Features of determination of discount rate for energy producing investment projects

Number, year
3(79), Vol. 1, 2014
UNC 681.5.0171

FEATURES of determination of discount rate for ENERGY producing investment projects

Valeriy I. Havrysh, Ph.D., D.Sc., professor

Interest in using biomass as feedstock for biofuel production has been increasing recently due to concerns about volatile oil prices, climate change, and so on. Producing of renewable energy involves large risks, while requiring heavy capital investment with relatively long payback periods when compared with other business sectors.

To arrive at a solution to the project evaluation problem, one will need to determine the level of discount rate for each project within an acceptable margin of error. The discount rate for a given project is typically determined by using risk-free market rates plus a market risk premium adjusted in relation to the volatility of the investment compared to the market. In practice, however, the discount rate is still subjective and dependent on corporate or other experience factors.

Several types of investment appraisals, such as payback period, accounting rate of return (ARR), internal rate of return (IRR), profitability index, and net present value (NPV), can be used to assess an investment project. The NPV is the most common project evaluation approach used by firms. The NPV index at the tth year depends on the selection of the discount rate, which can greatly affect the economics and decision making, particularly in capital-intensive projects.

A Discount Rate is used to convert projected cash flows into a present value to enable comparison of competing options for which the cash flows reflect differences in both timing and amounts. The Discount Rate reflects the Rate of Return expected by an investor to compensate the investor for placing capital at risk in a project.

Several studies estimating the Discount Rates have been conducted. Most of the above deals with the use of Discount Rates in the context of investment evaluation. But they do not take into account energy price dynamic. This decreases the precision of determination and, as a result, investment appraisals.

The dynamics of inflation and changing of energy resources prices, especially of motor fuel, have been analyzed. It is determined that the dynamics of the last factor can both improve and worsen the financial indicators of investment projects. The mutual influence of inflation and changing of energy resources prices on the incomes of these projects has been revealed. A method for determining the discount rate, taking into account the above factors has been offered.

The economic model developed here can be used to assess the discount rate of a renewable energy producing projects. The application results of the base case revealed that the calculated value as a rule less than one obtained without influence of energy price dynamic by 3…4 %.

This study provides a solid base for further research in assessing the discount rate of the biofuel facility.

Key words:
discount rate, risk, inflation, energy resources, investment

Valeriy I. Havrysh, Ph.D., D.Sc., professor. FEATURES of determination of discount rate for ENERGY producing investment projects


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