Discount Rate Choice Research Articles

An Intergenerational Issue: The Equity Issues Due to Public–Private Partnerships; The Critical Aspect of the Social Discount Rate Choice for Future Generations

This paper investigates the impact of Social Discount Rate (SDR) choice on intergenerational equity issues caused by Public–Private Partnerships (PPPs) projects. Indeed, more PPPs mean more debt being accumulated for future generations leading to a fiscal deficit crisis. The paper draws on how the SDR level taken today distributes societies on the Social Welfare Function (SWF). This is done by answering two sub-questions: (i) What is the risk of PPPs’ debts being off-balance sheet? (ii) How do public policies, based on the envisaged SDR, position society within different ethical perspectives? The answers are obtained from a discussion of the different SDRs (applied in the UK for examples) according to the merits of the pertinent ethical theories, namely libertarian, egalitarian, utilitarian and Rawlsian. We find that public policymakers can manipulate the SDR to make PPPs looking like a better option than the traditional financing form. However, this antagonises the Value for Money principle. We also point out that public policy is not harmonised with ethical theories. We find that at present (in the UK), the SDR is somewhere between weighted utilitarian and Rawlsian societies in the trade-off curve. Alas, our study finds no evidence that the (UK) government is using a sophisticated system to keep pace with the accumulated off-balance sheet debts. Thus, the exact prediction of the final state is hardly made because of the uncertainty factor. We conclude that our study hopefully provides a good analytical framework for policymakers in order to draw on the merits of ethical theories before initiating public policies like PPPs.

Climatic Cost-benefit Analysis Under Uncertainty and Learning on Climate Sensitivity and Damages

Cost-benefit analyses on climate change have drawn considerable critique, primarily due to contestable choices of discounting and high uncertainties in climate sensitivity and climatic damages. Consequentially, it is argued that cost-benefit analysis can suggest mitigation rates that are nearly arbitrary. This article investigates how firm conclusions can be made from cost-benefit analysis if the main uncertainties are considered endogenously in the analysis and an extensive sensitivity analysis is carried out regarding the contestable assumptions.The SCORE model is used to calculate optimal emission pathways and carbon prices that hedge against climate sensitivity and damage risks using a wide range of plausible parametrizations. In a vast majority of cases the near-term emissions fall between 1.5 °C and 2 °C emission pathways, giving thus support for the Paris Agreement targets. Sequential decision-making allows hedging against uncertainties and readjusting mitigation efforts over time to reflect new information, leading to diverse stabilization temperatures in the long-term. Assumptions on mitigation costs, climate sensitivity and damages affect optimal near-term mitigation and long-term stabilization temperature more strongly than the discount rate choice. The consideration of parametric uncertainty on climate sensitivity and damages adds a substantial risk component to carbon pricing, while learning can induce significant price volatility in a decadal timescale.

Pay the farmer, or buy the land?—Cost-effectiveness of payments for ecosystem services versus land purchases or easements in Central Kenya

Payments for Ecosystem Services (PES) have emerged as a popular conservation tool, yet evaluation alongside other direct conservation strategies remains piecemeal. We prospectively compared cost-effectiveness of PES to Land Purchases or Easements (LPE) in Central Kenya. We spatially predicted opportunity costs and land prices using household survey and literature data, and sampled conservation management costs from four regional conservation organizations. We simulated a fixed-budget, spatial ecological–economic site selection process for conservation intervention (PES or LPE) over 30years. We included effects of land markets, property value fluctuations, rising agricultural productivity and climate change. Depending on the scenario, the LPE strategy led to larger reserves (by 26%–610%), better representation of mammal species' ranges (by 47%–112%) and lower unit costs (by 26%–48%). Adding a yearly egalitarian social development payment to the LPE strategy did not increase costs beyond the basic PES model. Our findings were robust to discount rate choice, but cost savings of LPE only materialized after about a decade. Furthermore, Kenyan law restricts foreign land ownership and the use of land easements, thus simpler institutional requirements make PES a more immediate, if less effective, property-based tool.

The impact of duration on management's discount rate choice

Previous research finds that firms increase their assumed discount rates to minimize their reported pension benefit obligation. This paper demonstrates that firms whose pension plans have short durations lower their discount rates (rather than increase them), since a lower discount rate decreases their pension expense. These results are especially relevant in the present climate of low interest rates and more firms freezing their defined benefit pension plans, thereby shortening the duration of their obligations. Given its importance in shaping management motivation we believe that firms should be required to disclose the duration of their future obligations.

