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Actually, discount rate should reflect the company's cost of capital and not be used as a screening measure. Cost of capital is truly defined only as interest on bank loans and return realized by corporate investors as dividends and stock appreciation. If you choose a high discount rate, higher than one's cost of capital, you are in effect selecting to be "not in favor" of long-term, long life projects, because you are essentially assigning little or no value to cash flows that occur later in the life of the project. In fact, with a high discount rate, you will be "more in favor" of investments with high earning rates but short lives, such as water drive projects, which are difficult to replace successfully on a continuous, on-going basis. Companies that do this actually put themselves on a treadmill, with ever increasing reserve replacement requirements that one-day soon, after they reach a certain size, can't be met. This is why many companies' growth will eventually flat line, and they have no other choice but to look for merger opportunities to maintain continued shareholder commitment. On the other hand, choosing a low discount rate will result in long term, large-reserve projects and sustainable growth over many years. The bottom line is that investment opportunities should be valued on a discount rate that is a function of the company's cost of capital and that a selection of a discount rate that is too low is not as detrimental to the company's long term growth and survival as the selection of a discount rate that is too high. We will talk more next issue about the appropriate use of rate of return, and other criteria, in ranking investment opportunities.
Back to October 2003 Newsletter
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