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In the past module, we concentrated on calculating the returns part of the project. All our articles were focused on calculating cash flows and we saw the various special cases that arise while determining cash flows and determined how we must deal with them. This module is all about the other component i.e. risk. The cash flows are nominal figures. To determine the true value of the project, we need to find out an appropriate discount rate for our project. This article is a primer in this regard. It will clear out the first and the most prevalent confusion pertaining to discount rates.
Let’s say that we have a company “A”. At the present moment, the cost of capital for company A, with its existing projects is 12%. Company A is planning to undertake a new project. The cash flows have been determined. It is now time to discount them. What do you think? Would using a 12% discount rate be appropriate?
The answer is that it is not appropriate and here is the reason why:
A company’s risk is measured by the rate at which its cash flows are being discounted currently by the market. This is the company’s cost of capital. The important thing to realize is that this cost reflects the riskiness of the projects that have been undertaken by the company in the past. So, if company A currently has 6 projects running, this discount rate of 12% is a measure of the riskiness of those 6 projects.
Project risk, on the other hand, is independent of company’s risk. It doesn’t really matter if Company A has a 12% discount rate. If the new project is considerably more risky than the past projects undertaken by A then the discount rate must reflect this additional risk. The project needs to be evaluated on its own merits. The discount factor must determine the riskiness of a probable future course of action rather than that of past actions.
What Happens if We Use The 12% Discount Rate?
The general tendency is to use the past discount rate for selecting future projects. However, this is an error and could lead to at least two big consequences for the company, if not more. The two mistakes are:
The bottom line therefore is that the discount rate used must represent the risk of the project and not that of the company. This distinction is very subtle but very important.
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