Inside NPV: What is the Net Present Value Discount Rate?

NPV or "net present value" is the adjustment made, in most cases, to a future amount to equate it to current economic value. This adjustment is made to determine the current amount needed that will make the plaintiff whole for amounts that would be earned or received in the future. This adjustment uses a discount rate and net present value formula. The discount rate is normally the sum of a money factor and a risk factor.

The Money Factor

The money factor is the rate of return the plaintiff can expect to receive on an award. Two items affect the rate:

1.The time horizon for the investment – This is based on how the monies will be received in the future. In cases involving loss of wages or payments for future medical costs, the monies will be needed over a specific time period. For example, if the award is for future wage loss, the years until retirement may be used.

2. The expected return on the investment –The expected return depends on the:
a.financial risk of those assets
b.prevailing financial market conditions.

The financial risk ordinarily consists of default and time components. An investment with a guaranteed return of principal is less risky than one without a guarantee. An asset that matures in less time is less risky than a longer-term maturity 1.

The measurement of prevailing market conditions is a problematic aspect of the rate of return. There is no consensus as to what information should be used. Some theories suggest that the historical trend in asset returns is the best indicator of future returns. Other theories suggest that the current expectation of investors is the best indicator. The Theory of Efficient Capital Markets (ECM) suggests that since financial markets provide sufficient information, the current return is the best indicator of the future return 2. This approach has some practical advantages.

Determining the current price of an asset is easy, accurate and verifiable. On the other hand, the choice of the data for historical trend analysis is subjective. The measurement of investor expectation is difficult and sensitive to the survey method.

Computing the Money Factor

Our approach to computing the money factor is:

•Use a portfolio of U.S. government securities of varying maturities between 3-months and 10-years. Where income taxes are a significant issue we may substitute a portfolio of state and local tax-free municipal bonds.

•Use the current yield information 3.

•Blend the varying maturities over different time horizons.

We use U.S. Treasury securities with varying maturities for two reasons. First, the default risk is, other than cash, among the lowest. Second, the varying maturities permit adjustment for time risk.
We use current information to reduce the chance of bias in the rate. Current information is easily accessible, verifiable and updatable. Finally, the blending of maturities assures that we have included the effect of time risk in our rate. The various weightings applied to the maturities focus on the relative contribution of time risk.

This approach, often used, has two advantages over some of the others discussed. One, it is consistent with current economic theory regarding the efficient operation of the capital markets. Two, it is transparent, verifiable and easy to understand.

The Risk Factor

The risk factor is the adjustment added to the money factor that reflects the uncertainty common to future projections. The traditional approach to determining the risk factor is based on corporate finance theory. This approach uses the returns on assets similar to the enterprise in question. This information is ordinarily reliable and readily available. For example, if the projection involves a large corporation, the economist may select the returns on similar large-capitalization companies traded on listed stock exchanges.

Although the same theory applies, this approach is not appropriate in most matters involving individuals. The reliable data for comparable individuals is rarely available. In the absence of reliable comparable data the economist must rely on his/her expert judgment to determine the risk factor.

When economists determines the risk factor in cases involving individuals, they often consider the following financial and economic factors:

1.Actual history of the individual. Commissions or other performance incentives may affect the usefulness of the past earnings as a predictor of future earnings.
2.The occupation of the individual.
3. The employer’s industry is often considered when it is cyclical or regulated.
4.Legal constraints on the individual such as union contracts, employment agreements and company compensation guidelines may be examined.

In addition, economists may also consider the risk factors that have been included elsewhere in the analysis. They may include life and worklife expectancy and labor force participation of the individual.

Finally, there are factors too speculative to be considered in the analysis. They will include, for example, the probability of catastrophic accidents or natural disasters impacting the individual.

In summary, the application of the net present value adjustment to future losses may be significant depending on the time period. The inclusion of estimates of the money and the risk factors provides a reliable basis for determining the appropriate discount rate.

1. This assumption is at the root of monetary analysis about the nature and importance of the Yield Curve concept.
2. See, for example, B.G, Malkiel, Randon Walk Down Wall Street, 5th Edition, 1990.
3. Information is based on daily U.S. Treasury Yield Report available at www.ustreas.gov