If you’ve ever spoken with a potential investor in the process of seeking funding, you’ve probably heard them speaking about something called discount rates.
No, they aren’t looking to get a cheap price on your product as part of the investment deal.
Rather, discount rate is a concept used to understand the present value of future cash flows, owing to the fact that a sum of money today is worth more than future money (the principle of the time value of money).
In this article, we’re going to explore that concept.
We’ll explore what discount rate is, why it’s used, and how to calculate it, diving into some examples to illustrate.
What is a discount rate?
Discount rate is a term that has two meanings:
- The rate of interest that a country’s central bank charges other financial institutions to borrow funds (also known as the bank rate or base rate).
- The interest rate used to calculate NPV when you wish to determine the present value of future cash flows.
For the purposes of this conversation, we’ll be considering the second definition of discount rate.
When you or an investor is interested in the present value of your company’s future cash flows, you may wish to calculate the company’s net present value (NPV) in order to perform a discounted cash flow (DCF) analysis.
Okay, looks like a couple of other definitions are in order:
- NPV. NPV is the difference between the present value of cash inflows and the present value of cash outflows over a specified period of time. The discount rate is one of the components used to calculate NPV.
- DCF. DCF is a valuation method designed to estimate the value of an investment based on expected future cash flows, discounting them to their present value using the discount rate.
When you wish to calculate NPV or DCF, you’ll first need to figure out your discount rate, one of several important components in the NPV formula.
Why is a discount rate used?
The main application for discount rate is as part of the NPV formula.
That said, there are a few important reasons for the incorporation of a discount rate in these calculations.
Accounting for the time value of money and valuing future cash flows
One important truth is that money is not worth the same amount across different time periods, owing to inflation, the opportunity cost of investing, and varying interest rates.
The general rule here is that a dollar today is worth more than a dollar tomorrow, which is worth more than a dollar in one year.
This principle is known as the time value of money.
The discount rate helps us account for this principle since we are looking at future cash flows but wish to understand them in the context of today’s value.
If, for instance, you’re considering an investment of $100,000, which is expected to return $130,000 in two years, this may, on the surface, seem like a reasonable expenditure. However, if the time value of money is such that the present value of that future $130,000 is actually $90,000, then it paints a very different picture.
We use the discount rate to help incorporate this information into investment decision-making and calculations.
Assessing future value against risk
Understanding the present value of future cash flows by using a discount rate is also important to evaluate the potential value of an investment against its potential risk.
Of course, you’ll only want to go ahead with a new internal project if the expected revenue — expressed in terms of its present value — outweighs the costs of pursuing that opportunity.
Investors will make the same assessment when considering whether or not to invest in your company.
Having assessed the potential risks involved with a project, business leaders and investors will want to weigh this up against the present value of expected cash flows, the calculation of which requires a discount rate.
Calculating NPV as part of DCF analysis
If you’re looking to better understand your company’s future cash flows and how current or potential projects, investments, or strategic business changes will impact them, then you’ll want to perform a discounted cash flow analysis.
For this, you’ll first need to calculate your net present value (NPV), for which you’ll need to have your discount rate handy.
Clearly, there are some important reasons why you’ll want to know what your discount rate is. Let’s turn our attention to how to work that out.
How to calculate discount rate
The discount rate isn’t something you calculate per se.
Rather, you use a number drawn from a different source, which you may have already previously calculated or may simply be an already established figure.
For example, many investors choose to use a “required rate of return” as their discount rate. That is, the ROI percentage they expect to generate, as a minimum, from a given investment.
Beyond that, there are a couple of other metrics commonly used as the discount rate.
Weighted Average Cost of Capital (WACC)
WACC is a very commonly used discount rate in corporate finance. This metric represents the average rate of return a company is expected to pay to its shareholders annually.
