Example

King Tobacco Company has entered into negotiations with the State of New Columbia to compensate the state for its health-related costs related to tobacco use. The company says it will pay the State of New Columbia $200,000,000 for the payments incurred by the state over the last twenty year -- which have averaged $10 million per year for the last 20 years.

New Columbia's attorney general, who may be seeking other elected offices, likes the proposed settlement with King Tobacco. The headlines will read: "Attorney general negotiates a $200 million settlement. What is wrong with this? How has King Tobacco gotten a good deal? What should the headline read?

Answer:

The attorney general (a lawyer, no doubt) apparently failed to consider the time value of money. That is, $1 paid 20 years ago is not worth $1 today. The headline should read, "Attorney General leaves millions on the bargaining table." This failure to consider the time value of money, a kind of addled thinking, has routinely arisen in tobacco compensation cases. See "Should Tobacco Companies Pay the Present Value of Damages?"

Accepting the notion that a $1 loss to the state 20 years ago should result in more than a $1 compensation today only begins the analysis. There is also the matter of deciding the interest rate that should be applied to those 20-year-old losses. What interest rate should be used in determining the current value of the state's past tobacco-related costs?

• the risk-free rate of US Treasury notes
• the state's cost of borrowing
• the tobacco companies' cost of debt
• the tobacco companies' cost of equity

What are the different results? See attached spreadsheet. What policy determinations does each of these various discount rates reflect?