The net present value (NPV) approach can be used to evaluate investment possibilities and business appraisals. To determine the investment’s feasibility, analysts must employ a reasonable discount rate.
Inflation is defined as an increase in prices that results in a decrease in the value of money. Inflation reduces the purchasing power of money. As a result, due to inflation, $ 100 now will be worth less in 5 years.
Interest rates and inflation are inversely connected. It means that if the inflation rate is higher, the interest rate will be lower, and vice versa.
A lower present value of a cash flow is obtained by using a greater discount rate. The net present value of future cash flows drops as future cash flows are discounted at a greater discount rate.
What influences the discount rate?
The mining staff of the Canadian securities commissions will use technical reports filed on the system for electronic document analysis and retrieval (SEDAR), which were prepared by highly credible sources such as international consulting firms, well-known experts, and major mining companies, to find examples of industry consensus or approaches to specific issues and techniques. However, one assumption on which SEDAR appears to be split is the appropriate discount rate to use when determining a project’s net present value (NPV).
Many project elements and attributes influence discount rates, including the marketability of the commodity to be mined, the project’s location, its stage of development, and the size and capabilities of the project’s owner. While SEDAR reports can be helpful recommendations, it’s crucial to make sure the reports a firm uses as sources for evaluating its project’s discount rate are from mining companies of similar size, stage of development, and features. When choosing discount rates for a project, a company’s primary consideration is the rate of return that will most likely attract a large investor. Frequently, the company’s actual discount rate does not address the risks of the specific project.
To begin, different discount rates for different commodities should be applied. Mixed base metal/precious metal projects, such as copper-gold, are likely to have greater discount rates than precious metal projects, such as silver-gold. Because precious metal projects face fewer barriers to selling their product, they should be discounted at a basic rate of six to eight percent; base metal projects should be discounted at ten percent; and industrial minerals or specialty metals with no purchase agreements in place and no clear marketing strategy should be discounted at an additional two to three percent.
The discount rate should also take into account the project’s jurisdiction. Projects based in Chile or Nevada, for example, are unlikely to receive additional discounts to their cash flows because these jurisdictions are seen as relatively stable jurisdictions for developing long-term mines. However, due to the uncertainties surrounding mining taxation, some projects in Australia may now be eligible for further discounts. Due to sovereign risk perceptions, as well as political and taxation uncertainty, projects in the Democratic Republic of Congo may need to add five to seven percent to the discount rate.
Higher discount rates should also be utilized when accurate information on access and the mining or processing processes to be used is insufficient, or when environmental sensitivities and permitting requirements are unknown. A project in production, for example, would be considered low-risk, so no additional discount would be applied; a project in the Preliminary Economic Assessment stage, on the other hand, might have an additional two to three percent discount rate applied to cover unknowns related to project definition and cost accuracy. In the latter case, however, a corporation should be cautious against handicapping the project by employing unduly conservative production costs and process characteristics they should already be compensated for by changes in the discount rate.
Another important thing to examine is the project owner’s size and experience. No further discount would be applied to the cash flows if the owner is a well-known big miner with proven operations and mine development experience in the project’s jurisdiction. If the owner is a junior with limited development and operational experience, if it faces obstacles in developing major infrastructure requirements, or if it has had no previous exposure to mine development in the project’s jurisdiction, a two-to-three percent increase in the discount rate may be considered.
When choosing a suitable discount rate for NPV, all of the criteria listed should be taken into account. Also, as previously said, when examining comparable disclosure by reliable sources on SEDAR, caution should be applied. The discount rate utilized in a financial analysis of a major’s operating gold project in Nevada should not be used as the discount rate for a junior’s base metal project in Mali that is in the PEA stage.
What effect does inflation have on interest rates?
Inflation. Interest rate levels will be affected by inflation. The higher the rate of inflation, the more likely interest rates will rise. This happens because lenders will demand higher interest rates in order to compensate for the eventual loss of buying power of the money they are paid.
Is it true that increasing the discount rate lowers inflation?
The discount rate is a key measure of the state of credit in a given economy. Because raising or lowering the discount rate affects banks’ borrowing costs and, as a result, the rates they charge on loans, it is viewed as a tool for combating recession or inflation. The discount rate is also employed to deal with balance-of-payments imbalances, or to control foreign capital flows.
What causes the discount rate to fluctuate?
When the demand for goods and services exceeds the supply, inflation occurs. To enhance output, businesses hike prices and take out loans. The Federal Reserve adjusts the discount rate to compensate for this imbalance, with the purpose of removing money from circulation and reducing demand. The higher discount rate makes borrowing money from the Federal Reserve more expensive for depository institutions. Depository institutions have less money to lend since they are reducing their borrowing. Demand for goods and services falls as money sources dry up, weakening the economy.
Is the discount rate comparable to inflation?
