-year loss period are as follows: YearLost ProfitsDiscount RatePresent Value 1$1,0005%$952.38 2$1,0005%$907.03 3$1,0005%$863.84 4$1,0005%$822.70 5$1,0005%$783.53 Total$5,000$4,329.48 Discount Rates for Lost Profits: A Question of Fact and Appropriate Approach By Allyn Needham, PhD, CEA 4 The Value Examiner Litigation ConsultingMany experts find that even though the math is straightforward, determining the appropriate numerator (lost profits amount) and denominator (discount rate) is complex and troublesome. These variables may vary from expert to expert, leaving litigating parties with sometimes quite different results from the same data. (Determining the number of years of lost profits is a separate issue.) Robert Dunn and Everett Harry discussed the difference in approaches for the numerator and denominator: Some CPA experts project the plaintiff’s hoped-for income stream, modify those losses to a realistic expectation by factoring in future risks and then discount the adjusted future losses to a present value at a risk- reduced, relatively low discount rate. Other experts project the hoped-for-but-lost amounts and then apply a higher discount rate that already incorporates risk or uncertainty to determine the present value. 1 These authors argue for the former approach—that is, adjusting the future losses and applying a risk-reduced discount rate. They argue that “modeling” provides a more accurate analysis. I agree with this approach and discuss it in more detail below. The modeling approach involves “examining the interactive components of a financial outcome” and “analyzing various input factors (sensitivity analysis).” In a litigation setting, “working with a spreadsheet program to address variables (risk) that influence projected earnings helps [an expert] to arrive at appropriate financial- damages information to offer the court.” 2 Even if taken in its simplest form, the two models discussed by Dunn and Harry provide divergent paths for the numerator (lost profits) and the denominator (discount rates). Because these two methodologies require quite different approaches, two differing camps of opinions have emerged, each championing its side. Courts have found both methodologies acceptable for calculating the present value of lost profits. 1 Robert L. Dunn and Everett P. Harry, “Modeling and Discounting Future Damages,” Journal of Accountancy 193, no. 1 (January 2002): 2. 2 Ibid. 3 Everett P. Harry, “Lost Profits and Lost Business Value—Differing Damages Measures,” Dunn on Damages, Issue 1 (Winter 2010): 6. 4 AICPA Prospective Financial Information Guide, updated as of July 15, 2021, Section 6.31. Modeling versus Business Valuation Approach Modeling lost profits calculations remains controversial, with much of the criticism coming from the business valuation community. On this issue, Harry wrote: Some experts argue that certain principles of finance and economics developed based upon our free market system, including its capital markets, necessarily guide and constrain the calculation of business damages for litigation. In particular, these experts believe that lost profits damages cannot materially exceed, if at all, the lost business value of an enterprise. The debate on this topic continues perhaps, in part, because a growing number of professionals are attaining business valuation accreditations and applying the related body of knowledge for free market asset valuations to litigation damages computation assignments.” 3 For an economic damages assignment, it is not uncommon for adjustments to be made to future cash flow projections. To begin this process, an expert’s request for documents may include prior financial statements, business tax returns, internal budgets, and projections created for internal use (preferably prior to the litigated dispute) or to be provided to investors or lenders reflecting the anticipated profits during the loss period. In addition, interviews with persons having knowledge of the business, industry, or transactions involved in the litigation may also prove helpful. However, “In considering these sources of information, the entity determines whether they are unduly optimistic or pessimistic, and if they are, that fact should be taken into account when preparing prospective financial information.” 4 Even if a review of the provided data shows the future projections to be consistent with prior performance, the cash flows still contain a level of uncertainty. “The cash flows themselves usually come from management’s estimates of the firm’s future performance. As such, they are necessarily subject Many experts find that even though the math is straightforward, determining the appropriate numerator (lost profits amount) and denominator (discount rate) is complex and troublesome. 5 May | June 2024 A Professional Development Journal for the Consulting Disciplinesto uncertainty relating to matters specific to the firm as well as to broader issues, such as the general state of the economy, advances in technology, effectiveness of management, labor issues, actions of competitors, price of raw material, etc.” 5 Because of this uncertainty, an expert should consider whether to accept the plaintiff’s projections at face value. Adjustments might be necessary to compensate for actions other than those brought about by the alleged wrongful act. Aswath Damodaran of New York University’s Stern School of Business has addressed the need for an expert to focus on adjusting cash flows for business valuations: “‘When your valuations go awry, it is almost never because of the mistakes that you made on the discount rate and almost always because of errors in your estimates of cash flows (with growth, margins, and reinvestment),’ he writes. Therefore, you should focus on making the most accurate cash flow projections possible and include all risks, instead of ‘obsessing about the minutiae of discount rates.’” 6 It appears Damodaran’s position has been making its way into the standards for measuring fair value. “Language in FASB ASC 820, Fair Value Measurement, suggests a conceptual preference for capturing risk in cash flows rather than in a discount rate adjustment. But there’s a 5 Christopher S. Sontchi, “Valuation Methodologies: A Judge’s View,” American Bankruptcy Institute Law Review 20, no. 1 (Spring 2012): 8. 