Catalog

	Table of Contents
p. 32 of 74 BACK | NEXT I. Introduction II. Background III. The Economic Rationale of A Project IV. Macroeconomic and Sectoral Context V. An Integrated Approach To Economic Analysis VI. Identification and Quantification of Costs and Benefits VII. Valuation of Economic Costs and Benefits VIII. Large Projects, Linkages, and National Affordability IX. Least-Cost and Cost-Effective Analysis X. Investment Criteria: Economic Viability XI. Discount Rate XII. Uncertainty: Sensitivity and Risk Analysis XIII. Sustainability of Project Effects XIV. Distribution of Project Effects XV. Projects and Policies XVI. Appendices XVII. Others

Guidelines for the Economic Analysis of Projects

---

XI. Discount Rate

142. Bank practice is to use a rate of 10 or 12 percent to calculate the net present value of a project, or to compare with the internal rate of return, for economic analysis. However, economic rates of return differ considerably between sectors and countries, and different countries vary in their capacity to repay foreign borrowing. From time to time, an appropriate discount rate for economic analysis should be calculated for each country to compare with the existing practice. The concern here is with a discount rate for economic analysis with benefits and costs estimated in economic prices.

143. A discount rate for economic analysis can be estimated in different ways. Four of these approaches to estimation focus on

• the economic rate of return on alternative marginal projects or the economic opportunity cost of capital, so that investments can be selected that show a minimum rate of return that is not exceeded by other possible investments;
• the real cost of foreign borrowing, which ensures that investment funds are committed to projects that will be able to meet the country's debt obligations, especially where investment is highly dependent on inflows of foreign capital;
• the real rate of return in the capital market, which will indicate the return a project must earn before investors will forego more liquid types of investment to invest in physical assets; and
• the overall demand and supply of investment funds, to provide an overall estimate of the economic price of capital.

144. Various sources of information can be used to obtain an estimate of the rate of return on investments in the economy. At one level, national income accounting data converted to economic prices can be used to calculate a national level profit estimate. This should then be compared with a national capital stock estimate, which may not be available. At a second level, sector or corporate data is used to estimate a weighted average return in financial prices. This return then needs to be converted to economic prices using national parameter estimates. At a third level, studies of recently accepted and rejected projects are used to identify a minimum economic rate of return that appears acceptable to the government. These approaches generally give a range of estimates for the economic opportunity cost of capital, on the basis of aggregate data at the national and sectoral level, and data incorporating appraisal optimism at the project level.

145. The real costs of foreign borrowing may be easier to estimate where it is appropriate. The cost of foreign borrowing varies between different sources. The relevant cost is the marginal or highest cost of borrowing on current or projected loans, where the cost of borrowing includes the interest rate and other costs, such as front-end and commitment fees, and risk premiums. This cost needs to be converted into real terms. The marginal cost of foreign borrowing can be deflated by an export or import price index depending on whether the major source of repayments in foreign currency will come from expanded exports or imports foregone. In the absence of specific data on foreign loans, a world rate, such as the London interbank offer rate (LIBOR) adjusted for administration fees and a risk premium, can be used. In the absence of data on export and import prices, a world price index, such as the manufacturing value-added index, can be used for deflating purposes. The resulting real cost of foreign borrowing provides the minimum rate of return a project or subproject should achieve at economic prices.

146. There are different sources of capital funds in the domestic economy: insurance or pension funds, investment and commercial banks, venture capital operations, and bond and stock markets. Rates of interest or return on these different sources of capital can be deflated to real terms and converted to economic prices. Moreover, the return must be acceptable to those using the funds. The real cost of domestic borrowing will be the rate that balances the supply of funds from savers with the demand for funds from investors. Projects should provide a return greater than the sources of funds that finance them. However, capital markets and, especially, interest rates, are frequently regulated, controlled, or small, and may not provide an appropriate measure of economic return on financial investment.

147. More generally, the economic price of capital can be estimated as a weighted average of the demand and supply price. The marginal productivity of capital provides an estimate of the demand price for investment funds. The supply price of savings will be given by a social rate of time preference, a rate beyond which savers are willing to give up present for future consumption. The supply of savings from different groups of lenders can be compared with the demand for investment funds from different groups of borrowers. Elasticity estimates of the responsiveness of supply and demand to changes in real interest rates are used to arrive at the weighted average of the demand and supply price of capital (see Appendix 20).

Back F. Project Investments and The Budget	Next XII. Uncertainty: Sensitivity and Risk Analysis