A Simple Discounting Rule Author(s): Fischer Black Reviewed work(s): Source: Financial Management, Vol. 17, No.

2 (Summer, 1988), pp. 7-11 Published by: Blackwell Publishing on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665521 . Accessed: 07/01/2012 10:55
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Simple

Rule Discounting

FischerBlack
New York, Sachs& Company, at Blackis a partner Goldman, Fischer NY.

How can we discountfuturecash flows fromeither an actual or proposed investment?When the future cash flows are certain,we discountthem at a riskless In we ratewith an appropriate maturity. principle, can observethe rate we want by looking at the price of a pure discountbond. In practice,however,such bonds and maybe unavailable, pricinga couponbondmaybe tax factorsand call features.Even so, complicatedby we can probablycome up with a reasonableapproximateprice. Whenthe futurecashflowsareuncertain, discountbecomesmore complex.In general,the rightproing cedure will be one that depends on the covariance between the cash flow and aggregateconsumption, which can be highly state-dependent. In a simpler model, the discountingprocedurewill dependon the
0

betweenthe changein the expectedcash covariances betweennowandthe time flow andthe marketreturns of the cashflow.2 In certain special cases, the correctrule is to discount the expectedcash flow at a constant rate that depends on the beta of the cash flow'svalue and the market'sexpectedreturn.This rule requiresthat we know three items besides pure discountbond prices: the expectedcash flow, the cashflow beta, and the exAll pectedreturnon the market. aredifficultto estimof ate.3If we startwith the joint distribution the cash we flow andpriormarketreturns, will use the betaand the expectedmarketreturnin estimatingthe expected cashflow;then we will reusethem to discountit. Undercertainconditionsthesetwousesfor the beta and the expectedmarketreturnwill canceleach other out. The presentvalueof the cashflowwill then be in-

I am grateful to Richarad Ruback for many helpful discussions of this topic, and to Carliss Baldwin, Eugene Fama, Michael Jensen, Phillip Jones, Mark Latham, Robert Merton, Stewart Myers, Stephen Ross, and William Schwert for comments on an earlier draft. IFor examples of models in which this is true, see [2,8,9,11,14]. Cornell [5] points out some practicaldifficulties in using this procedure. 7

2For example, see Brennan [4], Treynor and Black [15], and Fama [7]. 3These difficulties are discussed by Myers and Turnbull [12] and by Fama [7].

FINANCIAL 1988 MANAGEMENT/SUMMER

dependentof both the beta and the expectedmarket return.We can solve for the presentvalueby estimating the cash flow-assuming that all priormarketreturnswereequalto the interestrate.Thenwe discount the cashflow at the sameinterestrate. In practice,this may be an easy ruleto use. We do not estimate a joint distribution cash flows with of priormarketreturns.We just estimatethe cash flows for one possible sequenceof marketreturns.(We do this assuming that subnormaleconomic conditions cause the market return be only equalto interest,at to the risklessrate,in each period).Thenwe discountat the interestrate. We do not even have to estimatethe expectedcash flows. A simplerway may be to estimatethe cash flow assumingan arbitrary and an beta market return.Thenwe discountat arbitrary expected a ratethatuses the same beta and the same expected marketreturn. It is important startwith conditionalexpected to cash flows, rather thanunconditional ones. It is easier and it certainlytakes to formconditional expectations less effortto discountconditional expectedcash flows ones. thanunconditional An examplewill help us to explainhow to use the rule.Assumethatthe short-term risklessinterest is rate constantat 10%peryear, andthatthe expectedreturn on themarket somehowknownto be constant 20% is at per year. Now supposethat a firm is consideringan investment with a cash payoffat the end of each year thatdependson the marketreturn thatyear. When for the marketreturnis 10%, the payoff for the year is return 20%, the payoff is $150,000. Whenthe market is $250,000. The payoff increases or decreases by or $10,000 for eachpercentage pointincrease decrease return theyear. Eachyear, the payoff for in the market will dependon thatyear's marketreturn,but not on returns prioryearsor on anything for else. Thepayoffs will follow this pattern year afteryear into the indefinite future. To estimatethe presentvalue of the payoffs from thisinvestment, use thesimplediscounting and we rule the 20%expectedreturn the market,making on ignore no attempt estimatethe beta of the project,nor any to of its cashflows. We assumethateachyear's payoffis $150,000, because that is what it will be when the returnon the marketis equal to the constantinterest rate, 10%. Then we discounta perpetualstreamof value $150,000 payoffsat 10%,which gives a present of $1,500,000.