Environmental liabilities and diversity in practice under international financial reporting standards

PurposeThe purpose of this paper is to encourage accounting regulators to address diversity in practice in the reporting of environmental liabilities. When Canada changed to International Financial Reporting Standards (IFRS) in 2011, Canadian regulators asked the IFRS Interpretations Committee to interpret whether the discount rate to value environmental liabilities should be a risk-free discount rate. Old Canadian GAAP, and current US GAAP, allow for a higher discount rate, resulting in commensurately lower liabilities. International regulators refused to address this issue expecting no diversity in practice in Canada.Design/methodology/approachThe focus is on a sample of Canadian oil and gas and mining firms. These domestic industries play a major role internationally and have significant environmental liabilities. The method is empirical archival, tracking firm characteristics and discount rate choice on transition to IFRS.FindingsThere is significant diversity in practice. About one-third of the sample firms choose a higher discount rate, avoiding a major increase in environmental liabilities on transition to IFRS. The evidence suggests that these firms have relatively larger environmental liabilities and that the discount rate decision is a strategic choice.Research limitations/implicationsThe sample is based on one country and may only be reflecting local anomalies that have no broader implications.Practical implicationsDiversity in practice in accounting for environmental liabilities is not acceptable. Accounting regulators should act to create consistent and comparable reporting practice.Social implicationsFirms and managers facing larger environmental liabilities can choose to minimize environmental liabilities under IFRS, while it is the general public and society at large that bear the ultimate risk.Originality/valueThe paper pushes forward the debate on whether recognized environmental liabilities should reflect the interests of equity investors, or if other investors and stakeholders should be taken into account.

Economic consequences of mandatory GAAP changes: The case of SFAS No. 158

This study examines management's reaction to the SFAS No. 158 requirement to recognize previously disclosed post-retirement benefit obligations on the balance sheet. The results indicate that managers attempted to mitigate the impact of the standard by increasing the assumed pension discount rate in subsequent periods. Further, the discount rate choice was related to the magnitude of the SFAS No. 158 balance sheet adjustment. Specifically, firms with larger required liability adjustments and more volatile pension assets and obligations were more likely to increase their discount rates. The findings have important implications for research regarding the economic consequences of accounting regulations and in particular the debate surrounding recognition versus disclosure since they indicate that managers react to the relocation of information from the financial statement footnotes to the balance sheet.

An Empirical Examination Of Pension Rate Estimates: A Benchmark Approach

<p class="MsoNormal" style="text-align: justify; margin: 0in 0.5in 0pt; mso-pagination: none;"><span style="font-size: 10pt;"><span style="font-family: Times New Roman;">In this paper, we analyze pension rate choices for a sample of 495 firms over the thirteen-year period from 1994-2006. In recent years, articles have appeared in business publications alleging abuse of the discretion afforded to management in setting pension rates, particularly the pension discount rate and expected rate of return on plan assets. We find that pension discount rate estimates and expected rate of return estimates generally comply with the authoritative requirements, although there appears to be a smoothing effect in setting pension discount rates as well as a lag in fully reflecting economic conditions. We find evidence consistent with discount rate choice being influenced by deteriorating economic conditions, and possibly passage of the Sarbanes-Oxley Act. We also find that, in general, firms’ expected rate of return assumptions tend to reflect their long-run internal rates of return on pension assets, although the recessionary influences in the early 2000s were not fully reflected in the expected rates of return toward the end of our test period. There is also a sizeable minority of firms (approximately 27%) for which their expected rates of return on plan assets consistently overstate their actual, long-run returns.</span></span></p>

A Generalized Approach to Multigeneration Project Evaluation

1. IntroductionIt is well-known that the choice of discount rate plays a significant role in the ranking of projects with varying time paths of costs and benefits. For public projects, the choice of the appropriate social discount rate (SDR) is not clear-cut even in the context of short-lived projects in which costs and benefits occur within a single generation. In particular, when capital taxes produce a wedge between gross and net rates of return, should one discount at the economy's rate of return (the before tax rate) or the individual's rate of return (the after tax rate)? In the single-generation context, the literature falls in two camps.1 One camp argues that the appropriate SDR is a weighted average of the gross and net rates of return with weights typically determined by the fractions of resources drawn from consumption and private investment, respectively.2 A second camp argues that future benefits should be discounted at the net rate of return, but that the initial investment should be multiplied by a scale factor so that the direct costs of the project can be expressed in terms of consumption units.3Both approaches suffer from severe implementation problems. For the first approach, there is no general formula for the weights needed to calculate the SDR as a weighted average of two market rates of return (Dreze 1974). Indeed, the appropriate SDR to use is project-specific (Stiglitz 1982). Without a systematic methodology to derive project specific SDRs, the weighted average approach is hard to implement. For the second approach, which equalizes the SDR to the net rate of return, the scale factor--the opportunity cost of public investment--must be quantified. The opportunity cost of public investment depends on whether resources come from private investment or consumption and on the calculation of the present value of the future consumption yielded by a unit of capital discounted at the net rate of return; that is, the shadow price of capital. As Lind (1997) points out, however, there is no general agreement on a specific procedure for calculating the shadow price of capital. Indeed, the concept of the opportunity cost of public investment suffers the same project dependence problem as the first view of the SDR (Diamond 1968).Multigeneration projects such as nuclear waste disposal, natural resource conservation, or even Social Security reform further complicate discount rate choice. Specifically, intergenerational equity, in addition to intertemporal efficiency, plays a role in determining the appropriate social discount rate for multigeneration public project evaluation.4 As in the single-generation context, there are two competing views on the appropriate discount rate when evaluating multigeneration projects: the descriptive and the prescriptive approaches.5The descriptive approach to discounting is a market-based approach. It does not rely on an explicit social welfare function (SWF) or the pure time preference rate embedded in the SWF. However, the descriptive approach works under the assumption that intergenerational compensation through changes in the tax/debt policy is available.6 It is argued that, under appropriate intergenerational compensation, the market rates of return are still relevant for calculating the SDR for multigeneration project evaluation, and, in general, the SDR should be a weighted average of the gross and net rates of return. This descriptive view of setting the SDR equal to the market return appears to underlie the Office of Management and Budget's (OMB) adoption of 7% as the appropriate discount rate for federal programs.7The intent of the prescriptive approach is to use the social discount rate as an expression of ethical judgment on how consumption of future generations should be compared to consumption of current generations. …

