Time varying costs of capital and the expected present value of future cash flows

Ian Davidson, Xiaojing Song, Mark Tippett

Research output: Contribution to journalArticle

4 Citations (Scopus)

Abstract

The use of an inter-temporally constant discount rate or cost of capital is a strong assumption in many exante models of finance and in applied procedures such as capital budgeting. We investigate how robust this assumption is by analysing the implications of allowing the cost of capital to vary stochastically over time. We use the Feynman–Kac functional to demonstrate how there will, in general, be systematic differences between present values computed on the assumption that the currently prevailing cost of capital will last indefinitely into the future and present values determined by discounting cash flows at the expected costs of capital that apply up until the point in time at which cash flows are to be received. Comparisons are also made with the environmental economics literature where similar problems have been addressed by invoking a ‘gamma discounting’ methodology.
Original languageEnglish
Pages (from-to)129-146
Number of pages18
JournalThe European Journal of Finance
Volume21
Issue number2
Early online date20 Jun 2013
DOIs
Publication statusPublished - 2015

Keywords

  • cost of capital
  • Feynman–Kac functional
  • gamma discounting
  • present value
  • wiener process

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