See Also:
EBITDA Definition
Cost of Capital Funding
Arbitrage Pricing Theory
Capital Budgeting Methods
Required Rate of Return
Discount Rate Definition
The discount rate definition, also known as hurdle rate, is a general term for any rate used in finding the present value of a future cash flow. In a discounted cash flow (DCF) model, estimate company value by discounting projected future cash flows at an interest rate. This interest rate is the discount rate which reflects the perceived riskiness of the cash flows.
Discount Rate Explanation
Using discount rate, explained as the risk factor for a given investment, has many benefits. The purpose is to account for the loss of economic efficiency of an investor due to risk. Investors use this rate because it provides a way to account and compensate for their risk when choosing an investment. Furthermore, this provides, with each choice, a buffer to provide for the chance of failure in an investment over time as well as many investments over a portfolio. Though risk is somewhat of a sunk cost, still include it to add a real-world element to financial calculations. It is a measure used to prevent one from becoming “calculator rich” without actually increasing personal wealth.
In DCF model, there are two methods to get discount rate: weighted average cost of capital (WACC) and adjusted present value (APV). For WACC, calculate discount rate for leveraged equity using the capital asset pricing model (CAPM). Whereas for APV, all equity firms calculate the discount rate, present value, and all else.
The Discount Rate should be consistent with the cash flow being discounted. For cash flow to equity, use the cost of equity. For cash flow to firm, use the cost of capital.
Discount Rate Formula
A succinct Discount Rate formula does not exist; however, it is included in the discounted cash flow analysis and is the result of studying the riskiness of the given type of investment. The two following formulas provide a discount rate:
First, there is the following Weighted Average Cost of Capital formula.
Weighted Average Cost of Capital (WACC) = E/V * Ce + D/V * Cd * (1-T)
Where:
E = Value of equity
D = Value of debt
Ce = Cost of equity
Cd = Cost of debt
V = D + E
T = Tax rate
Then, there is the following Adjusted Present Value formula.
Adjusted Present Value = NPV + PV of the impact of financing
Where:
NPV = Net Present Value
PV = Present Value
Calculation
See the following calculation of WACC and APV.
For WACC:
WACC = $10,000/$20,000 * $2,000 + $10,000/$20,000 * $1,000 * (1-.3) = $1,050,000
If:
E = $10,000
D = $10,000
Ce = $2,000
Cd = $1,000
V = $20,000
T = 30%
For APV:
APV = $1,000,000 + $50,000 = $1,050,000
If:
NPV = $1,000,000
PV of the impact of financing = $50,000
Discount Rate Example
For example, Donna is an analyst for an entrepreneur. Where her boss is the visionary, Donna performs the calculations necessary to find whether a new venture is a good decision or not. She does not need a discount rate calculator because she has the skills to provide value above and beyond this. Donna is the right hand woman to the entrepreneur which she aspires to be. But she first needs to prove herself in the professional world.
Donna’s boss wants to know how much risk he has taken on his last venture. He would like, eventually, to find the discount rate business valuation to judge levels for performance and new ventures alike.
Donna’s boss gives Donna the financial information she needs for one venture. She finds the discount rate (risk) using the following equation:
WACC = $10,000/$20,000 * $2,000 + $10,000/$20,000 * $1,000 * (1-.3) = $1,050,000
If:
E = $10,000
D = $10,000
Ce = $2,000
Cd = $1,000
V = $20,000
T = 30%
Next, Donna’s boss has her find the discount rate for another venture that he is involved in. The results are below:
Adjusted Present Value = NPV + PV of the impact of financing
Where:
NPV = Net Present Value
PV = Present Value
Donna appreciates her experience with her employer. As a result, she is sure that with this experience she can find the path to mentor another just like her.