We learned about the time value of money using a basic model in the previous section. In reality, a variety of factors influence the value of a potential investment. In the following part, these factors will be briefly discussed.
We combined the notion of “inflation” with another concept called “discount rate” in the preceding example.
Inflation is the process through which the price of things rises over time, and it can be used to estimate the future value of money.
Nonetheless, “Discount rate” is a word that applies to both individuals and businesses.
A+ “The “discount rate” refers to the expected return on investment for any given organization.
Most people, for example, keep their money in banks.
If a consumer keeps their money in the bank, the bank will give them interest.
The interest rate is usually very low, like 0.05 percent.
So, if you put $1,000 in a bank for ten years, you’ll get the same expected return as previously, plus a.05 percent rise per year.
You might obtain a better return on your money if you put it in a stock rather than a bank.
You might be able to receive a 4-percent return on your investment.
This becomes your discount rate if you can consistently receive a 4% return.
That way, you may compare the investment’s rate of return to your own discount rate while deciding whether investments are right for you.
As you can see, a person’s (or a company’s) discount rate is frequently different from the rate of inflation.
But, if money’s purchasing value is eroding (due to rising costs of things i.e. inflation), and you can grow your money at a different rate, how can you figure out how much cash you’ll need today to make a significant purchase later?
This is indicated in the formula below.
The inflation rate is again iINF, and the discount rate is d.
“The number of terms (typically years) used in the calculation is represented by “n.”
You may calculate the FPW once you know it “An investment’s “Present Worth” (PW).
The PW is the amount of money required right now (invested at d) to buy anything in the future (with an inflation rate of iINF).
The password is:
Where C0 is the price of the item you want to buy.
In the example below, the present value is calculated using both the discount rate and inflation.
For instance, your company recently erected a big utility-scale photovoltaic power plant.
The plant’s total cost is $100 million, and it is up and running.
The system includes dozens of big inverters that will need to be updated in around 7 years.
How much cash does your company need now, invested at your company’s discount rate of 6%, to purchase 20 inverters at a cost of $20,000 each, in order to purchase the inverters in 7 years?
Assume a 3% annual inflation rate.
Solution: If your company bought it today, it would cost $20,000*20 = $4 million.
However, the corporation will make the purchase in seven years, at which time the cost of the inverters would rise owing to inflation.
As a result, we employ the Present Worth formula instead.
We’ll start by calculating the current worth factor.
As a result, your organization will need to spend around $3.3 million now at a rate of 6% in order to make the inverter purchase in 7 years.
A corporation may need to borrow money from a bank in order to undertake these huge purchases.
When a bank lends money to a company, it considers it an investment and expects to be repaid with additional money.
This money is referred to as interest (from the standpoint of the organization receiving the loan).
For the use of money lent or for postponing the repayment of a debt, interest is paid on a regular basis at a certain rate.
If you borrow $1,000 from a bank and pay it back at a 3% interest rate, you will owe the bank $1,030 at the end of the year.
What happens if the discount rate goes up?
When the discount rate is increased to account for risk, it rises. Discount rates that are higher result in lower present values. Because of the highest rate of earning, a larger discount rate suggests that money will rise more swiftly over time. Let’s say two distinct projects each generate $10,000 in cash over the course of a year, but one is riskier than the other.
Why does raising interest rates bring inflation down?
Interest rates are its primary weapon in the fight against inflation. According to Yiming Ma, an assistant finance professor at Columbia University Business School, the Fed does this by determining the short-term borrowing rate for commercial banks, which subsequently pass those rates on to consumers and companies.
This increased rate affects the interest you pay on everything from credit cards to mortgages to vehicle loans, increasing the cost of borrowing. On the other hand, it raises interest rates on savings accounts.
Interest rates and the economy
But how do higher interest rates bring inflation under control? According to analysts, they help by slowing down the economy.
“When the economy needs it, the Fed uses interest rates as a gas pedal or a brake,” said Greg McBride, chief financial analyst at Bankrate. “With high inflation, they can raise interest rates and use this to put the brakes on the economy in order to bring inflation under control.”
In essence, the Fed’s goal is to make borrowing more expensive so that consumers and businesses delay making investments, so reducing demand and, presumably, keeping prices low.
What happens when interest rates are greater than inflation?
- When the rate of inflation outpaces the rate of interest generated on a savings or checking account, the investor loses money.
- In the United States, the Consumer Price Index (CPI) is the most widely used method of calculating inflation.
- Many people argue that indexing Social Security payments to the Consumer Price Index (CPI) is insufficient.
- Investing in Treasury Inflation-Protected Securities (TIPS), government I bonds, stocks, and precious metals can help preserve investments from inflation.
Inflation favours whom?
- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
What happens if the discount rate goes down?
A lower discount rate makes borrowing money cheaper for commercial banks, resulting in an increase in accessible credit and lending activity across the economy.