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INTRODUCTION
     Attorneys who try business cases have little guidance on developing and arguing discount rates. While discount rates are often contested issues in a variety of cases, it is difficult to find Arkansas case law or other published legal authority to support arguments regarding discount rates. This is particularly true in the context of developing a discount rate for the purpose of calculating lost business profits or for arriving at the value of a business using the discounted cash flow method. For example, neither the Arkansas Model Jury Instructions - Civil nor the leading treatise on Arkansas damages deals specifically with the issue of developing a discount rate for lost business profits or business valuation. See Arkansas Model Jury Instructions 2220 (5th ed. 2005); Howard Brill, Arkansas Law of Damages § 6-1 (5th ed. 2004). There are treatises that deal with these issues. See, e.g., Robert L. Dunn, Recovery of Damages for Lost Profits Lawpress Corp. (6th ed. 2005); Shannon P. Pratt, Business Valuation: Discounts and Premiums (2001); Shannon P. Pratt, Valuing a Business (4th ed., McGraw-Hill, 2000). However, as helpful as treatises like these are to evaluate the finer points of discount rates and their components (as well as other aspects of business valuation and damages), attorneys and judges base their arguments on case law. This article presents the development of discount rates in an understandable and useable format for the purpose of assisting courts and practitioners as they further develop the law in this area.

DEVELOPING A DISCOUNT RATE
     Before a discount rate is developed or evaluated, it must first be understood what a discount rate measures. By "discount rate," the financial community means an annually compounded rate at which each increment of expected income is discounted back to its present value.¹ Said another way, it is a rate used to convert a series of future cash flows to a single present value. This rate is a forward-looking rate based upon the estimated returns and is often used interchangeably with "cost of capital" and "required rate of return."
     The concept of using a discount rate to convert expected future returns to present value may be stated as: "Value today always equals future cash flow discounted at the opportunity cost of capital."² Quite simply, a discount rate measures expected and perceived risk of return. Energy Capital Corp. v. United States, 302 F.3d 1314, 1333 (D.C. Cir. 2002). Using a built-up approach to developing a discount rate requires consideration of the following:

     A great deal of time could be spent in discussing the intricacies of the foregoing considerations. However, that is beyond the scope of this article, which is simply to identify the components of a discount rate and then to discuss their relative application to a different series of engagements, i.e.:

• Business Valuation
• Commercial Damage Litigation
• Personal Injury Litigation

Why should a person care about the magnitude of the discount rate used in the above engagements? Quite simply, the higher the discount rate, the lower the value of the business or loss calculations. Conversely, the lower the discount rate, the higher the value of the business or loss calculations. The impact of the discount rate can vary in each type of engagement as discussed below.

BUSINESS VALUATION
     There are three methods used in traditional business valuation:

• Asset Method
• Income Method
• Market Method

     The focus of this article is the Income Method. Two approaches to consider are: (1) the capitalization of income method, and (2) the discounted future income method. These methods are recognized in authoritative treatises in the area of business valuation and damage calculation, such as those cited above in the introduction. In the first approach, a capitalization rate is developed and then applied to the historical income of the subject company. A capitalization rate is the discount rate less long-term sustainable growth. The discounted future income method involves projecting the future income of the subject company and then discounting that projected income to present value. However, when employing either method, one must develop a discount rate. The development of the discount rate under either method would be similar to the approaches noted in Table II. Both of these methods would produce a valuation of $40,000,000, as illustrated in the following table:⁶
     If the discount rate in the preceding model were changed from 25% to 20%, the value would also change, because, as stated previously, the lower the discount rate, the higher the value:

TABLE IV - CAPITALIZED
ECONOMIC INCOME METHOD
USING A 15% CAPITALIZATION RATE
__________________________________
                                              Year 1
Economic
income (cash flow)              $ 8,000,000

Divided by: Discount
rate 20% minus growth
rate 5%
(i.e., capitalization rate)             15%

Valuation of entity               $53,333,333

The illustration in Table IV results in an increase in value of $13,333,000 simply by using a discount rate of 20%, a difference of just five percentage points. Thus, small changes in the discount rate can cause large differences in the overall value, making the development and analysis of the rate a very important part of a case.

