Adjusting Your Discount Rate
the RIGHT Way

The selection of your discount rate to use in forestry projects depends on your time preference for spending money now versus later. It also depends on how you are using the discount rate you select. Is it before taxes or after taxes? Is it before inflation or after?

One of the basic challenges we are faced with in any business investment situation is the appropriate discount rate to use in determining the profitability of projects. Often, we derive this rate by looking for something comparable to other investments of similar risk and longevity. However, this comparison is complicated when some investments are adjusted for inflation while others are not. In other instances some investments may be listed before taxes have been levied, while others have not been. This makes direct comparisons very difficult, but not impossible.

Before we look at the idea of moving between tax rates and inflation we need to have a brief discussion of Effective Annual Interest Rates and Nominal Annual Interest rates. It is standard practice to specify interest rates in annual terms. However, when interest is compounded in continuous, daily, monthly, or quarterly terms, but presented in annual terms, a question arises as to the meaning of the annualized rate. We need a mechanism to deal with this. When the annual rate is calculated by multiplying the periodic rate by the number of interest bearing periods per year, it becomes the nominal annual rate. The rate at which it is actually earned or paid is called the effective annual rate. Nominal interest is the annual interest rate without considering the effect of any compounding. Effective interest is the annual interest rate, taking into account the effect of compounding during the year.
 

Fortunately, the procedure of adjusting your discount rate to appropriately represent inflation and taxes has been made easier recently in a Southern Journal of Applied Forestry article by Steven H. Bullard and John E. Gunter. The article:

Adjusting Discount Rates for Income taxes and Inflation: A Three Step Process
SJAF 24(4) 2000 pp193-195.
Southern Journal of Applied Forestry
Society of American Foresters
   Download this article as a PDF file!

Using the procedures of these authors, you can easily adjust your discount rate appropriately and then use it in the investment formulae and in the decision criteria also found in this section of the My-Forest.com web domain. The proper application of these principles requires that you combine the principles of discount rate with inflation (in the Economics Section) and taxes (in the Forest Taxation Section).

The authors point out in their article that there are 3 basic steps to selecting the appropriate discount rate:
 
 

In the shaded diagram to the right, find the quadrant that represents the current discout rate you are using:	Quadrant I ib.t. Nominal Rate, Before Taxes Quadrant II ia.t. Nominal Rate, After Taxes Quadrant III rb.t. Real Rate, Before taxes Quadrant IV ra.t. Real Rate, After Taxes
Find the quadrant that represents the equivalent rate you would like to calculate
Using a specific tax rate and/or inflation rate, apply the appropriate formulae.

Read through the list below and select the transition you want to complete. Click on the appropriate formulae and you will be taken to the appropriate calculation page that includes a few words about the transition.
 
 

Quadrant  Transition	Adjustment to be made	Formulae
I  II	Nominal Rates, before taxes to after taxes
II  I	Nominal rates, after taxes to before taxes
I  III	Before-tax rates, nominal to real
III  I	Before-tax rates, real to nominal
II  IV	After-tax rates, nominal to real
IV  II	After-tax rates, real to nominal
III  IV	Real rates, before taxes to after taxes
IV  III	Real rates, after-taxes to before taxes
I  IV	Nominal rate, before taxes to Real rate, after taxes

Where:

i = the nominal (inflated) discount rate
r = the real (uninflated) discount rate
f = the annual rate of inflation
t = the marginal income tax rate

b.t. indicates a before tax discount rate
a.t. indicates an after-tax discout rate

and all rates are expressed in decimal percents

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