Three Methods for Determining Discount Rates - Coursework Example

Discount Rate: Overview: A discount rate is used to convert flows of costs and benefits over time into a net present value. There are two key reasonsfor doing this. The first is to determine whether a project is worthwhile, that is whether or not it has a positive net present value. The second reason is to compare two projects that achieve the same objective but have different timeframes. For example a discount rate can be used to inform the choice between a lease option and a buy option for accommodation if trying to choose the most cost effective approach (Roll, 1977). The discount rate which is used in financial calculations is usually chosen to be equal to the cost of capital. Some adjustment may be made to the discount rate to take account of risks associated with uncertain cashflows, with other developments. The discount rates typically applied to different types of companies show significant (Warner, 2001): Startups seeking money: 50 - 100 % Early Startups: 40 - 60 % Late Startups: 30 - 50% Mature Companies: 10 - 25% Reason for high discount rates for (Warner, 2001): Reduced marketability of ownerships because stocks are not traded publicly Limited number of investors willing to invest Startups face high risks Over optimistic forecasts by enthusiastic founders. Evaluating an investment project can require the use of approaches designed to integrate the consideration of the flexibility and uncertainties associated with the investment opportunity under study (Robert Wilson, 1982). Regardless of the approach adopted, a project evaluation, based on deterministic hypotheses, is nonetheless inevitable at some given moment. The problem that arises is the choice of the 'conventional' method which helps to determine the project value with due integration of the financing related aspects. As Brealey and Myers (Robert Wilson, 1982) show it, various methods can be used, including standard WACC, Arditti-Levy, equity residual and adjusted present value. Historically, with certain assumptions, the consistency of these methods has been demonstrated by comparing them in pairs by Robert Wilson, 1982. However, this consistency could also suggest the existence of a single approach underlying these different methods, and from which they could all derive. NPV The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment. It should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix (Ross,1976). Managers may use models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Some believe that a higher discount rate is more appropriate when a project's risk is different from the risk of the firm as a whole(Ross,1976). In capital budgeting the correct risk adjusted discount rate for future cash flows is independent of whether the flow is a cost or a revenue. Contrary to a widely disseminated view in some popular textbooks and elsewhere, costs are not especially safe (nor risky), and accordingly costs should not be discounted at especially low risk adjusted discount rates (Robert, 1998). Three Methods for Determining Discount Rates 1. The historical approach: One approach to find discount rates is to assume that the average rate which has been observed in the past will continue into the future. Typically, those who use this approach rely on the real interest rates which have been reported over a decade. What analysis of these rates indicates is that real rates were fairly stable over the period 1950-1970, at approximately 3 percent. During the oil crisis, of the early 1970s, real interest rates fell, sometimes becoming negative. Towards the end of that decade, however, they began to rise again and it appeared that they would return to their historical level. But the rise continued beyond 3 percent and since 1983 real interest rates have consistently remained above that level. Indeed, real interest rates have remained above 4 percent for so long that it is now difficult to justify the use of a rate lower than that. 2. Forecasting agencies: Another method of determining discount rate for risky projects is by taking the help of forecasting agencies, which provide forecasts of such economic variables as GNP, the unemployment rate, and inflation. They also forecast other variables, including the real rate of interest. Extreme caution must be used when employing these firms' long-term forecasts, however. First, the mathematical models which they employ are built specifically to make short- term forecasts. Second, long-term forecasts cannot be made without imposing assumptions about many factors which are outside the mathematical models developed by these agencies, such as foreign interest rates, exchange rates, and government monetary and fiscal policy. Finally, private forecasters have little incentive to produce accurate long-term forecasts. A consulting firm's reputation will not hinge in any way on the accuracy of its current forecasts concerning, say, the level of unemployment in 2020. The forecasts which customers use to evaluate the agencies' accuracy are those which have been made into the near future, not the distant future. Hence, it is forecasts of one or two years on which consulting firms concentrate their resources. The real rate of interest, on the other hand, must commonly be forecast twenty or thirty years into the future. 