THE DISCOUNT RATE IN PERSONAL INJURY CASES VS. THE DISCOUNT RATE IN COMMERCIAL DAMAGE LITIGATION
     As Professor Brill notes, the considerations regarding the discount rate in personal injury cases are usually limited, and considerable discretion is given to a jury to determine the appropriate discount rate. While expert testimony is not required to establish the appropriate discount rate in such cases, experts are often presented, and their testimony is usually given great weight by the jury.
     Experts on the discount rate applicable in personal injury cases sometimes provide similar testimony regarding the discount rate for lost business profits or the value of a business. However, the methodology for developing the appropriate discount rate in personal injury cases and business cases is markedly different. An attorney who is unaware of these differences is not likely to effectively present arguments against the expert who uses the personal injury methodology in a business case. For example, the methodology to develop a discount rate in a personal injury case does not consider key components of business risk. As illustrated in Table 2, the discount rate in a business case will consider issues such as the size of a business and the risks associated with its specific industry, neither of which is a consideration in the development of discount rates in personal injury cases. Cf. Olson v. Nieman's, Ltd., 579 N.W.2d 299 (Iowa 1998). Thus, the issues discussed regarding business cases are significant to the proper development of a discount rate for use in those cases.
     As Professor Brill notes in section 6-1 of his treatise, a plaintiff in a personal injury case will argue for a low discount rate and a defendant will attempt to convince the fact-finder why a higher discount rate is more appropriate. Howard Brill, Arkansas Law of Damages § 6-1 (5th ed. 2004). The reason for these competing strategies is obvious: The lower the discount rate, the higher the award of future earnings. These same competing strategies are also present in the business case. However, while argument has its place, attorneys in business cases often find themselves on the plaintiff's side in one case and then on the defendant's side in another case. Indeed, it is not uncommon in a business case for there to be claims, counterclaims, cross-claims, and third-party claims in the same case. That type of alignment of parties and claims makes it all the more important to establish the basic considerations for the development of discount rates in business cases. The proper use of these considerations to develop an appropriate discount rate will result in fair and just damage awards. In addition, in the event a damage award appears to be the result of passion or prejudice, the considerations in this article can assist the courts in reviewing such awards against objective criteria related to the discount rate.

IDENTIFYING THE PROPER
STANDARD OF VALUE: FAIR VALUE VS. FAIR MARKET VALUE
     Fair market value is a value which assumes what a hypothetical willing buyer would pay a hypothetical willing seller. Rev. Rul. 59-60, 1959-1 C.B. 237. In contrast, fair value "is determined by ascertaining all assets and liabilities of the business and the intrinsic value of its stock rather than merely appraising its market value." Crismon v. Crismon, 72 Ark. App. 116, 121-122, 34 S.W.3d 763, 767 (2000) (Griffen, J., dissenting) (citing American Gen. Corp. v. Camp, 190 A. 225,228 (Md. 1937)). The distinctions between fair value and fair market value are important in business valuation cases using the discounted cash flow method because, as discussed below, the considerations for the development of a discount rate may be more focused to specific narrow issues if fair value is the standard. See Shannon P. Pratt, Valuing a business 32 (McGraw-Hill, 4th ed. 2000).
     Arkansas cases are undecided on whether fair market value or fair value is the appropriate value for use in business cases. In the case of Crismon v. Crismon, the Arkansas Court of Appeals noted that the Arkansas Supreme Court "has explicitly approved the use of the 'fair market value' standard for valuing closely held businesses in a marital property division context." 72 Ark. App. at 119, 34 S.W.3d at 765. The authors are unaware of any reported Arkansas case which has decided that issue in the context of other types of cases. Attorneys should review Arkansas cases and statutes for particular types of claims to determine whether the measure of damage requires a determination of fair market value or fair value because use of the incorrect standard can render the evidence presented in support of a discount rate meaningless.

