Theories
Discounting Rate Calculation; The First Step in Investment Project’s Evaluation Author: DiscountingRate.com Feasibility study process of investment projects, has been based on one principle and it is preparation of projected costs and revenues during the project’s life, including cost of capital beside all other project’s costs such as machineries and equipment, civil costs and axillary in construction phase, and raw material, energy and labor in production phase. Cost of capital, is equal to the interest rate, in cases of loan and bond as sources of finance. But in case of equity capital in a specific investment project, the cost of capital must be determine based on minimum acceptable rate of return for the investor that shows the opportunity cost of equity capital (investor’s money) in the specific project. Discounting rate or the cost of capital for the equity capital is equal to minimum acceptable rate of return (MARR) that shows the opportunity cost of the investor’s money and must be calculated based on the project’s risk level, in each investment project. In this regard, the discounting rate that shows the MARR for the investor, would increase project to project, based on the project’s risk level. In addition, the discounting rate for the total investment is equal to weighted average cost of capital of different sources of finance such as loans, bonds, grants and equity capital. Indeed, when the equity capital is not the only source of finance, so the cash flow of equity capital would be separated from the cash flow of total investment and each one would have their specific financial structure. In other hand, as the calculation of the present value of costs and revenues performs based on the discounting rate (cost of capital), so we need the WACC as the discounting rate to calculation the NPV or net present value of total investment cash flow and the MARR as the discounting rate to calculation the NPVE or the net present value of equity capital cash flow. One of the most popular mistakes in feasibility study process of investment projects, is to applying the same discounting rate as the minimum acceptable rate of return (MARR) in calculating the present value of costs and revenues of equity capital cash flows and also in calculating the weighted average cost of capital. In many entities that are stakeholders of investment projects such as consulting firms, banks, financial institutes, ministries, governmental organizations, investment banks, investment holding companies and manufacturing companies that all of them are always involved in feasibility study of investment projects, they use always a constant MARR as the discounting rate to evaluating different projects. The main point is that the MARR or the equity capital discounting rate must be determine according to the project’s risk level. Actually, the risk free rate is the base rate for the MARR that would increase related to the risk level of the project. For example, if the revenue structure of a project is completely US Dollar based, and if the risk free rate in Dollar currency is 2 percent, so the discounting rate for the equity capital or the MARR can be 5% for the very low risk projects to even 50% for the very high risk projects. DiscountingRate.com as an international website, presents services to the investors and the consultants to calculate the MARR or the discounting rate for the equity capital cash flow, through the answering an specific questions about the revenue structure and also different dimensions of the risk to determine the risk level or the project. Also, the website’s users can choose to continue to the second step to calculate the WACC or the discounting rate of the total investment cash flow, through the filling a table that ask the user about the combination of the sources of finance of the project, such as the share of loans, bonds, grants and the equity capital and also the interest rate of each loan.