Few textbooks comment on the discount rate on future investment costs, but the ones I have seen use risk-free rates on future investment costs , and WACC on future cashflow.
Industry practitioners however apply WACC discount rate also on future investment costs.
What are the reasons for using risk-free rate on future investment costs?
Thanks for you answer Milan B. Vemić
, let me exemplify the question I tried to raise:A project needs to make a committing final investment decision of a project at t=0. The investment cost incurs at t=5, and the expected cashflow incurs for the subsequent years t=6...25. WACC is 7%
For NPV calculations, should i use
(a) WACC to discount both investment costs and cashflow or
(b) use risk-free rate to discount investment costs and WACC to discount cashflow?
Indsutry practitioners do (a), it seems, textbooks suggest (a). What is correct and why ?
Interesting question Klaus Vogstad Milan B. Vemić
. I am following the discussion with keen interest.Out of curiosity, what is the capital structure of the deal?
OK, after some discussions with colleagues, here is what I have learned so far:
When there is significant risk exposures between cashflows, they should be attribued different risk-adjusted required returns. The most relevant paper i found so far is the Article Project valuation when there are two cashflow streams
by Magne Emhjellen and Chris M. AlaouzeTo bring some clarity, i have made a simple example (see attached image):
Suppose you in this year (2020) get an offer to rent an apartment for the year 2025. You have to decide and sign a fixed price contract of 100 kNOK (=10 k€) this week, with payments due in 2025. You will not use the flat yourself, but want to rent it out for an expected 110 kNOK. The market is a bit risky, so you require 7% WACC.
I would use 7% WACC to discount the house rent to 2020, should I use WACC (7%) or risk-free rate (4%) to discount the house rent contract ?
My answer is that I should use the risk-fre rate of 4%, because the contract is not exposed to market risk. Using risk-free rate on the contract cost, returns negative NPV, while using WACC returns positive NPV. However, the revenues are clearly more risky than the contract, so no risk premium should be added - and it will have the opposite effect, underestimating the costs
The quiz is not clear enough to guide meaningful discussions.
I also suspect that the questioner might not have studied the theme, practice work examples and digested the use of discounting rate properly - and I do not need to do guesses of the intentions of the presenter of the topic.
To demonstrate the information and knowledge gap duly displayed in the formation of the topic under discussion; it state that the use of 7% WACC; Sir, an individual who rents a space for 5 years can not and does not need to apply the WACC rate principle as discounting factor . To get to know the reasons, please go back and read relevant literature on project evaluation and discounting methods and feed us back right here
Chris enyioma Alozie 1 the example was made up to cut to the core of the problem: How to make an NPV on a project with negative and positive revenue streams with different market risk exposure. Whether the investor need to use WACC or not for the example is irrelevant.
2. You misread the example. It does not describe an individual renting for 5 years, but an opportunity to rent an appartment for the year 2025 for a fixed price, that in turn can be rented out with some expected but uncertain revenues. Please go back and make sure you have read the case properly before you start questioning my experience project evaluations
3 If my intentions were not clear with this example, where I want to know which discount rate to use on the negative cashflow as described in the example, (a) risk-free rate or (b) risk-adjusted rate (WACC), then I dont think it would help to provide example from the real world case I am working on that are more complicated
Thank you Klaus for providing better illustration. Whether the proposed evaluation assignment is meant for net-worth individual , quoted companies or government entity ; one of the most appropriate rate to apply is the rate of interest of borrowed fund invested or to be invested in the 5 year rent. Second, where internally packaged funds and loan or funds from quoted companies plus borrowed fund is used in investing in the said 5 year advance rent, then the WACC principle and WACC as discounting rate can be applied. Hope this is not ambiguous. The third point is the issue of risk-premium. Please DON Klaus risk-free rate is quite different from WACC. Kindly make special note of this fact and cross-check from Literature. Risk-free premium should be defined in the context of the project and sub-sector to which the investment operates. Normally, it falls within the range of 2 -5 percent or alternatively, the evaluator states the baseline risk-free rate of return - this calls for advanced research - I wish to avoid to be misquoted.
DON Klaus I want to believe prima-facie position has been established to buttrss my earlier comments.
Thank you
It is important to remember that each investment is "original" and should be studed in an individual way. So that, there should be the analyse of e.g. the "condition" of an investment, the phase of its development etc. What's more, we should identify the purpose. That's the reason why once is wacc, but sometimes cost of debt.
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