Introduction
When determining the economic efficiency of a certain project, one of the main complexities is the rationale and choice of the discount rate since it serves as the important parameter of the surrounding economic environment. Capital budget decisions depend not only on how correctly and efficiently future cash flows are estimated. The adopted discount rate has a significant effect on the result of calculations. In other words, any project can be made profitable by lowering this parameter in estimated calculations. At the same time, work can be disadvantageous if this indicator is increased. Therefore, an accurate justification for the discount rate is the first step in determining the effectiveness of budget allocation, which is particularly relevant in terms of debt.
Complexities in Adjusting Discount Rates and the Influence of Debt
In case the definition of the capital structure for a particular project is determined, the discount rate becomes alternating, or step-by-step, which complicates the assessment of efficiency. As an example, it is possible to bring any company that takes much credit for its work. As the project is implemented and the debt is repaid, the share of equity capital and, therefore, the discount rate, will increase (Sarofim and Giordano 1016). On the other hand, for creditors and the firm itself, the risk should be reduced in order to conduct productive and profitable activities. Hence, this calculation option reflects the value of the discount rate inadequately.
In general, using the weighted average cost of capital (WACC) as the discount rate has significant advantages since it can be used to make a conclusion regarding possible alternatives to the use of resources. In particular, it can be the return of money to shareholders and creditors in proportion to their contributions. However, this indicator has certain limitations for its use, which can complicate the work process. For instance, it is a constant value, but during the implementation of the project, it can change if additional capital is raised. Also, as Bova remarks, WACC averages all the risks of the company, while the threats of projects can vary greatly in their degree and nature (50). Using this indicator as a discount rate suggests that the internal rate of return (IRR) should be higher than the cost of capital (Bova 50). Finally, WACC includes risk adjustment, which is then included in the compound interest calculation formula. Companies’ managers cannot be sure that threats will increase gradually with the same rate for all investments. Thus, using the weighted average cost of capital as a discount rate allows the deeper assessment of a particular economic situation.
Beta for the Influence of Debt
When the debt-equity ratio changes, the beta of the firm remains the same. As Sarofim and Giordano note, it is easy to see that an increase in the debt-equity ratio leads to an increase in the beta-coefficient on the company’s shares (1019). It looks logical since high ratio leads to the fluctuations of the firm’s profit after paying taxes (Bova 51). Conversely, a decrease in the debt-equity ratio may lead to lowering the beta coefficient for the company’s shares because its profit becomes less susceptible to fluctuations if all the fees are paid.
Conclusion
The discount rate is an essential indicator that should be respected in the process of allocating capital budget funds. Some risks and complexities may arise when working with this variable. However, the timely assessment of changes can help to solve any problems and achieve stable profits, despite credit obligations. Beta for the influence of debt is the value that is also important in the calculation of financial activity, and its fluctuations affect the ratio of debt to equity significantly.
Works Cited
Bova, Francesco. “Discussion of Accounting for Biological Assets and the Cost of Debt.” Journal of International Accounting Research, vol. 15, no. 2, 2016, pp. 49-51.
Sarofim, Marcus C., and Michael R. Giordano. “A Quantitative Approach to Evaluating the GWP Timescale Through Implicit Discount Rates.” Earth System Dynamics, vol. 9, no. 3, 2018, pp. 1013-1024.