Choice of an appropriate discount rate

The difficulty with selecting a discount rate rests on whether the correct rate for the risk/return has been derived. A number of things are relevant here

- The place of the Water Authorities as single customer. The business is possibly at risk if the Water Authorities choose to look in another place for their water supplies. This may signify that a higher discount rate is more appropriate

- The funding of the capacity expansion. This may have an force on the discount rate if the debt/equity mix of the company is significantly altered. A number of things are relevant here

(a) Higher gearing is probable to induce higher costs of equity

(b) Higher equity financing may decrease the cost of equity, but increase the overall WACC if we move off our minimum WACC.

- a lower discount rate may perhaps be more appropriate to the extent that a long term contract implies secure income streams

- Different components of the cash flows may possibly have different variability and it may thus not be appropriate to discount them all at the same rate.