COMMERCIAL DAMAGE
LITIGATION
     When engaged, the expert usually has to develop: (1) the business' lost profits, (2) the length of the damage period, and (3) the appropriate discount rate to apply to the lost profits analysis. In commercial damages analysis, the assessment of the risk process is often incorporated into the discount rate, not the income stream. The built-up discount rate development for business valuation, as outlined above, is an approach that assesses risk and thus can be a starting place for development of a discount rate for commercial damages.
     One type of discount rate that should be considered is the weighted average cost of capital ("WACC"). When net cash flow to all invested capital (i.e., equity + debt) is discounted, the appropriate discount rate is the WACC. The WACC is a blending of the rate of return on debt (i.e., the company's borrowing rate) with the cost of equity capital (return on the market equity of the company). This rate incorporates the perceived variability of risk of the projected cash flow, as well as the risk of the return to the note holder and equity investor, into the chosen discount rate. Some experts believe that the return on equity of a specific plaintiff should be used. If the return on equity of a specific plaintiff is used, the return on equity would be the net income after corporate tax divided by the total equity at market value. This would necessitate valuing the business to get the market value of equity. Other experts consider the after tax cost of capital to be the appropriate discount rate. In considering any approach to the development of a discount rate, the important principle is that all approaches include a risk assessment which develops a discount rate greater than the risk free rate. By using the WACC or a suitable alternative to develop the company's actual cost of capital, a party should be made economically whole over time.
     Whether a particular methodology is appropriate for use in a specific case must be determined by the facts and circumstances of that case. For example, if the company has no debt, it would not be appropriate to use the WACC.
     Courts have held that the determination of the appropriate discount rate is a question of fact. See, e.g., Energy Capital Corp. 302 F.3d at 1332. The following cases provide a perspective on the variety of issues presented regarding to discount rates: Energy Capital Corp. v. United States, 302 F.3d 1314 (Fed. Cir. 2002) (10.5% discount rate); Kool, Mann, Coffee & Co. v. Coffey, 300 F.3d 340 (3d Cir. 2002) (growth rate of 7.5% and discount rate of 18.5%); Purina Mills, L.L.C. v. Less, 295 F. Supp. 2d 1017 (N.D. Iowa 2003) (parties did not propose discount rate; court used the U.S. Treasury Maturity Index rates); Olson v. Nieman's, Ltd., 579 N.W.2d 299 (Iowa 1998) (19.4% discount rate including a 14.4% rate of return for publicly held corporations and an additional 5% to reflect market risk); Munters Corp. v. Swissco-Young Indus., Inc., 100 S.W.3d 292 (Tex. App. 2003) (10%); Knox v. Taylor, 992 S.W.2d 40 (Tex. App. 1999) (competing experts urged growth rates of 25% vs. 6% and discount rates of 7% vs. 30%). Some of these cases contain detailed discussions of the discount rate, while others contain no analysis of the rate or the considerations leading to its development. However, it is probably safe to generalize that court opinions contain more detailed treatment of discount rates when the attorneys were better prepared to develop their arguments on that issue.

PERSONAL INJURY LITIGATION
     The engagement in a personal injury case usually includes the injured party's annual pre-tax lost income, the time period before returning to work or retirement, and a discount rate. With these components, the expert develops the present value of the injured party's losses, which represents the amount that would make him or her whole.
      When considering the discount rate to use in these cases, there are fewer disagreements among experts concerning the range of appropriate rates. Most experts use a net discount rate approach, which is the interest rate (usually the rate of U.S. Treasury Certificates) less the rate of inflation over a period of time. This would be the real rate as opposed to the nominal rate. The real rate is typically between 1% and 3%, which represents real interest rates over a relatively long time period in the United States.
     Using the real rate of return as the discount rate assumes that the income stream is risk free. This may not make sense at first blush, but a risk-free rate is the base assumption for this type of analysis and is used by many experts in the field.

THE MEASURE OF DAMAGE
     Attorneys should also determine the measure of damage applicable to a claim in a business case, because the measure of damage may affect the development of the appropriate discount rate. For example, if the claim is that the acts of the defendant completely destroyed the plaintiff's business, then the measure of damage is arguably the value of the business as opposed to lost profits. Ronald W. Eades, Jury Instructions in Commercial Litigation § 17.07 (2d. ed., Matthew Bender & Co. 2002).
     The calculation of lost profits considers profits on a company's income statement for the appropriate period of loss and then discounts the profits by the discount rate discussed above. In contrast, the discounted cash flow method for valuing a business considers the cash flow of a business and values the business by projecting those cash flows over an appropriate period and multiplying them by the discount rate as discussed above. Gold v. Ziff Commc'ns Co., 748 N.E.2d 198 (Ill. App. 2001). The methodologies for the development of the discount rate in assessing the business's lost profits and its value involve different considerations. Therefore, the measure of damages should be determined before any attempt is made to develop the discount rate.

CONCLUSION
     The development of discount rates incorporates a significant amount of judgment by an expert. However, there are agreed methods for developing an appropriate discount rate and those methods require consideration of certain known criteria. This article is a starting point for attorneys and judges. It identifies certain objective components involved in the development of discount rates which eliminate some of the unnecessary guesswork that is often encountered in this type of engagement. Ultimately, the development of these concepts by attorneys and judges will improve the quality of business valuations and damage awards that depend upon proper discount rates.

ENDNOTES
1. Shannon P. Pratt, Cost of Capital: Estimation and Applications 6 (2d ed. 2002).
2. Richard A. Brealey & Steward C. Myers, Principals of Corporate Finance 73     (Irwin McGraw-Hill, 8th ed. 2006).
3. Robert L. Dunn & Everett P. Harry, Modeling and Discounting Future Damages,     193 J. Acct. 49, 49-55 (2002).
4. Ibbotson Associates, Stocks, Bonds, Bills and Inflation (SBBI) 2005 Yearbook:     Valuation Edition 41 (Michael W. Barad ed., Ibbotson Associates 2005).
5. Pratt, supra note 1, at 68.
6. Shannon P. Pratt, Valuing a Business 211 (McGraw-Hill, 4th ed. 2000)•