investment. Additionally, companies often use a hurdle rate, the minimum acceptable return for an investment or project, typically based on WACC plus a risk premium. Another key measure is the Internal Rate of Return (IRR), which represents the discount rate at which the net present value (NPV) of a project’s cash flows equals zero, making it useful for evaluating and comparing investment opportunities. Discount rates within financial analysis are often kept constant 21 . This allows the investor to have a fixed assumption around the cost of capital, risk and required rate of return over a given investment period, whilst analysing opportunity costs and maintaining a consistent approach when comparing multiple investment opportunities. Static discount rates are referred to as exponential discounting , as the present value of future rewards decreases exponentially overtime and therefore, the weight of future value declines over time, gradually trending to 0. This framework assumes time consistency: for example, an individual’s preference between receiving $100 today versus $110 in one year is treated as equivalent to their choice between $100 in ten years and $110 in eleven years. Such models are normative in nature, prescribing how rational investors should discount future cash flows under the assumptions of modern finance theory. While mathematically elegant and widely adopted as the industry standard, the model may oversimplify and fails to capture behavioural characteristics, such as present bias or changing preferences over time, especially as risk appetites shift with circumstances, such as volatility. 22 The same concept applies to the propensity to invest in areas such as climate change mitigation, where shifting perceptions of risk are amplified by increasingly severe repercussions. This raises a critical question concerning whether such models should adapt when underlying assumptions and variables change due to shifts in risk appetite or economic volatility. Moreover, certain behavioural biases can also be observed with the choice of the discount rate. Conventional models assume unbounded rationality (also known as perfect rationality), which views decision-making optimization as a fully rational process of finding an optimal choice given the information available. This contrasts with the reality of ‘bounded rationality’ 23 , which recognises the discrepancy between the assumed optimisation of homo economicus and the vagaries of actual human behaviour. Perfectly rational decisions are often infeasible in practice because of the intractability of decision problems and the finite computational resources available to decision- makers. From this perspective, a discount rate may be interpreted as a bounded rationality approach to investment decisions: decision makers rest on subjectively determined aspiration levels. Consequently, humans often do not undertake a full cost-benefit analysis to determine the optimal decision, but rather, choose an option that fulfils their adequacy criteria rather than a rationally optimal one. Berg (2003, 2014) 24 proposed the use of behavioural economics as a normative tool in terms of critiquing NPV models suggesting that the model was influenced by normative logics of 21 See more at: Hayes, A. (2023). Discount Rate Defined: How It’s Used by the Fed and in Cash-Flow Analysis. [online] Investopedia. Available at: https://www.investopedia.com/terms/d/discountrate.asp. 22 See Shiller, R.J., 1990. Market volatility and investor behaviour. The American Economic Review , 80 (2), pp.58-62; Shiller, R.J., 2003. From efficient markets theory to behavioural finance. Journal of economic perspectives , 17 (1), pp.83-104. 23 ' Bounded rationality is the idea that rationality is limited when individuals make decisions, and under these limitations, rational individuals will select a decision that is satisfactory rather than optimal: Sent, E.M., 2018. Rationality and bounded rationality: you can’t have one without the other. The European Journal of the History of Economic Thought , 25 (6), pp.1370-1386. See also Simon, H.A., 1990. Bounded rationality. In Utility and probability (pp. 15-18). Palgrave Macmillan, London, Jones, B.D., 1999. Bounded rationality. Annual review of political science , 2 (1), pp.297-321. 24 Berg, N., 2003. Normative behavioural economics. The Journal of Socioeconomics , 32 (4), pp.411-427, Berg 2014, "The consistency and ecological rationality approaches to normative bounded rationality." Journal of Economic Methodology 21.4: 375-395.
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