2.2  Why Risk is an Issue in determination of Discount Rates

Discussion of risk in project evaluation is mostly about the risk that actual financial outcomes are different from those projected in advance.  As outlined above, if two investments are identical, but one contains more risk, the rational investor will take this into account in their evaluation of options.

Practitioners use a variety of approaches to address risk within a financial analysis.  These include:

•  sensitivity analysis of major variables including Discount Rates and cash flow drivers;

•  adjustments to cash flows and/or Discount Rates to reflect perceived risks; and

•  utilising categories of Discount Rates such as different rates for expansion of existing projects versus entry into new projects.

Whatever approach is adopted, where DCF is used, a Discount Rate will be required.  It is important that its basis is understood and the relationship between the treatment of risk in the cash flows and the Discount Rate is consistent.

In developing the Methodology it was considered desirable that a sound framework be used for objective derivation of Discount Rates.  This required consideration of the theory behind the relationship between risk and Discount Rates.

There are a number of established theoretical approaches that can be used to measure this relationship.  However, the CAPM was selected as the most appropriate for the purposes of this Guidance.  It has a greater level of practical usage, it is simpler to apply and has the greater availability of required reference data.  Overall, its attributes were considered to be reflective of current better practice.  More detail on the operation of CAPM is provided below.

The premise that underpins CAPM, in the finance theory, is that the Rate of Return from an asset, or investment should compensate owners for risk that cannot be eliminated by Diversification through investing in other assets.  This type of risk is called Systematic Risk and is sometimes referred to as market, or non Diversifiable Risk.

Systematic Risk is a measure of the extent to which a particular project's (or asset's) returns are likely to vary relatively more (or less) than a portfolio of projects (or assets) across the market.  The measure of Systematic Risk is known as Beta, and will vary from project to project.  The Beta determines the additional return that an investor, including a Public Sector investor, would require to compensate them for investing in that project and thereby taking on the Systematic Risk of that project.  Beta is discussed further in section 2.5 below.

On the other hand, non-systematic (also known as project-specific or diversifiable) risk can be diversified away by investors and accordingly is not recognised in the Discount Rate.  However, such risk, as described in Volume 4: Public Sector Comparator Guidance, should be reflected in the risk adjusted project cash flows.