11

Selecting a Discount Rate or MARR

The discount rate, or MARR , I imposes a condition of minimum profitability

which a projecj or project increment must meet to qualify for acceptance. Be-
cause it affects whether a project will be accepted or rejected and how much
will be spent on it, the value of the discount rate is a key ingredient in an
economic evaluation . If it is set too high, some projects which are economic
will be rejected ; if too low, some projects which are uneconomic will be ac-
cepted.
Chapter 8 explains, in the context of the time value of money, what the
discount rate is and why it is needed to convert costs and benefits to time-
equivalent values. This section provides guidance in determining the appropri-
ate value of the discount rate for various applications .

11.1 THEORETICAL VALUE OF THE DISCOUNT

RATE

The discount rate should reflect the rate of return available on the next best
investment opportunity of similar risk to the project in question. The numerical
value of the discount rate should reflect the "opportunity cost" that investors
experience when they forego the return on the next best investment to invest in
a given activity or project .
If your best alternative investment opportunity yields 10%, for example, you
should require a project of similar risk to yield more than 10% to prefer it to
the best alternative . Setting the discount rate at 10% requires , in effect, that at

'Most of the economic evaluation methods treated incorporate the minimum acceptable rate of
return in the form of a discount rate. The internal rate of return and the overall rate of return
methods instead compare the solved-for rate of return against the investor's MARR. The discount
rate and the MARR are equivalent in theory and value; the tenn inology differs depending on how
the rate is used. Rather than repeat both tenns each time, we use " discount rate" in this chapter.

153

R. T. Ruegg et al., Building Economics: Theory and Practice

© Springer Science+Business Media New York 1990
154 2 / What You Need to Know to Apply the Methods

least a 10% return be realized before a project appears desirable on economic

grounds .

11.2 AFTER-TAX DISCOUNT RATES

In setting the discount rate, you should be aware of the difference between after-
tax and before-tax rates. If a project evaluation is performed on a before-tax
basis, with no adjustment of cash flows for taxes, the discount rate should be
on a before-tax basis. If the valuation is on an after-tax basis-which is the
recommended approach when taxes apply-the discount rate or MARR should
also be on an after-tax basis . Analysis of business decisions requires an after-
tax discount rate.
There are few, if any, tax effects in evaluating cost-saving investments for
the homeowner. Yet the use of an after-tax discount rate is also usually appro-
priate for the homeowner because savings in housing costs for the homeowner
are like tax-free income in that no taxes are owed on them. In effect, these
savings are after-tax income.
The after-tax discount rate is calculated from a before-tax rate using equation
11-1.

(11-1)

where

D at = after-tax discount rate,

D bt = before-tax discount rate, and
T = combined federal and state marginal income tax rate (see Section
13.2.1).

11.3 REAL AND MARKET DISCOUNT RATES

In setting the discount rate, you should also keep in mind the distinction be-
tween "real" discount rates (those which exclude purely inflationary or defla-
tionary changes in the general price level) and "market" discount rates (those
which include changes in the general price level).
You can remove the inflation component from a market discount rate and
convert it to a real discount rate by using equation 11-2.

d= [1 + D] _ 1 ( 11-2)
1 + I