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Financial Discount Rates in Project Appraisal

In the financial appraisal of a project, the cashflow statements are constructed from two points of view: the Total Investment (TI) Point of View and the Equity Point of View. One of the most important issues is the estimation of the correct financial discount rates for the two points of view. In the presence of taxes, the benefit of the tax shield from the interest deduction may be excluded or included in the free cashflow (FCF) of the project. Depending on whether the tax shield is included or excluded, the formulas for the weighted average cost of capital (WACC) will be different. In this paper, using some | Financial Discount Rates in Project Appraisal Joseph Tham Abstract In the financial appraisal of a project, the cashflow statements are constructed from two points of view: the Total Investment (TI) Point of View and the Equity Point of View. One of the most important issues is the estimation of the correct financial discount rates for the two points of view. In the presence of taxes, the benefit of the tax shield from the interest deduction may be excluded or included in the free cashflow (FCF) of the project. Depending on whether the tax shield is included or excluded, the formulas for the weighted average cost of capital (WACC) will be different. In this paper, using some basic ideas of valuation from corporate finance, the estimation of the financial discount rates for cashflows in perpetuity and single- period cashflows will be illustrated with simple numerical examples. INTRODUCTION In the manual on cost-benefit analysis by Jenkins and Harberger (Chapter 3:12, 1997), it is stated that the construction of the financial cashflow statements should be conducted from two points of view: 1. The Total Investment (or Banker’s) Point of View and 2. The Owner’s (or Equity) Point of View. The purpose of the Total Investment Point of View is to “determine the overall strength of the project.” See Jenkins & Harberger (Chapter 3:12, 1997). Also, see Bierman & Smidt (pg 405, 1993). In practical project appraisal, the manual suggests that it would be useful to analyze a project by constructing the cashflow statements from the two points of view because “it allows the analyst to determine whether the parties involved will find it worthwhile to finance, join or execute the project”. See Jenkins & Harberger (Chapter 3:11, 1997). For a recent example of the application of this approach in project appraisal, see Jenkins & Lim (1988). In practical terms, the relevance and need to construct and distinguish these two points of view in the process of project selection is unclear. .