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The practice of estimating the term structure of discount rates

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  • Freeman, Mark C.
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    Abstract

    It is extremely difficult, in practice, to precisely estimate the term structure of discount rates for capital budgeting purposes. In this paper I argue that, with only minor adjustments to current standard practice, a corporate treasurer can determine a multi-period cost of capital that is both theoretically robust and likely to be sufficiently accurate for most practical purposes. For this to be the case, corporations should have a preference for using real, rather than nominal, discounted cash flow techniques.

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    Bibliographic Info

    Article provided by Elsevier in its journal Global Finance Journal.

    Volume (Year): 19 (2009)
    Issue (Month): 3 ()
    Pages: 219-234

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    Handle: RePEc:eee:glofin:v:19:y:2009:i:3:p:219-234

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    Web page: http://www.elsevier.com/locate/inca/620162

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    Keywords: Capital budgeting Discounted cash flow analysis Cost of capital Risk-free rate Real analysis;

    References

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    1. Van Horne, James C., 1971. "A Note on Biases in Capital Budgeting Introduced by Inflation," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 6(01), pages 653-658, January.
    2. John Y. Campbell, 1992. "Intertemporal Asset Pricing Without Consumption Data," NBER Working Papers 3989, National Bureau of Economic Research, Inc.
    3. M. J. Brennan, 1997. "The Term Structure of Discount Rates," Financial Management, Financial Management Association, vol. 26(1), Spring.
    4. Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, vol. 56(1), pages 247-277, 02.
    5. Jow-Ran Chang & Mao-Wei Hung, 2002. "Intertemporal hedge for inflation risk," Applied Economics Letters, Taylor & Francis Journals, vol. 9(4), pages 241-243.
    6. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
    7. Fama, Eugene F., 1977. "Risk-adjusted discount rates and capital budgeting under uncertainty," Journal of Financial Economics, Elsevier, vol. 5(1), pages 3-24, August.
    8. Weitzman, Martin L., 1998. "Why the Far-Distant Future Should Be Discounted at Its Lowest Possible Rate," Journal of Environmental Economics and Management, Elsevier, vol. 36(3), pages 201-208, November.
    9. Pizer, William & Newell, Richard, 2000. "Discounting the Distant Future: How Much Do Uncertain Rates Increase Valuations?," Discussion Papers dp-00-45, Resources For the Future.
    10. Nelson, Charles R, 1976. "Inflation and Capital Budgeting," Journal of Finance, American Finance Association, vol. 31(3), pages 923-31, June.
    11. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    12. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
    13. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
    14. Constantinides, George M., 1980. "Admissible uncertainty in the intertemporal asset pricing model," Journal of Financial Economics, Elsevier, vol. 8(1), pages 71-86, March.
    15. Martin D. D. Evans, 1998. "Real Rates, Expected Inflation, and Inflation Risk Premia," Journal of Finance, American Finance Association, vol. 53(1), pages 187-218, 02.
    16. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May.
    17. Constantinides, George M, 1982. "Intertemporal Asset Pricing with Heterogeneous Consumers and without Demand Aggregation," The Journal of Business, University of Chicago Press, vol. 55(2), pages 253-67, April.
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    Cited by:
    1. Freeman, Mark C., 2009. "Yes, we should discount the far-distant future at its lowest possible rate: a resolution of the Weitzman-Gollier puzzle," Economics Discussion Papers 2009-42, Kiel Institute for the World Economy.

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