RE:Rate cut by Bank of Canada reduces discount rate A large cut in interest rates by the Bank of Canada affects the economic discount rate, which is a key factor in calculating the present value of future cash flows from infrastructure projects.
1. Discount Rate and Present Value: The economic discount rate represents the cost of capital or the opportunity cost of investment. In infrastructure projects, future revenues and costs are discounted back to their present value (PV) to reflect the time value of money. A lower discount rate reduces the amount by which future cash flows are discounted, increasing their present value.
2. Impact on Economic Rate of Return (ERR): Since infrastructure projects often have long-term benefits, a lower discount rate raises the present value of these future benefits. This, in turn, leads to a higher economic rate of return (ERR), which measures the project’s profitability relative to its costs. A higher ERR makes the project more financially attractive, as future revenues now weigh more heavily in the cost-benefit analysis.
3. Cost of Capital: Lower interest rates typically reflect a lower cost of borrowing for governments or private investors. When financing infrastructure projects, cheaper capital (due to lower interest rates) reduces the overall cost of the project, further improving the ERR.
In summary, a large cut in interest rates lowers the discount rate, increases the present value of future cash flows, and boosts the economic rate of return for long-term projects, making them more financially viable.