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. 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. 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. Fixed Income Essentials. Tools for Fundamental Analysis. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. As a result of government intervention, there would be both direct economic benefits e. The costs associated with government intervention could include productivity losses incurred by industry as a result of the prohibition on off-shore drilling, waste dumping, and net fishing.
Finally, private industry could be required to purchase costly equipment to comply with new regulations related to the treatment of industrial waste products. These purchases are a form of abatement cost. An abatement cost is a cost borne by industry to mitigate the damaging impact of an environmental externality that the industry has created. Table 1 examines the benefits and costs associated with the government action. Therefore, the present value of total benefits falls short of the present value of lost production during the year study timeframe, resulting in a benefit-cost ratio of 0.
The outcome of the analysis, however, is highly sensitive to the discount rate. When a 3 percent rate is used, government intervention would yield a benefit-cost ratio in excess of 1.
When a 10 percent discount rate is used, present value costs exceed benefits and result in a benefit-cost ratio of 0. The high discount rate reduces the benefit-cost ratio, because the costs associated with abatement and the reduction in fish harvests are experienced disproportionately during the first half of the year analysis timeframe, whereas the tourism and recreational benefits of the sanctuary are relatively low in the near-term but grow steadily throughout the study timeframe.
Figure 3 demonstrates this point graphically by examining the cumulative net benefits of total benefits and costs. As shown, the regulations fail to generate net benefits until Year Prior to Year 18, the total cumulative costs associated with the program exceed total benefits.
From Year 18 forward, however, the decision to establish a marine sanctuary and impose stronger regulations on industry would be expected to reap positive net benefits to society.
But what happens to the costs to industry if the habitat degrades and there are no fish to catch in the future. Table 1 demonstrates that the illustrative analysis is beginning to capture this point because beginning in Year 8, the catch under the sanctuary alternative exceeds that realized under the no-action alternative.
In the absence of the sanctuary, the damage caused by the various activities described previously will lead to a decline in the fish population and long-term revenue to commercial fisherman.
Because the damage will mount over time, the selection of a longer time horizon will result in a higher benefit-cost ration due to the long-term benefits associated with protecting the marine habitat and preserving the sustainability of future fish runs. It is important to note that there is a misconception that a project with the highest benefit-cost ratio should be selected when, in fact, the project that yields the highest net benefits to society is most desirable.
In the example demonstrated in Table 2, the benefit-cost ratio is maximized with Alternative C but welfare is maximized with Alternative E. Table 2. Debate in the literature on discounting has often focused on how to select the correct discount rate. In reality, there is no one, single accepted discount rate used by all economists when performing benefit-cost analysis. Due to the nature of time preference and the opportunity cost of capital, however, economists generally agree that, as ethically challenging as the decision can be, a positive discount rates should be used when valuing future benefits and costs.
In practice, discount rate are generally prescribed by the funding agency. Political concerns, in some cases, are considered when discount rates are chosen. However, arbitrarily selecting discount rates to meet short-term political goals could have long-term consequences. For example, high discount rates tend to discourage projects with high up-front costs and long paybacks, such as dam construction and new mineral extraction operations, but they also discourage coastal restoration and wetlands protection programs.
Conversely, low discount rates encourage coastal restoration and wetland protection programs but also encourage dam construction and mineral extraction. Regardless of the rate chosen, it is important to remember that the discount rate is a key determinant in the outcome of an analysis, and for each project, a single rate must be applied to all future benefits and costs.
Bellas, A. A Primer for Benefit Cost Analysis. Working Paper. Seattle, Washington. Silver Spring, MD. OMB Circular A Washington, D. Environmental Protection Agency. Guidelines for Preparing Economic Analyses. EPA R Greeley-Polhemus Group, Inc. IWR Report R Army Corps of Engineers. Fort Belvoir, VA. Hanley, N. Splash eds. Edward Elgar. Northampton, MA. Harrington, K. Alexandria, VA. Hartwick, J. The Economics of Natural Resource Use. Second Edition. Addison Wesley Longman. New York, NY.
Lazo, J. McClelland, and W. Pages to Discounting is justified by the expectation of economic growth. However, Ramsey did not take environmental considerations and resource exhaustion into account.
High discount rates imply giving low values to future damages, and thus, betting against the environment and future generations. A distinction can also be made between public or social discount rates and private discount rates. This is because individuals private sector are mostly concerned with their own welfare in the very short term, and they are risk-averse, discounting future benefits heavily. On the other hand, the public sector society as a whole tends to have a longer-term perspective, entailing lower discount rates.
Considering nations or societies with time horizons in the thousands of years, discounting the future at all is highly questionable. This is one of the most heavily debated issues in ecological economics. Discount rates of even 1—2 percent per year shift the costs of environmental degradation to later generations, and reduce incentives for long-term environmentally favourable projects. From the environmental point of view, instead of exponential discounting when assessing future costs and benefits, a slowly declining rate of discount reaching zero percent per year could be used to give more value to the future.
However, sometimes it is argued that a low discount rate equivalent to a low rate of interest, therefore cheap loans from the banks will promote investments that might be environmentally damaging. This means that there is need for a second filter to ensure their environmental sustainability Padilla, ; Philibert,
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