Risk discount rate

Disscuss with fellow Actuarial forum members about what is being asked in Actuarial Interviews
Post Reply
ShikhaAgarwal
Jr. Member
Posts: 25
Joined: 22 Apr 2018, 14:57
Status: Offline

08 May 2018, 18:07

Hello,
How the risk discount rate used to discount future cashflows is determined?
Does anyone have any idea?

Thankyou.


Sent from my SM-G611F using Actuarial Info mobile app


User avatar
Mayank
Site Admin
Posts: 215
Joined: 06 Oct 2017, 11:19
Status: Offline

08 May 2018, 21:25

May you find this useful! :)
Screenshot_20180508-212414.jpg
You do not have the required permissions to view the files attached to this post.
Mayank Goyal
ShikhaAgarwal
Jr. Member
Posts: 25
Joined: 22 Apr 2018, 14:57
Status: Offline

08 May 2018, 21:51

Okay. Then how risk free rate is determined?
I know its the rate of interest given by govt on its bonds. But how govt choose what rate to give?

Sent from my SM-G611F using Actuarial Info mobile app

Abhinandan7
Newbie
Posts: 9
Joined: 07 Oct 2017, 14:20
Status: Offline

09 May 2018, 17:02

Risk Discount Rate - This is a topic that needs a lot of amplified discussion. [I'll limit myself to be on the point]
[simply
 जितना आपको देना पड़ेगा प्रोजेक्ट के finance  के लिए उतना आपको प्रोजेक्ट से भी चाहिए, तो उससे थोड़ा ज्यादा पे आप प्रोजेक्ट को value  कर दोगे :) - but let's go into some detail. I am not a working professional so I am just writing what I think may be the case in practice ]

For commercial companies, a company can be seen as a portfolio of projects [i.e. they take on different projects to run their business]
To carry those projects, company needs finances which they basically get from bond and equity market.

Now the lenders and shareholders will demand returns for the finance provided, which the company must meet. Although for shareholders this is at the discretion of the company, the company must give the smooth return to the owners.

[the question is again here that what return - interest rate etc –will they demand? = I think it is somewhat subjective based on demand for and supply of loan capital and subject to some legislative and regulatory requirements.
You just think if you give loan to someone in a professional manner what factors you might consider – perhaps- credibility, term. Demand for your loan, some of your subjective needs which can be met by those interest, no exploitation of borrower etc. ]


So, after financing the projects the company must be able to earn at least that much return on project undertaken which fulfil the outgo on finances and at the same time must not leave their owners (shareholders) at worse off position. (in fact need to earn more for them).
To do this, that least earning must be some WACC (I suppose you are aware of this).

Specifically, if a project is identified and passes the initial appraisal then for the detailed appraisal risk discount rate is needed to discount the projected cashflows to see the viability of the project.The company already has some sort of project undertaken that aggregates or combined to represent a particular risk profile for the company.
  1. Now if the project is as risky as the company’s current risk profile  (mainly systematic risk) then the cost of incremental capital (the extra borrowed capital to finance this particular project) will be considered and at least this much needs to be earned on project.
    this incremental cost of capital which is used is the minimum WACC at optimal capital structure (which you know from CT2).

  2. If the project has more systematic risks than company then the above minimum WACC at optimal capital structure is increased by some arbitrary number (may be in light of some similar projects of other companies, which may be hard to find so subjectivity comes to the play).
[Now you may also wonder how one can know whether a project has more systematic risk or not – well the company must have some calculative method and data on some standardised index of risky assets and can project some required return on considered project to calculate the project beta for measuring systematic risk. They may also guess from experience of their previous projects.]

For public companies, social cost and benefits are also allowed for. So risk free rate is also impacted by subjectivity.
For insurance companies, a project is actually financed from internal long term fund. Thus they look whether the project is good investment or not comparably and return on internal long term fund may be taken as discount rate.

Apart from all the above discussion, one thing for sure that risk discount rate is predominantly effected by the Subjectivity as to reflect the needs and requirement- the type of risk they want to take on, the return they really require etc. Too much precision is also not required as the NPVs may not change significantly by minimal changes.

By the way it'll be better if some working professional put some light on this matter.
Thank You for reading,
Swargesh Kant Tripathi
 
ShikhaAgarwal
Jr. Member
Posts: 25
Joined: 22 Apr 2018, 14:57
Status: Offline

09 May 2018, 17:27

Hey Swargesh,
I must say. You are good. And it all does make sense now.
Thankyou very much.
Shikha.

Sent from my SM-G611F using Actuarial Info mobile app


Abhinandan7
Newbie
Posts: 9
Joined: 07 Oct 2017, 14:20
Status: Offline

09 May 2018, 20:15

:) 👍 :) 👍
User avatar
Mayank
Site Admin
Posts: 215
Joined: 06 Oct 2017, 11:19
Status: Offline

09 May 2018, 21:42

Whoa Swargesh! You're too good! Thanks a ton for clearing it for all :)
Mayank Goyal
Abhinandan7
Newbie
Posts: 9
Joined: 07 Oct 2017, 14:20
Status: Offline

09 May 2018, 22:30

Always ready to help if I can :) ​​​​​​.
​​​​Thanks to all for the appreciation.

Post Reply
Actuarial Blogs Insurology

icon icon