Question

6Almost all investment decisions involve a time dimension.

a) Outline the role of the discount rate in such decisions.

b) What factors are taken into account in the choice of the discount rate?

c) What additional considerations come into play in the choice of the discount rate when public sector investment projects (as distinct from private sector projects) are involved?

Answer 1

Dear Student,

Please find below answer to your questions

A) Role of discount rate in investment decision making

Abstract

Discount rate plays an important role in investment decision making. Let us understand the concept of "Discount Rate "

It can can be described as "The discount rate is the interest rate used to determine the present value of future cash flows in a discounted cash flow (DCF) analysis.

This helps determine if the future cash flows from a project or investment will be worth more than the capital outlay needed to fund the project or investment in the present."

It only makes sense for a company to proceed with a new project investment if its expected revenues are larger than its expected costs in other words, it needs to be profitable.

The discount rate makes it possible to estimate how much the project's future cash flows would be worth in the present.

An appropriate discount rate can only be determined after the firm has approximated the project's free cash flow.

Once the firm has arrived at a free cash flow figure, this can be discounted to determine the net present value (NPV).

Setting the discount rate isn't always easy decision. Even though many companies use weighted average cost of capital (WACC) as a underlying factor for the discount rate, other methods can be used as well.

In situations where the new project investment is considerably more or less risky than the company's normal operation, it may be best to add in a risk premium in case the cost of capital is undervalued or the project does not generate as much cash flow as expected.

B) Factors need to taken into account in the choice of the discount rate

Below listed factors need to consider when Choosing a Discount Rate

1) The ability to meet or exceed the projections.

2) The value and marketability of tangible assets which could be recovered if the operations failed.

3) Cost to duplicate operations/ barriers to entry.

4) Marketability of the commodity and its future prospect.

5) The location of the project and market access.

6) The stage of development, and the size and capability of the project's owner.

C) Additional considerations come into play in the choice of the discount rate when public sector investment projects (as distinct from private sector projects) are involved

The social welfare is maximized when the government uses discount rates when investment done in public sector.

The government should allocate its budget to maximize social welfare. When the net present value (NPV) is used as the basis of project choice, the discount rate critically influences budget allocation.

Discount rate for a government project should reflect the risk premium (compensation for uncertainty) that is normally demanded in the market,in addition to the time preference of individuals.

Those projects have very risk in future For Example, Hydraulic System Installation - cost-benefit analyses need to done rigorously.

Also Utility Maximization need to be considered those projects are only focused on the consumption by the individuals. For Example, Projects like Food Distribution Systems.

Paying a price higher or lower than the fair market price for risk-free cash flows would make individuals worse or better off by effectively reducing or increasing the total budget,

For Example, Say your cost of capital for average-risk projects is 10 percent. If you view a project as slightly riskier, you may bump your discount rate up to 10.5 percent or 11 percent. If it's considerably riskier, you may go up to 16 percent or more.

-------------

Hope my answer have cleared all your queries, I really appreciates your positive feedback !!

Thank You !!

--------------