Discounted Cash Flow Analysis
Sympheny leverages discounted cash flow (DCF) analysis to determine the present value of expected future cash flows. This approach is crucial for long-term energy projects, as it accounts for various financing factors, such as the cost of capital, loan structures, and risk premiums, ensuring that both initial investments and future cash flows are properly evaluated.
Interest Rate:
Interest Rate as Financing Cost: When you take out a loan (especially an amortized one, with regular payments), the interest rate directly reflects the cost of borrowing that money. It's what the lender charges you.
Discounting Future Cash Flows: The interest rate can also be used to calculate the present value of money expected in the future (a process called discounting). In this case, it reflects the opportunity cost of capital, that is, the return you might earn if you invested the money elsewhere. To cover risks such as price fluctuations or project-specific uncertainties, a risk premium is added to this rate.
Dual Use: In practice, the interest rate is often used both as the cost of financing and as part of the discount rate. This means that the effective discount rate can be constructed by combining the cost of financing with an additional risk premium.
Inflation Rate:
The inflation rate is the expected annual percentage increase in the general price level of goods and services. It indicates the decline in the purchasing power of money over time and plays a critical role in long-term financial analysis as it affects both costs and revenues of future cashflows in real terms.
The assumption is that the rate of inflation is the same for all costs.
Discount Rate:
This rate is used to convert future cash flows into their present value, reflecting the opportunity cost of capital and associated risks. The discount rate is derived by adjusting the nominal interest rate for inflation, thereby producing a real rate that excludes inflation effects.
The discount rate also plays a key role in converting one-time costs into an equivalent annual cost (EAC). This is accomplished using the Capital Recovery Factor (CRF).
Weighted Average Cost of Capital (WACC):
In the context of energy planning, the WACC is often used as the discount rate in DCF analysis. When cash flows are expressed in real terms (with inflation already accounted for), users might set WACC as the interest rate with inflation assumed to be zero, which results in the discount rate aligning with the interest rate.
In Sympheny, these parameters are defined by users along with other inputs in the Stage Parameters step. For more details, see the documentation here.