We can also value these payoffs startingfrom the expected payoffs and using the payoff betas. In this on example,thebetafor eachpayoffdepends time:it is high in theyearbeforethe payoffdate,butzerobefore that, since the payoff dependsonly on the marketreturnin the yearbeforethe payoff.Thus, the discountthat ing procedure uses betasis complex- so complex thatthereis no easyway to show how it appliesto this example.

II.Excess Returns
Let'sassumea worldwherethe simplecapitalasset pricingmodelholdsin eachinfinitesimal period.There are no taxesor transaction costs. Supposeyou are offered a cash flow at the end of a shortperiodstarting at time t, wherethe dollaramountof the cashflowwill be equalto the percentage excessreturnon the market on a dollar investmentover that period. The excess returnis the marketreturnminusinterestat the shorttermrisklessinterestratefor the period.Whatwould you payfor this cashflow? You wouldpaynothing.You canget the samecash flow without puttingup any money.You simplyborrow to invest in the marketat the startof the period. Since you put up no money,the presentvalue of the payoff from this investmentmust be zero. Thus the presentvalue of the excessreturnon the marketover some futureperiodmustbe zero.4Similarly, presthe ent value of any multipleof the excess returnon the marketmust be zero. You just borrow a different amount investin themarket.In fact, the amount to you borrowcandependin anyway on pastmarket returns. The present value of a multipleof the market's excess return,where the multiplierdependsin any way on will be zero. The same is trueof past marketreturns, excess returns securities on otherthanthe market. And the multiplier dependon anyvariables will be can that known at time t, even thoughthey may be unknown today.

I. An Example

Ill. Joint Normality Other and Distributions

In the simplestcasethe cashflowandmarket returns in prior periods follow a joint normal distribution. Thus the cash flow is a constant,plus constantstimes the variousmarketreturns, cashflowinplusa random
4This is a special case of the arbitrage result obtained by Ross [13]. Margrabe [10] has a very similar result.

RULE DISCOUNTING SIMPLE BLACK/A

dependent of all the market returns.The expected value of the randomcashflow is zero. Thevalueof a sumis the sumof thevalues.Thevalue of a constantis obtainedby discountingthe constant usingthe priceof a discountbond.The value of a constantmultipleof the marketreturnis the value of the same multiple of the market excess return plus the value of the same multipleof interestfor the period. Since the excessreturnportionhas a valueof zero,we just discountthe interestportion using the price of a discountbond. The value of the randomcash flow is zero. In otherwords,we startwith a cash flow writtenas a linearfunctionof marketreturns.We replaceeach marketreturnby interestat the risklessratefor the apby propriateperiod, and discountby multiplying the priceof a purediscountbond that maturesat the time random of the market return. ignorethe purely We part we of the cashflow.Sincethe periodsareinfinitesimal, betweenthe startand do notworryaboutthe difference the end of the period. Now supposethat the cash flow is a constanttimes one plusthe returnon the marketfor the entireperiod betweennowandthe timeof the cashflow.5If we know in advancethe varianceand expectedreturnson the market,the resultingdistributionwill be lognormal. We will not be able to describeit as joint normalwith the marketreturnsin prior periods.But the present value of a constanttimes one plus the marketreturn over anyperiodmustbe that constant,becausewe can duplicatethe payoffby investingthat constantin the market. We can also solve for thatconstantby assuming the marketreturnequalsthe interestin each period,and then discountusing the same interestrates.Thus the case as well as the simpleruleworksfor the lognormal joint normalcase.In fact,it workswhetherthe market returnis lognormalor not. It works for any process governingthe marketreturn.The presentvalue of a constanttimes one plus the marketreturnis that constant. the Bya similarargument, simplerulealsoworksfor securitiesother than the market.It works when the cashflow is a constanttimesone plusthe returnon any for security the entireperiodbetweennowandthe time of the cashflow.It evenworksforanarbitrary portfolio. The cash flow can be a constant times one plus the

