2.1.1 What is a Discount Rate and what is it used for?
A Discount Rate is used to convert projected cash flows into a present value to enable comparison of competing options for which the cash flows reflect differences in both timing and amounts. The Discount Rate reflects the Rate of Return expected by an investor to compensate the investor for placing capital at risk in a project.
The DCF methodology follows a process whereby all future cash flows are projected over a given period and then adjusted to a common reference date using the Discount Rate. The Discount Rate reflects the time value of money and the premium that is required by investors in the project to compensate them for the Systematic Risk inherent in the project. Thereby, converting future cash flows into equivalent present cash flows and allowing VFM to be measured between options on a consistent basis. The concept of Systematic Risk is further explained below.
In the context of potential PPP procurement decisions, the Public Sector is choosing between assembling the components of service delivery (often requiring significant upfront capital costs, as well as ongoing operational costs) versus procuring service outputs (often involving regular periodic payments for delivery of a service to agreed service specifications).
Example - Time Value of Money |
The following demonstrates the application of Discount Rates in comparing two highly simplified cash flows and why it reflects the time value of money. |
In this example we have two cash outflows each totalling $1 500 over five years. Option A incorporates an initial investment of $1 000 in year 0 with anticipated operating cash outflow of $100 in years one to five. In comparison, Option B assumes higher operating cash outflow of $300 in years one to five but without any need for an initial investment in year 0. |
Table 1 - Comparison of Alternate Cash Flow Streams
Option A | |||||||
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total | |
Cash Outflow | 1,000 | 100 | 100 | 100 | 100 | 100 | 1,500 |
NPC @ 10% | 1,000 | 91 | 83 | 75 | 68 | 62 | 1,379 |
Option B | |||||||
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total | ||
Cash Outflow | 300 | 300 | 300 | 300 | 300 | 1,500 | |
NPC @ 10% | 273 | 248 | 225 | 205 | 186 | 1,137 | |
The NPC represents the summation of each year's discounted cash flow. Each year's cash flow is discounted by the Discount Rate of 10 per cent per annum for the relevant number of years.
As the above table shows, on a pure cash flow basis, each option has equal merit, as they both require a cash outflow of $1 500. However, on the basis that a dollar today, is worth more than a dollar tomorrow, Option B is more attractive in today's cash terms as the NPC to the Public Sector in today's dollar terms is $1 137, which is lower than the NPC for Option A of $1 379.