Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/233088 
Year of Publication: 
2021
Series/Report no.: 
Working Paper No. 003.2021
Publisher: 
Fondazione Eni Enrico Mattei (FEEM), Milano
Abstract: 
Because of risk aversion, any sensible investment valuation system should value less projects that contribute more to the aggregate risk, i.e., that have a larger income elasticity of net benefits. In theory, this is done by adjusting discount rates to consumption betas. But in reality, for various reasons (Arrow-Lind and WACC fallacies, market failures), most public and private institutions and people use a discount rate that is rather insensitive to the risk profile of their investment projects. I show in this paper that the economic consequences of the implied misallocation of capital are dire. To do this, I calibrate a Lucas model in which the investment opportunity set contains a myriad of projects with different expected returns and risk profiles. The welfare loss of using a single discount rate is equivalent to a permanent reduction in consumption that lies somewhere between 15% and 45%, depending upon which familiar discounting system is used. Economists should devote more energy to support a reform of public discounting systems in favor of what has been advocated by the normative interpretation of modern asset pricing theories over the last four decades.
Subjects: 
Discounting
Investment Theory
Asset Pricing
Carbon Pricing
Arrow-Lind Theorem
WACC Fallacy
Rare Disasters
Capital Budgeting
JEL: 
G12
H43
Q54
Document Type: 
Working Paper

Files in This Item:
File
Size





Items in EconStor are protected by copyright, with all rights reserved, unless otherwise indicated.