returnon anyportfoliofor the entireperiodbetween now andthe time of the cashflow.The compositionof the portfoliocanbe changing constantly. Assume thatwe revise our expectationabouta futurecashflow according the followingrule.6The exto pected cash flow at the startof each period times a random revisionfactoris the expectedcash flow at the endof the period.Therevisionfactoralways a mean has withthe of one, andfollowsa joint normaldistribution marketreturnfor the same period.At the end of the last period, the expectedcash flow equals the actual cash flow. Successiverevisionsare independent. The one-periodversion of this case has been discussedabove.(It is a joint normalcase.) Note thatthe expectedcash flow conditionalon the marketreturn beingequalto interestfor the periodis lowerthanthe expectedcashflow.We do not need the expectedcash flow at all. We simply discount the conditional expectedcashflow at the risklessinterestrate. We repeatthe processfor the first periodof a twoperiodexample.The value of the cashflow at the end with the firstperiod's of the firstperiodis joint normal revision.To findthe valueat the startof thefirstperiod, we figurethe expected valueconditionalon the market returnbeing equal to risklessinterestfor the period, and discountat the interestrate. We can repeat this of processfor anynumber steps.The simpleruleworks again.We find the expectedvalue of the cashflow, asreturn sumingthatthe actualmarket equalsinterestfor the periodfor everyperiodbetweennow and the time of the cash flow. We then discount this value using those sameinterestrates.

IV.Multiplicative Revisions

V. Options

When won't the simple discountingrule work? When the cash flow is a non-linearfunctionof the marketreturnin any given period, holdingfixed the marketreturnsin otherperiods. This means the rule will not work for an option.7An option on one plus

6This is a rule discussed by Fama [7]. 7This is pointed out by Myers and Turnbull [12]. A more general discounting procedure that does apply to options is given in [4,6,14,15]. A still more general procedure is derived by Banz and Miller [1]. They use the notion of estimating cash flows contingent on what the market does in a more general way than I. Thus the simple discounting rule can be regarded as a special case of their analysis. It can also be regarded as an application of Theorem 2 in Breeden and Litzenberger

5This is a special case of the result obtained by Margrabe [10] and by Ross [13].

[3].

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FINANCIAL 1988 MANAGEMENT/SUMMER

the marketreturn,for example,has a payoffequal to the truncateddistributionof possible end-of-period values of the marketportfolio.The untruncated distributioncan be discountedwith the simple rule, but distribution. The option alwayshas not the truncated a positivevalue, but applyingthe simple discounting will ruleto the truncated distribution give a zero value if the option'sexercisepriceis sufficiently high.So, the simplerulewill not work.

VI.Estimationand Extensions
Most thinkthat it is easier to form conditionalexones. Why?If we form pectationsthanunconditional our conditionalexpectationsby doing regressionson we pastdataandpluggingin the conditions want,why can'twe just takethe samplemeanfromthe samepast It data,anduse it for an unconditional expectation? is the ofteneasierto estimate slopeof a relation involving securityreturnsthanto estimateits intercept,but the conditional dependson boththe slope and expectation be the intercept.Whey shouldthe intercept estimated thanthe samplemean from past more accurately any data? most do not thinkof formingexpectations Perhaps frompastdatain thisway. Maybetheystartwith ideas variousstatesof aboutwhatthecashflow will be under of the world, multiplyby the probabilities the states, andsum. Thiswill give the unconditional expectation. If this is what people do, then forminga conditional expectationwill be easier than formingan unconditional one; they will not need as many probabilities, norneedto do as muchsumming.Or, perhaps managbetweenthe cash flow and ers knowthe linearrelation returns.In thatcase, they mustknow the priormarket marketreturnsto know the unconditional expected expectedcashflow. It is easierto formthe conditional expectedcash flow since you do not need to estimate the expectedmarketreturnfor each period. It turnsout, though,that the presentvalue of the cashflow is independent whatwe assumeaboutthe of expectedmarketreturnin this case.The higherthe expected marketreturn,the higherthe expectedfuture cashflow,butthe higherthe discountrate.Thuswe can, if we wish,follow the modifiedprocedure. Imaginean economicscenario, estimateits cashflow,andcalculate the marketreturnfor it. Then discountthe cash flow usinga ratebasedon an expectedmarketreturnequal to thatmarketreturn. Thisscenariomaybe easierto imaginesinceit need not be as drearyas one where the marketreturnonly equalsinterestin each period.It maybe easier to es-

