Social Discount Rates Essay Example | Topics and Well Written Essays - 1500 words

Social Discount Rates - Essay Example 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. 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. 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 rat