In this video we introduce the concept of discount rates. So far we've used interest rates, for our future value and present value calculations, but more generally discount rates are used in renewable energy project finance. It's important we understand how they're calculated for larger organizations such as banks and other investors. Interest rates versus discount rates. A discount rate is a factor used to discount future income or payments the same as we have been using interest rates. There are many methods for financing renewable energy projects. Interest rates are only one of several ways to discount future cash flows. A project may use a variety of financing instruments including savings, loans such as debt, equity which is meaning selling ownership, or some combination of the above. All of these influence the discount rate. What discount rate to use? Let's talk about each of these characteristics. There are various methods to determine discount rates or different components of calculations for discount rates, these include the cost of debt, opportunity cost of capital, cost of selling equity, weighted average cost of capital, and hurdle rates. We'll talk about each of these. Capital here is defined as cash used for productive or investment purposes. For our purposes capital and cash are essentially synonyms. Also discount rates are sometimes called discount factors, it means the same thing. They are synonyms as well. Cost of debt is typically the interest rate associated with that debt. Types of debt include private loans from banks, friends and family or investors, bonds which are sold in public markets by large companies. Promissory notes between banks, investors, and companies are all ways of raising debt. The discount factor in this case is then the total cost of that debt which is the interest rate on the debt and the annualized cost of securing debt. Often large loans require a lot of upfront work from lawyers, and accountants, and others, and that cost has to be built into the discount factor. The opportunity cost of capital refers to alternative uses for available cash that we have to invest, perhaps savings or other cash accounts. We're going to assume that we have limited cash to invest; we're not infinitely rich or the corporation isn't infinitely rich, but it has multiple investment opportunities available to it each with an expected rate of return. We've done that analysis and we think we know what we can expect to get back from each of these investments. Which do we choose? While the discount rate is set to the highest rate of return among alternatives. If we have a bunch of alternative projects we can invest in, we know how much we are going to get back on each of them. It's pretty simple, choose the project with a best rate of return and use that as our discount rate. That's the bogey or the hurdle that we need to clear in order to invest in some other project that presents itself. We evaluate new projects using this discount rate, a pretty simple concept. Equity is selling partial ownership or equity in a company to raise capital or cash. Public corporations sell equity on stock markets. Private corporations may sell equity through private bilateral agreements with other companies, bilateral meaning between two parties. Partnerships including limited liability corporations may bring in new partners. The partners buy in to raise equity, and the discount rate then is the new-equity owners' share in the profits. It turns out it's the most expensive form of capital because new-owners share profits forever. If we have a very successful company that makes lots and lots of money over time and new-owner has 10 percent share of that lots and lots of money, that's much more expensive than getting debt. But oftentimes new companies cannot borrow money because they have no track record, so they have to resort to selling equity in order to raise capital to grow. Well, when we put all this together, we get the weighted average cost of capital. This is where we use multiple sources for new capital and we have to glom them together or average them together in order to come up with a discount rate. We use multiple capital sources, such as: savings, loans, and equity to finance our project. The discount rate then is the weighted factors according to the capital raise, so the more capital we raise from debt every year that weight will be. As an example suppose we use 50 percent to fund our project we use 50 percent savings at three percent annual interest, and 50 percent loan at seven percent. This is an easy calculation. It does take the average of the two since they're both equally weighted, and we come out with an average of five percent as our weighted average cost of capital or our discount rate. Another way that companies and large organizations set discount rates is to create a hurdle rate. A hurdle rate is the minimum acceptable rate of return on new investments. The new investments must clear this hurdle rate to be considered. If they don't return enough to clear the hurdle they're not considered. It provides a uniform discount rate across an organization, so it's easy to apply in that case and it saves time and energy calculating individual project rates. Discount rate is set by an organization or a company based on whole number of factors such as we have looked at, but it's uniform across the organization. To make things little more clear, let's take a look at some examples. Let's suppose a homeowner wants to install a large solar PV system. What type of discount rate would the homeowner use if the purchase cost is financed with a loan? Interest rate is pretty obvious answer. Homeowner has other projects as alternatives to the PV system that they could invest in or here the opportunity cost of capital might be appropriate. The homeowner will use money from a variety of sources such as: savings, investments, and loans. Well, here the weighted cost of capital looks good. Finally, the homeowner wants to make at least eight percent on any investments. This clearly is a hurdle rate that must be met for the homeowner to invest in the solar PV system. Here's some examples of discount rates in practice. Another important factor when establishing discount rate is risk. The riskier the project, the higher is the discount rate. Risky projects have higher discount rates than proven projects. Risky renewable energy projects will be more heavily discounted than well established and known project types. For example, in the picture at the right is an orbiting satellite with solar panels. It's beaming energy back to a receiving station on the ground via microwaves. This hasn't been done, so a project like this would be considered very risky. Putting solar PV on a residential rooftop wouldn't be very risky. It's well established, people know how it's going to work and they know it'll be reliable. The satellite idea on the other hand is very risky. It may work, it may not, and it'll be very expensive. In summary, discount rates are used to discount future incomes or payments. Interest rates are only one of several ways to discount future cash flows. Other measures are the cost of debt, which are interest cost plus the cost of acquiring the debt, cost of new equity, opportunity costs of capital, weighted average cost and hurdle rates, but whatever we do we must always adjust for project risk. Risky projects will demand a higher discount rate than safe, secure, well-known projects. In the next video we'll talk about discounted cash flows, net present value, and internal rate of return. We'll see you there.