3. Market rates: The third source of information concerning future real rates of interest is the money market. When an investment firm which believes that inflation will average 2 percent per year purchases 20 year bonds paying 6 percent, it is revealing that it expects the real rate of interest will average 4 percent over those 20 years. (The real rate of interest is the 6 percent observed, or "nominal," rate of interest net of the 2 percent inflation.) Thus, if we knew the rate of inflation which investors were forecasting, that forecast could be used to deflate the nominal rates of interest observed in the market in order to obtain the implicit, underlying real rates. At the moment, such forecasts can be obtained with some accuracy. Not only do surveys of investors conclude that there is considerable agreement among them with respect to their forecasts of inflation - generally between 2 and 3 percent - but we know that the government is strongly committed to maintaining a long-run inflation rate below 3 percent. Thus, we can be confident that investors predict real rates of interest which are no less than the observed, nominal rates less 3 percent. Finding the correct discount rate requires a deeper analysis of why people prefer a given "quantity" of present benefit over the same "quantity" of future benefit. Economists emphasize two explanations: the opportunity cost of forgone benefits, and pure time preference (Robert Wilson, 1982). Economists base the concept of social opportunity cost on the productivity of capital. Generally, investment of resources today generates a larger quantity of resources available for future consumption. Thus, the future return from investment (which itself represents forgone present consumption) is essentially a future flow of consumption. The interest rate, and thus the discount rate, reflect the opportunity cost of relinquishing present consumption (Stephen, 1983). The pure time preference principle is grounded mostly in impatience; people prefer receiving benefits immediately over receiving them some time in the future. Economists sometimes call the discount rate derived from this principle the Social Time Preference Rate (Turner). Pure time preference also may evidence a belief that future societies are likely to be richer, making an extra dollar of benefit worth less in the future than it is to the current society. Economists often call this rationale for discounting the "diminishing marginal utility" argument. Most economists agree that the discount rate that the time preference explanation suggests--which we will call the social discount rate--is substantially lower than the rate that the opportunity cost indicates (Gramlich). Current estimates, based on the long-term real rate of return on riskless investments (Treasury notes and bonds), are in the neighborhood of one percent (Robert, 1982). Conclusion: In a world without taxes, the social discount rate should equal the opportunity cost. But the tax system drives a wedge between the two (Robert, 1982). For example, if individuals use a two-percent discount rate for personal consumption, they will choose to save only if given a two-percent return. But to generate a two-percent return after taxes to consumers, firms must invest in projects offering a higher return. If business and personal taxes take a combined "bite" of fifty percent out of firm income by the time it reaches shareholders, the firm will need to earn a four-percent return in order to give shareholders their two-percent after-tax return. Thus, in this simple example, the social discount rate is two percent, while the implicit opportunity cost of capital is four percent. As we will see, the distinction between the social discount rate and the opportunity cost of capital has crucial importance for cost-benefit analysis (Robert, 1982). References: Gramlich, Guide to Benefit-Cost Analysis at 102 (cited in note 40). Jonathan Baron, Thinking and Deciding 438 (Cambridge, 1988). Pearce and Turner, Economics of Natural Resources at 213 (cited in note 48). Robert Ariel, 1998, Risk adjusted discount rates and the present value of risky costs.The Financial Review 33 (1), 17-30. doi:10.1111/j.1540-6288.1998.tb01604.x Robert C. Lind, 1982 A Primer on the Major Issues Relating to the Discount Rate for Evaluating National Energy Options, in Robert C. Lind, et al. Discounting for Time and Risk in Energy Policy 24-32. Robert Wilson, 1982, Risk Measurement of Public Projects, in Lind, Discounting for Time and Risk at 205. Roll, R., "A Critique of the Asset Pricing Theory's Tests", Journal of Financial Economic, March 1977, pp. 129-176 Ross, S. A. "The Arbitrage Theory of Capital Asset Pricing." Journal of Economic Theory, December 1976, pp. 343-362. Stephen A. Marglin, 1983, The Social Rate of Discount and the Optimal Rate of Investment. Warner, John T., and Saul Pleeter, "The Personal Discount Rate: evidence from Military Downsizing programs", The American Economic Review, Volume 91, Number 1 March 2001, pp.33-53 Read More