Subject 301 April 1999 Q3

Hi, in this question the first part asks about the factors to be considered when determining the risk discount rate. I am struggling to understand the 2nd part which asks to describe the additional complications that would arise if there were separate borrowing and lending rates. The solution talks about accumulating at 2 different rates... I am battling to understand this as I had the impression that the risk discount rate is only one rate...

 

I've not got access to the qn/sol'n you are looking at but it is a misconception that there is only one discount rate applied. Whilst in practise I have only seen one but most sol'ns do refer to applying different rates to different types of cashflows.

I guess the idea is that you could say that different liabilities could be backed by different types of assets dependant on the relative degree of certainty of arising or volatility in size. That leads to different assumptions as the start point is often a risk free rate + a margin that reflects the volatility of your asset mix.

Any other thoughts out there?

Just goes to show what you see in practise and theory can be different.

 

It was the first past exam question in revision booklet 4. I remember from CT5 in profit testing interest on reserves could be different to the risk discount rate. However, interest on reserves were incorporated into the cashflows. Surely if there are different borrowing and lending rates this should be incorporated into the cashflows without any effect on the risk discount rate

 

The risk discount rate should allow for the level of risk attaching to the cashflows - once the company has borrowed funds to finance the project the set of future negative cashflows are pretty much fixed (i.e. the loan must always be repaid). Positive returns from the project may be less certain and hence are more 'at risk'. For this reason separate rates may be applied to the two sets of cashflow to allow for this difference in risk. Hope this helps!


<Edit>
Think of the rate applying to the income from the project as the lower discount rate applying to the certain cashflows (e.g. loan payment out), plus a margin for risk.