Financial Discount Rates in Project Appraisal

In the financial appraisal of a project, the cashflow statements are constructedfrom two points of view: the Total Investment (TI) Point of View and the EquityPoint of View. One of the most important issues is the estimation of the correctfinancial discount rates for the two points of view. In the presence of taxes, the benefitof the tax shield from the interest deduction may be excluded or included in the freecashflow (FCF) of the project. Depending on whether the tax shield is included orexcluded, the formulas for the weighted average cost of capital (WACC) will bedifferent. In this paper, using some......
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Financial Discount Rates in Project Appraisal Financial Discount Rates in Project Appraisal Joseph ThamAbstract In the financial appraisal of a project, the cashflow statements are constructedfrom two points of view: the Total Investment (TI) Point of View and the EquityPoint of View. One of the most important issues is the estimation of the correctfinancial discount rates for the two points of view. In the presence of taxes, the benefitof the tax shield from the interest deduction may be excluded or included in the freecashflow (FCF) of the project. Depending on whether the tax shield is included orexcluded, the formulas for the weighted average cost of capital (WACC) will bedifferent. In this paper, using some basic ideas of valuation from corporate finance,the estimation of the financial discount rates for cashflows in perpetuity and single-period cashflows will be illustrated with simple numerical examples.INTRODUCTION In the manual on cost-benefit analysis by Jenkins and Harberger (Chapter3:12, 1997), it is stated that the construction of the financial cashflow statementsshould be conducted from two points of view:1. The Total Investment (or Banker’s) Point of View and2. The Owner’s (or Equity) Point of View. The purpose of the Total Investment Point of View is to “determine the overallstrength of the project.” See Jenkins & Harberger (Chapter 3:12, 1997). Also, seeBierman & Smidt (pg 405, 1993). In practical project appraisal, the manual suggeststhat it would be useful to analyze a project by constructing the cashflow statementsfrom the two points of view because “it allows the analyst to determine whether theparties involved will find it worthwhile to finance, join or execute the project”. SeeJenkins & Harberger (Chapter 3:11, 1997). For a recent example of the application ofthis approach in project appraisal, see Jenkins & Lim (1988). In practical terms, the relevance and need to construct and distinguish thesetwo points of view in the process of project selection is unclear. That is, under whatcircumstances would we prefer to use the present value of the cashflow statementfrom the total investment point of view (CFS-TIP) rather than the present value of thecashflow statement from the equity point of view (CFS-EPV)? Jenkins & Harbergerprovide no discussion or guidance on the estimation of the appropriate discount ratesfor the two points of view. The conspicuous absence of a discussion on theestimation and calculation of the appropriate financial discount rates from the twopoints of view is understandable. See Tham (1999). Within the traditional context ofproject appraisal, the relative importance of the economic opportunity cost of capital,as opposed to the financial cost of capital, has always been higher. However, in somecases, the financial cost of capital may be as important, if not more, in order to assessand ensure the financial sustainability of the project. Due to the lack of discussion inthe manual, we do not know the explicit (or implicit) assumptions with respect to therelationship between the present value of the CFS-TIP and the present value of the ProjN.DocCFS-EPV. For example, under what conditions would it be reasonable to assumethat equality holds between the two points of view? Jenkins & Harberger (Chapter 3:11, 1997) write: “If a project is profitable from the viewpoint of a banker or the budget office but unprofitable to the owner, the project could face problems during implementation.”This statement suggests that, in practice, inequality in the two present values is to beexpected and could be a real possibility rather than the rare exception. However, thestatement raises many questions. If in fact there is inequality in the present values,what is the source of the inequality? The above statement does not even hint at apossible reason for the divergence in the two present values. What is the meaning orinterpretation of the two present values? The interpretation of the two points of view is particularly problematic whenthe present values have opposite signs. The meaning or practical significance of thisdivergence for project selection is not explained nor is it grounded in any theory ofcashflow valuation. If in fact, the inequality holds, then it is conceivable that thepresent value in one point of view is positive, while the present value in the otherpoint of view is negative or vice versa. In project selection, when would it bedesirable to prefer one present value over the other (if at all) or do both present valueshave to be positive in order for a project to be selected? The interpretation of the discrepancy between the (expected) present v ...