Discount Rate and Discount Rate of Return

Discount Rate and Discount Rate of Return

           

The discount rate is meant to represent the cost of capital or the required rate of return for a project. In the low inflation and interest rate environment that exists at the moment, both the cost of capital and the required rate of return on investments in the general economy have been falling. This would suggest that the discount rate in UK used to evaluate this project should also be lower than that used in the past.

UK regulators have recently been indicating that permitted real rates of return for the various industries subject to tariff controls may be in the range 5 to 6 per cent. Where the timing of expenditure differs between investment options, the discount rate chosen can have an impact on the determination of the least cost option. Therefore it is important to investigate the sensitivity of the various options to changes in the discount rates used. 

It should not be surprising that in times of international monetary instability, there is renewed interest in the definition and analysis of discount rate and the discount rate of return. One analytical framework that seems particularly suited to the analysis of the problem of exchange risk is the well-known Capital Asset Pricing Model  (CAPM) (Sharpem, 1964). CAPM is a two parameter, single period model focusing on the expected return of an asset and the asset’s riskiness (Lackman, 1996). Risk is measured by the variance of the asset’s rate of return over time measured by ex-post data. Generalizing this framework to handle assets denominated in different currencies (with an added element of risk due to the presence of foreign exchange and so the possibility of devaluation) appeared to be a straightforward extension of the CAPM in its domestic context (Grubel, 1968).

 

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