SOCIAL DISCOUNT RATE

In normal private sector discounted cash flows, the discount rate, is usually the cost money or the opportunity cost of investment and the concern is with the marginal rate. The marginal rate is the rate which would be earned by the private sector if additional capital allowed further private investment to occur. However, the public sector's perspective is different. The four commonly used rates are: The pragmatic solution by Treasury is the application of a standard set of alternative rates to see whether or not the outcome is sensitive to such variations. The preferred discount rate by Treasury is about 6% per annum with sensitivity testing at 3% and 9% (2000). A higher discount rate would favour maintenance options as against asset replacement that is, high returns against cost. Further, short term options are favoured by high discount rates.

SOCIAL TIME PREFERENCE RATE (STPR)

The "social time preference rate" (STPR) represents society's preference for present as against future consumption. Put another way, the STPR measures the additional future consumption required to exactly compensate for postponement of a unit of present consumption. Conceptually, the STPR may vary from the individual's preference for present rather than future consumption # for example, if individuals systematically take decisions which fail to take account of the needs of future generations, the STPR will be lower than the private time preference rate. Commonly, estimates of social time preference rates are about 2-4%.

SOCIAL OPPORTUNITY COST (SOC)

In contrast, the social opportunity cost (SOC) rate represents the return on the investment (rather than the consumption) elsewhere in the economy which is displaced by the marginal public sector project. While, with fully competitive markets, the two rates should converge, in the presence of tax and other distortions, the SOC is generally considered to be larger than the STPR. Because the stream to be discounted; the net benefits stream, is a consumption rather than an investment entity, it can be argued that the STPR is the more appropriate discount rate concept. However, its use raises the difficulty that the resources required for a public project may displace projects in the private sector which would have earned a return greater than the STPR.

This difficulty can (in theory) be overcome with the use of two discount rates instead of one: that is, capital costs are compounded forward using the SOC rate and are then discounted back at the STPR rate. Alternatively again, a weighted average of the STPR and the SOC can be used, with the weights reflecting the relative proportions of consumption and investment that the public project displaces. Estimates of social opportunity costs are about 7-10%.

PROJECT SPECIFIC COST OF CAPITAL

Because it is so difficult to measure the above rates it has been argued that the cost of money to the government should be used instead. That is, the interest rate at which government borrows funds in the market. This rate has been criticised because of the dominant position of the government in the capital market, the variability of interest rates and the wide range of factors which impact on interest rates.

The rate is an important offshoot of the SOC approach and is based on the Capital Asset Pricing Model (CAPM ) developed to explain the relationship between the return expected by shareholders in a private sector firm and the"market risk" characteristics of the shares. Market Risk can be defined as the risk to which all business enterprises are exposed through the cyclicality of the economy and business conditions. In the CAPM method equity holders seek a risk premium in compensation for the price volatility of their investment. Estimates of the size of the average market risk premium are influenced markedly by the period over which it is calculated. In Australia estimates vary from a low of 2.1% to a high of 7.9% with 6% a widely used parameter.

While all businesses are exposed to the risk, it is said to be undiversifiable and some firms and industry sectors are more or less riskier than others. Market risk is measured through the beta factor. While the market as a whole has a beta factor of 1, low risk firms and sectors will have betas of substantially less than one and high risk firms will have betas of substantially more than one. Resource companies have high betas while food retailing firms have low ones.

The beta is multiplied by the average risk premium to yield a project or industry specific risk premium. Additionally, in estimating a customised cost of capital through this procedure, the specific risk premium is built on to a generic risk free rate, which is found from Treasury's long term (10 year) bond rate and state variations. Since the early 1980s, the risk free rate has averaged about 5%pa in real terms. It should be noted that long term Treasury bonds are considered risk free only in the technical sense that the nominal return at the end of the term is assured and there is no market risk. Other risks such as inflation uncertainty, are not avoided.

COST OF FUNDS RATE

Finally, the discount rate may be based on the direct or observed "cost of funds". For the Commonwealth Government, this approach implies basing the discount rate on the cost of borrowing (in most circumstances the long#term bond rate) since at the margin, funds are likely to be raised through borrowing rather than through additional taxation. This approach explicitly reflects a Commonwealth financial perspective and is likely to be inconsistent with the economy wide perspective embodied in the Social Time Preference Rate and Social Opportunity Cost concepts. The approach is relevant however, where the project alternatives involve no more than contrasting cash flow streams reflecting different financial arrangements and where the cash flows are reasonably certain.

An example is the comparison of the construction of a building by public works and the instalment purchase of the same building.