I vaguely remember my MBA international trip to Vietnam in 2009 where we visited a number of local companies including Intel whose general manager for Vietnam was an US expat with finance background. Having just finished my MBA finance course, I was curious as to how Intel evaluated its projects. I asked him this question during our Q&A session. The answer took me completely by surprise ... Every project at Intel apparently had to exceed a threshold IRR of 15% for it to receive appoval. This is not what I was taught as part of my MBA course. Discount rate was not supposed to be a steady constant, but is rather derived using weighted average cost of capital. It is a reflection of the systemic risk (not idiosyncratic risk) of the project that one cannot diversify.
Also, we were told never to use a company wide discount rate as every project is unique and tends to have a systemic risk profile of its own. What I found out later is that Intel's methodology through wrong is not an exception , but rather the norm. Most of the companies if not all in corporate America have a standard hurdle rate in place that needs to be met before capital investments are approved. While this makes valuation and decision making process easy, it certainly can lead to painfully wrong decisions.
Unfortunately, very few people in corporate world understand the true significance of discount rate and how it should be derived and what it should reflect. There are a number of people who argue that one should use a higher discount rate for riskier projects. This is a wrong way of encapsulating project specific risk. Discount rate was not meant to capture the overall risk posed by a project; just rather the systemic risk or the risk imposed by macro-economic and political changes . In other words, it is a reflection of how sensitive your future cash flow projections are to factors such as a recession, political turmoil etc. The higher the sensitivity , the higher the discount rate. For example, the cash flows of a consumer utilities company is insensitive to macro economic and/or political changes as the demand for power should stay more or less the same . So the discount rate should be low. The same cannot be said for a hotel or a high end restaurant whose customers and revenue tend to increase with an increase in discretionary income. Also risk free rate and market risk premium are never constant. So having a static discount rate across time not only ignores project specific differences, but also changing market conditions.
Finally, systemic risk as pointed out above should never be confused with idiosyncratic or project specific risk. The best way to capture project specific risk is not by tweaking discount rates, but rather by accommodating for them in future cash flow projections. One approach is to come up with multiple scenarios for projecting cash flows : say best case, worst case and most likely case. These cash flows can then be discounted using the same discount rate so that decision makers have a clear perspective of possible outcomes leading to a focus on the risks and potential mitigation activities . Read the following McKinsey article for more details on how to avoid a risk premium that unnecessarily kills your project.
Also, we were told never to use a company wide discount rate as every project is unique and tends to have a systemic risk profile of its own. What I found out later is that Intel's methodology through wrong is not an exception , but rather the norm. Most of the companies if not all in corporate America have a standard hurdle rate in place that needs to be met before capital investments are approved. While this makes valuation and decision making process easy, it certainly can lead to painfully wrong decisions.
Unfortunately, very few people in corporate world understand the true significance of discount rate and how it should be derived and what it should reflect. There are a number of people who argue that one should use a higher discount rate for riskier projects. This is a wrong way of encapsulating project specific risk. Discount rate was not meant to capture the overall risk posed by a project; just rather the systemic risk or the risk imposed by macro-economic and political changes . In other words, it is a reflection of how sensitive your future cash flow projections are to factors such as a recession, political turmoil etc. The higher the sensitivity , the higher the discount rate. For example, the cash flows of a consumer utilities company is insensitive to macro economic and/or political changes as the demand for power should stay more or less the same . So the discount rate should be low. The same cannot be said for a hotel or a high end restaurant whose customers and revenue tend to increase with an increase in discretionary income. Also risk free rate and market risk premium are never constant. So having a static discount rate across time not only ignores project specific differences, but also changing market conditions.
Finally, systemic risk as pointed out above should never be confused with idiosyncratic or project specific risk. The best way to capture project specific risk is not by tweaking discount rates, but rather by accommodating for them in future cash flow projections. One approach is to come up with multiple scenarios for projecting cash flows : say best case, worst case and most likely case. These cash flows can then be discounted using the same discount rate so that decision makers have a clear perspective of possible outcomes leading to a focus on the risks and potential mitigation activities . Read the following McKinsey article for more details on how to avoid a risk premium that unnecessarily kills your project.