The formula for WACC is fairly complex:
WACC=(EV×Re)+(DV×Rd×(1−Tc))\text{WACC} = \left(\frac{E}{V} \times Re\right) + \left(\frac{D}{V} \times Rd \times (1 - Tc)\right)WACC=(VE×Re)+(VD×Rd×(1−Tc))
Where:
- E = Market value of equity
- D = Market value of debt
- V = Total value (E + D)
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate
Capital Asset Pricing Model (CAPM)
If you’re looking for a discount rate to calculate the cost of equity (when weighing up equity investments), you might wish to use the capital asset pricing model to understand the cost of equity.
The formula here is:
Re=Rf+β×(Rm−Rf)Re = Rf + \beta \times (Rm - Rf)Re=Rf+β×(Rm−Rf)
Where:
- ReReRe = Cost of equity
- RfRfRf = Risk-free rate (e.g., yield on government bonds)
- β\betaβ = Beta of the stock (a measure of its volatility compared to the market)
- RmRmRm = Expected market return
Adjusted Present Value (APV)
A third discount rate that investors and finance leaders may choose to use, especially in highly leveraged transactions where they wish to take into consideration any benefits of raising debt, is APV.
This is a much simpler formula:
APV = NPV + PV of the impact of financing
Where:
- NPV = Net present value
- PV = Present value
Discount rate example
To get a better idea of how discount rates work in practice, let’s explore an example using the WACC method.
First, you need to calculate your WACC, which we’ll use as the discount rate.
Remember, we need the following data points:
- E = Market value of equity
- D = Market value of debt
- V = Total value (E + D)
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate
For the purposes of our calculations, let’s say that:
- E = $500 million
- D = $300 million
- V = $800 million
- Re = 8%
- Rd = 5%
- Tc = 25%
Here’s what the formula will look like for us:
WACC=(0.625×8%)+(0.375×5%×(1−0.25))\text{WACC} = (0.625 \times 8\%) + (0.375 \times 5\% \times (1 - 0.25)) WACC=(0.625×8%)+(0.375×5%×(1−0.25)) WACC=5%+1.40625%=6.40625%\text{WACC} = 5\% + 1.40625\% = 6.40625\%WACC=5%+1.40625%=6.40625%
Thus, the discount rate using WACC would be approximately 6.41%.
Now that we have our discount rate, we can use it to estimate the present value of future cash flows.
Let’s say we have a project that we are considering investing in, that is projected to drive $200,000 in additional revenue over the next five years.
Here’s the formula we’re going to use:
PV=P×1−(1+r)−nrPV = P \times \frac{1 - (1 + r)^{-n}}{r}PV=P×r1−(1+r)−n
Where:
- PPP = Payment per period ($200,000)
- rrr = Discount rate per period (6.41% or 0.0641)
- nnn = Number of periods (5 years)
Let's calculate this.
The present value of receiving $200,000 per year over 5 years, with a discount rate of 6.41%, is approximately $833,158.58.
That means that if the cost of the project is, say, $900,000, we’ll likely not move forward. If, on the other hand, the project requires an investment of $500,000, there is a reasonable upside to the project, and we may wish to go ahead.
Types of discounted rates for cash flow
In corporate finance, a few different kinds of discount rates are used to discount future cash flows to a present value.
These are:
- Weighted Average Cost of Capital (WACC). This is used to calculate the enterprise value of a company.
- Cost of Equity. This is used to calculate the equity value of a company.
- Cost of Debt. This is used to calculate the value of a bond or fixed-income security.
- Risk-Free Rate. This is used to account for the time value of money.
- A predefined hurdle rate. This is used when investing in internal corporate projects.
Get cash flow savvy
Discount rate is an important component in the calculation of NPV, a way of representing the present value of future cash flows.
However, you’ll need more than just your discount rate.
In order to calculate NPV, you need to have an estimate of what those future cash flows will be.
Financial operations platforms can help create accurate cash flow forecasts based on previous financials, current growth trends, and spending analysis.
Discover how BILL can transform your cash flow forecasting by signing up or requesting a demo today.
