Multiperiod Financial Discount Rates in Project Appraisal: The No-Tax Case (Suat Chiet Khau Tai Chinh Nhieu Giai Doan Trong Tham Dinh Du an: Truong Hop Khong Co Thue)
Fulbright Economics Teaching Program Working Paper
40 Pages Posted: 10 Mar 2000
Date Written: August 1999
Abstract
The typical assumption about cashflows in perpetuity is not appropriate in practical project appraisal because the length of project life is always finite. In this paper, I discuss the calculation of multiperiod financial discount rates for a project with a finite life. For simplicity, I assume that there are no taxes. The analysis is conducted without and with inflation.
There are two possibilities for calculating the discount rates. First, we may assume that a constant debt-equity ratio is maintained during the life of the project. In this case, the loan schedule is constructed to keep the debt-equity ratio constant for the life of the project. Since the debt-equity ratio is constant, the Weighted Average Cost of Capital (WACC) and the return to equity e will be constant.
Second, the loan schedule may be fixed for the life of the project. In this case, as the loan is repaid, the debt-equity ratio changes because the principal is being repaid over the life of the project. In each period, the return to equity e will be a function of the debt-equity ratio for the period. The return to equity e varies with the change in the debt-equity ratios. The return to equity e will be adjusted to keep the WACC constant.
By explicitly calculating the appropriate discount rate for each period of the project with a finite life, it is not necessary to assume that the debt-equity ratio is constant and the cashflows are in perpetuity.
JEL Classification: D61, G31, H43
Suggested Citation: Suggested Citation