6 “Focus More on 'CF' than the 'D,' says Damodaran,” BVWire, Issue #173-1, February 8, 2017. 7 “Time to End the ‘Dumping Ground’ for Cash Flow Risk?,” BVWire, Issue #176-3, May 17, 2017. 8 Shannon P. Pratt and Roger J. Grabowski, Cost of Capital in Litigation: Applications and Examples, 4th ed. (Hoboken, NJ: John Wiley & Sons, 2010). perception that too many valuation experts simply accept the projections they are given without question and then dump some extra percentage points into the discount rate for the DCF [discounted cash flow] analysis.” 7 It has been my experience that a large percentage of financial experts estimating lost profits are also business appraisers with professional certifications. Because of their training and experience, the same type of thinking discussed by Damodaran enters the process for calculating lost profits. Some in the business valuation community argue that Dunn and Harry misunderstood the use of hoped-for cash flows. They also argue that it is impossible to remove all risk from projections of lost future income and that attempts to do so are unreliable. Finally, they argue that the Dunn and Harry framework is incompatible with conventional methods. Roger Grabowski and Shannon Pratt were particularly concerned with the use of a risk-free rate for discounting future lost profits. “The most common error in discounting lost profits is in using a risk-free discount rate. … Plaintiffs often argue that lost profits should be discounted at a risk- free rate of interest. This is incorrect. Economics literature supports the use of a risk-adjusted rate, as do the judicial opinions that consider the issue carefully.” 8 6 The Value Examiner Litigation ConsultingSummarizing the differences between the two sides, Dunn and Harry argue that higher discount rates do not provide the desired results when estimating lost profits, and Grabowski and Pratt argue that the use of a risk-free rate or even a lesser discount rate overcompensates the plaintiff. Risk Free or Risk Adjusted While championing modeling for lost profits analyses, Dunn and Harry did not call for the use of a risk-free rate. “If the expert believes the damages model represents the lost income stream with a high degree of certainty, he or she may elect to use only a safe rate for discounting. But a discount rate greater than the risk-free level may be appropriate if the facts warrant it.” 9 Harry argues that the rationale for lesser discount rates is based on differing economic theories for valuing businesses and lost profits. “[T]he discount rate used for the business valuation to reflect an asset transfer price from a willing seller to a willing buyer is greater than the discount rate appropriate for a plaintiff suffering a constructive forced sale of an asset.” 10 In my practice, I follow the Dunn and Harry approach whenever possible. I adjust my cash flow projections to provide a reasonable, risk-reduced result. I then apply a risk-adjusted discount rate. This approach has allowed me to opine on discount rates as low as 5 percent (for short- term loss periods over one to two years) and as high as 36 percent (for overly optimistic management projections that had, in the past, failed to meet company expectations). I have not offered a risk-free rate for discounting in a commercial damages case but I have seen financial experts on the opposing side of disputes do so. Most lost profits reports I review follow a more traditional business valuation build-up method for arriving at a discount rate, as opposed to a risk-adjusted rate applied to modeled financial data. However, I have found that both approaches are generally accepted by the courts, which are willing to leave the decision of the appropriate discount rate to the trier of fact. To this point, this article has discussed the two overarching approaches for discounting lost profits: modeling the cash flow with a risk-adjusted discount rate and a non-modeled cash flow with a greater discount rate. While these two approaches offer alternate methods for determining lost 9 Robert L. Dunn and Everett P. Harry, “Modeling and Discounting Future Damages,” Journal of Accountancy 193, no. 1 (January 2002): 51–52. 10 Harry, “Lost Profits and Lost Business Value—Differing Damages Measures,” 6. 11 Chesapeake and Ohio Railroad Company v. Kelly, 241 U.S. 485, 489 (1916). 12 Ibid., 491. 13 Jones and Laughlin Steel Corp. v. Pfeifer, 462 U.S. 523, 536–537 (1983) (internal citations omitted). profits, there are multiple underlying approaches that may be used for building the appropriate discount rate. These underlying approaches are discussed in federal and state court decisions and addressed in financial literature. The remainder of this article reviews lost profits decisions in trial and appellate courts, as well as financial literature supporting various approaches. Selected decisions highlight the varying approaches applied in lost profit matters and the disparity of rates that result from them. I hope this information will assist readers in making sense of the range of discount rates that have been accepted by the courts. U.S. Supreme Court—Risk-Free and Risk- Adjusted Rates While the U.S. Supreme Court has provided guidance for discount rates in other areas of litigation, no Supreme Court decision has provided the foundation for discounting lost profits. The Supreme Court set an early standard for discount rates in personal damages cases. The Court has long agreed with the following principle of finance: provided money can earn interest and any amount of money is worth more the sooner it is received. In its 1916 Chesapeake decision, the Court stated, “It is self-evident that a given sum of money in hand is worth more than the like sum of money payable in the future.” 