What is Discounting?
In relation to the time value of money, which argues that a dollar today is worth more than a dollar tomorrow, discounting can be defined as the act of estimating the present value of a future payment or a series of cash flows that are to be received in the future. Discounting is a key element in valuing future cash flows.
- Discounting refers to the act of estimating the present value of a future payment or a series of cash flows that are to be received in the future.
- A discount rate (also referred to as the discount yield) is the rate used to discount future cash flows back to their present value.
- When discounting the cash flows of investments or business ventures, it is vital to note that the discount rates used will vary depending on various elements.
When it comes to business ventures and investments, assets are considered to not carry value unless they come with cash flow generation potential. It means that they can produce cash flows that allow the business owner or investor a return.
Examples of such cash flows can be interest received from a bond or fixed-term deposit, or dividends received from a stock. The future cash flows’ present value is obtained by using a discount rate or factor and applying it to the cash flows.
A discount rate (also referred to as the discount yield) is the rate used to discount future cash flows back to their present value. In corporate finance, cash flows are normally discounted at a company’s weighted average cost of capital (WACC), its hurdle rate, or the required rate of return. The hurdle rate is the return that investors anticipate concerning the risk associated with the investment they have made.
When discounting the cash flows of investments or business ventures, it is vital to note that the discount rates used will vary depending on various elements. An important element when estimating a suitable discount factor would be the stage at which the business venture is at, in terms of the business cycle. Mature companies, for example, are likely to have lower discount rates than start-ups or early-stage businesses.
Start-ups tend to be discounted at relatively higher rates to account for the risk associated with the investment and uncertainties on the guarantee of the future cash flows. Founders tend to derive optimistic projections for their ventures, and due to their reduced marketability, there is a limited number of investors who are willing to take on the investments.
The projected cash flows for start-ups that are seeking money can be discounted at any rate between 40% to 100%, early-stage start-ups can be discounted at any rate between 40% to 60%, late start-ups can be discounted at 30% to 50%, and mature company cash flows can be discounted at 10% to 25%.
To derive a discounted value or the present value, the following equation can be used:
- FV is used to denote the future value of cash flow
- r is used to denote the discount rate
- t is used to denote the time period that an investment will be held for
The present value can also be the sum of all future cash flows discounted back. It is known as the Net Present Value (NPV).
Consider a future cash flow of $100, which is set to be received in four years. The discount rate is given at 15%. What is the present value?
An Excel example of a more complex PV computation can be seen below:
Types of Discount Rates
The types of discount rates commonly used in corporate finance include:
- Weighted Average Cost of Capital (WACC): Normally used to compute a company’s enterprise value.
- Cost of equity: Can be used to calculate a company’s equity value.
- Cost of debt: Used for bond and fixed-income security valuation.
- A pre-defined hurdle rate: Generally used in evaluating corporate projects that are internal and to account for the time value of money
- Risk-free rate: Used in calculating the cost of equity (as calculated using the CAPM)
Uses of Discount Rates
Discount rates can be used to account for risk associated with a potential investment and the time value of money. The rate also represents a company’s opportunity cost and can act as a hurdle rate used for decision making.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ 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: