Question

2A- From Theory and Practice in Policy Analysis, 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?

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Answer 1

Solution

The situations is simple financial discounting appropriate is the Discounting is the process of determining the present value of a payment or a stream of payments that is to be received in the future. Given the time value of money, a dollar is worth more today than it would be worth tomorrow. Discounting is the primary factor used in pricing a stream of tomorrow's cash flows.

ROA was derived from financial options valuation. It therefore works best under conditions that resemble (perfect) financial markets: perfect information, perfect competition (no arbitrage), liquid assets. But basically valuation can work on real assets provided that there is some sensible information about expectations/uncertainty. The hard part of valuation in the real world is that there often is very limited information on long run uncertainty (provided that you assume that valuation which covers the long run can work at all, as Keynes said: “in the long run we are all dead

All financial theory is consistent here: every time managers spend money they use capital, so they should be thinking about what that capital costs the company. There can be many sources of capital, and the weighted average of those sources is called WACC (Weighted Average Cost of Capital). For most companies it’s just a weighted average of debt and equity, but some could have weird preferred structures etc so it could be more than just two components.

Time Value of Money and Discounting

When a car is on sale for 10% off, it represents a discount to the price of the car. The same concept of discounting is used to value and price financial assets. For example, the discounted, or present value, is the value of the bond today. The future value is the value of the bond at some time in the future. The difference in value between the future and the present is created by discounting the future back to the present using a discount factor, which is a function of time and interest rates.

For example, a bond can have a par value of $1,000 and be priced at a 20% discount, which is $800. In other words, the investor can purchase the bond today for a discount and receive the full face value of the bond at maturity. The difference is the investor's return. A larger discount results in a greater return, which is a function of risk.

Discounting and Risk

In general, a higher the discount means that there is a greater the level of risk associated with an investment and its future cash flows. For example, the cash flows of company earnings are discounted back at the cost of capital in the discounted cash flows model. In other words, future cash flows are discounted back at a rate equal to the cost of obtaining the funds required to finance the cash flows. A higher interest rate paid on debt also equates with a higher level of risk, which generates a higher discount and lowers the present value of the bond. Indeed, junk bonds are sold at a deep discount. Likewise, a higher the level of risk associated with a particular stock, represented as beta in the capital asset pricing model, means a higher discount, which lowers the present value of the stock.