Many factors affect investment decisions, and exponential discounting is one of the most important. It is a method that allows one to value a company, project or other asset. You will use the expected cash flows and take into account the time-value of money. Exponential discounting strives to value cash flows in the future as how much you would currently invest to get the future cash flow. It uses a specific rate of return.
An important hallmark of exponential discounting is that it assumes times consistency. The declination is at a consistent rate. Distance between two points is all that is important when finding the discount factor, not the time when it occurs. This can cause the strategy to be less accurate, and this inaccuracy must be understood when investment decisions are made.
The discounted present value formula is DPV = FV/(1+i)^n = FV(1-d)^n. The discounted present value is DPV, the nominal value of a future cash amount is FV, the interest rate is I, the discount rate is d, and the amount of years before the cash flow comes is n.
Exponential discounting allows people to make more informed decisions about investments because it gives them a better idea of what the investment may actually be worth because of the foresight into future risk and valuations. The discount rate looks to take into account factors that may not be predictable such as the chance that the money will not return as expected. Of course it is important to understand the role of inflation when making investments, and exponential discounting can help accommodate that.
Exponential discounting allows investors to take risk into account when choosing investments. There is no guarantee in most investments that the money will be there. The weighted average cost of capital (WACC) is often utilized as an excellent way to take time value of money and risk premium into account.
One criticism of exponential discounting is that there is no one way to tell exactly what the discount rate should be. According to the Bren School of Environmental Science and Management at the University of California, there is no consensus when choosing an appropriate discount rate. An example was given where over 2000 PhD level economists responded with different ideas on the discount rate.
There are also problems with intergenerational equity. Non-exponential discounting has been seen in human behavior. Thus this may not be as accurate a picture as can be seen in other methods and lead to investment decisions that are not as sound. An alternative to exponential discounting is hyperbolic discounting. This takes into account that in the short-turn discount factors fall at a greater rate than in a longer time span.
According to Aislie (1991) exponential discounting is generally utilized in financial markets. Using something else may create opportunities in arbitrage. These may be exploited.
It is important to understand the intricacies of exponential discounting because of its great affect on investment decisions. Consider the implications of this practice when managing your financial portfolio.