We are aware about the time value of money and how money today is worth more than in the future, owing predominantly to inflation and opportunity cost.
Over the past years, the costs of borrowing in the Middle East has been gradually increasing. Some economists attribute this to continuously depressed oil prices, which directly impact the liquidity of oil dependent economies. Lower liquidity directly increases the opportunity cost of money and hence, the cost of borrowing.
Hence, in a recent arbitration I was working on, the key element of the claim was around the discount factor. Essentially, when the deal was struck 5 years ago, interest rates used to forecast the future earnings of the hotel were significantly lower.
How does the greater cost of borrowing today impact the forecasted earnings? An argument arose that the increased interest costs means the hotel now needs to provide a greater return in future. This is not as simple as increasing occupancy charges to boost RevPAR. Especially in an economy where there is a significant expected inflow of hotel rooms soon, which impacts RevPAR. One may argue that rising tourists will absorb this, however, that is subjective. For example, whilst the London Olympics did boost tourism, many argue that it was not to the levels expected.
Of course, when a feasibility is for internal management purposes it can be easily modified to suit expectations considering changing economic conditions and tourism numbers. When it is being used for the basis of a financial arbitration, the discount factor can be the centre of attention.
I am keen to know, if other experts who have worked on similar situations, have dealt with varying discount factors. Thoughts?
Hi Zayd. Seems to me that if the discount factor used at the moment of the decision some years ago was rooted in the then long term rates of interest as well as the then expected return to equity, that cannot be faulted. The latter element of WACC should pick up risk and one risk is that things change.... Ian