Confusion regarding the appropriate Discounting Rate

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Permalink Reply by Dipu James on January 30, 2010 at 1:28am

each project has its own risk, the discount rate is directly linked to the risk remember higher the return greater the risk.

So the WACC used should be that of a similar or comparable project, get the beta of the comparable company unlever the same and use the CAPM formula to pull out your WACC ;-).

Its not difficult as it sounds you can find templates for WACC in the forum;-) hope this helps....

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Permalink Reply by Johnni on January 30, 2010 at 5:41am

Maybe better just to discount the equity portion you provide, with the return you require. Discount the debt with the after tax cost of debt. People often forget to accomodate the changing capital structure in the WACC. and i find it non transparent.

R

Johnni

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Permalink Reply by Brent Wheeler on January 30, 2010 at 5:26pm

It is critical here to make sure the discount rate you use reflects the risk inherent in the project's cashflows - so Dipu's suggestion makes sense (note the method he suggest to "back out the debt).

If, as an angel you are supplying equity, then it is risk to your equity which is critical.

if, as angel (and much less typical, you are providing debt then it is risk to your debt which is critical

If you are generous to enough to be providing both then risk to the mix of equity and debt is critical.

The common sense rule applies here - "how am I likely to lose my shirt?"

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Permalink Reply by Vikas Golchha on February 3, 2010 at 6:56am

Fine with that approach but as an angel investor you must use your own cost of capital (required rate of return) as the floor. The individual may have an excellent and virtually risk-free project, but it still will have to meet the florr requirements of your required rate of return.

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Permalink Reply by Brent Wheeler on February 3, 2010 at 1:29pm

Indeed - see posts below where I suggest there asre two things of interest

1. The project hurdle
2. The investors hurdle

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Permalink Reply by Sachidanand (Sacha) Singh on February 3, 2010 at 1:59pm

But Brent, in a competitive market if all investors have access to the capital markets, won't the opportunity cost of all investors (investor hurdle) should be the same, determined by the project risks? (Of course, variations may occur due to differences in risk assessment.)

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Permalink Reply by Brent Wheeler on February 3, 2010 at 2:40pm

Assuming risk aversity is identical across investors, transaction costs are broadly the same for everyone and thus everyone holds or can hold the same fully diversified portfolio - yes.

This is also a long run condition. Different portfolios are in different stages of "maturity" at any given point in time are they not?

My observation is that the combination of these disturbances leads to different investors being in different positions - and thus having different appetites to invest - at any given instant in time.

No?

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Permalink Reply by Sachidanand (Sacha) Singh on February 3, 2010 at 10:08pm

Yes, diversity in investors’ risk aversion (e.g. Pension Fund vs Hedge Fund) and the stages of their existing portfolios will impact their required rates of returns from investments. But divergence in their required rates will lead them to different projects, don’t you think so? I think it is unlikely that the same project would be funded by two investors at two widely divergent rates?

Small differences do occur, mainly because the project managers often seek quick financial closure.

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Permalink Reply by Johnni on February 3, 2010 at 6:22pm

@Sacha – I respectfully disagree!

A given investors hurdle rate is a function of:

A. Investors own cost of capital. (Debt and equity).. Well cost of debt is not the same for all investors, since the banks perceptions of a given investors risk, is partly a function of his individual/asystematic risk for the bank, and the banks current portfolio. (It is also because investors cost of debt are different, that interest rate swaps are so popular.)

B. Risk aversion – Risk is one word but not one thing and as Brent stated, a given investors risk appetite is partly a function of time “portfolio Maturity” and a number of other individual factors. So we are not dealing with some CAPM efficient frontier, but a time variant multi-dimensional space.

This is project finance. The concept of backing out the average unlevered beta of a peer group/investment, re-lever and somehow think you have accounted for all risk is illusional at best. Again there are many factors..what about illiquidity or minority risk premiums. There is properly allot of asystematic risk left investor simply cannot diversify away.

Now surely you could try to find the significant factors and have multi factor model, but factors move in and out of significance over time. For me it is at least as prudent for an investor to say fx..my hurdle rate is risk free+500 basis points.

It seem everybody is trying to push this into the MPT box.

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Permalink Reply by Sachidanand (Sacha) Singh on February 3, 2010 at 10:25pm

Johnni,
I feel investor’s cost of funds should not affect opportunity cost of projects. In a competitive market, prices should be independent of the cost of funds of the buyers. My credit rating may be worse than yours but we will buy a car (same car) at exactly the same price. Having said that, I do realize that the market for new cars is different from the market for projects.

About seven years back I was associated with financing a small road construction project - project cost ~ 250 million USD. The investors included some of the largest Indian banks whose appetites were limited because at that time there were many road projects going on and they had sectoral limits on their exposures. Consequently, by the time of closing, there were some smaller banks and even a non-bank financial institution among the investors. The cost of funds of the major banks was lower than that of the smaller banks, which was lower than that of the NBFI. The interest charged by different investors were indeed different but that was because there were not enough large investors. The project company had agreed to pay higher interest to smaller banks and to NBFI because there were not enough larger banks i.e. the market was not competitive enough. The late entrants – smaller banks and NBFI – got higher returns not because their costs of funds were higher but because the project company wanted to close the project as early as possible.

Diversity in risk aversion should, I feel, lead to different investors to different projects rather than demand different returns from same project.

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Permalink Reply by Brent Wheeler on February 3, 2010 at 10:46pm

My point Sacha (and I have failed to get it across !!!!) is not that project risk will differ as between investors. It won't.

What will differ is whether or not and on what terms and conditions a given investor will invest. An ice cream is an ice cream is an ice cream - but not all punters want to buy ice creams!!!!

At the limit all overnight govt bonds issued by the NZ govt (say) are utterly and absolutely identical and can be valued absolutely and without argument..... not everyone is invested however.

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Permalink Reply by Sachidanand (Sacha) Singh on February 3, 2010 at 11:13pm

Exactly; well put.

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