Estimating Discount Rates
39 Pages Posted: 9 Apr 2015
Date Written: April 8, 2015
Discount rates are essential to applied finance, especially in setting prices for regulated utilities and valuing the liabilities of insurance companies and defined benefit pension plans. This paper reviews the basic building blocks for estimating discount rates. It also examines market risk premiums, as well as what constitutes a benchmark fair or required rate of return, in the aftermath of the financial crisis and the U.S. Federal Reserve’s bond-buying program. Some of the results are disconcerting. In Canada, utilities and pension regulators responded to the crash in different ways. Utilities regulators haven’t passed on the full impact of low interest rates, so that consumers face higher prices than they should whereas pension regulators have done the opposite, and forced some contributors to pay more. In both cases this is opposite to the desired effect of monetary policy which is to stimulate aggregate demand. A comprehensive survey of global finance professionals carried out last year provides some clues as to where adjustments are needed. In the U.S., the average equity market required return was estimated at 8.0 per cent; Canada’s is 7.40 per cent, due to the lower market risk premium and the lower risk-free rate. This paper adds a wealth of historic and survey data to conclude that the ideal base long-term interest rate used in risk premium models should be 4.0 per cent, producing an overall expected market return of 9-10.0 per cent. The same data indicate that allowed returns to utilities are currently too high, while the use of current bond yields in solvency valuations of pension plans and life insurers is unhelpful unless there is a realistic expectation that the plans will soon be terminated.
Keywords: discount rates, applied finance, market risk premiums, finance, estimating discount rates
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