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

Davidson, Ian, Song, Xiaojing and Tippett, Mark (2015) Time varying costs of capital and the expected present value of future cash flows. The European Journal of Finance, 21 (2). pp. 129-146. ISSN 1351-847X

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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.

Item Type: Article
Uncontrolled Keywords: cost of capital,feynman–kac functional,gamma discounting,present value,wiener process
Faculty \ School: Faculty of Social Sciences > Norwich Business School
Depositing User: Pure Connector
Date Deposited: 12 Dec 2013 09:24
Last Modified: 21 Apr 2020 22:19
URI: https://ueaeprints.uea.ac.uk/id/eprint/45108
DOI: 10.1080/1351847X.2013.802248

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