**5.2 Use of the discount rate**

The net present value method has numerous advantages over the internal rate of return method. Above all, it is simpler to calculate and it isn't sensitive to the flaws arising from the multiple internal rate of return, the non-additive internal rate of return and other specific flaws that are associated with the internal rate of return method.

However, although we can avoid all the flaws of the internal rate of return method when using the net present value method, we encounter a problem of setting up the discount rate.

Let's take a case study on an investment project with a duration of 20 years. For easier calculation, a presumption of constant annual cash flow is made. A project is feasible when the net present value, calculated from equation 3, is equal to or higher than 0.

Fig. 4. Non-conventional cash flows in engineering projects, owing to maintenace and

cash outflows for the maintenance

cash inflows from the operation

... ...

According to Pšunder and Ferlan (2007) only slightly more than one-third of mechanical engineers are acquainted with multiple internal rate of return, so overcoming the multiple internal rate of return can cause problems in practice. However, the problem can be overcome by discounting the article with the change of sign to the period, represented by the article of the same sign in cash flow as the discounted one. A further possibility for overcoming the multiple internal rate of return problem is, according to Puxty and Dodds (1991), using the net present value rule. It would have no difficulty in giving the correct

periods (years)

The net present value method has numerous advantages over the internal rate of return method. Above all, it is simpler to calculate and it isn't sensitive to the flaws arising from the multiple internal rate of return, the non-additive internal rate of return and other specific

However, although we can avoid all the flaws of the internal rate of return method when using the net present value method, we encounter a problem of setting up the discount rate. Let's take a case study on an investment project with a duration of 20 years. For easier calculation, a presumption of constant annual cash flow is made. A project is feasible when the net present value, calculated from equation 3, is equal to or higher than 0.

flaws that are associated with the internal rate of return method.

overhauls.

 cash flow

advice.

**5.2 Use of the discount rate** 

 initial investment


In a 20-year project, the constant cash flow at a discount rate of 10 percent must amount to at least 10.6 percent of the investment on the annual level in order for the analysis to provide a positive indication. Meanwhile, at a 15 percent discount rate, it needs to be approximately 1.5 times as high, as seen from Table 4.

Table 4. Constant annual cash flows necessary (as a proportion of the initial investment outlay) for a positive indication of the present value analysis (modified after Pšunder and Cirman, 2011).

When a 20-year project generates a constant annual cash flow that amounts to 10 percent of the investment on the annual level, the net present value will be higher than 0 at a discount rate of 9 percent, but lower than 0 at a discount rate of 10 percent. The advice from the method will change, owing to changes in the discount rate. This example shows how important precise setting of the discount rate is.

The impact of the discount rate is comparatively diminished when projects are shorter and when the discount rate level is higher. However, even with 5-year projects and discount rates over 10 percent, the setting up of the discount rate could be decisive for the advice from the net present value method.

The survey conducted in February and March 2011 among appraisers in Slovenia by Pšunder and Cirman (2011) shows that experts have a quite unified opinion about the risk free rate. The average nominal risk-free rate in the survey was 4.20 percent. This average corresponded to the returns on bonds issued by the Republic of Slovenia with a maturity of seven to eight years. By using the calculated average real rate of return, they established that the respondents' average expected future inflation was 2.25 percent, which means the respondents expect slightly higher inflation in Slovenia than the target inflation set by the

Use of Discounted Cash Flow Methods for Evaluation of Engineering Projects 645

opinions about risk free rate are quite unified, but not by the risk premium (Pšunder and

Despite the wide use of discounting methods, there is still incomplete knowledge about them. To ensure the reliability of discounting methods, project managers must be acquainted with the deficiencies and drawbacks of the methods, particularly of the internal rate of return method. With the net present value method, it is vital to apply professionally proven methods when establishing the discount rate. Only this will ensure that the results of

Brozik D. (n.d.). The Reinvestment Assumption. Date of access: 28.9.2011, Available from:

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Cirman, 2011).

**7. References** 

the analysis will be reliable and credible.

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Ljubljana.

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European Central Bank (2.00 percent). The univariate statistics on risk-free rates of return are presented in Table 5.

Table 5. Risk-free rates of return and expected inflation (Pšunder and Cirman, 2011).

The experts' opinion was not so unified considering the risk premium. The experts considered the risk premium for improvements (additions to building etc.) at 4.91 percent (mean). The standard deviation was 3.07. As the risk premium is added to the risk free rate when calculating the discount rate, the discount rate may also vary immensly. Consequently the net present value method might give very varying advice when used.
