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Choice of Discount Rates
Discount Rates are the controlling value in NPV and DCF calculations.
Discounting cashflows to achieve a Net Present Value (NPV) is not without problems but it has one great advantage it makes all the results directly comparable and it is transparent how you got there.
The problems usually arise when different tenderers decide what Discount Rate to apply. But even here, when the principles are applied correctly the selection of the Discount Rate by the tenderer tells us a lot about them and what they think of our project.
For example if a Bank requires or offers a high margin over Base Rate say 5-8% then either it considers you a bad risk or they are themselves. However, if they offer a lower margin 1-3% then the risks can be considered as lower.
To help in understanding the Discount Rate it can be considered almost as the rate of return required by the investor which includes costs, risks and lost opportunities.
Therefore, the discount rate which is used for evaluating projects will vary between different firms or even between projects.
As investment risks are related to time the discount rate choice is even more problematical with long projects that have varying risks, for example PFI projects currently carry a higher perceived risk during the construction phase than the operation phase* .
This means the discount rate value is not universal in time nor is it necessarily valid geographically on a country-wide basis.
For example, the Bank of England might announce its discount rate which influences the commercial banks' interest rates, but even this is not necessarily the most appropriate discount rate for businesses to use in analysing or comparing projects.
The discount rate used to evaluate a project should reflect:-
The cost of the capital (which is unique to the business concerned) - most people have an expectation that their wealth will be greater in the future, so the relative value to them of a particular sum of money will be correspondingly less in the future so an investor, shareholder or lender, requires a return on that investment.
The risk of the project to the business - the benefit of money received now is certain whereas, because there is no guarantee that you will be alive next year, the benefit of money received next year is uncertain there is, therefore, a risk with any investment and that risk tends to grow with time.
The opportunity cost of that capital - money received now can be 'put to work' to earn a return so that, in a year's time it will have accumulated in value.
See Risk in Discount Rate Selection for more detailed analysis.
Therefore, businesses usually apply a discount rate that is substantially higher than the rate of interest charged by, or paid by, the bank to reflect the higher risk involved in most projects relative to investing in the central bank (the central bank interest rate or bond yields can be considered as risk-free and so represent the lower limit of the range of feasible discount rates).
In Private Finance Initiative (PFI) projects the UK Government uses the interest rate, (its own cost or price of capital) as a proxy for the discount rate.
It is certain that the PFI contractor will not be able to borrow at the same rate as the Government nor will all the contractors tendering be able to borrow at the same rate or have a similar WACC (weighted average cost of capital).
*This is the assumption that is currently made when refinancing PFI projects at a lower rate once construction is completed. However The Solution Organisation carried out a high level risk assessment in 2002 and found that with current knowledge and processes the operation phase carries the higher risk.
It also implies it is a “risk free” investment as there is no risk margin added to the cost of capital. Clearly this is not the case as demonstrated by Railtrack’s Administration and the obvious risks in trying to evaluate cost in use for the next 25 – 35 years. Instead they require tenderers to account for Risk elsewhere in their cost plan.
In any case the cost of using a resource (and that includes capital) is not always accurately reflected by its price. The general rule is that the discount rate used to evaluate a project should also reflect the opportunity cost of capital as well.
Projects are not assessed on a stand alone basis as the business will have a range of alternative investment possibilities open to it. By tying up capital in one project, it is sacrificing the possibility of investing the capital in other activities.
The concept of opportunity cost is therefore that the discount rate used must reflect the profitability of the best alternative investment opportunity, in other words the rate of return that is being sacrificed by choosing this project rather than that another.
In practice, companies do not really have their own money. Either they borrow it (debt) or raise it from shareholders (equity) and the banks or investors expect that their money is returned either with interest on the debt or with dividends to shareholders.
The cost of obtaining capital depends on how much of the company's capital is in the form of loans and how much of it comes from shareholders. Shareholders funds are more expensive than Bank borrowing to reflect the risk of each investment. Banks will require 1st charges over business assets to protect their investment which is not available to Shareholders.
The rate of return required by Banks maybe 1 or 2% over base rate but Shareholders will require between 5 and 15% over base depending on historic profit performance, growth rates, what other companies achieve, and the volatility of the company's share price compared to the rest of the stock market.
The ratio of this borrowing produces the Weighted Average Cost of Capital or WACC. A simplified example is a business has £20m of investor’s cash and they require 10% return or £2m per year. It also has £25m of long term Bank borrowings at 5% or £1.25m per year. The current WACC for this business is therefore 7.22% which varies over time as base rates and investor expectations change.
Remember that when a company retains profits from previous years the money is still 'owned' by the company's shareholders who expect it to be used to create future profits. Retained profits are often the most expensive way to fund investments.
Because companies see their investment projects as meeting the requirements of their shareholders and creditors, the discount rate is sometimes referred to as the required rate of return. (Note this is different to the Internal Rate of Return, IRR.)
For a government performing an economic appraisal of a project involving public expenditure, the marginal capital-output ratio of the economy can be used as an indication of the appropriate discount rate as long as Risk and Opportunity Cost is accounted for elsewhere.
The marginal capital-output ratio indicates how productively an economy as a whole uses capital and is defined as the amount of additional output which results from each additional unit of capital invested.
This information would usually be available from the central statistical office. The rationale behind this is that if a project generates a higher rate of return than the economy as a whole, then it should be considered viable.
In practice, governments, public institutions and companies have a test discount rate (TDR), often also called a hurdle rate, that they generally apply, and will not invest if the project gives an internal rate of return (IRR) below this.
Choice of Discount Rate Discount rate IRR