Financial markets influence real projects and thus the real economy.
Financial markets determine the discount rate of firms, for example, by linking market-wide asset return averages to the firm using the Capital Asset Pricing Model (CAPM), and they enable the separation of ownership and management. Both facts lead to a lack of commitment among equity holders, shorter investment horizons, and higher required returns.
Shareholders lack commitment to the firm they invest in, due to the highly dispersed ownership in general and the abundance of alternatives: at any 81 Time Value of Money and Sustainability
Table 1. Discounted Cash Flow Analysis with Positive Cash Flows Early and Negative Cash Flows Late.
0 1 2 3 4 5 6 7 8 9 10
Panel A
CF 100 100 100 100 100 100 100 100 100 100 100
PV 100 90.91 82.64 75.13 68.30 62.09 56.45 51.32 46.65 42.41 38.55
NPV 43.70 NPV>0 Acceptance of project
Discount rate 10%
Panel B
CF 100 100 100 100 100 100 100 100 100 100 100
PV 100 95.24 90.70 86.38 82.27 78.35 74.62 71.07 67.68 64.46 61.39
NPV 6.28 NPV<0 Rejection of project Discount rate 5%
Notes:TheDCFis performed with a 10% discount rate (Panel A) and a 5% discount rate (Panel B). The cash flows from year 0 to year 10 illus- trate that relatively high discount rates can lead to the acceptance of a project that is unsustainable given the significant costs in years 610 (Panel A). Panel B shows that such a project is rejected for a 5% discount rate.
DIRKBAURANDTHOMASLAGOARDE-SEGOT
Table 2. Discounted Cash Flow Analysis with Negative Cash Flows Early and Positive Cash Flows Late.
0 1 2 3 4 5 6 7 8 9 10
Panel A
CF 100 100 100 100 100 100 200 200 200 200 200
PV 100 90.91 82.64 75.13 68.30 62.09 112.89 102.63 93.30 84.82 77.11
NPV 8.32 NPV<0 Rejection of project Discount rate 10%
Panel B
CF 100 100 100 100 100 100 200 200 200 200 200
PV 100 95.24 90.70 86.38 82.27 78.35 149.24 142.14 135.37 128.92 122.78
NPV 145.50 NPV>0 Acceptance of project
Discount rate 5%
Notes:TheDCFis performed with a 10% discount rate (Panel A) and a 5% discount rate (Panel B). The cash flows from year 0 to year 10 illus- trate that relatively high discount rates can lead to the rejection of a project that is sustainable given the significant positive cash flows in years 610 (Panel A). Panel B shows that such a project is accepted for a 5% discount rate.
83TimeValueofMoneyandSustainability
point in time, shareholders can exit by selling their shares on the secondary market.3 Aligning corporate governance with the interests of shareholders biases investment strategies toward the short term, which is sometimes infor- mally referred to as the “dictatorship of the quarterly report.” This mechan- ism is magnified by the development of managerial compensation schemes, such as stock options, seeking to align the remuneration of senior managers with the interests of shareholders. The explicit objective of these mechanisms is to refocus managerial attention toward the maximization of share prices.
This would not be a problem if the management considered investing in long- term projects. However, due to the separation of ownership and control, managers are often given insufficient time to invest in projects that do not lead to immediate returns. The shareholder governance principle appears to stand in sharp contradiction with the intra-generational and intergenera- tional equity principles of sustainable development.4
One common characteristic of the models that assess project feasibility is that they equalize the time value of money with the required rate of return of the firm’s debt holders (cost of debt capital) and equity holders (cost of equity capital), itself considered an exogenous factor depending on observed equilibrium conditions in the capital market (Sharpe, 1964). The weighted average cost of capital (WACC) corresponds to a weighted aver- age of the cost of equity capital (CE) and the cost of debt capital (CD), net of corporate income tax (t):
WACCẳ D
DỵEð1tịCDỵ E DþECE
where D and E represent the value of corporate debt and equity, respec- tively. Finally, the required return on equity (CE) is estimated separately; a common approach is to use the capital asset pricing model (CAPM).5The CAPM can be written as follows
CE ẳEðRiị ẳRFỵβiðEðRMị RFị
whereE(Ri) denotes the expected or required rate of return of firmiwhich is equal to the cost of equity capital, RFis the risk-free return component, usually the yield of a “safe” government bond,E(RM) is the expected return of the market comprising all available assets andβ (beta) is the sensitivity of the firm’s shares to market movements in excess of the risk-free rate (the
“equity risk premium”).
The CAPM shows that a firm’s cost of equity capital is determined essentially by its β, as the risk-free rate and equity premium are the same for all firms.
TheNPV using the weighted average cost of capital (WACC) as a dis- count rate is then written as follows:
NPV ẳ IO0ỵ CF1
ð1ỵWACCị1ỵ…ỵ CFT
ð1ỵWACCịT
One interesting implication of the relationship between the discount rate and sustainability is that firms with more debt financing would tend to accept more sustainable projects than firms with more equity financing if the cost of debt is lower than the cost of equity. The debt-equity implica- tions for sustainability also point to the non-neutrality of the capital struc- ture. The potentially positive role of debt financing for sustainability also stresses that in this context equity is not necessarily better than debt.
However, the focus in this chapter is on sustainable (real investment) pro- jects and not on sustainable debt.
The above examples highlight one implicit feature of financial theory:
the time value of money and thus the discount rate being largely deter- mined by capital markets, all decisions made by capital owners have an impact on sustainability (Lagoarde-Segot, 2015).