Fair Value Accounting and Gains from Asset Securitizations: A Convenient Earnings Management Tool with Compensation Side-Benefits

We provide evidence that managers use the discretion afforded by fair-value accounting rules to manage the size of reported securitization gains. We show that the ambiguity allowed in discount rate choice is one way that managers can influence these gains. We investigate whether CEO compensation is less sensitive to securitization gains than to other earnings components in the presence of proxies for how independent (outsiders, females, fewer CEO-selected directors) and informed (financial expertise) directors are. We find weak evidence of less earnings management in firms with more independent boards, but find no evidence that our director characteristics influence CEO pay-sensitivity to the gains. Thus, boards do not appear to intervene and adjust compensation for implementation problems related to fair-value accounting rules for securitizations.

The choice of discount rate for external reporting purposes: Considerations for standard setting

Currently, there is no general standard concerning the choice of the discount rate to be used when calculating the present value of an asset or liability for external reporting purposes. This paper provides an analysis of the issues that should be considered in establishing such a standard. Six candidate rates are evaluated based on six criteria of high quality accounting standards identified from the literature. No rate candidate dominates on all points. Accordingly, the paper proposes the underlying structure of a comprehensive discount rate–choice accounting standard, which would resolve most of the issues identified in the paper.

Choice of Pension Discount Rate in Financial Accounting and Stock Prices

Under present financial accounting standards, in Japan and in U.S., firms can choose pension discount rates, which they use for earnings measurement, at their discretion. First, this paper investigates, what factors affect their choice of pension discount rates. The sample firms in this paper reduced their discount rates, when market interest rate declined in 1990s, more slowly than the tendency in the market. We analyze the causes of this delay by logit model. Regression results show that, given declining interest rate, the significant factor affecting the firms' choice is not leverage, but profitability (return on equity: ROE). Second, this research investigates empirically how stock prices reflect the size of pension discount rate. Both unamortized pension obligations and pension expenses in the year are positively associated with stock prices. However, the coefficients for the firms, whose discount rates are higher than median, are smaller than those for the firms choosing lower rates. Those coefficients are not significantly different from zero. These results indicate that the firms, which chose lower pension discount rates, are valued higher. This asymmetric result is consistent with the first point in this paper, concerning the firms' motives for pension discount rate choice. Key Words: Pension accounting; Discount rate; Earnings response coefficients; Capital market; Japan

Contemporary UK market valuation methods for over-rented investment properties: a framework for risk adjustment

This paper develops the recent series of papers published in the Journal of Property Research on the market valuation of investment properties by contemporary approaches. In the previous papers, an arbitrage model has been developed and compared with the real value and short cut or modified DCF alternatives to the valuation of fully let and reversionary properties. This paper investigates the application of these models to over-rented properties where the existing contract rent is in excess of the current rental value. This examination reveals some interesting insights into the applications of the various models concerning the need to be explicit regarding future rental growth and concludes that models which do not reveal their rental growth assumptions can still be successfully applied to the over-rented situation. The paper examines the discount rate choice within contemporary approaches and maintains that the low-risk discount rate, based upon the risk free fixed interest rate adjusted for risks based upon covenant strength and property illiquidity, is a more appropriate input than a discount rate based upon other property risks such as cash flow change uncertainty and obsolescence (equated yields). It also highlights areas for future research to improve the information base for the discount rate choice.

DISCOUNT RATE CHOICE AND THE APPLICATION OF DURATION FOR CAPITAL BUDGETING DECISIONS

ABSTRACT The duration measure of weighted average life has been applied in the capital budgeting literature as a measure of project liquidity. Duration is superior to payback methods because it considers both the timing and present value of the entire cash flow stream. However, the literature is ambivalent on the choice of discount rate in calculating project duration. For duration to properly serve as a project liquidity measure, the internal rate of return should be used to discount future cash flows. Examples show that using the firm's cost of capital to calculate duration fails to measure the time to recover initial project outlays in present value dollars.

Discount Rate Choice and Efficiency in Exhaustible Resource Allocation

Employing a simple continuous-time model, J. Rowse (1990) finds small percentage social welfare losses when using the wrong discount rate to allocate an exhaustible resource. This study finds the same result using a discrete-time model incorporating several important complexities, including rising unit supply costs and demand functions that distinguish among short-term, medium-term, and long-term price responses. Certain non-efficiency performance measures are found to vary much more in percentage terms than social welfare as the improper rate diverages from the social rate. It is argued that these results are general and their implications are briefly discussed.