Use The Right Discount Rate, Or You Are Losing Money!



Author: Jonathan Surls Advisory Consultant at ABB

The discount rate plays a significant role in long term expansion planning studies. The lower the discount rate, the more likely the plan will call for higher capital investments early. The higher the discount rate, the more likely the plan will call for smaller capital investments and push higher capital investments into the longer term. Understanding the impact of discount rates is key to understanding the reasons for utility capital asset decisions.
The discount rate is tied directly to the theory of the time value of money. If offered $2,000 now or $2,050 next year, how would you make that decision? Assuming a risk free interest of rate of 3%, $2,000 today is equal to $2,060 next year. Therefore, you would desire the $2,000 now versus the $2,050 next year because you could invest that money today and earn an additional $10 dollars. However, if market risks indicated that interest rates may fall, you might desire the $2,050 next year because your investment might only yield $2,040. When evaluating capital projects, the discount rate is used to evaluate the present worth of all past and future cash flows relevant to the study. The projects are evaluated in terms of Net Present Value which is the summation of all the cash flows valued at their present worth.

When calculating the Net Present Value of Revenue Requirements, it is important that utilities use the correct discount rate otherwise they may be over valuing or under valuing assets. Utilities often use the Before Tax Weighted Cost of Capital or the After Tax Weighted Cost of Capital. The Before Tax Weighted Cost of Capital is the weighted average of the utility’s interest on debt and equity, excluding tax impacts. For example, if a utility has 50% debt at an interest rate of 7.06% and 50% equity at a rate of 11.50% then the weighted cost of capital is (0.5*7.06) + (0.5*11.50) = 9.28%. When calculating the After Tax Weighted Cost of Capital, the calculation is modified because debt costs are tax deductible. Thus the cost of debt is now 1 minus the tax rate multiplied by the cost of debt. Therefore, if we continue our example and say that the effective income tax rate is 35%, we now see that the After Tax Weighted Cost of Capital is (0.50*7.06*(1-.35)) +(0.50*11.50) = 8.04%.

The question now becomes whether a utility should use the Before Tax Weighted Cost of Capital or the After Tax Weighted Cost of Capital. The answer all depends on whether or not the utility is including taxes in their Revenue Requirement calculations. If a utility is considering taxes in the calculation of Revenue Requirements, they must use the After Tax Weighted Cost of Capital. The consequences of an entity valuing a decision based on the Before Tax Weighted Cost of Capital while the true project cash flows include the tax impacts is a potential to undervalue the asset decision. Consider the example of a decision to spend $1,880 now or $2,050 next year. If you use the Before Tax Weighted Cost of Capital, with the value of the future dollars at $1,875, you might elect to defer the spending decision to next year. However, had you considered the tax consequences of the decision and used the After Tax Weighted Cost of Capital, the value of the future dollars would have been $1,897 and you would have been better off spending $1,880 today. Thus it is critical that a utility treats the weighted cost of capital in the same way it treats the revenue requirements.

Find out more, at Advisors Consulting, about capital investment decisions, expansion planning, and the electrical utility industry.