Advanced Capital Budgeting by Bierman Harold. Smidt Seymour

Author:Bierman, Harold.,Smidt, Seymour.
Language: eng
Format: epub, pdf
ISBN: 9781317828822
Publisher: Taylor & Francis (CAM)

DEFAULT-FREE RATE OF DISCOUNT

There are several situations in which it is desirable to use a discount rate that reflects as nearly as possible the pure default free time value of money, and not include an adjustment for any associated risk. One such situation is the discount rate used in calculating the present value of a series of certainty equivalents. The certainty equivalents reflect the project's risk. Another situation is that in which one wants to construct a risk adjusted discount rate by adding a risk premium to pure time value of money rate. There are many discount rates that have been suggested for these purposes. Among them are the two possibilities we shall consider in this section: (1) interest rate of government securities, and (2) interest rate of long-term bonds of the firm.

The term risk-free might be used to describe the interest rate of government securities. This is suggestive, but not strictly accurate. There are certain risks that cannot in practice be eliminated and that affect all interest-bearing securities to a greater or lesser extent.

One source of risk arises because of uncertainty about the future price level. Expectations about possible future price levels influence the market determination of interest rates. Buyers of bonds will tend to be hurt if the price level rises; hence they require a higher interest return with an expected price-level increase than with an expected price-level decrease, or with constant prices.

Another source of risk arises because of the possibility of changes in the term structure of interest rates. Normally, the interest rate on bonds will vary with the number of years to maturity even when there is no risk of default on the bonds. Bonds that mature in a few years may have higher (or lower) yields than bonds that mature in the more distant future. If there is no risk of default, the lender can always be sure of earning the going yield by buying a default-free bond of given maturity and holding it until it matures. The possibility exists, however, that some other strategy would result in earning a higher yield. If investors want to lend money for a five-year period and expect a decline in interest rates, they may be able to earn a higher yield by buying a fifteen- or twenty-year bond and selling it after five years than by buying a five-year bond and holding it to maturity. When this strategy of investing in long-lived securities is followed, however, there is no longer any guarantee that a given minimum rate of interest will actually be earned for the shorter holding period.

A lender wishing to avoid the uncertainty that results from the possibility of changes in the term structure of interest rates may be unable to do so. An investment in short-term debt instruments, such as treasury bills, will lead to uncertainty about the rates that will be earned when the time for reinvesting these funds arises. An investment in longer-term securities will lead to uncertainty about the actual return that will be realized if the securities must be liquidated before they mature.

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