Discount Rate

What is a Discount Rate?

In corporate financeCorporate Finance OverviewCorporate finance deals with the capital structure of a corporation, including its funding and the actions that management takes to increase the value of, 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 CF 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., required rate of return, or the hurdle rateHurdle Rate DefinitionA hurdle rate, which is also known as minimum acceptable rate of return (MARR), is the minimum required rate of return or target rate that investors are expecting to receive on an investment. The rate is determined by assessing the cost of capital, risks involved, current opportunities in business expansion, rates of return for similar investments, and other factors that 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 rates derived from 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. of a business, as part of a Discounted Cash Flow (DCF)Discounted Cash Flow DCF FormulaThis article breaks down the DCF formula into simple terms with examples and a video of the calculation. Learn 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 opportunity costOpportunity CostOpportunity cost is one of the key concepts in the study of economics and is prevalent throughout various decision-making processes. 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 Value (EV)Enterprise Value, or Firm Value, is the entire value of a firm equal to its equity value, plus net debt, plus any minority interest 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 – 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. – 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 RateThe 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 commonly considered to equal to the interest paid on a 3-month government Treasury bill, generally the safest investment an investor can make. – 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 a non-discounted 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 represents what they could earn on a similar investment.

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 the 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 rate of return is the minimum acceptable compensation for the investment’s level of risk. 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. may seem scientific, there are 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 the 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)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI 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.
• Internal Rate of Return (IRR)Internal Rate of Return (IRR)The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment.
• 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.
• Valuation MethodsValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions