Question

One of the most important aspects to project evaluation is to make a correct estimate of the discount rate. Explain how the “discount rate” is derived and assess its significance in relation to other factors that are also important to project evaluation. i want minimum 800 words.

Answer 1

Yes the discount rate is the most important aspect of project evaluation: the discount rate is calculated as below:

WACC = weight of debt *cost of debt *(1- tax rate) + weight of equity * cost of equity

Lets presume,the proportion of debt increases ,the tax shield provided by debt will bring down the WACC, that is the return required by the investors reduces,thus bringing an increase to the value of the project.

The higher the risk, the higher the discount rate :

Risk associated with a project are:

1)project risk 2) market risk 3) economy risk 4) Country risk

the discount rates can be higher in the following cases :

a) when the interest rates are higher, it happens generally in times of inflation

b) when there is too much debt taken to finance the project,which is perceived to be risky levels of debt.

c) when the company is in a risk prone industry

d)if the company operates in a risky political environment.

e) when the bond holders feel that they require a higher return on their investments,keeping in mind the risky project.

the discount rate reflects three factors:

i.the risk free rate: interest earned on the risk free investment

ii. the inflation premium

iii. a risk premium

the future cash flows are very important factor in determining the viability of the project :

suppose we have the project A

the outlay is $10,000

the cash flows are :

1. 8000

2. 6000

discounting these cash flows at the discount rate we can determine the viabillity of the project :

'whether we should accept or reject. thus, we would determine how important is the discount rate in discounting the expected cash flows and determiming whether we should accept or reject the project.

if the inital outlay is less than the discounted cash flows then the project should be accepted.

the cash flows can be either in the form of an annuity or different cash flows evey year.