Managing Risk Through the Discount Rate
When we look at an investment proposal there are many layers of risk or uncertainty for which we need to be compensated.
In such an arbitrary and complex process as DCF analysis, the discount rate becomes critical. This is especially true where the organisation does not have a shortage of capital, and there is large scope for discretionary investment.
Significant sums of money can be allocated through Discounted Cash Flow techniques, but no model, nor accuracy of data, will help that process without an accurate and meaningful discount rate.
In determining the discount rate, there is a range of risk-related points that have to be considered. These are:
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Sovereign Risk Monetary value as expressed in a currency will always carry with it a risk component related to the political certainty of the issuing country, especially where there is the possibility of currency degradation, political turmoil, change of Government priorities, nationalisation, privatisation and re-
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Bank Risk In the current economic and financial environment, bank risk is very real and very difficult to accurately assess. The recent collapse of the Barings bank as a result of unauthorised trading is a clear example. Bank risk can also be expressed as the difference in margins between secured government debt and bank debt.
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Corporate Risk The corporate credit rating will help determine a company's risk profile. By way of a very specific example, corporate risk could be isolated by identifying the margin on returns from bank investments versus corporate debentures. Where debentures are available, these are typically issued at a higher rate than bank investments.
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Project Risk The Corporate Risk component carries with it the risk value of all the activities of the business. Certain projects have special risk factors above or below the average level of risk: eg. an oil company planning to drill in difficult or uncommon terrain.
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Profit Margin Once you have accounted for Project Risk you have reached a rate which equals the Internal Rate of Return (the 'breakeven' point). Here, the cash flows have been discounted for time value and risk to a net zero pound value, such that the Net Present Value of the project is exactly zero. Of course, we need more than a zero (risk weighted) return. A profit margin can be added to the discount rate to reflect our need for a reasonable return on the project. The same result could also be achieved by using the Net Present Value amount as a decision filter.
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Scarcity Margin Unfortunately, not all organisations have excess capital and often the capital budgeting process can function more as capital rationing. Here, we have to apply a scarcity margin to our discount rate to eliminate from selection the lower returning projects.
Assuming that our DCF calculation and assumptions are accurate then the scarcity margin represents lost future profits (Opportunity Costs). The Capital Scarcity Loss is likely to be greatest in difficult economic times where prices are depressed and current investment can yield steep future returns. |
So in looking at the discount rate from the perspective of returns, it should be understood that the rate is a composite of many other rates, which are (in ascending order of importance):
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the Risk Free Rate, which simply represents the preference for 'now', but with no risk
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the Official Rate, which reflects both the preference for now plus the sovereign risk of the country. These rates are the official interest rates
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the Bank Savings Rate, which adds in the bank risk factor
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the Cost of Funds, which is the rate the company pays on its borrowings after its risk margin (over the bank) is added in
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the Internal Rate of Return, which is the point where the project risk is balanced against the project returns and the Net Present Value of the project is therefore exactly zero
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the Optimal Discount Rate, which represents the ideal rate to evaluate projects given risk adjustments and profit needs
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the Rationing Discount Rate, which effectively overrides all the notional components of the discount rate by functioning as a rationing tool where investment funds are scarce.
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Finally the discount rate is not a fixed number, once calculated, either in time or to all phases of the project its not a one size fits all.
For example and major infrastructure project may take 5 years to complete before operating for 35 years.
Is it right to apply the same discount rate to both the construction and operation phases?
Is it right to apply the same discount rate to both the construction and operation phases?
Once the construction phases complete the risks are changed significantly, does this mean a different discount rate?
During the 35 year operations Contract the government will change at least 7 times. How will future administration simply this project all the rate of return it generates at that time?
Staff are staying in one job for shorter periods will we still have the core competencies to run this project in 10 years?
You can appreciate from this example there are real problems with trying to develop a compound rate that covers maximum expenditure in the first 2 to 5 years and income for 35 years.
This is one of the real problems with DCF that discounting is really only effective in the early period of a long project whereas the risks change with time and after 15+ years variances in cashflow have very little effect on the initial NPV.
