Tcl - Understanding Discounting in Litigation - April 2007 - the Civil Litigator
| Publication year | 2007 |
| Pages | 23 |
| Citation | Vol. 36 No. 4 Pg. 23 |
2007, April, Pg. 23. TCL - Understanding Discounting in Litigation - April 2007 - The Civil Litigator
The Colorado Lawyer
April 2007
Vol. 36, No. 4 [Page 23]
April 2007
Vol. 36, No. 4 [Page 23]
Articles
The Civil Litigator
The Civil Litigator
Understanding Discounting in Litigation
by Peter Schulman, C. Brad Peterson
The Civil Litigator articles address issues of
importance and interest to litigators and trial lawyers
practicing in Colorado courts. The Civil Litigator is
published six times a year.
Article Editors:
Don Kelso, Denver, of Holme Roberts & Owen LLP -
(303) 861-7000, donald.kelso@ hro.com; Eric Bentley, Colorado
Springs, of Holme Roberts & Owen LLP - (719)
473-3800,
eric.bentley@hro.com
eric.bentley@hro.com
About the Authors:
Peter Schulman, CPA, CIRA, is a partner with the
accounting firm of Hein & Associates LLP in Denver -
pschulman@heincpa.com. C. Brad Peterson is a partner with the
law firm of Hutchinson Black and Cook, LLC in Boulder -
peterson@hbcboulder.com.
Discounting future income streams to present value
has a significant impact on damages. Many attorneys and
judges may not adequately understand discounting. Also
discounting frequently is poorly explained to triers of fact
This article provides an intuitive and practical explanation
of discounting.
The adage that $1 today is worth more than $1 tomorrow is a
familiar one. It means $1 today can be invested at a rate of
return that should increase the original investment
Discounting future dollars to present value is an important
part of a litigation damages analysis, and often is the
subject of sharply disputed expert testimony. Using practical
and intuitive examples, this article examines why the adage
is valid, provides practice tips for present-value
computations, and discusses the impact of such computations
on damages.
Compounding to Determine Future Value
Compounding to determine the future value of an initial sum
is the reverse of discounting future dollars to present
value. An example of compounding to determine future value is
calculating the appreciation in a savings account and
determining what the account will be worth in the future.
Because many people are more comfortable with the process of
compounding than discounting, this article reviews a few
examples of compounding before turning to the process of
discounting.
$100,000 Compounded at 5% Interest
Assume an initial sum of $100,000 is invested at an interest
rate of 5% per annum, compounded annually for five years.
After one year, the principal and accrued interest equal
$105,000; after two years, $110,250; after three years,
$115,763; after four years, $121,551; and after five years,
$127,628. Note that the annual interest is $5,000 in the
first year only. The effect of compounding is to increase the
accrued interest in each of the subsequent years. Figure 1
illustrates this future-value concept.(fn1)
The amounts shown in the right-hand column of Figure 1 are
the future value of the initial $100,000, based on a 5% rate
of return, compounded annually.
$500,000 Compounded at 5% Interest
Using identical arithmetic as that used to calculate the
future value of an initial sum of $100,000, Figure 2
demonstrates how five $100,000 promissory notes, with
maturities ranging from one to five years, would grow at a 5%
annual compounded growth rate, yielding a future value of
$580,191.
The amounts in the far-right columns of Figures 1 and 2 are
the same because both examples assume a growth rate of 5%
per annum. The only difference between Figures 1 and
2 is that Figure 1 involves a single $100,000 investment and
Figure 2 involves five $100,000 investments. The dollars in
the far-right column of Figure 2 also could represent, for
example, a lost-profits analysis for a business that earned
$100,000 this year and, but for the defendant's breach,
anticipated increasing its profits 5% for each of the next
five years. The future-value analysis is the same for this
lost-profits scenario.
The Importance of Time
The significant effect that time has in determining future
values and present values often is underappreciated. In 1626,
the Dutch bought the island of Manhattan for 60
Guilders,(fn2) which is approximately $35 at today's
exchange rate. This purchase often is viewed as a very small
price to pay, given the current value of Manhattan. On the
other hand, if this $35 had been invested for 381 years at 5%
per annum, compounded annually, it would have grown to more
than $4 billion. Conversely, the present value of $4 billion,
discounted at 5% per annum for 381 years, is approximately
$35.
The Importance of Rate
The preceding example shows the impact time has on a
future-value analysis. The compounding rate also affects the
analysis. Assume a newspaper is 1/100 of an inch thick. If
the newspaper is doubled over on itself, and then doubled
again for a total of 100 times, the newspaper would be
approximately 34 billion light years thick - thicker than the
known universe.(fn3) Thus, the newspaper that started out
1/100 of an inch thick becomes roughly twice the thickness of
the known universe as a result of compounding. This example
demonstrates that if both the time period and rate are
significant, the power of compounding cannot be...
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