timate the cash flow conditionalon good economic conditions and then to discount as if the expected marketreturnwere equal to the actualmarketreturn for those conditions.Using this modifiedprocedure, the beta we use will not matteras long as we use the the samebetaforprojecting cashflowandfordiscountThismeanswe will not haveto worryabouthaving ing. just the rightbeta. Outlinedbeloware some possibleextensionsof the basicrule. (i) In a simple model with taxes,where personal and corporatetax rates are the same, but where and firmspayno dividends individuals no cappay inital gainstaxes,the rulewoulduse the after-tax terest rate. We would first estimate cash flows conditionalon marketreturnsthat are alwayserate.Thenwewould qualto interestat the after-tax discountat the after-tax interestrate. (ii) In morecomplexmodelswherethereis an optimal capital structure,and where dividendand capitalgains taxes matter,the rule will be more complex.If we are worriedabout a farmerwhose cashflowsdependon commodity pricesandcorrefuturesprices,andnot in anyotherways sponding thenwe canuse a modon the stockmarket return, cashflowsasified rule.We estimatethe farmer's Then all futurespricesremainunchanged. suming we discountas before. (iii) Finally,we can use the consumptionversion of the capitalasset pricingmodel.8In this casewe estimatethe cash flows assumingthat a portfolio withtotalconcorrelated whosereturnis perfectly has a returnin each periodequal to insumption for terestat the rateappropriate thatperiod.Then as before. we discount

References
Claims: 1. R.W. Banz and M.H. Miller, "Pricesfor State-Contingent Some Estimatesand Applications,"Journal of Business (October 1978), pp. 653-672. 2. D. Breeden, "AnIntertemporal Capital Asset Pricing Model with Stochastic Consumption and Investment Opportunities,"Journal of Financial Economics (September 1979), pp. 265-296. 3. D.T. Breeden and R.H. Litzenberger, "Pricesof State-Contingent Claims Implicit in Option Prices,"Journal of Business (October 1978), pp. 621-651. 4. M.J. Brennan, "AnApproach to the Valuation of Uncertain Income Streams,"Journal ofBusiness.(October 1978), pp. 653-672.

8See, for example, Breeden [2].

SIMPLEDISCOUNTING RULE BLACK/A

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5. B. Cornell, "The Consumption Based Asset Pricing Model: A Note on Potential Tests and Applications,"Journal of Financial Economics (March 1981), pp. 103-108. 6. U. Dothan and J. Williams, "Term-RiskStructures and the Valuation of Projects,"Journal of Financial and QuantitativeAnalysis (November 1980), pp. 875-905. 7. E.F. Fama, "Risk-Adjusted Discount Rates and Capital Budgeting Under Uncertainty,"JournalofFinancial Economics (August 1977), pp. 3-24. 8. J.B. Long, "Consumption-Investment Decisions and Equilibrium in the Securities Market,"in Studies in the Theoryof Capital Markets,M. C. Jensen (ed.), New York, Praeger, 1972, pp. 146222. 9. R.E. Lucas, Jr., "Asset Prices in an Exchange Economy," Econometrica (November 1978), pp. 1429-1445.

10. W. Margrabe, "Alternative Investment Performance Fee Arrangements and Implications for SEC Regulatory Policy,"Bell Journal of Economics (Autumn 1976), pp. 716-718. 11. R.C. Merton, "An Intertemporal Capital Asset Pricing Model," Econometrica (September 1973), pp. 867-887. 12. S.C. Myers and S.M. Turnbull, "CapitalBudgeting and the Capital Asset Pricing Model: Good News and Bad News,"Journal of Finance (May 1977), pp. 321-332. 13. S.A. Ross, "A Simple Approach to the Valuation of Risky Streams,"Journal of Business (July 1978), pp. 453-475. 14. M. Rubinstein, "The Valuation of Uncertain Income Streams and The Pricing of Options," Bell Journal of Economics (Autumn 1976), pp. 407-425. 15. J.L. Treynorand F. Black, "CorporateInvestmentDecisions," in Modern Developments in Financial Management, S.C. Myers (ed.), New York, Praeger, 1976, pp. 310-327.

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