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

2. 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.

3. 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* =
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.

4. 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?

5. 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?

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

7. 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.

8. Government is sometimes selective in whether to apply discount rates

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

10. 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

11. Appendix: Supporting material

12. NAO reports are available here:
The sale of Eurostar
The privatisation of Royal Mail
Financial institutions landscape
The economic regulation of the water sector
The choice of finance for capital investment

13. 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

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