- **1 Introduction: Background and significance of the economic opportunity cost of capital (EOCK)**<sup>**1**</sup>

**The official discount rate that informs decision making on investment options—known as the social discount rate or the economic opportunity cost of capital (EOCK)—is critically important to policy makers.** The EOCK is an economic price for the valuation of savings and investments and their contribution to economic production in the coming years. Investment projects use a combination of inputs or real resources (such as land, labor, and capital) to produce outputs that society is willing to pay for, whether directly or indirectly. The decision to fund a public project will displace private investments and consumption. Taking this into consideration and using market information, the EOCK is used as a hurdle rate to determine the desirability of implementing projects.

**During the last decade, the Mexican finance ministry (** **_Secretaría de Hacienda y Crédito Público_ or SHCP) used a benchmark real discount rate of 12 percent to estimate the net economic benefits of alternative investment proposals (DOF, 2012).** This official rate, which was underpinned by the findings of a study conducted by Sergio L. Rodriguez-Medrano (2009), was correspondingly utilized by all public sector agencies whose project proposals are approved by the investment unit— _Unidad de Inversiones_ —of the SHCP. In view of significant macroeconomic developments in recent years (note, for example, that Mexico’s credit rating has improved considerably in recent years, resulting in a lower cost of equity and debt), the Mexican government took the initiative to reassess the estimation of the country’s EOCK. In this paper we analyze Mexico’s EOCK taking into account the recent improvements in the country’s economic and financial structure as well as in the international capital markets.

**The findings of this study provide the basis for a new recommended discount rate that could be used in the selection of public sector investment projects in Mexico, and suggest an approach with potentially wide applicability beyond this particular case study.** In addition to updating and expanding the Rodriguez methodological approach—a version of the weighted cost of capital (top-down) approach (Harberger, 1972b)—through a detailed analysis of the 2003–2011 period, we propose an enhanced methodology to estimate Mexico’s EOCK going forward. With the proposed approach we arrive at two principal recommendations for the Mexican government: (1) a significant downward adjustment of the EOCK—specifically, a single value EOCK that could be reduced to 10 percent, allowing for some flexibility with higher risk investments; and (2) that the EOCK be regularly updated.

**In high-risk cases such as market-oriented public projects or large commercial publicprivate partnerships (PPPs), it may be advisable to use a higher discount rate, which could be assessed using the supply price (bottom-up) approach discussed in this study.** In the Mexican case, the high-risk distinction could be particularly important for companies like PEMEX, as well as utilities and infrastructure projects that depend on user fees to cover

> 1 The World Bank report “Mexico: Estimation of the Economic Opportunity Cost of Capital for Public Investment Projects” includes the analysis and the findings of this paper and a more extensive set of annexes providing further background information.

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