What is the role of discount rate in cost-benefit analysis?

2 Why does the discount rate matter?

The discount rate matters because it can have a significant impact on the outcome of CBA. Depending on the discount rate, a project or policy that looks beneficial at one rate may look undesirable at another. For example, suppose you are evaluating a project that costs $1,000 today and generates $200 per year for 10 years. If you use a 5% discount rate, the net present value (NPV) of the project is $522, which means it is worth doing. However, if you use a 10% discount rate, the NPV drops to $23, which means it is barely worthwhile. If you use a 15% discount rate, the NPV becomes negative, which means it is better to reject the project.

3 How to choose the discount rate?

Choosing the discount rate for CBA is not a straightforward task, as different approaches may lead to different rates depending on the perspective and purpose of the analysis. The social rate of time preference (SRTP) is one option, which reflects society's present-future value ratio and can be estimated from market interest rates, consumption growth rate, or ethical judgments. Another choice is the social opportunity cost of capital (SOCC), which factors in the alternative use of resources invested in a project or policy and can be estimated from average return on capital, marginal productivity of capital, or weighted average cost of capital. Finally, the shadow price of capital (SPC) adjusts the SOCC for taxation or market failures by multiplying the SOCC by a factor that reflects the marginal excess burden of taxation or marginal social benefit of public spending.

4 How to apply the discount rate?

Once you have chosen the discount rate, you can apply it to the benefits and costs of the project or policy over time. Two main methods exist to do this: net present value (NPV) and benefit-cost ratio (BCR). The NPV method subtracts the present value of the costs from the present value of the benefits, giving you the net gain or loss from the project or policy. A positive NPV indicates that the project or policy is beneficial, while a negative NPV indicates that it is undesirable. The BCR method divides the present value of the benefits by the present value of the costs, giving you a ratio of benefits to costs. A BCR greater than one indicates that the project or policy is beneficial, while a BCR less than one indicates that it is undesirable.

5 What are the challenges and limitations of the discount rate?

The discount rate is not a precise or objective measure and is subject to uncertainty, variability, and controversy. Changes in the discount rate may be due to economic and social conditions, such as higher rates during periods of high inflation, low growth, or high risk. Furthermore, the discount rate may differ across sectors, regions, or countries due to the availability and productivity of capital, preferences and expectations of people, and institutional and environmental factors. Additionally, the discount rate is sensitive to the time horizon, distributional effects, and intergenerational equity of the project or policy. For instance, a lower rate may be applied for long-term projects that affect future generations or for projects that benefit the poor or marginalized groups.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?