The folly of discount based valuations Con Keating Gresham College London, March 2016

Social Time Preference Rates Neo-Liberalism defined: The elevation of market-based principles and techniques of evaluation to the level of state endorsed norms The most dangerous book in the world THE GREEN BOOK – Appraisal and Evaluation in Central Government The rate to be used 3.5% real But with a term structure Ramsey Formula – Where rho is the impatience rate, g economic growth and Inverse Theta is marginal elasticity of utility or relative risk aversion In HMT’s estimation, ρ has two elements, a catastrophe term and a social preference function amounting in total to 1.5% In general, uncertainty of any form lowers the discount rate. Period Years Discount Rate3.50%3.00%2.50%2.00%1.50%1.00%

Other Methods and Pensions There are numerous other ways of approaching project valuation – cost benefit etc. Casey provides a good discussion of the other methods and the issues with them in “Applying social investment principles to the provision of long-term cares: issues for consideration” Perhaps the most common place for discount rates to be widely discussed is funded pensions. The most common actuarial method is to use the expected return on assets to discount the estimated ultimate liabilities. But suppose a scheme is 75% funded and the expected return on these is 8%, then the discount rate needs to be 0.75*.08 = 6%, not 8%. Accounting standards specify that government or corporate bond yields should be used. These are exogenous, which introduces bias and volatility into valuations and the corporate financial statements

Claims in Bankruptcy The claim that would be admitted in bankruptcy proceedings is a good measure of the current value of a company’s liability. Suppose we have issued a zero coupon bond which matures in five years, which was issued long ago at a 5% discount rate, then the admitted claim amount would be 100*(1/(1.05^5)) = % Suppose further that we have issued also a zero coupon bond which has the same maturity, but which was issued at 10%, then the admitted claim would be 100*(1/(1.10^5)) = % The claim arising from a conventional bond (acceleration) is the principal advanced and the unpaid (promised) coupon. There is no difference in value between cumulative accrual and discounted PV Markets price securities in distress to reflect these differences. What matters here is what was originally promised and pensions should be no different. The rate promised is the internal rate of return that equalises contributions and estimated pension payments. Long Finance paper. Whether that is secure or not depends on the profitability of the sponsor company. In setting the Ultimate Forward Rate in Germany at 3.40%, the BAFIN say they expressly considered the profitability of the German corporate sector.