Proving Damages for

Lost Profits:

Discounting at the Cost

of CapitalProfessor Robert M. Lloyd

University of Tennessee College of

Law

rlloyd@utk.edu

865.974.6840

Most financial economists believe the

weighted-average cost of capital

(“WACC) is the appropriate rate for

discounting lost profits

• WACC is what it costs the plaintiff to obtain

the money it needs in its business

• WACC includes the cost of equity as well as

the cost of debt

The basic idea is that by receiving the lost

profits award at the time of judgment

instead of over time, the plaintiff has

avoided the necessity of paying for that

amount of capital.

The cost of borrowing is not an

appropriate measure of the discount rate

• A common fallacy is that the discount rate

should be based on the interest that would

be saved if the plaintiff used the damage

award to pay down its debt.

• This fails to account for the fact that an

enterprise with less debt has to pay less for

its equity capital.

WACC is calculated by:

• Determining the cost of each of the firm’s

sources of capital

• Multiplying that cost of by the percentage of

the firm’s capital attributable to that

component

• Summing the results

Example: Firm has two sources of capital,

debt that costs 5%, and equity that costs

12%. The total capital is 40% debt and

60% equity.

WACC = (.05 x .40) + (.12 x .60) = 0.092 or

9.2%

Determining the cost of debt:• Interest expense is tax-deductible, so the cost of

loans must be adjusted to show the after-tax

cost.

• Example: Firm pays 8% interest on a loan. Firm’s

marginal tax rate is 25%. Firm’s after-tax cost of

the loan is 6%.

Determining the cost of equity capital is

complex

● A variety of methods are used

● The methods are the same as those used to

value future cash flows when determining

the value of a firm

For large publicly-traded companies, the

capital asset pricing model (“CAPM”) is

most often used

● CAPM is based on the premise that a cash flow

certain to be received is more valuable than an

uncertain cash flow with equivalent expected

value

● The developers of CAPM received a Nobel Prize

in Economics for their work

Under CAPM,

Cost of equity = Rrf + (Beta x RPM)

where

Rrf = the risk-free rate of return

Beta = (volatility of this stock)/(volatility of

the market as a whole)

RPM = the risk premium of the market as a

whole

The build-up method is the most

commonly used method for smaller

companies.

As the name indicates, the cost of equity

is determined by summing the

components of the various factors that

affect it.

As with CAPM, the analyst begins with a

risk-free rate and adds to it a premium

for risk.

This premium may include:

● A general equity risk premium

● A small company premium

● A company-specific premium

For extensive discussion of the cost of

capital, see Shannon P. Pratt & Roger J.

Grabowski, Cost of Capital: Applications

and Examples (3d ed. 2008)

Where possible, the cost of capital used to

discount profits lost on a discrete project

is the cost of capital attributable to that

project.

● If the project is riskier than the plaintiff’s

business as a whole, the cost of capital will

reflect that and so should the discount rate.

Where Marriott International sought lost profits

on a management contract for a new hotel, the

court noted that Marriott’s WACC was 6.5%, but

it discounted the lost profits at 7.5% because

this income stream was “more risky than

Marriott’s aggregate stream of income.”

In re M Waikiki LLC, 2012 Bankr. LEXIS 2398 (Bankr.

D. Haw. 2012)

In a similar case, another bankruptcy court

discounted lost profits by adding 1% (for risk) to

the plaintiff’s WACC with respect to each of

two breached contracts and 2% to the WACC

with respect to a third contract involving

slightly more risk.

In re MSR Resort Golf Course,LLC, 2012

Bankr. LEXIS 3702 (Bankr. S.D.N.Y. 2012)

Other cases using the

plaintiff’s cost of

capital to discount lost

profits

A judge of the United States Court of

Claims performed a sophisticated cost of

capital analysis to determine that a 17%

discount rate was the proper rate to

apply to profits lost when the

government breached a contract.Spectrum Sciences & Software, Inc. v. United

States, 98 Fed. Cl. 8, 26 (2011).

When an expert in a coal-mining case used

a 10% discount rate based on the

company’s cost of capital, a bankruptcy

judge increased the rate to 15% “in light

of the normal attendant risks of mining

coal.”In re Clearwater Natural Resources, L.P., 421 B.R.

392, 399 (Bankr. E.D. Ky. 2009).

Even plaintiff’s

experts use cost of

capital to discount

future profits

One plaintiff’s expert discounted income

at the plaintiff’s cost of equity capital,

which he calculated at 20.6%.RMD, LLC v. Nitto Americas, Inc., 2012 U.S. Dist.

LEXIS 158107 (D. Kan. 2012) at *24

Another plaintiff’s expert discounted lost

profits at the plaintiff’s “weighted

average costs of capital and funding,

which was 7.44%.”

NCMIC Finance Corp. v. Artino, 637 F.

Supp.2d 1042, 1074 (S.D. Iowa 2009).