Question

After reading Theory and Practice in Policy Analysis chapter 7 by M. Granger Morgan, Please answer the below Questions:

In what situations is simple financial discounting appropriate?

Is a “real options” perspective better? In what ways?

Are discount rates constant?

Should we use the same discount rate for different decisions, or are there situation-specific rates?

Are things more remote spatially similar to those that are more remote temporally: does a “spatial discount rate” make sense?

In general, what do you think of the applicability of discounting concepts?

Answer 1

Discounting is basically determining the present value of a cash flow which is to be received in future. Here Time value of money comes into play which states that a dollar today is more worth than a dolar tomorrow because the value of dollar received in future would decrease due to discounting. This abstract gives a idea that simple financial discounting is appropraite in making day to day financial decision for households and big firms. For eg,

1. To buy a bike worth $ 50,000 today or the same bike to buy at $60,000 6 months later.

2. Which project to choose? one that gives a cash inflow of $500 every month or a project that gives cashinflow of $6000 every year.

Real option valuation perpective is better because it helps in capital budgeting the options of decisions that businesses can make. It helps to choose the next best opportunity to be profitable.  Real option strategy extends its application in corporate finance for decision making in conditions of uncertainty in general. These techniques are developed for financial options to also adopt "real-life" decisions. For eg,

1. It helps R&D managers to allocate their R&D budget among diverse projects

2. To work or to forgo years of income for higher studies.

Real option valuation is a business startegy formulation tool that forces decision makers to define their assumptions underlying their projections explicitily.

Discount rates are not constant. They depend majorly on the market interest rate, Tax rate and inflation explicitly. Discount rates follow the same pattern or one can say are directly proportional to market interest rates. Discount rate is basiclly the rate at which the value of money decreases. This explanation above clearly shows that the discount rate differ with the type of decisions to be taken but highly depends on the economic performance of the market. This is where environmental and spatial discount rates concept come into play.

Traditional discounting methods can many a times underestimate long-term sustainability of the economies. This is where adjusting the traditional discount rate to arrive at an environmental discount rate helps. Spatial discount rate represents the rate at which the diffusion of environmental effects of economic activities is discounted over space.