What is a Discount Rate?
In corporate financeCorporate Finance OverviewCorporate Finance involves the financial aspect of businesses wherein sources of funds are determined, existing assets invested, excess profits distributed. Corporate finance also includes the tools and analysis utilized to prioritize and distribute financial resources. The ultimate purpose of corporate finance is to, a discount rate is the rate of return used to discount future cash flowsCash FlowCash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time period. There are many types of Cash Flows and important uses for it in running a business back to their present value. This rate is often a company’s Weighted Average Cost of Capital (WACC)WACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt. The WACC formula is = (E/V x Re) + ((D/V x Rd) x (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator, required rate of return, or the hurdle rateHurdle Rate DefinitionA hurdle rate is the rate of return that must be achieved before accepting and funding an investment project. Hurdle rates are used in financial modeling to calculate NPV. If IRR > Hurdle Rate then the investment creates value. The rate is determined by assessing the cost of capital, risks involved, opportunity cost investors expect to earn relative to the risk of the investment.
Other types of discount rates include the central bank’s discount window rate and probability-based risk adjustments.
Why is a Discount Rate Used?
A discount rate is used to calculate the Net Present Value (NPV)Net Present Value (NPV)Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present. NPV analysis is a form of intrinsic valuation and is used extensively across finance and accounting for determining the value of a business, investment security, of a business as part of a Discounted Cash Flow (DCF)Discounted Cash Flow DCF FormulaThe discounted cash flow DCF formula is the sum of the cash flow in each period divided by one plus the discount rate raised to the power of the period #. This article breaks down the DCF formula into simple terms with examples and a video of the calculation. The formula is used to determine the value of a business analysis. It is also utilized to:
- Account for the time value of moneyTime Value of MoneyThe time value of money is a basic financial concept that holds that money in the present is worth more than the same sum of money to be received in the future. This is true because money that you have right now can be invested and earn a return, thus creating a larger amount of money in the future. (Also, with future
- Account for the riskiness of an investment
- Represent the opportunity costOpportunity CostOpportunity cost is one of the key concepts in the study of economics and is prevalent throughout various decision-making processes. Opportunity is the for a firm
- Act as a hurdle rate for investment decisions
- Make different investments more comparable
Types of Discount Rates
In corporate finance, there are only a few types of discount rates that are used to discount future cash flows back to the present. They include:
- Weighted Average Cost of Capital (WACC) – for calculating the enterprise valueEnterprise ValueEnterprise Value, or Firm Value, is the entire value of a firm equal to its equity value, plus net debt, plus any minority interest, used in valuation. It looks at the entire market value rather than just the equity value, so all ownership interests and asset claims from both debt and equity are included. of a firm
- Cost of EquityCost of EquityCost of Equity is the rate of return a shareholder requires for investing in a business. The rate of return required is based on the level of risk associated with the investment, which is measured as the historical volatility of returns. Learn the cost of equity formula with examples and download the Excel calculator – for calculating the equity value of a firm
- Cost of DebtCost of DebtThe cost of debt is the return that a company provides to its debtholders and creditors. Cost of debt is used in WACC calculations for valuation analysis. Learn the formula and methods to calculate cost of debt for a company based on yield to maturity, tax rates, credit ratings, interest rates, coupons, and – for calculating the value of a bond or fixed-income security
- A pre-defined hurdle rate – for investing in internal corporate projects
- Risk-Free RateRisk-Free RateA Risk-Free Rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the Risk-Free rate is – to account for the time value of money
Discount Rate Example (Simple)
Below is a screenshot of a hypothetical investment that pays seven annual cash flows with each payment equal to $100. In order to calculate the net present value of the investment, an analyst uses a 5% hurdle rate and calculates a value of $578.64. This compares to an undiscounted total cash flow of $700.
Essentially, an investor is saying “I am indifferent between receiving $578.64 all at once today and receiving $100 a year for 7 years.” This statement takes into account the investor’s perceived risk profile of the investment and an opportunity cost that they can earn on a similar investment.
Discount Rate Example (Advanced)
Below is an example from CFI’s financial modeling course on Amazon. As you can see in the screenshot, a financial analyst uses an estimate of Amazon’s WACC to discount its projected future cash flows back to the present.
By using WACC to discount cash flows, the analyst is taking into account the estimated required rate of returnRequired Rate of ReturnThe required rate of return (hurdle rate) is the minimum return that an investor is expecting to receive for their investment. Essentially, the required expected by both equity and debt investors in the business.
WACC Example
Below is a screenshot of an S&P Capital IQCapIQCapIQ (short for Capital IQ) is a market intelligence platform designed by Standard & Poor’s (S&P). The platform is widely used in many areas of corporate finance, including investment banking, equity research, asset management and more. The Capital IQ platform provides research, data, and analysis on private, public template that was used in CFI’s Advanced Financial Modeling Course to estimate Amazon’s WACC.
To learn more, check out CFI’s Advanced Valuation Course on Amazon.
Issues with Discount Rates
While the calculation of discount rates and their use in financial modelingWhat is Financial ModelingFinancial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model. A 3 statement model links income statement, balance sheet, and cash flow statement. More advanced types of financial models are built for valuation, plannnig, and may seem scientific, it is in fact not. There are so many assumptions that are only a “best guess” about what will happen in the future.
Furthermore, only one discount rate is used at a point in time to value all future cash flows, when in fact interest rates and risk profiles are constantly changing in a dramatic way.
When using WACC as a discount rate, the calculation centers around the use of a company’s betaBetaThe beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns., which is a measure of the historical volatility of returns for an investment. The historical volatility of returns is not necessarily a good measure of how risky something will be in the future.
Additional Resources
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™FMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy. 
certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
- Coupon RateCoupon RateA coupon rate is the amount of annual interest income paid to a bondholder based on the face value of the bond. Government and non-government entities issue bonds to raise money to finance their operations. When a person buys a bond, the bond issuer promises to make periodic payments to the bondholder
- Internal Rate of Return (IRR)Internal Rate of Return (IRR)The Internal Rate of Return (IRR) is the discount rate that sets the net present value of an investment equal to zero. This guide to calculating IRR will give several examples and who why it's used in capital budgeting, private equity and other areas of finance and investing. If IRR is greater than cost of capital,
- Unlevered BetaUnlevered Beta / Asset BetaUnlevered Beta (Asset Beta) is the volatility of returns for a business, without considering its financial leverage. It only takes into account its assets. It compares the risk of an unlevered company to the risk of the market. It is calculated by taking equity beta and dividing it by 1 plus tax adjusted debt to equity
- Valuation MethodsValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance
