Guide to COST-BENEFIT ANALYSIS of investment projects - Ramiri

ANNEX BTHE CHOICE OF THE DISCOUNT RATEThe financial discount rateAs a general, and quite uncontroversial, definition, the financial discount rate (FDR) is the opportunity cost ofcapital. Opportunity cost means that when we use capital in one project we sacrifice a return on another project.Thus, we have an implicit cost when we sink capital into an investment project: the loss of income from analternative project.In academic literature and in practice we can find, however, differing views regarding the discount rate that shouldbe used in the financial analysis of investment projects.There are at least three approaches:- the first one estimates the actual (weighted average) cost of capital. The benchmark for a public projectmay be the real return on Government bonds (the marginal direct cost of public funds), or the longtermreal interest rate on commercial loans (if the project needs private finance), or a weighted averageof the two rates. This approach is very simple, but it may be misleading: the best alternative projectcould earn much more than the actual interest rate on public or private loans;- the second approach establishes a maximum limit value for the discount rate as it considers the returnlost from the best investment alternative. In other words, the alternative to the project income is notthe buying back of public or private debt, but it is the return on an appropriate financial portfolio;- the third approach is to determine a cut-off rate as a planning parameter. This implies using a simplerule-of-thumb approach, i.e. a specific interest rate or a rate of return from a well-established issuer ofsecurities in a widely traded currency, and then to apply a multiplier to this minimum benchmark.Table B.1 shows some estimates for real rates of return on financial assets as a starting point for the choice of thefinancial discount rate. We can then think that non-marginal investors and experienced professionals are able toobtain higher than average returns. Supposing project proposers are experienced investors, then a rate of returnmarginally higher than the mean of the values in the table will better fit our requirements.Table B.1Indicative estimates for the long-term annual financial rate of return on securitiesAsset Class Nominal Annual Return Estimates% Real Annual Return Estimates*%Large Stocks 9,0 6,4Mid/Small Stocks 10,7 8,1International Stocks 9,1 6,5Bonds 4,8 2,2Cash Equivalent 3,2 0,6Inflation 2,6 -Simple average 107 4,76A 20-year horizon is used and asset classes correspond to indexes. ‘Large stocks’ to S&P 500, ‘Mid/Small’ to Russell 2000 index, ‘Internationalstocks’ to MSCI AEFE, ‘Bonds’ to Lehman Aggregate Bond Index and ‘Cash equivalent’ to the 3 month T-Bill Index.* The Fisher formula was used because of low inflation; r = i −πwhere r is the real rate i the nominal rate and inflation is π. The more general rule is1+ir = −11 +πTable B.1 suggests that a 5% financial discount rate is marginally higher than the average value of a portfolio ofdifferent securities.107A weighted average of these rates, according to the relative significance of the various assets in a ‘typical portfolio’, might be moreappropriate than a simple un-weighted average. This should be estimated country by country.205