Example c Operational management activity: pure risks
Appendix 6 Discount rate
Appendix 6 Discount rate
In this Appendix, you can read about the function of the discount rate, why a distinction is made between private and public financing and why the discount rate differs per period.
1. What is the discount rate?
The function of the discount rate in the PPC is to bring together the net cash flows in across the years - essentially, to combine them into one amount, namely the net cash value - in order to make a comparison between the various implementation scenarios possible. Cash flows in different years cannot be added up automatically. After all, the euro you have in your pocket at this moment may be invested with interest, which means that this euro's nominal value will increase in the future. Furthermore, future net cash flows may be more negative than expected. This is a risk any rational investor wants to be compensated for. The discount rate corrects future cash flows for the time value of money and the associated risk.
In principle, the discount rate is the same as the return the investments which are necessary to realise the Project would have made if the money were spent in a different but similar manner. The similar manner means an investment in a project with a similar scope and risk. The required return on high-risk projects is higher, because an investor requires a higher return for a higher risk. After all, investors do not like risks and always choose the investment with the least risk at a particular return, or vice versa. The level of the return always reflects the amount of risks incurred in a project.
Theoretically, the discount rate can be divided into the following components:30
• the risk-free interest rate;31
• risk premium. 32
Action 3D of module 3 and Appendix 4 explain how you can determine the level of the discount rate in the PPC.
30 The scientific basis for the discount rate is the CAPM model, which can be found in virtually all basic books
about financing.
31 The PPC uses the nominal risk-free interest rate, or the interest including inflation, and not the real risk-free
interest rate. This nominal risk-free interest rate is usually estimated based on the interest on government bonds.
32 More specifically, this concerns a premium for non-diversifiable risks. These are risks an investor cannot
mitigate by investing in multiple projects. One example of a diversifiable risk is the increase of the oil price. The profit of a company which uses oil as a raw material will be negatively influenced by an increase of the oil price. However, an increase in the oil price is positive for a company which works in oil field exploration. By investing in both companies, an investor may mitigate the risk associated with an increase in the oil price. However, if factors affect the entire market, they cannot be diversified and an investor will seek compensation.
2 Why is the same discount rate used for the public and private implementa-
tion scenario?
For the level of the discount rate in the PPC, it does not matter if a public or private party finances the project. The difference between a public and a private investor becomes clear when we look at investments from the point of view of citizens as taxpayers and citizens as shareholders. When a market player finances a project, the shareholders/investors run financial risks. After all, the return on investment influences the profit of the market player. The profits are divided among the shareholders in the form of current or future dividend distributions and they also determine the value of the shares.
The position of taxpayers can be compared to a certain extent to the position of shareholders: in the end, taxpayers run the risk of investment costs being higher than budgeted, or of financial yields being lower. In the end, taxpayers pay for unforeseen financial setbacks because future taxes will be higher. One important difference between taxpayers and shareholders is that the risk is imposed on the first group and shareholders decide whether or not to run a risk. Shareholders may demand compensation for risks in the form of a higher expected return, while taxpayers only hope they will receive compensation.
Not every taxpayer is also a shareholder, but in order to estimate which price a taxpayer would want as compensation for the risk, the citizen as the shareholder is the best comparison. Therefore, the central government uses the same risk premium as is customary on the market, in other words the return that private investors expect. Since the required returns of a public and private investor are the same, the discount rate is the same for both parties.
3 Is project financing by the government always more favourable?
The discount rate in the PPC is the same as the return for which private parties are willing to finance a project. This return is usually much higher than the interest on government bonds paid by the central government in order to attract capital. This gives rise to the question whether or not it is more advantageous for the central government to directly finance the project on its own (as in the public implementation scenario).
It is a common misconception that government funding leads to lower project costs because the government can borrow at cheaper rates. In project financing, the project should be the focus, and not the project implementer. The cost of capital in projects is determined by the risk and not by the source.
The interest on government bonds paid by the central government is lower than the interest at which financial institutions can attract capital and much lower than the interest at which companies can attract funding for a particular investment. This is because the government hardly runs any risks, because setbacks can be passed on to the taxpayers.
67 Appendix 6 Discount rate
The fact that the government can borrow at cheaper rates therefore does not play a role in the choice between public or a private financing.33
4 How come the risk premium for the same type of project may differ per
period?
The risks of a project determine the level of the premium of the risk-free interest rate in the discount rate. These risks may be differently assessed per period. For instance, since the economic crisis, investors have demanded higher prices (return) for projects with the same risks as before. You cannot deduce from this that prices after the economic crisis are too high or prices before the crisis were too low. Fluctuations in the market interest rate are part and parcel of an efficiently functioning market. The risk premium in the market interest rate is also constantly influenced by risk perception (are there many or few risks?), and by the price charged for these risks.
The risk premium is first and foremost determined by risk perception of the market. Centuries ago, an implied risk of business trips was that a vessel could fall from the edge of the world, and investors expected compensation for this risk. Nowadays, investors want compensation for the risk that the financial system may collapse. Only in hindsight can it be determined how real a risk was. Which risks investors perceive and how substantial they perceive these risks to be differs per period.
The price demanded by investors for a particular level of risk is not stable either. Like with other products, such as insurance policies, these risks are influenced by supply and demand. This also explains that the interest on government bonds is sometimes negative. When in a particular period investors look for low-risk investment en masse, they are willing to accept a lower, and sometimes even negative, interest rate.
In an efficiently functioning market, the scope of the risks and the price demanded for them can be best estimated based on market information such as share prices, because they contain all available information.
33 The underlying assumption is that the financial market works efficiently. If this is (temporarily) not the case,
public or private financing may indeed be a decisive factor in the PPC. If need be, the Ministry of Finance will set up a more detailed analysis which may lead to a (temporary) amendment to the guidelines in the PPC for private financing. Until then, it should be used as the point of departure in the PPC that there is no difference between public and private financing.