Estimating the Economic Opportunity Cost of Capital for Kenya

ABSTRACT: The social or economic discount rate is used to estimate the net present value -NPV- of an investment. This process is for recognizing the worthwhile projects among all the available choices, so only those with a higher positive NPV will be implemented. What rate to be used as this discount rate, and its size has been always an issue among economists. One of the most reliable approaches is based on the fact that the source of funds is borrowing from the capital market; therefore the economic cost of capital is an appropriate value to be considered as the discount rate. This value can be measured by calculating the funds sourced from the capital market, and estimating the economic opportunity cost for these funds. In this thesis developing a general framework for the estimations of economic opportunity cost of capital -EOCK- is the objective. The reason to estimate this value is for using it as the discount rate in investment decisions for Kenya. Methodologically, the funds obtained from the capital market are ultimately sourced from three places, postponed or displaced investments, postponed or forgone consumption, and inflows of foreign sources. The first step in getting EOCK is to obtain the economic cost of funds from each of these three sources, and the second step is to calculate the weighted average of these three values. The results show that the estimated discount rate ranges from 10% to 14.5% in real terms. As a conclusion, a 12% real discount rate is an appropriate rate for Kenya to be used in project evaluation, and investment decision making. Keywords: economic opportunity cost of capital, discount rate, project evaluation, Kenya. …………………………………………………………………………………………………………………………