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Discount Rates are Hurdles, Not Targets

This post includes themes addressed in the Applied Forest Finance course.

When applying Net Present Value (NPV) in finance to evaluate investments, it’s appropriate to use a discount rate that reflects the marginal cost of capital of the firm. In business school, I learned the importance of a company’s weighted average cost of capital and, to this day, find it intuitive, relevant, operable and important as a source of information for discount rates. Beating the cost of capital creates value for the firm and trailing the cost of capital destroys wealth.  If firm A raises capital at 6% and firm B finances projects at 8%, firm A has the advantage, seven days a week. They have a lower “hurdle” to jump.

The weighted average cost of capital is analogous to a credit score. If the market believes you’re a credit risk, it will charge you more to borrow money.

This is half of the story when it comes to estimating discount rates for timberlands, or any specific asset class. Many firms “build up” a discount rate that starts with a suitable risk-free rate (usually a long-term U.S. Treasury bond) and add a “risk premium” to account for the risk of investing in timberland relative to those bonds. In interviewing timberland appraisers about discount rates, they focus on the rate of return expected from potential and probable timberland investors.

Let’s recap. Different firms have different risk profiles which dictate their ability to access money to invest. And different assets (or projects) have different risk profiles which necessitate different “discount” rates to account for the uncertainty associated with future cash flows.

Trouble begins with the fact that many firms or investors have an asset-specific discount rate in mind – their expected rate of return – rather than accounting for their cost of capital. In isolation, this does not matter much if your firm is well-capitalized and a good credit risk. But “backing into” a discount rate prioritizes the deal over the risk of the asset or the capability of the firm.

When firms apply a risk-adjusted, weighted average cost of capital for timberland investments, they contemplate the fact that any financing would occur at the cost of capital of the firm. This subjects the timberland asset to the same test any other asset would be expected to pass: does it generate returns competitive to any other project or investment contemplated by the firm that has a similar risk profile?

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