Choosing a Discount Rate

Our clients often ask for guidance in choosing a discount rate for present value calculations. This post presents some background on present value and considerations to bear in mind when choosing a discount rate.

A fiscal impact analysis will identify costs and benefits over a period of time accruing to a city or county from an economic development project. Since the timing of the individual costs and benefits is important, the analysis should take into account the time value of money. The way to account for the time value of money is to discount the flow of revenues and costs and evaluate them based on their present value. The present value is a way of expressing dollars to be paid or received in the future, in today’s dollars. A dollar today is worth more than a dollar a year from now, since an invested dollar would yield a rate of return or interest over the year.

Discount Rate
The connection between future dollars and today’s dollars is the discount rate. The discount rate represents the decision maker’s patience – the lower the discount rate the more patient one is, the higher the discount rate the more impatient. We recently evaluated energy efficiency investments which included significant upfront costs and incremental savings each year during the 20-year life of the efficiency measure. Only with a discount rate below 1% would the present value of benefits exceed the present value of costs. In this case the organization would have to be extremely patient.

So what is the right discount rate?
Theory suggests the discount rate should be the opportunity cost of the project relative to other investments. Since a city or county may invest in other projects or capital investments, municipal bond rates are a good measure of this opportunity cost. Right now, 10-year municipal bond rates are about 2.06% to 2.37% based on credit rating (AAA to A). The project’s opportunity cost may also be considered against other private investments. In this case, the 10-year corporate bond rates are 2.49% to 3.15%.

Currently, these bond rates are extremely low as a result of the overall interest rate environment in the economy. Remember, a low discount rate means the organization is very patient. We believe using a discount rate in the 2% to 3% range may distort the city or county’s decision-making process. Recently, we’ve recommended economic development organizations use a discount rate of 4% to 5%.

Ultimately, the discount rate should be evaluated regularly based on interest rate conditions and the city or county should feel comfortable with the rate. The city or county may already use a standard discount rate, in which case you may choose to use this rate to evaluate economic development projects.