Discounting

Discounting is a method used to adjust the monetary values of economic goods from different time periods to a standard basis for comparison. It involves converting the value of cash flows occurring at different time periods to a base year value, generally the year in [Page 139]which the analysis is being conducted (i.e., present value). The calculations use a discount rate, which reflects the time value of economic resources by discounting future monetary flows to the base year or present value.

The concept underlying discounting is known as time value or time preference, which refers to the tendency for people to prefer economic benefits to accrue sooner rather than later. This preference is well supported by empirical evidence, having been a topic of discussion in economic literature for nearly two centuries. However, it wasn't until the 1960s that debates on how to determine the appropriate discount rate started to dominate economic discussion. Fifty years later, the question has still not been conclusively settled.

When costs and benefits associated with a particular economic activity occur at different points in time, using a simple summation of cash flows is not appropriate because this ignores the effects of monetary inflation, changes in specific markets or the overall structure of the economy, or changes in pertinent technologies—in short, all of the risks and uncertainties of the future. Discount rates attempt to quantify the combined value of these effects. Because they deal with unknown future events, discount rates necessarily involve estimation, and the object in constructing a discount rate is to predict as accurately as possible the trends for all important factors. To the extent the effort is successful, discounting is an invaluable tool with which to compare different courses of action, such as weighing the relative costs (also known as opportunity costs) associated with making any one investment rather than any other. Discounting is an integral part of cost benefit analysis, which is used, among other things, to decide on investments in environmental technology, conservation, and pollution control.

Controversies among experts on how best to construct the discount rate have included the following: (1) whether the discount rate should reflect the private investment rate, social opportunity cost rate, the social time preference rate, or some other rate; (2) whether public and private sector projects should be discounted using the same discount rate; (3) whether discount rates should vary by type of investment, as well as by sector; (4) whether differential discounting should be used for costs and benefits; (5) whether different discount rates should be used for projects with unequal life expectancies; (6) how risk and uncertainty should be included in the discount rate; and (7) whether the nominal discount rate or the real discount rate should be employed.

There are numerous analytical methodologies that use the principle of discounting including net present value, internal rate of return, discounted payback period, cost-benefit analysis, and life cycle analysis. The choice of discount rate can profoundly affect the outcome of an analysis since even small variations in the discount rate can significantly bias a cost study by tilting the scales away from one project to another or even changing a positive net present value to a negative net present value. For this reason, it is imperative for business managers and investors to understand the discount rate being used in the analyses that form the basis for their operating and investment decisions. Life cycle analysis was developed explicitly to incorporate both future direct and indirect costs into business models by using a discount rate.

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