What is the best way to determine the discount rate in a cost-benefit analysis?

1 Discount rate basics

The discount rate reflects the opportunity cost of capital, which is the return that could be earned by investing in an alternative project or asset with similar risk and duration. The higher the discount rate, the lower the present value of future benefits and costs, and vice versa. Therefore, the discount rate affects the net present value (NPV) and the benefit-cost ratio (BCR) of a project, which are the common indicators of its economic viability. A project is considered economically feasible if its NPV is positive or its BCR is greater than one, meaning that its benefits outweigh its costs.

3 Methods for estimating the discount rate

When estimating the discount rate, there are several methods to consider, depending on the type and source of the project, the availability and reliability of data, and the assumptions and preferences of the analyst. For instance, one method is to use the interest rate of a relevant market instrument, such as a government bond, as a proxy for the discount rate. This is simple and transparent but may not reflect the true opportunity cost of capital or the risk and uncertainty of the project. Alternatively, you can calculate a weighted average cost of capital (WACC) based on the capital structure of the project or firm. This is widely used for private CBA as it reflects financial performance and risk but may not capture social benefits or externalities. The social rate of time preference (SRTP) is another method which derives the discount rate from the social rate of time preference. This is often used for social CBA as it considers intergenerational equity and sustainability but requires estimating parameters with ethical and empirical uncertainty. Lastly, you can adjust the market interest rate with a shadow price of capital (SPC) to account for distortions in the capital market. This is also used for social CBA as it corrects for divergence between private and social opportunity cost of capital but requires estimating marginal cost of public funds.

4 Criteria for selecting the discount rate

When determining the discount rate for a Cost-Benefit Analysis (CBA), there is no definitive answer as different methods can yield different results and imply different trade-offs and implications. Therefore, the choice of the discount rate should be guided by criteria such as consistency, transparency, and sensitivity. Consistency means that the discount rate should be in line with the perspective, objective, and scope of the CBA. For example, a social CBA should use a social discount rate while a private CBA should use a private discount rate. Moreover, the discount rate should be consistent with the expected benefits and costs of the project in terms of their nature, timing, and distribution. Transparency requires that the analyst clearly states the method, data, and assumptions used to estimate it so that users and stakeholders can understand and evaluate its rationale and validity. Finally, sensitivity analysis tests how results and conclusions of the CBA change when different values or ranges of the discount rate are used. This helps to assess its robustness and uncertainty as well as identify critical values or thresholds that affect its economic feasibility and efficiency.