Are you interested or discounted? Explaining discount rates with mini-case studies: Matthew Rees 1 March 2016

Government uses discount rates to make investment decisions QUOTE FROM THE GREEN BOOK Discounting is a technique used to compare costs and benefits that occur in different time periods. It is a separate concept from inflation, and is based on the principle that, generally, people prefer to receive goods and services now rather than later. This is known as ‘time preference’. For individuals, time preference can be measured by the real interest rate on money lent or borrowed. Amongst other investments, people invest at fixed, low risk rates, hoping to receive more in the future (net of tax) to compensate for the deferral of consumption now. These real rates of return give some indication of their individual pure time preference rate. Society as a whole, also prefers to receive goods and services sooner rather than later, and to defer costs to future generations. This is known as ‘social time preference’; the ‘social time preference rate’ (STPR) is the rate at which society values the present compared to the future.

Market-based discount rates support decisions about selling assets MORE QUOTES: “NPV is the primary criterion for deciding whether government action can be justified” “Social Time Preference Rate”: 3.5% real, (6.09% nominal) 1.035*1.025-1=0.060875 In the private sector, the cost of capital is generally higher than in the public sector “Compare the current market value of the asset plus the NPV of any other cost-benefit effects due to disposal (e.g. efficiency gains) with the NPV of retaining it in the public sector” Public vs. private ownership Retain or sell? The social net present value of a stream of future net income from an asset (which uses the Green Book discount rate of 3.5%) will, other things – including efficiency – remaining equal between the public and private sector, always be higher than the private sector value which will be based on a higher private sector discount rate. And from this, it may be deduced that other things remaining equal, this will always favour retention of the asset in public ownership. This is a mistake … [read guidance for details] The overall market-based risk discount can … be used in calculation of both the asset retention and the asset disposal scenarios.

A change in ownership may affect the future cash flow of a business “Hooper recommended that the government should go further to allow Royal Mail access to private capital and commercial disciplines” Private ownership = stronger commercial performance? Ѳ? Private ownership = identical performance? Worse performance?

Forecasts are fallible because it is hard to predict the future PAST: Low cost airlines 1995 PRESENT: Investment in new trains 1998 [see report!] Actual 2004, 08 FUTURE: New rail competition?

The present value of a future cash flow reduces as the discount rate is increased

GOVT SALE: discount rate ranged from The same valuation can be derived by a wide range of discount rates GOVT SALE: discount rate ranged from 8½ to 17% UBS was an adviser at the time and used the 8.5% rate to value the company. DfT’s early valuation of Eurostar in June 2013 used a discount rate of 8.5%–9.5% for this reason.

Government is sometimes selective in whether to apply discount rates

The role of debt has increased Gearing in the water sector has increased since privatisation Private equity ownership has largely replaced the stock market

Concluding remarks Government uses discount rates: When it decides whether to invest When it decides whether to sell assets Regulators use discount rates: When they set prices for natural monopolies Investors use discount rates: When they buy, sell and invest This type of analysis is useful, but it can be very tricky Reducing the risk of bias or error will require: Clarity on the key assumptions to avoid embarrassment and learn from mistakes Less ‘political’ estimates, (e.g. to justify a chosen outcome) Cross-checks using a variety of techniques Sensitivity analysis and “what if” scenarios

Appendix: Supporting material

NAO reports are available here: The sale of Eurostar https://www.nao.org.uk/wp-content/uploads/2015/11/The-sale-of-Eurostar.pdf The privatisation of Royal Mail https://www.nao.org.uk/wp-content/uploads/2014/04/The-privatisation-of-royal-mail.pdf Financial institutions landscape https://www.nao.org.uk/wp-content/uploads/2015/09/Financial-institutions-landscape.pdf The economic regulation of the water sector https://www.nao.org.uk/wp-content/uploads/2014/07/The-economic-regulation-of-the-water-sector.pdf The choice of finance for capital investment https://www.nao.org.uk/wp-content/uploads/2015/03/The-choice-of-finance-for-capital-investment.pdf

Capital asset pricing model CAPM is used routinely to estimate the cost of capital Capital Asset Pricing Model WACC = Ke*(e/(d+e)) + Kd*(1-t)*(d/(d+e)) Where: Ke = Rf+Beta*(Rm-Rf) Cost of equity: Eurostar is the only provider of train services through the Channel Tunnel It can be difficult to estimate beta where there is a lack of directly comparable companies with listed shares Need to start with a list of similar businesses

Private sector debt is generally priced at a premium to public debt to reflect risk