Time and Discounting in Private and Public Decision Making
Edited by David J. Pannell and Steven G.M. Schilizzi
Chapter 3: Avoiding Simplistic Assumptions in Discounting Cash Flows for Private Decisions
David J. Pannell SUMMARY Applied economists typically use a set of simplifying assumptions when applying discounting methods, including the following: • The discount rate is the actual or implied rate of interest on a financial instrument, commonly a bank account. • The discount rate is constant over time. • Tax is not relevant. • Risk is not relevant, or is included in the discount rate. • Inflation rates on prices of inputs and outputs are identical and constant. • Productivity growth over time is zero. However, these assumptions are not always realistic. For example, in formulating long-term management advice to farmers in Australia the following conditions would apply: • Tax directly affects the appropriate discounting procedure because, for example, tax in Australia is paid on the nominal rate of interest earned, not the real rate. • Historically, inflation rates for prices of farm inputs have been higher than for sale prices of outputs. It might reasonably be expected that this trend of declining real output prices will continue. 25 26 Economics and the Future • Agriculture has well documented trends of rising yields and productivity over time. Indeed, differences in productivity growth can be distinguished for different types of farm enterprises (for example, crops versus livestock). Although it is not difficult to include complexities like these in investment analyses and methods to do so are well developed in the finance literature, it is often not done in practice. This chapter presents methods to adjust the usual formulae for discounting to take account of some of these complexities. A numerical...
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