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:
- Social time
preference rate (STPR)
- Social
opportunity cost (SOC)
- Project
specific cost of capital
- Cost of funds
rate.
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.