1 Introduction
A discount rate is used to convert flows of costs and benefits over time into a net present value. There are two key reasons for doing this. The first is to determine whether a project is worthwhile, that is whether or not it has a positive net present value. The second reason is to compare two projects that achieve the same objective but have different timeframes. For example a discount rate can be used to inform the choice between a lease option and a buy option for accommodation if trying to choose the most cost effective approach.
The government is often looking at proposals that have costs and benefits occurring over different time periods. The proposals cover a range of issues including investment in state owned enterprises, crown entities and departments, and social, environmental, and regulatory policy choices. The use of discounting enables the different cost and benefit flows to be converted into a single net present value number for decision-making.
When the results of any cost benefit analysis are clear-cut, the choice of discount rate is not material. In this situation it would not matter if the discount rate were 10% or 5%, the results would still be a positive net present value or a negative net present value. Unfortunately, not all decisions the government makes are clear-cut. When the government is making judgements, the choice of discount rate matters as it can affect the decision made.
This paper has eight sections. Section 2 describes the different economic approaches to the setting of discount rates. Section 3 takes the two main economic approaches and considers how the social rate of time preference and social opportunity cost can be estimated in broad terms. The fourth section discusses the various models to estimate the social opportunity cost in more detail. Section 5 outlines the methods currently used in the New Zealand public sector. Section 6 examines the assumptions required to apply the weighted average cost of capital to estimate a social opportunity cost discount rate. Section 7 outlines a worked example. It takes the general assumptions in section 6, determines the remaining assumptions for a particular circumstance and works through the relevant calculations. Finally section 8 concludes.
