How to choose a discount rate--and justify it -, Learning Economics... Solved!


How to choose a discount rate--and justify it

In general there are three possible justifications for choosing a discount rate for your cost benefit analysis. The three justifications are used to explain how people perceive costs and benefits affecting them in different time periods. Because there are a lot of mechanisms within an economy that account for valuing money in different time periods (the most obvious is the interest rate on loans, but inflation and other factors can play a role) they tend to be the predominate choice when choosing a discount rate. The three most common justifications for discount rates are:

1) Cost of borrowing funds. The first and most appropriate justification for choosing a discount rate would be the cost of borrowing the money or capital to run a project. This justification makes the most sense if you are actually going to borrow funds to complete your project. In this scenario you would want your benefits to grow at a rate faster than the interest rate on the loan you made to make the project possible.

As an example, you can imagine obtaining a loan from the bank at 10%. This would mean that the discount rate you would use in your project would be 10%. You would hope that any benefit you accrue in the future grows faster than 10% because if it does not than the real profit that you are making (the benefit minus the cost plus interest) is going to be negative.
If you are running an analysis for a business or the government then you can look at the actual interest rate that will be charged on the loan or bond. Specifically for local governments, you may do a search for the municipal bond rates to find what local governments are paying on the money they borrow.

2) Alternative rates of investment. This approach focuses on the opportunity cost of the project. Generally agencies will have a couple of choices of where they can invest their budgets. By looking at the best alternative project and using its expected rate of return, we can estimate a discount rate.
For example, imagine a firm has the choice of investing in an alternative project that would return 8%. Then the opportunity cost of investing in the primary project would be a return of 8%. This means that the primary project would have to see net benefits grow by at least 8% per year in order for the project to make sense.

A practical example of this approach would be to look at the interest rate on CDs in a bank, or perhaps the most recent return on the stock market (like the S&P 500), although this has the potential of giving really high or negative discount rates because of the volatile nature of the stock market.

3) Social rate of time preference. The final justification for choosing a discount rate (and perhaps the most complicated) is to attempt to use the social rate of time preference. This means that you are able to estimate the preferences of society as to the timely distribution of resources. For example, is society happy with paying high taxes so future generations are better off? Does society want lower taxes and high spending now? The answer to these questions can help us decide on a discount rate that is appropriate for public policy decisions.

A good discount rate that is appropriate for estimating the social rate of time preference varies between 1 and 10 percent. The lower discount rate will value future benefits and costs higher than a higher discount rate. Official US government policies mandates discounts rates between 3 and 10 percent depending on the time frame and the type of project. Several academic sources stress that longer time frame projects should use a lower discount rate (otherwise future benefits and costs are virtually 0).

As a conclusion, most inter-generational projects should use a 2.5% discount rate; anything higher or lower would need strong justification. It is also good practice to run the analysis with multiple discount rates in order to explore how much your choice of discount rate would have to change in order to change the decision of the project.