11 The decision went on to say that future losses should be discounted with a “best and safest” interest rate. 12 This position was confirmed in the Court’s Pfeifer decision: It has been settled since our decision in Chesapeake and Ohio R. Co. v. Kelly that “in all cases where it is reasonable to suppose that interest may safely be earned upon the amount that is awarded, the ascertained future benefits ought to be discounted in the making up of the award.” … The discount rate should be based on the rate of interest that would be earned on “the best and safest investments.” Once it is assumed that the injured worker would definitely have worked for a specific term of years, he is entitled to a risk-free 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. 13 7 May | June 2024 A Professional Development Journal for the Consulting DisciplinesAs the court noted in this personal injury case, before discounting, an expert must determine the specific number of years the injured or deceased would have worked and then determine the lost wages based on that loss period. There is an assumed level of certainty and, therefore, a lower level of risk, not often found in commercial damages cases. In its 2004 decision in Till, the Supreme Court addressed issues regarding cramdown interest rates for secured loans in bankruptcy matters. 14 In his plurality opinion for the Court, Justice Stevens wrote: “[Reorganization] plans that invoke the cramdown power often provide for installment payments over a period of years rather than a single payment. In such circumstances, the amount of each installment must be calibrated to ensure that, over time, the creditor receives disbursements whose total present value equals or exceeds that of the allowed claim.” 15 The decision rejected the use of three methods for setting the appropriate interest rate: the coerced loan rate, the presumptive contract rate, and the cost of funds rate. It approved the use of the formula approach. This approach is similar to the build- up method. As opposed to beginning with a risk-free rate, as the build-up method generally does, the formula approach begins with the national prime lending rate. To this rate, risk premiums are added, depending on certain factors related to the bankruptcy. This decision also set a range of safe harbor interest rates that could be used. These rates ranged from prime plus 1 percent to prime plus 3 percent. As noted by Justice Stevens, “[T]his requirement obligates the court to select a rate high enough to compensate the creditor for its risk but not so high as to doom the [reorganization] plan. If the court determines that the likelihood of default is so high as to necessitate an ‘eye-popping’ interest rate, the plan probably should not be confirmed.” 16 In this decision, the Court acknowledged the need for adjusting the prime rate for risk relating to the ability of the debtor to repay the creditor. Although the decision is precedent only for secured loans in Chapter 13 bankruptcies, many bankruptcy and appellate courts have 14 Till v. SCS Credit Corp., 541 U.S. 465 (2004). This was a plurality decision. There were four justices in favor, one justice (Thomas) concurring, and four dissenting. Justice Stevens, who wrote the Pfeifer decision, also wrote the Till decision. 15 Ibid., 469. 16 Ibid., 480–481 (internal citations omitted). 17 See, e.g., In re Texas Grand Prairie Hotel Realty, LLC, 710 F.3d 324 (5th Cir. 2013). 18 Till, 485 (internal citations omitted). 19 Ibid., 487. found it instructive and informative for applying the same standard to secured loans in Chapter 11 matters. 17 In his concurring opinion, Justice Thomas expressed a different view on the appropriate interest rate: This case presents the issue of what the proper method is for discounting deferred payments to present value and what compensation the creditor is entitled to in calculating the appropriate discount rate of interest. Both the plurality and the dissent agree that “[a] debtor’s promise of future payments is worth less than an immediate payment of the same total amount because the creditor cannot use the money right away, inflation may cause the value of the dollar to decline before the debtor pays, and there is always some risk of nonpayment." Thus, the plurality and the dissent agree that the proper method for discounting deferred payments to present value should take into account each of these factors, but disagree over the proper starting point for calculating the risk of nonpayment. 18 Justice Thomas went on to state that in order to satisfy the Bankruptcy Code, “the plan need only propose an interest rate that will compensate a creditor for the fact that if he had received the property immediately rather than at a future date, he could have immediately made use of the property. In most, if not all, cases, where the plan proposes simply a stream of cash payments, the appropriate risk-free rate should suffice.” 19 In concurring with the plurality, Justice Thomas allowed the formula approach to become the acceptable method for determining a cramdown interest rate for secured debt; however, he argued that a risk-free rate will suffice. This would compensate the creditor for the time value of money without consideration of risk factors beyond the risk of default. Both decisions set precedents in areas where financial experts may be asked to testify as to the appropriate interest rate. They are instructive and informative regarding the high court’s thinking. But, of course, they do not specifically address discounting lost profits. 8 The Value Examiner Litigation ConsultingI Need Estate Planning I'm Getting a Divorce Certified Valuation Analyst I'm Missing Out My Partnership is Dissolving Visit www.theCTI.com/BVTC or Call (800) 677-2009 Early registration discounts available. Dates and locations subject to change. Consultants' Training Institute ® Business Valuation Certification and Training Virtual Training Schedule June 10–14, 2024 August 12–16, 2024 October 14–18, 2024 November 11–15, 2024 NACVA’s Certified Valuation Analyst® (CVA®) designation is the only valuation credential accredited by the National Commission for Certifying Agencies® (NCCA®), the accreditation body of the Institute for Credentialing Excellence™ (ICE™), and the ANSI National Accreditation Board® (ANAB®). 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